Chapter 1 The Evolution of the Modern Firm Chapter Contents
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Introduction The World in 1840 Doing Business in 1840 Conditions of Business in 1840: 1840: Life Without Without a Modern Infrastructure !a"#le 1$1: The "ergence "ergence of Chicago Chicago The World in 1&10 Doing Business in 1&10 !a"#le 1$2: 'es#onding to the Business n(iron"ent: The Case of "erican Whaling Business Conditions in 1&10: *Modern* Infrastructure !a"#le 1$%: (olution of of the +teel Industr, Industr, The World Toda, Doing Business Toda, The Infrastructure Toda, !a"#le 1$4: cono"ic -,rations -,rations and Traffic -ridloc. -ridloc. in Thailand Three Di Different Worlds: Consistent r rinci#les Ch Changing Conditions an and da#ti(e +trategies !a"#le 1$/: Infrastructure and "erging "erging Mar.ets: The 'ussian 'ussian ri(atiation ri(atiation rogra" !a"#le 1$3: Building ational ational Infrastructure: Infrastructure: The Transcontin Transcontinental ental 'ailroad Cha#ter +u""ar, 6uestions
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Chapter Summary
This cha#ter anal,ses the 7usiness en(iron"ent in three different ti"e #eriods: 1840 1&10 and the #resent$ It loo.s at the 7usiness infrastructure "ar.et conditions the sie and sco#e of a fir"s acti(ities and a fir"s res#onse res#onse to changes$ This historical #ers#ecti(e sho9s that that all successful 7usinesses 7usinesses ha(e used si"ilar si"ilar #rinci#les to ada#t ada#t to 9idel, (ar,ing 7usiness conditions in order to succeed$ Businesses in the #eriod 7efore 1840 9ere s"all and o#erated in localied "ar.ets$ The sie of a 7usiness 9as restricted 7, the lac. of #roduction technolog, technolog, #rofessional "anagers ca#ital and largescale distri7ution net9or.s$ The li"ited trans#ortation and co""unication infrastructures "ade it ris., for 7usinesses to e!#and and restricted the" to s"all local "ar.ets$ ;9ners ran their o9n 7usinesses and de#ended on "ar.et s#ecialists to "atch the #roducts 9ith the needs of the 7u,ers$ There 9ere forces in #lace ho9e(er that that 9ould ena7le 7usinesses 7usinesses to e!#and their their econo"ic acti(it, o(er a larger geogra#hic area$ The infrastructure for conducting 7usiness e!#anded tre"endousl, 7, 1&10$ e9 technologies #er"itted the higher (olu"e of standardied #roduction$ The e!#ansion of the rail s,ste" #er"itted the relia7le distri7ution of "anufactured goods to a 9ider geogra#hic area$ The telegra#h ena7led 7usinesses to "onitor and control su##liers distri7utors and factories$
uisition distri7ution distri7ution and retailing=eli"inating the need to rel, on inde#endent factors su##liers and agents$ The gro9th in the sie and enhance"ent of functional res#onsi7ilities res#onsi7ilities or horiontal integration 9as critical to "anage these large organiations$ rice 9ars dro(e 9ea.er ri(als out of the "ar.et as the fir"s tried to 7uild (olu"e and s#read the fi!ed costs$ Businesses esta7lished "anagerial hierarchies to ad"inistrate and coordinate the (arious functions 7eing #erfor"ed 9ithin the organiation$ organiation$ These hierarchies ga(e rise to a class of #rofessional "anagers 9ho 7eca"e e!#erts in certain functions #erfor"ed 7, the fir" and the, 7eca"e a source of co"#etiti(e ad(antage$ But the goals of these "anagers had to 7e aligned 9ith that of the fir"$ Large hierarchical fir"s 9ould do"inate the first half of the 20t h centur,$ The entire 7usiness infrastructure has undergone "assi(e changes o(er the last %0 ,ears$ I"#ro(e"ents in trans#ortation co""unication and financial infrastructures ha(e facilitated the glo7aliation of "ar.ets increasing co"#etition and ha(e #laced a #re"iu" on >uic.ness and and fle!i7ilit,$ fle!i7ilit,$ Inno(ations in technolog, ha(e "ini"ied "ini"ied the ad(antages of largescale #roduction facilities and ha(e "ade it #ossi7le for fir"s to coordinate e!tre"el, co"#le! tas.s o(er large distances 9ithout 7eing (erticall, integrated$ +"aller and flatter organiations are the #referred 9a, of structuring fir"s to ta.e ad(antages of these changes$ These changes ha(e created o##ortunities as 9ell as constraints$ The, ha(e "ade the
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"odern "ar.et#lace a glo7al one 7ut the, ha(e also increased the nu"7er of co"#etitors at the sa"e ti"e$ Technological Technological inno(ations ha(e gi(en fir"s "ore control and decreased the geogra#hic distances 7ut the, ha(e also allo9ed s"aller ni"7le fir"s to co"#ete 9ith 7ig fir"s in "eeting the ra#id changes in consu"er needs$ Well Well de(elo#ed financial "ar.ets ha(e lo9ered the cost of ca#ital 7ut these sa"e "ar.ets ha(e "ade large fir"s targets for #otential hostile ta.eo(er$ The three #eriods 9ith 9idel, different 7usiness #ractices and infrastructure illustrate that a consistent set of #rinci#les ha(e to 7e a##lied to changing 7usiness conditions conditions in order to i"#le"ent a successful 7usiness strateg,$ strateg,$ The 7usiness tactics used 7, fir"s (aried fro" one #eriod to another to "eet the different 7usiness circu"stances 7ut the econo"ic #rinci#les and the 7eha(ioral relationshi#s used to for" the tactics are general$ These #rinci#les and relationshi#s ha(en?t ha(en?t changed and can 7e a##lied to 9ide (ariet, of 7usiness circu"stances$ B, @udiciousl, a##l,ing these #rinci#les "anagers can successfull, ada#t their fir"s 7usiness strateg, to their co"#etiti(e en(iron"ent$
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Approaches to Teaching this Chapter
This cha#ter encourages students to 7e cogniant of the "ost A7irds e,e (ie9 one can ada#t of the conte!t in 9hich fir"s co"#ete 9hat are the o##ortunities and constraints that result fro" current state state of the 9orlds de(elo#"ent de(elo#"ent This cha#ter is intended to shed light on so"e .e, strategic conce#ts de(elo#ed later in this 7oo. including: the fluidit, of fir" 7oundaries the i"#ortance of scale and sco#e the i"#ortance of through#ut and ho9 technolog, and infrastructure affect strategic choices$ Definitions: Infrastructure: assets that assist in the #roduction or distri7ution of goods and ser(ices that an indi(idual fir" can not #ro(ide such as trans#ortation Eroads 7ridges etc$) teleco""unications teleco""unications financing$
Through#ut: the "o(e"ent of in#uts and out#uts through a #roduction #rocess Fertical Fertical integration: the act 7, 9hich fir"s choose to #roduce ra9 "aterials andGor distri7ute finished goods the"sel(es rather than rel, on inde#endent su##liers etc$ Horiontal integration: gro9th in sie and enhance"ent of functional res#onsi7ilities in a 7usiness area$ ath De#endence: the de#endence of an actor?s #osition on its starting conditions initial decisions and histor,$ ou "ight 9ant to discuss that the .e, 7usiness issues in 1840 Eris.iness large nu"7er of o9nero#erators inefficienc, inefficienc, etc$) and their causes E#oor co""unications co""unications lac. of technolog, etc$) can 7e seen toda, in "an, e"erging "ar.ets Efor e!a"#le Tanania Tanania I(or, Coast and oland)$ ou could also raise issues of the "ista.es that Western fir"s could "a.e in *e"erging "ar.ets* if the, "isunderstand 7asic 7usiness conditions$ The Chicago e!a"#le is a terrific illustration of ho9 technological changes can change the en(iron"ent under 9hich fir"s o#erate$ It 9ould 7e interesting to as. students 9h, Chicago e"erged as the center of distri7ution if grain ele(ator technolog, 9as a(aila7le throughout the Mid9est at the ti"e$ It 9ill co"e out that Chicago?s location 9ith access to the -reat La.es and Mississi##i 'i(er created the ad(antage$ It 9as essentiall, a *hu7* as in the airline industr, toda,$ toda,$ uite a different trend i$e$ the (irtual cor#oration$ Mention the largest "anufacturers "anufacturers of athletic foot9ear in the 9orld
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Ei.e Boss Benetton and Tre.) 9hich are *net9or.* fir"s$ !#lain the conce#t of *net9or.* fir"s$ ou could also "ention ho9 *glo7al* fir"s are facing si"ultaneous #ressures to 7oth coordinate on a 9orld9ide scale and #ass "ore decisions do9n to local "anagers$ In addition to these e!a"#les it "a, 7e hel#ful to encourage ,our students to dra9 on their o9n lifeG9or. e!#eriences and thin. of the follo9ing: 1) n industr, that is do"inated 7, a fe9 large co"#anies$ Wh, "ight that 7e 2) n industr, that consists of "an, s"all co"#anies$ Wh, "ight that 7e %) n industr, that is highl, go(ern"entregulated$ Ho9 has it affected industr, structure and the sie and sco#e of the fir" 4) co"#an, that is (erticall, integrated$ Wh, is that /) Ho9 9ould ,ou descri7e the industr, that ,ou "ost recentl, Eor currentl,) 9or.ed in What functions did it #erfor" inhouse What functions did it outsource 3) Can ,ou thin. of an in(ention that dra"aticall, changed the 9a, 7usiness 9as conducted in a #articular industr, Can ,ou thin. of a deregulation effort that dra"aticall, changed the 9a, 7usiness 9as conducted in a #articular industr, 5) ic. one industr, and tal. a7out the role of finance trans#ortation go(ern"ent and technolog, 9ithin that industr,$
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Suggested Harvard Case Studies1
rochni.: ri(atiation of a olish Clothing Manufacturer HB+ &%&40%8 'e($ 1G/G&4$ This case 7rings to life the conce#t that .e, 7usiness issues in 1840 Eris.iness large nu"7er of o9nero#erators inefficienc, etc$) and their causes E#oor co""unications lac. of technolog, etc$) e!ist toda, in "an, e"erging "ar.ets such as oland$ While this case can 7e an interesting first introduction to case anal,sis it is also a #articularl, good e!a"#le of (alue creation and a strategic turnaround 7ased on a differentiation strateg, 9hich 9ill 7e discussed in Cha#ter 11$ House of Tata HB+ &5&203/$ This case traces the e(olution of the largest 7usiness grou# in India$ Its #ri"ar, focus is on the organiational structure of the grou# and ho9 it changed in res#onse to internal and e!ternal forces$ The instructor can lin. the a7sence of infrastructure as 9ell as go(ern"ental #olicies to fir" acti(ities and o(erall #erfor"ance$ This cha#ter is useful for illustrating so"e of the conce#ts in the follo9ing cha#ters: 1 2 / 14 1/ and 13$
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These descri#tions ha(e 7een ada#ted fro" Harvard Business School's Catalog of Teaching Materials
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Etra !eading
Business histor, is an acade"ic field in its o9n right 9ith a large (olu"e of sources to choose fro" for additional reading$ Instructors 9ishing to #ro(ide additional reading or su##le"ental lectures should consult the follo9ing sources: tac. J$ and $ assell$ A New Economic View of American History !nd Ed $ orton 1&&4$ Chandler $D$ "atori <$ and T$ Hi.ino Eeds) Big Business and the "ealth of Nations# Ca"7ridge K$$: Ca"7ridge Kni(ersit, ress 1&&5$ Chandler $D$ and H Dae"s Eeds$)$ Managerial Hierarchies$ Com%arative &ers%ectives on the ise of the Modem (ndustrial Enter%rise $ Ca"7ridge: M: Har(ard Kni(ersit, ress 1&80$ Chandler $D$ and '$+$ Tedlo9$ The Coming of Managerial Ca%italism $ Ho"e9ood IL: Ir9in 1&8/$ Chandler $D$ The Visi)le Hand $ Ca"7ridge M: Bel.na# 1&55 Chandler $D$ Scale and Sco%e$ The *ynamics of (ndustrial Ca%italism $ Ca"7ridge M: Bel.na# 1&&0$ Cochran T$C$ and W$ Miller$ The Age of Enter%rise$ A Social History of (ndustrial America$ e9 or. Har#er and 'o9 1&31$ -alenson D$ W$ Eed$)$ Mar+ets in History$ Economic Studies of the &ast $ Ca"7ridge K$$: Ca"7ridge Kni(ersit, ress 1&8&$ rug"an $ ,eogra%hy and Trade $ Ca"7ridge M: MIT ress 1&&1$ La"oreau! $ '$ and D$ 'aff Eeds)$ Coordination and (nformation$ Historical &ers%ectives on the -rgani.ation of Enter%rise $ B' Chicago: Kni(ersit, of Chicago ress 1&&/$ La"oreau! $ '$ and 'aff D$ and $ Te"in Eeds) /earning )y *oing in Mar+ets 0irms and Countries B' Chicago Kni(ersit, of Chicago ress 1&&& ollard +$ *Industrialiation and the uro#ean cono",* Economic History eview 23 o(e"7er 1&5%: 3%3348$ Te"in $ Eed) (nside the Business Enter%rise$ Historical &ers%ective on the 1se of (nformation B' Chicago Kni(ersit, of Chicago ress 1&&1$
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Ans"ers to End of Chapter #uestions 1$
%hy is infrastructure essential to economic development&
Infrastructure includes those assets that assist in the #roduction or distri7ution of goods and ser(ices that fir"s the"sel(es cannot easil, #ro(ide$ Infrastructure facilitates trans#ortation co""unication and financing$ It includes 7asic research 9hich can ena7le fir"s to find 7etter #roduction techni>ues$ The go(ern"ent also has a .e, role 7oth 7ecause the go(ern"ent affects the conditions under 9hich fir"s do 7usiness Ee$g$ regulations) and 7ecause the go(ern"ent is a direct su##lier of infrastructure Ee$g$ interstate high9a,s)$ Infrastructure reduces the costs associated 9ith 7usiness transactions there7, "a.ing these transactions feasi7le$ '$ %hat is throughput& (s throughput a necessary condition for success of modern )usiness&
Through#ut is the "o(e"ent of in#uts and out#uts through a #roduction #rocess$ Without access and assurance of a su##l, of in#uts a successful 7usiness enter#rise 9ould not 7e #ossi7le$ *$ (n light of recent do"nsi+ing and restructuring of Corporate America, "as Chandler-s eplanation of )enefits of si+e incorrect&
In the earl, #art of the t9entieth centur, the #re(ailing 7usiness infrastructure "ade it efficient for a fir" to #roduce in a large scale and achie(e a fa(ora7le cost structure through econo"ies of scale$ This "ade it i"#erati(e that if a fir" 7uilt u# #roduction ca#acit, it had to e!#and and ca#ture all of the "ar.ets de"and$ B, doing so a fir" 9ould assure a through#ut of sufficient (olu"e and generate #rofits$ The a"ount of ad"inistrati(e coordination re>uired 9ithin fir"s increased 9ith their e!#ansion in sie since fir"s 9ere #erfor"ing a 9ider (ariet, of functions "ore fre>uentl,$ The fir"s de(elo#ed large "anagerial hierarchies that 9ere res#onsi7le for coordination and "onitoring all the tas.s of a fir" in this 7usiness en(iron"ent$ Mar.et conditions and the 7usiness infrastructure ha(e changed significantl, in the last %0 ,ears$ Inno(ations in technolog, ha(e eli"inated the ad(antages of largescale #roduction$ d(ances in co""unications ena7les fir"s to coordinate co"#le! transactions o(er large distances and 9ith a large nu"7er of other institutions$ This has reduced the need for fir"s to 7e large in sie or 7e (erticall, integrated$ The glo7aliation of the "ar.et#lace has intensified co"#etition and has #laced a #re"iu" on >uic.ness and fle!i7ilit,$ o9ada,s fir"s are a7le to ser(e a larger nu"7er of custo"ers 7etter 7, 7eing s"aller in sie and "ore fle!i7le to shifts in consu"er needs$ This has 7een "ade #ossi7le 7, the changes in technolog, and in the 9a,s of doing 7usiness$ fir"s sie is no longer "easured 7, its o(erhead sie 7ut 7, the length and 7readth of its reach$ Chandlers 7enefit of sie still holds in this current "ar.et#lace$ ;nl, no9 the (irtual sie of a fir" is "ore i"#ortant than its #h,sical sie$ .$ The technology to create a modern infrastructure is more "idely availa)le today than at any time in history$ Do you thin/ this "ill ma/e it easier for developing nations to create modern economies that can compete "ith the economies of developed nations&
es the 9idel, a(aila7le technolog, for creating "odern infrastructure 9ill "a.e it
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easier for de(elo#ing nations to create "odern econo"ies that can co"#ete 9ith the econo"ies of de(elo#ed nations$ The changes in ca#ital "ar.ets ha(e "ade it #ossi7le for de(elo#ing nations to ac>uire the huge a"ounts of ca#ital needed to 7uild infrastructure at co"#etiti(e #rices >uite easil,$ There are a large nu"7er of glo7al fir"s that ha(e the e!#ertise for 7uilding trans#ortation co""unication and #roduction infrastructure fro" scratch at a large scale$ The 7iggest stu"7ling 7loc. #re(enting the creation of "odern infrastructure in a de(elo#ing nation is the go(ern"ent of that countr,$ If the go(ern"ent of a de(elo#ing nation does not focus on "oderniing the infrastructure and s#ends its resources else9here the de(elo#ing nation 9ill not ha(e a "odern econo",$ 0$ T"o features of developing nations are an a)sence of strong contract la" and limited transportation net"or/s$ Ho" might these factors affect t he vertical and hori+ontal )oundaries of firms "ithin these nations&
9ell de(elo#ed 7od, of contract la9 "a.es it #ossi7le for transactions to occur s"oothl, 9hen contracts are inco"#lete 9hile e!tensi(e trans#ortation net9or.s allo9 7etter coordination and faster flo9 of goods and ser(ices across geogra#hic "ar.ets$ De(elo#ing nations face 9ea.nesses in 7oth of these as#ects of "odern infrastructure$ !tensi(e (ertical integration occurs in these countries 7ecause fir"s face e!traordinaril, high transaction and coordination costs$ To full, e!#loit #roduction o##ortunities fir"s needing to "a.e significant sun. in(est"ents 9ill also need a relia7le su##l, of in#uts and distri7ution channels$ The lac. of contract la9 "a.es the fir"s relationshi# 9ith its su##liers and distri7utors "ore (ulnera7le to holdu% %ro)lems than are fir"s in industrialied nations$ t the sa"e ti"e the lac. of trans#ortation net9or.s forces fir"s to coordinate their distri7ution and allocation acti(ities 9ithin the fir"s 7oundaries to ensure s"ooth functioning of the (alue chain$ To ensure relia7ilit, and o(erco"e high transaction and coordination costs fir"s ha(e the incenti(e to (erticall, integrate$ The lac. of trans#ortation net9or.s ho9e(er also 9ill effecti(el, reduce the sie of a fir"s "ar.et and the scale and sco#e econo"ies that are attaina7le$ This 9ill reduce the fir"s a7ilit, to effecti(el, integrate (erticall,$ 'egarding horiontal 7oundaries fir"s in de(elo#ing nations face t9o co"#eting forces$ ;n the one hand 9ithout the su##ort of a trans#ortation infrastructure fir"s are una7le to trans#ort their out#uts to geogra#hicall, distant consu"ers$ This force reduces the scale of a fir"s #roduction of a #articular good$ Ho9e(er since consu"ers coordination and transaction costs are lo9ered 7, doing 7usiness 9ith a fir" that offers a 9ide selection of goods fir"s in de(elo#ing countries ha(e an incenti(e to offer "ulti#le #roducts as o##osed to s#ecialiing in a single #roduct$ Indeed "an, of these fir"s are conglo"erates 9ith 7usiness acti(ities enco"#assing al"ost an entire (ertical chain as 9ell as #roducts across "an, different sectors$
The current 7usiness infrastructure in astern uro#e lac.s a "odern financial co""unication or trans#ortation infrastructure$ This has forced fir"s to o#erate in
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localied "ar.ets and increased the ris.s of an, 7usiness enter#rise o#erating on a large scale$ +"all fa"il,o#erated fir"s that rel, on distri7ution s#ecialists and "ar.et "a.ers to "atch the 7u,ers 9ith the sellers do"inate the "ar.et$ Most 7usiness is conducted locall, 9ith trades 7eing #ro(ided for s"all to9ns 7, one s"all inde#endent "ar.et #ro(ider$ The go(ern"ents of these countries ha(e a "a@or role to #la,$ If the, o#en u# their countries to the efficient "ar.et forces and in(est in "odern infrastructure then the fir"s in these "ar.ets 9ill lea#frog the era of 7ig 7usinesses that Knited +tates 9ent through in the first #art of the t9entieth centur,$ These fir"s 9ill ado#t the latest changes in technologies co""unications and financial engineering$ The fir"s 9ill 7e s"all and ni"7le in order to "eet the ra#id shifts in the "ar.et #lace$ The successful ones although s"all in sie 9ill 7e 7ig (irtuall, due to their e!tensi(e reach across their countries as 9ell as the 9orld$ There 9ill 7e no difference 7et9een a successful fir" fro" K$+ or astern uro#e$ ;n the other hand if the go(ern"ents of the astern uro#ean countries do not o#en u# their "ar.ets or fail to de(elo# their infrastructures s"all fa"il,o#erated fir"s in localied "ar.ets 9ill do"inate the econo",$ The econo"ies of these countries 9ill not see an, significant gro9th$ 3$ Ho" might 2$S industry have evolved differently if strong anti4trust la"s had )een in place as of 1566&
In the first half of the t9entieth centur, the #re(ailing 7usiness en(iron"ent led to the gro9th of (erticall, and horiontall, integrated fir"s$ The fir"s had ra#idl, e!#anded #roduction ca#acities to reach the "ini"u" efficient scale$ The e!#ansion of #roduction facilities cul"inated in o(erca#acities in "ost industries 9hich led to destructi(e #rice ri(alr, as fir"s tried to 7uild (olu"e and s#read their fi!ed costs$ The 9ea.er fir"s 9ere dri(en out of an industr,$ The reduced nu"7er of fir"s then had an o##ortunit, to collude and increase #rofits$ +tronger antitrust la9s in that #eriod 9ould ha(e #re(ented a fe9 fir"s fro" do"inating a single industr, Ee$g$ +tandard ;il) and reduced the incidence of collusion a"ong the fir"s there7, #ro(iding consu"ers 9ith "ore econo"ic sur#lus$ uiring their ri(als$ uisitions 9ould ha(e 7een "ore of a financial decision than an industr, strateg, one$ In turn the role of cor#orate head>uarters 9ould ha(e 7eco"e the role of financial ad(isor and #ortfolio "anager a lot sooner than it actuall, did$ Indeed Chandler discusses the constraining effects of Astronger antitrust en(iron"ents Ein -er"an, -reat Britain) in his 1&&0 7oo. Scale and Sco%e$ The *ynamics of (ndustrial Ca%italism $ 7$ (n the past half4century, several cities have )een identified "ith specific industries: A/ron8tires9 Macon8carpets9 Sunnyvale8computer chips9 rlando8tourism$ %hy do such centers emerge& ;iven evolving technology, "hat is their future&
cluster of fir"s all 7ased in the sa"e regionGcit, and 9hose fortunes are integrall, lin.ed to one another is a recent 9orld9ide econo"ic #heno"enon$ The fir"s in one of these Aclusters are in related industries oriented to selling outside their region the, are interde#endent and the, co"#ete 9ith each other internationall,$ The fir"s in a Acluster ha(e si"ilar #roduction technologies "aterial and resource needs the, sell
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into si"ilar "ar.ets and rel, on the sa"e econo"ic foundations for their co"#etiti(eness$ This Aclustering #heno"enon occur due to the follo9ing reasons: These regions ha(e di(erse fir" 7ases i$e$ large fir"s o#erating at the efficient scale and s"all fir"s co"#eting on fle!i7ilit, and s#eed of r eaction$ •
B, 7eing in these regions fir"s ha(e access to glo7al "ar.ets the latest technolog, and resources that are una(aila7le else9here$ •
The fir"s are a7le to create co"#an, lin.ages Ee$g$ 7u,ersu##lier relationshi# or strategic alliances) 9ith fe9er coordination #ro7le"s since the, are located close to each other$ •
There is a ra#id diffusion of inno(ation a"ong the fir"s since their close location allo9s e"#lo,ees to "o(e fro" one fir" to another$ This "o(e"ent of e"#lo,ees sti"ulates co"#etition and allo9s all the fir"s in the area to share the fruits of technological inno(ations$ +ince "ost of the inno(ations are concentrated 9ithin a region it allo9s the fir"s in this region to do"inate the glo7al "ar.et$ •
These regions all ha(e a selfsufficient (alueadded chain that "ini"ies the chances of success of a fir" located outside the region$ +u##ort industries de(elo# around the coreindustries to co"#lete the (alue chain$ The reasons 9h, an, cluster de(elo#s are co"#le! and colored 7, idios,ncratic conditions and historical de(elo#"ents$ +o"e localied industries de(elo# into clusters 9hile others 7eco"e highl, concentrated$ +o"e clusters are (er, sta7le 9hile others change fre>uentl,$ •
It is >uite li.el, that si"ilar regions 9ill continue to a##ear in the future since this Aclustering #heno"enon creates a Afeed7ac. loo# that strengthens the co"#etiti(e ad(antages of the fir"s located in these regions$ Ho9e(er current inno(ations in co""unication and trans#ortation technologies are reducing the i"#ortance of the d,na"ics of 7eing in a Aclustered region$ The trend is to9ard (irtual cor#orations or a net9or.ed fir" and the i"#ortance of geogra#hic #ro!i"it, for deter"ining success is shrin.ing$ 5$ The advent of professional managers "as accompanied )y s/epticism regarding their trust"orthiness and ethics in controlling large corporate assets on )ehalf of shareholders$ Today this s/epticism remains and has changed little since the founding of the managerial class a century ago$ %hy has it remained so strong&
The gro9th of "anagerial hierarchies fostered the e"ergence of a class of #rofessional "anagers "an, of 9ho" o9ned little or no share of the 7usiness$ Hence #ri"ar, cause of the s.e#ticis" is this se#aration of o9nershi# and control=si"ilar to the s.e#ticis" one "ight feel u#on hearing a #ar.ing (alet clai" that AsGhe treats the cars as herGhis o9n$ These indi(iduals tended not to ha(e 9or.ed their 9a, u# in a #articular 7usiness 7ut rather ha(e 7een trained as engineers or in 7usiness school$ ;n 7ehalf of the o9ners these "anagers a##lied their e!#ertise in control and coordination to the fir" and its 7usiness units$ In doing so the, #ioneered the standardied collection of data on a fir"s o#erations and 9ith it the 7eginnings of cost accounting$
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These changes in the nature of the fir" and its "anagers caused #ro7le"s and conflicts$ +ince there 9as little #recedent for the ra#id gro9th of fir"s at this ti"e gro9th of (olu"e and e!#ansion into ne9 "ar.ets could easil, lead to o(ere!#ansion and o(erca#acit,$ The de(elo#"ent of internal controls needed for coordination and efficienc, could easil, turn into e!cessi(e 7ureaucrac,$ The (er, s.ill that ne9 #rofessional "anagers e!hi7it in guiding the gro9th of their fir"s raises the #ro7le" of ensuring that these "anagers continue to 9or. in the 7est interest of o9ners rather than for their o9n ends$ Ironicall, these #ro7le"s 7eco"e #articularl, acute 9hen "anage"ent 9ell aligned 9ith shareholder interests is "ost needed during do9nturns in the fir"s #roduct "ar.et$ 16$ The (nternet )oom of the late 1556-s "as hailed as the advent of a y '66', ho"ever, it "as clear that the ne" economy had not arrived on schedule$ %ith the advent of the (nternet, digiti+ation, and related innovations, "hat fundamental aspects of the economy have changed& %hich aspects have remained the same& %hy has the
While "an, hailed the Internet as ha(ing a revolutionary i"#act on glo7al infrastructure e(ents so far suggest the affect of the Internet on glo7al infrastructure is "ore accuratel, coined evolutionary al7eit #rett, significantl, so$ The Internet has affected each co"#onent of infrastructure$ Clearl, affected has 7een communications: e!a"#les of the affect are too "an, to enu"erate here 7ut consider the increased ease 9ith 9hich consu"ers can 7e "atched 9ith sellers$ "ong the "an, affects of this is to "a.e feasi7le 7usiness o##ortunities that once could not e!#ect to find enough consu"ers to achie(e a sufficient scale of o#eration i$e$ a 7outi>ue s#ecialiing in the sale of sunglasses for #ets$ ut succinctl, the Internet has reduced the costs of search for 7u,ers of e(er,thing fro" #et sunglasses to industrial in#uts$ uent cha#ters 9ill introduce the idea that gro9th in de"and cou#led 9ith an increase in co"#etition a"ong sellers has an a"7iguous outco"e on #rofita7ilit,$ Finance is si"ilarl, affected 7, for e!a"#le the increased ease 9ith 9hich #ro(iders of ca#ital "ight find see.ers of ca#ital and infor"ation a7out the fir"s and industries the, "ight in(est in$ ?roduction Technologies that 9ere less feasi7le 9ithout a "echanis" for sharing infor"ation in real ti"e are feasi7le using the Internet$ Transportation is also i"#ro(ed as a result of the a(aila7ilit, of real ti"e infor"ation$ The government has a ",riad of uses for the Internet fro" infor"ation disse"ination cri"inal in(estigations etc$ While the Internet has clearl, i"#acted the costs associated 9ith transactions a"ong fir"s and indi(iduals and this reduction in costs has had nontri(ial affects the Internet has not altered the #rinci#les of "icroecono"ics that #redict 9ith high accurac, the outco"e of econo"ic interactions in reasona7l, free "ar.ets such as in the K$+$
12
1%
Chapter ' The Hori+ontal >oundaries of the Firm: Economies of Scale and Scope Chapter Contents 1) 2)
Introduction Where do cono"ies of +cale Co"e uare 'ule and h,sical ro#erties of roduction • 4) +#ecial +ources of cono"ies of +cale and +co#e cono"ies of +cale and +co#e in urchasing • cono"ies of +cale and +co#e in d(ertising • cono"ies of +cale in 'esearch and De(elo#"ent • !a"#le 2$%: The ce Hard9are Cor#oration !a"#le 2$4: The
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1/
Chapter Summary
This cha#ter intends to hel# the student understand ho9 to "ore full, ans9er the follo9ing >uestions in strateg,: Ho9 do 9e define our fir" What acti(ities do 9e do 9hat are our fir"s 7oundaries While the (ertical 7oundaries of the fir" Ediscussed in Cha#ter %) illustrate 9hich acti(ities the fir" 9ould #erfor" itself and 9hich it 9ould lea(e to the "ar.et the horiontal 7oundaries of the fir" refer to the sie Eho9 "uch of the total #roduct "ar.et 9ill the fir" ser(e) and sco#e E9hat (ariet, of #roducts and ser(ices does the fir" #roduce)$ This cha#ter argues that the horiontal 7oundaries of the fir" de#end criticall, on econo"ies of scale and sco#e$ cono"ies of scale and sco#e are #resent 9hene(er largescale #roduction distri7ution or retail #rocesses #ro(ide a cost ad(antage o(er s"all #rocesses$ cono"ies of scale e!ist 9hene(er the a(erage cost #er unit of out#ut falls as the (olu"e of out#ut increases$ cono"ies of sco#e e!ist 9hene(er the total cost of #roducing t9o different #roducts or ser(ices is lo9er 9hen a single fir" instead of t9o se#arate fir"s #roduces the"$ In general ca#ital intensi(e #roduction #rocesses are "ore li.el, to dis#la, econo"ies of scale and sco#e than are la7or or "aterials intensi(e #rocesses$ B, offering cost ad(antages econo"ies of scale and sco#e not onl, affect the sies of fir"s and the structure of "ar.ets the, also sha#e critical 7usiness strateg, decisions such as 9hether inde#endent fir"s should "erge and 9hether a fir" can achie(e longter" cost ad(antages in the "ar.et through e!#ansion$
13
Approaches to Teaching this Chapter Definitions:
roductLe(el cono"ies of +cale: reductions in unit cost attri7uta7le to #roducing "ore of a gi(en #roduct in a gi(en #lant$ +hortrun cono"ies of +cale: reductions in unit cost attri7uta7le to s#reading fi!ed costs for a #lant of a gi(en sie$ These arise 7ecause of increased utiliation of a #lant of a gi(en ca#acit,$ Longrun cono"ies of +cale: reductions in unit costs attri7uta7le to a fir" s9itching fro" a lo9 fi!edGhigh (aria7le cost #lant to a high fi!edGlo9 (aria7le cost #lant$ These arise due to ado#tion of technologies or larger #lants that ha(e higher fi!ed costs 7ut lo9er (aria7le costs$ The distinction 7et9een long and shortrun scale is (er, i"#ortant"ista.ing shortrun econo"ies of scale for longrun econo"ies could lead a fir" to the false conclusion that its unit costs 9ill continue to fall if it e!#ands ca#acit, once its e!isting ca#acit, is full$ roductLe(el cono"ies of +co#e: reductions in unit cost attri7uta7le to a fir"s di(ersification into se(eral #roducts #roduced in the sa"e #lant$ !a"#les include an, #rocess in 9hich there are che"ical 7,#roducts fro" the sa"e reaction such as cro# rotation and oil refining$ nother e!a"#le is a #roduct that shares a .e, co"#onent or set of co"#onents 9hose #roduction is characteried 7, econo"ies of scale such as digital 9atches and electronic calculators$ final e!a"#le is a fir" that utilies off #ea. ca#acit, such as s.i resorts garden stores and s#orting goods stores$ lantLe(el cono"ies of +co#e: reductions in unit cost attri7uta7le to a fir"s di(ersification into se(eral #roducts #roduced in different #lants$ !a"#les include airline hu7ands#o.e s,ste"s$ urchasing cono"ies: reductions in unit cost attri7uta7le to (olu"e discounts$ Large (olu"e 7u,ers "a, 7e a7le to achie(e >uantit, discounts that are not a(aila7le to s"aller(olu"e 7u,ers$ !a"#les include hos#ital and hard9are store #urchasing grou#s$ 'ND cono"ies: reductions in unit cost due to s#reading 'ND e!#enses$ uire a "ini"u" nu"7er of scientists and researchers 9hose la7or is indi(isi7le$ s the out#ut of the la7 e!#ands 'ND costs #er unit "a, fall$ Mar.eting cono"ies: 1) econo"ies of scale due to s#reading ad(ertising e!#enditures o(er larger "ar.ets and 2) econo"ies of sco#e due to 7uilding a re#utation of one #roduct in the #roduct line 7enefiting other #roducts as 9ell$
15
Indi(isi7ilit,: so"e in#uts cannot 7e scaled do9n 7elo9 a certain "ini"u" sie e(en as out#ut shrin.s to ero$ !a"#les include railroad and airline ser(ice$ Learning Cur(e: reductions in unit costs that result fro" the accu"ulation of .no9 ho9 and e!#erience$ rogress 'atio: the slo#e of the learning cur(e the #ercentage 7, 9hich C declines as the fir" dou7les cu"ulati(e out#ut$ Core Co"#etenc,: the collecti(e .no9ho9 9ithin an organiation a7out ho9 to 9or. 9ith #articular technologies or #articular t,#es of #roduct functionalit, Ee$g$ %M in coatings and adhesi(es and Canon in #recision "echanics fine o#tics and "icroelectronics)$
Hori+ontal >oundaries Horiontal 7oundaries are those that define ho9 "uch of the total #roduct "ar.et the fir" ser(es Esie) and 9hat (ariet, of related #roducts the fir" offers Esco#e)$ The 7asic >uestion is: AWhat strategic ad(antages are conferred on a fir" 7, 7eing large or 7, ha(ing a 7road sco#e of #roducts +ieGsco#e can re#resent an ad(antage for three reasons$ The first t9o reasons 7elo9 9ill 7e discussed later in the te!t$ 'eason O% 7elo9 is the focus of Cha#ter 2$ • Si.e 2 Mar+et &ower $ LargerGdi(ersified fir"s "a, 7e a7le to e!ercise "ono#ol, #o9er or set the ter"s of co"#etition for other fir"s in the industr,$ Si.e 2 Entry Barriers $ ;nce a fir" o9ns a large #osition in the "ar.et it "a, 7e • (er, difficult to dislodge it$ That is #otential entrants and e!isting fir"s "a, 7e deterred fro" attac.ing this fir"s core 7usiness$ good e!a"#le of this is 7rand #roliferation in 7rea.fast cereals$ Si.e 2 /ower 1nit Costs $ large fir" "a, 7e a7le to #roduce at a lo9er cost #er • unit than a s"all fir" "a,$ @earning Curve Ma.e certain students can distinguish the difference 7et9een econo"ies of scale and the learning cur(e 9hich s#ea.s to cumulative out#ut not le(els of out#ut$
18
ad(antage "a, not 7e As#reada7le$ That is a #atent is not s#reada7le nor are #ersonal ser(ices such as in restaurants$ Economies of Scale8Scope Determine Mar/et Structure B, stud,ing the histor, of an industr, and e!a"ining the characteristics of successful fir"s "anagers can assess the i"#ortance of sie and other fir" characteristics$
s. students to #re#are thoughts on the follo9ing >uestions 7efore the lecture: Consider the industr, ,ou 9or.ed in 7efore co"ing to school$ What role if an, • did econo"ies of scale or sco#e #la, in deter"ining the nu"7er and sie of fir"s in this industr, Did econo"ies of scale or sco#e affect the ease 9ith 9hich ne9 fir"s could enter the industr, rahalad and Ha"el tal. a7out Acore co"#etencies 7, 9hich the, "ean s#ecial s.ills fir"s ha(e in 9or.ing 9ith #articular technologies$ The, argue that in "a.ing di(ersification decisions fir"s should e!#loit their core co"#etencies$ !#lain 9hat this "eans using the conce#t of econo"ies of sco#e$ Can ,ou thin. of an e!a"#le of 9here the fir" ,ou 9or.ed for le(eraged its core co"#etencies •
!a"#les 2$1 and 2$4 discuss the hu7ands#o.e s,ste" and "a.e the #oint that it leads to econo"ies of sco#e and has had an i"#ortant effect on the structure of the K$+$ airline industr,$ et the "ost #rofita7le fir" in the industr, E+outh9est) does not ha(e such a s,ste"$ !#lain ho9 an industr, could ha(e a #roduction technolog, characteried 7, econo"ies of scale or sco#e ,et a s"all fir" could 7e "ore #rofita7le in the long run$ •
1&
Suggested Harvard Case Study '
De Beers Consolidated Mines HB+ &%&1053$ Descri7es the #ro7le"s facing De Beers at the start of 1&8%$ De Beers had since its for"ation in 1888 e!ercised a large "easure of control o(er the 9orld su##l, of dia"onds$ In 1&8% the co"#an, itself "ined o(er 40P of the 9orlds natural dia"onds and through "ar.eting arrange"ents 9ith other #roducers distri7uted o(er 50P$ uestions in #re#aration for the case: a) What are the characteristics of rough dia"onds that create challenges in sustaining a "ono#ol, of this trade 7) Wh, does De Beers re>uire different countries to #a, different co""ission to #artici#ate in the s,ndicate c) Wh, "ight dia"ond #roducers agree to #artici#ate in the s,ndicate as o##osed to selling their out#ut on their on d) What forces #ro"#t dia"ond #roducers to e!it the s,ndicate House of Tata HB+ &5&203/ Esee earlier cha#ters) Hude#ohl Bre9ing Co"#an, HB+ &%810&2$ Hude#ohl is a #ri(ate co"#an,$ resents the #ro7le" of ho9 an esta7lished regional 7re9er can sur(i(e the onslaught of national 7re9eries so"e of 9hich are 7eing crosssu7sidied 7, di(ersified #arent co"#anies$ 'e>uires detailed anal,sis of 9hat o#erations are #rofita7le and un#rofita7le for Hude#ohl in addition to industr, and co"#etiti(e anal,sis$ This cha#ter can 7e taught 9ith so"e co"7ination of the follo9ing cha#ters: 2 / 11 and 12$ ou "a, 9ant to as. students to thin. of the follo9ing >uestions in #re#aration for the case: a) Ho9 9ell is H doing Is Bo7 ohls o#ti"is" a7out Hs future @ustified 7) Ho9 ha(e the funda"ental econo"ics of the 7eer 7usiness changed o(er the 20%0 ,ears #rior to the ti"e of the case Ha(e these changes hel#ed or hurt H c) What are the "ar.ets that H co"#etes in Which are Hs strongest "ar.ets Which are its "ost #rofita7le "ar.ets d) Ho9 efficient are Hs "anufacturing and distri7ution facilities in co"#arison 9ith other 7eer co"#anies Which acti(ities need to 7e changed or dro##ed e) What are Hs strengths What resources or assets does H ha(e that its co"#etitors do not ha(e Does ohls strateg, e!#loit Hs resources ca#a7ilities and co"#etiti(e ad(antages f) What alternati(e strategies "ight ohl ada#t More generall, ho9 9ould ,ou 2
These descri#tions ha(e 7een ada#ted fro" Harvard Business School 3445647 Catalog of Teaching Materials#
20
reco""end that H #osition itself in the 7eer "ar.et gi(en Hs resources and assets and gi(en the strategies of its ri(als in the 7eer industr, g) rofit nal,sis 7, +eg"ent: Calculate or esti"ate Hs #roduction costs and #rofit "argins for each of its four A#roduct lines sho9n in Ta7le B: E1) draft 7eer sold to inde#endent distri7utors E2) draft 7eer distri7uted 7, H E%) #ac.aged 7eer sold to inde#endent distri7utors E4) #ac.aged 7eer distri7uted 7, H$ h) Falue dded: Ksing the a7o(e #rofit calculations calculate the (alue added at each stage of Hs (ertical chain$ Can ,ou e!#lain the differences in the #rofita7ilit, across these #roduct lines i) +eg"ent nal,sis: To the e!tent #ossi7le calculate Hs "ar.et share in each of its "ar.et seg"ents$ EWhat are the criteria ,ou are using to distinguish Hs different "ar.et seg"ents) +i"e Dar7, Berhad=1&&/ HB+ &5&5015 $ +i"e Dar7, is one of +outh sias largest regional conglo"erates$ t the ti"e of the case 1&&/ it is conte"#lating entr, into the fast gro9ing financial ser(ices sector in Mala,sia through ac>uisition of a Mala,sian 7an.$ This is in .ee#ing 9ith its acti(ities "irroring those of the Mala,sian econo",$ resents a discussion of 9hether to #roceed 9ith the ac>uisition$ -ets at the underl,ing sources of (alue creation of the conglo"erate in the institutional conte!t 9hich affect the costs and 7enefits of 7road cor#orate sco#e es#eciall, the e(ol(ing ca#ital "ar.et and the tight interrelationshi# 7et9een 7usiness and #olitics$ This cha#ter can 7e taught 9ith so"e co"7ination of the follo9ing cha#ters: 2 % 4 10 and 13$ ou "a, 9ant to as. students to thin. of the follo9ing >uestions in #re#aration for the case: a) What are the sources of co"#etiti(e ad(antage for a fir" that is affiliated 9ith +i"e Dar7, 7) (aluate the >uote in the 7eginning of the case: Aou need to carr, a fair a"ount of 9eight to "a.e an i"#ression in sian "ar.ets$ c) Wh, is o##ortunistic 7eha(ior a concern Does re#utation "atter "ore in Mala,sia than in the K$+$ Eor in other ad(anced econo"ies) Ho9 does +i"e Dar7, address these concerns d) What are so"e of the institutional (oids filled 7, +i"e Dar7, through acting as an inter"ediar, in the financial "ar.ets To 9hat e!tent is 7eing di(ersified i"#ortant for filling these institutional (oids e) +hould +i"e Dar7, ha(e a co""on 7rand na"e used in all its co"#anies f) Wh, "ight a talented indi(idual #refer to 9or. at +i"e Dar7, rather that at an undi(ersified co"#an, g) Is +i"e Dar7,s relationshi# 9ith the go(ern"ent an,thing 7ut an asset h) Ho9 is +i"e Dar7, doing relati(e to other Mala,sian co"#anies i) +hould +i"e Dar7, ac>uire KMBC
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Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
Boston Consulting -rou#$ &ers%ectives on E8%erience $ Boston: Boston Consulting -rou# 1&50$ Chandler $$ Scale and Sco%e$ The *ynamics of (ndustrial Ca%italism $ Ca"7ridge M: Bel.na# 1&&0$ +tigler -eorge J$ The -rgani.ation of (ndustry $ Ho"e9ood IL: 'ichard D$ Ir9in 1&38$
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Ans"ers to End of Chapter #uestions 1$ A firm produces t"o products, and B$ The production technology displays the follo"ing costs, "here Ci, represents the cost of producing i units of and units of B: C6,06 166 C0,6 106 C6,166 '16 C16,6 *'6 C0,06 '.6 C16,166 066 Does this production technology display economies of scale& f scope&
This technolog, does not dis#la, econo"ies of scale$ The cost #er unit of "a.ing /0 units of is Q2 and the cost of "a.ing 100 units of is Q2$10$ +ince the cost #er unit does not decrease as the >uantit, of increases this technolog, does not dis#la, econo"ies of scale in the #roduction of $ The result is analogous in loo.ing at the costs of "a.ing R as 9ell as loo.ing at the costs of "a.ing R and together in greater >uantities$ This technolog, does dis#la, econo"ies of sco#e in the #roduction of R and $ The cost of "a.ing / units of R is Q1/0 and the cost of "a.ing /0 units of is Q100$ Made se#aratel, the total cost of "a.ing / units of R and /0 units of is Q2/0$ The cost of "a.ing / units of R and /0 units of together is Q240$ '$ Economies of scale are usually associated "ith the spreading of fied costs, such as "hen a manufacturer )uilds a factory$ >ut the spreading of fied costs is also important for economies of scale associated "ith mar/eting, !GD, and purchasing$ Eplain$
%hat is the difference )et"een economies of scale and learning economies&
cono"ies of scale are said to e!ist if a(erage costs decrease as out#ut increases$ Learning econo"ies a source of econo"ies of scale refer to a reduction in a(erage costs due the accu"ulation of e!#erience and .no9ho9$ 0$ A firm contemplating entering the mar/et "ould need to invest 166 million in a production plant or a)out 16 million annually on an amorti+ed )asis$ Such a plant could produce a)out 166 million pounds of cereal per year$ 2$S$ )rea/fast cereal ma/ers sell a)out * )illion pounds of cereal$ %hat "ould )e the average fied costs if the cereal ma/er captured a ' percent mar/et share& %hat "ould )e the disadvantage if it achieved only a 1 percent share&
The a(eraged fi!ed cost is Q10"illionG100 "illion #ounds or Q0$10$
2%
2 #ercent "ar.et share 9ould 7e $02S % 7illion #ounds or 30 "illion #ounds$ The a(erage fi!ed cost 9ould 7e Q10 "illionG30 "illion #ounds or Q0$135$ If the fir" ca#tured onl, 1 #ercent share a(erage fi!ed cost 9ould 7e Q10 "illionG%0 "illion #ounds or Q0$%%% so the fir" 9ould 7e disad(antaged 7, Q$2% #er #ound relati(e to a #lant that ran at ca#acit,$ $ Historically, product mar/ets "ere dominated )y large firms and service mar/ets )y small firms$ This seems to have reversed itself some"hat in recent years$ %hat factors might )e at "or/&
roduct "ar.ets ha(e traditionall, 7een ca#ital intensi(e 7usinesses 9ith a large #ortion of total costs tied u# in fi!ed and se"ifi!ed costs$ ##l,ing the cu7es>uare rule to #roduct "ar.ets 9e .no9 that the #h,sical #ro#erties of #roduction traditionall, allo9ed fir"s to e!#and ca#acit, 9ithout co"#ara7le increases in cost$ Increased utiliation of #roduction facilities allo9ed fir"s to s#read fi!ed costs o(er additional units and lo9er a(erage costs$ uentl, these significant econo"ies of scale allo9ed larger fir"s to do"inate$ ;(er ti"e shifting en(iron"ental factors ha(e altered the en(iron"ent of #roduct "ar.ets$ The o7ser(ation that fir"s in #roduct "ar.ets are shrin.ing indicates the afore"entioned econo"ies of scale "a, no longer 7e the "ost #er(asi(e contri7utor to fir" success$ +o"e e!#lanations 9ould include the de(elo#"ent of cost sa(ing technologies such as co"#uters and co""unications de(elo#"ents that reduce coordination costs$ Large fir"s ad(antage 9ith res#ect to in(entor, "a, ha(e di"inished due to the de(elo#"ent of stronger (endorGcusto"er relationshi#s (ia JIT arrange"ents or @oint (entures as 9ell as ad(anced #roduction #lanning techni>uesGsoft9are$ ui##ed to ada#t to change "a, enter the "ar.et$ The shift fro" s"all to larger fir" do"inance in ser(ice "ar.ets is #ri"aril, due the reliance of these fir"s on la7or as the #rinci#al factor of #roduction$ Traditional theor, #osits that la7or does not e!hi7it #ro#erties of indi(isi7ilit,$ s such s"aller fir"s 9ere una7le to dedicate e"#lo,ees to clients 9ithin a s#ecific industr, or 9ith si"ilar needs$ Doing so allo9s e"#lo,ees to scale the learning cur(e "ore ra#idl, and i"#ro(es #roducti(e efficienc,$ Larger fir"s are "ore ca#a7le of su##orting such focused acti(ities allo9ing the" to s#read o(erhead costs o(er increased (olu"e$ $
Ban.s #ro(ide con(enient TMs to their custo"ers 9ho o#en an account and regularl,
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#a, for the 7an.s ser(ices$ To offer these con(enient TMs a 7an. "ust #urchase the "achines and the infrastructure necessar, to integrate all of the"$
AH,#er"arts could concei(a7l, achie(e se(eral econo"ies of scale 7, offering a 9ide arra, of consu"er #roducts in one store$ uic.l, 7u,s in 7ul. and 7eco"es a desira7le channel in the e,es of #roduct "anufacturers$ Des#ite these #otential 7enefits there are so"e li"its to econo"ies of scale$
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The "agnitude of learning 7enefits is often e!#ressed in ter"s of a slo#e$ The slo#e for a gi(en #roduction #rocess is calculated 7, e!a"ining ho9 far a(erage costs decline as cu"ulati(e #roduction out#ut dou7les$ It is i"#ortant to use cu"ulati(e out#ut rather than out#ut during a gi(en ti"e #eriod to distinguish 7et9een learning effects and other scale effects$ 16$ During the 1576s, firms in the Silicon Kalley of Iorthern California eperienced high rates of turnover as top employees moved from one firm to another$ %hat effect do you thin/ this turnover had on learning4)y4doing at individual firms& %hat effect do you thin/ it had on learning )y the industry as a "hole&
