ECON 308 Week 8-9

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ECON 308 Week 8-9

• Chapter 8 Economics of StrategyCreating and
  capturing value

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Case Wal-Mart

• Wall Mart
• Most profitable retailer in the world, 5,170
  stores,1.6 million emp.
• 1962 First store opens rural Arkansas, small
  towns
• 1993 q2 1997 stock value dropped
• Slow growth in value till 1997.
• 2005 220 billion in sales, 10.3 billion net
  income
• Responses to problems in mid 1990s
• New international super-centers
• E-commerce sites
• Experimented with traditional sized grocery
  stores in Arkansas
• By 1998 the stock was performing well again

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Superior Performance?

• Beating the market over a long period
• What accounts for the success of these firms?
• Should all properly managed firms expect superior
  performance?
• What actions can managers take to generate
  superior performance?
• Can managers enhance financial returns by
  diversification?
• Do all firms eventually drop back to the pack?

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Strategy

• General policies intended to generate profits
• Choice of industry
• Combination of products and services
• Competitive and cooperative behaviors
• Strategies evolve as circumstances change
• Strategies must create and capture value

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Economic Strategy Maximizing long-run
profitability

• Economic Profit Total Revenue Total Cost
• Increase Total Revenue ( Price x Quantity)
• How to Increase Price?
• Price is Demand determined
• Increase Value of the product to customer
• How to increase Quantity?
• Decrease Total Economic Cost
• Efficiency in purchase
• Efficiency in production

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Transaction costs

• Consumer transaction costs
• product search
• learning product characteristics and quality
• negotiating terms of sale
• enforcing agreements
• Producer transaction costs
• negotiating terms
• legal expenses

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Creating Value
Price
Supply
Consumer Surplus
P
ProducerSurplus
ProducerSurplus
Demand
Q
Quantity/Time
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Creating Value Reduce Transaction Costs
Price
Supply with Producer Transaction Costs
Producer-borne transaction costs
Consumer Surplus
P
ProducerSurplus
Consumer-borne transaction costs
Demand with Consumer Transaction costs
Q
Quantity/Time
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Value creation

• Reduce production costs or producer transaction
  costs
• shift supply curve to the right
• Reduce consumer transaction costs
• shift demand curve to the right
• Shift demand to the right by other means
• Devise new products and services

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Transaction Cost Creating Value

• Consumer Transaction Costs
• Costs of search
• Costs of learning about product quality
• Costs of Negotiation
• Producer Transaction Costs
• Costs of negotiation
• Attorney fees to draft sales agreements
• Examples
• Dell eliminates the middle man in direct web-site
  PC sales and splits the gain between themselves
  and the buyer
• Early Wall Marts were in rural areas reducing
  transportation costs by opening stores closer to
  customers.
• Kraft Lunchables
• Terrorist Attacks and the Airline Industry

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Creating Value Advertising

• Major economic function Provide information
  about the product.
• Lowers Search Cost
• Lowers Quality Identification Costs
• Second Function Create value in the minds of
  consumers
• Lowenbrau
• Perfumes

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Creating Value Reducing Consumer Waiting Time

• Cable Installation4 hour window
• Doctors Office Patients Waiting
• How to value your time
• Salary 50,000
• Employee Cost to firm 50,000
• 100,000 / 2000 hours 50 per hour.

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Creating Value Alternative Product Pricing

• Pricing Complements
• Cut the price of the complement and increase the
  sales of both products
• Applications
• Printers and Personal Computers
• Razors Blades
• Pepsi Frito, and Lays Potato Chips
• Pricing Substitutes
• Raise the price of a substitute
• Applications
• Dont allow people to bring food into a theater
• Airlines restrict the use of cell phones

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Creating Value Product Quality

• Product Quality
• Profit is increased if MR gt MC
• Marginal Revenue depends on value created for
  Customer
• Product Quality Examples
• Titanium Golf Clubs
• Parabolic Skis

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Technology and Value

• Rapidly falling cost of information processing
• Streamline Order processing, shipments,
  payables, receivables
• Create custom products for smaller groups of
  customers
• Reduce transaction costs with suppliers and
  customers

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Converting Organizational Knowledge into Value

• Hardware physical Assets
• Software Soft Assets, formulas, recipes for
  creating value (can be replicated)
• Wetware Employees brainpower (biological
  computer)
• Firm owns 1,2 but only rents Wetware.
• Must convert 3 into 1,2
• Macdonalds Fillet of Fish

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Capturing value

• Long Run Profitability in Competitive Markets
• Economic Profit
• Accounting Profit
• Firms with Market power
• With barriers to entry
• Without barriers to entry

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Market power comparison
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Market powerPorters five forces that affect
Market Power

• Potential rivals
• Existing rivalry
• Substitute products
• Buyer power
• Supplier power

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Porters Five Forces Affecting Market Power
Potential Rivals
Upstream
Downstream
Current Rivals
Buyers
Sellers
Substitute Products
Value/supply Chain
Competitive Environment
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Capturing Value What Works?