"#lo,ees "a, 7e (ie9ed as assets of the fir"$ Ho9e(er unli.e other fir" assets Ee$g$ ca#ital e>ui#"ent 7uildings etc$) hu"an assets 9al. out the door on a dail, 7asis and "a, ta.e 9ith the" the .no9ledge that the, ac>uired 9hile at the fir"$ Both e"#lo,er and e"#lo,ee are e!#osed to ris.s 9ithin their relationshi#$ While fir"s "ust in(est 7oth ti"e and dollars to #ro(ide e"#lo,ees 9ith for"al and e!#eriential training in order to "a!i"ie #roducti(e efficienc, fir"s are e!#osed to the ris. of their assets going else9here$ Con(ersel, e"#lo,ees "ust in(est ti"e in learning fir" s#ecific s.ills and forgo alternate e"#lo,"ent o##ortunities to re"ain at the fir"$ s turno(er increases fir"s are less inclined to in(est in e!tensi(e training as the, cannot retain the 7enefit of learning o(er ti"e$ This is co"#ounded 7, the ad(erse conse>uences of sharing (alua7le infor"ation 9ith e"#lo,ees that can 7e #assed on to co"#etitors$ roducti(e efficienc, is further ha"#ered as there are fe9er e!#erienced e"#lo,ees a(aila7le to #ro(ide onthe@o7 training for ne9 e"#lo,ees$ dditionall, fir"s ha(e little incenti(e to incur the su7stantial cost of training "ore indi(iduals$ uentl, e"#lo,ees "a, 7e less inclined to "a.e a relationshi#s#ecific in(est"ent in de(elo#ing s.ills a##lica7le to the fir" and the industr, as a 9hole$ ;(erall internal learning is reduced$ Con(ersel, high turno(er contri7utes greatl, to learning 7, the industr, as a 9hole as it allo9s industr, #artici#ants to freeride off the s.ills and .no9ledge 9or.ers ac>uired at a gi(en fir" since e"#lo,ees ta.e their e!#ertise 9ith the"$ Industr, learning is enhanced further if the .no9ledge and s.ills ac>uired are transfera7le rather than fir" s#ecific$ dditionall, as e"#lo,ees "o(e 7et9een fir"s their net9or. of #rofessionals 9ith 9ho" to share ideas e!#ands therefore #ro"oting the flo9 of infor"ation 7et9een fir"s$
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Chapter * The Kertical >oundaries of the Firm Chapter Contents 1) Introduction 2) Ma.e Fersus Bu, K#strea" Do9nstrea" • !a"#le %$1: Fertical Disintegration in the har"aceutical Industr, Defining Boundaries • +o"e Ma.eorBu,
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Chapter Summary
The #roduction of an, good or ser(ice usuall, re>uires a 9ide range of acti(ities organied in a (ertical chain$ roduction acti(ities are said to flo9 fro" u#strea" su##liers of ra9 in#uts to do9nstrea" "anufacturers distri7utors and retailers$ cti(ities in the chain include #rocessing and handling acti(ities 9hich are associated directl, 9ith the #rocessing and distri7ution of in#uts and out#uts and #rofessional su##ort acti(ities such as accounting and #lanning$ This cha#ter intends to hel# the student understand ho9 to ans9er so"e funda"ental >uestions in strateg, na"el,: Ho9 do 9e define our fir" What acti(ities do 9e do What do 9e lea(e to the "ar.et This is .no9n as the A"a.eor7u, #ro7le"$ The cha#ter #resents se(eral "a.eor7u, fallacies:
fir" should 7u, to a(oid incurring associated costs$ This argu"ent ignores the fact that the fir" it 7u,s fro" 9ill ha(e to incur these costs and 9ill charge accordingl,$ •
fir" should "a.e in order to .ee# associated #rofits$ This argu"ent ignores the fact that these #rofits usuall, re#resent the return necessar, to attract in(est"ents and 9ould 7e re>uired of the fir" that "a.es @ust as the, are re>uired of inde#endent fir"s$ •
Ferticall, integrated fir"s can #roduce an in#ut at cost and thus ha(e an ad(antage o(er nonintegrated fir"s 9ho "ust 7u, in#uts at "ar.et #rices es#eciall, at ti"es of #ea. de"and or scarce su##l,$ This argu"ent ignores hidden o##ortunit, costs to the (erticall, integrated fir"$ B, ha(ing the in#ut to #roduce its final out#ut it forgoes outside sales in the o#en "ar.et$ The cha#ter contains a nu"erical e!a"#le to illustrate the #oint$ •
The solution to the "a.eor7u, decision de#ends on 9hich decision leads to the "ost efficient #roduction$ This is deter"ined 7, assessing the 7enefits and costs of using the "ar.et$ >enefits of 2sing the Mar/et !easons to >uy
Tangi7le 7enefits: Mar.et fir"s are often a7le to achie(e econo"ies of scale and learning econo"ies in #roduction of an in#ut that are unattaina7le to fir"s that choose to "a.e the in#ut the"sel(es$ Mar.et fir"s ha(e other ad(antages: 9hile a di(ision 9ithin a hierarchical fir" "a, hide its inefficiencies 7ehind co"#le! "onitoring and re9ard s,ste"s inde#endent fir"s "ust sur(i(e the disci#line of "ar.et co"#etition$ •
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This encourages #roducti(e efficienc, and inno(ation$ Intangi7le 7enefits: Ferticall, integrated fir"s can tr, to re#licate "ar.et incenti(es 7ut "a, encounter #ro7le"s associated 9ith "oti(ation Eagenc, costs) and internal lo77,ing for resources Einfluence costs)$ •
Costs of 2sing the Mar/et Economic Foundations of Contracts
The costs of using the "ar.et ste" fro" the unli.elihood of 9riting a co"#lete contract$ The cha#ter contains a discussion of the role of contracts and contract la9 in "ar.et e!change and introduces the i"#ortant conce#t of inco"#lete contracts$ Contracts are needed 7ecause all 7ut the si"#lest of transactions 9ill e!#ose each #art, to the ris. of o##ortunistic 7eha(ior 7, their trading #artner$ co"#lete contract one that #ro(ides a co"#lete and thorough s#ecification of the res#onsi7ilities and rights of each #art, in the relationshi# 9ould co"#letel, #rotect the #arties fro" o##ortunistic 7eha(ior$ Ho9e(er the re>uire"ents of co"#lete contracting are e!tre"el, rigorous therefore "ost real9orld contracts are inco"#lete to so"e degree$ n inco"#lete contract in(ol(es so"e a"7iguit, or o#enendedness a7out the rights and res#onsi7ilities of each #art, in the relationshi#$ contract "a, 7e inco"#lete for se(eral reasons: 7ounded rationalit, difficulties in s#ecif,ing or "easuring #erfor"ance and as,""etric infor"ation$ Inco"#lete contracts result in #otential "ar.et failures: Ksing the "ar.et often #resents coordination #ro7le"s$ This is es#eciall, #ro7le"atic for in#uts 9ith design attri7utes that re>uire a careful fit 7et9een different co"#onents$ The cha#ter details / e!a"#les of A"isfit that "ight result fro" using the "ar.et relati(e to the outco"e of coordinating internall,: ti"ing sie color se>uence 'ND$ •
Ksing the "ar.et "ight result in lea.age of #ri(ate infor"ation$ When se#arate fir"s contract 9ith each other to engage in e!change the, learn a7out each others sales gro9th #lans etc$ •
Ksing the "ar.et generates transactions costs$ This cha#ter de(elo#s the conce#t of transaction costs in great detail and discusses ho9 the, 9or. to deter"ine the (ertical 7oundaries of the fir"$ The "ain e"#hasis in this section of the cha#ter is the cost of ar"s length "ar.et transactions$ •
The follo9ing section de(elo#s three i"#ortant conce#ts that are needed to understand 9h, "ar.et e!change can entail transaction costs: relationshi#s#ecific assets >uasi rents and the holdu# #ro7le"$ 'elationshi#s#ecific assets are #h,sical siterelated or hu"an assets that are intended s#ecificall, for use 9ith a gi(en trading #artner$ These assets 7ecause of their s#ecificit, ha(e lo9er (alue in alternati(e uses$ ;nce in(est"ents ha(e 7een "ade in relationshi#s#ecific assets the difference 7et9een actual re(enue and the ne!t 7est alternati(e re(enue creates >uasirents$ The situation 9hen one #art, e!tracts >uasirents fro" the other is called the holdu# #ro7le"$ 6uasirents can 7e e!tracted 7, renegotiating the contract or 7, ta.ing ad(antage of inco"#lete as#ects of the contract$ The hold u# #ro7le" raises the costs of e!change in se(eral 9a,s it "a,: 1) increase the a"ount of ti"e and "one, s#ent in negotiations 2) lead to distrust %) encourage Ao(erin(est"ent 7, inducing the #arties to safeguard their #ositions through in(esting in stand7, facilities or other su##liers and 4) lead to one #art, threatening to refrain fro" "a.ing relationshi#s#ecific
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in(est"ents there7, lo9ering #roducti(it,$ The a7o(e suggests 9h, (ertical integration "ight 7e a good alternati(e to "ar.et contracting 9hen the e!change in(ol(es inco"#lete contracting and relationshi# s#ecific assets$ There are three reasons 9h, (ertical integration "a, 7e a good alternati(e: (ertical integration "a, 1) result in go(ernance arrange"ents that #ro(ide "ore #o9erful dis#ute resolution and greater fle!i7ilit, in ada#ting to changing circu"stances 2) introduce a Are#eated relationshi# that reduces uncertaint, and "a.es relationshi#s#ecific in(est"ent "ore #rofita7le and %) allo9 organiational culture to #ro"ote an at"os#here of coo#eration$
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Approaches to Teaching this Chapter
In the #ast the "aterial in cha#ter % and 4 Ea good co"7ination) has constituted t9o three hours of lecture "aterial$ Definitions: ccounting #rofit: the si"#le difference 7et9een re(enues and e!#enses$
r"slength transactions $ one in 9hich autono"ous #arties each acting in their o9n selfinterest e!change goods and ser(ices$ Contract$ an agree"ent that defines the conditions of an e!change$ Dedicated assets $ those "ade for one s#ecific transaction$ cono"ic #rofit: the difference 7et9een the #rofits earned 7, in(esting resources in a #articular acti(it, and the #rofits that could ha(e 7een earned 7, in(esting the sa"e resources into the "ost lucrati(e alternati(e acti(it, Eo##ortunit, costs)$ uired to do and 9hat rights each has in the relationshi#$ Mini"u" efficient scale: s"allest out#ut at 9hich a(erage cost is "ini"ied$ h,sical asset s#ecificit, $ assets 9hose #h,sical or engineering #ro#erties are s#ecificall, tailored to a #articular transaction$ rocessing acti(ities: ra9 "aterials ac>uisition goods #rocessing and asse"7l,$ 6uasi'ents$ the difference 7et9een the re(enue the seller actuall, recei(es and 9hat it "ust recei(e to 7e induced not to e!it the relationshi# Ee! #ost)$ 6's occur 9hen contract negotiations directl, 7enefit one #art, at the e!#ense of the other or 9hen one #art, can ta.e actions that the other cannot sto# 7ecause of inco"#lete contracts andGor 7eing loc.ed into a relationshi#$ 'elationshi#s#ecific in(est"ent $ one "ade to su##ort a s#ecific transaction$ '+I cannot 7e rede#lo,ed to another transaction 9ithout so"e loss of #roducti(it, of the asset or 7, incurring additional cost$ 'ent$ the difference 7et9een the re(enue the seller actuall, recei(es and the "ini"u" a"ount of re(enue the seller "ust recei(e to "a.e it 9orth9hile to enter the relationshi# Ee! ante)$ 'ent is e>ui(alent to econo"ic #rofit$ +ite s#ecificit, $ assets located side7,side$
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+u##ort acti(ities: accounting finance hu"an resources "anage"ent strategic #lanning Eacti(ities that su##ort each ste# along the chain)$ Transaction Costs $ costs of organiing and transacting e!changes$ Transfer rice: an internal #rice 7et9een di(isions of a (erticall, integrated fir"$ When there is a highl, co"#etiti(e "ar.et outside for the internall, #roduced acti(it, or in#ut the transfer #rice should 7e e>ual to this outside "ar.et #rice$ Fertical Boundaries: acti(ities that define 9hat the fir" #erfor"s itself as o##osed to #urchasing fro" the "ar.et$ arl, ste#s in the (ertical chain are u#strea" in the #roduction #rocess later ste#s are do9nstrea"$ Falue Chain: the identification of ste#s in the (ertical chain 9here the "ost (alue is added$ This #rocess ta.es the (ertical chain and #uts dollar (alues to it$ Fertical Chain: the #rocess that 7egins 9ith the ac>uisition of ra9 "aterials and ends 9ith the distri7ution and sale of finished goods$ s students .no9 fro" Cha#ter 1 the fir"?s 7oundaries are fluid$ Hierarchical fir"s 9ere do"inant for a 9hile toda, a 9ide (ariet, of fir"s e!ist 9ithin industries$ Ho9 do fir"s decide 9hich acti(ities to #erfor" and 9hich to lea(e to the "ar.et There are t9o di"ensions to a fir"?s 7oundaries: horiontal and (ertical$ Discuss the differences in these t9o definitions$ The follo9ing outline #ro(ides infor"ation useful for lecturing a7out this "aterial: The Kalue Chain Michael orter introduced the conce#t of the (alue chain in 1&8/$ His sche"e ta.es the (ertical chain and #uts dollar (alues to it$ This hel#s to identif, those ste#s in the (ertical chain 9here the "ost (alue is added$ The (alue chain is critical to the conce#t of #ositioning Eho9 the fir" chooses to create (alueGdifferentiate itself for custo"ers) 9hich 9ill 7e discussed later$ The (alue chain is a tool that #ortra,s the fir" as 7eing "ade u# of a set of (aluecreating acti(ities$ The (alue of a good as it "o(es through the (alue chain is e>ual to the #rice it can 7e sold for in the "ar.et$ When the chain consists of inde#endent fir"s these #rices are easil, identified$ When the chain consists of consecuti(e ste#s done 9ithin the sa"e fir" these #rices "a, or "a, not 7e identified$ These are called transfer #ricesa #rice that tries to "easure 9hat a fair "ar.et #rice 9ould 7e for a good #assed through an internal "ar.et$ These #rices are often 7ased on co"#arisons 9ith si"ilar goods sold in the outside "ar.et$
orter?s chain has fi(e #ri"ar, acti(ities: 1) #urchasingGin(entor, handling 2) #roduction %) distri7ution 4) salesG"ar.eting and /) custo"er ser(ice and three su##ort acti(ities: 1) hu"an resources "anage"ent 2) research and de(elo#"entGdesign and %) cor#orate infrastructure$ Whether ,ou or ,our students 9ish to use orter?s classification or not the (alue chain is a useful 9a, of s,ste"aticall, thin.ing a7out the (arious 9a,s in 9hich the fir" creates (alue$
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The (alue chain conce#t here #re(ie9s a "a@or the"e of the 7oo.: (alue added de#ends on consu"er (alue costGefficienc, and the a7ilit, of the fir" to e!tract so"e of the difference 7et9een the t9o$ Most Common Ma/e4or4)uy Fallacies
1$ Bu, to a(oid the costs of "a.ing$ This argu"ent ignores the fact that the fir" it 7u,s fro" 9ill ha(e to incur these costs and 9ill charge accordingl,$ That is 9hoe(er "anufactures the #roduct 7ears the ris. of fluctuating (olu"es if it?s costl, for ,ou then it is #ro7a7l, costl, for others as 9ell$ Moreo(er an outside fir" "a, 7e a7le to ha(e a greater nu"7er of su##liers for its #roduct or it "a, si"#l, 7e "ore efficient than ,our fir"$ !a"#le: Intel licenses #roduction to outside fir"s$ Does this a(oid cost ;nl, if the outside fir"s offer so"e ad(antage$ In this case the outside fir"s can 7etter handle ca#acit, due to sco#e econo"ies$ 2$ Ma.e to a(oid #a,ing #rofits to others$ It is useful to consider 9here #rofits are co"ing fro": 1) rofit "a, 7e the nor"al ris. ad@usted return to the *"a.er$* That is #rofits "a, re#resent the return necessar, to attract in(est"ents and 9ould 7e re>uired of the fir" that "a.es internall, @ust as the, are re>uired of inde#endent fir"s or 2) rofit "a, co"e fro" "ono#ol, #o9er$ If a su##lier charges Q%00000 for a #roduct that costs Q200000 to #roduce 9h, doesn?t so"eone else enter the "ar.et Without an ans9er to this >uestion ,ou can?t 7e so sure of the sa(ings of "a.ing ,ourself$ %$ ssure su##l, and a(oid fluctuating #rices during #ea. de"and or short su##l,$ If ,ou start to "anufacture ,ou actuall, start to #la, the role of co""odit, s#eculator$ !easons to >uy 1$ "ar.et s#ecialist sells to "an, 7u,ers and can 7etter ta.e ad(antage of econo"ies of scale and sco#e than an inhouse de#art"ent could if it #roduced onl, for its o9n needs$ If there are econo"ies of scale then the "a.eor7u, decision can 7e resol(ed 7, deter"ining 9hether the fir" or its inde#endent su##liers are 7etter a7le to achie(e the"$ cono"ies of scale are #resent 9hene(er costs fall as (olu"e increases Ethis is discussed in the ri"er)$ These econo"ies are usuall, associated 9ith fi!ed in(est"ents$
If 6 Mini"u" fficient +cale EM+) then "a.e$ This situation can 7e seen in Ca"#7ell?s decision to 7ac.9ard integrate into sou# can #roduction$ •
If 6 U M+ then 7u,$ Costs can 7e decreased if there is additional #roduction$ Who is "ore li.el, to ta.e on added #roduction the fir" or its #artner We generall, o7ser(e that it is easier and "ore li.el, for the inde#endent #artner to gro9$ •
The i"#ortance of econo"ies of scale in defining the 7oundaries of the fir" also e!tend to indi(idual acti(ities EThe di(ision of la7or is li"ited $$$)$ da" +"ith 9rote a7out a #in factor, in 9hich so"e 9or.ers onl, "ade straight #arts so"e "ade the cro9ns and so"e #ut the" together$ This #rocess "ade sense 7ecause 1) cono"ies of +caleroutiniation of t9o factors i"#ro(ed the #roducti(it, of the s#ecialists and 2) Large De"andthere 9as enough de"and for #ins that each 9or.er could 7e .e#t 7us,
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doing @ust one tas.$ +"ith descri7ed this di(ision of la7or as natural in an, "ar.et as (olu"e increases enough to @ustif, s#ecialists$ s. students 9here this #la,s in toda,?s 7usiness en(iron"ent$ +o"e e!a"#les include s#ecialists in soft9are #ro7le"s restaurants in Chicago Eas discussed in the te!t) s#ecialied la9 fir"s E#ersonal in@ur, di(orce cor#orate etc$) and s#ecialists in "edicine$ 2$ fficienc, and Incenti(es$ Inde#endent fir"s "a, ha(e "ore incenti(e to inno(ate than a di(ision 9ithin a fir" 7ecause de#art"ents can ne(er 7e sure if the, are "a.ing Glosing "one,$ That is the o9ner of an inde#endent fir" faces stern disci#line fro" the "ar.et and .ee#s e(er, dollar he "a.es$ Con(ersel, it is harder to "atch #a, to #erfor"ance for indi(idual "anagers of internal di(isions$ fficienc, and incenti(e concerns include: Transfer #ricingit is hard to deter"ine the a##ro#riate #rices to charge internal di(isions$ uit, concernssee HoustonGTenneco e!a"#le • Influence costslo77,ing for resources "a, lead to 7iased infor"ation and • destructi(e co"#etition 9ithin the fir" internal di(isions "a, lo77, each other raising the cost of #roduction$ Ksing inde#endent fir"s allo9s ,ou to .ee# these issues distinct$ •
%$ Culture$ Consolidation of inde#endent fir"s can also create legendar, culture clashes$ Houston ;il and MineralsGTenneco e!a"#le of #a, e>uit, • !a"#les include IBM and 'ol" +on, and Colu"7iaGTri+tar Ban. of "erica • and Continental Ban.$ In su""ar, the "ar.et is a #o9erful force for technical efficienc, and inde#endenceGautono", is a #o9erful "oti(ator$ These forces "ust 7e 9eighed against those that fa(or integration Eoutlined 7elo9)$ !easons to Ma/e 1$ Coordination Costs$ The ste#s in the (ertical chain "ust fit together$ uence: Curriculu" 9ithin a uni(ersit, •
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are those for 9hich failure to o7tain a #recise fit is (er, costl,$ s. students for e!a"#les: fashion EBennetton color "atch) co"#uter soft9are Eo#erating s,ste" code) etc$ It is not o7(ious that ,ou 9ant contracts to 7e #erfect: 1) Tighter contracts "a, 7e "ore costl, to 9rite and enforce$ 2) +tiff #enalties for #oor #erfor"ance can create ris.s for contractors and certainl, can dri(e u# the cost of the contract$ Moreo(er ,ou "a, not 7e a7le to accuratel, co"#ute the costs and 7enefits associated 9ith "a.ing or 7u,ing and "a, therefore not accuratel, negotiate 9ith the inde#endent fir"$ 1a$ u"erical !a"#le on Coordination Costs 7u,er needs a #erisha7le ite" deli(ered e!actl, on ti"e$ n, ti"e lost 9ill dra"aticall, escalate the 7u,er?s costs Eor reduce its 7enefits)$ The su##lier?s costs decrease the slo9er it is deli(ered Efaster deli(er, is "ore costl,)$ Total Cost to >uyer of Delay more Day of Delay Seller
Marginal Cost to >uyer of 1 Cost of Day of Delay
% da,s earl, 2 da,s earl, 1 da, earl, ;nTi"e 1 da, late 2 da,s late % da,s late 4 da,s late
Q0 Q0 Q0 Q0 Q50 Q1200 Q%000 Q10000
• •
•
• • •
Total ?roduction Seller of 1 more
Marginal Cost Savings to
Q0 Q0 Q0 Q50 Q11%0 Q1800 Q5000
Q1000 Q&25 Q8// Q584 Q514 Q34/ Q/55 Q/10
Q5% Q52 Q51 Q50 Q3& Q38 Q35
When ite" is deli(ered on ti"e MC to 7u,er of dela, V MC sa(ings to seller of dela, contractual solution can 9or. in this e!a"#le if a #enalt, on the seller of slightl, "ore than Q50 #er e!tra hour of dela, 9ill deter the #roducer fro" dela,ing deli(er, 7e,ond the due date$ But s"all "ista.es in #ricing ha(e significant conse>uences$ +u##ose the 7u,er and seller stri.e a contract 9ith *"ista.enl,* sti#ulates a #enalt, of Q35$/0 #er da,$ Knder this #enalt, the seller sa(es "ore in #roduction costs than it #a,s in #enalties if it deli(ers the ite" % da,s late Ecost sa(ings of Q584/55V205 (ersus #enalt, of %SQ35$/0VQ202$/0)$ The seller 9ouldn?t deli(er four da,s late 7ecause the cost sa(ings fro" 1 "ore da, late EQ35) is less than the #enalt,$ Deli(er, % da,s late has disastrous conse>uences for the 7u,er$ Because onti"e deli(er, is essential "arginal cost of dela, to 7u,er rises ra#idl,$ Centralied coordination 7et9een 7u,er and seller is needed to ensure onti"e deli(er,$ If 9e i"agine the 7u,er and seller as de#art"ents 9ithin the sa"e (erticall, integrated fir" 9e could i"agine this coordination 7eing done 7, a "anager 9hose @o7 is to ensure onti"e #erfor"ance of ti"esensiti(e co"#onents Esee the article on Microsoft in !tra 'eading)$
17$ !a"#le ach ,ear #rofessors order case #ac.ets to 7e co#ied and deli(ered to the uni(ersit, 7oo.store$ When #ac.ets are deli(ered late this is an e!a"#le of *holdu#* 7ecause
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there is nothing the #rofessors can do 9hen #ac.ets are late$ What 9ould #rofessors do to re"ed, this #ro7le" Erofessors could 9rite contracts 9ith the (endors that included a #enalt, for each da, late$ rofessors could also "o(e the co#,ing inhouse to ha(e "ore control o(er the #rocess$) What are the costs of doing this E+tudents co"e un#re#ared to class etc$) This e!a"#le 9ill re"ind students of the e!a"#le used in Cha#ter %$ 2$ Lea.age of #ri(ate infor"ation$ This cost "a, see" o7(ious to students 7ut it is certainl, 9orth discussing$ Dealing 9ith inde#endent "ar.et s#ecialists "a, re>uire di(ulging #ro#rietar, #roduct infor"ation$ ou "a, 7e a7le to constrain the use of certain infor"ation gained in a deal through contracting or #atent #rotection 7ut such #rotection is not ironclad$ !a"#les: *'el,ing on outside su##liers is not a ga"e for the nai(e #la,er$ It • de"ands careful stud,$ If ,ou 7ungle a relationshi# 9ith the Ja#anese ,ou can lose ,our technolog, ,our 7usiness$* 'oger Le(in F of Technolog, and De(elo#"ent Rero! There 9as also an issue 9ith Intel?s loss of #atent #rotection fro" foundr, licenses$ • ou "a, 9ish to #oll the class for other e!a"#les$ %$ Transactions costs$ co""on the"e in discussing costs of using the "ar.et is the inade>uac, of contracts and other legal #rotections in securing the desiredrelationshi# 7et9een #artners$ Transactions costs generall, refer to the cost of organiing and transacting e!changes 7et9een ar"slength #artners in the "ar.et$ n i"#ortant ele"ent of transactions costs is the cost of negotiating 9riting and enforcing contracts$ These costs in turn de#end on the #ossi7ilit, of costs resulting fro" the holdu# #ro7le" Eand relationshi#s#ecific assets)$ Alternatives to Ma/e4or4)uy It "a, 7e useful to as. students 9hat the, 9ould consider alternati(es to either "a.ing or 7u,ing$ ;ne such alternati(e is longter" contracting$ This o#tion eli"inates so"e fle!i7ilit, that is es#eciall, i"#ortant in declining econo"ies E9here ,ou "a, not .no9 if the fir" 9ill 7e around in the longter")$ +uch fle!i7ilit, is not as critical in gro9ing econo"ies 9here all the #la,ers are e!#ected to continue to do 9ell EJa#anese eiretsu)$ Definitions: Contracting and Transactions Costs The li"itations of relationshi#s guided 7, contract ar e "ostl, criticall, e!#osed in the third cost of rel,ing on the "ar.et Eas #resented in Cha#ter %) transaction costs$ Transaction costs generall, refer to the cost of organiing and transacting e!changes 7et9een ar"slength #artners in the "ar.et$ n i"#ortant ele"ent of transaction costs is the cost of negotiating 9riting and enforcing contracts$ These costs in turn de#end on the #ossi7ilit, of costs resulting fro" the holdu# #ro7le"$ To understand the holdu# #ro7le" it is necessar, to descri7e inco"#lete contracts relationshi#s#ecific assets rents and >uasirents$ (ncomplete Contracts Contracts cannot entirel, eli"inate o##ortunis" the, cannot al9a,s 7e co"#lete for the follo9ing reasons:
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Bounded rationalit,there rationalit,there are li"its to our ca#acit, to #rocess infor"ation deal 9ith co"#le!it, co"#le!it, and rationall, #ursue our o7@ecti(es$ Contracts therefore often include such ter"s as Aacce#ta7le to #u7lisher rather than s#elling out e!actl, 9hat is acce#ta7le$ s. the students 9hether the, ha(e an, e!#erience 9ith contracts that left out things 7ecause the, 9ere si"#l, too difficult to 9or. through$
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Difficult, s#ecif,ingG"easuring s#ecif,ingG"easuring #erfor"anceanother reason 9h, "an, contracts use such ter"s as Aacce#ta7le is that it "a, 7e difficult to s#ecif, a set of o7@ecti(e criteria that constitute Aacce#ta7le$ s. the students 9hether the, can identif, an, e!a"#les of contracts 9here #erfor"ance is difficult to s#ecif, or "easure #
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Hidden infor"ationoccurs infor"ationoccurs 9hen one #art, .no9s "ore than the other a7out the conditions under 9hich the transaction 9ill occur$ These conditions "ight deter"ine the o#ti"al contract 7ut the #art, 9ith #ri(ileged infor"ation "a, choose not to di(ulge it$ s. the class if the, ha(e an, e!a"#les of contracts that 9ould ha(e 7een different if 7oth #arties had the sa"e infor"ation$
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Hidden ctionactions ctionactions that affect #erfor"ance 7ut cant 7e o7ser(ed$ s. the class if the, ha(e an, e!a"#les of "ar.et relationshi#s that "a, 7e distorted 7, hidden action Ee$g$ C; co"#ensation contracts franchise relationshi#s)
!elationship4Specific (nvestments ssets can 7e relationshi#s#ecific relationshi#s#ecific for "an, reasons: +ite s#ecificit,locating grain ele(ator ne!t to rail lines • h,sical asset s#ecificit,d,es "olds "ade s#ecificall, for one use • Hu"an asset s#ecificit,s#ecialied .no9ledge of ones clients #ro@ect •
no9ing that a #artner has "ade an '+I a fir" "a, e!#loit contractual inco"#leteness 7, atte"#ting holdu#$ This can 7e illustrated 9ith a nu"erical e!a"#le$ leading co"#uter soft9are fir" holds holds the co#,right co#,right to a Eample: +u##ose that a leading statistical soft9are #ac.age$ It 9ished to hire an e!#ert statistician to de(elo# a ne9 "odule that it 9ill then "ar.et as an inde#endent addon to the 7asic #ac.age$ It hires Dr$ +"ith a statistician at a local uni(ersit,$ uni(ersit,$ To "oti(ate +"ith to 9rite a #o9erful and userfriendl, #rogra" it offers an u#front fee of Q10000 #lus ro,alties re#resenting /0P of gross sales$ Before agreeing to the contract +"ith co"#utes the e!#ected #rofits$ +he esti"ates that de(elo#ing the soft9are 9ill ta.e 2/0 hours$ +he routinel, consults at Q%00 #er hour so she esti"ates the cost of her ti"e to 7e Q5/000$ Based on sales of a si"ilar "odule for a co"#eting statistical #ac.age she 7elie(es that the soft9are 9ill gross a7out Q130000$ Thus she e!#ects to recei(e Q80000 in ro,alties #lus the u#front fee of Q10000 for a total e!#ected #a,"ent of Q&0000$ Based on these calculations she 7elie(es that the e!#ected e!#ected re(enue e!ceeds the e!#ected e!#ected costs 7, Q1/000 and agrees to de(elo# the soft9are$ It turns out that the #ro@ect re>uires onl, 200 hours to co"#lete$ et et +"ith faces a #ro7le" 9hen she deli(ers deli(ers her finished #roduct: #roduct: the fir" infor"s her that one one of its e"#lo,ees in his s#are ti"e has de(elo#ed a soft9are #ac.age al"ost as good as hers
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and does not 9ant to her the /0P ro,alt, she 9as #ro"ised$ If she does not re negotiate 9ith the" the fir" 9ill "ar.et this other #rogra" at a lo9er #rice and her #ac.age 9ill not rea# the the le(el of sales she had #redicted$ #redicted$ +he reluctantl, agrees to a 2/P ro,alt, on the condition that the fir" does not "ar.et the other #roduct$ (en if her #ac.age reaches a sales le(el of Q130000 she 9ill end u# losing Q10000 EQ30000 9Ee!#enses) Q10000Eu#front #a,"ent) Q40000Ero,alties))$ +"ith has 7een Aheldu#$ +he "ade an '+I of Q30000 9orth of her ti"e 9hen she de(elo#ed the soft9are that could onl, 7e used 9ith this fir"s statistical #ac.age$ Her 9or. has no inde#endent (alue$ The fir" reneged on its initial agree"ent 9ith +"ith 7, 7ringing out the the alternati(e #ac.age at the the last "inute$ ou can 9al. students through the nu"7ers: When the contract 9as first offered +"ith calculated an e!#ected #rofit of Q1/000$ This is her rent fro" the deal$ +"ith could also ha(e co"#uted that after she sin.s Q30000 of ti"e into a #ro@ect that has no alternati(e "ar.et (alue and #ro(ides onl, Q10000 in u#front fees she 9ill loo. for9ard to re(enues of Q80000$ This Q80000 re#resents her >uasirent$ Because 6'' +"ith is in a #osition to 7e heldu#$ s. students to thin. of e!a"#les fro" their o9n e!#eriences$
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Based on 200 hours of 9or. +"iths +"i ths actual e!#enses EQ30000) 9ere less than her original esti"ate EQ5/000)$
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Suggested Harvard Case Study .
ucleon EHB+ 4 &3&2041 and Teaching Teaching ote O /3&20&/ ): This case 7rings to life the conce#ts fro" Cha#ters % and 4 7, illustrating illustrating ho9 one co"#an, struggled 9ith the "a.eor7u, decision$ It sho9s ho9 one co"#an, 9eighed the costs of rel,ing on the "ar.et (ersus (ertical integration$ It also discusses the difficulties of contracting 9hen there are relationshi#s#ecific assets and introduces #otential coordination #ro7le"s$ It also illustrates that there is a strong interrelationshi# interrelationshi# 7et9een the "a.eor7u, decision and cor#orate strateg,$ This case relies on decision tree and F anal,sis$ If ,ou use this case it "ight 7e useful to re(ie9Gintroduce these techni>ues$ The (alue of these tools is not that the, gi(e the *right* ans9er 7ut that the, force students to confront the hidden assu"#tions of their >ualitati(e anal,ses and the (ulnera7ilities of the infor"ation the, #rocess$ ou "a, 9ant to as. students to thin. of the follo9ing thought >uestions in #re#aration for the case: a) Descri7e Descri7e the (ertical (ertical chain chain for 7iotechnolo 7iotechnolog, g, #roduction #roductions$ s$ What *"a.e* *"a.e* decisions decisions has ucleon alread, "ade What *7u,* decisions has it alread, "ade (aluate these decisions$ 7) What "a.e or 7u, decisions confront ucleon in this case re there an, other o#tions 7esides those "entioned in the case that ucleon "ight e!#lore c) ss ssu"e u"e that that the the cost cost and re(enu re(enuee #ro@ecti #ro@ections ons in the case are correct correct$$ Based Based on these figures can ,ou assess the relati(e "erits of the (arious #ro#osals Do ,ou ha(e an, reason to >uestion the cost and re(enue #ro@ections in the case d) What other other factors factors "ust ucleon ucleon consider consider 7efore 7efore reaching reaching a final decision decision When all factors are ta.en together 9hat should ucleon do e#siCola Be(erages HB+ Case &%&00%4 : : 'es#onding to changes in e#siColas e#siColas co"#etiti(e en(iron"ent 'oger nrico #resident and C; of e#siCo World9ide World9ide Be(erages for"ed a tas. force to in(estigate a #ossi7le reorganiation of e#sis do"estic soft drin. 7usiness$ 7usiness$ The tas. force reco""ends reorganiing reorganiing along geogra#hic lines$ lines$ The grou# has #ut forth t9o o#tions: 1) full decentraliation decentraliation or 2) a "atri! organiation$ organiation$ s. students to anal,e anal,e the o#tions and "a.e their o9n #ro#osals for carr,ing out a reorganiation$ The, should also 7e as.ed to consider consider other o#tions to deal 9ith e#sis #ro7le"s that dont center on reorganiation$ reorganiation$ This case can 7e assigned 9ith so"e co"7ination co"7ination of cha#ters: % 4 5 8 & 12 1% 1/ 13 and 18$ ou "a, 9ant to as. students to thin. of the follo9ing thought >uestions in #re#aration for the case: a) erfor" erfor" a fi(e forces forces anal,s anal,sis is on the soft soft drin. drin. indust industr, r,$$ What What is ,our ,our >ualitati( >ualitati(ee assess"ent of this industr, 7) Wh, are concentrate #roducers #roducers li.e Co.e and e#si so #rofita7le c) Wh, do concen concentrate trate #roduc #roducers ers ha(e ha(e an incenti( incenti(ee to 7u, 7ottl 7ottlers ers d) Wh, are 7ottler 7ottlerss gi(en the the right to 7ottl 7ottler er Co.e or e#si e#si in #er#etuit #er#etuit, , 4
These descri#tions descri#tions ha(e 7een ada#ted ada#ted fro" Harvard Business School 3445647 Catalog of Teaching Materials#
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hili#s Co"#act Disc Introduction Introduction HB+ &5&20%/$ &5&20%/$ resents the #ers#ecti(e #ers#ecti(e of hili#s in 1&5& after technical de(elo#"ent of the CD 9as co"#lete 7ut three ,ears 7efore it 9as introduced co""erciall,$ co""erciall,$ t that ti"e ti"e hili#s "anage"ent had to decide 9hether to atte"#t to esta7lish a CD standard through an alliance 9ith another consu"er electronics fir"$ fir"$ 'aises >uestions regarding regarding the costs and 7enefits 7enefits of standardiation o#ti"al #ricing of CD #la,ers and discs Egi(en their co"#le"entarit,) co"#le"entarit,) o#ti"al #ricing of a dura7le good and the effects of #ro#rietar, infor"ation on entr, strategies$ lso re>uires anal,sis anal,sis of se(eral related industries 9ith s#ecial attention attention to o##ortunities to in(est in(est in #roduct s#ecific ca#ital$ This case can 7e assigned 9ith so"e co"7ination of cha#ters: % & and 14$ ou "a, 9ant to as. students to thin. of the follo9ing >uestions in #re#aration for the case: a) What are are the cost and and 7enefits 7enefits to hili#s hili#s in ha(ing ha(ing its its standard standard acce#ted acce#ted as as the industr,9ide industr,9ide for"at Ein the hard9are)Ho9 does the degree of hili#s (ertical integration effect its incenti(es incenti(es in the de(elo#"ent of the hard9are Ho9 does its (ertical integration effect effect its chances of ha(ing its standard 7eing ada#ted Ho9 does its (ertical integration effect ho9 #rofita7le hili#s 9ill 7e in the hard9are$ 7) Ho9 does hili#s o9nershi# o9nershi# in a record co"#an, co"#an, effect its #osition #osition in the "ar.et for hard9are c) Will Will hard9are hard9are "anufac "anufacturers turers 7e 7e a7le to success successfull, full, engage engage in in #roduct #roduct differentiation differentiation What factors effect effect ,our ans9er d) Knder Knder 9hat condition conditionss should should hili#s hili#s 7uild e!tensi e!tensi(e (e disc #ressing #ressing ca#acit, ca#acit, n the K$+$ and under 9hat condition should hili#s 9ait one ,ear
To"7o9 encil Co$ Ltd$ EHB+ O &3&2011 and Teaching ote O /3&%025): This case illustrates ho9 another fir" Ein another countr,) struggles 9ith a si"ilar "a.eor 7u, #ro7le"$ While the "ost "ost #ro"inent issues in the the case are the *7oundaries of the the fir"* >uestions the case also raises issues related to #roduct "ar.et co"#etition and the role of #roduct (ariet, (ariet, "ar.eting channels and organiational organiational issues in(ol(ing the coordination of "ar.eting sales and #roduction inside To"7o9$ To"7o9$ The case also #resents the differences 7et9een eiretsu Enet9or.s of longter" relationshi#s) and ar"slength "ar.et contracting$ It introduces students to the idea that assign"ent of o9nershi# rights can sol(e #ro7le"s that arise due to #h,sical asset s#ecificit, Eholdu# hu"an asset s#ecificit,)$ s s 9ith ucleon Esee cha#ter %) it sho9s that there are strong relationshi#s 7et9een #roduction strateg, strateg, #roduct "ar.et strateg, strateg, and the "a.eor 7u, decision$ This case can 7e taught 9ith so"e co"7ination of the follo9ing cha#ters: % 4 11 12 1/ and 13$ ou ou "a, 9ant to as. students to thin. of the follo9ing follo9 ing >uestions in #re#aration for the case: a) What is is To"7o9 To"7o9 encils current financial financial #osition Loo. at To"7o To"7o9s 9s financial state"ent and co"#are their financial ratios to Mitsu7ishis Mitsu7ishis$$ In #articular 9hat 9ould the i"#act 7e on To"7o9s #rofits if the, could reduce their in(entor,Gsales ratio to Mitu7ishis le(el 7) Is the Ja#anese #encil industr, #rofita7le #rofita7le re there so"e so"e seg"ents that are "ore #rofita7le than others others c) Co"#are Co"#are the (ertical (ertical chains chains for for 9ooden #encil #encilss and the ;7@ect ;7@ect ; #encil #encil E9hich E9hich 9ill 7e our "eta#hor for "echanical #encils in general)$ re the differences in the (ertical sco#eG(ertical 7oundaries in these t9o chains consistent 9ith the underl,ing econo"ics econo"ics of "a.e or 7u, decisions Wh, does ;ga9a ;ga9a feel the need to ree!a"ine the #roduction s,ste" for the ; #encil gi(en that To"7o9s To"7o9s
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(ertical relationshi# ha(e ser(ed the" 9ell for so long d) What reco""endations 9ould ,ou "a.e for To"7o9 Consider 7oth the "ar.et #osition E#roduct line >ualit, #rice #oint etc$) the horiontal and (ertical sco#e and the organiation of the co"#an,$
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Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
Coase 'onald AThe ature of the
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Ans"ers to End of Chapter #uestions 1$ Descri)e the vertical chain for the production of computer games$
+tudents ha(e a great deal of lee9a, in ans9ering this >uestion 9hich is designed to get students to thin. a7out the co"#le!ities of an actual (ertical chain$ '$ A manufacturer of pencils contemplates )ac/"ard integration into production of rape seed oil, a /ey ingredient in manufacturing the ru))er4li/e material called factice that forms the eraser$ !ape seed oil is traded in "orld commodity mar/ets and its price fluctuates as supply and demand conditions change$ The argument has )een made in favor of vertical integration:
nsuring su##l, "ight 7e a (alid argu"ent for (ertical integration if the "ar.et for ra#e seed oil 9ere e!tre"el, illi>uid and inefficient 7ut it is traded freel, on 9orld co""odit, e!changes$ In this case there are no econo"ic 7enefits to (ertical integration that cannot 7e achie(ed through "ar.et e!change an ar"slength transaction is si"#l, internalied 9ithin the fir" if transfer #rices are set at the "ar.et le(el$ Ho9e(er if transfer #rices are held constant this 9ill lead to inefficient use of ra#e seed oil$ The fir" 9ill fail to use the o#ti"al >uantit, of ra#e seed oil in do9nstrea" #roduction and 9ould su7sidie its u#strea" di(ision 9hen "ar.et #rices 9ere lo9 or su##ort its do9nstrea" di(ision 9hen "ar.et #rices 9ere high$ *$ Matilda >ottlers, )y virtue of a lifetime contract, has eclusive rights to distri)ute >ig ;ator products in several Australian states$ >ig ;ator has a seven percent share of these states$, similar to its nation"ide share$ Matilda uses its monopsony po"er to pay a lo"er price for >ig ;ator products than does any other distri)utor in the 2$S$ (s this sufficient ustification for >ig ;ator to )uy out Matilda >ottlers&
Big -ator should not auto"aticall, 7u, out Di!ie si"#l, 7ecause Di!ie is a7le to #a , a lo9er #rice for Big -ators #roducts$ 'ather Big -ator should deter"ine 9hether there is a (ertical "ar.et failure that 9ould @ustif, a decision to (erticall, integrate$ 'easons Big -ator should not (erticall, integrate: •
• • • •
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The #rofits earned 7, Matilda Bottlers E9hich incor#orate the discounted #rice for Big -ator roducts) 9ill 7e incor#orated in the #rice that Big -ator #a,s for Matildas 7ottling o#eration$ Therefore Big -ator cannot a(oid gi(ing Matilda so"e or all of the 7enefit of Matildas current "ono#son, #osition$ +u##lier and distri7utor goals are aligned sell out#ut for "a!i"u" #rofits$ erfor"ance is eas, to o7ser(e and out#ut is "easura7le$ Transactions are fre>uent and si"#le and are eas, to contract$ B, allo9ing the distri7utor to .ee# #rofits the "anufacturer is ensuring that the distri7utor 9ill continue to "a.e relationshi# s#ecific in(est"ents and to run an efficient distri7ution o#eration$ The distri7utor controls the a"ount of effort to #ut into distri7ution so it "a, 7e
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good to allo9 the distri7utor to share so"e #rofit in order to #ro(ide incenti(es$ 'easons Big -ator should (erticall, integrate: • •
'elationshi# s#ecific in(est"ent is re>uired fro" the distri7utor so the relationshi# "a, 7e su7@ect to a hold u# #ro7le"$ If #roduct #rices are dri(en so lo9 that hold u# is causing (ertical "ar.et failure or that e!cessi(e costs are incurred Efro" distrust fre>uent contract renegotiations less relationshi# s#ecific in(esting or in(esting to ensure e!#ost 7argaining #o9er) then the "anufacturer "a, consider integrating into the distri7utor$ The "anufacturer should o9n the distri7utor 7ecause it ulti"atel, co""ands "ost of the sur#lus in the national arena$
.$ (n each of the follo"ing situations, "hy are firms li/ely to )enefit from vertical integration& a$
A grain elevator is located at the terminus of a rail line$
grain ele(ator o9ner 9ould 7enefit fro" (ertical integration for se(eral reasons: •
•
Coordination Costs: The use of "ar.et fir"s often #resent coordination #ro7le"s$ This is #ro7le"atic for in#uts 9ith design attri7utes that re>uire a #recise fit 7et9een different co"#onents$ It "a, 7e that storage 7ins and railcars need to 7e so designed$ Ti"ing is another i"#ortant factor 9ith grain$ The grain o#erator 9ould 9ant to shi# the grain as soon as #ossi7le to a(oid s#oilage etc$ +ince onl, one rail line o#erator is li.el, to e!ist it 9ill ha(e fe9 incenti(es to closel, coordinate 9ith the grain ele(ator o9ner$ Ha(ing centralied ad"inistrati(e control as an integrated fir" 9ould sol(e these coordination #ro7le"s$ Transactions Costs: rranging for ti"el, #ic.u# and deli(er, through contracts could 7e e!tre"el, difficult and costl, to enforce if the rail line o#erator lac.s co"#etition and can act o##ortunisticall,$
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rocessing fficiencies: Locating assets side7,side "a, allo9 the o#erators to econo"ie on trans#ortation or in(entor, costs or to ta.e ad(antage of #rocessing efficiencies$ EThis is a conce#t called site s#ecificit, 9hich is discussed in Cha#ter %$)
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cono"ies of +cale: The grain o#erator "a, 7e a7le to achie(e distri7ution econo"ies of scale 7, ha(ing its o9n rail o#eration as o##osed to contracting 9ith indi(idual trans#ortation #ro(iders$
)$ A manufacturer of a product "ith a national )rand name reputation uses distri)utors that arrange for advertising and promotional activities in local mar/ets$
The "anufacturer 9ould 7enefit fro" (ertical integration for se(eral reasons: •
Coordination Costs: The "anufacturer 9ill 7e 7etter a7le to coordinate national and local ad(ertising and #ro"otions thus con(e,ing a consistent "essageG7rand i"age across local "ar.ets and "a!i"iing the i"#act of ad(ertising and #ro"otions on sales$ E+e>uencing)$
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•
•
The "anufacturer can 7etter coordinate the release of ne9 #roducts 9ith local ad(ertising and #ro"otional acti(ities$ ETi"ing)$ "anufacturers o9n distri7utorsGsales force 9ill 7e focused on selling onl, its #roducts 9hereas inde#endent distri7utors ha(e co"#eting interests since the, 9ill also 7e selling #roducts fro" ri(al "anufacturers$ Ma, e(en 7e that the distri7utors #ro"otional acti(ities (iolate the "anufacturers intended i"age of the #roduct$ EThis is related to transactionsGcontracting costs 9hich is discussed in Cha#ter %$)
c$ A )iotech firm develops a ne" product that "ill )e produced, tested, and distri)uted )y an esta)lished pharmaceutical company$
The 7iotech fir" 9ould 7enefit fro" (ertical integration for se(eral reasons : •
•
•
Coordination Costs: -i(en the le(el of i"#ortance of the design attri7utes E"i! of co"#onent che"icals #erfor"ance s#ecifications etc$) for a ne9 7iotech #roduct the coordination of these acti(ities is critical for the #har"aceutical co"#an, to a(oid #otentiall, costl, "ista.es$ Lea.age of ri(ate Infor"ation: The 7iotech fir" 9ill li.el, ha(e to di(ulge #ro#rietar, #roduct infor"ation in order for the #har"aceutical co"#an, to "anufacture the ne9 #roduct$ s a result the 7iotech fir" ris.s gi(ing u# (alua7le #roduct design infor"ation that could 7e used 7, the #har"aceutical co"#an, to de(elo# a co"#eting #roduct$ Transaction Costs: In order to #re(ent the #har"aceutical co"#an, fro" #roducing or distri7uting a co"#eting #roduct the 7iotech fir" 9ould ha(e to incur significant contracting costs$ nforce"ent in #articular could 7e difficult gi(en the co"#le!it, of the #roduct$
0$ Consider the follo"ing pairs of situations$ (n each pair, "hich situation is more li/ely to )e suscepti)le to coordination pro)lems&
The .e, to anal,ing coordination #ro7le"s is in esti"ating ho9 costl, s"all errors are$ a$ Maintenance of a homeo"ner-s la"n )y a gardening company versus maintenance of a foot)all or soccer stadium-s grass turf )y a gardening company$
The "aintenance of a stadiu"s turf is "ore susce#ti7le to coordination #ro7le"s$ There could 7e se(eral reasons for this including: •
•
The s#ecific design attri7utes associated 9ith a co"#etiti(e #la,ing field such as the #articular t,#e of grass the length of grass etc$ re>uire significant attention to ensure the field "eets #la,ing standards$ The e!istence of these t,#es of design attri7utes 9ould necessitate careful contracting to a(oid the ris. of coordination 7rea.do9ns$ Ti"ing the gardening co"#an, "ust #erfor" its tas.s in ad(ance of and 7et9een ga"es and the 9atering and chal.ing of the stadiu"$ erfor"ing "aintenance after a s#ecified ti"e 9ould ha(e a significant negati(e i"#act on the stadiu" o9ner$ That is the stadiu" o9ner has a (er, stee# "arginal cost cur(e and "a, ha(e to
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i"#ose significant #enaltiesGincenti(es to counteract #otential coordination #ro7le"s$ )$ Design of a tool)o to hold tools versus design of a "afer to hold the "ires of a microscopic silicon chip$
The design of a 9afer to hold a silicon chi# 9ould 7e "ost susce#ti7le to coordination #ro7le"s$ s a7o(e ,ou could argue that design attri7utes and ti"ing could 7e t9o of the reasons for this: •
Design ttri7utes The chi# "anufacturer 9ill ha(e to s#ecif, the #articular di"ensions 9afer attri7utes "anufacturing #rocesses etc$ to ensure the #ro#er "anufacturing of the 9afers$ Ksing a "ar.et fir" to "anufacture the 9afer 9ill increase coordination costs since these s#ecifications 9ill ha(e to 7e detailed in the contract$
•
Ti"ing roduction of the 9afer 9ill ha(e to 7e scheduled to coincide 9ith the chi# "anufacturers schedule$
$ 2niversities tend to )e highly integrated L many departments all )elong to the same organi+ation$ There is not a technical reason "hy a university could not consist of freestanding departments lin/ed together )y contracts, much in the same "ay that a net"or/ organi+ation lin/s freestanding )usinesses$ %hy do you suppose that universities are not organi+ed in this "ay&
The underl,ing reasons 7ehind the e!istence of Aintegrated uni(ersities include: •
Coordination Costs: There are se(eral issues 9ith regard to coordination including: 1) ti"ing indi(idual de#art"ents "ust coordinate around a co""on acade"ic calendar and 2) se>uencing a co""on se>uence of courses to9ards degree re>uire"ents needs to e!ist$ rranging these ele"ents through contracts 9ould 7e e!tre"el, difficult and costl, to achie(e$
•
;rganiational Issues: The uni(ersit, de#art"ents are 7ound 7, ties of social si"ilarit, such that the, (alue their association 9ith each other in addition to an, "onetar, issues in(ol(ed in their de#art"ents$ This co""it"ent su##le"ents the "ore for"al go(ernances inside the uni(ersit, "a.ing internal go(ernance "ore effecti(e than "ar.et go(ernance$ Culture can also co"#le"ent for"al go(ernance "echanis"s 9ithin the uni(ersit, "a.ing the internal organiation "ore effecti(e than the "ar.et could 7e$ Contracting a co""on culture for a Anet9or.ed uni(ersit, #ro"ises to 7e (irtuall, i"#ossi7le$
•
cono"ies of +cale: B, re"aining integrated a uni(ersit, can ta.e ad(antage of se(eral econo"ies of scale including: 1) #urchasing econo"ies of scale 2) "ar.eting econo"ies of scale in attracting 7oth students and #rofessors %) the s#reading of fi!ed in(est"ents such as real estate infor"ation technolog, and s#ortsrelated in(est"ents and 4) the s#reading of ad"inistrati(e o(erhead$ These acti(ities could not 7e acco"#lished as efficientl, through contracting$
43
3$ %hy does assymetric information lead to inefficient actions&
Contracting is not feasi7le 9hen actions and infor"ation are not (erifia7le$ arties 9ho are una7le to contract "a, forgo the o##ortunit, to "a!i"ie the (alue of their co"7ined out#uts$ 7$ Some contracts, such as those )et"een municipalities and high"ay construction firms, are etremely long "ith terms spelled out in minute detail$ thers, such as )et"een consulting firms and their clients, are short and fairly vague a)out the division of responsi)ilities$ %hat factors might determine such differences in contract length and detail&
ualit, etc$ When #erfor"ance under a contract is e!tre"el, co"#licated to s#ecif, as one 9ould e!#ect in the case of the consulting contract it "a, 7e difficult to ela7orate each #art,s rights and res#onsi7ilities 9ithin a 9ritten contract$ The language in such contracts is often left (ague and o#enended 7ecause it is not clear 9hat constitutes fulfill"ent of the contract$ This >uestion is si"ilar to the carleasing e!a"#le used in the te!t$ 5$ <(f the corporate govenerance function can not protect specific assets, then firms may as "ell transact at arms4length$= Discuss$
The fir" ac>uiring the assets of another fir" ac>uires 9ith those assets the right to de#lo, the assets as the fir" sees fit$ Through integration a fir" can use its rights o(er ac>uired assets to ad@ust for e!a"#le the le(el of in(est"ent in relationshi# s#ecific in(est"ents to "a!i"ie the (alue of the integrated fir"$ The fir" relies on its internal go(ernance function to e!ecute its rights o(er ac>uired assets$ If internal go(ernance cannot facilitate the desired outco"e 7ecause the #arties in(ol(ed 9ith the transaction 7elie(e internal go(ernance is not strong enough to insure that all #arties 9ill reco(er at least the o##ortunit, cost of their o9n efforts Ethat is #arties still fear e!#ost hold u#) then the fir" "a, not see an increase in its (alue after integration$ 16$ Suppose that Arnold Sch"ar+enegger AS pays >esan/o, Dranove, and Shanley >DS an advance of 0 million to "rite the script to Incomplete Contract , a movie version of their immensely popular tet on )usiness strategy$ The movie contract includes certain script reJuirements, including the stipulation that AS gets to play a strong, silent )usiness strategist "ith superhuman analytic po"ers$ >DS spend 166,666 "orth of their time to "rite a script that is tailor4made for the e4Terminator AS, that is$ After revie"ing the script, AS claims that it fails to live up to the contractual reJuirement that he have several passionate love scenes, and he attempts to renegotiate$ ;iven the am)iguity over "hat constitutes passion, >DS are forced to agree$ a$ %hat "as >DS-s rent&
BD+ 'ent V ctual 'e(enue Mini"u" 'e(enue BD+ re>uires to enter the contract
45
V Q/000000 Q100000 V Q4&00$000 )$ %hat "as their Juasi4rent& %hat assumptions did you ma/e to compute the latter&
! ost ;##ortunit, Cost of the +cri#t V 0 Mini"u" 'e(enue BD+ 'e>uires to re(ent !it V ! ost ;##ortunit, Cost Y Faria7le Costs U 0 Y Q100000 V Q100000 6uasirent V ctual 'e(enue Mini"u" 'e(enue to re(ent !it Q/000000 Q0 V Q/000000 To co"#ute >uasirent 9e assu"e that the scri#t is tailor"ade for +ch9arteneggar and hence has no alternati(e (alue Eignoring the rec,cling (alue of the actual #a#er used)$ 11$ (n many modern 2$S$ industries the follo"ing patterns seem to hold: %hat factors might eplain these patterns& a$ Small firms are more li/ely to outsource production of inputs than are large firms9
+"all fir"s are "ore li.el, to outsource the #roduction of in#uts 7ecause the, are una7le to reach the necessar, scale efficiencies inhouse$ Fertical integration 9ould lea(e the" unco"#etiti(e$ )$ Standard inputs such as a simple transistor that can )e used )y several electronics manufacturers are more li/ely to )e outsourced than
Co"#le! in#uts are "ore li.el, to 7e "ade inhouse than standard in#uts 7ecause the s#ecificit, of these #roducts and the assets re>uired to #roduce the" leads to the Zhold u# #ro7le"$ The u#strea" fir" is at ris. fro" the e!#ro#riation of the #rofits it "a.es fro" the #roduction of the in#uts 9hich are 9orth less in alternati(e uses$ s a result the u#strea" fir" 9ill underin(est and fail to #roduce the in#uts at the o#ti"al le(el of >ualit, and efficienc, for the do9nstrea" fir" 9hich "a, also 7e e!#osed to high costs if there is an, su##l, disru#tion$ Therefore it is often "ore efficient for the do9nstrea" fir" to ta.e control of the #roduction of co"#le! in#uts the"sel(es$
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Chapter . rgani+ing Kertical >oundaries: Kertical (ntegration and its Alternatives Chapter Contents 1) Introduction 2) Technical fficienc, (ersus genc, fficienc, cono"iing • The Technical fficienc,Ggenc, fficienc, Tradeoff and Fertical Integration • 'ealWorld (idence • !a"#le 4$1: The Firtual Cor#oration Fertical Integration and sset ;9nershi# • !a"#le 4$2: Fertical Integration of the +ales
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Chapter Summary
This cha#ter e!a"ines 9h, (ertical integration differs across industries across fir"s 9ithin the sa"e industr, and across different transactions 9ithin the sa"e fir"$ The first #art of this cha#ter assesses the "erits of (ertical integration as a function of the industr, fir" and transactions characteristics$ It then #resents e(idence on (ertical integration fro" studies of a nu"7er of s#ecific industries including auto"o7iles aeros#ace and electric utilities$ The ne!t section e!a"ines 9hether there "ight 7e other factors a#art fro" those discussed in Cha#ter % that "ight dri(e a fir"s decision to (erticall, integrate$ This cha#ter focuses on t9o alternati(e classes of e!#lanation$ ;ne is theor, offered 7, +anford -ross"an and ;li(er Hart that stresses the role of asset "anage"ent and its effect on in(est"ents in relationshi# s#ecific assets as a .e, deter"inant of (ertical integration$ The second theor, anal,es A"ar.et i"#erfections "oti(ations for (ertical integration$ The final #ur#ose of this cha#ter is to e!#lore other 9a,s of organiing e!change 7esides ar"s length "ar.et contracting and (ertical integration$ The alternati(es discussed include: 1) ta#ered integration Ei$e$ "a.ing and 7u,ing) 2) @oint (entures and strategic alliances %) Ja#anese +eiretsu and 4) i"#licit contracts su##orted 7, re#utational considerations$
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Approaches to teaching this chapter Definitions genc, fficienc,: The e!tent to 9hich a fir"s ad"inistration andGor #roduction costs are raised due to transaction and coordination costs of ar"s length "ar.et e!changes or agenc, and influence costs of internal organiation$
Technical fficienc,: The e!tent to 9hich a fir" uses leastcost #roduction techni>ues$ Ta#ered Integration: co"7ination of (ertical integration and "ar.et e!changes$ Knder this #rocess the fir" "a.es so"e >uantit, of the in#ut internall, and 7u,s the rest fro" inde#endent fir"s$ +trategic lliance: T9o or "ore fir"s agree to colla7orate on a #ro@ect or to share infor"ation or #roducti(e resources$ Joint Fenture: #articular t,#e of strategic alliance 9here t9o or "ore fir"s create and @ointl, o9n a ne9 inde#endent organiation$ eiretsu: Close se"ifor"al relationshi#s a"ong 7u,ers and su##liers 7est e"7odied 7, the Ja#anese$ I"#licit Contract: Knstated understanding 7et9een #arties in a 7usiness relationshi#$ vervie" This cha#ter co(ers different seg"ents 9hich can 7e taught se#aratel,$ The first section is an e!tension of Cha#ter %$ This section discusses the tradeoffs that go into a decision of 9hether or not to (erticall, integrate$
+cale and sco#e econo"ics: fir" gains less fro" (ertical integration the greater the a7ilit, of outside "ar.et s#ecialists to ta.e ad(antage of econo"ics of scale and sco#e relati(e to the fir"$ •
roduct "ar.et scale and gro9th: fir" 7enefits "ore fro" (ertical integration the larger the scale of its #roduct "ar.et acti(ities$ •
sset +#ecificit,: fir" 7enefits "ore fro" (ertical integration 9hen #roduction of in#uts in(ol(es in(est"ents in relationshi#s#ecific assets$ •
t the end of this section real 9orld fir"s are e!a"ined to see if the, 7eha(e according to this theor, "uch e(idence suggests that the, do$ The ne!t section introduces an alternati(e theor, de(elo#ed 7, +anford -ross"an and ;li(er Hart for co"#aring (ertical integration 9ith "ar.et e!change$ The "ain #oint of this section is that in co"#aring (ertical integration 9ith "ar.et e!change it is i"#ortant to understand 9ho has the residual rights of control$ 'esidual rights of control are defined as the rights of control that are not e!#licitl, stated in the contract$
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If one thin.s of (ertical integration as the changing rights of control o(er .e, assets it affects the efficienc, of e!change$ The econo"ic (alue created is >uite different and it has an i"#ortant effect on the efficienc, of transactions$ The third section discusses the instances 9here co"#anies "ight 9ant to (erticall, integrate due to "ar.et i"#erfections$ It e!a"ines situations 9here (ertical integration is ai"ed at undoing the effects of "ar.et i"#erfections or increasing "ar.et #o9er$ This section "a, 7e s.i##ed 9ithout loss of continuit,$ The last section discusses alternati(es to (ertical integration and ar"s length "ar.et e!change$ It introduces four alternati(es na"el,: ta#ered integration @oint (entures the Ja#anese eiretsu and longter" i"#licit contracts$ The "ain #oint is that so"e econo"ic tradeoffs are useful in thin.ing a7out decisions and desira7ilit, of these organiations$ Technical vs$ Agency Efficiency The relationshi# 7et9een Technical and genc, efficienc, is one of the "ain the"es of this cha#ter$
T V cost of #roducing the acti(it, inhouse cost of #roducing the acti(it, 7, a "ar.et s#ecialist assu"ing that 7oth #roduce as efficientl, as #ossi7le$
*Transactions* cost 9hen acti(it, is #erfor"ed 7, a "ar.et s#ecialist is defined 7roadl, to include: direct costs of negotiating contracts costs of safeguards against holdu# costs of safeguards against holdu#$ • inefficiencies due to underin(est"ent in relationshi#s#ecific assets and lost • o##ortunities for cost sa(ings due to "istrust$ costs associated 9ith 7rea.do9ns in coordination and s,nchroniation 9hen • acti(it, is #urchased$ •
V *transactions* cost 9hen acti(it, is #roduced inhouse *transactions* cost 9hen acti(it, is #ro(ided 7, a "ar.et s#ecialist$
*Transactions* cost 9hen acti(it, is #roduced inhouse include: agenc, and influence costs that arise 9hen hardedged "ar.et incenti(es are re#laced 7, softedged incenti(es of internal organiation$ •
C V T Y V the full cost difference 7et9een (ertical integration and reliance on "ar.et s#ecialist$ When C is #ositi(e inhouse #roduction is more costl, than reliance on "ar.et s#ecialists 9hen C is negati(e inhouse #roduction is less costl, than reliance on "ar.et s#ecialists$
Managerial (mplications Belo9 are four general rules for "anagers of 9hen to rel, on the "ar.et and 9hen to #erfor" tas.s inhouse$
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1$
ely on mar+et for routine items= %roduce in6house items that re>uire s%ecific investments in design engineering or %roduction +now6how# sset s#ecificit, is high (ertical integration is 7est$ • sset s#ecificit, is lo9 reliance on "ar.et is 7est •
2$ ely on mar+et for items that re>uire large u% front investments in %hysical ca%ital or organi.ational ca%a)ilities that outside firms already have# When outside s#ecialist 7enefit fro" significant econo"ies of scale reliance on the "ar.et is 7est$ When inhouse di(ision can ca#ture nearl, all econo"ies of scale in acti(it, • (ertical integration is 7est$ •
%$ • •
Vertical integration is usually more efficient for )igger firms than for smaller#
Larger scale of #roduct "ar.et acti(ities (ertical integration is 7est$ +"aller scale of #roduct "ar.et acti(ities reliance on "ar.et is 7est$
4$ Technological advances in telecommunications and data %rocessing have tended to lower coordination costs ma+ing reliance on the mar+et more attractive# • •
Lo9 coordination costs reliance on "ar.et is 7est$ High coordination costs (ertical integration is 7est$
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Suggested Harvard Case Studies
Hude#ohl Bre9ing Co"#an, HB+ &%810&2 Esee earlier cha#ters) e#siCola Be(erages HB+ Case &%&00%4 Esee earlier cha#ters) hili#s Co"#act Disc Introduction HB+ &5&20%/ Esee earlier cha#ters) To"7o9 encil Co$ Ltd$ HB+ &3&2011 Esee earlier cha#ters)
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Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
nderson $ and D$C$ +ch"ittlein *Integration of +ales uences of 'egulating -asoline Distri7ution* egulation 1&&% ##$ 3%5/$ Ca(es '$ and D$ Barton Efficiency in 1S Manufacturing (ndustries Ca"7ridge: MIT ress 1&&0$ Chandler $D$ Jr$ Scale and Sco%e$ the *ynamics of (ndustrial Ca%italism Ca"7ridge M: Bel.na#1&&0$ Clar. '$ The :a%anese Com%any e9 Ha(en: ale Kni(ersit, 1&5&$ Da(ido9 W$H$ and M$+$ Malone The Virtual Cor%oration e9 or.: Har#er Business 1&&2$ -ross"an +$ and 0$ Hart *The Costs and Benefits of ;9nershi#: Theor, of Fertical and Lateral Integration* :ournal of &olitical Economy &4 1&83 ##$3&151&$ Jos.o9 $ *Fertical Integration and LongTer" Contracts: The Case of CoalBurning lectric -enerating lants* :ournal of /aw Economics and -rgani.ation %%
//
;h"ae $ *The -lo7al Logic of +trategic lliances* Harvard Business eview March#ril 1&8& ##$14%1/4$ err, M$$ *
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Ans"ers to End of Chapter #uestions 1$ %hy is the
The technical efficienc, line re#resents the "ini"u" cost of #roduction under (ertical integration "inus the "ini"u" cost of #roduction under ar"slength "ar.et e!change$ The technical efficienc, line is a7o(e the !a!is indicating that the "ini"u" cost of #roduction under (ertical integration is higher than the "ini"u" cost of #roduction under ar"s length "ar.et e!change irres#ecti(e of the le(el of asset s#ecificit,$ The reason costs are higher under internal organiation is that outside su##liers can aggregate de"ands fro" other 7u,ers and thus can ta.e 7etter ad(antage of econo"ies of scale and sco#e to lo9er #roduction costs$ The agenc, efficienc, line re#resents the transactions costs 9hen #roduction is (erticall, integrated "inus the transactions costs 9hen it is organied through an ar"s length "ar.et e!change$ The agenc, efficienc, line is #ositi(e for lo9 le(els of asset s#ecificit, and negati(e for high le(els of asset s#ecificit,$ When asset s#ecificit, is lo9 the #ro7a7ilit, of hold u# is lo9$ In the a7sence of a significant ris. of hold u# "ar.et e!change is li.el, to 7e "ore agenc, efficient than (ertical integration 7ecause inde#endent fir"s often face stronger incenti(es to inno(ate and to control #roduction costs than di(isions of (erticall, integrated fir"s Esee cha#ter %)$ genc, costs of "ar.et e!change increase 9ith the le(el of asset s#ecificit,=a7o(e so"e threshold of asset s#ecificit, using the "ar.et entails higher transactions costs than using an internal organiation$ '$ Eplain "hy the follo"ing patterns seem to hold in many industries: a$ Small firms are more li/ely to outsource production of inputs than are large firms$
A+tandard in#uts are "ore li.el, to 7e outsourced than Atailor"ade in#uts for t9o reasons$
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+econd 9hen outsourcing tailor"ade in#uts it is difficult to "onitor #erfor"ance and >ualit,$ ualit, e!#ectations in a contract is usuall, not feasi7le$ The outside fir"s 9ould incur higher transactions costs$ In addition the increase in design s#ecifications and co"#le! co"#onents 9ould accentuate the ad(antages of (erticall, integrating according to the assets#ecificit, h,#othesis$
ssu"ing inco"#lete contracts -ross"an and Harts argu"ent is su""ed as follo9s: •
;9nershi# rights deter"ine the resolution of the "a.eor7u, decision$ The o9ner of an asset has residual rights of control not s#ecified in the contractual agree"ent$
•
When o9nershi# is transferred these residual rights are #urchased$ The, are lost 7, the selling #art, 9hich funda"entall, changes the legal rights of that #art,$
•
There are t9o t,#es of decisions: contracti7le E(erifia7le o#erating decisions) and noncontracti7le Eun(erifia7le u#front in(est"ents in relationshi# s#ecific assets)$ When negotiations 7rea. do9n control o(er o#erating decisions re(erts to the #art, 9ith residual right of control o(er rele(ant assets$
•
The #o9er in the relationshi# is deter"ined 7, the nature of the (ertical integration$
•
;9nershi# should 7e gi(en to the unit 9hose in(est"ents ha(e the strongest i"#act on the total #rofits of the (enture$
7ro.erage fir"s assets are tied to each of its clients and clients are the largest source of total #rofits of the fir"$ The nature of the relationshi# 7et9een a stoc.7ro.er and client is relationshi#s#ecific$ The 7ro.er has o9nershi# of each of hisGher clients$ The 7ro.er is in(esting the ti"e and infor"ation into de(elo#ing these relationshi#s$ Therefore the 7ro.er has the o9nershi# of those assets$ ccordingl, the 7ro.er has residual rights to the o9nershi# and control of clients$ When o9nershi# of the 7ro.er changes the 7ro.ers relationshi#s#ecific assets the selling #art, the original 7ro.erage fir" loses the clients$ While o9nershi# of s#ecialied #h,sical assets can 7e transferred o9nershi# of s#ecialied hu"an ca#ital cant 7e$ The 7ro.erage house si"#l, #ro(ides #roducts$ It is the 7ro.er 9ho sources and ser(ices their clientele$ The nature of the #roduct Estoc. trades) dictates that 7ro.erage houses allo9 the stoc. 7ro.ers to .ee# client lists$ Custo"ers often ha(e an incenti(e to s9itch their 7ro.erage 7usiness to o7tain 7etter (alue for "one,$ This is #articularl, true for clients doing high (olu"e of trades$ In these circu"stances it 7eco"es i"#ortant for the 7ro.er to generate e!tra effort to .ee# the client$ If the 7ro.er has the o9nershi# of the asset Eclient list) he is not su7@ect to ?holdu#? 7, the 7ro.erage house$ If he did not o9n the client list the 7ro.erage house could force the 7ro.er to acce#t lo9er
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co""issions$ This 9ould reduce the incenti(e for the 7ro.er to tr, hard to generate 7usiness for the 7ro.erage house$ .$ Analysts often array strategic alliances and oint ventures on a continuum that )egins "ith
o$ lliances and @oint (entures fall so"e9here 7et9een ar"slength "ar.et transactions and full (ertical integration$ s in ar"s length "ar.et transactions the #arties to the alliance re"ain inde#endent 7usiness organiations$ But a strategic alliance in(ol(es "uch "ore coordination coo#eration and infor"ation sharing than an ar"s length transaction$ @oint (enture is a #articular t,#e of strategic alliance in 9hich t9o or "ore fir"s create and @ointl, o9n a ne9 inde#endent organiation$ The fir"s in(ol(ed 9ith a @oint (enture integrate a su7set of their fir"s assets 9ith the assets of one or "ore other fir"s$ 0$ %hat does the eiretsu system have in common "ith traditional strategic alliances and oint ventures& %hat are some of the differences&
eiretsu are closel, related to su7contractor net9or.s 7ut the, in(ol(e a so"e9hat "ore for"alied set of institutional lin.ages$ Ksuall, the .e, ele"ents of the (ertical chain are re#resented in a .eiretsu$ The fir"s in a .eiretsu e!change e>uit, shares and #lace indi(iduals on each others 7oards of directors=K$+$ fir"s are in "an, cases #rohi7ited fro" these #ractices under the K$+$ antitrust la9s$ $ The follo"ing is an ecerpt from an actual strategic plan company and product names have )een changed to protect the innocent:
Acme@s %rimary raw material is &VC sheet that is %roduced )y three maor vendors within the 1nited States# Acme a small consumer %roducts manufacturer is consolidating down to a single vendor# Continued growth )y this vendor assures Acme that it will )e a)le to meet its needs in the future# Assume that AcmeNs chosen vendor "ill gro" as forecast$ ffer a scenario to Acme management that might convince them that they should rethin/ their decision to rely on a single vendor$ %hat do you recommend that Acme do to minimi+e the ris/s that you have identified& Are there any dra")ac/s "ith your recommendation&
c"e "ust ha(e a (alid reason for using a single su##lier$ .e, "erit of c"e?s a##roach is asset s#ecificit, on the (endor?s side 9hen the (endor "ight 7e encouraged to "a.e s#ecific in(est"ents$ Ho9e(er there is the #otential of holdu# #ro7le"s created 7, decreasing the nu"7er of (endors do9n fro" three to one$ The li.elihood of holdu# #ro7le"s 9ould de#end on the degree of asset s#ecificit, and s9itching costs$ The a"ount of i"#licit and e!#licit costs related to holdu# #ro7le"s 9ould de#end on the le(el of in(entor, custo"ers? e!#ectations and 7rand re#utation$
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In order to "ini"ie its ris.s c"e could second source or 7ac.9ard integrate E#artiall, or full,)$ +econd sourcing or 7ac.9ard integration #rotects the fir" fro" holdu# 7ut "a, dri(e costs 7, reducing #urchasing discounts increasing #roduction coordination and re>uiring additional in(est"ents 7, the second source$ n alternati(e solution 9ould 7e for c"e to consider ta#ered integration$ Ta#ered integration #oses the usual "a.eor7u, #ro7le"s such as high costs coordination #ro7le"s and #oor incenti(es$ 3$ Shaefer Electronics is a medium4si+e producer a)out 17 million in sales in 155* of electronic products for the oil industry$ (t ma/es t"o main products 4 capacitors and integrated circuits$ Capacitors are standardi+ed items$ (ntegrated circuits are more comple, highly customi+ed items made to individual customer specifications$ They are designed and made to order, they reJuire installation, and sometimes reJuire post4sale servicing$ ShaeferNs annual sales are sho"n in the ta)le )elo"$ Shaefer relies entirely on manufacturersN representatives M!Ns located throughout the 2nited States to sell its products$ M!Ns are independent contractors "ho sell ShaeferNs products in echange for a sales commission$ The companyNs representatives are not eclusive 4 they represent manufacturers of related )ut non4competing products such as circuit )rea/ers, small s"itches, or semiconductors$ ften a customer "ill )uy some of these related products along "ith integrated circuits or an order of capacitors$ M!Ns have long eperience "ithin local mar/ets, close ties to the engineers "ithin the firms that )uy control systems, and deep /no"ledge of their needs$ (n the mar/ets in "hich they operate, M!Ns develop their o"n client lists and call schedules$ They are fully responsi)le for the epenses they incur in selling their products$ nce the M! ta/es an order for one of Shaefer-s products, Shaefer is then responsi)le for any installation or post4sale servicing that is needed$ Shaefer recently hired t"o different mar/eting consultants to study its sales force strategy$ Their reports contained the conclusions reported )elo"$ ?lease comment on the soundness of each conclusion$ a$ OShaefer should continue to sell through M!Ns$ %hether it uses M!Ns or an in4house sales force, it has to pay sales commissions$ >y relying on M!Ns, it avoids the varia)le selling epenses e$g$, travel epenses for salespeople it "ould incur if it had its o"n sales force$ As a result, ShaeferNs selling epenses are lo"er than they "ould )e "ith an in4house sales force of compara)le si+e, talent, and /no"4 ho"$O
The conclusion of this "ar.eting consultant is unsound it is "a.eor7u, fallac, O1 the fallac, states that a fir" should 7u, rather than "a.e 7ecause 7, doing so it a(oids setu# and #roduction costs associated 9ith "a.ing$ In this #articular case +haefer does not a(oid (aria7le selling e!#enses 7, rel,ing on M'?s$ resu"a7l, the M's 9ill negotiate a co""ission rate that 9ill allo9 the" Eo(er so"e reasona7le #eriod of ti"e) to co(er their (aria7le selling e!#enses such as tra(el costs$ This rate 9ill 7e higher than the rate that +haefer 9ould #a, to other9ise e>uall, talented .no9ledgea7le and #roducti(e inhouse sales #eo#le 9hose selling e!#enses 9ill 7e rei"7ursed directl, 7, +haefer rather than indirectl, through the co""ission$
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)$ OSelling through M!Ns made sense for Shaefer "hen it "as first getting started and speciali+ed in capacitors$ Ho"ever, given its current product mi, it "ould not "ant to set itself up the "ay it is no" if it "ere designing its sales force strategy from scratch$ >ut "ith "hat it has got, Shaefer should )e etremely cautious a)out changing$O
Initiall, +haefer utilied outside sales re#resentati(es to "ar.et its standardied #roducts in 1&80$ Historicall, fir"s relied on inde#endent "ar.eting agents to sell and distri7ute fairl, standardied #roducts$ This strateg, "ade sense 7ecause the selling #rocess did not re>uire s#ecialied .no9ho9 or e!#ertise to sell according to the assets#ecificit, h,#othesis$ Ho9e(er there are li"its to econo"ies of scale and sco#e in selling and distri7uting custo"ied #roducts$ If +haefer 9as de(elo#ing its sales force strateg, in 1&&% it 9ould "a.e sense for +haefer to esta7lish an internal sales force fro" scratch$ +haefer is selling standardied and custo"ied #roducts 9hich do not hold si"ilar sales strategies$ M'?s are #ro7a7l, not the 7est 9a, to sell custo"ied #roduct such as the ICs$ uiring s#ecialied in(est"ents in hu"an ca#ital or in e>ui#"ent and facilities$ nother factor against ha(ing the M'?s selling the ICs is coordination costs$ Knder the current arrange"ent an M' 9ho then has to co""unicate 9ith +haefers design and "anufacturing #eo#le to de(elo# the s#ecs for the custo"ers order "a.es the sale$ nd after the sale has 7een co"#leted the M' 9ould ha(e to arrange 9ith +haefer for installation and #ostsale ser(icing$ Ksing M's sales staff "a, co"#ro"ise coordination 7et9een design "anufacturing sales and installation and #ostsale custo"er ser(ice$ This situation lea(es +haefer (ulnera7le to co"#etitors 9ho can #erfor" the order ta.ing design "anufacture deli(er, and installation "ore >uic.l, than +haefer$ In addition the sales#erson?s #ersonal relationshi# 9ith the custo"er is #articularl, i"#ortant for de(elo#ing a longter" sales strateg,$ In this *relationshi#s#ecific* situation +haefer 9ill need to #ro(ide #ostsale ser(icing and #otentiall, sell future #roducts$ If the sales #rocess 7egins 9ith an M' a custo"er?s #ri"ar, lo,alt, "a, 7elong to the M' rather than to +haefer$ The M'?s *o9nershi#* of the client list 9ould #ro(ide it 9ith considera7le 7argaining #o9er o(er +haefer 9hich 9ould "a.e it difficult for +haefer to: E1) .ee# costs and sales co""ission lo9 E2) enforce sales >uotas and E%) control the ti"e the M'?s s#end #ushing +haefer?s #roducts (ersus other #roducts$ We dont .no9 for sure that an, of these #ro7le"s are actuall, occurring 7ut one slight 7it of e(idence that "a, 7e suggesti(e of a #ro7le" is that since 1&&0 +haefers sales of integrated circuits ha(e gro9n less ra#idl, than the industr, as a 9hole 9ould #redict$ Ksing contracts andGor co""ission schedules 9ould assist in "onitoring #erfor"ance ho9e(er this arrange"ent 9ould 7eco"e relati(el, "ore costl,$ Therefore 9hen transactions in(ol(e relationshi#s#ecific assets *"a.ing* is often #referred to *7u,ing$* ;(erall in the IC 7usiness +haefer is not @ust selling a #h,sical #roduct it is selling its ca#a7ilities to custo" design #roduce and install a de(ice that 9ill sol(e a #articular need for a #ros#ecti(e custo"er$ n inhouse sales #erson is li.el, to ha(e "ore
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s#ecific .no9ledge of +haefer?s a7ilit, to ada#t its designs to sol(e #articular custo"er needs than an M' 9ho 9ould 7e una7le to #ro(ide si"ilar and e!tensi(e details due to its (arious #roducts$ While it is true that M's .no9 a lot a7out their clients? needs and #ro7a7l, .no9 so"ething a7out the ca#a7ilities of the "anufacturers the .e, >uestion is: is the M's? .no9ledge a7out +haefer?s #roducts sufficient enough to allo9 +haefer to co"#ete effecti(el, against ri(als 9ho are aggressi(el, #ushing their a7ilities to sol(e s#ecific custo"er #ro7le"s$ ;f course this line or argu"ent 7egs the >uestion of 9h, +haefer could not #ro(ide training for its M'?s to enhance their .no9ledge a7out +haefer?s #roducts$ #ossi7le ans9er relates to the earlier discussion of asset s#ecificit,$ ro(iding an M' 9ith training a7out the ca#a7ilities and technological s#ecifications of +haefer?s #roducts creates relationshi#s#ecific assets that further ce"ent the de#endence of +haefer on its "anufacturer re#s$ The #ossi7ilit, that its M's "ight engage in holdu# reduces the "arginal (alue of an, in(est"ent +haefer "ight "a.e in its relationshi# 9ith the"$ Thus 9hile #ro(iding training to the M'?s "a, see" li.e a good idea in #rinci#le it is far fro" clear that its 7enefits out9eigh the costs$ The a7o(e considerations 9ould argue against using M's in the first #lace 9hen starting a sales force fro" scratch$ Ho9e(er note that if +haefer needed to decide 9hether to alter its current situation then other considerations 9ould affect +haefer?s decision$ ri"aril, the iron, of relationshi#s#ecific assets is that the, can create de#endenc, relationshi#s that are difficult or costl, to 7rea.$ Des#ite the #otential hold u# #ro7le"s for higher co""issions and 9or.ing less 9ith M'?s the u# front costs of de(elo#ing relationshi#s 9ith clients and learning ho9 to sell +haefer?s #roducts are less than starting an inhouse sales force fro" scratch at this ti"e$ The le(el of attracti(eness of M's is higher at this current #oint than it 9ould ha(e 7een if +haefer 9ere designing its sales force strateg, fro" scratch$
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Chapter 0 Diversification Chapter Contents
1) 2) • •
%) • • •
4) • • •
/) 3)
Introduction !a"#le /$1: Changes in Di(ersification uiring for +,nerg,: Ban."erica Bu,s Continental otential Costs of Di(ersification Managerial 'easons for Di(ersification Benefits to Managers fro" c>uisitions ro7le"s of Cor#orate -o(ernance The Mar.et for Cor#orate Control and 'ecent Changes in Cor#orate -o(ernance erfor"ance of Di(ersified
3%
Chapter Summary
This cha#ter #ro(ides a logical continuation of the discussion on (ertical and horiontal 7oundaries$ Cha#ters 2% and 4 loo.ed at the 7enefits and costs of integration$ The current cha#ter e!a"ines the nu"erous rationales for di(ersification$ We argue that 9hile all reasons for di(ersification "a, logicall, follo9 the "anagers #ers#ecti(e as an agent to co"#an, shareholders so"e reasons "a.e "ore econo"ic sense than do others$ Di(ersification has no dou7t #la,ed an i"#ortant role in sha#ing the landsca#e for "erican 7usinesses$ ;(er the last centur, fir"s ha(e e!#erienced four 9a(es of di(ersification$ The first 9a(e started at the turn of the 20 th centur, 9ith the creation of trusts and later holding co"#anies that #ro(ided structure to o#ti"ie decisions reduce co"#etition and achie(e econo"ies of scale for a grou# of fir"s$ With antitrust la9s in #lace the second 9a(e occurred during the 1&20s 9hen nu"erous co"#anies integrated to create "a""oth cor#orations 9hich ulti"atel, turned "an, industries into oligo#olies$ The 1&30s e!#erienced the third 9a(e 9hen conglo"erates gre9 7, ac>uiring unrelated 7usinesses$ The final and fourth 9a(e in the 1&80s sa9 hea(il, le(eraged in(est"ents as a 9a, to 7ring under(alued 7usinesses into conglo"erate organiations$ cono"ies of sco#e #ro(ide the #ri"ar, rationale for di(ersification$ These econo"ies can 7e deri(ed 7, selling similar %roducts $ uisitions for reasons of financial di(ersification alone add little (alue to shareholder 9ealth since shareholders the"sel(es can di(ersif, through ca#ital "ar.ets as or e(en "ore efficientl,$ Li.e9ise di(ersification ai"ed at redistri7uting ca#ital fro" one 7usiness to another can 7e "ore efficientl, #erfor"ed in the financial "ar.ets since financial institutions generall, ha(e e!#ertise in #ro(iding 7an.ing functions$ Lastl, if a fir" is under(alued then efficient ta.eo(er "ar.ets 9ill 7idu# the A7argain target fir" until the unrealied (alue is 7id a9a,$ Di(ersification can econo"ie on transaction costs if coordination a"ong the inde#endent fir"s ha(e higher transaction costs or holdu# #ro7le"s due to relationshi#s#ecific in(est"ents$ Ho9e(er the "erged fir" 9ill face influence costs and "ore incenti(e effects than inde#endent fir"s nor"all, face$ lternati(e a##roaches to "ergers such as @oint (entures strategic alliances or "inorit, #artici#ation can i"#ro(e on the transaction costs #ro7le"s of integration 7ut ha(e
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their o9n go(ernance issues$ Managerial incenti(es that are not aligned 9ith the o7@ecti(es of the shareholders "a, #ro"#t e!ecuti(es to #ursue unrelated ac>uisitions "an, of 9hich do not create (alue$ +uch di(ersification carries agenc, costs$ Managers "a, di(ersif, as a "eans to "aintaining e!ecuti(e #ositions$ uasirent 7ecause the ne9 o9ners do not recognie the i"#licit contracts 7et9een a fir" and its sta.eholders$ The, 7elie(e this affects the entire econo", 7ecause sta.eholders in other fir"s o7ser(e the redistri7ution of 9ealth and 7eco"e hesitant to "a.e fir"s#ecific in(est"ents$ This lac. of in(est"ent decreases the (alue of fir"s throughout the econo",$ ee#ing agenc, costs in "ind it is little sur#rise that se(eral studies ha(e sho9n that di(ersified fir"s generall, #erfor" #oorl, in the long run$ Michael orter found that nearl, onethird of all ac>uisitions 7et9een 1&/0 and 1&8/ e(entuall, chose to di(est$ Larr, Lang and 'ene +tult #ro(ide further e(idence that o(erdi(ersification can lead to cor#orate inefficienc,$ +ince the 1&80s 7usinesses ha(e 7egun to focus "ore on ac>uisition of "ore closel, related 7usinesses$ The result has 7een "ore #ositi(e returns on in(est"ent$ In su" di(ersification can create (alue although the 7enefits %er se relati(e to nondi(ersification re"ain ne7ulous and eas, to "is"anage$ The lac. of clear association 7et9een si"#le "easures of di(ersit, 9ithin a 7usiness #ortfolio and o(erall cor#orate #erfor"ance contri7utes to the challenges of defending or ad(ocating di(ersification$
3/
Approaches to Teaching this Chapter Definitions
Di(ersification$ The act of #roducing in "ore than one #roduct "ar.et$ Conglo"erates$
• • • •
Financial !easons 'educes the ris. of #erfor"ance Internal Ca#ital Mar.ets 'educe 'is. of 7an.ru#tc, Ta! d(antages
Managerial !easons Managers li.e e"#ire 7uilding • ersonal stoc. o9nershi# • Hostile Ta.eo(ers E+hleiferG+o"ers argu"ent) • Career concerns Ereducing ris. of getting fired 7etter career #aths incenti(es) • Managerial entrench"ent •
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ther !easons Managerial econo"ies Erecruiting to# "anage"ent 7ench"ar.ing "anagers) • Mar.et o9er • -enerall, not that i"#ortant to 7roadl, di(ersified fir"s$ Ho9e(er there are • interesting #oints to discuss$ Multi#oint contact "a, 7e a 9a, of sustaining collusion$ If a fir" is es#eciall, • large it "a, esta7lish "ulti"ar.et contact$ +ince a large di(ersified co"#an, 9ill face ri(als in "an, "ar.ets there are lots of strategic o#tions a(aila7le if it can sustain collusion$ This is essentiall, a re#eated #risoners dile""a ga"e since the large fir" 9ill faceoff in "an, "ar.ets and can retaliateG"a.e "o(es in "an, "ar.ets$ E+ee Disne, article referenced under e!tra reading) Dee# #oc.ets "a, facilitate #redator, 7eha(ior$ B, di(ersif,ing a fir" "a, 7e • a7le to achie(e Adee# #oc.ets and 7eco"e a fiercer co"#etitor and engage in #redator, #ricing$ n e!a"#le of this is the MicrosoftGIntuit deal$ ntr, 7arriers •
s. students to #re#are thoughts on the follo9ing 7efore the lecture: • • •
!a"#les of conglo"erates The unrelated di(ersification of ITTITT +heraton ITT Holdings ITT Industries Ehotels insurance auto"oti(e #arts) +trengths that nheuser Busch is le(eraging 9ith agle +nac.
6uestions ,ou "a, 9ant to as.: • • •
Knder 9hat circu"stances is a co"#an,s strateg, of reducing ris. (alua7le for shareholders Knder 9hat circu"stances is it (alua7le for "anagers When 9ould it "a.e sense to tie the 7onus for a C; not onl, to the #erfor"ance of the co"#an, 7ut also to the #erfor"ance of other fir"s in the industr,
35
Suggested Harvard Case Study 0
Ban. ;ne 1&&% HB+ &%&404%$ This case e!#ores geogra#hic and #roduct di(ersification of a K$+$ Asu#erregional 7an. during a #eriod of industr, deregulation$ It also deals 9ith ac>uisition as a "ode of di(ersification$ Coo#er Industries Cor#orate +trateg, E) &%&10&/$ This case descri7es the de(elo#"ent of a successful cor#orate strateg, 7ased on the ac>uisition and su7se>uent consolidation of lo9technolog, "anufacturing co"#anies$ House of Tata HB+ &5&203/ Esee earlier cha#ters) e#siCo: Fie9 fro" the Cor#orate ;ffice HB+ &3&%058$ This case descri7es the three 7usiness seg"ents of e#siCo E7e(erages snac. foods and restaurants)$ It then e!#lores the co"#etiti(e en(iron"ent 9ithin each seg"ent and the res#onses of e#siCos 7usinesses$ The case is useful for "oti(ating a discussion a7out 9hether or not the s,nergies 9ithin this organiation "erit the fir" continuing as is or is a change to the organiation is 9arranted$ The case 9ill also generate a discussion a7out 9hat organiation encourages or discourages the s,nergies a"ong seg"ents$ +i"e Dar7, Berhad=1&&/ HB+ &5&5015 Esee earlier cha#ters)
/
These descri#tions ha(e 7een ada#ted fro" Harvard Business School 3445647 Catalog of Teaching Materials#
38
Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
Boston Consulting -rou# &ers%ectives on E8%erience# Boston: Boston Consulting -rou# 1&50$ AClash of Titans: Disne, Ti"e Warner Just ee# Bu"#ing K# gainst ach ;ther "all Street :ournal #ril 14 1&&%$ Collis D$J$ and C$$ Montgo"er,$ Cor#orate +trateg,: 'esource Based##roach Boston M: Ir9in Mc-ra9Hill 1&&8$ -oold M$ Ca"#7ell $ and M$ le!ander$ Cor%orate /evel Strategy$ Creating Value in the Multi)usiness Com%any# e9 or.: John Wile, and +ons Inc$ 1&&4$ Hos.isson '$$ and M$ $ Hitt$ *ownsco%ing$ How to Tame the *iversified 0irm#;!ford K$$: ;!ford Kni(ersit, ress 1&&4$ Jensen M$C$ Acli#se of the u7lic Cor#oration Harvard Business eview +e#te"7er;cto7er 1&8&$ Mortgo"er, C$$ ACor#orate Di(ersification :ournal of Economic &ers%ectives +u""er 1&&4 #ages 13%158$ 'u"elt '$ $ Strategy Structure and Economic &erformance# Boston: Di(ision 'esearch -raduate +chool of Business d"inistration 1&54$ Tanne7au" J$ ADi(ersification -i(es e9 +#ice to 'estaurants$ "all Street :ournal Ma, 8 1&&/$
3&
Ans"er to End of Chapter #uestions 1$ The main reason that firms diversify is to achieve economies of scope$ Discuss$
The e!#loitation of econo"ies of sco#e is a traditional efficienc, enhance"ent rationale for di(ersification$ If econo"ies of sco#e e!ist it is less costl, for a #roducer of #roduct to "o(e into the #roduction of #roduct B than it 9ould 7e for a ne9 fir" to enter the "ar.et for #roduct B$ The sources of sco#e econo"ies 9ere e!#lored in cha#ter 2$ Ho9e(er the e"#irical e(idence on di(ersification does not a##ear to 7e 9ell e!#lained 7, the #ursuit of traditional sco#e econo"ies$ rahalad and Bettis argue that "anagers of di(ersified fir"s "a, see the"sel(es as deri(ing econo"ies of sco#e though their #roficienc, in s#reading scarce to# "anage"ent s.ills across no"inall, unrelated 7usiness areas= so called do"inant general "anage"ent logic$ This logic a##lies "ost directl, 9hen "anagers de(elo# s#ecific s.ills and see"ingl, unrelated 7usinesses rel, on these s.ills for success$ Ho9e(er the do"inant general "anage"ent logic is "ista.enl, a##lied 9hen "anagers de(elo# #articular s.ills 7ut di(ersif, into 7usinesses that do not re>uire the" or "anagers #ercei(e the"sel(es as #ossessing a7o(ea(erage general "anage"ent s.ills 9ith 9hich the, can @ustif, an, di(ersification$ In addition to econo"ies sco#e three 7road rationales for di(ersification are financial s,nergies econo"iing on transactions costs and #ursuit of "anagerial Eo(er fir") o7@ecti(es$ The financial s,nergies rationale argues that the longter" success of a gro9ing fir" re>uires it to de(elo# a #ortfolio of 7usinesses that assures an ade>uate and sta7le cash flo9 9ith 9hich to finance its acti(ities$ lthough #ortfolio strategies "a, s"ooth cash flo9s and #ro# u# e!#anding or trou7led 7usinesses the, do not necessaril, create additional (alue for the o9ners of the fir"s$ cono"ist Da(id Teece argues that the "ulti#roduct fir" is an efficient choice 9hen coordination a"ong inde#endent fir"s is co"#licated 7, transactions costs and the associated hold u# #ro7le"s$ transactions costs e!#lanation for horiontal di(ersification is analogous to the e!#lanation for (ertical integration #resented in cha#ters 4 and /$ Both (ertical and horiontal relationshi#s often in(ol(e relationshi# s#ecific in(est"ents$ When the selfinterested 7eha(ior of inde#endent fir"s @eo#ardie the (alue of these in(est"ents integration is a solution$
Henr, Manne has argued for the e!istence of a "ar.et for cor#orate control$ ccording to Manne cor#orate control is a (alua7le asset that e!ists inde#endentl, of econo"ies of scale and sco#e$ If this is so then a "ar.et for this control e!ists and o#erates such that the "ain #ur#ose of a "erger is to re#lace one "anage"ent tea" 9ith another$ The "anage"ent tea" in charge of a fir" "ust continuall, generate "a!i"al (alue for shareholders$ If a tea" fails to generate sufficient (alue o7ser(ers of the fir" 9ill notice this #oor #erfor"ance and co"#eting "anage"ent tea"s can dis#lace the incu"7ents (ia ta.eo(er$ The #otential for co"#etiti(e 7idding once a tender offer has 7een "ade 9ill ensure the highest (aluation for fir"s and the largest return for shareholders$ Ho9e(er the successful 7idder "a, need s#ecialied .no9ledge andGor
50
resources to 7ring to a co"7ination or else the e!#ected 7enefits fro" the ta.eo(er "a, not 7e achie(ed due to #oor i"#le"entation or "a, e(en ha(e 7een 7id a9a, in the auction that follo9ed the initial tender offer$ The i"#lication is that the "ar.et for cor#orate control argu"ent needs to 7e su##le"ented 7, a sco#e or Arelatedness argu"ent$ 'ichard 'u"elt "easured Arelatedness according to ho9 "uch of a fir"s re(enues 9ere attri7uta7le to #roduct "ar.et acti(ities that had shared or related technological characteristics #roduction characteristics or distri7ution channels$ If the 7idder does not #ossess assets that can 7e co"7ined 9ith the assets of the ac>uisition that together 9ould generate "ore (alue than these assets 9ould generate se#aratel, it is li.el, that the ac>uirer has o(er#aid for the ac>uisition$ *$ Ho" is epansion into ne" and geographically distinct mar/ets similar to diversification& Ho" is it different&
-eogra#hic e!#ansion "a, 7e "oti(ated 7, reasons si"ilar to those for di(ersification: cono"ies of +co#e$ !#ansion "a, allo9 the fir" to s#read the cost of tas.s such as de(elo#"ent research esta7lishing 7rand e>uit, or financial s,ste"s$ B, e!#anding into a "ar.et 9ith si"ilar re>uire"ents as the esta7lished "ar.et a fir" needs little additional in(est"ents to de(elo# s.ills in these tas.s to rea# 7enefits in the fir"s e!#anded "ar.et$ uit,$ uisition the 7u,er "a, change organiational routines of the ac>uired fir" and "a, ha(e no co""it"ent to "aintain the e!isting i"#lied contracts$ In geogra#hical e!#ansion the fir" re"ains one and thus "ore li.el, #er#etuates Eor e(en reinforces) routines and i"#lied contracts alread, esta7lished$ Ta! d(antages$ Di(ersification through ac>uisition of a highl, le(erage fir" can #ro(ide a ta! shelter for a 7u,er 9ith e!cess cash flo9$ International e!#ansion in addition to ta! shelter ad(antages can use differences in ta! and tariff rates to ta.e e!#loit "ore #rofita7le transfer #ricing sche"es$
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Learning Cur(e$ Di(ersification naturall, leads "anagers to learn ne9 lines of 7usiness or industr, #ractices$ -eogra#hical e!#ansion on the other hand allo9s "anagers to learn local conditions that hel# the" further entrench in the sa"e 7usiness line$ Managers in other geogra#hical regions accelerate the fir"s learning o(erall learning cur(e 7, sharing infor"ation regarding the sa"e 7usiness$ Culture$ The nature of cultural 7arriers "a, differ significantl, and hence influence coordination costs$ Di(ersification "a, lead to issues regarding ho9 to "esh differing "anage"ent st,les and fir" cultures$ -eogra#hic e!#ansion #articularl, those into international territories "a, need to face issues in addition to those "entioned a7o(e such as language and ethnic differences$
The first #art of this ans9er dra9s fro" ,ans and Stern The roduct Mar.et and the Mar.et for AIdeas: Co""ercialiation +trategies for Technolog, ntre#reneurs Consider the target fir" as an Aidea Ethat is a set of intellectual #ro#ert,)$ +u##ose the Aidea can 7e #rotected E.e#t #ro#rietar,) D the s#ecialied co"#le"entar, assets Einfrastructure needed for full co""ercialiation) are difficult to re#licate$ Here the suggestion is that the inno(ator "ight 7e ac>uired 7, a fir" 9ho o9ns the co"#le"entar, assets$ Both fir"s Etarget and ac>uirer) are e"#o9ered in the negotiation #rocess: the inno(ator is e"#o9ered 7, the #ro#rietar, nature of their idea and the o9ner of the co"#le"entar, assets is e"#o9ered 7, the necessit, and scarcit, of these assets$ 7 The ac>uiring fir" earns a return on their o9nershi# of s#ecialied co"#le"entar, assets and inno(ators earn a return on their ideas$ Here there is a gain fro" the ac>uisition$ nother scenario in 9hich ac>uiring "ight #a, off: the idea is difficult to .ee# #ro#rietar, the s#ecialied co"#le"entar, assets are difficult to re#licate Ere#utation7ased ideas trading): Here if the fir"s 9ith s#ecialied and difficult to re#licate assets also ha(e e!cess ca#acit, in those assets it 9ould 7e in their interest to 7uild a re#utation for ;T Astealing ideas that are #itched to the" 7ut rather licensing or ac>uireing these ideas Eagain e(en though the idea is difficult to .ee# #ro#rietar, and 9ould 7e eas, to co#, resist this te"#tation)$ The fir" 9ho de(elo#s a re#utation for ac>uiring idea fir"s rather than [email protected] ideas 9ill get a good idea flo9 and .ee# their co"#le"entar, assets used at ca#acit, rather than facing #otential idle ti"es$ -oing along another #ath: Di(ersification "a, "aintain so"e (alue to a fir" that has the #otential for catastro#he such as 7an.ru#tc,$
If the inno(ator atte"#ted to de(elo# these assets fro" scratch it is #ossi7le sGhe 9ould not succeed andGor the creation of these assets 7, t he inno(ator 9ould not 7e cost effecti(e$
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7usinesses 9ithin hilli# Morris #ro(ide #rotection fro" co"#lete 7an.ru#tc, should the fir" lose its to7acco 7usiness$ nother line of reasoning that assu"es that ca#ital "ar.ets are not efficient a fir" can hel# di(ersif, shareholder ris. 7, identif,ing under(alued assets$ +o"e co"#anies "a, ha(e #articularl, strong s.ills in finding under(alued assets and thus "a.e 7etter di(ersification decisions than shareholders could find other9ise$ Loo.ing at the 7road definition of di(ersification to include (ertical integration there e!ist situations 9hen a fir" "a, create shareholder (alue 7, ac>uiring: •
Consider a (ertical "ar.et failure for a scarce resource that constitutes a critical in#ut for the sur(i(al of a co"#an,$ fir" "a, 9ant to 7ac.9ard integrate should a holdu# #ro7le" rele(ant to the fir" or co""on to the industr, threaten the fir"s a7ilit, to co"#ete$
•
Bac.9ard integration can e!#loit "ar.et #o9er necessar, to o7tain in#uts critical to the co"#an,$ The ustralian read,"i! concrete industr, illustrates this idea$ +e(eral #la,ers in this highl, co"#etiti(e industr, chose to (erticall, integrate 9ith su##liers in the >uarr, industr, 9hich for a long ti"e held oligo#ol, #o9er$ While such ac>uisitions "a, not create shareholder 9ealth as econo"ic gains fro" integration "a, 7e included in the ac>uisition #rice these concrete co"#anies safeguard their 7usinesses$ In fact three fir"s no9 do"inate the ustralian read, "i! concrete industr,$ B, e!#loiting "ar.et #o9er through di(ersification these fir"s "itigate the chances for failure of their fir"s and thus reduce the ris. 7orne 7, their shareholders$
•
Closel, held co"#anies are not re>uired to disclose infor"ation to the sa"e e!tent as #u7lic co"#anies$ Hence closel, held co"#anies "a, ha(e additional infor"ation a7out the ris.iness of their in(est"ents that their shareholders "a, not ha(e$ Thus as,""etric infor"ation ena7les #ri(atel, held fir"s to understand to a greater e!tent ho9 to di(ersif, on 7ehalf of its shareholders$
0$ %ith the gro"ing num)er of firms that speciali+e in corporate acJuisitions e$g$, >er/shire Hatha"ay, !, there appears to )e a very active mar/et for corporate control$ As the num)er of specialist firms epands, "ill control arguments )e sufficient to ustify acJuisitions& Do you thin/ that relatedness "ill )ecome more or less important as competition in the mar/et for corporate control intensifies&
Control argu"ents #ro#ose that fir"s s#ecialiing in cor#orate ac>uisitions ha(e uni>ue s.ills in identif,ing an under(alued fir" and that these s#ecialists e!tract undetected (alue 7, re#lacing a fir"s e!isting "anage"ent 9ith a "ore efficient one$ s the nu"7er of s#ecialists increase it 7eco"es "ore li.el, that "ore than one s#ecialist 9ill detect the under(alued fir"$ With intensified co"#etition follo9s the e!#osure of the originall, undetected (alue 9hich then gets 7id a9a,$ EIn fact the 9inners curse argues that the fir" "a, 7e #urchased for "ore than its (alue$) Therefore as the nu"7er of s#ecialist fir"s e!#ands it 9ill 7e less li.el, that control argu"ents 9ill 7e (alid$ Thus the control argu"ent 9ill not sufficientl, e!#lain 9h, "anage"ent tea"s 9ould continue to 7id$
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Mergers "a.e econo"ic sense 9hen the (alue of the "erged fir"s e!ceeds the su" of the (alues of the se#arate fir"s$ While re#lacing "anage"ent 9ith "ore efficient "anage"ent can i"#ro(e financial #rofits these actions %er se generall, do not create (alue 7ut rather si"#l, reduce the costs of inefficienc,$ In order to create shareholder (alue the "erged fir"s "ust e!#loit s,nergies including scale and sco#e econo"ies$ +,nergies "ost li.el, e!ist 7et9een "anage"ent tea"s that ha(e de(elo#ed co"#le"entar, .no9ledge 7ases$ Therefore as the "ar.et for cor#orate control intensifies in search of creating (alue relatedness 9ill 7eco"e "ore i"#ortant$
$ ?rofessor Dranove-s son has )een shoveling sno" for his neigh)ors at 0 per hour since last year, using his dad-s shovel for the o)$ He hopes to save up for a )icycle$ The neigh)ors decided to get a sno" )lo"er, leaving the )oy a fe" dollars short and sorely disappointed he /no"s that his dad "ill not contri)ute a pennyR Ho" is this situation different from that descri)ed )y Shleifer and Summers& (s there an efficiency loss as a result of the neigh)ors- actions&
+hleifer and +u""ers argu"ent is su""ed as follo9s: •
Wealth redistri7ution "a, ad(ersel, affect econo"ic efficienc, 9hen the ac>uired 9ealth is in the for" of >uasirents e!tracted fro" sta.eholders ha(ing relationshi#s#ecific in(est"ents in the target fir"$
•
"#lo,ees de(elo#ing fir"s#ecific assets are (ulnera7le to ha(ing >uasirents ta.en 7, ne9 o9ners 9ho are not 7ound to honor the i"#licit contracts "ade 9ith old o9ners$ "#lo,ees cannot readil, sell fir"s#ecific assets to other e"#lo,ers at a co"#ara7le #rice to that 9hich the, currentl, recei(e$
The e"#lo,ee of this e!a"#le differs in that he has no sun. or fi!ed costs$ Because he uses his fathers sho(el his >uasirents are identical to his total #a,$ dditionall, his ser(ice is not restricted to the relationshi# 9ith this client$ There is no efficienc, loss in this case$ The neigh7ors ha(e elected to (erticall, integrate #urchasing a "eans of sno9 re"o(al and doing it inhouse instead of renting the ser(ice$ The 7o, did not ha(e a relationshi#s#ecific in(est"ent in the neigh7ors ,ard$ He can easil, transfer his ser(ice to other ho"es on the 7loc. so long as the, do not ha(e the ti"e or desire to re"o(e their sno9 inhouse$ Klti"atel, in order to re"ain in this 7usiness longter" the 7o, or his dad 9ould ha(e to increase their technological ca#acit, and #urchase a sno97lo9er$ 3$ Suppose you o)served an acJuisition )y a diversifying firm and that the aftermath of the deal included plant closings, layoffs, and reduced compensation for some remaining "or/ers in the acJuired firm$ %hat "ould you need to /no" a)out this acJuisition to determine "hether it "ould )e )est characteri+ed )y value creation or value redistri)ution&
Falue creation occurs if the result of the ac>uisition generates "ore (alue to the sta.eholders of the fir" than ho9 "uch the, held 7efore the ac>uisition$ +u##ose for e!a"#le the 7u,er introduces ne9 technolog, to the ac>uired fir" and that this ne9 technolog, reduces o#erations costs for the ac>uired fir"$ Conse>uentl, the cost reduction ena7les the ac>uired fir" co"#ete "ore aggressi(el, in its traditional "ar.et
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and earn higher #rofits$ In this case e(en if the ne9 technolog, leads to la,offs and reduced co"#ensation the "erger creates (alue$ Falue redistri7ution occurs 9hen a #art, 7rea.s an i"#lied co""it"ent 9ith the creator of (alue in order to e!#loit >uasirents$ +u##ose e"#lo,ees 9ere to de(elo# fir"s#ecific s.ills that increase the #rofita7ilit, and thus the (alue of the fir"$ +u7se>uentl, the fir" reduces their salaries to increase o#erating "argins$ In this case the fir" e!#ro#riates the rents fro" the source that created the (alue$ The ac>uiring fir" ta.es the (alue o9ed the e"#lo,ees in their i"#lied contracts$ Hence in order to deter"ine 9hether an ac>uisition creates (alue or redistri7utes (alue ,ou 9ill need to .no9: E1) 9hether the (alue of the "erged co"#anies e!ceeds the su" of the (alues of the indi(idual co"#anies E2) 9ho or 9hat constitutes the creati(e source of added (alue and E%) 9hether that source recei(es the econo"ic >uasirents attri7uted to the ne9 (alue added$ s a follo9 u# to this >uestion can a di(estiture=the o##osite of di(ersification= in(ol(ing significant la,offs creates (alue Consider the case of defense contractor -eneral D,na"ics in 1&&1$
It is difficult to e(aluate ho9 a fir" #erfor"s under different for"s of o9nershi#$ n a##roach 9ould 7e to co"#are the fir" to other fir"s in their industr, 7efore and after the, ha(e co"#leted si"ilar restructuring$ Ho9e(er since e(en direct co"#etitors "a, e"7od, different sets of critical resources and since "an, (aria7les affect #erfor"ance so"e s,ste"ic and others idios,ncratic these co"#arison #ro(ide li"ited (alue 7e,ond s#eculation$ In industries 9ith localied #roduct "ar.ets Ei$e$ hos#itals radio stations ne9s#a#ers) co"#arisons of different o9nershi# #atterns across "ar.ets "a, shed light on this >uestion$
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Chapter Competitors and Competition Chapter Contents 1) Introduction 2) Co"#etitor Identification and Mar.et Definition The Basics of Co"#etitor Identification • utting Co"#etitor Identification to ractice • !a"#le 3$1: +u7stitutes and Co"#etition in the ostal +er(ice -eogra#hic Co"#etitor Identification • %) Measuring Mar.et +tructure !a"#le 3$2: Defining CocaColas Mar.et 4) Mar.et +tructure and Co"#etition erfect Co"#etition • !a"#le 3$%: DogatDog World: The De"ise of the ;nline et +u##l, Industr, Mono#ol, • !a"#le 3$4: The ;C Cartel Mono#olistic Co"#etition • !a"#le 3$/: ricing in the irline Industr, ;ligo#ol, • !a"#le 3$3: Cournot >uili7riu" in the Corn Wet Milling Industr, /) (idence on Mar.et +tructure and erfor"ance rice and Concentration • ;ther +tudies of the Deter"inants of rofita7ilit, • 3) Cha#ter +u""ar, 5) 6uestions
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Chapter Summary
This cha#ter e!#lores the lin. 7et9een "ar.et structure and co"#etition$ The cha#ter 7egins 9ith a discussion of ho9 to identif, co"#etitors define "ar.ets and descri7e "ar.et structure$ ualitati(e 9a, to define a "ar.et: t9o #roducts are in the sa"e "ar.et if the, are su7stitutes$ fter defining su7stitutes this cha#ter considers se(eral a##roaches to defining "ar.ets and identif,ing co"#etitors: de"and elasticities #rice correlations and trade flo9s$ The cha#ter also introduces t9o 9a,s to "easure ho9 concentrated the "ar.et is: the fir" concentration ratio and the Herfindal Inde!$ This cha#ter then considers co"#etition and financial #erfor"ance 9ithin four 7road classes of "ar.et structure: #erfectl, co"#etiti(e "ar.ets "ono#olisticall, co"#etiti(e "ar.ets oligo#olistic "ar.ets and "ono#ol, "ar.ets$ "ar.et is #erfectl, co"#etiti(e Esee cono"ics ri"er) if there are "an, sellers$ In this "ar.et consu"ers #ercei(e the #roduct to 7e ho"ogeneous and e!cess ca#acit, e!ists$ The cha#ter discusses ho9 each of these characteristics discourages an, one fir" fro" raising its #rices and 9h, industr, #rofits are dri(en to ero$ Mono#olistic co"#etition descri7es "ar.ets in 9hich there are "an, sellers and each seller is slightl, differentiated fro" the rest$ n oligo#ol, is a "ar.et in 9hich the actions of indi(idual fir"s "ateriall, affect the industr, #rice le(el$ The cha#ter introduces t9o theories on ho9 fir"s 7eha(e in an oligo#olistic "ar.et the Cournot >uantit, co"#etition "odel and the Bertrand #rice co"#etition "odel 9hich are further ela7orated on in cha#ters 5 and 8$ The a7o(e e!a"ination suggests that "ar.et structure is related to the le(el of #rices and #rofita7ilit, that #re(ail in an, gi(en "ar.et$ The cha#ter concludes 9ith a discussion of e(idence on the relationshi# of "ar.et structure and fir" and industr, #erfor"ance$ +#ecificall, the last sections of this cha#ter su""arie the results of research on the relationshi# 7et9een #rice and concentration the effects of ad(ertising on #rice the lin. 7et9een econo"ies of scale and "ar.et structure and connection 7et9een concentration and #rofita7ilit,$
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Approaches to Teaching the Chapter Definitions
Mar.et +tructure: nu"7er and sie of fir"s that co"#ete 9ithin a "ar.et$ Mar.et Definition: #rocess of identif,ing the "ar.et or "ar.ets in 9hich a fir" co"#etes$ Mono#sonist: a fir" is a "ono#sonist if it faces little or no co"#etition in one of its in#ut "ar.ets$ In other 9ords "ono#son, is a "ar.et 9ith "an, sellers 7ut onl, one 7u,er$ +u7stitutes: #roducts tend to 7e close su7stitutes if a) the, ha(e the sa"e or si"ilar #roduct #erfor"ance characteristics 7) the, ha(e the sa"e or si"ilar occasions for use c) the, are sold in the sa"e geogra#hic "ar.et$ T9o #roducts are su7stitutes if an increase Edecrease) in the #rice of one leads to an increase Edecrease) in the >uantit, de"anded of the other$ rice Correlations: a 9a, of deter"ining 9hether t9o sellers are in the sa"e "ar.et$ If t9o sellers are in the sa"e "ar.et their #rice changes should 7e highl, correlated$ Trade ualit,* is often difficult to deter"ine$ In theor, #roducts and B 9ould 7e (erticall, differentiated if all consu"ers agreed that #roduct is higher >ualit,$ Horiontal Differentiation: "a.ing a #roduct distincti(e fro" those of co"#etitors$ If #roducts and B 9ere horiontall, differentiated so"e consu"ers 9ould #refer #roduct and other consu"ers 9ould #refer #roduct B$ Cournot rice Co"#etition: a "odel designed to e!#lain ho9 fir"s 9ill 7eha(e in an oligo#ol, 7ased on the assu"#tion that each fir" selects a >uantit, to #roduce and the resulting total out#ut deter"ines "ar.et #rice$ Bertrand rice Co"#etition: a "odel 9hich e!#lains ho9 fir"s 9ill 7eha(e in an oligo#ol, 7ased on the assu"#tion that each fir" selects a #rice and "eets all de"and for that #roduct at that #rice$
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fir" Concentration 'atio: a 9a, to "easure ho9 concentrated an industr, is 7, gi(ing the co"7ined "ar.et share of the largest fir"s in the "ar.et$ E48 and 20 fir"concentration ratios are co""on$) Herfindahl Inde!: a 9a, to "easure ho9 concentrated an industr, is 7, su""ing the s>uared "ar.et shares of all the fir"s in the "ar.et$ vervie" s a "eans of introducing "an, of the to#ics in this cha#ter as. students to dra9 on their o9n 9or. e!#erience and identif, the co"#etitors in an industr, 9ith 9hich the, are fa"iliar: • • • • • • • • • • • •
What 9ere the .e, forces sha#ing the nature of co"#etition and the o##ortunities for "a.ing #rofit in that industr, What if an,thing did fir"s do to insulate the"sel(es fro" these forces Was the #roduct or ser(ice that their fir" sold ho"ogenous or heterogeneous What 9ere so"e of the su7stitutes for the #roduct or ser(ice that E,our) fir" #roduced Do the su7stitutes that co"e to "ind fit the definition of su7stitute gi(en in the cha#ter Is geogra#h, a factor in defining this "ar.et Were there "an, co"#etitors or is this industr, do"inated 7, a fe9 fir"s What 9as the #ricing co"#etition li.e in this industr, Did ,our fir" ha(e control o(er #ricing Was this industr, go(ern"entregulated and 9hat effect did go(ern"ent regulation ha(e on #ricing and co"#etition Would ,ou characterie this industr, as #erfectl, co"#etiti(e "ono#olisticall, co"#etiti(e an oligo#ol, or "ono#ol, Can ,ou thin. of industries that ha(e Bertrand or Cournot d,na"ics Industries that #roduce agricultural #roducts or co""odities tend to ha(e Bertrand d,na"ics 9hile industries 9ith high fi!ed costs are "ore li.el, to ha(e Cournot d,na"ics$
The a7o(e discussion should generate #lent, of e!a"#les 9hich 9ill hel# students understand so"e of the 9a,s to define a "ar.et$ Eamples: Defining a Mar/et .e, learning #oint of this cha#ter is that there are "an, #ossi7le 9a,s to define a "ar.et and the definition of "ar.et is often highl, contested$ ;ut of all #ossi7le definitions of a "ar.et so"e are 7etter than others and it is i"#ortant to realie 9hich definition of a "ar.et is "ore a##ro#riate$ The cha#ter #ro(ides t9o great e!a"#les of "ar.et definition and co"#etition the #ostal ser(ice and the soft drin. industr,$
The follo9ing e!a"#les 9ill hel# students understand ho9 there are "an, #ossi7le definitions of a "ar.et and ho9 ,our co"#etiti(e anal,sis of a "ar.et 9ill change de#ending u#on 9hat "ar.et definition ,ou ado#t: 1) The )eer industry : ;ne can define the 7eer industr, nationall, regionall, or locall,$ ;n a national le(el "icro7re9eries do not re#resent a significant #ercentage of the
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7eer sold in the K+$ Ho9e(er in certain local "ar.ets "icro7re9eries re#resent a fairl, large "ar.et share and it 9ould 7e a "ista.e to ignore their #resence$ 2) The airline industry : In certain routesG"ar.ets airlines are not onl, co"#eting 9ith other airlines for custo"ers the, "a, 7e co"#eting 9ith other for"s of trans#ortation or e(en other for"s of co""unication$ uantitati(e 9a,s to define a "ar.et it is useful to ha(e the students #re#are so"e cases in con@unction 9ith this cha#ter$ ntitrust cases such as the #ro#osed "erger of e#si and Dr$ e##er are useful 7ecause the, often #ro(ide data necessar, to a##l, the >uantitati(e techni>ues to define a "ar.et and "easure "ar.et structure li.e the Herfindahl inde! and nfir" concentration ratio$ When re(ie9ing >uantitati(e 9a,s to define a "ar.et it is i"#ortant to #oint out the difference 7et9een the nfir" concentration ratio and the Herfindahl inde!$ The nfir" concentration ratio is not sensiti(e to (ariations in dis#ersions 7et9een the "ar.et shares 9hile the Herfindahl inde! ta.es these (ariations into account$ Mar/et Structure This cha#ter discusses four 7road t,#es of "ar.ets: #erfect co"#etition "ono#olistic co"#etition oligo#ol, and "ono#ol,$ lthough the theor, of #erfect co"#etition 9as introduced in the cono"ics ri"er it "a, 7e hel#ful to re(ie9 the characteristics of a #erfectl, co"#etiti(e "ar.et[
1) there are "an, sellers 2) consu"ers #ercei(e the #roduct to 7e ho"ogenous %) e!cess ca#acit, e!ists [and ho9 each of these features contri7ute to fierce #ressure to reduce #rices$ +ellers ha(e no control o(er #rices and VMC$ !a"#les of #erfectl, co"#etiti(e "ar.ets include co""odities and agricultural #roducts E9hich are often traded on e!changes) li.e sil(er gold 7arle, sugar coffee etc$ lthough fe9 "ar.ets are #erfectl, co"#etiti(e in the sense that each fir" faces a #erfectl, horiontal de"and cur(e for a ho"ogenous #roduct "an, "ar.ets are almost #erfectl, co"#etiti(e$ The .e, difference 7et9een "ono#olistic co"#etition and #erfect co"#etition is that under "ono#olistic co"#etition the goods #roduced 7, each seller are horiontall, differentiated$ s a result so"e 7u,ers are 9illing to #a, slightl, "ore for a good #roduced 7, one seller than another$ It does not "ean that one #roduct is 7etter than another for all consu"ers$ 'ather one class of consu"ers #refers a good 9ith a certain
80
characteristic 9hile another class of consu"ers 9ould #refer so"ething else$ The te!t #oints out that geogra#h, is an i"#ortant source of differentiation$ Mono#olistic co"#etition enco"#asses a huge nu"7er of "ar.ets toda, as co"#anies constantl, tr, to differentiate their #roducts fro" their co"#etitors$ !a"#les of "ono#olistic co"#etiti(e "ar.ets include: dr, cleaners tooth#aste sha"#oo laundr, detergent #eanut 7utter @eans roller7lades etc$ Branded #roducts and restaurants are great e!a"#les of "ono#olisticall, co"#etiti(e "ar.ets$ In #erfectl, co"#etiti(e and "ono#olisticall, co"#etiti(e "ar.ets entr, is a constant threat and sellers disregard the choices of s#ecific co"#etitors$ In an oligo#ol, ho9e(er the #ricing and #roduction strategies of indi(idual fir"s in a "ar.et affect the industr, #rice$ Here it "a, 7e hel#ful to 9or. through the Cournot and Bertrand "odel e!a"#le #ro(ided in the cha#ter$ The e!a"#le in the cha#ter also illustrates that #rofits of these fir"s are less in an oligo#ol, than if the, acted as a "ono#ol, in other 9ords fir"s in an oligo#ol, do not 9or. to "a!i"ie industr, #rofits$ The athletic foot9ear industr, Ei.e L -ear and Con(erse) is a great e!a"#le of an oligo#ol, and one to 9hich "ost students can relate$ Knli.e in a #erfectl, co"#etiti(e "ar.et a "ono#ol, fir" has co"#lete control o(er #ricing and the >uantit, it chooses to #roduce$ "ono#olist 9ill #roduce until "arginal re(enue V "arginal cost$ If "arginal re(enue "arginal cost then the "ono#olist could still #roduce "ore and increase #rofits$ If "arginal re(enue U "arginal cost the "ono#olist could cut 7ac. on #roduction and increase #rofits$ "ono#olist #roduces less than fir"s in an oligo#ol, and can charge higher #rices as a result$ There are (er, fe9 fir"s that ha(e "ono#ol, #o9er and there is antitrust legislation in the K+ designed to 7rea. u# fir"s that ha(e "ono#ol, #o9er$ Ho9e(er a fir" "ight ha(e "ono#ol, #o9er 7ecause of the follo9ing reasons: #atent co#,rights go(ern"ent license or econo"ies of scale$ There are instances 9here "ono#olies are dee"ed efficient and acce#ta7le$
81
Suggested Harvard Case Study 3
Cater#illar HB+ &%8/253 $ Descri7es the structure and e(olution of the earth "o(ing e>ui#"ent industr, 9orld9ide in the #ost 9ar era #articularl, focusing on de(elo#"ents in the 1&80s and 1&50s$ Descri7es Cater#illars strateg, in 7eco"ing the do"inant 9orld9ide co"#etitor 9ith industr, "ar.et share e!ceeding /0P$ Includes details on CTs "anufacturing "ar.eting research and de(elo#"ent and organiational #olicies$ Concludes 9ith a descri#tion of so"e en(iron"ental changes occurring in the earl, 1&80s and raises the >uestion of ho9 these "ight effect Cater#illar Tractor Co$s record 1&81 #erfor"ance and re>uire changes in its highl, successful strateg,$ ou "a, 9ant to as. students to thin. of the follo9ing >uestions in #re#aration for the case: a) Descri7e the .e, dri(ers to Cater#illars historical success$ 7) Descri7e changes in the co"#etiti(e en(iron"ent and e!#lain ho9 these changes "ight i"#act CT$ De Beers Consolidated Mines HB+ &%&1053 Esee earlier cha#ters) Harnischfeger Industries: ortal Crains EHB+ O&%&11%0): This case further e!#lores the lin. 7et9een "ar.et structure and co"#etition$ Harnischfeger the "ar.et share leader is facing increasing co"#etition in the #ortal crane industr, and 9ants to regain "ar.et share 9ithout engaging in a #rice 9ar$ The ;il Tan.er +hi##ing Industr, in 1&8%: EHB+ O&%840%4): This case #ro(ides an e!a"#le of industr, ca#acit, o(ere!#ansion in the shi##ing industr, in 1&8%$ The K$+$ irline Industr, in 1&&/ J$ Dana orth9estern Kni(ersit, EHB+ also has a case 9ith the sa"e title): This case focuses on the K+ airline industr, and ser(es as an introduction to industr, anal,sis$ Discussion t,#icall, co(ers horiontal 7oundaries of the fir" econo"ies of scale and sco#e e!it and entr, decisions and the long run d,na"ics of industr, and si"#le strategic #ositioning$ The case also discusses ,ield "anage"ent and other o#erations as#ects of the industr,$
5
These descri#tions ha(e 7een ada#ted fro" Harvard Business School 3445647 Catalog of Teaching Materials#
82
Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
Ba.er J$ and T$ Bresnahan ?*The -ains fro" Merger or Collusion in roduct Differentiated Industries* :ournal of (ndustrial Economics %% 1&88: ##$425444$ Bau"ol W$ J$ anar and '$ Willig Contesta)le Mar+ets and the Theory of (ndustry Structure e9 or.: Harcourt Brace Jo(ana(ich 1&82$ Bresnahan T$ and $ 'eiss *ntr, and Co"#etition in Concentrated Mar.ets* :ournal of &olitical Economy && 1&8&: &&5100& Cha"7erlin $H$ The Theory of Mono%olistic Com%etition Ca"7ridge M: Har(ard Kni(ersit, ress 1&%%$ iinga $ and T$ Hogart, *The ro7le" of -eogra#hic Mar.et Definition 'e(isited: The Case of Coal* Antitrust Bulletin 2% 1&58:118$ orter M$ and $M$ +#ence *?The Ca#acit, !#ansion Decision in a -ro9ing ;ligo#ol,: The Case of Corn Wet Milling* in McCall J$J$ Eed$) The Economics of (nformation and 1ncertainty Chicago IL: Kni(ersit, of Chicago ress 1&82 ##$ 2/& %13$ +ch"alensee '$ *Interindustr, +tudies of +tructure and erfor"ance* in +ch"alensee '$ and '$ Willig Eeds$) The Hand)oo+ of (ndustrial -rgani.ation "sterda": orth Holland 1&8&$ +ch"alensee '$ *+tudies of +tructure and erfor"ance* in +ch"alensee '$ and '$ Willig Eeds$) The Hand)oo+ of (ndustrial -rgani.ation "sterda": orthHolland 1&8&$ +ha#iro C$ *Theories of ;ligo#ol, Beha(ior* in cha#$ 3 in Willig '$ and '$ +ch"alensee Eeds$) The Hand)oo+ of (ndustrial -rgani.ation "sterda": orth Holland 1&8&$ +tigler -$ and '$ +her9in *The !tent of the Mar.et* :ournal of /aw and Economics 28 1&8/: ##$ ////8/$ Weiss L$ Eed$) Concentration and &rice Ca"7ridge M: MIT ress 1&8&$
8%
Ans"ers to End of Chapter #uestions 1$ %hy are the concepts of o"n and cross4price elasticities of demand essential to competitor identification and mar/et definition&
The "agnitude of consu"er res#onses to changes in a #roduct "ar.ets Eor industr,s) #rice is "easured 7, the o9n#rice elasticit, of de"and 9hich e>uals the #ercentage change in a #roduct "ar.ets sales that results fro" a 1 #ercent change in #rice$ If an industr, raises #rice and conse>uentl, loses "ost of its custo"ers to another industr, Eor industries) 9e conclude that the "ar.et under consideration faces close su7stitute #roducts Eor the #roduct "ar.et co"#etes 9ith other #roduct "ar.ets)$ Measuring the o9n#rice elasticit, of de"and tells us 9hether a #roduct faces close su7stitutes 7ut it does not identif, 9hat those su7stitutes "ight 7e$ We can identif, su7stitutes 7, "easuring the cross#rice elasticit, of de"and 7et9een t9o #roducts$ The cross#rice elasticit, "easures the #ercentage change in de"and for good that results fro" a 1 #ercent change in good R$ The higher is the cross#rice elasticit, the "ore readil, consu"ers su7stitute 7et9een t9o goods 9hen the #rice of one good is increased$ '$ (n a recent antitrust case, it "as necessary to determine "hether certain eliteschools mainly the (vy @eague schools and M(T constituted a separate mar/et$ Ho" "ould you go a)out identifying the mar/et served )y these schools&
The "ar.et can 7e identified in #art 7, the custo"ers and 7, residual de"and anal,sis$ To deter"ine if the Zelite schools co"#rised a se#arate "ar.et 9e could conduct a sur(e, to unco(er 9ho the a##licants to these schools Econsu"ers) 9ere and 9hich other schools did these a##licants a##l, to$ If the a##licants 9ere fro" the sa"e #ool of highschool students and if the, did not a##l, outside the Zelite schools this 9ould tend to identif, the Zelite schools as a se#arate "ar.et$ In addition 9e could stud, the #ricing and enroll"ent histor, of these schools to see if their #ricing decisions 9ere constrained 7, the #ossi7ilit, that consu"ers 9ill s9itch to sellers outside the "ar.et$ If these schools collecti(el, raised their #rices co"#ared to other schools Econtrolling for changes in de"and) and did not see a dro# in their enroll"ent Ere(enues) then the, "a, constitute a se#arate "ar.et$ *$ Ho" "ould you characteri+e the nature of competition in the restaurant industry& Are there su)mar/ets "ith distinct competitive pressures& Are there important su)stitutes that constrain pricing& ;iven these competitive issues, ho" can a restaurant )e profita)le&
The restaurant industr, can 7e descri7ed as e!hi7iting "ono#olistic co"#etition as there are "an, sellers in the "ar.et 7ut each seller is slightl, differentiated fro" the rest$ restaurant can 7e horiontall, differentiated 7, the t,#e of cuisine its ser(es the >ualit, of the food the ser(ice the a"7ience and d\cor and the location$ The #rices that can 7e charged for these differentiating features are constrained in large #art 7, the geogra#hic location of the restaurant and the local co"#etition$ Consu"ers 9ill tend to not tra(el long distances for their "eal no "atter ho9 differentiated the #roduct$ The consu"ers 9ill 9eigh the con(enience of the location against the #rice of the "eal and so cross#rice elasticit, of de"and "a, 7e high$ +u7stitutes to restaurant "eals are ho"e #re#ared "eals and froen dinners$ The restaurant 9ill 7e #rofita7le if it has a su#erior location$
84
relati(el, inelastic$
.$ Ho" does industry4level price elasticity of demand shape the opportunities for ma/ing profit in an industry& Ho" does firm4level price elasticity of demand shape the opportunities for ma/ing profit in an industry&
The industr, #rice elasticit, of de"and indicates the #ercentage change in >uantit, de"anded #er #ercentage change in #rice 9hen all fir"s si"ultaneousl, change #rice$ It deter"ines the li"its on fir"s? a7ilities to #rofit fro" collecti(e #rice increases and thus sha#es #rofit o##ortunities in en(iron"ents 9here fir"s are a7le to coordinate their #ricing 7eha(ior to "ore closel, rese"7le that of a "ono#olist$ The fir" le(el #rice elasticit, of de"and indicates the #ercentage change in a fir"s >uantit, de"anded #er #ercentage change in #rice 9hen that fir" changes its #rice 7ut other co"#eting fir"s do not$ This elasticit, 9ill deter"ine the #ercei(ed 7enefits fro" a #rice cut ai"ed at stealing 7usiness fro" co"#etitors$ The larger the elasticit, is Ein a7solute (alue) the stronger the te"#tation is on the #art of a fir" to cut #rice$ This elasticit, thus sha#es industr, #rofita7ilit, 7, influencing the li.elihood of desta7iliing #ricecutting 7eha(ior 7, fir"s$ Thus the greater the fir"le(el elasticit, of de"and the greater is the #otential for #rice 9ars and reductions in o(erall #rofits$ 0$ %hat is the
When a fir" e!#ands its out#ut it reduces the "ar.et #rice and thus lo9ers the sales re(enue of its ri(als=this is referred to at the Are(enue destruction effect$ ach fir" see.s to "a!i"ie its o9n #rofit and not total industr, #rofit$ The s"aller is a fir"s share of industr, sales the greater the di(ergence 7et9een its #ri(ate gain and the re(enue destruction effect fro" out#ut e!#ansion$ This suggests that as the nu"7er of fir"s in an industr, e!hi7iting Cournot co"#etition increases the greater is the di(ergence 7et9een the Cournot e>uili7riu" and the collusi(e outco"e$ $ Ho" does the calculation of demand responsiveness in @inesville change if customers rent t"o videos at a time& %hat intuition can you dra" from this a)out the magnitude of price competition in various types of mar/ets&
'ecall fro" the cha#ter that there is a (ideo store at each end of +traight +treet 9hich is 10 "iles long$ ach store carries identical in(entor,$ There are 100 (ideo rental custo"ers in Lines(ille and their ho"es are e>uall, s#aced along the street$ When custo"ers decide 9hich store to (isit the, ta.e t9o factors into account: the #rice that each store charges for a (ideo and the cost of tra(elling to the store$ Intuiti(el, if custo"ers rent t9o (ideos at a ti"e trans#ortation costs 9ould 7e a s"aller #ercentage of their total costs and custo"ers 9ould 7e 9illing to tra(el further if one (ideo store charged less than the other did$ s trans#ortation costs decrease as a #ercentage of total costs the, 9ould 7eco"e less i"#ortant in the transaction and a store could gain "ore fro" the #rice decrease$
8/
If ,ou thin. of Ztrans#ortation costs as Zhoriontal differentiation then ,ou can a##l, this reasoning to a (ariet, of "ar.ets$ s #roduct differentiation declines in i"#ortance consu"ers are "ore 9illing to s9itch to another #roduct$
3$ Iumerous studies have sho"n that there is usually a systematic relationship )et"een concentration and price$ %hat is this relationship& ffer t"o )rief eplanations for this relationship$
Leonard Weiss su""aried he results of #rice and concentration studies in o(er 20 industries including ce"ent railroad freight su#er"ar.ets and gasoline retailing$ He finds that 9ith fe9 e!ce#tions #rices tend to 7e higher in concentrated "ar.ets$ Consider an industr, 9ith a high concentration ratio 7ecause there are a s"all nu"7er of Cournot co"#etitors$ If each fir"s share of industr, sales is large the di(ergence 7et9een a fir"s #ri(ate gain and the re(enue destruction effect fro" out#ut e!#ansion is s"all$ Hence total industr, out#ut and #rice are closer to the le(els that 9ould 7e chosen 7, a #rofit"a!i"iing "ono#olist$ lternati(el, an industr, 9ith a high concentration ratio that has a s"all nu"7er of sellers is a7le to engage "ore successfull, in tacit collusion$ 7$ The relationship descri)ed in Juestion 3 does not al"ays appear to hold$ %hat factors, )esides the num)er of firms in the mar/et, might affect margins&
n i"#ortant source of (ariations in #ricecost "argins across industries is due to regulation #roduct differentiation the nature of sales transactions and the concentration of 7u,ers$ lso it is difficult to control for the 9a, in 9hich #rice cost "argins are calculated$ +ince the #redictions of econo"ic theor, #ertain to the "ar.et 7et9een #rice and "arginal cost #ricecost "argins should 7e co"#uted using "arginal cost$ Ho9e(er accounting cost data usuall, allo9 the researcher to infer a(erage cost rather than "arginal cost$ 5$ The follo"ing are the approimate mar/et shares of different )rands of soft drin/s during the 1576-s: Co/eP.69 ?epsiP*69 342pP169 Dr$ ?epperP 169 All other )randsP16$ a$ Compute the Herfindahl for the soft drin/ mar/et$ Suppose ?epsi acJuired 34 2p$ Compute the most merger Herfindahl$ %hat assumptions did you ma/e&
$4]2 Y $%]2 Y $1]2 Y $1]2 V Herfindahl inde! V $13Y$0&Y$01Y$01 V 0$25 If e#si and 5K# "erged: $4]2 Y $4]2 Y $1]2 V Herfindahl inde! V $13Y$13Y$01 V 0$%% The assu"#tions of the a7o(e include that the "ar.et shares of fir"s in the industr, do not change as a result of the "erger of t9o #la,ers Ee#si and 5K#)$ )$ Federal antitrust agencies "ould )e concerned to see a Herfindahl increase of the magnitude you computed in a, and might challenge the merger$ ?epsi could respond )y offering a different mar/et definition$ %hat mar/et definitions might
83
they propose& %hy "ould this change the Herfindahl&
e#si should consider a "ar.et definition that 9ould cause the "ar.et shares of fir"s to a##ear "ore frag"ented$ That is e#si should atte"#t to increase the sie of the deno"inator that deter"ines its "ar.et share$ Corp$ and ;ene ;ene Dancing Machines, compete through Cournot Juantity4setting competition$ The demand curve for the industry is ?166 L #, "here # is the total Juantity produced )y Chuc/ie > and ;ene ;ene$ Currently, each firm has marginal cost of .6 and no fied cost$ Sho" that the eJuili)rium price is 6, "ith each firm producing '6 machines and earning profits of .66$ E1) Π1 V 161 TC1 V E100 6 1 62 ) 61 40 61 E2) Π2 V 262 TC2 V E100 6 1 62 ) 62 40 62 o9 ta.e the deri(ati(e of each of the a7o(e 9ith res#ect to 6: E1) Ma! Π1 V 100 26 1 62 40 61 V %0 $/62 E2) Ma! Π2 V 100 26 2 61 40 62 V %0 $/61 o9 sol(e the a7o(e si"ultaneousl,: 61 V %0 $/62 V 61 V %0 $/E%0 $/6 1) 61 V 20 and so 7, s,""etr, 6 2 V 20 To find 9e use the "ar.et de"and cur(e: V 100 6 V 100 6 1 62 V 100 20 20 V Q30 nd finall, each fir"s #rofits: Π1 V
161 TC1 V E30S20) E40S20) V 1200 800 V Q400 and so 7, s,""etr,
Π2 V
262 TC2 V E30S20) E40S20) V 1200 800 V Q400
11$ Consider a mar/et "ith t"o hori+ontally differentiated firms, and B$ Each has a constant marginal cost of '6$ Demand functions are: # 166 L '? U 1?y #y 166 L '?y U 1? Calculate the >ertrand eJuili)rium in prices in the mar/et:
85
otice the for" of the de"and function the >uantit, R sells increases as the #rice charges increases$ Hence the each fir" i"#ro(es its #rofits 7, undercutting its ri(al and ca#turing a 9indfall in sales$ The onl, sta7le #rice co"7ination is at the #oint 9hen 7oth fir"s are charging MC$ rices 9ould not necessaril, fall to MC if the fir"s faced ca#acit, constraints$
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Chapter 3 Strategic Commitment Chapter Contents
1) Introduction 2) Wh, Co""it"ent is I"#ortant !a"#le 5$1: +trategic Co""it"ent and ree"#tion in the -lo7al irfra"e Mar.et: ir7us (ersus Boeing !a"#le 5$2: Co""it"ent and Irre(ersi7ilit, in the irline Industr, %) +trategic Co""it"ent and Co"#etition +trategic Co"#le"ents and +trategic +u7stitutes • Tough (ersus +oft Co""it"ents • Ta!ono", of Co""it"ent +trategies • !a"#le 5$%: Co""it"ent at ucor and K+R: The Case of Thin+la7 Casting 4)
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Chapter Summary
Decisions such as in(est"ent in ne9 ca#acit, or introduction of ne9 #roducts are e!a"#les of strategic co""it"ent$ +trategic co""it"ents are decisions that ha(e long ter" i"#act and are difficult to re(erse$ These decisions are different fro" tactical decisions 9hich ha(e a shortter" i"#act and are easier to re(erse$ uantities are strategic su7stitutes 7ecause an increase in >uantit, is the #rofit "a!i"iing res#onse to a co"#etitor?s reduction in >uantit,$ To illustrate the Cournot "odel the cha#ter descri7es ho9 the 9orld "ar.et for "e"or, chi#s follo9s the Cournot "odel of >uantit, setting$ The #rice dro#s of 1&84 caused "erican fir"s to not in(est in ne9 ca#acities Ja#anese fir"s res#onded 7, increasing their in(est"ents in ne9 ca#acit,$ In the &0s the sa"e situation is occurring 9ith +outh oreans e!#anding their ca#acit, 9hen "a@or Ja#anese fir"s ha(e scaled 7ac. #roduction due to soft local econo",$ The ne!t section anal,es the co""it"ent #rocess in t9o stages the fir" "a.es a strategic co""it"ent in stage 1 and then 7oth fir"s "a.e tactical decisions in stage 2$
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Co""it"ent decisions ha(e a direct effect and a strategic effect$ The direct effect assu"es that the co"#etitors 7eha(ior is constant and anal,es the incre"ental F of the decision$ The strategic effect factors in the co"#etiti(e side effects that occur 9hen the co"#etitor reacts to the fir"s in(est"ent$ uili7riu" "o(es to the south9est and in(ol(es a lo9er #rice for 7oth uili7riu" "o(es to the north9est and in(ol(es a higher #rice for
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Approaches to teaching this chapter
The student "ust 7eco"e fa"iliar 9ith the follo9ing definitions and conce#ts as descri7ed in this cha#ter: Definitions:
+trategic Co""it"ent: decision 7, a fir" that has a longter" i"#act and is difficult to re(erse$ Tactical Decision: decision 7, a fir" that can easil, 7e re(ersed and 9hose i"#act #ersists onl, in the short run$ Aggressi(e +trateg,: strateg, that in(ol(es a large and ra#id increase in ca#acit, and is ai"ed at increasing the fir"s "ar.et share$ A+oft +trateg,: a fir"s strateg, that in(ol(es no change in ca#acit,$ +trategic Co"#le"ents: occurs 9hen reaction functions of fir"s are u#9ard slo#ing$ The "ore of a certain action one fir" chooses the "ore of the sa"e action the other fir" 9ill o#ti"all, choose$ In the Bertrand "odel #rices are strategic co"#le"ents$ +trategic +u7stitutes: ;ccurs 9hen reaction functions of fir"s are do9n9ard slo#ing$ The "ore of a certain action that one fir" ta.es the less of that sa"e action the other fir" o#ti"all, chooses$ In the Cournot "odel >uantities are strategic su7stitutes$ Direct ffect: is the co""it"ents i"#act on the #resent (alue of the fir"s #rofits assu"ing that the fir" ad@usts it o9n tactical decisions in light of this co""it"ent 7ut that its co"#etitors 7eha(ior does not change$ +trategic ffect: ta.es into account the co"#etiti(e side effects of the co""it"ent i$e$ ho9 does the co""it"ent alter the tactical decisions of the ri(al and ulti"atel, the Cournot or Bertrand e>uili7riu"$ ;#tion Falue: of a dela, is the difference 7et9een the e!#ected net #resent (alue if the fir" in(ests toda, and the e!#ected net #resent (alue if the fir" 9aits until the uncertaint, resol(es itself$ ;#tion (alue is the outco"e of #reser(ing fle!i7ilit, or future o#tions o#en after a co""it"ent has 7een "ade$ Learnto7urn 'atio: This is the ratio of the Alearn rate the rate at 9hich ne9 infor"ation is recei(ed 7, the fir" that allo9s it to ad@ust its strategic choices and the A7urn rate the rate at 9hich the fir" is in(esting in the sun. assets to su##ort the strateg,$ ositioning nal,sis: ;ne of the ste#s in -he"a9ats fourste# fra"e9or. for anal,ing co""it"entintensi(e choices$ This anal,sis deter"ines the direct effect of the strategic co""it"ent$ It in(ol(es the anal,sis of 9hether the fir"s co""it"ent is li.el, to result in a #roduct "ar.et #osition in 9hich the fir" deli(ers su#erior consu"er 7enefits or o#erates 9ith lo9er costs than co"#etitors$
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+ustaina7ilit, nal,sis: +econd ste# in -he"a9ats fourste# fra"e9or. for anal,ing co""it"entintensi(e choices$ This anal,sis deter"ines the strategic effect of the co""it"ent 9hich could in(ol(e a for"al anal,sis of the net #resent (alue of alternati(e strategic co""it"ents$
uili7riu" 9hich fro" the #ers#ecti(e of the co""itting fir"s is inferior$ The 7est 9a, to illustrate this theor, is through a si"#le e!a"#le li.e the one gi(en in ta7le 5$1 of this cha#ter$ The ga"e theor, section of the #ri"er also introduces the 7asic ele"ents of ga"e theor, and the conce#t of ash >uili7riu"$ To illustrate the (alue of co""it"ent consider the e!a"#le fro" the te!t:
ggressi(e +oft
ggressi(e 12$/ 4$/ 1/ 3$/
+oft 13$/ / 18 3
If 7oth fir"s act si"ultaneousl, uili7riu" 7ecause each fir" is doing the 7est it can gi(e 9hat the other fir" is doing$ Ho9e(er if ertrand e>uili7riu"s de(elo#ed in cha#ter 3$ .e, #oint "ade in this cha#ter is that e!#ected for" of co"#etition can ha(e a "a@or influence on 9hether the co""it"ent is ulti"atel, 7eneficial to the co""itting fir"$ In this regard it is hel#ful to 9al. through e!a"#le in the te!t in 9hich fir" 1 "a.es a co""it"ent in stage 1 and 7oth fir"s "aneu(er tacticall, in stage 2$ This discussion concludes the i"#act of strategic co""it"ent on the "ar.et e>uili7riu" de#ends on 9hether the stage 2 tactical (aria7les are strategic co"#le"ents EBertrand) or strategic su7stitutes ECournot) and 9hether fir" 1 "a.es the fir" soft or tough Esee figure 5$3 Ta!ono", of +trategic Co""it"ents)$
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•
natural >uestion students "a, as. is ho9 can one access 9hether a "ar.et is Cournot or Bertrand so that the forgoing theor, can 7e a##lied to a real "ar.et$ We 9ould consider that to 7e an o(erl, literal inter#retation of the .e, learning #oints fro" this section$ In our (ie9 9hat is critical in an, real 9orld a##lication of this theor, is that anal,st 7e a7le to access 9hether the co""it"ent is a tough one or a soft one and 9hether that in turn 9ill induce co"#etitors or #otential entrants to act "ore aggressi(el, then the, 9ould ha(e had the for" not "ade the co""it"ent$
•
To hel# students understand the i"#act of Astrategic co""it"ents in real "ar.ets the e!a"#les in the cha#ter of ucor 9orld "ar.et for "e"or, chi#s and irline industr, studies are (er, useful$ The follo9ing case studies 9ill gi(e students hands on e!#erience in anal,ing strategic co""it"ents$
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Suggested Harvard Case Study 7
De Beers Consolidated Mines HB+ &%&1053 Esee earlier cha#ters) Du ont in Titaniu" Dio!ide HB+ &%8/140: This case illustrates the strategic logic and ris.s of #ree"#tion$ This case e!a"ines Du ont?s decision to add /00000 tons of ca#acit, to its titaniu" dio!ide #lant in 1&52 in order to *#ree"#t* the "ar.et$ -illettes Launch of +ensor HB+ &5&2028: This case discusses -illettes launch of its +ensor sha(ing s,ste"$ ;ne of the 7iggest #roduct launches e(er and e!a"ines -illettes decision to #osition sensor raor as a cartridge rather than as dis#osa7le in order to 7lunt #otential #rice co"#etition 9ith dis#osa7le raors$ Leading the Charge: The Launch of the -M Card EHB+ &%8/140): This case discusses -eneral Motors launch of the -M credit card in 1&&2$ The incenti(es under the -M card can 7e inter#reted as a .ind of targeted re7ate one of 9hose effects "a, 7e to soften #rice co"#etition in the auto"oti(e 7usiness$ ucor at a Crossroads HB+ &5&%0%&$ ucor is a "ini"ill deciding 9hether to s#end a significant fraction of its net 9orth on a co""erciall, un#ro(en technolog, in order to #enetrate a "ar.et$ This case is an integrati(e one designed to facilitate a full 7lo9n anal,sis of a strategic in(est"ent decision$ This case can 7e #re#ared 9ith so"e co"7ination of the follo9ing cha#ters: & 10 1% 14 and 1/$ ou "a, 9ant to as. students to thin. of the follo9ing >uestions in #re#aration for the case: a) Ho9 attracti(e do the econo"ics of thin sla7 casting loo. 7) Is thin sla7 casting li.el, to afford ucor a sustaina7le co"#etiti(e ad(antage in flat rolled #roducts c) Ho9 should ucor thin. a7out the uncertainties surrounding thin sla7 casting$
hili#s Co"#act Disc Introduction HB+ &5&20%/ Esee earlier cha#ters)
8
These descri#tions ha(e 7een ada#ted fro" Harvard Business School 3445647 Catalog of Teaching Materials#
&/
Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
(inash Di!it and Barr, ale7uff Thin+ing strategically$ The Com%etitive Edge in Business &olitics and Everyday /ife Ee9 or.: orton) 1&&1$ Bulo9 J$ -eana.o#olos and $ le"#erer AMulti"ar.et ;ligo#ol,: +trategic +u7stitutes and Co"#le"ents Journal of olitical cono", &% 1&8/: 488/11$ Chen M$J$ and I$C$ MacMillan Aonres#onse and Dela,ed 'es#onse to Co"#etiti(e Mo(es Di!it $$ and '$+$ ind,c. In(est"ents under Kncertaint, rinceton $J$: rinceton Kni(ersit, ress 1&&4$ The 'oles of Co"#etiti(e De#endence and ction Irre(ersi7ilit, cade", of Manage"ent Journal %/ 1&&2: /%&/50$ -he"a9at $ ACo""it"ent to a rocess Inno(ation: ucor K+R and Thin +la7 Casting Journal of cono"ics and Manage"ent +trateg,2 s#ring 1&&%: 1%%131$ -he"a9at $ ACo""it"ent: The D,na"ics of +trateg, e9 or.
&3
Ans"ers to End of Chapter #uestions 1$ %hat is the difference )et"een a soft commitment and no commitment&
In "a.ing no co""it"ent a fir" has not ta.en an action or "ade an in(est"ent that alters its o9n andGor its ri(als co"#etiti(e res#onses$ In contrast a soft co""it"ent is one that no "atter 9hat its co"#etitors do the fir" 9ill 7eha(e less aggressi(el, than if it had not "ade the co""it"ent$ Thus in a Cournot ga"e a soft co""it"ent 9ill cause the fir" to #roduce relati(el, less out#ut 9hile in a Bertrand ga"e a soft co""it"ent 9ill induce the fir" to charge a higher #rice than if it had not "ade the co""it"ent$ '$ Ho" are commitments related to sun/ costs&
co""it"ent is a difficult to re(erse action or in(est"ent that alters the su7se>uent co"#etiti(e interaction 7et9een a fir" and its ri(als #resu"a7l, to the ad(antage of the fir" "a.ing the co""it"ent$ sun. cost is a cost that has alread, 7een incurred and cannot 7e reco(ered$ In order for an action or in(est"ent to ser(e as a co""it"ent ri(al fir"s "ust 7elie(e the fir" 9ho "ade the in(est"ent 9ill indeed alter their future 7eha(ior$ The .e, to the credi7ilit, of the fir"s strategic co""it"ent is irre(ersi7ilit,$ If a fir" could reco(er the cost of its strategic co""it"ent after it 9as set in "otion "uch credi7ilit, 9ould 7e lost$ Therefore the higher the #ro#ortion of an in(est"ent that is sun. the "ore li.el, that in(est"ent 9ould ser(e as a strategic co""it"ent$ *$ Eplain "hy prices are usually strategic complements and capacities are usually strategic su)stitutes$
If an increase Edecrease) in a #articular action on the #art of one fir" is "et 7, an increase Edecrease) in the sa"e action on the #art of another fir" than the actions are said to 7e strategic co"#le"ents$ If t9o fir"s sell identical #roducts and one fir" lo9ers its #rice the other fir" 9ill lose "an, of its custo"ers$ Most li.el, a fir" can #artiall, restore #rofits 7, res#onding to the #rice cut of its ri(al 7, a #rice cut of its o9n$ Hence #ricecutting often elicits #ricecutting and so #rices are usuall, strategic co"#le"ents$ If an increase Edecrease) in a #articular action on the #art of one fir" is "et 7, a decrease Eincrease) in the sa"e action on the #art of another fir" than the actions are said to 7e strategic su7stitutes$ If a fir" e!#ands ca#acit, it is #rofit "a!i"iing for the fir"s ri(als to choose lo9er ca#acities$ +ince a choice of high ca#acit, 7, a fir" often elicits a res#onse of lo9er ca#acit, 7, ri(al fir"s ca#acit, is usuall, a strategic su7stitute$ .$ %hy did Fuden)erg and Tirole only identify four of the eight possi)le strategic commitment strategies& f the four they did not identify, "hich do you thin/ firms might actually adopt&
The follo9ing are four strategic co""it"ent #ossi7ilities that
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the in(est"ent$ 2$ +trategic Co"#le"ents: Co""it"ent "a.es the fir" soft and the fir" does not "a.e the in(est"ent$ %$ +trategic +u7stitutes: Co""it"ent "a.es the fir" tough and the fir" does not "a.e the in(est"ent$ 4$ +trategic +u7stitutes: Co""it"ent "a.es the fir" soft and the fir" "a.es the in(est"ent$ The reason
The #ur#ose of a co""it"ent is to alter the future 7eha(ior of the fir" and of the fir"s ri(als in such a 9a, as to i"#ro(e the net #resent (alue of the #rofits of the fir" "a.ing the co""it"ent$ If a fir" announces a ca#acit, e!#ansion 7ut the fir"s announce"ent is not credi7le the 7eha(ior of ri(al fir"s 9ill not 7e effected 7, the announce"ent$ Hence the announce"ent has no strategic effect 9hatsoe(er if the fir"s credi7ilit, is in dou7t$ If the fir" actuall, 7uilds the ca#acit, ri(al fir"s ha(e no choice 7ut to alter their 7eha(ior in res#onse to the e!#ansion of ca#acit,$ If the fir"s are Cournot co"#etitors fir"s 9ill react 7, choosing a lo9er ca#acit, if their ri(al has e!#anded their ca#acit,$ Had the fir" si"#l, "ade an announce"ent rather than actuall, 7uilding the ca#acit, ri(al fir"s could ha(e chosen higher ca#acit, forcing the announcing fir" to Areneg on its announce"ent as its 7est res#onse to its ri(als ignoring its initial announce"ent$ $ An esta)lished firm is considering epanding its capacity to ta/e advantage of a recent gro"th in demand$ (t can do so in t"o "ays$ (t can purchase fungi)le, general4purpose assets that can )e resold close to their original value, if their use in the industry proves unprofita)le$ r it can invest in highly speciali+ed assets that, once they are put in place, have no alternative uses and virtually no salvage value$ Assuming that each choice results in the same production costs once installed, under "hat choice is the firm li/ely to encounter a greater li/elihood that its competitors "ill also epand their capacity$
In order to 7e effecti(e co""it"ent "ust 7e (isi7le understanda7le and irre(ersi7le$ The .e, is irre(ersi7ilit,$ In general a significant in(est"ent in a highl, s#ecialied relationshi# s#ecific asset has a high co""it"ent (alue$ The (alue is greater 7ecause the asset has no other use$ s the >uestion states once the #lant is 7uild the fir" has no o#tion 7ut to utilie it 9ithin this #articular industr,$ This sends a strong signal to the co"#etition and the, 7eha(e less aggressi(el,$ Hence if the fir" in(ests in a fungi7le asset there is higher li.elihood that its co"#etitors 9ill also e!#and their ca#acit,$ 3$ Consider a monopoly producer of a dura)le good, such as a supercomputer$
&8
The good does not depreciate$ nce consumers purchase the good from the monopolist, they are free to sell it in the
Mono#olist of a dura7le good faces a #ro7le" that can 7e stated in t9o 9a,s:: • •
Mono#olist of toda, is in co"#etition 9ith "ono#olist of to"orro9 since the good is dura7le$ The good sold toda, has a su7stitute in for" of good fro" the #ast Ei$e$ secondar, "ar.et)
ither 9a, entr, of fir"s or su7stitutes 9ill erode "ono#ol, #rofits$ t the e!tre"e "ono#olist of dura7le goods has no "ar.et #o9er due to the Aentr, and Asu7stitution effect$ This causes "ono#olist to reduce #rice in the su7se>uent #eriod$ Hence rational consu"ers 9ill e!#ect lo9er #rices for" the "ono#olists and "a, decide to 9ait$ Mono#olist "a.ing a credi7le co""it"ent 9ill reduce the a7o(e effect$ This cha#ter gi(es an e!a"#le in for" of "ost fa(ored custo"er clause EMertrand price competitors$ The 2$S$ manufacturer lo))ies the 2$S$ government to give it an eport su)sidy, the amount of "hich is directly proportional to the amount of output the firm sells in the European mar/et$
-i(en that the t9o fir"s are co"#eting as Bertrand #rice co"#etitors stage 2 tactical (aria7les are strategic co"#le"ents$ K$+$ go(ern"ent su7sid, 9ould reduce K$+$ fir"s "arginal costs in uro#e reducing the #rice$ This "a.es fir" 1 tough i$e$ no "atter 9hat its uro#ean counter#art charges fir" 1 9ould charge a lo9er #rice 9ith the su7sid,$ This shifts fir" 1s reaction cur(e in9ards Esee figure 8$4) "o(ing Bertrand e>uili7riu" south9est$
&&
+ince the fir"s are co"#eting in a Cournot industr, their actions are strategic su7stitutes$
5$ Consider t"o firms competing in a Cournot industry$ ne firm L !oom/in Enterprises L is contemplating an investment in a ne" production technology$ This ne" technology "ill result in efficiencies that "ill lo"er its varia)le costs of production$ !oom/in-s competitor, Adams, Co$, does not have the resources to underta/e a similar investment$ !oom/in-s corporate financial planning staff has studied the proposed investment and reports that at current output levels, the present value of the cost savings from the investment is less than the cost of the proect, )ut ust )arely so$ Io", suppose that !oom/in Enterprises hires you as a consultant$ Bou point out that a complete analysis "ould ta/e into account the effect of the investment on the mar/et eJuili)rium )et"een the !oom/in Enterprises and Adam Co$ %hat "ould this more complete analysis say a)out the desira)ility of this investment&
'oo".ins cor#orate financial #lanning is considering onl, the direct effect of the in(est"ent in the ne9 #roduction technolog,$ "ore co"#lete anal,sis 9ould also consider the strategic effect of this #ro@ect on the "ar.et e>uili7riu"$ s su""aried in uili7riu" de#ends on 9hether the t9o fir"s are strategic co"#le"ents or strategic su7stitutes and on 9hether the co""it"ent "a.es the fir" Atough or Asoft$ s the t9o fir"s are co"#eting in Cournot industr, their tactical (aria7les are strategic su7stitutes$ In other 9ords if 'oo".in nter#rises increases #roduction da" Co$s reaction 9ould 7e to decrease #roduction$ The in(est"ent 9ill "a.e 'oo".in nter#rises Atough i$e$ 'oo".in nter#rises 9ill #roduce "ore out#ut than it 9ould ha(e had it not "ade the co""it"ent$ s sho9n in
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"ar.et 9ould 7e a soft co""it"ent it 9ould cause the fir"s co"#etitor to increase its #roduction and 7e "ore aggressi(e$ ntr, 9ould thus ha(e a negati(e strategic effect$ Ho9e(er the situation 9ould 7e re(ersed if entering this ne9 "ar.et causes an increase in the total >uantit, of out#ut the fir" #roduced in the Cournot "ar.et$ This 9ould occur if the fir" had a "arginal cost function that decreases 9ith its total out#ut$ In that circu"stance the fir"s reaction function in the Cournot "ar.et 9ould shift out9ard "a.ing the entr, decision a tough co""it"ent$ In e>uili7riu" the co"#etitor 9ould decrease #roduction and 7e less aggressi(e and this action 9ould ha(e a #ositi(e strategic effect$ 16$ The chapter discussed a situation in "hich a Cournot competitor "ould refrain from entering a geographically distinct mar/et for its product, even though it "ould have a monopoly in that mar/et$ 2nder "hat circumstances "ould this incentive )e reversed&
The a7o(e fir" is considering an in(est"ent that "a.es the fir" soft on its ri(als$ Ksing the ta!ono", 9hen the nature of stage 2 tactical (aria7les is strategic su7stitutes ECournot co"#etition) and the in(est"ent "a.es the fir" soft the strateg, of #roceeding 9ith the in(est"ent is la7eled A+uicidal +i7erian this la7el indicates the ad(erse strategic affect$ The ca#acit, constrained fir" 9ill relin>uish share in the "ar.et it currentl, co"#etes in as a result of entering another "ar.et hence entering a ne9 "ar.et is a.in to handing "ar.et share o(er to its e!isting ri(al in its e!isting "ar.et$ If the direct effect of entering the ne9 "ar.et is sufficient #ositi(e Ethat is greater than the loss of #rofits in the fir"s e!isting "ar.et) then entering the ne9 "ar.et "a, 7e reasona7le$ 11$ This Juestion refers to information in Juestion 16 in Chapter $ Chuc/ie > Corp$ is considering implementing a proprietary technology they have developed$ The onetime sun/ cost of implementing this process is *06$ nce this investment is made, marginal cost "ill )e reduced to '0$ ;ene ;ene has no access to this, or any other cost4saving technology, and its marginal cost "ill remain at .6$ Chuc/ie >-s financial consultant o)serves that the investment should not )e made, )ecause a cost reduction of 10 on each of the '6 machines results in a savings of only *66, "hich is less than the cost of implementing the technology$ (s the consultant-s analysis accurate& %hy or "hy not& Compute the strategic effect of the investment$
E1) Π1 V 161 TC1 V E100 6 1 62 ) 61 40 61 E2) Π2 V 262 TC2 V E100 6 1 62 ) 62 2/ 62 o9 ta.e the deri(ati(e of each of the a7o(e 9ith res#ect to 6: E1) Ma! Π1 V 100 26 1 62 40 61 V %0 $/62
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E2) Ma! Π2 V 100 26 2 61 2/ 62 V %5$/ $/61 o9 sol(e the a7o(e si"ultaneousl,: 61 V %0 $/62 V 61 V %0 $/E%5$/ $/6 1) 61 V 1/ and 6 2 V %5$/ $/E1/) V %0 To find 9e use the "ar.et de"and cur(e: V 100 6 V 100 6 1 62 V 100 1/ %0 V Q// nd finall, each fir"s #rofits: Π1 V
161 TC1 V E//S1/) E40S1/) V 82/ 300 V Q22/ and
Π2 V
262 TC2 V E//S%0) E2/S%0) V 13/0 5/0 V Q&00
The fir" 9ho in(ested in the cost sa(ing technolog, does sa(e Q1/ on the ;'I-IL 20 units it #roduced$ Ho9e(er there are additional effects: The fir" is a7le to use its cost ad(antage to ta.e share fro" its ri(al: The fir" used to sell 20 units at Q30 Ere(enue Q1200)$ o9 the fir" sells %0 units at Q// Ere(enue Q13/0)$ The fir"s used to @ointl, earn Q2400 no9 the, @ointl, earn Q245/$ +o the consultant failed to count the gain in units E"ar.et share) the in(esting fir" 9ould en@o,$ Belo9 9e la, out the effects the fir" 9ho "a.es the in(est"ent gets: Q20 S 1/ V Q%00 cost sa(ings on original 20 Q// S 10 V Q//0 ne9 units sold at ne9 #rice as a result of ha(ing a cost ad(antage Q/S20 V Q100 loss in re(enue on original units as a result of selling the" at a ne9 #rice Q2/S10 V Q2/0 cost of "a.ing 10 "ore units total increase in #rofits: Q/00 EQ&00 Q400) While the consultant ac.no9ledged the gain of Q%00 the consultant did not address the other effects$
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Chapter 7 The Dynamics of ?ricing !ivalry Chapter Contents 1) Introduction 2) D,na"ic ricing 'i(alr, Wh, the Cournot and Bertrand Models re ot D,na"ic • Intuition • Co"#etitor 'es#onses and TitforTat ricing • TitforTat ricing 9ith Man, uili7riu" • Wh, is TitforTat so Co"#elling • Misreads • !a"#le 8$2:
3) 5)
Cha#ter +u""ar, 6uestions
10%
Chapter Summary
Through e!a"#les and theor, Cha#ter 8 further e!#lores industr, ri(alr, and e!a"ines 9hat conditions affect the intensit, of #rice co"#etition in an industr,$ Wh, are so"e fir"s a7le to coordinate their #ricing 7eha(ior to a(oid costl, #rice 9ars 9hile other fir"s engage in (icious #rice 9ars This cha#ter introduces a set of "odels and anal,tical fra"e9or.s that hel# e!#lain 9h, fir"s co"#ete as the, do$ These "odels 7uild on the ideas introduced in Cha#ter 3$ Ho9e(er unli.e Cha#ter 3 these "odels are d,na"ic that is the, assu"e fir"s engage in re#eated interactions 9ith each other$ This cha#ter introduces a theor, of ri(alr, to e!#lain ho9 fir"s act 9hen the, "eet re#eatedl, o(er ti"e=a d,na"ic that is not full, enco"#assed in the Cournot or Bertrand oligo#ol, "odels$ The first section descri7es a scenario 9here t9o fir"s co"#eting in the sa"e industr, 9ith the e!act sa"e #roduct and cost structure could charge "ono#ol, #rices and rea# "ono#ol, #rofits 9ithout "eeting or engaging in #rice collusion$ This d,na"ic #ricing ri(alr, theor, su##orts this intuition and further suggests that an, #rice 7et9een the "ono#ol, #rice and "arginal cost C can 7e sustained as an e>uili7riu"$ The cha#ter uses the ter" Acoo#erati(e #ricing to refer to these situations in 9hich fir"s are a7le to sustain higher #rofits than 9ould 7e #redicted 7, the Cournot and Bertrand "odel$ This e!a"#le and theore" #ro(e that coo#erati(e #ricing is #ossi7le 7ut not guaranteed$ There are strategies that a fir" can ado#t to increase the li.elihood that coo#erati(e #ricing 9ill occur in their "ar.et$ The cha#ter focuses on the #ros and cons of the tit6 for6tat strategy a strateg, that is a##ealing in its si"#licit, and its #o9er$ The cha#ter goes on to discuss four "ar.et structure conditions and 9hether the, hel# or hinder fir"s fro" achie(ing coo#erati(e #ricing and co"#etiti(e sta7ilit,: "ar.et concentration structural conditions that affect reaction s#eeds and detection lags as,""etries a"ong fir"s and "ulti"ar.et contact$ lthough "ar.et structure strongl, affects a fir"s a7ilit, to sustain coo#erati(e #ricing this cha#ter discusses four 9a,s in 9hich fir"s can facilitate coo#erati(e #ricing: though #rice leadershi# ad(ance announce"ents of #rice changes "ost fa(ored custo"er clauses and unifor" deli(ered #ricing$ The cha#ter discusses each of these "ethods in turn$ The last section of this cha#ter addresses non#rice co"#etition such as co"#etition 9ith res#ect to #roduct >ualit,$ This #art of the cha#ter e!#lores ho9 "ar.et structure influences a fir"s decision to choose its le(el of #roduct >ualit,$ It also e!a"ines the role that consu"er infor"ation #la,s in sha#ing the nature of co"#etition 9ith res#ect to >ualit,$ +#ecificall, if consu"ers do not ha(e #erfect infor"ation a7out #roduct >ualit, or if a consu"er cannot gauge >ualit, a le"ons "ar.et can e"erge Ei$e$ cars health insurance)$ When sellers ha(e "ar.et #o9er the >ualit, the, #ro(ide de#ends on the "arginal cost and "arginal 7enefit of increasing >ualit,$ The "arginal 7enefit of increasing >ualit, de#ends on the increase in de"and 7rought on 7, the increase in >ualit, and the incre"ental #rofit earned on each additional unit sold$ This i"#lies that a fir"s #ricecost "argin is an i"#ortant deter"inant of its incenti(es to raise >ualit,$
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Approaches to Teaching this Chapter
Cha#ters 8 and & ha(e the "ost difficult "icroecono"ics content and students 9ith 9ea.er "icroecono"ic 7ac.grounds 9ill find these cha#ters es#eciall, challenging$ In teaching this cha#ter one could 7egin 7, tal.ing a7out the notion of #rice coo#eration 9hich is the a7ilit, of fir"s 9ithin an industr, to collecti(el, a(oid the *#risoners? dile""a* outco"e of #ricing that is to do 7etter than the, 9ould do in a static Bertrand or Cournot e>uili7riu"$ The first section of Cha#ter 8 de(elo#s a theoretical fra"e9or. E7ased on a re#eated #risoners dile""a ga"e "odel) for loo.ing at fir"s? incenti(es to de(iate fro" coo#erati(e outco"es$ This fra"e9or. has (er, #o9erful i"#lications for ho9 "ar.et structure conditions i"#act the li.elihood of fir"s to achie(e #ricing coo#eration$ >uation 8$1 sets forth a condition for the coo#erati(e #ricing outco"e to 7ean e>uili7riu" in a noncoo#erati(e ga"e of #rice setting$ This condition can then 7e used to de(elo# insights a7out ho9 "ar.et structure affects the intensit, of #ricing ri(alr,$ The ne!t section de(elo#s this #oint in detail$ This section is the heart of the cha#ter$ The instructor should co(er carefull, ho9 "ar.et concentration as,""etries a"ong fir"s "ulti"ar.et contact reaction s#eeds and detection lags affect the sustaina7ilit, of coo#erati(e #ricing$ It is then natural to follo9 u# this "aterial 9ith a co(erage of facilitating #ractices: #rice leadershi# ad(ance announce"ent of #rice changes "ost fa(ored custo"er clauses unifor" deli(ered #ricing and strategic use of in(entories and order 7ac.logs$ The *6ualit, Co"#etition* section of the cha#ter discusses the other di"ensions 7esides #rice along 9hich co"#etition can ta.e #lace$ This section does not follo9 directl, the earlier #arts of the cha#ter and can easil, 7e dro##ed$
10/
Suggested Harvard Case Study
Cater#illar HB+ &%8/253 Esee earlier cha#ters) De Beers Consolidated Mines HB+ &%&1053 Esee earlier cha#ters) ucor at a Crossroads HB+ &5&%0%& Esee earlier cha#ters) hili#s Co"#act Disc Introduction HB+ &5&20%/ Esee earlier cha#ters)
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Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
!elrod '$ The Evolution of Coo%eration e9 or.: Basic Boo.s 1&84$ Bernhei" B$D$ and M$ Whinston *Multi"ar.et Contact and Collusi(e Beha(ior* AN* :ournal of Economics 21 +#ring 1&&0: 123$ Cha"7erlin $H$ Mono%olistic Com%etition Ca"7ridge M: Har(ard Kni(ersit, ress 1&%% #$ 48 Di!it $ and B$ ale7uff Thin+ing Strategically#6 The Com%etitive Edge in Business &olitics and Everyday /ife e9 or.: orton 1&&1$ Drano(e D$ and M$ +atterth9aite *Mono#olistic Co"#etition When rice and 6ualit, are ot erfectl, ;7ser(a7le* AN* :ournal of Economics Winter 1&&2: /18/%4$ re#s D$M$ A Course in Microeconomic Theory rinceton J: rinceton Kni(ersit, ress 1&&0 ##$ %&2%&%$ Merrilees W$ *nato", of a rice Leadershi# Challenge: n (aluation of ricing +trategies in the ustralian e9s#a#er Industr,* :ournal of (ndustrial Economics RRRI March 1&8%:2&1%11$ +chellingTho"as$ The Strategy of Conflict Ca"7ridge M: Har(ard 1&30$ +cherer <$M$ and D$ 'oss (ndustrial Mar+et Structure and Economic &erformance e9 or.: Houghton Mifflin 1&&1$ +#ence $M$ *Mono#ol, 6ualit, and 'egulation* Bell :ournal of Economics 1&5/: 41542&$ +tigler -eorge J$ * Theor, of ;ligo#ol,* :ournal of &olitical Economy 52 E1)
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Ans"ers to End of Chapter #uestions 1$
Consider a fir" Efir" R) 9hose out#ut is onl, slightl, differentiated fro" the out#ut of other fir"s in the industr,$ If the fir" Rs ri(als lo9er their #rices than fir" R 9ill loose significant "ar.et share and 9ill conse>uentl, suffer a reduction in #rofits$ Collecti(el, the fir"s in the industr, ha(e lo9er #rofits after a #rice reduction= ho9e(er it is #ossi7le that e(en though the total #rofit #ie is s"aller so"e fir"s are 7etter off after the #rice reduction$ Ho9e(er since total industr, #rofits are lo9er "ore fir"s see their #rofits decline than see their #rofits increase=hence 9e can #resu"e that on a(erage fir"s #refer industr, #rice to 7e high$ '$ %hy do misreads and misudgements encourage firms to lo"er prices&
Consider 9hat "ight ha##en 9hen t9o fir"s are #la,ing titfortat and there is a chance that a coo#erati(e "o(e is "isread an uncoo#erati(e one$ The fir" that "isreads the coo#erati(e "o(e as an uncoo#erati(e one res#onds 7, "a.ing an uncoo#erati(e "o(e in the ne!t #eriod$ The fir" lo9ers #rice in order to enforce the titfortat strateg,$ It is #ossi7le that a fir" "ista.es the actions of its ri(al as aggressi(e and so reacts 9ith a #rice cut in order to #rotect (olu"e$ *$ Firms operating at or near capacity are unli/ely to instigate price "ars$ >riefly eplain$
uantit, the, sold 7efore the #rice reduction$ Ho9e(er this loss can 7e offset 7, an increase in units sold due to the no9 lo9er #rice$ If a fir" is at or near ca#acit, its a7ilit, to e!#and >uantit, sold is constrained and hence the fir" cannot reco(er the forgone #rofits fro" selling each unit at a lo9er "argin$ The ca#acit, constrained fir" has little incenti(e to initiate a #rice reduction$
.$
The relati(e le(els of #rofita7ilit, fro" coo#erating and defecting in the collusi(e #ricing ga"e are 9hat 9ill ulti"atel, deter"ine the sta7ilit, of #rice coo#eration$ Mar.et share is onl, i"#ortant in so far as it is often a good #ro!, for #rofita7ilit,$ rice"atching 7eha(ior 9ill not necessaril, lea(e "ar.et shares unchanged$
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le(el of 7enefits in the the "ar.et "a, (ar, as #rices change$ change$ In addition changes changes in "ar.et share "a, also occur if "o(e"ents in #rice allo9 one fir" to de(elo# a "ore fa(ora7le 7rand i"age or re#utation re#utation or if net9or. e!ternalities e!ternalities are at 9or.$ uall,$ If
Circu"stantial e(idence of titfortat titfortat #ricing is relati(el, eas, to find$ find$ u7lic #ricing 7eha(ior li.e the ad(ance ad(ance announce"ent of #rice changes changes and the use of co""it"ents co""it"ents to "eet the lo9est a(aila7le #rice su##ort #rice coordination and sta7ilit, as does si"#lified #ricing 7eha(ior 7eha(ior such as ha(ing annual #ricing re(ie9s$ Ho9e(er hard e(idence of titfortat #ricing is "uch harder to co"e 7, unless fir"s are foolish enough to #ut a collusi(e agree"ent agree "ent in 9riting$ ou 9ould 9ant detailed data on historical #rices and fir" #rofits in an atte"#t to discern #ricing #atterns that su##ort a7o(ea(erage industr, #rofita7ilit,$ #rofita7ilit,$ ;ne such telltale #attern is a #unish"ent strateg, strateg, 9here all fir"s lo9er #rice to Z#unish a renegade fir" that reduces its #rice unilaterall,$ unilaterall,$ Then after a #eriod all fir"s raise their #rice 7ac. to the #re(ious higher le(el$ Ho9e(er fir"s fir"s can al9a,s argue that e!ternal circu"stances circu"stances are res#onsi7le for the #rice "o(es$
s the argu"ent in the Mcinse, article #oints out there are ris.s in(ol(ed in ado#ting the titfortat strateg,$ strateg,$ Misreading #ricing "o(es "ade "ade 7, co"#etitors can lead to alternating coo#erati(e and uncoo#erati(e res#onses or all uncoo#erati(e res#onses$ When the #ossi7ilit, of "isreads e!ists it "a, 7e 7eneficial for a fir" to ado#t a "ore forgi(ing strateg, to reduce the li.elihood of detri"ental res#onses to a co"#etitors #rice de(iations$ Ho9e(er ado#ting ado#ting the titfortat titfortat strateg, 7efore 7efore a #rice 9ar ensues can ser(e as a #o9erful deterrent sustaining "ono#ol, "ono#ol, #ricing at a noncoo#erati(e e>uili7riu"$
3$ Studies Studies of pricing pricing in the the airline airline industry industry sho" sho" that that carriers carriers that domin dominate ate hu)
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airports Delta in Atlanta, 2SAir in ?itts)urgh, American American in Dallas tend to charge higher fares, on average, for flights in and out of the hu) airport than other, non4dominate, carriers flying in and out of the hu)$ %hat might eplain this pattern of prices&
There are se(eral reasons 9h, do"inant hu7 airlines can charge higher #rices than non do"inant carriers fl,ing in and out of the hu7$ uenc, that hu7 airlines #ro(ide reduces the nu"7er of su7stitute flights a(aila7le for consu"ers$ This shifts the de"and for the hu7 airline out reducing reducing the #rice elasticit, for the hu7 airlines flights$ nd finall, finall, s"aller airlines "a, reduce #rices 7elo9 the hu7 airline airline #rices 7ecause the the do"inant airline has little little incenti(e to retaliate 9ith a #rice 9ar$ 7$ (t is often often argued argued that price price "ars "ars may )e more more li/ely li/ely to occur occur during during lo" lo" demand periods than during high demand periods$ periods$ This chapter ma/es ma/es that argument$ Are there there factors that might reverse this implication& That is, can you you thin/ of reasons "hy the attractiveness of deviating from cooperative pricing might actually )e greater during )ooms high demand than during )usts lo" demand&
De(iation fro" coo#erati(e coo#erati(e #ricing can occur during during econo"ic 7oo"s$ During #eriods of high de"and gaining the do"inant "ar.et share #osition 9ill ca#ture a higher #ercentage of industr, industr, #rofits$ lso recogniing recogniing the ine(ita7le ine(ita7le do9nturn in their their "ar.et follo9ing a 7oo" #eriod a fir" "a, 7e te"#ted to ca#ture #rofits to ser(e as a cushion during an econo"ic econo"ic do9nturn$ -aining a do"inant do"inant "ar.et share is "ore #rofita7le during a 7oo" 7oo" than during a do9nturn$ do9nturn$
B, ado#ting a conte"#oraneous "ost fa(ored custo"er clause EM
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a(erage e>uili7riu" #rice 9ill increase as 9ell $
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Chapter 5 Entry and Eit Chapter Contents 1) Introduction 2) +o"e
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Chapter Summary
The focus of this cha#ter is on the d,na"ics of entr, and e!it in the "ar.et#lace$ In general entrants into an industr, reduce the "ar.et share of fir"s in the industr, and intensif, co"#etition through #roduct introduction and #rice co"#etition$ This in turn reduces #rofits for all co"#eting fir"s in the industr,$ Li.e9ise 9hen a fir" e!its an industr, "ar.et share for re"aining fir"s is increased #rice and #roduct co"#etition is reduced and #rofits increase$ fir" 9ill enter a "ar.et if the net #resent (alue of e!#ected #ostentr, #rofits e!ceed the sun. costs of entr,$ fir" 9ould e!it a "ar.et if the e!#ected future losses e!ceed the sun. costs of e!it$ uire"ents and li"ited access to resources are all e!a"#les of structural entr, 7arriers$ !it 7arriers arise 9hen fir"s ha(e o7ligations that the, "ust .ee# 9hether the, #roduce or not$ !a"#les of such o7ligations include la7or agree"ents and co""it"ents to #urchase ra9 "aterials o7ligations to in#ut su##liers and relationshi# s#ecific in(est"ents$ The cha#ter contains a discussion of the strategies that incu"7ents e"#lo, to deter entr, or hasten e!it 7, co"#etitors$ Li"it #ricing #redator, #ricing and ca#acit, e!#ansion change entrants forecasts of the #rofita7ilit, of #ostentr, co"#etition and thus reduce the threat of entr, andGor #ro"ote e!it$ Li"it #ricing refers to the #ractice 9here7, an incu"7ent fir" can discourage entr, 7, its a7ilit, to sustain a lo9 #rice u#on facing entr, 9hile setting a higher #rice 9hen entr, is not i""inent$ redator, #ricing is the #ractice of setting a #rice 9ith the o7@ecti(e of dri(ing ne9 entrants or incu"7ent fir"s out of the industr,$ Li"it #ricing and #redator, #ricing strategies can succeed onl, if the entrant is uncertain a7out the nature of #ostentr, co"#etition$
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The last section of this cha#ter discusses sur(e, of #roduct "anagers a7out their use of entr, deterring strategies$ roduct "anagers re#orted that the, rel, "uch "ore on entr,deterring strategies Eaggressi(e #rice reduction intense ad(ertising to create 7rand lo,alt, and ac>uiring #atents) than strategies that affect the entrants #erce#tion Eenhancing fir"s re#utation through announce"ents Li"it #ricing and holding e!cess ca#acit,)$ Managers also re#orted that the, are "ore li.el, to #ursue entr,deterring strategies for ne9 #roducts than for e!isting #roducts$
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Approaches to teaching this chapter
The student "ust 7e fa"iliar 9ith the follo9ing definitions and conce#ts as descri7ed in Cha#ter & : Definitions:
cco""odated ntr,: e!ists if structural entr, 7arriers are lo9 and either Ea) entr, deterring strategies 9ould 7e ineffecti(e or E7) the cost to incu"7ents of tr,ing to deter entr, e!ceeds the #otential 7enefits fro" .ee#ing entrants out$ Bloc.aded ntr,: e!ists if incu"7ents need not underta.e an, entr,deterring strategies to deter entr,$ Bloc.aded entr, "a, result 9hen there are structural entr, 7arriers or if entrants e!#ect unfa(ora7le #ostentr, co"#etition #erha#s 7ecause the entrants #roduction is undifferentiated fro" that of the incu"7ents$ Deterred ntr,: e!its 9hen incu"7ents can .ee# entrants out 7, entr,deterring strategies$ ntr,: occurs as ne9 fir"s 7egin #roduction and sales in a "ar.et$ ntr, can occur under t9o different situations: Ea) 7, ne9 fir"s that 9ere #re(iousl, not in the industr, or E7) di(ersif,ing fir"s 9hich are fir"s that 9ere in 7usiness 7ut 9ere not #re(iousl, doing 7usiness in that "ar.et$ !it: occurs 9hen a fir" ceases to #roduce in a "ar.et$ !it fro" an industr, occurs 9hen a fir" ceases to o#erate co"#letel, or continues to o#erate in other "ar.ets 7ut 9ithdra9s its #roduct offerings fro" the industr, under consideration$ To e!it an industr, a fir" sto#s #roduction and either rede#lo,s or sells off its assets$ Incu"7ent: fir" that is alread, in o#eration in a "ar.et # Li"it ricing: refers to the #ractice 9here7, an incu"7ent fir" can discourage entr, 7, charging a lo9 #rice 7efore entr, occurs$ The entrant o7ser(ing the lo9 #rice set 7, the incu"7ent infers that #ostentr, #rice 9ould 7e as lo9 or e(en lo9er and that entr, into the "ar.et 9ould therefore 7e un#rofita7le$ erfectl, Contesta7le: descri7es the condition 9hen a "ono#olist cannot raise #rices a7o(e co"#etiti(e le(els$ In theor, the threat of entr, can constrain a "ono#olist fro" raising #rices$ ostentr, Co"#etition: the conduct and #erfor"ance of fir"s after entr, has occurred$ redator, cts: are entr, deterring strategies 7, an incu"7ent that a##ear to reduce its #rofits until one account for the additional #rofits that it earns 7ecause the acts deter entr, or #ro"ote e!it 7, co"#etitors$ redator, ricing: refers to the #ractice of setting #rice 9ith the o7@ecti(e of dri(ing ne9 entrants or e!isting fir"s out of 7usiness$ +trategic ntr, Barriers: e!ists 9hen incu"7ent fir"s ta.e e!#licit actions ai"ed at deterring entr,$ ntr,deterring strategies include ca#acit, e!#ansion li"it #ricing and #redator, #ricing$
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+tructural ntr, Barriers: result 9hen incu"7ents ha(e natural cost or "ar.eting ad(antages or 7enefits fro" fa(ora7le regulations$ Lo9 de"and highca#ital re>uire"ents and li"ited access to resources are all e!a"#les of structural entr, 7arriers$ ?articular attention must )e paid to the follo"ing concepts: •
•
ntr, reduces share increases co"#etition and reduces #rofits$ !it has the in(erse effects$ Barriers to entr, are a "a@or factor in e(aluating entr, conditions into a "ar.et$ The case studies and e!a"#les in the te!t hel# the student identif, the different t,#es of 7arriers$ It is i"#ortant the student 7e a7le to not onl, understand the 7arriers to entr, in the e!a"#les 7ut to also 7e a7le to a##l, this .no9ledge to other industries$
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ostentr, Co"#etition is ho9 entrants assess their 9illingness to enter a "ar.et$ Thus Incu"7ent fir"s "a, use entrancedeterring strategies to a(ert entrance 7, ne9 fir"s$
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+tudents "ust understand the assu"#tions under 9hich li"it #ricing 9ill and 9ill not 9or.$ ssu"ing that a fir" considering entering a "ar.et has #erfect "ar.et infor"ation li"it #ricing 9ould ne(er 9or. for an incu"7ent fir"$ It is onl, 9hen the entrant is unsure a7out the le(el of #ostentr, #rices that li"it #ricing "a, 9or.$
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In order for a fir" to "a.e a successful entrance into a "ar.et it "ust 7e a7le to recognie a 9ide host 7arriers to entr, and antici#ate the "an, scenarios #ostentr, 7eha(ior 7, the entrants co"#etitors$
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Suggested Harvard Case Studies
5
Cater#illar HB+ &%8/253 Esee earlier cha#ters) De Beers Consolidated Mines HB+ &%&1053 Esee earlier cha#ters) The Dis#osa7le Dia#er Industr, in 1&54 HB+ &%8015/: This case descri7es the ra#idl, gro9ing dis#osa7le dia#er industr, in 1&54 a #eriod in 9hich rocter and -a"7les industr, leadershi# faced strong challenges fro" i"7erl, Clar. Johnson and Johnson and Knion Car7ide$ This illustrates one of the "ain the"es of the cha#ter: that a #otential entrant "ust antici#ate the li.el, reactions of incu"7ent fir"s 9hen deciding 9hether or not to enter a "ar.et$ This case also allo9s students to calculate the net #resent (alue of entr, under a (ariet, of #ossi7le #ostentr, scenarios$ ucor at a Crossroads HB+ &5&%0%& Esee earlier cha#ters) +i"e Dar7, Berhad=1&&/ HB+ &5&5015 Esee earlier cha#ters) +outh9est irlines HB+ &3&402%: +outh9est irlines a s"all intrastate carrier ser(ing Dallas Houston and +an ntonio 7egins ser(ice in 1&51 in the face of co"#etition 7, t9o larger entrenched airlines$ I"#ro(ed >ualit, ser(ice lo9er #rices and inno(ati(e ad(ertising and #ro"otional strateg, 7ring +outh9est to the 7rin. of #rofita7ilit, in earl, 1&5% 9hen its "a@or co"#etitor hal(es fares on +outh9ests "a@or route$ Manage"ent 9onders 9hat res#onse to "a.e$ The follo9ing are good #re#aration >uestions: a) Ho9 has +outh9est 7een a7le to lo9er costs so "uch 7) Ho9 ha(e the, 7een a7le to recruit so "an, fliers c) Ho9 did route selection hel# +outh9est e!ecute the a7o(e strateg,
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These descri#tions ha(e 7een ada#ted fro" Harvard Business School Catalog of Teaching Materials#
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Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
Bain J# Barriers to New Com%etition$ Their Character and Conse>uences in Manufacturing (ndus tries Ca"7ridge M: Har(ard Kni(ersit, ress 1&/3$ Bau"ol W$J$ anar and '$ Willig Contesta)le Mar+ets and the Theory of (ndustrial Structure e9 or.: Harcourt Brace Jo(ano(ich 1&82$ Dunne T$ 'o7ertM$J$ and +a"uelson L # &atterns of 0irm Entry and E8it in 1#S# Manufacturing (ndustries 'D Journal of cono"ics E9inter 1&88) ##$ 4&//1/$
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Ans"ers to End of Chapter #uestions &. Dunne, !o)erts, and Samuelson found that industries "ith high entry rates tended to also have high eit rates$ Can you eplain this finding& %hat does this imply for pricing strategies of incum)ent firms&
roduction e!hi7iting lo9 econo"ies of scale Ea condition that 9ea.ens entr, 7arriers) and re>uiring little or no in(est"ent in s#ecialied assets Ea condition that 9ea.ens e!it as 9ell as entr, 7arriers) is fre>uentl, o7ser(ed in industries e!hi7iting high entr, and high e!it$ Consider the follo9ing scenario:
ntr, and e!it rates "a, 7e affected 7, changes in the state of an industr,s technolog,$ It is li.el, that e(en for ser(ice and retail industries conditions that encourage entr, in an industr, also foster e!it$ .
ntr, is 7loc.aded if the incu"7ent need not underta.e an, entr,deterring strategies to deter entr,$ Bloc.aded entr, "a, result 9hen there are structural entr, 7arriers #erha#s 7ecause #roduction re>uires significant fi!ed in(est"ents$ Bloc.aded entr, "a, also result if the entrant e!#ects unfa(ora7le #ostentr, co"#etition #erha#s 7ecause the entrants #roduct is undifferentiated fro" those of the incu"7ents$ ntr, is deterred if the incu"7ent can .ee# the entrant out 7, e"#lo,ing entr, deterring strategies such as li"it #ricing #redator, #ricing and ca#acit, e!#ansion$ Moreo(er the cost of the entr,deterring strateg, is "ore than offset 7, the additional #rofits that the incu"7ent en@o,s in the less co"#etiti(e en(iron"ent$ Ho9e(er entr, deterring strategies are generall, "et 9ith (arious degrees of success$ Control of essential resources econo"ies of scale and sco#e and "ar.eting ad(antages of incu"7enc, are t,#es of entr, 7arriers$ The fir" 9ho is a7le to use one or a co"7ination of these entr, 7arriers to 7loc.ade entr, does not ha(e to acti(el, guard itself against entr, and so can focus on other acti(ities$ If entr, is deterred rather than 7loc.aded the incu"7ent "ust acti(el, engage in #redator, acts to discourage entr,$ threat of entr, 9ill "ost definitel, constrain the incu"7ent$ -i(en the incu"7ent
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"ight #refer to 7e #assi(e rather than acti(e a7out discouraging entr, 7loc.aded entr, 9ould 7e #refera7le to detera7le entr,$ . Eplain "hy economies of scale do not protect incum)ents from hit4and4run entry unless the associated fied costs are sun/$ Does the learning curve limit contesta)ility& If the fir"s in(est"ents are nonsun. this suggests the fir" can e!it and reco(er the costs of its in(est"ents$ This reduces the ris. associated 9ith entr, and therefore increases the li.elihood of hitandrun entr,$ If the fir" en@o,s lo9er costs as a result of the learning cur(e the "ar.et is less li.el, to 7e contesta7le$ The learning fir"s en@o, as a 7,#roduct of one #roduction #rocess are unli.el, to 7e a##lica7le to other #rocesses hence the learning is tied to this #articular acti(it,$ +ince the learning cannot lea(e the acti(it, hitandrun entr, is less attracti(e$ *. Ho" a firm )ehaves to"ard eisting competitors is a maor determinant of "hether it "ill face entry )y ne" competitors$ Eplain$
If a fir" is Atough to9ards e!isting co"#etitors Efor e!a"#le the fir" is in(ol(ed in #rice or non#rice co"#etition) the fir" 9ill face less entr, 7ecause entrants 9ill e!#ect lo9er #rofits than if the incu"7ent 9ere "ore tolerant of entr,$ Ho9e(er if the incu"7ent has a Asoft stance to9ards the e!isting co"#etitors the entrant "a, ta.e this a signal for so"e acco""odation of entr, and thus the entr, rate could 7e higher$ The incu"7ent signals 9hat #ostentr, co"#etition 9ill 7e li.e through its current 7eha(ior to9ard other fir"s in the industr,$ +. %hy is uncertainty a /ey to the success of entry4deterrence&
ntr, deterring strategies include li"it #ricing #redator, #ricing and ca#acit, e!#ansions$ •
•
•
Li"it ricing: If entrants o#erated in a 9orld of certaint, it 9ould 7e difficult to find a rational e!#lanation for li"it #ricing$ In general entering fir"s "ust 7e uncertain a7out so"e characteristic of the incu"7ent fir" or the le(el of "ar.et de"and$ The incu"7ent 9ants the entrant to 7elie(e that #ost entr, #rices 9ill 7e lo9$ If the entrant is sure a7out the factors that deter"ine #ostentr, #ricing it can calculate the incu"7ents #a,offs fro" all #ossi7le #ostentr, #ricing scenarios and correctl, forecast the #ostentr, #rice$ If the entrant is uncertain a7out the #ostentr, #rice ho9e(er then the incu"7ents #ricing strateg, could affect the entrants e!#ectations$ redator, ricing: s 9ith li"it #ricing #redator, #ricing 9ould a##ear to 7e irrational if entrants o#erated under certaint,$ If ho9e(er entrants lac. certaint, then #ricecutting 7, an incu"7ent "a, affect the entrants e!#ectations of the incu"7ents future #ricing strategies$ ;#erating under uncertaint, "a.es it "ore difficult for the entrant to rule out a 7ad #ostentr, scenario and therefore #redator, #ricing "a, indeed discourage entr,$ !cess Ca#acit,: Knli.e #redator, #ricing and li"it #ricing e!cess ca#acit, can deter entr, e(en 9hen the entrant #ossesses full infor"ation a7out the incu"7ents costs and strategic direction$ If the incu"7ent is holding an entr, deterring le(el of ca#acit, it is actuall, in the incu"7ents interest to con(e, this infor"ation to 9ould 7e entrants$ If ho9e(er the incu"7ent is una7le to hold an entr,deterring
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le(el of in(est"ent then the incu"7ent "ight ho#e the entrant is uncertain a7out the le(el of ca#acit, the incu"7ent actuall, holds$
,. An incum)ent is considering epanding its capacity$ (t can do so in one of t"o "ays$ (t can purchase fungi)le, general purpose eJuipment and machinery that can )e resold at close to its original value$ r it can invest in highly speciali+ed machinery that, once it is put in place, has virtually no salvage value$ Assuming that each choice results in the same production costs once installed, under "hich choice is the incum)ent li/ely to encounter a greater li/elihood of entry and "hy&
The in(est"ent that is "ore (isi7le understanda7le and irre(ersi7le is "ore li.el, to deter entr,$ In general a significant in(est"ent in a highl, s#ecialied relationshi# s#ecific asset has a high co""it"ent (alue$ The (alue is greater 7ecause the asset has no other use$ ssentiall, the fir" 9hose in(est"ent has no outside o#tion has increased its o9n e!it 7arrier$ !it 7arriers can li"it the incenti(es for the fir" to sto# #roducing e(en 9hen the #re(ailing conditions are such that the fir" had it .no9 9ith certaint, that these conditions 9ould #re(ail 9ould not ha(e entered in the first #lace$ -i(en the fir" is less li.el, to e!it during #oor industr, conditions entr, is less attracti(e as industr, do9nturns 9ill generate lo9er o(erall #rofits than if fir"s could rede#lo, their assets to other uses$ s the >uestion states once the #lant is 7uild the fir" has no o#tion 7ut utilie it 9ithin this #articular industr,$ This sends a strong signal to the co"#etition and the, 7eha(e less aggressi(el,$ Hence if the fir" in(ests in a fungi7le asset there is higher li.elihood that entr, 9ill not 7e as deterred$ . (n most mode of entry deterrence, the incum)ent engages in predatory practices that harm a potential entrant$ Can these models )e reversed, so that the entrant engages in predatory practices& (f so then "hat are the practical differences )et"een incum)ents and entrants&
ntrants and incu"7ents roles can 7e s9itched in the theoretical "odels and the results 9ill hold true$ If the entrant has dee# #oc.ets then it can engage in #redator, #ractices to dri(e incu"7ent out$ Incu"7ents ha(e an ad(antage in that the, in "ost cases 9ould ha(e created 7rand lo,alt, or re#utation net9or. e!ternalities and lo9er costs due to learning cur(e$ Ta.ing all the a7o(e factors into account it is less li.el, that entrant 9ill #ursue #redator, #ractices$ . !ecall the discussion of monopolistic competition in chapter 3$ Suppose that an entrepreneur considered opening a video store along Straight Street in @inesville$ %here should the entrepreneur position the store& Does your ans"er depend on "hether additional entry is epected&
uall, s#aced along the street$ n entre#reneur 9ho does not e!#ect further entr, should #osition hisGher (ideo store in the center of Lines(ille to "ini"ie a(erage Atrans#ortation cost and to attract the "ost custo"ers$ The custo"ers at e>ual distance fro" the store 9ill ha(e e>ual
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trans#ortation cost to the store at the center and the a(erage trans#ortation cost for all custo"ers 9ould 7e the lo9est$ n entre#reneur 9ho e!#ects additional entr, should #osition his store in a location that 7alances the desire to achie(e as large a "ar.et as #ossi7le against the desire to soften as "uch as #ossi7le the #ostentr, #rice co"#etition$ This "ight su##ort the "erits of locating at one end of the street antici#ating that a ri(al "ight then enter at the other end$ Ho9e(er 7, locating at one end ,ou ta.e the ris. that a co"#etitor could locate right ne!t to ,ou$ ;n the other hand one "ight also 9ant to consider locating in such a 9a, as to discourage entr,$ -i(en that a #otential entrant 9ill antici#ate the se(erit, of #ost entr, co"#etition in its decision locating at the center of the street "a, 7e the "ost desira7le o#tion$ The entrant 9ould 9ant to locate as far a9a, as #ossi7le fro" the entre#reneur as #ossi7le in order to soften #rice co"#etition i$e$ it 9ould locate at one end of the street or the other$ But gi(en that the incu"7ent is in the center this "a, den, the entrant sufficient "ar.et share to allo9 it to 7e #rofita7le$
&/. Consider a firm selling t"o products, A and >, that su)stitute for each other$ Suppose that an entrant introduces a product that is identical to product A$ %hat factors do you thin/ "ill affect a "hether a price "ar is initiated, and ) "ho "ins the price "ar&
-i(en the incu"7ent is #roducing t9o su7stitute goods the incu"7ent has "ore lose if a #rice 9ar eru#ts$ The reason is if the incu"7ent lo9ers the #rice of good to "atch the #rice of the entrants identical offering the incu"7ent loses re(enues on good B as 9ell as on good 7ecause custo"ers 9ho used to #urchase B 9ill su7stitute to9ard good $ If e!it 7arriers are "ini"al the incu"7ent "ight #refer to e!it the "ar.et for good rather than endure a #rice 9ar$ The incu"7ent is "ore li.el, to sta, and fight if e!it 7arriers are high andGor good and B are 9ea. su7stitutes$ Clearl, the #ro7a7ilit, of a #rice 9ar decreases if the le(el of de"and for these goods is high relati(e to the co"7ined ca#acities of the fir"s$
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Chapter 16 (ndustry Analysis Chapter Contents
1) 2) • • • • •
%) 4) • • • •
/) 3)
Introduction erfor"ing a
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Chapter Summary
The roots of the field of industr, econo"ics and "ar.et co"#etition can 7e traced to the 1&%0s or earlier$ Ho9e(er the, had little i"#act on 7usiness strateg, until Michael orter #u7lished a series of articles in the 1&50s that cul"inated in his #ath7rea.ing 7oo. Com%etitive Strategy $ In his 7oo. orter #resented a con(enient fra"e9or. for e!#loring the econo"ic factors that affect the #rofits of an industr, and classified these factors into fi(e "a@or forces$ This cha#ter re(ie9s the fi(eforces fra"e9or. in the conte!t of the econo"ics of fir"s and industries$ ;ne assesses each force 7, as.ing AIs it sufficientl, strong to reduce or eli"inate industr, #rofits Because the fra"e9or. is co"#rehensi(e the #rocess of 9or.ing through each of the fi(e forces re>uires the s,ste"atic e(aluation of all the significant econo"ics factors affecting an industr,$ The fi(eforces fra"e9or. does ha(e se(eral li"itations: E1) it is not concerned 9ith the "agnitude or gro9th in de"and E2) it focuses on the entire industr, rather than on that industr,s indi(idual fir"s E%) it does not e!#licitl, account for the r ole of the go(ern"ent and E4) it is onl, >ualitati(e$ The cha#ter further uses the fi(eforces fra"e9or. to anal,se three s#ecific industries: hos#itals to7acco and Ha9aiian Coffee$
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Approaches to Teaching this Chapter ?urposes of the Frame"or/ ro(ides for assess"ent of industr, #rofita7ilit, • Identifies o##ortunities for success and threats to success • ro(ides 7asis for generating strategic choices • ##lies e>uall, 9ell to industrial and ser(ice sectors • (nternal !ivalry Internal ri(alr, refers to the @oc.e,ing for share 7 , fir"s in the "ar.et$ s 9as discussed in Cha#ters 5& fir"s "a, co"#ete on a nu"7er of #rice and non#rice di"ensions$ Do fir" interactions erode #rofits
there are nu"erous or e>uall, 7alanced co"#etitors slo9 industr, gro9th high fi!ed costs or storage costs lac. of differentiation or s9itching costs ca#acit, aug"ented in large incre"ents di(erse co"#etitors high strategic sta.es ho9 i"#ortant is this industr, high e!it 7arriers
>arriers to Entry Does the threat of entr, erode #rofits If entrants are not su7stantiall, differentiated fro" incu"7ents then entr, has t9o deleterious effects: 1)"ar.et shares of incu"7ent fir"s fall and 2) co"#etition to #rotect share leads to lo9er #rices and therefore to lo9er #rofit "argins$ ntr, is a .e, threat to the sta7ilit, of "ar.ets in 9hich there has 7een lo9 internal ri(alr,$
there are econo"ies of scale #roduct differentiation ca#ital re>uire"ents are high there are s9itching costs access to distri7ution channels Efor e!a"#le channel cro9ding) cost disad(antages inde#endent of scale #ro#rietar, #roduct technolog, fa(ora7le access to ra9 "aterials fa(ora7le locations go(ern"ent su7sidies learning or e!#erience cur(e go(ern"ent #olicies
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Su)stitutes and Complements Do su7stituteGco"#le"ent #roducts threaten to erode #rofits +u7stitute #roducts ha(e si"ilar A#roduct #erfor"ance characteristics that is the, #erfor" a si"ilar function at least to a certain e!tent$ +u7stitute #roducts ha(e the sa"e effect as entr, the distinction is "ore a "atter of degree$ Close su7stitutes lead to greater #rice ri(alr, and theft of "ar.et share than do 9ea. su7stitutes$ +u7stitute #roducts #ose the greatest threat 9hen the, re#resent ne9 technologies that 9ill 7enefit fro" a learning cur(e and "a, e(entuall, #ro(e su#erior to the technologies the, su7stitute for$ Co"#le"ents 7oost de"and for the #roduct in >uestion there7, enhancing #rofit o##ortunities for the industr,$ ;ne "ust 7e 9ar, of: trends 9hich i"#ro(e the #rice#erfor"ance of su7stitutes for the industr,s • #roduct su7stitutes #roduced 7, industries 9ith higher #rofits than the industr, under • consideration trends 9hich reduce the #rice#erfor"ance of co"#le"ents to the industr,s • #roduct
s. students for ideas on ho9 to >ualitati(el, descri7e a "ar.et$ +o"e ideas include: 1) #roducts ha(e si"ilar #roduct #erfor"ance characteristics E9hat the #roduct does for the consu"er) 2) #roducts ha(e si"ilar occasions of use and %) #roducts are sold in the sa"e geogra#hic "ar.et$ s. students to gi(e e!a"#les of su7stitute and co"#le"ent #roducts i$e$ What is a su7stitute for airline tra(el ns9ers "a, include train car fa! de#ending on the distance of tra(el relati(e #rices and #ur#ose of tra(el$ What is a co"#le"ent to airline tra(el ns9ers "a, include hotels ta!is and rental cars$
>uyer ?o"er Do 7u,ers ha(e sufficient #o9er to threaten industr, #rofits High 7u,er #o9er leads to intense internal ri(alr, since s"all #rice reductions can generate large gains in "ar.et share$ Bu,er #o9er is high 9hen: • • • • • • •
Bu,er #urchases a large (olu"e relati(e to sellers sales Bu,ers #urchases re#resent a significant fraction of the 7u,ers total costs roducts #urchased are standard or undifferentiated Bu,er faces fe9 s9itching costs Bu,ers #ose a threat of 7ac.9ard integration Industr,s #roduct is uni"#ortant to the >ualit, of the 7u,ers out#ut Bu,er has full infor"ation
Supplier ?o"er Do su##liers ha(e sufficient #o9er to threaten industr, #rofits gain this is related to concentration and the a7ilit, to sho# around$ +u##lier #o9er is high 9hen • •
+u##liers industr, is do"inated 7, fe9 co"#anies and is "ore concentrated than the industr, it is selling to +u##liers do not ha(e to contend 9ith other su7stitute #roducts for sale to the
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• • •
industr, The industr, is not an i"#ortant custo"er of the su##lier industr, The su##liers #roducts are differentiated or it has 7uilt u# s9itching costs The su##lier grou# #oses threat of for9ard integration
The Kalue Iet The Falue et fra"e9or. Eattri7uted to Branden7erger and ale7uff) addresses 9ea.nesses of orters fi(e forces anal,sis$ While orters fi(e forces fra"e9or. focuses on the negati(e s#illo(ers of a fir"s actions 9ith res#ect to other fir"s the Falue et ca#tures the notion that so"e actions fir"s ta.e ha(e #ositi(e s#illo(er effects on other fir"s in the industr,$ The Falue et 9hich consists of su##liers custo"ers co"#etitors and co"#le"entors assesses 7oth threats and o##ortunities to the industr,$ The Falue et is therefore a co"#le"ent to a fi(e forces anal,sis$ The cha#ter contains se(eral e!cellent e!a"#les$
+tudents should 7e a7le to "a.e the connection of 7u,er and su##lier #o9er to so"e of the conce#ts discussed in Cha#ter % and 4 for e!a"#le: •
Contracting costs: Cha#ters % and 4 address 9h, (ertical integration "ight 7e a good alternati(e to "ar.et contacting$ Indeed the degree to 9hich (ertical integration reduces transactions costs and i"#ro(es dis#ute resolution ada#ta7ilit, and re#eated e!changes it is often #refera7le to using "ar.et s#ecialists$ When "ar.et s#ecialists are used ho9e(er relati(e 7u,erGsu##lier #o9er affects these issues and "a, raise the cost of e!change$
•
Holdu#: s discussed in Cha#ter 4 the holdu# #ro7le" raises the costs of e!change 7, increasing the a"ount of ti"e and "one, #arties s#end in negotiations reducing trust in the relationshi# encouraging Ao(erin(est"ent or leading one #art, to threaten to refrain fro" "a.ing relationshi#s#ecific in(est"ents$ ll of these 7eha(iors affect the relati(e le(el of either 7u,er or su##lier #o9er$
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+9itching costs: Can 7u,ersGsellers s9itch to other fir"s When a relationshi# in(ol(es relationshi#s#ecific assets #arties cannot s9itch trading #artners costlessl,$ If ,ou 7u,ers ha(e no o#tions then ,ou ha(e su##lier #o9er$ If the su##lier has no o#tions then the 7u,er o9ns the #o9er$ This is discussed in Cha#ter 4$
•
s. students to #re#are thoughts on the follo9ing >uestions 7efore the lecture: •
Consider the industr, ,ou 9or.ed in 7efore returning to Egraduate) school$ What 9ere the .e, forces sha#ing the nature of co"#etition and the o##ortunities for "a.ing #rofit in that industr, What if an,thing did fir"s do to insulate the"sel(es fro" these forces
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7usiness consultant once argued that it is undesira7le to enter industries that are eas, to enter$ Is there an, 9isdo" in this ad(ice Wh, or 9h, not
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Suggested Harvard Case Studies
Cater#illar HB+ &%8/253 Esee earlier cha#ters) Cro9n Cor. and +eal HB+ &%58024 re($ %G84$ Descri7es the technical econo"ic and co"#etiti(e trends in the "etal container industr,$ The strateg, of Cro9n Cor. and +eal is then descri7ed in relation to these trends$ otential threats to Cro9ns future are outlined$ This case could 7e used to introduce students to orters fi(e forces "odel and as the case descri7es the #roduction #rocess a discussion a7out o#ti"al scale is a##ro#riate$ ou "a, 9ant to as. students to thin. of the follo9ing >uestions in #re#aration for the case: a) erfor" a fi(e forces anal,sis of the can "anufacturing industr, as of 1&55$ When #ossi7le 7ac. u# ,our anal,sis 9ith infor"ation fro" the case$ 7) Identif, (ia7le strategic #ositions in this industr,$ Ho9 i"#ortant are econo"ies of scale in this industr, c) Identif, the current strengths and 9ea.nesses of CC+$ What o##ortunities and threats does the current en(iron"ent #ose d) Does C++ ha(e a strategic #osition What is it What do ,ou thin. it should 7e re#are a "ission state"ent for CC+ 7ased on the #osition ,ou thin. it should ado#t$ e) Identif, concrete ste#s that Connell, should ta.e to i"#ro(e Cro9ns #osition$ Be sure to discuss the "o(e to alu"inu" the gro9th of en(iron"entalis" and o##ortunities o(erseas$ Tr, to de(elo# as cohesi(e a #lan as #ossi7le$ Does ,our #lan address the o##ortunities and threats identified 7, ,our econo"ic anal,sis Hude#ohl Bre9ing Co"#an, HB+ &%810&2 Esee earlier cha#ters) Ing(ar o"#rad and I HB+ &%&01%2 Esee earlier cha#ters) To"7o9 encil Co$ Ltd$ EHB+ O &3&2011 and Teaching ote O /3&%025): This case illustrates ho9 another fir" Ein another countr,) struggles 9ith a si"ilar "a.eor 7u, #ro7le"$ While the "ost #ro"inent issues in the case are the *7oundaries of the fir"* >uestions the case also raises issues related to #roduct "ar.et co"#etition and the role of #roduct (ariet, "ar.eting channels and organiational issues in(ol(ing the coordination of "ar.eting sales and #roduction inside To"7o9$ The case also #resents the differences 7et9een eiretsu Enet9or.s of longter" relationshi#s) and ar"slength "ar.et contracting$ It introduces students to the idea that assign"ent of o9nershi# rights can sol(e #ro7le"s that arise due to #h,sical asset s#ecificit, Eholdu# hu"an asset s#ecificit,)$ s 9ith ucleon Esee cha#ter %) it sho9s that there are strong relationshi#s 7et9een #roduction strateg, #roduct "ar.et strateg, and the "a.eor 7u, decision$ This case can 7e taught 9ith so"e co"7ination of the follo9ing cha#ters: % 4 / 11 12 1/ and 13$ ou "a, 9ant to as. students to thin. of the follo9ing >uestions in #re#aration for the case: a)
7)
What is To"7o9 encils current financial #osition Loo. at To"7o9s financial state"ent and co"#are their financial ratios to Mitsu7ishis$ In #articular 9hat 9ould the i"#act 7e on To"7o9s #rofits if the, could reduce their in(entor,Gsales ratio to Mitu7ishis le(el Is the Ja#anese #encil industr, #rofita7le re there so"e seg"ents that are "ore #rofita7le than others
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c)
d)
Co"#are the (ertical chains for 9ooden #encils and the ;7@ect ; #encil E9hich 9ill 7e our "eta#hor for "echanical #encils in general)$ re the differences in the (ertical sco#eG(ertical 7oundaries in these t9o chains consistent 9ith the underl,ing econo"ics of "a.e or 7u, decisions Wh, does ;ga9a feel the need to ree!a"ine the #roduction s,ste" for the ; #encil gi(en that To"7o9s (ertical relationshi# ha(e ser(ed the" 9ell for so long What reco""endations 9ould ,ou "a.e for To"7o9 Consider 7oth the "ar.et #osition E#roduct line >ualit, #rice #oint etc$) the horiontal and (ertical sco#e and the organiation of the co"#an,$
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Etra !eadings It "a, 7e useful to distri7ute the follo9ing to students:
Mc-ahan $ A+elected rofita7ilit, Data on K$+$ Industries and Co"#anies # orter Michael AHo9 Co"#etiti(e ues A%%lications Ca"7ridge M: Blac.9ell Business 1&&1 #ages /530$
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Ans"ers to End of Chapter #uestions 1$ (t has )een said that ?orter-s five forces analysis turns antitrust la"Pla" intended to protect consumers from monopoliesPon its head$ %hat do you thin/ this means&
orter fra"es the forces that #re(ent industr, #rofits fro" falling to the le(el that 9ould e!ist in a co"#etiti(e industr, as a A#ositi(e$ When a force is such that #rofits are held a7o(e the co"#etiti(e le(el the fi(e forces fra"e9or. suggests this force is for the good of the industr,$ The antitrust la9s are intended to #ush industr, #rofits to9ard the co"#etiti(e floor for the 7enefit of consu"ers Eand "ar.et efficienc,)$ '$ Comment on the follo"ing: All of ?orter-s "isdom regarding the five forces is reflected in the economic identity: ?rofit ?rice L Average Cost #uantity
The distri7ution of #rofits as defined in the a7o(e e>uation rationalies the anal,sis 7ehind orters fi(e forces$ ach of the (aria7les in the e>uation 7ears on or is affected 7, one or "ore of the fi(e forces discussed in the orter "odel$ Thus the relationshi#s 7et9een the forces influencing an industr, are ca#tured in the si"#le e>uation for econo"ic #rofits$ •
!ivalry: The e!istence of ri(alr, 9ould 7e reflected in #rice as 9ell as in >uantit,$ The #rediction is that increased ri(alr, 9ould dri(e #rices do9n and could also cause a redistri7ution of "ar.et shares$ 'i(alr, can also increase co"#etition for scarce in#ut resources and dri(e u# costs$
•
Su)stitute goods: The e!istence of close su7stitutes 9ould li"it the #rice #roducers in the industr, could charge$ +u7stitute #roducts can also reduce >uantit, 9hen those su7stitutes are #ercei(ed to 7e 7etter at satisf,ing custo"ers needs or 9hen the, are #riced lo9er and de"and for the #roduct is elastic$
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>uyer po"er: Bu,ers can force #rice do9n if the, hold "ore 7argaining #o9er than #roducers there7, con(erting #roducer #rofits to consu"er sur#lus$
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>arriers to entry: High 7arriers to entr, 9ill #re(ent co"#etitors fro" entering to dri(e #rices do9n allo9ing the current #roducers to "aintain higher #rices as 9ell as larger >uantities$
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Supplier po"er: If "anufacturers of an in#ut hold 7argaining #o9er then the, can increase the #rices the, charge for in#uts the su##liers can ca#ture a #ortion of the #rofits in the (alue chain$
The e!istence of #rofits suggests that co"#etitors 9ill certainl, atte"#t to enter the industr,$ The fi(e forces anal,sis identifies the factors that affect the distri7ution of (alue creation 9ithin the industr, E9hether it is to 7u,ers Econsu"er sur#lus) su##liers E#roducer sur#lus in another industr,) or co"#etitors Eco"#etition for #roducer sur#lus)) and >ualifies the e!tent to 9hich the ca#turing the #rofits a##ears feasi7le$ The e>uation can act as a si"#le "odel for orters #aradig"$
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*$ Ho" does the magnitude of scale economies affect the intensity of each of the five forces&
cono"ies of scale e!ist 9hen the a(erage cost of #roducing out#ut declines as the a7solute (olu"e of out#ut increases$ +cale econo"ies affect the nu"7er of co"#etitors that can co"#ete successfull, in an industr,$ There are li.el, to 7e fe9er fir"s in an industr, 9ith high scale econo"ies relati(e to total industr, out#ut than in an industr, 9here scale econo"ies are e!hausted at relati(el, lo9 le(els of out#ut$ +ince there are fe9er #la,ers the esta7lished incu"7ents 9ould each ha(e large "ar.et share and incur lo9 unit #roduction cost$ In this conte!t scale econo"ies 9ill affect the fi(e forces in the follo9ing 9a,$ >arriers to entry: +cale econo"ies raise the entr, 7arriers$ To 7ring cost to a le(el co"#ara7le to those of e!isting #la,ers an entrant 9ould ha(e to enter the industr, 9ith large ca#acit, and ris. strong reaction fro" the incu"7ents$ n alternati(e 9ould 7e to enter at a s"all scale and face a cost disad(antage$ Both o#tions are undesira7le to ne9 entrants$ !ivalry: +cale econo"ies can ha(e co"#eting effects on ri(alr,$ ;n the one hand scale econo"ies "a, intensif, ri(alr, 7ecause the #la,ers ha(e the incenti(e to increase their "ar.et share to sustain and dee#en their scale econo"ies$ 'i(alr, "a, ta.e the for" of #rice co"#etition ad(ertising 7attles and ne9 #roduct introductions$ ;n the other hand scale econo"ies "a, result in fe9er fir"s that could facilitate co""unication and A#eaceful coe!istence a"ong industr, #la,ers$ Su)stitutes: +cale econo"ies increase the threat of the su7stitute #roducts$ If the #rice#erfor"ance tradeoff of a su7stitute #roduct i"#ro(es fir"s 9ithin the industr, lose share 9hich reduces the industr,s o9n #rice#erfor"ance tradeoff$ >argaining po"er of suppliers : If high scale econo"ies result in fe9er fir"s in the industr, it is #ossi7le that the 7argaining #o9er of su##liers decreases$ argaining po"er of )uyers: Ksing the sa"e reasoning for su##lier #o9er scale econo"ies that lead to higher industr, concentration could decrease the 7argaining #o9er of 7u,ers$ uantities$ .$ Ho" does the magnitude of consumer s"itching costs affect the intensity of internal rivalry& The etent of entry )arriers&
The #resence of s9itching costs 9ould reduce the intensit, of internal ri(alr,$ +9itching costs are costs that consu"ers incur 9hen the, s9itch fro" one su##liers #roduct to anothers$ s such consu"ers 9hen faced 9ith s9itching costs 9ould not s9itch #roduct unless a co"#etitor can offer a "a@or i"#ro(e"ent in either #rice or #erfor"ance$ If s9itching costs are lo9 consu"ers are inclined to s9itch #roducts 9hen a co"#etitor offers 7etter #rice or ser(ice$ This could result in #rice and ser(ice co"#etition that 9ould intensif, the ri(alr, a"ong co"#etitors$ In the #resence of consu"er s9itching costs the 7ar for entrants is set higher$ The entrant "a, ha(e difficult, attracting consu"ers a9a, for incu"7ents$ ntrants should
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e!#ect to "ore easil, attract consu"ers 9ho ha(e ,et to #artici#ate in the #roduct (s$ the custo"ers of e!isting fir"s$ 0$ Consider an industry "hose demand fluctuates over time$ Suppose that this industry faces high supplier po"er$ >riefly state ho" this high supplier po"er "ill affect the varia)ility of profits over time$
-i(en an industr, 9hose de"and fluctuates o(er ti"e and an in#ut su##lier 9ith high su##lier the industr,s (aria7ilit, of #rofits 9ould decrease$ High su##lier #o9er e!ists 9hen an in#ut su##lier is a7le to negotiate #rices that e!tract #rofits fro" their custo"ers$ In this case the su##liers #o9er 9ould 7e reflected in hisGher a7ilit, to change #rices to reflect de"and 9ithin the custo"ers industr, o(er an, gi(en #eriod of ti"e$
Coo#etition is the conce#t that the forces that sha#e industr, #rofits are to a great e!tent the result of choices "ade 7, the indi(idual fir"s 9ithin the industr,$ s these fir"s 7eco"e "ore sa((, regarding the reaction of ri(als to their o9n actions the, 9ill choose actions that reduce the li.elihood of losing industr, #rofits to #rice 9ars consu"er sur#lus andGor ineffecti(e negotiations 9ith su##liers$ s each fir" co"#rehends its o9n role 9ithin the industr, fir"s can collecti(el, fashion strategies 9hich Acause a force to ha(e onl, a li"ited effect$ If fir"s ignore the conce#t of Acoo#etition the, "ust resign the"sel(es to si"#l, reacting to the industr, forces$ 3$ The follo"ing ta)le reports the distri)ution of profitson a per disc )asis for different steps in the vertical chain for music compact discs:
(ndustry
?rofits
Artist
$6
!ecord Company
1$76
!etailer
$6
2se the five forces to eplain this pattern$ Iote: The record companies, including the <>ig = L%arner, Sony, MCA, EM(, ?olygram and >M; Las "ell as smaller la)els, are responsi)le for signing up artists, handling technical aspects of recording, securing distri)ution and promoting the recordings$
ecorded Material (ndustry$ The industry is com%rised of record la)els that %roduce %romote and distri)ute recorded material mainly for home use# •
>arriers to Entry: cono"ies of scale in "ar.eting re#utation and esta7lished
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distri7ution net9or.s net9or.s create 7arriers to entr,$ entr,$ sta7lished fir"s fir"s also ha(e 7rand identification and custo"er lo,alt, 9hich ste" fro" #ast custo"er e!#eriences 9ith a #articular la7el$ !isting co"#etitors co"#etitors ha(e ties 9ith retail retail channels 7ased on long relationshi#s$ In addition the e!#erience cur(e gi(es e!isting co"#etitors cost ad(ant ad(antage ages$ s$ In su" A.no9in A.no9ing g the right right #eo#le #eo#le is a clich\ clich\ that cannot cannot 7e understated in this industr,$ industr,$ 'elationshi#s 7et9een distri7utors distri7utors and the "edia and retail stores deter"ine the success of an al7u"$ s these relationshi#s ta.e ti"e and are costl, to de(elo# the, #ose a for"ida7le 7arrier to entr,$ entr,$ •
differentiation$ 'ecord co"#anies !ivalry: La7els #ri"aril, engage in #roduct differentiation$ each ha(e artists signed on to to e!clusi(e recording contracts$ contracts$ 'i(alr, "a, ta.e the for" of Aco"#eting for the 7est artists ho9e(er ri(alr, generall, does not result in #rice co"#etition$
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Supplier ?o"er: Because there are "an, artists in the "ar.et E@ust add u# e(er, 9aiter and 9aitress in in the K$+$) and fe9 record la7els su##lier su##lier #o9er is lo9$ lo9$ The record co"#an, is res#onsi7le for recording distri7ution and #ro"otion$ Thus the artist de#ends hea(il, on the record co"#an,s acti(ities if the artist ho#es to 7eco"e a hit$ Initiall, the artist has little #o9er to negotiate #rofits a9a, fro" the record record la7el$ Ho9e(er Ho9e(er once the artist artist 7eco"es 7eco"es a hit hisGher #o9er 9ithin 9ithin the relationshi# "a, increase$ The e!tent to 9hich the artists artists #o9er increases de#ends on ho9 confident the record la7el is that the, can in(ent a ne9 star fro" the large #ool of A9anna 7ees$ If stars are difficult to e"ulate or re#lace their share of #rofits along the (ertical (ertical chain increases$
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industr, sells its out#ut to to retailers$ The retailer stoc.s >uyer ?o"er: The "usic industr, #roducts that a##eal to the indi(iduals 9ho #urchase the out#ut and use the out#ut to generate generate ho"e entertai entertain" n"ent ent$$ 'e#uta 'e#utatio tion n is an i"#ort i"#ortant ant asset asset in "usic "usic retailing$ Consu"ers #refer to go to retailers retailers 9ho ha(e a re#utation for 7eing 7eing 9ell stoc.ed 9ith a large selection of #roducts that a##eal to the consu"ers tastes$ 'eta 'etail iler erss also also attr attrac actt "o "ore re cust custo" o"er erss if the, the, ha(e ha(e a re#u re#uta tati tion on for for 7ein 7eing g .no9ledgea7le a7out the artists courteous a7out re#lacing da"aged "aterial and reasona7l, #riced #riced a"ong other attri7utes$ attri7utes$ s re#utation re#utation "a, i"#ose a "oderate "oderate 7arrier to entr, entr, retailers ha(e a degree of #o9er 9ithin the (ertical chain$ Higher the 7arriers to entr, are in retailing the "ore #rofits retailers earn along the (ertical chain$
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Su)stitutes: !a"#les of su7stitutes for recorded "aterial are 7oo.s "againes tele(ision "o(ies and an, other for" of entertain"ent that can 7e consu"ed in the ho"e$ Ho9 consu"ers collecti(el, collecti(el, feel a7out these su7stitutes su7stitutes effects the su" of #rofits along the (ertical chain$
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Cha#ter 11 Strategic ?ositioning for Competitive Advantage Chapter Contents 1) Intr Introd oduc ucti tion on 2) Co"#etiti Co"#etiti(e (e d(antag d(antagee Co"#etiti(e d(antage Defined • What Matters More for rofita7ilit,: The Mar.et or the uinn !tracting rofits fro" Cost and Benefit d(antage: The I"#ortance of the rice • lasticit, of De"and Co"#aring Cost and Benefit d(antages • !a"#le 11$5: +trategic ositions ositions in the K$+$ Credit Card Industr,: Ca#ital ;ne (ersus MB A+tuc. in the Middle • !a"#le 11$8: 11$8: Continental irlines: irlines: Mo(ing to the fficienc,
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Chapter Summary
The #ur#ose of this cha#ter is to de(elo# a conce#tual fra"e9or. for characteriing and anal,ing a fir"s strategic #osition 9ithin an industr,$ industr,$ This fra"e9or. e"#lo,s si"#le econo"ic conce#ts to characterie necessar, conditions for a strategic #osition to create a co"#etiti(e ad(antage in the "ar.et$ This cha#ter is organied into the the follo9ing sections$ The first section e!#lores the conce#t of co"#etiti(e ad(antage and argues that a fir" can achie(e a co"#etiti(e ad(antage 7, creating "ore (alue than its ri(als create$ fir" that creates "ore total (alue can si"ultaneousl, earn higher #rofits and deli(er higher net 7enefits than its co"#etitors$ The a7ilit, to create (alue de#ends on 7oth the fir"s cost #osition and its differentiation #osition #osition relati(e to its co"#etitors$ co"#etitors$ Knderstanding ho9 a fir" creates (alue and ho9 it can continue to do so in the future is a necessar, first ste# in diagnosing a fir"s #otential for securing a co"#etiti(e ad(antage in the "ar.et#lace$ ro@ecting a fir"s #ros#ects for creating (alue into the future also in(ol(es e(aluating 9hether changes in "ar.et de"and and technolog, are li.el, to threaten ho9 the fir" Eor the entire industr,) creates (alue$ This section also clarifies the distinction distinction 7et9een redistri7uting e!isting (alue and creating additional (alue$ The ne!t section co(ers the anal,tical tools tools and conce#tual foundations$ foundations$ The conce#ts of "a!i"u" 9illingness to #a, #a , consu"er sur#lus and (alue created are defined$ !a"#les of A9in9in 7usiness o##ortunities o##ortunities are gi(en$ The conce#ts of (alue creation and co"#etiti(e ad(antage ad(antage are lin.ed$ The section argues that in order for a fir" to earn #ositi(e econo"ic #rofit in an industr, in 9hich co"#etition 9ould other9ise dri(e econo"ic #rofita7ilit, to ero the fir" "ust create "ore econo"ic (alue than its ri(als ri(als Ethat is "ore B C)$ The (alue chain is descri7ed descri7ed and de#icted in in figure 11$10$ 11$10$ The i"#ortance of distincti(el, distincti(el, different and su#erior resources is discussed in the conte!t of the fir"s fir"s a7ilit, to create "ore (alue$ The section goes on to discuss (alue redistri7ution and (alue ca#ture$ The follo9ing section discusses the econo"ic and organiational organiational logic of t9o 7road alternati(e a##roaches to #ositioning: #ositioning: cost ad(antage and differentiation ad(antage$ This section co"#ares the t9o strategies and discusses 9hen a cost ad(antage strateg, is 7etter than a differentiation strateg, strateg, and vice versa$ In general a #osition 7ased 7ased on a su#erior cost #osition is a##ro#riate 9hen: • • • •
cono"ies of scale and learning are #otentiall, significant 7ut no fir" in the "ar.et see"s to 7e e!#loiting the"$ ;##ortunities for enhancing the #roducts #ercei(ed 7enefit B are li"ited 7, the nature of the #roduct$ Consu"ers are relati(el, #rice sensiti(e and are un9illing to #a, "uch of a #re"iu" for enhanced #roduct #roduct >ualit, >ualit, #erfor"ance or i"age$ The #roduct is a search good rather than an e!#erience good$
Building a co"#etiti(e ad(antage 7ased on su#erior differentiation is li.el, to 7e relati(el, "ore attracti(e 9hen: •
su7stantial su7stantial seg"ent of consu"ers is 9illing to #a, a significant #rice #re"iu" for attri7utes that enhance B$
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cono"ies of scale and learning are significant and e!isting fir"s 7ecause of their sie or cu"ulati(e e!#erience are alread, e!#loiting the"$ The #roduct is an e!#erience good rather than a search good$
This section e!#lores ho9 a fir"s #ositioning #ositioning strateg, also dri(es its o#erating strategies for its functional areas such as "ar.eting "ar.eting o#erations and engineering$ This section also considers 9hether a fir" can #ursue 7oth a cost ad(antage and differentiation strateg, si"ultaneousl,$ The final sections co(er "ar.et seg"entation and targeting strategies and ho9 these strategies are tied to a fir"s a##roach a##roach to creating (alue$ lso discussed discussed is the conce#t of strategic grou#s$
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Approaches to Teaching this Chapter
Cha#ter 11 introduces a fra"e9or. to stud, a fir"s strategic #osition 9ithin an industr,$ Definitions Co"#etiti(e d(antage: a fir" has a co"#etiti(e ad(antage 9hen it out#erfor"s Ei$e$ earns higher rates of #rofita7ilit, than) co"#etitors 9ho sell in the sa"e "ar.et$
Consu"er +ur#lus$ the difference 7et9een 9hat a consu"er is 9illing to #a, for a good and 9hat she actuall, #a,s$ ercei(ed Benefit $ the highest #rice a consu"er is 9illing to #a, for a good$ Indifference Cur(e $ a cur(e that illustrates #rice>ualit, co"7inations that ,ield a constant le(el of consu"er utilit,$ Consu"ers are indifferent a"ong the different #rice>ualit, co"7inations offered along this cur(e$ Falue Created$ the difference 7et9een the (alue that resides in the finished good and the (alue that is sacrificed to con(ert ra9 in#uts into finished #roducts$ Consu"er urchase arit,: e!ists 9hen fir"s #rice>ualit, #ositions line u# along the sa"e indifference cur(e that is 9hen fir"s are offering a consu"er the sa"e a"ount of consu"er sur#lus$ 'esources: fir"s#ecific assets such as #atents and trade"ar.s 7rand na"e re#utation installed 7ase organiational culture and 9or.ers 9ith fir"s#ecific e!#ertise or .no9ho9$ Ca#a7ilities: clusters of acti(ities that a fir" does es#eciall, 9ell in co"#arison 9ith other fir"s$ e, +uccess
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Broad Co(erage +trateg,: a strateg, that is ai"ed at ser(ing all of the seg"ents in the "ar.et 7, offering a full line of related #roducts$ +trategic -rou#s: set of fir"s 9ithin an industr, that are si"ilar to one another and different fro" fir"s outside the grou# on one of "ore .e, di"ensions of their strateg,$ The follo9ing outline #ro(ides a useful starting #lace for lecturing a7out the cha#ter$ Competitive Advantage fir" has a co"#etiti(e ad(antage 9hen it out#erfor"s Ei$e$ earns higher rates of #rofita7ilit, than) co"#etitors 9ho sell in the sa"e "ar.et$ This cha#ter defines co"#etiti(e ad(antage "ore #recisel, than it is defined in traditional strategic "anage"ent literature$ This definition e"#hasies that a fir" has a co"#etiti(e ad(antage if it is a7le to rea# higher #rofits than other fir"s in the industr, are 9hereas other definitions e"#hasie the a7ilit, of a fir" to distinguish its #roducts in the e,es of consu"ers$ Consumer Surplus and Kalue Created In a gi(en transaction:
Falue Created V
•
•
•
• • •
EBu,ers ercei(ed Benefit rice) Y Erice Cost) V Consu"er sur#lus Y rofit V EB ) Y E C) V BC
B reflects the (alue consu"ers deri(e fro" consu"ing the #roduct less an, costs Eother than #urchase #rice) of ac>uiring using or "aintaining the #roduct$ Thus it is the "a!i"u" a"ount consu"ers are 9illing to #a, for the #roduct$ B is the net 7enefit fro" consu"#tion and is called consu"er sur#lus Es,non,"ous 9ith Zdeli(ered (alue in "ar.eting te!ts$) Thin. of consu"ers choosing fro" a"ong fir"s offering the sa"e #roduct on the 7asis of consu"er sur#lus$ B in relation to C deter"ines the "agnitude of (aluecreated 7ut the #rice deter"ines ho9 "uch of the (alue created is ca#tured 7, the fir" as #rofit C and ho9 "uch is ca#tured 7, consu"ers as consu"er sur#lus B $ Industr, structure is a .e, deter"inant of C and thus is a .e, deter"inant of the #ro#ortion of total sur#lus ca#tured 7, fir"s$ In general the le(el of B is deter"ined 7, the attri7utes of a fir"s #roducts E7enefit dri(ers) and the 9eight that consu"ers gi(e to the"$ The le(el of C is deter"ined 7, a co"7ination of factors that 9e refer to as cost dri(ers$ Ee$g$ econo"ies of scale e!#erience in#ut #rices$)
ou "ight 9ant to as. students the follo9ing >uestions: What is an e!a"#le of an industr, 9here there is lots of sur#lus created 7ut not "uch ca#tured 7, fir"s To achie(e co"#etiti(e ad(antage a fir" "ust create "ore (alue than co"#etitors Ehigher BC)$ Wh, This leads into the ne!t learning #oint$ @in/ )et"een Competitive Advantage and Kalue Creation s the cha#ter suggests it is useful to thin. of co"#etition a"ong fir"s as an Aauction 9here fir"s A7id for consu"ers on the 7asis of consu"er sur#lus$ The fir"
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that offers the highest consu"er sur#lus 9ill get the consu"ers 7usiness$ If a fir" creates "ore (alue higher B C than its co"#etitors this fir" 9ill 7e a7le to "atch consu"er sur#lus 7ids of co"#etitors and end u# 9ith higher #rofit on the sale$ This is 7est illustrated 7, a nu"erical e!a"#le:
If
Does fir" offer higher B EDifferentiation +trateg,) Does fir" ha(e lo9er C ECost osition) ;r 7oth E+tuc. in the "iddle)
Concepts for thin/ing a)out Kalue Creation
orters Falue Chain: s illustrated in
Cost d(antage: Create "ore (alue than co"#etitors 7, ha(ing lo9er C for the sa"e B E7enefit #arit,) or not too "uch lo9er B E7enefit #ro!i"it,)$ fir" can e!#loit its cost ad(antage 7, charging a #rice that is lo9 enough to offset its B disad(antage Eif an,) 7ut high enough that the fir" can earn higher #rofits than co"#etitors Esee
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Cost dri(ers related to fir" sie or sco#e such as econo"ies of scale econo"ies of sco#e and ca#acit, utiliation$ Cost dri(ers related to cu"ulati(e e!#erience i$e$ learning cur(e$ Cost dri(ers inde#endent of fir" sie sco#e or cu"ulati(e e!#erience: in#ut #rices location econo"ies of densit, #rocess efficienc, go(ern"ent #olic,$ Cost dri(ers related to organiation of transactions: organiation of the (ertical chain agenc, efficienc,
!a"#les of fir"s that ha(e 7uilt their co"#etiti(e #osition on a cost ad(antage include Duont in Ti; 2 a"aha in #ianos and ualit, features aesthetics) • Co"#le"entar, goods or ser(ices Ee$g$ #ostscale ser(ices s#are #arts) • Characteristics that sha#e consu"er e!#ectations of #erfor"ance >ualit, or cost in • use Ee$g$ re#utation installed 7ase) +u7@ecti(e i"age Ee$g$ dri(en 7, ad(ertising "essages #ac.aging) • !a"#les of fir"s that ha(e successfull, #ursued differentiation strategies include Honda accord (s$ Do"estic sedans and Ma,tag in 9ashers$ Challenge students to co"e u# 9ith their o9n e!a"#les of fir"s that follo9 a differentiation strateg,$ Michael orter has argued in his 7oo. Co"#etiti(e +trateg, that the #ursuit of differentiation ad(antage is inco"#ati7le 9ith the #ursuit of cost ad(antage$ ou "ight 9ant to #ose the follo9ing >uestion to the class: Can a fir" ha(e 7oth cost N differentiation ad(antages What are so"e e!a"#les of this EBre,ers ice crea") short ans9er ,es[ 7ut tradeoffs do e!ist E>ualit, is not often free)
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Suggested Harvard Case Study 16
Hude#ohl Bre9ing Co"#an, HB+ &%810&2 Esee earlier cha#ters)$ rochni.: ri(atiation of a olish Clothing Manufacturer HB+ &%&40%8: This case e!a"ines the challenge of creating (alue 9hen the en(iron"ent changes dra"aticall,$ rochni. a olish clothing fir" 7eca"e one of the first fi(e state enter#rises to 7e #ri(atied 7, the olish go(ern"ent and to 7e listed in 1&&1 on the ne9l, for"ed olish stoc. e!change$ rochni.s old 9a,s of creating (alue 9ere no longer effecti(e and the fir" had to de(elo# ne9 s.ills$ To"7o9 encil Co$ Ltd$ HB+ &3&2011Esee earlier cha#ters)
10
These descri#tions ha(e 7een ada#ted fro" Harvard Business School 3445647 Catalog of Teaching Materials#
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Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
Christensen $ and L$
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Ans"ers to #uestions at End of Chapter 1$ Ho" can the value chain help a firm identify its strategic position&
The (alue chain is a techni>ue for descri7ing the (ertical chain of #roduction$ The (alue chain is also a useful de(ice for thin.ing a7out ho9 (alue is created in an organiation$ The (alue chain de#icts the fir" as a collection of (aluecreating acti(ities such as #roduction o#erations "ar.eting and distri7ution and logistics$ ach acti(it, in the (alue chain can #otentiall, add to the 7enefit EB) that consu"ers get fro" the fir"s #roduct and each can add to the cost EC) that the fir" incurs in #roducing and selling the #roduct$ fir" creates "ore (alue than co"#etitors onl, 7, #erfor"ing so"e or all of these acti(ities 7etter than the, do$ We can often categorie strategic #ositions into t9o 7road categories either a cost ad(antage or a differentiation ad(antage$ If a fir" out#erfor"s other fir"s in acti(ities that generate su#erior B Edifferentiation) or in acti(ities that generate a lo9er C Ecost) the fir"s strategic #osition should rel, on these acti(ities$ '$ Analysts sometimes suggest that firms should outsource lo" value4added activities$ Do you agree or disagree&
fir" should outsource (alueadded acti(ities that other fir"s can generate at lo9er cost than can the fir" itself$ Ho9e(er the fir" should not outsource an acti(it, that can 7e #erfor"ed chea#er 7, another fir" 7ut in gi(ing u# the acti(it, the fir" su7@ects itself to significant hold u# andGor transactions costs$ *$ T"o firms, Alpha and >eta, are competing in a mar/et in "hich consumer preferences are identical$ Alpha offers a product "hose )enefit > is eJual to 166 per unit$ >eta offers a product "hose )enefit > is eJual to 30 per unit$ Alpha-s average cost C is eJual to 6 per unit, "hile >eta-s average cost C is eJual to 06 per unit$ a %hich firm-s product provides the greatest value created
l#ha
Beta
B V Q100
BB V Q5/
C V Q30
CB V Q/0
KA .6
K> '0
B V #ercei(ed 7enefit C V cost and F V (alue created$
In an industr, e>uili7riu" in 9hich the fir"s achie(e consu"er sur#lus #arit, the
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#rofit "argin EC) of fir" l#ha 9ill e!ceed the #rofit "argin of fir" Beta 7, Q1/$ Consu"ers 9ill 7e 9illing to #a, u# to Q1/ "ore for fir" l#has #roduct$ ote that this a"ount is the sa"e as the difference in (aluecreated 7, the t9o fir"s$ uals its unit cost #lus the additional 7enefit it creates relati(e to fir" Beta: V C Y EF FB) .$ Consider a mar/et in "hich consumer indifference curves are relatively steep$ Firms in this industry are pursuing t"o positioning strategies: some firms are producing a )asic product that provides satisfactory performance9 others are producing an enhanced product that provides performance that is superior to that of the )asic product$ Consumer surplus parity currently eists in the industry$ Are the prices of the )asic and the enhanced product li/ely to )e significantly different or a)out the same& %hy& Ho" "ould the ans"er change if the consumer indifference curves "ere relatively flat&
Indifference cur(es illustrate #rice>ualit, co"7inations that ,ield the sa"e consu"er sur#lus$ The fact that the indifference cur(e is stee# "eans that consu"ers are 9illing to #a, significantl, "ore for a good that is of higher >ualit,$ Therefore the #rices of the 7asic and the enhanced #roduct are li.el, to 7e significantl, different$ ;n the other hand the #rices of the t9o goods 9ould 7e a7out the sa"e if the consu"er indifference cur(es 9ere relati(el, flat$
ccording to Chandler ca#italintensi(e industries en@o, econo"ies of scale$ s a result those that can #roduce in (olu"e achie(e significant cost reductions$ fe9 fir"s 9ill control the "ar.et$ necessar, ingredient in the success of these fir"s is through#ut$ The "ar.eting de#art"ent identifies "ar.ets secures distri7ution and deter"ines the #rice at 9hich the fir" can sell its "assi(e out#ut$ In la7orintensi(e industries there are fe9 natural sources of scale econo"ies and large fir"s ha(e no inherent cost ad(antage o(er s"all fir"s$ There can 7e "an, fir"s and a7sent #roduct differentiation the "ar.et 9ill 7e co"#etiti(e 9ith fe9 #rofit o##ortunities$ The role of the "ar.eting de#art"ent is to differentiate the fir"s #roducts in the "ind of the consu"er$ The "ar.eting de#art"ent 7eco"es a core source of (alue in the fir"$ With successful differentiation the "ar.et 7eco"es "ono#olisticall, co"#etiti(e or if i"age differentiation is e!tre"el, successful oligo#olistic$ Mar.eting dri(es this e(olution of "ar.et structure$ $ (n the value4creation model presented in this chapter, it is implicitly assumed that all consumers get the identical value e$g$ identical > from a given product$ Do the main conclusions in this chapter change if consumer tastes differ, so that some get more value than others do&
The "ain conclusions of this cha#ter are as rele(ant if consu"er tastes differ as 9hen all consu"ers get identical (alue$ If e(er, consu"er o7tained a different B fro" a #articular good there 9ould still e!ist "eaningful seg"ents that 9ould 7e #rofita7l, ser(ed 7, #articular fir"s=rather than each consu"er en@o,ing the sa"e consu"er sur#lus each 9ould o7tain a different sur#lus$ Consu"ers 9ould #urchase as long as
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their consu"er sur#lus 9as #ositi(e=this is true 9hether consu"ers ha(e the sa"e (aluation or not$ The fact that the le(el of sur#lus consu"ers recei(ed 9as different across consu"ers does not funda"entall, change the anal,sis$ 3$ (dentify one or more eperience good$ (dentify one or more search goods$ Ho" does the retailing of eperience goods differ from the retailing of search goods& Do these differences help consumers&
n e!#erience good is a #roduct 9hose >ualit, can 7e assessed onl, after the consu"er has actuall, consu"ed the #roduct$ ualit, of his auto"o7ile until he has dri(en that auto"o7ile for se(eral 9ee.s$ search good is one 9hose o7@ecti(e >ualit, attri7utes the t,#ical 7u,er can easil, access at the ti"e of #urchase$ uestion=the attri7utes of the good s#ea. for the"sel(es$ When selling an e!#erience good sellers "ust often send signals to 7u,ers that the good 9ill not disa##oint"ent the 7u,er #ost#urchase$ +ince the 7u,er does not get to full, a##reciate the good until after the good is consu"ed the 7u,er 7u,s under uncertaint,$ The sellers re#utation for deli(ering #roducts that #erfor" as #ro"ised 7eco"es an i"#ortant feature of the #urchase #rocess$ The selling #rocesses associated 9ith search and e!#erience goods hel# insure that consu"ers #urchase goods closer to their Aideal good$ Both #rocesses reduce the ris.s of 7u,ing under uncertaint,=the attri7utes of search goods are re(ealed at the ti"e of #urchase and re#utation and other credi7le signals are used to guide consu"ers in their #urchases of e!#erience goods$ 7$ !ecall from Chapter ' Adam Smith-s dictum
Knder a focus strateg, a fir" concentrates either on offering a single #roduct or ser(ing a single "ar.et seg"ent or 7oth$
roduct s#ecialiation: the fir" concentrates on #roducing a single t,#e of #roduct of a (ariet, of different "ar.et seg"ents$ -eogra#hic s#ecialiation: the fir" offers a (ariet, of related #roducts 9ithin a
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narro9l, defined geogra#hic "ar.et$ Custo"er s#ecialiation: the fir" offers a (ariet, of related #roducts to a #articular class of custo"ers$ iche strateg,: a fir" #roduces a single #roduct for a single "ar.et seg"ent
The 7asic econo"ic logic of a focus strateg, is that the fir" is so"eti"es a7le to achie(e dee# econo"ies of scale 7, concentrating on a #articular seg"ent or a #articular #roduct that is 9ould 7e una7le to e!#loit if it e!#anded 7e,ond the seg"ent or #roduct it is concentrating on$ The gro9th of a "ar.et can "a.e a focus strateg, that at one ti"e 9as not feasi7le 7eco"e a (er, #rofita7le o##ortunit,$ -ro9th "ight also increase the 7enefits of econo"ies of scale for the focuser$ If a "ar.et gro9s to the #oint 9here a fir"s econo"ies of scale are e!hausted the fir" "ight ha(e to 9orr, a7out entr,$ 5$
learning cur(e strateg, is one in 9hich a fir" see.s to reduce costs 7, learning$ This is 7ut one of "an, 9a,s in 9hich a fir" can achie(e a cost ad(antage$ ;ther cost dri(ers include: econo"ies of scale econo"ies of sco#e ca#acit, utiliation econo"ies of densit, #rocess efficienc, go(ern"ent #olic, and a fir"s location$ Learning cur(es can also confer >ualit, ad(antages$ If there is a first "o(er ad(antage in esta7lishing a #articular >ualit, #osition Esa, the goods are e!#erience goods) then it "a, #a, to #ush aggressi(el, do9n the learning cur(e to gain that >ualit, ad(antage$ Therefore #ursuing a learning cur(e strateg, could 7e ad(antageous to 7oth fir"s that see. a cost ad(antage and fir"s that see. to differentiate their #roducts$ 16$ Consumers often identify )rand names "ith Juality$ Do you thin/ )randed products usually are of higher Juality than generic products and therefore ustify their higher prices& (f so, "hy don-t all generic product ma/ers invest to esta)lish )rand identity, there)y ena)ling them to raise price&
sta7lishing a 7rand na"e is (er, costl, for fir"s$ Large su"s of ca#ital "ust 7e in(ested continuall, o(er a long #eriod of ti"e 7efore a fir" earns a significant 7rand identit,$ In the sale of e!#erience goods=goods 9hose >ualit, cannot 7e assessed 7efore the, are #urchased and used=the re#utation for >ualit, that a fir" esta7lishes can 7e a significant ad(antage$ Consu"ers can reason that a fir" 9ho has in(ested continuall, in its 7rand identit, is unli.el, to chisel on >ualit, and ris. de#reciating its #recious 7rand i"age$ In other 9ords incurring the cost of esta7lishing a 7rand identit, is a "eans for fir"s to signal to consu"ers that the fir" offers >ualit, #roducts$ Hence the e!#ectation is that 7randed #roducts are of higher >ualit, than generic #roducts and should therefore garner higher #rices$ We should not e!#ect ho9e(er that all sellers of e!#erience goods 9ould 7rand their goods$ ualit, sensiti(e$ fir" 9ho incurs costl, "ar.eting "a, find itself una7le to #ass this cost on to custo"ers 9ho do not sufficientl, (alue the signal that the fir" is selling a higher >ualit, #roduct$ lso esta7lishing a 7rand identit, is less attracti(e to sellers of search goods or goods
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9hose >ualit, and other attri7utes can 7e esta7lished at the ti"e of sale$ +ince the consu"er can ascertain the >ualit, of the #roduct directl, signals of >ualit, are not necessar,$ Hence sellers of search goods "ight 7e 7etter off selling their #roducts under a generic la7el$ Theoreticall, a consu"er should not #a, a #re"iu" for a 7randed search good 7ecause the 7rand na"e does not confer an, additional infor"ation$ 11$ (ndustry 1 consists of four firms that sell a product that is identical in every respect ecept for production cost and price$ Firm A-s unit production costs are 16 percent less than the others are, and it charges a price that is one percent less than the others do$ (ndustry ' consists of four firms that sell a product that is identical in every respect ecept for production cost and price$ Firm -s unit production costs are 16 percent less than the others are, and it charges a price that is 7 percent less than the others do$ Sta)le demand and compara)le entry )arriers characteri+e )oth industries$ The a)ove situations have prevailed for years$ The managers of the a)ove firms are very smart and are surely acting in the )est interest of their o"ners, "hose only goal is to maimi+e profits$ >ased on this information only, can you determine "hich industry has the highest price4cost margin i$e$ price4unit production cost as a percentage of price and "hy&
The .e, here is to recognie that the fir" 9ith the cost ad(antage in each industr, is follo9ing a different strateg, for e!#loiting its cost ad(antage$ In industr, 1 the cost leader E
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Chapter 1' Sustaining Competitive Advantages Chapter Contents 1) Introduction 2) Ho9 Hard Is It to +ustain rofits Threats to +ustaina7ilit, in Co"#etiti(e and Mono#olisticall, Co"#etiti(e Mar.ets • (idence: The ersistence of rofita7ilit, • %) +ustaina7le Co"#etiti(e d(antage !a"#le 12$1: !#loiting 'esources: The Mattel +tor, The 'esourceBased Theor, of the uili7riu" /) Cha#ter +u""ar, 3) 6uestions
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Chapter Summary
Co"#etiti(e ad(antage in a co"#etiti(e "ar.et is not sustaina7le in the long run$ The resource7ased theor, of the fir" de"onstrates ho9 #rofits are reduced through co"#etition ne9 "ar.et entrants and i"itation a"ong other reasons$ The resource7ased theor, states that for a fir" to "aintain long run e!cess #rofits its resources "ust "eet four conditions: 'esource heterogeneit,: the resources and ca#a7ilities underl,ing fir" #roduction • are heterogeneous across fir"s$ In a #articular industr, since fir"s are all different there "ust 7e so"e 9hose resources are su#erior to other fir"s for co"#eting in the industr,$ These fir"s 9ith su#erior resources are a7le to #roduce their out#ut "ore efficientl, Elo9er costs) andGor are a7le to #roduct goods that satisf, consu"ers "ore than the goods offered 7, other fir"s$ !ante 7arriers to co"#etition: other fir"s cannot recognie the (alue that the • resource creates u# front$ If the (alue of the resource 9ere co""on .no9ledge co"#etition to ac>uire the resource 9ould ha(e dri(en u# the #rice of ac>uiring it initiall, = #erha#s u# to the #oint 9here the rents are co"#letel, dissi#ated$ In other 9ords e!ante 7arriers to co"#etition #resu"e i"#erfect infor"ation in "ar.et$ I"#erfect "o7ilit,: generall, "eans that the su#erior resource cannot 7e traded Eor • if the resource can 7e traded there are reasons it 9ouldnt 7e as #roducti(e in the hands of another #roducer)$ If a resource could 7e used @ust as effecti(el, or "ore effecti(el, 7, a co"#etitor the o##ortunit, cost of utiliing the resource offsets the #rofits generated 7, the resource$ I"#erfect "o7ilit, i"#lies the e!istence of cos#ecialiation$ !#ost 7arriers to co"#etition: insure that the co"#etiti(e ad(antage associated • 9ith heterogeneit, is #reser(ed$ +u7se>uent to a fir" gaining a su#erior #osition and earning rents there "ust 7e forces that li"it the co"#etition for those rents$ If another fir" can o7tain the sa"e resources there is no e! #ost li"it$ !a"#les include #atents e!#erience cur(es and o9nershi# of scarce in#uts$ lthough the a7o(e suggests that there is a high Ahurdle to generating econo"ic rents in the long run research has sho9n that although high #erfor"ance fir"s #rofits do decline in the long run and those of lo9 #erfor"ance co"#anies increase the, do not con(erge$ This lac. of con(ergence could arise fro" the fact that there are fe9 true Aco"#etiti(e "ar.ets in the 9orld or the #resence of so"e degree of resource7ased ad(antage$
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Definitions
'egression to the Mean E'e(ersion to the Mean) : In the case of e!tre"el, good Eor #oor) #erfor"ance 7, a co"#an, there is a high #ro7a7ilit, of this co"#an, returning to a less e!tre"e Eor a(erage) #erfor"ance in su7se>uent #eriods$ This i"#lies that fir"s 9ill so"eti"es ha(e the a7ilit, to generate e!traordinaril, high Eor lo9) rents through uns#ecifia7le factors such as luc. 7ut in the long run 9ill re(ert 7ac. to a(erage #erfor"ance$ Cost of Ca#ital: fir" s#ecific rate of return s#ecified 7, the "ar.ets (ie9 of a fir"s ris.iness 9hich deter"ines the cost of raising ca#ital$ If the fir" is una7le to e!ceed this e!#ected return the, 9ill 7e una7le to attract in(estors ca#ital$ Co"#etiti(e d(antage: The a7ilit, of a fir" to out#erfor" its industr, a(erage and earn higher rents than the nor"$ fir"s com%etitive advantage is su7@ect to issues of sustaina7ilit, other9ise the fir"s e!ce#tional #erfor"ance 9ill 7e (ulnera7le to a regression to the mean $ 'esourceBased Theor, of the uasirents$ ECurrent rents less the ne!t 7est o#tion$) Co+#ecialied ssets: ssets that are "ore (alua7le and deri(e "ore rents 9hen used together$ Isolating Mechanis"s: Mechanis"s that li"it the e!tent to 9hich a fir"s co"#etiti(e ad(antage can 7e du#licated or neutralied 7, co"#etitors$ The, are to co"#anies 9hat 7arriers to entr, are to an industr,$ Causal "7iguit, : !ists if the cause of a fir"s a7ilit, to create (alue is o7scured and onl, i"#erfectl, understood$ !ternal o7ser(ers co"#etitors find it difficult to .no9 9h, one fir" can create an ad(antage and therefore cannot du#licate the co"#an,s a7ilit, to e!tract rents$ +ocial Co"#le!it,: +ource of a fir"s co"#etiti(e ad(antage "a, lie in its inter#ersonal ca#a7ilit, Esuch as trust 9ith su##liers relationshi#s 9ith clients)$ The a7ilit, to create or "anage this ad(antage "a, 7e too co"#le! and e!#ensi(e to re#licate easil, there7, leading to increase sustaina7ilit, of their co"#etiti(e ad(antage$ et9or. !ternalities: !ist 9hen the 7enefits of a #roduct to a consu"er gro9s as the co""unit, of users of this #roduct increase in sie$ The e!a"#le in the cha#ter is 6W'T .e,7oard$ Conceptual Applications Choose a ?rofita)le Company and (nvestigate
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+tudents are fa"iliar 9ith doens of co"#anies that see" to ha(e sustained #rofita7ilit, for "ore than a handful of ,ears$ Instructors could assign short re#orts a7out indi(idual fir"s to (erif, and e!#lain 9h, #rofits 9ere sustained or 9h, sustaina7ilit, changed$ Which of the "echanis"s discussed in the cha#ter 9ere .e, to this #rofita7ilit, Ho9 long does the student 7elie(e the fir" 9ill 7e a7le to "aintain that ad(antage Choose a >arrier and Eplore one of the 7arriers to i"itation are i""uta7le$ Technological legal regulator, and cultural factors continuall, redefine the e!tent and #o9er of these ad(antages$ Instructors "ight 9ant to ha(e the students in(estigate one 7arrier and ho9 it has e(ol(ed in recent histor,$ With an understanding of historical changes the students "ight 7e a7le to #redict 9hat future changes 9ould "ean for industr, co"#etition$ arriers ccur +tudents "a, also in(estigate co"#etition fro" an industr, le(el$ Which 7arriers occur in 9hich industries Does historical #rofita7ilit, of co"#anies "atch student e!#ectations 7ased on the a(aila7ilit, of these i"#edi"ents Ho9 >uic.l, are s#ecific industries changing n e!a"#le fro" the co"#uter soft9are 9orld: if a uni(ersal soft9are recognition s,ste" 9ere to 7e de(elo#ed that allo9ed sea"less recognition of all soft9are #rogra"s irres#ecti(e of o#erating s,ste" Esuch as +un?s Ja(a ?a##lets? "ight turn out to 7e) ho9 9ould this change Microsoft?s Windo9s net9or. e!ternalit, ad(antage Would ##le 7e a7le to gain share in this altered en(iron"ent +tudents could also co"#are industries$
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Suggested Harvard Case Studies
De Beers Consolidated Mines HB+ &%&1053 Esee earlier cha#ters) ucor at a Crossroads HB+ &5&%0%& Esee earlier cha#ters)
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Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
Broc. -$ W$ The 1S Com%uter (ndustry# A Study of Mar+et &ower $ Ca"7ridge M: Ballinger1&5/$ Carroll $ Big Blues$ The 1nma+ing of (BM $ e9 or.: Cro9n 1&&%$ DeLa"arter '$ Big Blue$ (BM's 1se and A)use of &ower $ e9 or.: Dodd Mead 1&83$
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Ans"ers to End of Chapter #uestions 1$
Clearl, a fi(e forces anal,sis identifies "an, of the threats to sustaina7ilit,$ fi(e forces anal,sis identifies the factors 9hich i"#act o(erall industr, #rofits$ Ho9e(er the fi(e forces does not e!#lain 9h, so"e fir"s in an other9ise #erfectl, co"#etiti(e "ar.et "a, 7e a7le to sustain #ositi(e econo"ic #rofits o(er long #eriods e(en though the industr, on a(erage earns ero #rofits$ The fi(e forces fra"e9or. is not a##ro#riate for anal,ing the differential in #erfor"ance across fir"s$ co"#lete anal,sis of sustaina7ilit, "ust address the differences in resources and ca#a7ilities #ossessed 7, each fir"$ '$ Mueller-s evidence on profit persistence is *6 years old$ Do you thin/ that profits are more or less persistent today then *6 years ago& Vustify your ans"er$
Muellers results suggest that fir"s 9ith a7nor"all, high le(els of #rofita7ilit, tend on a(erage to decrease in #rofita7ilit, o(er ti"e 9hile fir"s 9ith a7nor"all, lo9 le(els of #rofita7ilit, tend on a(erage to e!#erience increases in #rofita7ilit, o(er ti"e 7ut high #rofita7ilit, fir"s and lo9 #rofita7ilit, fir"s do not con(erge to a co""on "ean$ Muellers 9or. i"#lies that "ar.et forces are a threat to #rofits 7ut onl, u# to a #oint$ ;ther forces a##ear to #rotect #rofita7le fir"s$ While Muellers 9or. is %0 ,ears old it is li.el, a si"ilar stud, #erfor"ed currentl, 9ould ,ield analogous results$ Man, of the forces that acted to #rotect #rofits %0 ,ears ago are still (er, rele(ant Efor e!a"#le econo"ies of scale in "anufacturing andGor 7randing)$ High #rofit industries still currentl, attract entr, 7ut "an, of these industries also en@o, forces that inhi7it the degree of co"#etition fir"s face$ *$ Co/e and ?epsi have sustained their mar/et dominance for nearly a century$ ;eneral Motors and Ford have recently )een hard hit )y competition$ %hat is different a)out the product8mar/et situation in these cases that affects sustaina)ility&
;ne #ro7le" facing the auto industr, is e(en the "ost #o#ular of cars such as uit, un"atched 7, Detroit$ +tudies sho9 that #eo#le do not necessaril, thin. that Co.e tastes 7etter than 'C$ Ho9e(er the i"age and 7rand e>uit, that e#si and Co.e ha(e 7uilt u# o(er the ,ears has created a lo,al follo9ing 7ecause consu"ers a##arentl, (alue this 7rand e>uit, and re9ard the fir"s 9ith re#eat #urchases$ -M and
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ad(antages rooted in econo"ies of scale that the, ha(e are difficult to .ee# #ro#rietar, 7ecause of i"ita7ilit, or e"#lo,ee turno(er etc$ and if the, ha(e an enforcea7le #atent it e(entuall, e!#ires and 7eco"es a(aila7le to other co"#anies or in so"e cases it can 7e in(ented around$ Co.e and e#sis Areci#e for creating their tastes and their i"ages is essentiall, ini"ita7le$
ssets are cos#ecialied 9hen the, are "ore (alua7le 9hen used together than 9hen se#arated$
a) -aining a co"#etiti(e ad(antage re>uires an in(est"ent in a factor or factors that allo9 the co"#an, to "a.e #rofits in e!cess of those of their co"#etition$ Ho9e(er a si"#le in(est"ent does not guarantee co"#etiti(e ad(antage$ In(est"ents in factors that do not #ro(ide e!cess #rofits are a 9aste of "one,$
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that the co"#an,s ad(antage is not #a,ing off in e!cess #rofits or a #ositi(e net #resent (alue$ 7) Managers and shareholders often ha(e different goals and ideas of 9hat is 7est for the co"#an,$ uit, holders "a, hold the co"#an,s stoc. for reasons other than clai"ing a share of the co"#an,s future inco"e such as di(ersification and ris.hedging and thus "a, 7e un9illing to shift the focus of the co"#an,$ $ Do you agree or disagree "ith the follo"ing statements a)out sustaining advantage& A$ (n a mar/et "ith net"or/ eternalities, the product that "ould potentially offer consumers the highest <>4C= inevita)ly comes to dominate$
In a "ar.et 9ith net9or. e!ternalities it is not necessaril, true that the #roduct that 9ould #otentiall, offer consu"ers the highest ABC co"es to do"inate$ $ 2sually high performing firms may get that "ay either )y outpositioning their competitors, )elonging to high performing industries, or )oth$
High #erfor"ance in the long run re>uires that the co"#an, out#erfor" their co"#etition through ini"ita7le strategies or use of factors such as out#ositioning ones co"#etition$ This is true for all industries not @ust high #erfor"ing ones$ C$ (f the sun/ costs of entering industry A eceed the sun/ cost of entering industry >, there "ill certainly )e fe"er firms in industry A than in industry >$
Higher suc. costs of entering an industr, 9ill "a.e ne9 co"ers hesitate to enter the "ar.et$ If all conditions other than the sun. costs are the sa"e the higher the sun. cost the fe9er the ne9 entrants$ Ho9e(er if the net #resent (alue of entering an industr, is #ositi(e fir"s 9ill enter$ In other 9ords 9e cannot conclude that the le(el of sun. costs is #erfectl, negati(el, correlated 9ith the nu"7er of fir"s in the industr, 9ithout accounting for other factors such as the le(el of o(erall de"and in the industries$
If the "e"7ers of the >uartet #roduce "ore (alue together than the, do as soloists or as "e"7ers of different grou#s then the, could 7e (ie9ed as cos#ecialied assets$ Ho9e(er each "e"7er of the ronos 6uartet is considered trada7le$ If an, #la,er can >uit the ronos 6uartet and @oin another grou# and the sa"e Eor "ore) total (alue is
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generated then the "e"7ers 9ould not 7e e!a"#les of cos#ecialied assets$ 3$ %hich of the follo"ing circumstances are li/ely to create first mover advantages: A$ Ma"ell House introduces the first free+e dried coffee$
There are no net9or. e!ternalities or s9itching costs 9ith freeedried coffee$ case "a, 7e "ade for #ossi7le re#utation and 7u,er uncertaint, effects that is if Ma!9ell house can #ioneer a #roduct and esta7lish a re#utation for >ualit, #ree!isting custo"ers "a, 7e un9illing to s9itch and ne9 custo"ers 9ill see. out the #ioneer 7ecause of its re#utation$ Ho9e(er this effect is (er, uncertain$ If another 7rand co"es along that tastes 7etter consu"ers can easil, s9itch$ If Ma!9ell house can #atent the freeedr,ing #rocess and it cannot 7e Ain(ented around the #atent "a, offer a sustaina7le first "o(er ad(antage$ It is also #ossi7le that the #roduct 9ould offer first "o(er disad(antages$ If Ma!9ell House in(ests all its "one, in one #rocess 7ut another co"#an, Afreerides on its "ar.eting and creates a 7etter #roduct Ma!9ell house could face a first "o(er disad(antage$ >$ A consortium of 2S firms introduces the first high4definition television$
There is a #otential first "o(er ad(antages to the introduction$ The in(ention "ight 7e #atenta7le$ It is also #ossi7le that the introduction 9ill offer the consortiu" the net9or. e!ternalit, ad(antage in that it can 7eco"e the A7ase f or the co"#le"entar, soft9are ETF #rogra""ing #ro(iding that these #rogra"s "ust "eet the consortiu"s standard) and for future ho"eentertain"ent o##ortunities$ Consu"ers 9ill 9ant to 7u, hard9are that "eets the standard so the, can recei(e the TF #rogra"s and tie in to future co"#le"entar, hard9are if it co"es a7out$ nother #ossi7le ad(antage is the learning cur(e effect$ If the consortiu" successfull, introduces the technolog, the, "a, 7e a7le to #roduce larger (olu"es earlier than their co"#etition$ disad(antage could arise if the high definition tele(ision 9as the 9rong A7et i$e$ its the 9rong technolog, or a different consortiu" introduces a different standard that do"inates the K+ consortiu"s$ C$ Smith line introduces Tagamet, the first effective medical treatment for ulcers$
The first #ossi7le ad(antage 9ould again 7e legal i$e$ #atent #rotection$ If +"ith line "ar.ets the Taga"ent as a #ioneer the, "a, 7e a7le to gain custo"ers and .ee# the" through re#utational effects and the fact that s9itching costs 9ould 7e high$ If #h,sicians learn ho9 to treat #atients using Taga"ent and #atients #refer to #urchase a #roduct 9ith 9hich #h,sicians are e!#erienced Taga"ent "a, secure a first "o(er ad(antage$ custo"er 9ho had used Taga"ent successfull, for ,ears "a, 7e un9illing to s9itch for a ne9er less tested #roduct unless offered a strong incenti(e to s9itch$ +"ith lines se(eral ,ear head start could also gi(e the" an insur"ounta7le ad(antage in ter"s of the learning cur(e$ Ho9e(er it is #ossi7le that su7stitute #roducts can Afree ride on +"ith lines "ar.eting efforts$ D$ %al4Mart opens a store in Iome, Alas/a$
This can 7e a sustaina7le first "o(er ad(antage if the "ar.et d,na"ics of o"e las.a are such that there are not enough #otential custo"ers in o"e to let t9o or "ore stores o#erate at an efficient scale$ This assu"es that WalMart is the first store to
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o#en$ 7$ Each of the follo"ing parts descri)es a firm that "as an early mover in its mar/et$ (n light of the information provided, indicate "hether the firm-s position as an early mover is li/ely to )e the )asis of a sustaina)le competitive advantage$ A$ An early mover has the greatest cumulative eperience in a )usiness in "hich the slope of the learning curve is one$
The learning cur(e is the decreasing "arginal costs of #roduction corres#onding 9ith an increase in (olu"e o(er ti"e$ learning cur(e of one "eans that costs do not decrease or increase as a function of (olu"e o(er ti"e and thus sho9 that there is no learning cur(e ad(antage for this #articular fir"$ >$ A )an/ has issued the largest num)er of automated teller cards in a large ur)an area$ >an/s vie" their a)ility to offer ATM cards as an important part of their )attle for depositors, and a customer-s ATM card for one )an/ does not "or/ on the ATM systems of other )an/s$
This #otentiall, is a sustaina7le ad(antage$ Issuing a large nu"7er of cards does not gi(e a sustaina7le ad(antage unless there is a corres#ondingl, large nu"7er of TMs to use the" at and if all other TM cards dont 9or. at the"$ Ha(ing the largest nu"7er of TMs "ight grant a econo", of scale ad(antage that other 7an.s cannot afford to du#licate$ Ha(ing the largest nu"7er of TMs and TM cards "ight also create a net9or. e!ternalit, in that fir"s 9ith installed 7ases larger than their co"#etitors has an ad(antage 9hen co"#eting 9ith co"#etitors 9ith s"aller 7asis$ This ad(antage could 7e easil, lost$
This >uestion is a7out first "o(e ad(antage and "ini"u" efficient scale$ fir" does #ossess a first "o(er ad(antage if it achie(es "ini"u" efficient scale and no other fir" can do so$ This descri7es the fir" in >uestion until the "ar.et for the su7stitute colla#ses$ When the T%M "ar.et e!#ands "ore fir"s can achie(e econo"ies of scale and the first "o(er ad(antage "a, 7e lost$ If ho9e(er the fir" has a 9ell de(elo#ed 7rand na"e it 9ill ha(e an ad(antage as these ne9 custo"ers launch their initial #urchases of T%M$ &$ (n defending his company against allegations of anticompetitive practices, >ill ;ates claimed that if someone developed an operating system for personal computers that "as superior to Microsoft-s %indo"s -50 operating system, it "ould Juic/ly )ecome the mar/et leader, ust as ;ates- DS system )ecame the mar/et leader in the early 1576-s$ pponents countered that the mar/et situation in the late 1556-s "as different than in the early 1576-s, so even a mar/edly
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superior operating system might fail to capture significant mar/et share$ Comment$
This is a great e!a"#le of the #o9er of net9or. e!ternalities$ The installed 7ase of Microsoft Windo9s o#erating s,ste"s increased #reci#itousl, 7et9een earl, 1&80 and late 1&&0$ ach of these users has #urchased and learned to use soft9are that is co"#ati7le 9ith the Windo9s o#erating s,ste"$ ach of these users has constructed 9or.sheets and docu"ents in their Windo9s co"#ati7le soft9ares$ oth offer surround4sound music at a Juality that approaches the original studio master recordings from "hich they are made$ Standard compact discs degrade sound Juality due to format limitations$ Although there are fe" dedicated SACD or DKDA players, it is possi)le to manufacture DKD players "ith SACD and8or DKDA circuitry for an additional for an additional 064066 per format, depending on the Juality of the play)ac/$ SACD is supported )y Sony, "hich offers the format on some of its mid4priced DKD players$ (t has also "on support from several classical music and a++ la)els, and has released recordings from several popular acts including the !olling Stones$ DKDA is )ac/ed )y the DKD consortium, and is included as a lo"4cost added feature in mid4priced DKD players from Denon, ?anasonic, and ?ioneer$ Ho"ever, fe" recording studios have em)raced the format thus far$ %hich format do you thin/ is most li/ely to survive the nascent format "ar& Should Sony compete for the mar/et or in the mar/et&
#roduct is said to 7e standardied 9hen so"e #rotocol is follo9ed in its #roduction such that users of the sa"e #roduct can interact 9ith each other andGor 9ith so"e set of co"#le"entar, goods that follo9 that #rotocol$ If a fir" is considering entering a "ar.et in 9hich a standard does e!ist Eor is li.el, to e"erge) there is "uch the fir" needs to consider="ore than can 7e addressed in ans9ering this >uestion s is the case 9ith an, fir" there is a share that ena7les the fir" to achie(e sufficient #rofita7ilit, to continue o#eration$ In the case of a fir" 9hose #roduct co"#lies 9ith a standard and the good is consu"ed 9ith a co"#le"entar, good EC and soft9are) the le(el of "ar.et share re>uired to achie(e #rofita7ilit, is affected not @ust 7, the fir"s o9n "ini"u" efficient scale 7ut the "ini"u" efficient scale in the #roduction of the co"#le"entar, goods$ Within a #roduct function there are "ulti#le #ossi7le standards that "ight e"erge=so"eti"es onl, one sur(i(es Eas in Cs since ##le is reall, delegated to a e(er decreasing niche) and so"eti"es "ulti#le standards coe!ist for "an, "an, ,ears Ecassettes and CDs or DFD and +CD)$ When 9e see "ulti#le standards the follo9ing is often the case: lternati(e standards are not su7stituta7le enough for "an, custo"ers$ That is o there is A"eaningful differentiation a"ong the offerings=9here7, one standard do"inates for one set of occasions of use and another standard do"inates for another set of occasions of use Efor e!a"#le cassettes are #orta7le and CDs ha(e
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o
7etter sound >ualit,)$ +ufficient #roduct #erfor"ance differences could @ustif, coe!istence$ +o"eti"es these alternati(e standards sell to difference seg"ents of consu"ers and so"eti"es the consu"er seg"ents o(erla#$ roducers of the co"#le"entar, goods can co(er all their costs$ That is the consu"ers are 9illing to #a, for the redundant costs of #roducing the co"#le"entar, goods for "ulti#le standards 7ecause the consu"ers (alue the differentiation 7et9een the standards$
Whether entering a ne9 or e!isting #roduct "ar.et for 9hich a co"#le"entar, #roduct is re>uired the fir" needs to consider the "ini"u" efficient scale of the co"#le"entar, good in setting its "ar.et share target$ The good descri7ed in the >uestion does not see" li.el, to 7e do"inated 7, one standard$ While +on, has done a good @o7 of getting so"e traction the fact that other hard9are "anufacturers are currentl, including the feature in their #roducts suggests that +on,s lead 9ill 7e contested$
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Chapter 1* The rigins of Competitive Advantage: (nnovation, Evolution, and the Environment Chapter Contents 1) Introduction 2) Creati(e Destruction Disru#ti(e Technologies • +ustaina7ilit, and Creati(e Destruction • !a"#le 1%$1: The +un. Cost ffect in +teel: The do#tion of the Basic ;!,gen ui#"ent Industr, 3) The n(iron"ent !a"#le 1%$4: The 'ise of the +9iss Watch Industr, 5) Managing Inno(ation !a"#le 1%$/: Co"#etence Histor, and -eogra#h,: The o.ia +tor, 8) Cha#ter +u""ar, &) 6uestions
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Chapter Summary
Cha#ter 1% e!a"ines the role of inno(ation as a source of co"#etiti(e ad(antage$ The origins of co"#etiti(e ad(antage accrue fro" the a7ilit, of fir"s to e!#loit o##ortunities to create #rofita7le co"#etiti(e #ositions that other fir"s are una7le or un9illing to do$ In short co"#etiti(e ad(antage arises 9hen a fir" is 9illing to inno(ate during #eriods of funda"ental Ashoc.s or discontinuities in the econo", to dis#lace e!isting #ractices and technologies$ The incenti(es to inno(ate can 7e attri7uted to three "ain effects: E1) the +un. Cost ffect E2) the 'e#lace"ent ffect and E%) the fficienc, ffect$ While the first t9o #heno"ena e!#lain the rationale for entrants to inno(ate the third effect #ro(ides #ossi7le reasons for incu"7ents to continuall, inno(ate$ In addition to the traditional theories of inno(ation discussed a7o(e that are rooted in neoclassical econo"ics the cha#ter also offers insight fro" the (ie9#oint of e(olutionar, econo"ics$ These theories e!a"ine the i"#act of the fir"s resources ca#a7ilities and histor, on inno(ation$ In short 9hile neoclassical econo"ics offer insights on the fir"s incenti(es to inno(ate the e(olutionar, theories #osit that so"e fir"s ha(e greater a7ilities to inno(ate than do others$ dditionall, the i"#act of a fir"s en(iron"ent E#articularl, its local en(iron"ent) on its incenti(e to inno(ate is also e!#lored$ In addition the cha#ter also e!a"ines the d,na"ics of inno(ation co"#etition$ 'egardless of 9hether co"#etition is "odeled as deter"inistic or #ro7a7ilistic #atent races the .e, is to antici#ate 'ND in(est"ents of co"#etitors$
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Approaches to Teaching this Chapter Definitions: Creati(e Destruction: n e(olutionar, #rocess 7, 9hich the #o9er of entre#reneurial inno(ation alters radicall, the co"#etiti(e "ar.et for the longrun 7etter"ent of consu"ers$ This co"#etiti(e ad(antage is achie(ed through the Adestruction of current sources of ad(antage and e!#loiting the ne9 o##ortunities$
+un. Cost ffect: The as,""etr, that e!ists 7et9een a fir" that has alread, "ade in(est"ents in a #articular technolog, or #roduct conce#t and a fir" that is #lanning such a co""it"ent$ The #rofit "a!i"iing decision for a fir" that has co""itted to the technolog, or #roduct "a, 7e to go ahead 9ith its de(elo#"ent 9hile the fir" that is still conte"#lating the idea "a, choose a different #ath$ This is due to the fact that #rior in(est"ents "a, ha(e 7een "ade that are s#ecific to a #articular technolog, or conce#t that "a.es it chea#er for the fir" to continue 9ith it$ 'e#lace"ent ffect: This 7elief suggests that challengers to "ono#olists 9ill in(est "ore in the ne!t generation technolog, than does the "ono#olist$ This is 7ecause the challenger stands to gain an entire "ar.et 9hile the "ono#olist 9ould onl, "aintain 9hat it currentl, has$ Through inno(ation the challenger stands to gain a "ono#ol, 9hile the "ono#olist can onl, re#lace itself$ fficienc, ffect: This theor, argues that an incu"7ent "ono#olists incenti(e to inno(ate is stronger than that of a #otential entrant 7ecause the "ono#olist stands to lose its "ono#ol,$ The 7enefit to 7eing a sole "ono#olist co"#ared to 7eing a "e"7er of a duo#ol, is greater than the 7enefit deri(ed fro" 7eing a "e"7er of a duo#ol, a co"#ared to not 7eing in the industr, at all$ In short the "ono#olist stands to lose "ore than the co"#etitor stands to gain$ Deter"inistic atent 'aces: This 9a, of (ie9ing co"#etition to inno(ate suggests there is onl, one 9inner na"el, the co"#an, that s#ends the "ost "one, on 'ND$ ro7a7ilistic atent 'aces: This (ie9 of co"#etition to inno(ate argues that the co"#an,s odds of sinning the race increases 9ith 'ND s#ending 7ut are not guaranteed 9ith su#erior s#ending$ (olutionar, cono"ics: Theor, that #osits that a fir"s decisions are deter"ined 7, routines or the 9ell#racticed #atterns of acti(it, ado#ted 7, that fir"$ ue "ar.ets 9ill allo9 for co"#etiti(e ad(antages to 7e 9on$
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Conceptual Applications Find a >rea/through and Eplore This cha#ter offers conflicting o#inions on the source of inno(ation and the nature of #atent races$ Instructors "a, 9ant their students to challenge these theories$
usiness Community ;ften 7usiness acade"ics focus too "uch attention on large "ulti"illion dollar fir"s the N-?s -old"an +achs? and H?s of the 9orld$ But 9hat a7out the entre#reneurs Who are the entre#reneurs in ,our co""unit, or a"ong the students What 9as the "ar.et o##ortunit, e!#loited 7, the local entre#reneur Wh, did sGhe inno(ate 9hen the large co"#anies in ,our co""unit, didn?t What does it ta.e to 7e one of these creati(e destro,ers (f Ecess ?rofits are indeed sustaina)le for long periods of time, is Capitalism Failing& +chu"#eter suggested that e!cess #rofits in a "ar.et are the result of "a@or "ar.et shifts created Eusuall,) 7, entre#reneurs$ He as.ed that the health of a "ar.et not 7e @udged according to e!cess #rofits 7, a fir" at an, #articular "o"ent$ 'ather +chu"#eter suggests that econo"ists and go(ern"ents should ta.e a longter" #erce#ti(e$ cono"ists and #oliticians continue to de7ate these issues$
What do the students 7elie(e are the characteristics of a health, "ar.et Can there 7e too "uch co"#etition EChina) Will a functioning s,ste" dri(e all e!cess #rofits out of the "ar.et e(entuall, Would t9ent, straight ,ears of #rofits 7, the Esa"e)
In 9hat industries does resource creation gain in i"#ortance o(er the fir"?s resource "o7iliation +o"e e!a"#le to consider: Microsoft?s Windo9s and the Ja(a challenge rocter and -a"7le (s$ other 7rand "anage"ent co"#anies WalMart?s "o(e into discount 9arehouses Honda and s"all "otor technolog, +on, and "iniaturiation ca#a7ilities$
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?ath Dependencies, Dynamic Capa)ilities and !outines +o"e acade"ic literature suggests that #rofit"a!i"iing decisions are "ade in a conte!t esta7lished 7, the routines and #re(ious successes of the co"#an,$ Can students identif, co"#anies that 9ere (icti"s of their o9n successes their o9n routines IBM and the K+ auto industr, are t9o clear e!a"#les$ The 9orld changed dra"aticall, 7ut the decision"a.ing #rocesses in these fir"s did not change$ IBM ignored the #ersonal co"#uter re(olution until it 9as al"ost too late$ The K+ auto industr, did not understand the >ualit, of their Ja#anese co"#etition and #aid dearl,$ ?orterNs Environment Argument Eplored Michael orter argues that co"#etiti(e ad(antage originates in the local en(iron"ent in 9hich the fir" is located$
With a 7asic understanding of orters #ro#osition students should >uestion 9hether this theor, is su##orta7le$ International students in the class should 7e as.ed to ta.e the lead on the credi7ilit, of orter?s 7elief$ Ho9 i"#ortant are factor and de"and conditions Is this 9orld(ie9 too deter"inistic Must the 7est #roducers of tunneling e>ui#"ent 7e fro" +9iterland or another "ountainous countr, If orter is right 9ith his theor, 9hat is the role of go(ern"ent #olic, in this "acro le(el discussion
While 9e do not discuss "an, of the inno(ations atte"#ted 7, large co"#anies instructors "a, 9ant to e!#ose students to the "ost in(enti(e of these techni>ues$ T9o interesting e!a"#les include the *intra#reneur* #rogra" at %M and Motorola?s *(enture ca#ital* di(ision$
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Suggested Harvard Case Studies
Cater#illar HB+ &%8/253 Esee earlier cha#ters) ucor at a Crossroads HB+ &5&%0%& Esee earlier cha#ters) hili#s Co"#act Disc Introduction HB+ &5&20%/ Esee earlier cha#ters) lso consider one of se(eral HB+ cases on Microsoft Dell co"#uter and ##le co"#uter$
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Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
D?(eni '$ Hy%ercom%etition$ Managing the *ynamics of Strategic Maneuvering $ e9 or.:
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Ans"ers to End of Chapter #uestions (s the etent of creative destruction li/ely to differ across industries& Can the ris/ of creative destruction )e incorporated into a five4forces analysis of an industry& 1$
Creati(e destruction is the #rocess 7, 9hich inno(ation introduces shoc.s or discontinuities that destro, old sources of ad(antage and re#lace the" 9ith ne9 ones$ The entre#reneurs 9ho e!#loit the o##ortunities these shoc.s create achie(e #ositi(e #rofits during the ne!t #eriod of co"#arati(e >uiet$
Clustering is essentiall, a result of need to 7e in close #ro!i"it, to either De"andside co"#le"entorsEa #la,er is ,our de"andside co"#le"entor if consu"ers ha(e a higher 9illingness to #a, for ,our #roduct 9hen the, ha(e that #la,ers #roduct too than 9hen the, @ust ha(e ,our #roduct) or +u##l,side Co"#le"entors Ea #la,er is ,our su##l,side co"#le"entor if su##liers ha(e a lo9er cost of #ro(iding in#uts to ,our 9hen the the,, #ro(ide in#uts for that #la,er too than 9hen the, @ust #ro(ide in#uts for ,ou$ We can thin. of 'ND as an i"#ortant Asu##lier to the #har"aceutical industr, Ee(en though 'ND is internall, su##lied)$ +ince fir"s can 7enefit fro" each others learning 9hen 9hen the, are in in close close #h,sical #h,sical #ro!i"it, costl, redundant 'ND outla,s outla,s are a(oided$ uto co"#anies can each generall, .ee# their su##liers at "ini"u" efficient scale all on their o9n$ lthough lthough i"#ro(e"ents i"#ro(e"ents in teleco""unications reduce the need for #h,sical #ro!i"it, indi(iduals 9ho share infor"ation find #ersonal contact to 7e the "ost effecti(e "echanis"$ %hat is the difference )et"een the efficiency effect and the replacement effect& Could )oth effects operate at the same time& (f so, under "hat conditions "ould the efficiency effect )e li/ely to dominate& 2nder "hat conditions "ould the replacement effect )e li/ely to dominate& *$
The 'e#lace"ent ffect: Credited to o7el #rie 9inning econo"ist enneth rro9$ Consider a drastic inno(ationonce it is ado#ted costs are so reduced that #roducers using the old technolog, 9ill not longer 7e (ia7le co"#etitors$ rro9 #ondered t9o scenarios: E1) the o##ortunit, to de(elo# the inno(ation is a(aila7le to a fir" that
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currentl, "ono#olies the "ar.et using the old technolog, E2) the o##ortunit, to de(elo# the inno(ation is a(aila7le to a #otential entrant 9ho if it ado#ts the inno(ation 9ill 7eco"e "ono#olist$ Knder 9hich scenario is the 9illingness to #a, to de(elo# the inno(ation greatest The "ono#olist retains its "ono#ol, Eit re#laces or canni7alies itself)$ The entrant gains a "ono#ol,$ The entrants -I is larger and hence so is its incenti(e to inno(ate$ The efficiency effect has to do 9ith the fact that the 7enefit to a fir" fro" 7eing a "ono#olist as co"#ared 9ith 7eing one of t9o co"#etitors in a duo#ol, is greater than the 7enefit to a fir" fro" 7eing a duo#olist as co"#ared 9ith not 7eing in the industr, at all Eand thus earning no #rofit)$ The "ono#olist has "ore to lose fro" another fir"?s entr, than the entrant has to gain fro" entering the "ar.et$ This "ainl, has to do 9ith the fact that entr, 9ill tend to dri(e #rices do9n$ The re#lace"ent effect tends to do"inate 9ith the E#ercei(ed) chance of inno(ation fro" outside the industr, is lo9$ The efficienc, effect "a, do"inate 9hen the "ono#olists failure to de(elo# the inno(ation "eans Eor is #ercei(ed to "ean) that ne9 entrants al"ost certainl, 9ill$ (n their article OStrategy as Stretch and @everage,O ;ary Hamel and C$ $ ?rahalad argue that industry ne"comers have a stronger incentive to supplant esta)lished firms from their leadership positions than esta)lished firms have to maintain their leadership positions$ The reason, they argue, is that a greater gap eists )et"een a ne"comerNs resources and aspirations as compared to a mar/et leader$O (s Hamel and ?rahaladNs argument consistent "ith profit4maimi+ing )ehavior )y )oth the leader and the ne"comer& (s their argument consistent "ith ideas from evolutionary economics& .$
Ha"el and rahalads argu"ent is consistent 9ith #rofit "a!i"iing 7eha(ior for fir"s #articularl, 9hen (ie9ed fro" the #ers#ecti(e of the returns that each of these fir"s e!#ect to earn fro" leadershi# #ositions$ leader has less incenti(e to e!#end large resources to "aintain its leadershi# #ositions 7ecause such actions onl, ser(e to "aintain its current #osition #er"itting the fir" to earn "ono#ol, #rofits 9hich it has alread, 7een earning #re(iousl,$ ;n the other hand 7, gaining the leadershi# #osition the entrant 9ould "o(e fro" a #osition fro" earning lo9 Eto ero) #rofits to a #osition of "ono#ol, #rofits$ The entrant thus has a greater incenti(e to su##lant the leader$ This #heno"enon is .no9n as the re%lacement effect $ Ha"el and rahalads argu"ent is also consistent 9ith ideas fro" e(olutionar, econo"ics$ uire a distinct change in routines$ ounger fir"s on the other hand is less constrained 7, histor, Ei$e$ routines are #erha#s less fir"l, esta7lished) and thus the, are 7etter a7le to res#ond to en(iron"ental changes in order to gain a co"#etiti(e ad(antage$
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0$
(s patent racing a +ero4sum game& A negative4sum game& Eplain$
n e!tre"e characteriation of a #atent race is that the first fir" to co"#lete the #ro@ect A9ins the #atent race and o7tains e!clusi(e rights to de(elo# and "ar.et the #roduct$ The losing fir"s get nothing$ -i(en this characteriation it is certainl, #ossi7le that the su" of the losses is greater than the 9inning fir"s net gain$ %hat are a firmNs dynamic capa)ilities& To "hat etent can managers create or Omanage into eistenceO a firmNs dynamic capa)ilities& $
fir"s d,na"ic ca#a7ilities refer to the fir"s a7ilit, to "aintain and ada#t the ca#a7ilities that are the 7asis for the fir"s co"#etiti(e ad(antage$ fir" that searches continuousl, to i"#ro(e its routines that is "a.es it an institutional #riorit, to continuall, search is "anaging into e!istence d,na"ic ca#a7ilities$ Ho9e(er a fir"s d,na"ic ca#a7ilities are inherentl, li"ited it can 7e difficult for a fir" to 7e as li7erated fro" its o9n histor, as it needs to 7e to find re(olutionar, as o##osed to e(olutionar, ideas$ uired co"#le"entar, assets that the, need to change the 9a, the, #roduce or do 7usiness$
ccording to orter local ri(alr, affects the rate of inno(ation in a "ar.et far "ore than foreign ri(alr, does$ lthough local ri(alr, "a, hold do9n #rofita7ilit, in local "ar.ets fir"s that sur(i(e rigorous local co"#etition are often "ore efficient and inno(ati(e than are international ri(als that e"erge fro" softer local conditions$ O(ndustrial or antitrust policies that result in the creation of domestic monopolies rarely result in glo)al competitive advantage$O Comment$ 5$
In his 7oo. The Com%etitive Advantage of Nations Michael orter argues that ri(alr, in the ho"e "ar.et is an i"#ortant deter"inant of a fir"s a7ilit, to achie(e co"#etiti(e ad(antage in glo7al "ar.ets$ In #articular orter argues that local ri(alr, affects the rate of inno(ation in a "ar.et to greater degree than glo7al co"#etition$ If fir"s are shielded fro" such ri(alr, through the creation of do"estic "ono#olies the, are less efficient and inno(ati(e co"#ared to international ri(als 9ho e"erge fro" en(iron"ents of (igorous local co"#etition$ +ince these fir"s are a7le to rea# "ono#ol, 7enefits in their ho"e "ar.et 9ithout ha(ing to 9orr, a7out the i"#ending threat of ne9 entrants there is less incenti(e to inno(ate and 7e efficient$ s such these do"estic "ono#olies are less ca#a7le of co"#eting in the glo7al "ar.et#lace$
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16$ (# (nc$ currently monopoli+es the mar/et for a certain type of microprocessor,
the $ The present value of the stream of monopoly profits from this design is thought to )e 066 million$ Enginola "hich is currently in a completely different segment of the microprocessor mar/et from this one and (# are contemplating spending money to develop a superior design that "ill ma/e the completely o)solete$ %hoever develops the design first gets the entire mar/et$ The present value of the stream of monopoly profit from the superior design is epected to )e 106 million greater than the present value of the profit from the $ Success in developing the design is not certain, )ut the pro)a)ility of a firmNs success is directly lin/ed to the amount of money it spends on the proect more spending on this proect, greater pro)a)ility of success$ Moreover, the productivity of EnginolaNs spending on this proect and (#Ns spending is eactly the same: Starting from any given level of spending, an additional 1 spent )y Enginola has eactly the same impact on its pro)a)ility of "inning$ The ta)le in the )oo/ illustrates this$ (t sho"s the pro)a)ility of "inning the race if each firmNs spending eJuals 6, 166 million, and '66 million$ The first num)er represents EnginolaNs pro)a)ility of "inning the race, the second is (#Ns pro)a4 )ility of "inning, and the third is the pro)a)ility that neither succeeds$ %hich company, if any, has the greater incentive to spend money to "in this
In order to understand the "oti(ations of the t9o co"#anies 9e need to first consider 9hat sta.es are in(ol(ed to these t9o #arties$ We can tr, to fra"e this #ro7le" using conce#ts fro" the cha#ter: enneth rro9 "ight suggest this is the classic re#lace"ent effect$ successful inno(ation for a ne9 entrant leads to a "ono#ol,$ successful inno(ation 7, the esta7lished fir" also leads to a "ono#ol, 7ut since it alread, had a "ono#ol, the gain fro" the inno(ation is less than it 9ould 7e for the #otential entrant$ Through inno(ation an entrant can re#lace the "ono#olist 7ut the "ono#ol, can onl, re#lace itself$ In this e!a"#le nginola in o7taining the 7rea.through 9ould earn Q3/0 "illion in total #rofits 9hile to I6 the 7rea.through 9ould onl, earn the" an additional Q1/0 "illion since their current technolog, is 9inning the" Q/00 "illion$ +ince nginola could theoreticall, gain a #rofit of Q3/0 "illion if it succeeds it 9ould 7e 9illing to s#end Q200 "illion on research since "ore "one, 9ould increase the #ro7a7ilit, of success$ If I6 correctl, antici#ates nginolas decision it 9ould ha(e to s#end Q200 "illion as 9ell so as to "a!i"ie its chance of success gi(en nginolas choice$ But 9h, 9ould a fir" in(est Q200 "illion to get a /0P chance of a Q1/0 "illion gain rro9s re#lace"ent effect suggests that nginola not I6 9ill 7e the inno(ator in this case$ Ho9e(er the efficienc, effect ta.es a different #oint of (ie9$ Here the incu"7ent "ono#olist antici#ates that #otential entrants "a, also ha(e the o##ortunit, to de(elo# the inno(ation$ The efficienc, effect "a.es an incu"7ent "ono#olists incenti(e to inno(ate stronger than that of a #otential entrant$ This is due to the fact that the 7enefit to a fir" fro" 7eing a "ono#olist is co"#ared 9ith that of 7eing a duo#olist$ The 7enefit to the entrant fro" achie(ing a duo#ol, #osition Eas co"#ared 9ith not 7eing in the industr, at all) is s"aller in a7solute ter"s than the (alue of the incu"7ents
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"ono#ol, #osition$ d(ocates of the efficienc, effect 9ould suggest that the "ono#olist 9ould lead the inno(ation$ The co"#an, 9ith the "ost to lose as o##osed to the "ost to gain 9ill dri(e change$ either the efficienc, effect nor the re#lace"ent effect a##lies #erfectl, to the situation a7o(e$ In this case the #ro7a7ilities gi(en a7o(e do not su##ort the efficienc, effect$ The 9inner is a "ono#olist=there is no as,""etr, 9here7, if the incu"7ent 9ins hisGher "ono#ol, #osition is "aintained and if the entrant 9ins heGshe 7eco"es a duo#olist$ +i"ilarl, the re#lace"ent effect suggests that the incu"7ents "arginal gain is s"aller than the entrants "arginal gain$ +ince the entrants success "eans the incu"7ent is out of the "ar.et the incu"7ents "arginal gain is not Q1/0 "illion 7ut is e>ui(alent to the entrants "arginal gain$ -i(en there is no as,""etr, the fir"s ha(e e>ual incenti(e to inno(ate$
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Chapter 1. Agency and ?erformance Measurement Chapter Contents 1) Introduction 2) The rinci#alGgent
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Chapter Summary
Indi(iduals E#rinci#als) often hire others Eagents) to 9or. on their 7ehalf$ n agent ho9e(er is si"ultaneousl, acting on in his o9n 7ehalf and so situations "a, arise 9here7, the agent "ight choose to #ro"ote his o9n interests at the e!#ense of the #rinci#als interests$ The #ro7le" created 7, this di(ergence in interests is called the %rinci%al6agent %ro)lem$ In order to align 7oth interests s#ecific contracts are used that s#ell out the ter"s of the agenc, relationshi#$ This cha#ter e!a"ines the agenc, relationshi# the (arious o##ortunities for sol(ing agenc, #ro7le"s 7, contracting the characteristics of an efficient contract and the conditions that lead to inefficiencies e(en 9hen 7est #ossi7le contracts are used$ (er, contract has to satisf, t9o t,#es of conditions: E1) the agent "ust 7e 9illing to acce#t the contract and E2) the actions the #rinci#al e!#ects the agent to ta.e "ust 7e co"#ati7le 9ith the incenti(es s#elled out in the contract$ Knder an ideal contract the agent 9ill not shir. and 9ill al9a,s ta.e the efficient action$ n ideal contract that #a,s the agent his threshold 9age Ethe 9age at least as great as the agent?s ne!t 7est alternati(e) is first7est efficient for the #rinci#al$ uatel, "easure the action or outco"e heGshe "a, instead use a #ro!,$ In order to reduce the #rinci#alagent #ro7le" #rinci#als "ust choose the agents co"#ensation "ethod carefull,$ %erformance6)ased contract "a.es a #a,"ent contingent on the agent "eeting so"e #res#ecified #erfor"ance o7@ecti(es$ T9o #ro7le"s arise: E1) it is difficult for the #rinci#al to set a %erformance standard and E2) the outco"e often is uncertain and cannot 7e co"#letel, controlled 7, the agent$ Kncertaint, of outco"e causes the #ro7le" that a #rinci#al often cannot distinguish #oor #erfor"ance due to shir.ing fro" #oor #erfor"ance due to 7ad luc. Eor due to factors outside the agents control)$ Hence a #erfor"ance7ased contract i"#oses an ele"ent of ris. on the agent$ The ris.a(erse agent "ust 7e co"#ensated for this ris. 9ith an e!#ensi(e ris. #re"iu"$ s a result of these #ro7le"s a contract usuall, co"7ines a fi!ed guaranteed #a,"ent and a #erfor"ance7ased #a,"ent$ In such a contract the #rinci#al and the agent share the ris. 9hich e!#lains 9h, these contracts are called ris+6sharing contracts $ The #rinci#al see.s a contract that offers the "ost 7alanced s#lit 7et9een fi!ed and #erfor"ance7ased co"#ensation$ The degree of #erfor"ance7ased co"#ensation de#ends on four distinct factors: 1) the agent?s ris. a(ersion 2) the agent?s effort a(ersion %) the "arginal contri7ution of effort to #rofita7ilit, and 4) the noisiness of the #erfor"ance "easure$ The ris. and effort a(erse the agent and the noisier the #erfor"ance "easure the less #erfor"ance 7ased co"#ensation should 7e used$ The greater the "arginal contri7ution of effort to #rofita7ilit, the "ore #erfor"ance 7ased co"#ensation should 7e used$
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The structure of agenc, contracts used can also hel# the #rinci#al to find agents 9ith desired characteristics$ This "echanis" is called sorting $ The le(el of 9ages or the structure of the incenti(e contract s,ste"aticall, influences the characteristics of a##licants$
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Approaches to Teaching Chapters 1. and 10 are com)ined )elo" Definitions:
rinci#alGgent ui(alent: The certain a"ount the decision "a.er 9ould 7e 9illing to acce#t in e!change for the ris., #a,off$ 'is.re"iu": This >uantit, is the a"ount that a #rinci#al "ust co"#ensate a ris. a(erse agent for acce#ting a #erfor"ance7ased contract 9ith so"e degree of (aria7ilit, in the outco"e$
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Multitas. rinci#le: When allocating effort a"ong a (ariet, of tas.s e"#lo,ees 9ill tend to e!ert "ore effort to9ard the tas.s that are re9arded$ fficienc, 9age: Li"ited lia7ilit, restricts #unish"ents for nonco"#liance$ The #rinci#al has to #a, the agent "ore than the agents o##ortunit, cost to #re(ent hi" fro" shir.ing$ This #a,"ent is called efficienc, 9age$ +orting: The le(el of 9ages or structure of the incenti(e contract can s,ste"aticall, influence the characteristics of the agents a #rinci#al can hire$ In general "ore a7le 9or.ers and ris. ta.ers #refer #a,for#erfor"ance arrange"ents 9hile 9or.ers 9ith lo9 "o7ilit, #refer co"#ensation sche"es 7ased on @o7 tenure$ gents 9ith li"ited lia7ilit, are "ore 9illing to ta.e highl, ris., (entures$ s far as structuring a discussion this cha#ter is an o##ortunit, for the instructor to rel, hea(il, on the 9or. e!#erience of the students: What @o7s ha(e ,ou had • Ho9 9as #a, deter"ined • If #a, 9as tied e!#licitl, to #erfor"ance 9hat #erfor"ance "easures 9ere used • Ho9 "uch of the (ariation in "easured #erfor"ance 9as under the control of • the e"#lo,ee and ho9 "uch 9as rando" Were there an, (aluecreating acti(ities that did not affect the #erfor"ance • "easure Were there an, non(aluecreating acti(ities that did affect the #erfor"ance • "easure If #a, 9as not tied e!#licitl, to #erfor"ance 9h, not • Were an, #erfor"ance "easures a(aila7le to the fir" • If so 9hat 9ould ha(e ha##ened if these "easures had 7een used o Were the a(aila7le "easures ris., o Would the 9rong acti(ities ha(e 7een re9arded o Student Assignments: Have Students Audit their "n %or/ Contracts Most students 9ill ha(e had a 9ide (ariet, of @o7s and 9or. contracts of their o9n$ It "ight 7e useful for the" to detail the co"#ensation sche"es E#rotecting salar, infor"ation of course) and anal,e 9hether the contracts re#resented the "ost efficient ones #ossi7le$
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#rofits and Main +treet insta7ilit, including the residential candidac, of at Buchanan$ What are the true effects of the destruction of the 9ageGtenure #rofile 9hen co"7ined 9ith "assi(e 7lue and 9hite collar la,offs record cor#orate #rofits and s.,roc.eting C; salaries If ,ou 9ere a C; and ,ou 9ere *forced* to la, off 10000 e"#lo,ees 9ould ,ou cut ,our o9n salar, Would ,ou cut the salaries of the *tourna"ent* losers What are the shortter" 7enefits and costs What are the longter" 7enefits and costs What are the costs to 7usinesses if e(er,one fro" e"#lo,ees leadershi# and stoc.holders is thin.ing shortter" !ogue Traders on %all Street There ha(e 7een a rash of uncontrolled securities traders 9ho ha(e lost "illions and e(en 7illions in 7ad 7ets$ The "ost fa"ous e!a"#le is ic. Leeson 9ho in 1&&/ 7rought do9n the (enera7le Barings Ban. 9ith a coc.tail of deri(ati(es in the sian "ar.ets$ Do students thin. that actions of these agents re#resent a 7rea.do9n of the agentG#rinci#al relationshi# If so ho9 9ould students change the incenti(e s,ste"s to re9ard successes 7ut not lead to tre"endous losses
There are also #lent, of "ore co""on situations in 9hich incenti(e s,ste"s can create #rinci#alG agent #ro7le"s$ What e!a"#les can students identif, in 7usiness situations at school 9ith their fa"ilies or in their co""unities The Technology !evolution and )serva)ility The agentG#rinci#al relationshi# is su##osed to i"#ro(e as the o7ser(a7ilit, of actions increases$ Massi(e changes in technolog, ha(e ena7led "anagers to "onitor al"ost as "uch infor"ation as the, 9ant$ What are the 7oundaries of this o7ser(a7ilit, Ho9 9ould nonshir.ers res#ond to increased o7ser(a7ilit, Do 9or.ers deser(e an, #ri(ac, or do onl, shir.ers as. for #ri(ac, Ho9 do #ri(ac, issues differ in #u7lic (ersus #ri(ate 9orlds What role does 9or.er choice or lac. of it #la, in this de7ate Team4)ased Structures and (ncentives Much of the 9or. in the 7usiness 9orld and at 7usiness schools is done in a grou# setting: se(eral indi(iduals contri7ute to a single #roduct$ When are tea" structures a##ro#riate If the #rocess and contri7utions of each indi(idual "e"7er are o7scured 7, this structure 9hat ha##ens to the incenti(e s,ste" What rules could ,ou #ut in #lace to hel# @udge the #erfor"ance of indi(idual tea" "e"7ers ?erformance standards in a rapidly changing environment Man, contracts are 7ased on industr, or co"#an, standards for indi(idual #erfor"ance: ho9 "an, 9idgets #roduced #er hour for e!a"#le$ +o"e industries and #rocesses are so ne9 or ha(e such illdefined technologies that no acce#ted #erfor"ance standards e!ist$ Ho9 9ould ,ou as a #rinci#al negotiate a #erfor"ance standard for such a #rocess or industr, What is the role of trust What is the role of o7ser(a7ilit, >ig ?icture Discussion #uestions: •
+hould a fir" tie an e"#lo,ee?s #a, to his or her onthe@o7 #erfor"ance Wh, or 9h, not
•
Do #a,for#erfor"ance incenti(es *9or.* What do 9e "ean 7, *9or.* in this
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sentence •
Wh, do #eo#le disli.e rando" (ariation in their 9ealth
•
If a fir" is to tie #a, to e"#lo,ee #erfor"ance then ho9 should #erfor"ance 7e "easured
•
What factors "a.e one #erfor"ance "easure *7etter* than another What are the #ros and cons of 7asing #a, on relati(e co"#arisons of e"#lo,ees? #erfor"ances
•
The e, oint to Bring ;ut in Discussion are: E1) T,ing #a, to #erfor"ance has costs and 7enefits$ E2) Benefits: Hel#s 9ith #ro7le"s relating to hidden action and hidden infor"ation$ E%) Costs: ll de#ends on the >ualit, of the #erfor"ance "easure$ There are three 9a,s a #erfor"ance "easure can 7e 7ad: E1) e!#oses e"#lo,ee to ris. E2) includes an acti(it, that does not create (alue E%) e!cludes an acti(it, that does create (alue$ The >uestion of 9hether and if so to 9hat e!tent to tie #a, to #erfor"ance de#ends on this costG7enefit 7alance$ ;ther e!a"#les to illustrate cha#ter conce#ts: E1) +orting: Ho9 does the high tuition for a MB education hel# sorting out the *right* students E2) The Fenture Ca#ital Industr, as an e!a"#le 9here contracts 7et9een in(estors and (enture ca#italist and 7et9een (enture ca#italists and issuers as 9ell as the structure of the li"ited #artnershi#s are dri(en 7, the #rinci#alagent #ro7le"$
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Suggested Harvard Case Study Chapter 1. and 10 com)ined
ordstro": Dissension in the 'an.s EHB+ &1&1002) ordstro" #a,s sales#eo#le on co""issions$ Illustrates selection and incenti(e effect of #a,for#erfor"ance$
Lincoln lectric Co"#an, EHB+ &%53028) Lincoln is fa"ous for #a,ing #iece rates to factor, 9or.ers$ Discuss age 1#otential dra97ac.s of #iece rate 7ased #a,$ Discussion the *s,ste"* Lincoln #uts in #lace to "itigate the effects of #iece rates$
utna" In(est"ents: Wor.^Ho"e EHB+ &80%011) utna" allo9s so"e e"#lo,ees to teleco""ute$ Discuss effects on #roducti(it, and i"#ortance of a(aila7ilit, of good #erfor"ance "easures for these e"#lo,ees$
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Etra !eadings Chapter 1. and 10 com)ined
The sources 7elo9 #ro(ide additional sources for the theories and e!a"#les of the cha#ter$ ggar9al 'a@esh and ndre9 $ +a"9ic. 1&&8 AThe other side of the Tradeoff: The I"#act of 'is. of !ecuti(e Co"#ensation?? Journal of olitical cono", 108 3/10/$ lchian $ and H$ De"set$ *roduction Infor"ation Costs and cono"ic ;rganiation* American Economic eview $ 32 1&52$ Ba.er -eorge 1&&2 AIncenti(e Contracts and erfor"ance Measure"ent?? Journal of olitical cono", 100 /&8314$ Doehringer $ and M$ iore$ Internal La7or Mar.ets and Man#o9er nal,sis$ Le!ington M: D$C$Health 1&51$ aster7roo. <$ and D$
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;,er aul 1&&8 A
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Ans"ers to End of Chapter 1. #uestions:
1$ 2sing your o"n eperience, if possi)le, identify three types of hidden information that could affect an agency relationship$ (dentity three forms of hidden action, as "ell$
2$ Suppose you "ere granted a Oris/y o)O of the type studied in this chapter$ The o) pays .6,666 "ith pro)a)ility 18', and 16,666 "ith pro)a)ility 18'$ %hat is your certainty eJuivalent for this ris/y payoff& To ans"er this Juestion, compare this ris/y o) to a safe o) paying 166,666 for sure$ Then reduce the value of the safe o) in 1,666 increments until you are indifferent )et"een the safe o) and the ris/y o)$ %hat is your certainty eJuivalent for a o) paying 16,666 or 156,666, each "ith eJual pro)a)ility& The C of the @o7 9ith a $/ #ro7a7ilit, of Q40000 and a $/ #ro7a7ilit, of Q130000 is higher than the C associated 9ith the @o7 that has a $/ #ro7a7ilit, of Q10000 and a $/ #ro7a7ilit, of Q1&0000$ The reason the C falls as the lo9 end dro#s and the high end increases is it is t,#ical for an indi(idual to #lace a higher (alue on incre"ental consu"#tion 9hen he is #oor co"#ared to 9hen he is rich$_ %$ (n the 2nited States, la"yers in negligence cases are usually paid a contingency fee eJual to roughly *6 percent of the total a"ard$ @a"yers in other types of cases are often paid on an hourly )asis$ Discuss the merits and dra")ac/s of each from the perspective of the client i$e$, the principal$ In negligence cases the client 9ill not #a, an, "one, to the la9,er unless the suit is (ictorious$ What is the ris. #rofile of a la9,er 9ho 9ill acce#t such a ris., #ro@ect Clearl, the selection #rocess 9ill dra9 ris. neutral or ris. lo(ing #ractitioners to these suits$ ;nl, certain #eo#le 9ill acce#t this Aall or nothing #ro#osition$ The client 9ill .no9 that it is in the interest of the la9,er to 9in and 9in >uic.l, 7ecause there are no other 7enefits other than the (ictor, settle"ent$ In other cases the client is offering hourl, 7illing to the la9,er$ ris. a(erse #ool 9ill 7e dra9n to these cases the la9,ers .no9 that there is a direct lin. 7et9een e(er, hour of 9or. and #a,"ent$ The client 9ill ha(e the ad(antage of seeing the ste# 7, ste# 9or. to9ard 9inning the la9suit through detailed 7illing state"ents 7ut sGhe "a, >uestion 9hether the la9,er reall, 9ants to 9in the case$ When the case is settled the la9,ers #a,"ents end$ In these situations the client "ust anal,e the hourl, 9or. or trust that the la9,er has the clients 7est interests at heart$ Contingenc, incenti(es 9ill also encourage "ore negligence suits$ While the hourl, #a,"ents 9ill force the client to calculate >uic.l, the true #ossi7ilit, of (ictor, the contingenc, la9,ers i"#ose no costs on the clients until (ictor, is assured$ Ho9e(er #laintiffs in #ersonal in@ur, cases often don?t .no9 9hether their clai"s are legall, (alid$ Contingenc, arrange"ents sol(e this hidden infor"ation #ro7le" 7, "oti(ating attorne,s to acce#t onl, those cases that ha(e a shot at 9inning$ When clients are "ore so#histicated Efor e!a"#le a large f ir" 9ith inhouse attorne,s 9ho hires a la9 fir" to handle s#ecific "atters) this selection effect is less i"#ortant$
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4$ Suppose a firm offers a divisional manager linear pay4for4performance contract )ased on the revenues of th e division the manager leads$ The managerNs pay is given )y: ?ay 0 F 1 a !evenue, "here 2 is a fied yearly salary and a is the fraction of the divisionNs revenue that is paid to the manager$ Suppose the la)or mar/et demand for this type of divisional manager increases, meaning the firm has to increase this managerNs pay in order to retain him or her$ Should the firm do this )y increasing the salary 2$ the commission a, or )oth& Eplain$ The content of this cha#ter suggests that onl, < should increase$ The reason is nothing a7out the nature of the @o7 has changed so if the #re(iousl, chosen salar, #lus #a,for#erfor"ance contract had struc. the correct 7alance 7et9een ris. and incenti(es then there is no reason t o change it$ /$ !egulated firms, such as electric utilities, typically have limited discretion over the prices they charge$ !egulators set prices to guarantee a fied return to the firmNs o"ners after gathering information a)out the firmNs operating costs$ Studies of eecutive pay practices have consistently sho"n that the compensation of utility CEs is significantly less sensitive to firm performance that of non4utility CEs$ Eplain "hy, using the tradeoff )et"een ris/ and incentives$ There isn?t as "uch sco#e for utilit, e!ecuti(es to 7enefit shareholders 7, for e!a"#le reducing cost$ If an e!ecuti(e in a nonregulated fir" ta.es actions to reduce the fir"?s costs then shareholders 7enefit$ Hence shareholders 9ant to "oti(ate e!ecuti(es to ta.e these actions and are 9illing to #a, the e!ecuti(e?s ris. #re"iu" in order to so$ If an e!ecuti(e in regulated fir" reduces costs the shareholders do not 7enefit$ Hence no reason to #a, the ris. #re"iu" associated 9ith t,ing #a, to #erfor"ance$ 3$ Firms often use Juotas as part of compensation contracts for salespeople$ A Juota4)ased contract may stipulate, for eample, that the salesperson "ill receive a 16,666 )onus if yearly sales are 1 million or more, and no )onus other"ise$ (dentify actions a firm does not li/ely "ant ta/en that the employee "ill )e motivated to ta/e under such a contract$ The sales#erson 9ill 7e highl, "oti(ated to generate sales u# to Q1 "illion$ Ho9e(er sales o(er the Q1 "illion "ar. do not generate additional co"#ensation for the sales#erson$ Hence the structure of this co"#ensation contract "a, induce the sales#erson to Aga"e the s,ste"$ uot a is unli.el, to 7e "et$ 5$ %hile it is, in principle, feasi)le for )usiness schools to "rite eplicit pay4for4 performance contracts "ith professors, this is rarely done$ (dentify dra")ac/s of the follo"ing performance measures for this o): a$ Ium)er of research articles pu)lished 7$ StudentsN ratings of professorsN courses c$ Dollar value of research grants "on d$ Starting salaries of students after graduation$
185
rofessors co"#ensation tied to student ratings of hisGher #erfor"ance: +trength: Inno(ation in the classroo" that leads to 7etter Erelati(e) #erfor"ance 9ould 7e • re9arded$ These re9ards 9ould "oti(ate the "ost inno(ati(e teachers Eor teachers 9ho #ercei(e the"sel(es to 7e inno(ati(e) to 9or. harder$ The chance of out#erfor"ing ones #eers "ight "oti(ate all teachers to 9or. • harder$ rofessors should not o7@ect to difficult "aterial 7eing added to the curriculu" • since the teacher is onl, concerned 9ith relati(e #erfor"ance$ Wea.nesses: rofessors "a, #ander to students to get ratings Egi(ing Aeas, s food etc$) • Much of >ualit, teaching is su7@ecti(e$ • ach #rofessor 9ould ha(e lessened incenti(e to share infor"ation 9ith other • #rofessors that "ight strengthen the co"#etition$ The o(erall >ualit, of education 9ould 7e reduced if #rofessors 9ere gi(en an incenti(e to 7e uncoo#erati(e 9ith each other$ If relati(e #erfor"ance 9ere affected 7, the >ualit, of the students #rofessors • 9ould tr, to #ass off #oorer students to other #rofessors 9hen these students did not reall, 7elong in those courses$ If the #rofessor could not re"o(e the #oor student fro" the class the #rofessors attitude to9ard this student "a, 7e affected$ If it 9as necessar, to alter for e!a"#le the sie of the #erfor"ance differential • needed in order to get the 7onus #rofessors "ight 7eco"e s.e#tical a7out the integrit, of the s,ste"$ n, change to the regi"e after the regi"e is i"#le"ented 9ould cause "uch an!iet, for #rofessors and 9ould di"inish the effecti(eness of the a##roach$ rofessors co"#ensation tied to nu"7er of articles #u7lished grants student salaries Eso"e a7solute "easure of #erfor"ance): +trengths: rofessors 9ill 7e co"#ensated for and therefore #erfor" "ore acti(ities that • create (alue Eat least fro" the #ers#ecti(e of the designers of the co"#ensation regi"e)$ rofessors do not face an i""ediate threat fro" sharing effecti(e teaching or • research techni>ues 9ith other #rofessors$ Wea.nesses: s all #rofessors a##roach the #erfor"ance 7ar the 7ar 9ill ine(ita7l, ha(e to 7e • "o(ed or the 7onus 9ill 7eco"e regular co"#ensation$ rofessors "a, co"e to realie the, are shooting for a "o(ing target and "a, co"e to resent this a##roach to earning their #a,$ rofessors "a, resent the addition of difficult "aterial to the curriculu" as an • a7solute #erfor"ance threshold is "ore difficult to "eet the "ore difficult is the "aterial$ rofessors "a, falsif, or Aga"e their #erfor"ance criteria$ ualit, 9hen it co"es to research$ •
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• • •
•
rofessors "a, s#end a su7o#ti"all, high a"ount of ti"e see.ing grants as o##osed to teaching or other (alua7le acti(ities$ (aila7ilit, of grant for e!a"#le is tied to econo"ic conditions not under the control of #rofessors$ If a7solute #erfor"ance 9ere affected 7, the >ualit, of the students #rofessors 9ould tr, to #ass off #oorer students to other classes 9hen these students did not reall, 7elong in else9here$ If the #rofessor could not re"o(e the #oor student fro" the class the #rofessors attitude to9ard this student "a, 7e affected$ +tudent salaries are tied to econo"ic conditions not under the control of the #rofessors$
8$ Suppose Minot Farm EJuipment Corp$ employs t"o salespeople$ Each covers an eclusive territory9 one is assign ed to Iort h Da/ota and the other to Sou th Da/ota$ These t"o neigh)oring plains states have similar agricultural economies and are affected )y the same "eather patterns$ Durham Tractor Co$ also employs t"o salespeople$ ne "or/s Iorth Carolina, "hile the other is assigned to regon$ Farm products and methods vary considera)ly across these t"o states$ Each firm uses the dollar value of annual sales as a per formance measure for salespeople$ %hich of the firms do you thin/ "ould )enefit most from )asing pay on its salespeopleNs relative performance& %hy& 'elati(e #erfor"ance as a 7asis for co"#ensation is useful for filtering out co""on shoc.s$ When conditions are good in orth Da.ota the, are li.el, to 7e good in +outh Da.ota as 9ell$ Hence using relati(e #erfor"ance e(aluation allo9s the fir" to shield these e"#lo,ees fro" the ris.s associated 9ith the >ualit, of the local far" econo",$ orth Carolina and ;regon are li.el, to 7e su7@ect to differing shoc.s and so using relati(e #a, e(aluation 9ill not 7e a##ro#riate$ &$ Consider a potential employee "ho values "ages )ut also values the opportunity to pursue non4"or/4related activities$ Bou may thin/ of these non4 "or/ activities as relating to family o)ligations such as childcare$ Suppose other o)s availa)le to this employee pay 166 per day, )ut reJuire the employee to "or/ at the companyNs facility, effectively eliminating the e mployeeNs a) ility to pursue non4"or/ act ivities$ (gnore OeffortO for the purposes of this pro)lem and assume the only agency pro)lem pertains to ho" the employee allocates his or her time$ Suppose that if the employee allocates all of his or her time in a day to O"or/O, then the employee creates 106 "orth of value gross of "ages for the firm$ The e mployee may also have access to t"o forms of Onon4"or/ O activities: 1 a high4value non4"or/ activity thin/ of unepected child care needs and ' a lo" value non4 "or/ activity thin/ of leisure 4 playing video games or "atching TK$ The employee values the a)ility to complete the high4value non4"or/ activity at '66, and values the a)ility to complete the lo"4value non4"or/ activity at 06$ a Suppose first that the lo"4value non4"or/ activity does not eist, and that the highvalue non4"or/ activity eists "ith pro)a)ility 6$16$ (nterpretation: there is a 16 chance that the employee "ill need to perform an important child4 care duty each day$ Suppose your firm is considering offering a telecommuting o) to this employee$ Assume here that if the employee telecommutes and th e high4value activity arise s, then the employee spends all his or her time on this activity and creates no value for the firm that day$
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(f the high4value non4"or/ activity does not arise, the employee spends all his or her time "or/ing on )ehalf of the firm$ %hat daily "age should you offer& %hat "ill your profits )eN& (s your firm )etter off than if it offered a non4telecommuting o) to the employee& %hy& ) Suppose no" that the lo"4value non4"or/ activity does eist$ 2nli/e the high4value activity "hich only arises "ith some pro)a)ility, the lo"4value activity is al"ays present$ Suppose also that the firm cannot pay this employee )ased on individual performance )ecause the availa)le performance measures are of insufficient Juality$ Suppose your firm offers a telecommuting o) you descri)ed in part a$ According to the multi4tas/ principle, ho" "ill the employee spend his or her time& Are your profits higher offering the telecommuting o), or the non4telecommuting o)& c Io" suppose that the firm does have access to a good measure of individual performance$ The firm can ma/e pay contingent on "hether the employee "or/s on the firmNs activity$ %hat o) telecommuting or non4 telecommuting and compensation arrangement fied, or fied plus some varia)le dependent on output maimi+es firm profits& Comment on the types of o)s "here on e might ep ect to see firms offering telecommuting$
Teleco""uting re>uires good E"eaning co"#lete and (erifia7le) "easures of indi(idual #erfor"ance$ ;ne reason for fir"s to re>uire e"#lo,ees to 9or. onsite is that doing so li"its e"#lo,ees? access to outside acti(ities=if the e"#lo,ee does not ha(e access to these alternati(e acti(ities it is "ore li.el, the e"#lo,ee 9ill 7e occu#ied doing their actual @o7 This is useful 9hen "easures of indi(idual #erfor"ance are not a(aila7le$ ote this offers an alternati(e e!#lanation to *#o9er* for 9h, higher ran.ing #eo#le 9ithin an organiation t,#icall, ha(e "ore control o(er their o9n schedules$ Consider a di(isional "anager 9ith NL res#onsi7ilit,: the fir" can use #rofits as a "easure of #erfor"ance and allo9 this e"#lo,ee to #ursue high(alue non9or. acti(ities 9ithout 9orr,ing that the #erson 9ill also #ursue lo9 (alue non9or. acti(ities$
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Chapter 10 (ncentives in Firms Chapter Contents 1) Introduction 2) I"#licit Incenti(e Contracts +u7@ecti(e erfor"ance (aluation • ro"otion Tourna"ents • fficienc, Wages and the Threat of Ter"ination • !a"#le 1/$1: ro"otion Tourna"ent at -eneral lectric %) Incenti(es in Tea"s !a"#le 1/$2: +toc. ;#tions for MiddleLe(el "#lo,ees 4) Career Concerns and LongTer" "#lo,"ent !a"#le 1/$%: Career Concerns of Mutual
1&1
Chapter Summary
This cha#ter contains a sur(e, of "an, different "echanis"s fir"s use to #ro(ide incenti(es 9hen e!#licit #a,forindi(idual #erfor"ance contracts are not feasi7le$ In cha#ter 14 "ost of the #erfor"ance "easures are li.el, (erifia7le$ Ho9e(er for "an, @o7s the a(aila7le #erfor"ance "easures are i"#erfect in so"e 9a,$ The "easures "a, 7e affected 7, rando" factors 7e,ond the e"#lo,ees control the, "a, re9ard acti(ities the fir" does not (alue or fail to re9ard acti(ities the fir" does (alue$ I"#licit incenti(e contracts are a##ro#riate 9hen it is i"#ortant that a range of #erfor"ance "easures are incor#orated$ I"#licit contracts allo9 fir"s to use su7@ecti(e assess"ents as #erfor"ance "easures$ The disad(antage of su7@ecti(e assess"ents is the su#er(isor faces the unsa(or, tas. of re9arding so"e 7ut not all of hisGher staff and the e"#lo,ee has an incenti(e to Alo77, his su#er(isor for a good e(aluation$ +trong incenti(es can 7e #ro(ided through the use of #ro"otion tourna"ents$ The sie of the #rie deter"ines the intensit, of the e"#lo,ees "oti(ation$ Instead of re9arding agents for good #erfor"ance #rinci#als can #re(ent agents fro" shir.ing Enoneffort) 7, #unishing the" for #oor #erfor"ance$ This ho9e(er 7eco"es difficult 9hen agents ha(e li"ited lia7ilit, that restricts the "a!i"u" #enalt, that can 7e i"#osed on the"$ In such a case the onl, o#tion the #rinci#al has is to "a.e the agent 9ant to .ee# the agenc, relationshi#$ In order to achie(e this the #rinci#al has to #a, to the agent "ore than the agents o##ortunit, cost Ethe threshold 9age) for good #erfor"ance$ +uch #a,"ents a7o(e the "ar.et 9age are called efficiency wages# (n this case the %enalty for the agent if he is caught shir+ing is the loss of his efficiency wage# uestion facing fir"s is who should decide on the a##ro#riate res#onse to a gi(en #iece of infor"ation$
1&2
Approaches to Teaching see a)ove as Chapters 1. and 10 are com)ined
Suggested Harvard Case Study see a)ove as Chapters 1. and 10 are com)ined
Etra !eadings see a)ove as Chapters 1. and 10 are com)ined
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Ans"ers to End of Chapter 10 #uestions:
(mplicit incentive contracts can )e some"hat difficult to communicate to a firmNs employees$ ften, firms "ill ma/e availa)le a set of re"ards raises, )onuses, or promotions to those employees "ith OgoodO performance, )ut "hat constitutes good performance is never eplicitly defined$ As part of the o)4 intervie" process, potential employees often spend many hours tal/ing to a large num)er of the firmNs employees$ %hile this practice helps the firm gain information a)out the potential employee, information is also trans mitted to the potential employee a)out the firm$ Eplain, using your o"n eperience if possi)le, "hat Juestions o) applicants as/ of intervie"ers, and ho" this may fill in important aspects of firmsN implicit incentive contracts$ 1$
Inter(ie9ees are often interested in the t,#ical career #ath 9ithin a fir" and fre>uentl, see. infor"ation a7out the characteristics of #eo#le 9ho are (ie9ed as successful 9ithin the fir"$ When the a##licant learns a7out e"#lo,ee turno(er 9here e"#lo,ees 9ho lea(e the fir" go and the t,#e of e"#lo,ee 9ho is content that heGshe is #rogressing 9ell at the fir" the a##licant is "ore a7le to deter"ine hisGher o9n Afit in that fir" and the li.elihood heGshe 9ill succeed in a career at the fir"$ %hat /inds of value4creating actions might not )e reflected in su)ective performance evaluations, as performed )y an employeeNs supervisor& Eplain ho" *64degree peer revie"s might mitigate this pro)lem$ %hat are some potential dra")ac/s associated "ith *64degree peer revie" as a performance measure& 2$
It is li.el, that students 9ill ha(e "an, good e!a"#les as there are "an, actions that create (alue for the fir" 7ut are difficult for su#er(isors to o7ser(e$ n analog, that "a, 7e useful for students to consider is: #ro@ect is done 7, a grou# of students ho9 9ell can the rofessor gi(e indi(idual grades 7ased on this grou# 9or. n e!a"#le in a @o7 conte!t: su#er(isors "a, not 7e a9are of ho9 "uch ti"e an indi(idual s#ends "entoring a lo9erle(el e"#lo,ee$ Mentoring is a (er, i"#ortant acti(it, fro" the #ers#ecti(e of the fir" as the "entoring #rocess i"#ro(es the fir"s #ool of hu"an ca#ital$ While #eer re(ie9s "itigate the #ro7le" of su#er(isors 7eing una7le to o7ser(e all the e"#lo,ees actions there are d ra97ac.s to the #eer re(ie9 #rocess$ The cha#ter discusses issues in(ol(ed 9ith co"7ining 9ith an, for" of relati(e #erfor"ance e(aluationthere "a, 7e sa7otage$
This is a tough >uestion$ The 7est student ans9er 9ould suggest #ossi7le details of an
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e"#lo,ees i"#licit contract 9ith i"7le$ The >uestion is 9hether as an e"#lo,ee of -iganticor# 9ill the e"#lo,ees i"#licit contracts the, had 9ith i"7le 9ill 7e honored good ans9er 9ould co(er the follo9ing #oints: Does - (alue the sa"e acti(ities that did ;r is a different set of acti(ities to 7e • re9arded Does - stand to gain a large financial 9indfall 7, 7rea.ing e!isting i"#licit • contracts Is there an o##ortunit, for - to Acherr, #ic. 9hich i"#licit contracts to 7rea. s - ,ou "a, 9ant to either E1) "a.e clear that ,ou intend to re9ard si"ilar • acti(ities as did or E2) "a.e clear 9hat ne9 acti(ities are to 7e re9arded$
T"o young partners at the consulting firm Macen+ie and Co call them >o) and Doug leave the firm to set up their o"n partnership$ They agree to try the partnership for one year, and to split the profits 06806$ ?rofits depend on the partnersN actions as follo"s: (f )oth "or/ hard, the ne" firm "ill ma/e profits of 1,066,666$ (f one of the consultants "or/s hard "hile the other shir/s, the firmNs profits "ill )e 1,106,666$ (f >o) and Doug )oth shir/, they "ill ma/e profits of 366,666$ Each partner is "illing to "or/ hard only if doing so earns him an additional '06,666 in a year$ Dra" this Opartnership gameO in matri form using ideas from the Ec onomics ?rimer$ Does this game have dominant strategies& %hat is the the Iash EJuili)rium& (s this partnership game a prisonersN dilemma& %hat is the relationship )et"een the prisonersN dilemma game and incentives in teams& 4$
Doug +hir.
Wor. 5/0000
5/0000
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Wor.
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+hir.
Bo7
The econo"ics of tea" incenti(es are identical to the #risoners dile""a$ The nash e>uili7riu" of this ga"e is to Ashir.$ The reason is that e(en though 9or.ing generates a higher #a,off for each 9or.er 9or.ing does not clear the Q2/0000 #re"iu" that 7oth Doug and Bo7 need to induce the" to 9or.$ Hence shir.ing is a do"inant strateg, no "ater 9hat Bo7 e!#ects Doug to do shir.ing is #referred 7, Bo7 and the sa"e can 7e said fro" Dougs #ers#ecti(e$
Consider a monopolist firm that consists of t"o functional divisions$ The manufacturing division produces the firmNs product, and the actions of the managers in manufacturing have a large effect on the firmNs costs$ The sales division mar/ets and sells the firmNs product, and the actions of the managers in sales have a large effect on the firmNs revenues$ a Eplain "hy the firm may "ant to use the firmNs revenue as a performance measure for the sales managers instead of the firmNs profit$ Eplain "hy measures of cost might )e preferred to measures of profit for motivating /$
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manufacturing managers$ ) (f the firm re"ards re"ards sales manager managerss on the )asis )asis of revenues revenues,, can it delegate delegate decisions over prices and Juantities to these managers& (f the firm did delegate these decisions, then "hat price "ould the sales managers choose to sell& c Suppose that )ecause )ecause sales managers managers are in constant constant contact "ith customers, customers, they have have the most most accura accurate te inform informati ation on a)out a)out the cur curre rent nt demand demand for the firm firmNs Ns prod produc uct$ t$ %hat %hat per perfo form rmanc ancee meas measur uree shoul should d the firm firm use use if it is essential essential to delegate pricing dec decisi isions ons to achiev achievee Juic/ Juic/ price price respo response nsess to changes in mar/et demand& 2se your discussion to identify the cost to the firm of delegating this pricing decision$
;ne nice thing a7out re(enue and cost as #erfor"ance "easures is that the, shield e"#lo,ees fro" ris.$ The fir" could if it 9anted #a, each "anager on the 7asis of fir" 9ide #erfor"ance$ But this 9ould "ean the "anufacturing "anager?s #a, 9ould (ar, 9ith shifts in de"and for the fir"?s #roduct$ This su7@ects the "anager to ris. 9ithout #ro(iding an, additional incenti(es$ +i"ilarl, #a ,ing the t he sales "anager 7ased on fir" f ir" #erfor"ance 9ould "ean that rando" shoc.s to in#ut #rices 9ould affect his #a, again 9ith no effect on incenti(es$ ;ne difficult, 9ith using these "ore focused "easures is that so"e decisions can?t 7e delegated$ uantit, 9here M' V 0$ Delegating this #ricing decision "eans "eans the fir" has to use #rofit as a #erfor"ance "easure$ "easure$ nd this i"#oses cost7ased ris. on this "anager i"#l,ing a ris. #re"iu" #re "iu"$$
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Chapter 1 Strategy and Structure Chapter Contents 1) Introduction 2) n Introd Introduc uctio tion n to +truct +tructure ure Indi(iduals Tea"s and Hierarchies • Indi(iduals +elfManaged Tea"s Hierarch, of uthorit, uthorit, Co"#le! Hierarch, • De#art"entaliation Coordination and Control !a"#le 13$1: The Di(ision of La7or "ong +ea"en: 150015/0 T,#es of ;rganiational +tructures • The
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Chapter Summary
This cha#ter discusses the interrelationshi# 7et9een structure and strateg, and the "utual fit necessar, to effecti(el, i"#le"ent 7usiness o#erations and change$ The successful i"#le"entation of a fir"s strateg, re>uires a##ro#riate organiational structures 9ithin the fir"$ lfred Chandler su""aried this conce#t as structure follows strategy strategy $ The cha#ter 7egins the discussion of fir" organiation at the tas. le(el$ Wor.ers Wor.ers can co"#lete tas.s individually$ These 9or.ers recei(e incenti(es 7ased solel, on their indi(idual outco"es$ Indi(iduals can 7e organied into tea"s$ Self6managed teams are #artiall, re9arded on tea" tea" #erfor"ance$ This structure structure 9or.s 9ell 9hen tea" tea" effort is "ore (alua7le than indi(idual efforts=such as 9hen there s#ecialiation e!ists a"ong grou# "e"7ers$ Tea"s 9ith a hierarchy of authority designate one "e"7er=a su#er(isor=to ta.e charge of "onitoring and coordinating the 9or. of others$ Co""unication and coordination re>uire"ents #artiall, deter"ine o#ti"al tea" structure$ ro@ects that re>uire fre>uent tea" interaction and intergrou# su##ort 7enefit "ost fro" self"anaged tea"s as o##osed to hierarchical structures$ When defining the co"#le! hierarchical structures fir"s should consider the #otential #ro7le"s and costs of de#art"entaliation de#art"entaliation and and coordination$ ;#ti"al ;#ti"al de%artmentali.ation 9ill de#end on the fir"s econo"ies of scale and sco#e transaction costs and agenc, costs$ Designers of a co"#le! hierarch, "ust also consider ho9 to resol(e conflicts resulting fro" de#art"entaliation$ Coordination a##roaches ensure the flo9 of infor"ation and facilitate decision "a.ing$ The autono"ous a##roach e"#hasies selfcontain"ent of 9or. units such as #rofit centers and res#onsi7ilit, centers$ Mini"al infor"ation flo9s outside these units 9hich are "easured 7, their achie(e"ent of highle(el goals$ The alternati(e a##roach e"#hasies lateral relations across 9or. grou#s such as infor"al relations or "ore for"alied "atri! organiations$ organiations$ The structure of large organiations usuall, fit into one of four categories$ structure or Kfor" Eunitar, functional) defines the unit for each 7asic The functional structure 7usiness function function of the fir" such as cor#orate di(isions$ di(isions$ Di(ision Di(ision of la7or "oti(ates this structure$
The multidivisional structure or Mfor" organies the fir" into grou#s segregated 7, #roduct line related 7usiness 7usiness units regions regions or custo"er t,#es$ t,#es$ dditionall, dditionall, these grou#ings or di(isions 9ill ha(e their o9n internal structures$ This structure addresses the li"itations of a functional structure in large di(ersified fir"s such as coordination difficulties and agenc, costs$ matri8 structure organies the fir" along "ulti#le di"ensions assigning hu"an resources to "ore than one di"ension si"ultaneousl,$ si"ultaneousl,$ uire"ents$ This structure is seen in Ja#anese +eiretsu organiations$ organiations$ •
Contingenc, theor, states that since three factors affect the relati(e efficienc, of different structures there does not e!ist a A7est organiational structure that fits all
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circu"stances of a fir"$ s the technology of a fir" changes the fir"s structure 9ill also need to change since technolog, defines the degree of tas. interde#endence$ Ja, -al7raith #ro#oses that ad(ances in infor"ation #rocessing increase the a"ount co"#le!it, and s#eed of a(aila7ilit, of information$ This leads to fir"s "a.ing "ore difficult decisions and less routine decisions o(er9hel"ing the fir"s decision"a.ing structure$ fir" can change its for"al organiation to address these changes$ lternati(el, lternati(el, it "a, create tea"s res#onsi7le for crossing esta7lished hierarchical 7oundaries creating a lateral organiation to aid in decision "a.ing$ n historical #ers#ecti(e of fir" structures #ro(ides e(idence that Chandlers thesis that structure follows strategy strategy re"ains true$ Large fir"s of the late nineteenth and earl, t9entieth centur, e!#loited ne9 technologies to 7eco"e leaders in a single "ar.et focus$ These fir"s successfull, used the functional structure to achie(e a s#ecialiation of la7or that led to econo"ies of scale in "anufacturing "ar.eting and distri7ution$ +uch econo"ies of scale then #ro"#ted fir"s to "o(e into ne9 7usinesses or "ar.ets$ s fir"s shifted their strateg, fro" a single 7usiness or "ar.et focus to di(ersification in #roduct lines the functional structure no longer 9or.ed 9ell and fir"s "o(ed to the "ultidi(isional "ultidi(isional structure$ With the ne9 structure di(ision "anagers 9ere "easured on the #rofitandloss of their di(ision and "onitored the acti(ities of the functional units 9ithin the di(ision$ Toda, fir"s aug"ent the traditional structures 7, creating net9or.s outsourcing so"e functions to contractors$ t the sa"e ti"e "ultinational fir"s face the uni>ue challenge of attaining econo"ies of scale and sco#e across nations ,et s#ecialiing 9ithin nations$ The "ultinational strateg, no9 "oti(ates structure that co"7ines "atrices and net9or.s$ The cha#ter concludes 9ith a discussion on 9hat other strategic or en(iron"ental factors in a fir" "a, influence the structure of the fir"$
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Approaches to Teaching this Chapter Definitions +elfManaged Tea"s: ;rganiing on the 7asis of 9or. grou#s each "e"7er 9or.s 9ith the other "e"7ers to set and #ursue co""on tas. o7@ecti(es$
Hierarch, of uthorit,: The s#ecialiation of one "e"7er of the grou# on the "onitoring and coordination of the 9or. of the other$ Less for"all, e"#lo,ees ha(e a 7oss under this hierarch,$ +#an of Control: The nu"7er of su7ordinates of a s#ecific su#er(isor$ The o#ti"al s#an of control is uni>uel, deter"ined 7ased on the co"#le!it, of the coordinating tas.s$ Co"#le! Hierarchies: The structure of "ost large fir"s in(ol(es "ulti#le grou#s and "ulti#le le(els of grou#ings$ This structure arises not @ust fro" the need to organie indi(iduals into grou#s 7ut to organie grou#s into larger grou#s$ De#art"entaliation: In(ol(es the di(ision of the organiation into for"al grou#s such as co""on functions in#uts locations or ti"e of 9or.$ Coordination: In(ol(es the "anaging of infor"ation 9ithin an organiation to facilitate su7unit decisions that are consistent 9ith each other and the organiational o7@ecti(es$ Control: ;rganiing functions that in(ol(e the e!ercise of decisionrights and rule "a.ing authorit, 9ithin the hierarch,$ uire"ents of co""on tas.s than 7, for"al lines of authorit,$ The Ja#anese +eiretsu is a leading e!a"#le of a net9or. structure$ Contingenc, Theor,: ##roach to organiing 9hich sees the 7est structure for an organiation de#ending on the uni>ue circu"stances facing that organiation$ Tas. Interde#endence: The e!tent to 9hich t9o or "ore #ositions de#end on each other to do their o9n 9or.$ Tho"#son sees three t,#es of interde#endence: reci#rocal se>uential and #ooled$
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Heuristics: rinci#les that reduce the a(erage ti"e decision"a.ers "ust s#end searching for solutions to difficult nonroutine #ro7le"s$ These #rinci#als are e"7edded in organiational structures and cor#orate cultures$ Students- Audit of their rgani+ational Structures
Most of the students 9ill ha(e 9or.ed in organiations 9ith co"#le! structures and ha(e had significant dealings 9ith se(eral others$ Discuss so"e of their e!a"#les in class$ What are the structures that students ha(e e!#erienced Do the, 7elie(e that the structure 9as a conscious decision of the fir" or a result of #ersonalities and historical circu"stances Which structures are easier to 9or. under
Challenge students to disco(er the do"inant structures in (arious industries$ Wh, do industries differ Ho9 does (ariet, 9ithin different industries (ar, re so"e industries ho"ogenous in the t,#es of structures re#resented in that industr, In #articular ha(e students in(estigate the co"#anies and industries that recruit at ,our ca"#us$ usiness Schools and Structure
If the structure of an organiation is one indication of the goals that an organiation is tr,ing to acco"#lish 9h, are 7usiness schools organied 7, functional e!#erience E"ar.eting strateg, finance) Does the structure of 7usiness schools reflect the structure of cor#orations Does it "atter What are the #ossi7le goals of 7usiness schools ossi7le goals "a, include training e"#lo,ees for "a@or recruiters #roducing cuttingedge research or training the ne!t generation of #rofessors$ re these goals internall, consistent When 9ould industr, focused de#art"ents Ereal estate trans#ortation consu"er #roducts) 7e a 7etter structure than the functional design
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Suggested Harvard Case Study
Ban. ;ne 1&&% HB+ &%&404% Esee earlier cha#ters) Boo llen N Ha"ilton: Fision 2000 HB+ &%&30%1$ In 1&&% Boo llen N Ha"ilton forsoo. its #re(iousl, highl, local organiational structure in order to ser(e "ultinational clients "ore effecti(el,$ The fir"s hu"an resource s,ste"s 9ere redesigned along 9ith the structure$ House of Tata HB+ &5&203/ Esee earlier cha#ters)$ Ing(ar o"#rad and I HB+ &%&01%2 Esee earlier cha#ters)$ ucor at a Crossroads HB+ &5&%0%& Esee earlier cha#ters)$ e#siCola Be(erages HB+ Case &%&00%4 'es#onding to changes in e#siColas co"#etiti(e en(iron"ent 'oger nrico #resident and C; of e#siCo World9ide Be(erages for"ed a tas. force to in(estigate a #ossi7le reorganiation of e#sis do"estic soft drin. 7usiness$ The tas. force reco""ends reorganiing along geogra#hic lines$ The grou# has #ut forth t9o o#tions: 1) full decentraliation or 2) a "atri! organiation$ s. students to anal,e the o#tions and "a.e their o9n #ro#osals for carr,ing out a reorganiation$ The, should also 7e as.ed to consider other o#tions to deal 9ith e#sis #ro7le"s that dont center on reorganiation$
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Etra !eadings The sources 7elo9 #ro(ide additional resources for the theories and e!a"#les of the cha#ter$
Bo9"an $ H$ and B$ M$ ogut Eeds$)$ edesigning the 0irm $ e9 or. : ;!ford Kni(ersit, ress 1&&/$ Burt '$ +$ Structural Holes $ Ca"7ridge M: Har(ard Kni(ersit, ress 1&&2$ Burton '$M$ and B$ ;7el$ Strategic -rgani.ational *iagnosis and *esign# Boston M: lu9er 1&&8$ Chandler $ D$ Scale and Sco%e$ The *ynamics of (ndustrial Ca%italism $ Ca"7ridge M: Har(ard Kni(ersit, ress 1&&0$ Chandler $D$ Strategy and Structure$ Ca"7ridge M: MIT ress 1&32$ C,ert '$ and J$ March$ A Behavioral Theory of the 0irm $ ngle9ood Cliffs J: renticeHall 1&3%$ ue"in $ The New (ndustrial -rgani.ation $ Ca"7ridge M: MIT ress 1&&1$ La9rence $ '$ and J$ W$ Lorsch$ -rgani.ation and Environment $ Boston: Har(ard Business +chool ress 1&83$ Lie7erstein H$ Beyond Economic Man $ Ca"7ridge M: Har(ard Kni(ersit, ress 1&80$ March J$ and H$ +i"on$ -rgani.ations $ e9 or.: Wile, 1&/8$ Miller -$ J$ Managerial *ilemmas $ Ca"7ridge K: Ca"7ridge Kni(ersit, ress 1&&2$ elson '$ '$ and +$ -$ Winter$ An Evolutionary Theory of Economic Change $ Ca"7ridge M: Bel.na# 1&82$ 6uinn J$ B$ (ntelligent Enter%rise# e9 or.:
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+tinchco"7e $ L$ (nformation and -rgani.ations $ Ber.ele, C: Kni(ersit, of California ress 1&&0$ +to#ford J$ and L$ Wells$ Managing the Multinational Enter%rise $ London: Long"ans 1&52$ Tho"#son J$ D$ -rgani.ations in Action $ e9 or.: Mc-ra9Hill 1&35$ $
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Ans"ers to End of Chapter #uestions
1$ A team of eight individuals must fold, stuff, seal, and stamp '06 preaddressed envelopes$ ffer some suggestions for organi+ing this team$ %ould your suggestions differ if, instead of '06 envelopes, the team "as responsi)le for processing '066 envelopes& For assem)ling personal computers& %hy&
The tas. relates to interde#endence co"#le!it, and (olu"e$ +tudents should loo. for econo"ies of scale sco#e or learning around 9hich to create an efficient structure$ Consider the i"#lications of the different 9a,s to structure tas.s$ If each letter is alread, "atched to its en(elo#e and the asse"7l, does not re>uire s#ecialied e>ui#"ent such as a sta"# "achine then each indi(idual can co"#lete all tas.s oneself$ The #ooled interde#endence of tas.s allo9s the 9or.ers to #erfor" indi(iduall, co"#leting the entire set of tas.s for each letter allocated$ If se>uential interde#endence a"ongst the tas.s e!ists then the indi(iduals "a, 9ant to for" a self"anaged tea" and an asse"7l, line$
If the tea" 9ere asse"7ling 2/0 #ersonal co"#uters then a hierarch, of authorit, and s#ecialiation a"ong the indi(iduals 9ould 7e "ore a##ro#riate$ +ince asse"7ling co"#uter s,ste"s re>uires e!#ertise in se#arate tas.s tea" "e"7ers should 7e assigned to the tas. for 9hich the, ha(e e!#ertise$ Moreo(er tas.s in co"#uter asse"7l, in(ol(e se>uential interde#endence$ Hence a su#er(isor 9ould hel# ensure the s"ooth flo9 of #roduction$ The su#er(isor could resol(e dis#utes that arise 9ithin the tea"$ '$ Consider a firm "hose competitive advantage is )uilt almost entirely on its a)ility to achieve economies of scale in producing small electric motors that are used )y the firm to ma/e hair dryers, fans, vacuum cleaners, and food processors$ Should this firm )e organi+ed on a multidivisional )asis )y product hair dryer division, food processor division, etc$ or should it )e organi+ed functionally mar/eting, manufacturing, finance, etc$&
This scenario highlights the 7alance 7et9een differentiation and integration e!#lained 7, the contingenc, theor,$ If co"#etiti(e ad(antage lies in #roduct differentiation a "ultidi(isional 7asis "ight "a.e sense$ Ho9e(er in this case the co"#etiti(e ad(antage lies in e!tensi(e and efficient "anufacturing of "otors$ Therefore fir" structure should su##ort that ad(antage$ This structure gi(es "anufacturing res#onsi7ilit, for the #roduction of "otors regardless of 9hich #roducts use the "otors$
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*$ %hat types of structures "ould a firm consider if it "ere greatly epanding in glo)al operations&
Contingenc, theor, argues that there does not e!ist a A7est organiational structure for all fir"s$ 'ather structure should focus on the "ost i"#ortant tas. confronting the co"#an,$ When deter"ining its o#ti"al structure the theor, suggests that a fir" consider three #ri"ar, issues$
s trade 7arriers in uro#e disa##ear N- "ust ree(aluate their structure$ Do"estic #roducers 9ill find "ore o##ortunities for scale and sco#e 9hen the "eaning of the ter" Ado"estic e!#ands fro" a single countr, to include all of the uro#ean Knion$ N- "a, find that "anagers in uro#ean countries "a, 7e du#licating tas.s 9hen each countr, faces the sa"e regulation fro" the uro#ean Knion$ These are argu"ents for a "ore centralied strateg,$ Ho9e(er decreased trade 7arriers "a, not eli"inate the countr, differences that ha(e "ade N- #roducts successful in uro#e$ If the countr, differentiation re"ains then the current structure "a, re"ain the o#ti"al structure$ 0$ (n the 1576s, Sears acJuired several financial services firms, including Allstate (nsurance and Dean %itter >ro/erage Services$ Sears /ept these )usinesses as largely autonomous divisions$ >y 1550, the strategy had failed and Sears had divested all of its financial service holdings$ >earing in mind the dictum that structure follo"s strategy, identify the strategy that Sears had in mind "hen it acJuired these )usinesses, and recommend a structure that might have led to )etter results$
+ears strateg, focused on 7eco"ing a onesto# sho# for the core "erican fa"il,$ +ears e!#ected that consu"ers 9ould see. traditional retail transactions and financial transactions in the sa"e store en(iron"ent$ This i"#lies a "ore co"#le! organiational structure to lin. the di(erse ser(ices$ It a##ears ho9e(er that +ears sa9 fe9 o##ortunities for econo"ies of scale or sco#e a"ongst the fir"s and therefore .e#t the fir"s as autono"ous di(isions$ The onl, connection a"ong the 7usinesses la, in the sharing of store floor s#ace$
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-i(en the lac. of scale and sco#e econo"ies the #ro@ect "a, ha(e 7een fla9ed fro" the start$ +ears "a, ha(e 7een a7le to i"#ro(e the situation 7, e!#loiting #ossi7le scale and sco#e econo"ies through the co"7ination of the t9o financial ser(ices co"#anies$ lternati(el, +ears could ha(e for"ed @oint (entures or other strategic alliances to target +ears custo"er 7ase rather than ac>uiring the fir"s$ $ Matri organi+ations first sprang up in )usinesses that "or/ed on scientific and engineering proects for narro" customer groups$ Eamples include Fluor, "hich )uilt oil refineries in Saudi Ara)ia, and T!%, "hich supplied aerospace eJuipment to IASA$ %hat do you suppose the dimensions of the matri "ould )e in such firms&
This "atri! 9ould li.el, ha(e t9o di"ensions: functional grou#s and #ro@ect grou#s$
The co"#an, deri(es a different 7enefit fro" each di"ension on the "atri!$ In the case of ui#"ent training o##ortunities and other engineers for infor"al consultation$ This #ro(ides econo"ies of scale including learning cur(e ad(antages for the fir"$ 'egarding the #ro@ect di"ension indi(iduals 9ould 7e re9arded for their contri7ution to the #ro@ect$ This allo9s the cor#oration to "easure each "a@or #ro@ect as its o9n #rofit and loss center$ The #ro@ect "anager ai"s to #rofita7l, deli(er #ro@ect results that "eet custo"er s#ecifications$ The #ro@ect "anager thus has the greater a7ilit, to "oti(ate and control the contri7utors to the #ro@ect than the "anager 9ould ha(e had in a functional organiation$
3$ (t is sometimes argued that a matri organi+ation can serve as a mechanism for achieving strategic fit L the achievement of synergies across related )usiness units resulting in a com)ined performance that is greater than the units could achieve if they operated independently$ Eplain ho" a matri operation could result in the achievement of strategic fit$
Matri! organiation gi(es the fir" fle!i7ilit, 7, organiing resources along t9o Eor "ore) di"ensions$ +uch co"7inations in turn ena7le the fir" to achie(e the o#ti"al le(els of staffing gi(en s#ecific scenarios$ +tochastic de"and can greatl, influence the a"ount or s.ill sets re>uired of resources$ uire nu"erous e!#erts fro" "ulti#le Centers$
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8$ Contingency theory suggests that it is possi)le to organi+e too much to meet the needs of the environment$ This "ould )e a case of strategic misfit $ Thin/ of an eample of misfit caused )y an inappropriate organi+ation design$ Eplain ho" a firm-s structure could systematically increase its costs and place it at a strategic disadvantage$ Contingenc, theor, is the idea that there is no unifor"l, A7est structure for all fir"s in all circu"stances$ Contingenc, theor, has focused on three factors that "a, affect the relati(e efficienc, of different structures: •
Technolog, and tas. interede#endence •
•
Infor"ation flo9s •
•
!a"#le: Teleco""unications ad(ances ha(e (astl, i"#ro(ed the a7ilit, of engineers and #roduct s#ecialists located #h,sicall, far a#art to co""unicate and coordinate #roduct design$ This reduction in the costs of coordination reduces the need for "e"7ers of a tea" to 7e in the sa"e #art of the fir"s for"al organiation or e(en to 7e #art of the sa"e fir"$ Hence a fir" "ight suffer strategic "isfit if it is o(erl, (erticall, integrated relati(e to the a7ilit, of coordination across fir"s$ !a"#le: ccording to the econo"ist -al7raith ad"inistrati(e hierarch, E7osses) de(elo# in order to handle Ae!ce#tions decisions that cannot 7e "ade easil, 7, a##l,ing standard organiations routines$ +uccessi(el, higher le(els of organiation are needed to handle "ore difficult e!ce#tions$ What follo9s fro" this argu"ent is that strategic "isfit occurs as the a"ount co"#le!it, andGor s#eed of infor"ation #rocessing that a fir" "ust underta.e to "a.e decisions changes 7ut the fir" does not change$ fir" 9ith a rigid hierarch, in an en(iron"ent 9here res#onses "ust co"e "ore ra#idl, is disad(antaged$
The tension 7et9een differentiation and integration •
!a"#le: La9rence and Lorsch note a tension in co"#le! organiations 7et9een the 7enefits of creating inde#endent s#ecialied 9or. grou#s Edifferentiation) and the need to integrate these grou#s into a cor#orate 9hole Eintegration)$ Differentiation #ro(ides the 7enefits of di(ision of la7or 7ut integration is necessar, to ca#ture the 7enefits of la7or di(ision$ Consider a "ulti#roduct food co"#an, that silos each of its #roducts$ Here the fir" "a, lose the 7enefit of using all of its #roducts together to gain le(erage o(er retailers$
5$ %hile the dot4com ventures of the late 1556s failed for many reasons, lac/ of organi+ation "as a significant one, especially in light of t he rapid gro"th of these ventures$ Eplain the organi+ational pro)lems that a small (nternet venture might have encountered as it gre" from a 0416 person operation into an operation 16 times as )ig, spanning multiple sites in multiple countries, and needing to interact regularly "ith multiple )usiness sta/eholders$
With a s"all nu"7er of e"#lo,ees coordination and control are relati(el, eas,$ Coordination and control in(ol(e issues of technical and agenc, efficienc,$ genc, efficienc, is affected 7ecause structures "a, differ in o##ortunities the, offer to
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decision "a.ers to #ursue #ersonal or unit o7@ecti(es that are inconsistent 9ith the o7@ecti(es of the fir"$ With onl, a fe9 9or.ers each can ha(e a significant i"#act on the fir" Eand therefore hisGher o9n) earnings$ s the fir" gro9s it is "ore feasi7le for indi(iduals to atte"#t to freeride on the efforts of others$ When the dotco"s 9ere ,oung the, 9ere so 7us, tr,ing to create their #roduct and collect custo"ers that "an, of these fir"s did not #ut in #lace a structure ca#a7le of handling "onitoring and infor"ation flo9s$
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Chapter 1 Strategy and Structure Chapter Contents 1) Introduction %) n Introduction to +tructure Indi(iduals Tea"s and Hierarchies • Indi(iduals +elfManaged Tea"s Hierarch, of uthorit, Co"#le! Hierarch, • De#art"entaliation Coordination and Control !a"#le 13$1: The Di(ision of La7or "ong +ea"en: 150015/0 T,#es of ;rganiational +tructures • The
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Chapter Summary
The cha#ter atte"#ts to assess the nature of #o9er and culture 9ithin large organiations and their effects on the goals and acco"#lish"ents of those organiations #articularl, 9here contractual agree"ents fail to #ro(ide ade>uate structure or guidance$ o9er is defined as the indi(iduals a7ilit, to acco"#lish his or her goals 7, "eans of resources o7tained through noncontractual e!change relationshi#s 9ith other actors$ There are fi(e general 7ases of #o9er: legiti"ate Efor"al) #o9er re9ard #o9er coerci(e #o9er and resource de#endence$ o9er can also 7e 7ased on i"age or re#utation$ +uccessful "anagers li.el, need to 7uild se(eral 7ases of #o9er$ The "ost co""on (ie9 of #o9er in organiations is 7ased on the idea of social e!change$ o9er arises fro" #ersistent ine>ualities in the ter"s of re#etiti(e social e!changes 7et9een a #air of indi(iduals concerning access to (alua7le resources$ The resource de#endence (ie9 argues that #o9er arises fro" de#endence relationshi#s 7ased on access to these resources$ Indi(iduals and fir"s see. to gain #o9er 7, reducing their de#endence on other actors 9hile increasing the de#endence of other actors on the"$ Indi(iduals 9ho control critical resources 9ill gain #o9er$ o9er is difficult to "easure$ The resource de#lo,"ent and resource "o7iliation #ers#ecti(es on #o9er see. to clarif, the e!change of #o9er in o7ser(ed une(en e!changes 7ut the, are not #recise$ Transactions costs are another 9a, to (ie9 #o9er arguing that #o9er co"es fro" the a7ilit, to reduce the costs associated 9ith transactions in(ol(ing (alua7le resources$ B, eli"inating an internal holdu# #ro7le" for e!a"#le "anagers can ac>uire great #o9er 9ithin an organiation$ o9er can also 7e o7tained 7, occu#,ing #articular locations 9ithin the structure of the fir"$ B, occu#,ing Astructural holes indi(iduals can create #o9er for the"sel(es 7, ser(ing as a lin. 7et9een different #arts of the organiation that "ight not interact other9ise$ If this lin.age creates (alue the #erson s#anning the structural hole 9ill gain #o9er$
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Approaching to Teaching the Chapter Definitions: oncontractual !change 'elationshi#s: Business situations that offer no clear authorit, structures 7et9een the actors$ Without a for"al structure the actors "ust negotiate the relationshi#$
Legiti"ate Efor"al) o9er: 'ooted in for"al authorit, legiti"ate #o9er is recei(ed as a conse>uence of occu#,ing a highran.ing #osition in the hierarch, of an organiation$ n,one occu#,ing that #osition has access to that #o9er regardless of #ersonal characteristics$ 'e9ard and Coerci(e o9er: The corollar, to legiti"ate #o9er these are located in a s#ecific hierarchical location and in(ol(e influencing others through re9ards and #unish"ents$ The, are not strong "oti(ational de(ices in longter" relationshi#s$ !#ert o9er: This t,#e of #o9er is deri(ed fro" the #ossession of s#ecialied .no9ledge that is (alued 7, so"e other actor or 7, the organiation as a 9hole$ This #o9er is unrelated to the #osition in the hierarch, of the e!#ert although e!#erts often get #ro"oted to higher #ositions in the structure$ 'eferent o9er: 'eferent #o9er is gained fro" the ad"iration of others$ 'ole "odels or charis"atic leaders ha(e referent #o9er$ s 9ith e!#ert #o9er this #o9er "ust 7e earned and can 7e >uic.l, lost$ +ocial !change: The transfer of resources a"ong #arties that occurs outside the ter"s of a "ar.et en(iron"ent$ 'esource De#endence: In an en(iron"ent 9ithout eas, contracting for e!change indi(iduals see. to gain #o9er 7, reducing their de#endence on the resources of others$ +tructural Hole: Identifies a relationshi# in a social net9or. in 9hich one actor is the critical lin. 7et9een indi(iduals or grou#s$ The indi(idual 9ho can s#an that hole 9ill gain #o9er 9ithin the organiation$ Clan Control: This s,ste" of organiational nor"s and (alues internal to a fir" acts as an alternati(e control s,ste" to the for"al #o9er of the organiational hierarch,$
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Conceptual Applications Student Audit of their %or/ Histories Instructors could as. students to 7ring in e!a"#les of their e!#eriences 9ith each of the for"s of #o9er as 9ell as (arious cor#orate cultures$ ach student can react to the central >uestions of the cha#ter$ ualif, the 7enefits or costs of each culture Which 9ill ada#t the >uic.est as the industr, e(ol(es Did these cultures dri(e econo"ic success or did the econo"ic challenges facing each co"#an, deter"ine the "ost efficient culture for that "ar.et !egional or (ndustrial Iorms >oston vs$ Silicon Kalley Much has 7een 9ritten a7out the cor#orate and cultural differences 7et9een the co"#uter industries in Boston Massachusetts and in +ilicon Falle, California$ The Boston co"#anies in general 9ere "ore li.el, to (erticall, integrate "aintain for"al en(iron"ents and retain 9or.ers for long tenures$ +ilicon Falle, fir"s "a.ing si"ilar #roducts 9ere in general "ore li.el, to use the "ar.et for their su##l, needs foster infor"al en(iron"ents and s9a# 9or.ers a"ong fir"s >uite often$
re there regional or industrial nor"s in ,our local 7usiness en(iron"ent Does the a##earance of these cultures 7unch in certain industries or geogra#hies or sies of fir"s re these cultures effecti(e for the co"#etiti(e challenges facing these co"#anies toda, Did the region and its econo"ic challenges create the cor#orate cultures or did indi(idual fir"s set the nor"s for the region Culture and the ?ace of Competitive Environmental Change The ra#idit, of change in (arious industries has increased dra"aticall, during the 20th centur,$ If *h,#erco"#etition* is >uic.l, 7eco"ing the nor" in "an, industries 9hat 9ill the future of cor#orate culture 7e If culture necessaril, drags 7ehind the needs of the fir" is *cor#orate culture* destined to 7eco"e #e@orati(e re there e!a"#les of cultures designed to 7e highl, sensiti(e to the en(iron"ental needs of the fir" re the, found 7, region or industr, or 7, indi(idual leadershi# +o"e ha(e suggested the +ilicon Falle, "odel descri7ed in the >uestion a7o(e 9ill soon @u"# to (arious other industries$ Is that li.el,
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Suggested Harvard Case Study 11
Ban. ;ne 1&&% HB+ &%&404% Esee earlier cha#ters)$ Boo llen N Ha"ilton: Fision 2000 HB+ &%&30%1 Esee earlier cha#ters)$ De Beers Consolidated Mines HB+ &%&1053 Esee earlier cha#ters)$ House of Tata HB+ &5&203/ Esee earlier cha#ters)$ Ing(ar o"#rad and I HB+ &%&01%2 Esee earlier cha#ters)$ +i"e Dar7, Berhad=1&&/ HB+ &5&5015 Esee earlier cha#ters)$
11
These descri#tions ha(e 7een ada#ted fro" Harvard Business School 3445647 Catalog of Teaching Materials#
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Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
Blau $ M$ E8change and &ower in Social /ife# e9 or.: Wile, 1&34$ Cole"an J$ +$ 0oundations of Social Theory $ Ca"7ridge M: Bel.na# 1&&0$ Croier M$ The Bureaucratic &henomenon $ Chicago: Kni(ersit, of Chicago ress 1&34$ Deal T$ and $ $ enned,$ Cor%orate Cultures The ites and ituals of Cor%orate /ife$ 'eading M: ddisonWesle, 1&82$ -eert C$ The (nter%retation of Cultures# e9 or.: Basic Boo.s 1&5%$ i#nis D$ The &owerholders $ Chicago: Kni(ersit, of Chicago ress 1&53$ otler J$ *o9er De#endence and ffecti(e Manage"ent* Harvard Business eview Jul,ugust 1&55$ Lau"ann $ and D$ no.e$ The -rgani.ational State $ Madison WI: Kni(ersit, of Wisconsin ress 1&85$ Lu.es +$$ o9er$ A adical View# London K: Mac"illan 1&54$ Lincoln J$ '$ and $ L$ alle7erg$ Culture Control and Commitment $ Ca"7ridge K: Ca"7ridge Kni(ersit, ress 1&&0 Miller -$ J$ The &olitical Economy of Hierarchy $ Ca"7ridge K: Ca"7ridge Kni(ersit, ress 1&&2$ ;dagiri H$ ,rowth through Com%etition Com%etition through ,rowth$ Strategic Management and the Economy in :a%an# ;!ford K: ;!ford Kni(ersit, ress 1&&4$ ;uchi W$$ Theor, X$ How American Business Can Meet the :a%anese Challenge $ 'eading M: ddisonWesle, 1&81$ erro9 C$ Com%le8 -rgani.ations$ A Critical Essay $ e9 or.: 'ando" House 1&83$ feffer J$ Managing with &ower &olitics and (nfluence in -rgani.ations $ Boston M: Har(ard Business +chool ress 1&&2$ feffer J$ &ower in -rgani.ations $ Marshfield M: it"an 1&81$ Thi7aut J$ W$ and H$ H$ elle,$ The Social &sychology of ,rou%s $ e9 or.: Wile, 1&/&$ Trice H$ M$ and J$ M$ Be,er$ The Cultures of "or+ -rgani.ations $ ngle9ood Cliffs J: rentice Hall 1&&%$
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Ksee" M$ E8ecutive *efense$ Shareholder &ower and Cor%orate eorgani.ation $ Ca"7ridge M: Har(ard Kni(ersit, ress 1&&%$ Willia"son ;$ The Economic (nstitutions of Ca%italism# e9 or.:
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Ans"ers to End of Chapter #uestions 1$ Ho" does the resource4dependence vie" of po"er differ from the perspective of transactions4costs economics& (n "hat situations "ould their predictions a)out economic transactions )e similar9 in "hich situations "ould they )e different&
The resourcede#endence (ie9 as e!#ressed 7, feffer "aintains that #o9er de(elo#s 7ecause there are resources controlled 7, a certain #art, Ean indi(idual or grou# 9ithin an organiation) that are i"#ortant to the fir" there are no readil, a(aila7le su7stitutes or alternati(e su##liers for those resources and contracting for the e!change of these resources 9ould 7e #rohi7iti(el, costl,$ Therefore other #arties 9ithin the organiation 7eco"e de#endent to the #art, that controls these resources$ Indi(iduals and fir"s see. to gain #o9er 7, getting access to these resources to reduce their de#endence on other #arties 9hile increasing other #arties de#endence on the"$ It is control of the resource itself that creates #o9er$ Transactionscosts econo"ics on the other hand argues that #o9er arises fro" the costs associated 9ith transactions it is the cost of e8changing the resource that creates #o9er$ Indi(iduals grou#s or fir"s that can reduce these costs to other affected #arties 9ill 7e the ones 9ho gain #o9er$
n indi(idual 9ho is (er, effecti(e at their @o7 in a situation 9here a re#lace"ent for that indi(idual 9ould 7e (er, difficult to secure 9ould de(elo# #o9er$ The degree of #o9er 9ould de#end on 9hose outside o#tions 9ere stronger or "ore credi7le the fir"s or the indi(iduals$ The #o9er an indi(idual "a, deri(e fro" doing hisGher @o7 9ell is a result of the thin "ar.et of indi(iduals 9ho could re#lace that 9or.er and not a result of the 9or.er "erel, 7eing co"#etent at their @o7$
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This >uestion also 7rings out the #oint that there are as#ects of an, relationshi# that cannot 7e controlled 7, contract$ Therefore e(en if the #rinci#al 9rites thorough contract there "a, 7e situations 9here it "a, 7e in the agents 7est interests to act in a 9a, that is not in the 7est interests of the fir"$ uate$ *$ %hat is the relationship )et"een the degree of regulation in an industry and the competitiveness of that industry& 2nder "hat conditions could etensive regulations foster a very competitive environment&
'egulator, acti(it, has huge influence on the strategic 7eha(ior of fir"s$ Court decisions ha(e defined the t,#es of structures that fir"s "a, e"#lo, as the, gro9 and di(ersit,$ Justice de#art"ent #olicies and standards along 9ith the courts ha(e constrained ho9 fir"s can 7eha(e ho9 the, ac>uire .no9ledge fro" their en(iron"ent 9hat t,#es of "ergers can 7e "ade and 9hat t,#es of li"its can 7e #laced on cor#orate decisions and influence acti(ities$ 'egulations could strategicall, ad(antage regulated fir"s$ The, can restrict entr, 9hich allo9s incu"7ents to en@o, greater scale and reduced #rice co"#etition$ The, can also li"it inno(ations that in@ure the ca#a7ilities of incu"7ents 9hile focusing co"#etition on those as#ects of the 7usiness at 9hich incu"7ents e!cel$ +o regulations that encourage entr, or fa(or ne9 9a, of doing 7usiness 9ould act to intensif, co"#etition$ .$ Ho" might favora)le location "ithin the interpersonal net"or/s "ithin a firm help an individual acJuire and maintain additional )ases of po"er&
o9er in an organiation is deri(ed fro" ha(ing access to (alua7le resources and controlling the transactions that surround the"$ n indi(idual 9ho occu#ies a #osition that has access to these resources or is in a #osition to influence the transactions that in(ol(e the" 9ill 7e a7le to ac>uire #o9er$ ;n an inter#ersonal le(el .no9ledge a7out the organiation can 7e a (alua7le resource$ Indi(iduals can gain access to this resource 7, 7eing 9ell connected to "an, others in the organiation$ This can facilitate for e!a"#le #ositi(e interactions 7et9een de#art"ents or di(isions that "ight not other9ise interact$ ccording to Burt these indi(iduals fill the Astructural holes 9ithin the organiation that ser(e as lin.s 7et9een resources and therefore create #o9er$ This can e!#lain for instance 9h, a "anager 9ho has access to se(eral i"#ortant functions 9ill ha(e "ore #o9er than 9ill a "anager 9ho has access to @ust one$ uarters ser(ing se(eral different di(isions 9ill t,#icall, ha(e "ore #o9er than a local #lant controller all else 7eing e>ual$ 0$ Social4echange vie"s of po"er tend to emphasi+e individual a)ilities to ma/e decisions and prevail in conflicts$ Ho" might po"er also )e associated "ith an
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individual-s a)ility to not ma/e decisions and avoid conflict&
While #o9er in organiations is often a function of the a7ilit, to "a.e tough decisions and #re(ailing in conflicts there are isolated situations 9here these s.ills are not as a##lica7le$ s uiring and "aintaining #o9erful 7ro.erage #ositions 9ithin an organiation or grou# can often 7e #redicated on the a7ilit, to re"ain neutral in dis#utes$ If one #art, in the relationshi# feels that the 7ro.er is not i"#artial 7ut is #ursuing her o9n interests instead the 7ro.er 9ill lose her #o9er$ Therefore indi(iduals in these #ositions "a, find it ad(antageous to a(oid conflict and not "a.e decisions in order to a##ear i"#artial and retain their #o9er$
While fir"s ha(e their o9n cultures the, are also #art of a large "acroculture that affects a 9ider set of fir"s and differ significantl, fro" cor#orate culture$
s Burt e!#lains a structural hole is a function of infor"ation or social net9or.s and is a relationshi# in the net9or. in 9hich one actor is the critical lin. 7et9een indi(iduals or entire grou#s$ To associate 9ith each other these indi(iduals or grou#s "ust go through the actor occu#,ing the structural hole there is no other access other9ise$ This #osition allo9s the indi(idual occu#,ing the lin. to use the control of infor"ation or resource flo9s as a source of #o9er$ In these relationshi#s (alue is often created 7, the lin.ing of resources 7et9een the grou#s or indi(iduals on each side of the structural hole$ That is the co"7ined resources (alue is greater than the su" of the resources used indi(iduall,$ B, creating this (alue each of the actors 9ill 7e a7le to e!tract so"e of the (alue fro" it$ s a conse>uence of 7ringing the grou#s together the #erson occu#,ing the structural hole
21&
9ill often 7e a7le to e!tract a good #ortion of the (alue created$
There are se(eral different 9a,s for a fir" to ha(e "ulti#le cultures 9ithin its 7oundaries$
Ironicall, the sa"e reasons that a fir"s culture "a, contri7ute to its sustained co"#etiti(e ad(antage are the sa"e reasons a fir" "a, find its culture creating a drag on its atte"#ts to change during #eriods of difficult,$ This is 7ecause a fir"s cultural influence is li.el, to de#end on intangi7le factors that are not easil, descri7ed and that re#resent the accu"ulated histor, of the fir" "uch 7etter than a descri#tion at an, #oint in ti"e$ Barne, identifies three factors that "ight allo9 a culture to 7e a source of sustaina7le co"#etiti(e ad(antage$ ;ne of these is that the culture "ust 7e ini"ita7le$ 'i(als 9ill i"itate a successful fir"s culture that is easil, i"itated and the ad(antage gained 7, the fir"s culture 9ill 7e negated$ Ho9e(er a culture that is not easil, i"ita7le "ust 7e also 7e (er, co"#le!$ This co"#le!it, 9ould "a.e it (er, difficult for internal "anagers to "odif, the culture in a short #eriod of ti"e$ fir" 9hose success is related to its culture 9ill li.el, find a #ositi(e align"ent 7et9een its
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culture and its goals$ When those goals change Eas 9hen the fir" finds its co"#etiti(e en(iron"ent changes) the accu"ulated histor, that goes into co"#rising a culture 9ill ta.e "uch longer to change$ Therefore the fir" finds its culture to 7e inertial in its effects in that culture re#resents the accu"ulation of histor, and routines of the fir"$ This inertia also "a.es culture a 7arrier to change 9hen changes "ight 7e needed that shar#l, di(erge fro" the fir"s histor, and routines$ 16$ Ho" can po"erful individuals influence a firm-s culture& Do
fir"s culture is a set of (alues 7eliefs and nor"s of 7eha(ior shared 7, "e"7ers of a fir" that influences e"#lo,ee #references and 7eha(iors$ "ore o#erational (ie9 is that culture re#resents the 7eha(iors guide#osts and e(aluati(e critieria in a fir" that are not s#elled out 7, contracts 7ut nonetheless constrain and infor" the fir"s "anagers and e"#lo,ees in their decisions$ ccording to re#s A culture[gi(es hierarchical inferiors an idea e! ante ho9 the fir" 9ill Areact to circu"stances as the, arise=in a (er, strong sense it gi(es identit, to the organiation$ Clearl, the leader of the organiation can ha(e a significant i"#act on the Aculture of that fir" as the indi(idual "ost res#onsi7le for (isi7l, e!hi7iting e!tolling de"onstrating and e!#laining the 7eha(iorial guide#osts that "a.e u# culture$ Ho9e(er culture "ust 7e inculcated in the e"#lo,ees 7, "ore than @ust the C;=so the C; alone does not deter"ine the culture of the organiation$
Institutional logics are the interrelated 7eliefs (alues "aterial #ractices and nor"s of 7eha(ior that e!ist in an industr, at an, gi(en ti"e$ It is difficult to gi(e a general ans9er to this >uestion 7ut an ans9er that contains s#ecific e!a"#les and uses the ter"inolog, #resented in the cha#ter is a good ans9er$ It is so"eti"es #ossi7le to lin. changes in industr, logics to s#ecific e!ternal sti"uli such that so"e e(ent can 7e seen as the cause of the industr, change$ In other industries ho9e(er changes in industr, logics occur as a result of "ulti#le sti"uli 9ithout a clear e!ternal #ush$ In these conditions the institutional logics a##ear to change inde#endentl, of e!ternal sti"uli and then lead to further changes in industr, #ractices$
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Chapter 17 Strategy and the ;eneral Manager Chapter Contents 1) Introduction 2) Historical ers#ecti(e on the -eneral Manager %) What do -eneral Managers Do Case +tudies of -eneral Managers • The 'oles of the -eneral Manager • The Tensions of Managerial Wor. • Changing Definitions of Managerial Wor. • 4) Cha#ter +u""ar,
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Chapter Summary This concluding cha#ter discusses the 7readth of o##ortunit, and res#onsi7ilit, for "odern general "anagers$ The general "anger E-M) is 7oth a #ro7le"sol(er and a (isionar,$ s a #ro7le" sol(er the -M defines and "anages the 7oundaries of the fir" sets a co"#etiti(e strateg, and o(ersees the fir"s internal incenti(es culture and structure$ s a (isionar, the -M identifies a sustaina7le #osition for longter" success$ -Ms use 7oth for"al and infor"al "eans to acco"#lish o7@ecti(es$ While rel,ing on >ualitati(e anal,ses as "uch or "ore than >uantitati(e anal,ses the, also rel, on for"al agendas and infor"ation net9or.s$ The -M "a, #la, one or all of se(eral roles: entre#reneur organierGi"#le"enter contractor facilitator co"#etitor and ree(aluatorGchanger$ Tensions arise 9hen these roles re>uire conflicting actions$ -Ms ha(e to change their roles in res#onse to changing technological regulator, and co"#etiti(e conditions$
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Suggestions to Teaching this Chapter This cha#ter "ore than "ost lends itself to a 9ideranging class discussion$ +tudents should 7e #ushed to en(ision the"sel(es as general "anagers and e!#lore no9 the issues the, 9ill face in that role$ Vo) Audits Can students #redict the influence roles and res#onsi7ilities of different @o7s in s#ecific organiations What >uestions 9ould students as. Ein research or of recruiters) to deter"ine the true nature of a #osition !oles We list se(eral roles of "anagers in this cha#ter$ Do students thin. the, could #rioritie these res#onsi7ilities
2) Managers? salaries ha(e s.,roc.eted in the last ten ,ears 9hile a(erage 9age earners ha(e seen little or no salar, increase$ Ha(e the ne9 roles and res#onsi7ilities of toda,?s "anagers sore defined these @o7s that the co"#ensation for senior "anagers should 7e 100 ti"es "ore than the a(erage 9or.er Can there 7e a "ar.etgenerated salar, that is too high Morals While 7e,ond the sco#e of this endea(or ethical situations are crucial issues facing "anagers of toda,?s cor#orations$ +tudents should e!#lore their #ersonal understanding of "oralit, and ethical li"its$ We list 7elo9 se(eral readings that "ight su##le"ent an ethics discussion$ %or/8@ife >alance Most e"#lo,ees 9restle 9ith ho9 to 7alance fa"il, and career$ The old sa,ing goes that no one sa,s on his death7ed *I 9ish I had s#ent "ore ti"e in the office$* Ho9 "uch of an indi(idual?s ha##iness co"es fro" the fulfill"ent of 9or. or the "aterial co"forts of life s senior "anage"ent #ositions 7eco"e "ore and "ore de"anding 9ill students ha(e to choose 7et9een a fa"il, and a high#o9ered @o7 If so ho9 9ould the, "a.e that decision Will the de"ands on senior "anage"ent change in a societ, do"inated 7, dual career or single #arent fa"ilies +hould the,
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Suggested Harvard Case Study 1'
The L,ric Dinner Theater HB+ &%830/5 B: These cases descri7e the efforts of De7orah Denen7erg to affect the turnaround of this ailing dinner theater$ s -eneral Manager she faces the #ro7le" of restoring the L,ric to #rofita7ilit, or ha(ing the 7usiness closed 7, its in(estors$ Case descri7es her efforts in the first si! "onths on the @o7$ +tudents should #re#are a co"#lete action #lan for Denen7erg$ Case B descri7es the actions she too.$ eter ;lafson HB+ &45/02/ : This case series descri7es the #ro7le"s facing a recent MB graduate in his @o7 as general "anager of a ca7le tele(ision co"#an, o9ned 7, a #arent cor#oration$ Case raises the issues of cor#orate di(isional relationshi#s and the difficulties facing an ine!#erienced "anager 9ho see"s to 7e recei(ing little su##ort$ Case B is a one#aragra#h case that adds to the data #resented$ Cases C and D focus on the strained relationshi# 7et9een the ne9 "anager and his 7osses$ Case #resents a descri#tion fro" the cor#orate #resident?s #oint of (ie9$
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These descri#tions ha(e 7een ada#ted fro" Harvard Business School 3445647 Catalog of Teaching Materials#
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Etra !eadings The sources 7elo9 #ro(ide additional resources concerning the theories and e!a"#les of the cha#ter$
Bail,n L$$ Brea+ing the Mold$ "omen Men and Time in the New Cor%orate "orld $ e9 or.:
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