• Barriers to entry
• Degree of rivalry
• Number of competitors
• Relative size of competitors
• Threat of substitutes
• Example Email and fax pose serious threats to
  profits for Federal Express and UPS
• Buyer and Supplier Power
• Example Microsoft and Intel in Personal
  Computers

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Superior factors of production

• People
• special talents or skills
• Physical assets
• prime real estate
• unique equipment
• But bidding for specialized assets may erode
  profits
• Some things are hard to copy
• Flexible Technology
• Team Production

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Producer surplus captured by superior assets
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Superior factors of productionagain

• Team production
• interdependencies among workers increase value
  beyond the sum of the parts
• luck or foresight may endow firms with unique
  team production capabilities
• Rivals may be unable to pinpoint source of
  advantage and unable to capture equivalent value

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Sustainability?
Rank 1970 2004
1 IBM Wal-Mart
2 ATT Exxon-Mobil
3 General Motors General Motors
4 Standard Oil of NJ Ford Motor
5 Eastman Kodak General Electric
6 Sears Roebuck Chevron-Texaco
7 Texaco Conoco-Phillips
8 General Electric Citigroup
9 Xerox IBM
10 Gulf Oil American International Group
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Increasing demand

• Increase expected product quality
• value added gt cost increase
• Reduce price of complements
• Raise price of substitutes
• limit entry of competitors

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Diversification

• Benefits
• Economies of Scope
• Example When one input is used in several
  products you may get a better price when ordering
  it.
• Promoting Complements
• Example Ford can advertise its auto-financing
  when advertising its cars

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Diversification

• Costs
• With larger firms it gets increasingly difficult
  to get lower level managers to act in the
  interests of the owners.
• Success in management of one area may not apply
  in other products

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Diversification

• Benefits
• Economies of scope
• Promoting complements
• Costs
• Bureaucracy
• Incompatible cultures

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Diversification and management

• Diversification for earnings volatility
• may not increase value
• Related diversification
• can increase value
• Capturing the gains
• does the firm bring some special resource to bear?

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Diversification

• When does diversification create value?
• Related Diversification
• Businesses serve common markets or use common
  technologies
• Example Disney operates theme parks, hotels,
  retail shops and TV stations. All are family
  oriented products. This can reduce consumer
  transactions costs for people searching for safe
  products for children.

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Strategy formulation

• Understanding resources and capabilities
• physical, human, and organizational capital
• Understanding the environment
• markets, technology, regulation, economic
  conditions
• Combining environmental and internal analyses
• Strategy and organizational architecture

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Strategy Formulation

• Business Environment
• Markets
• Input
• Output
• Technology
• Production
• Information
• Communication
• Government Regulation

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Framework for strategic planning
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To think about...

• Can a firm capture value on a sustained basis?
• Discuss.

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Market Power Profits

• Airbus and Boeing are two major producers of
  jumbo jets. Are these firms guaranteed to make
  high profits since there are only two large firms
  in the industry? Explain.
• No. Even if there are only two firms in the
  industry, they may compete vigorously to reduce
  prices and profits.

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Specialized Resource Economic Profits

• The Watts Brewing Company owns valuable water
  rights that allow it to produce better beer than
  competitors. The company sells its beer at a
  premium and reports a large profit each year. Is
  this firm necessarily making economic profits?
• No. Its advantage is that it owns a valuable but
  marketable asset. The firm may be only making
  normal profits given the opportunity cost of
  keeping the water rights itself rather than
  selling them to others in the marketplace. The
  company is more valuable because it owns the
  water rights. However, selling the rights to
  others might be the best way to capture this
  value.

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Political Competition

• Sun Resorts has a hotel on a Caribbean Island. It
  recently spent money to lobby the government to
  build a better airport and expand air service.
  Why did they do this? Do you think that Sun
  Resorts cares about how many airlines will serve
  the island?
• Airline service is a complement for Sun Resorts.
  Cheaper air service to the island increases the
  demand for Sun Resorts. Thus, Sun Resorts wants
  better airport service and lower airfares. Lower
  fares are more likely to result if there are
  several airlines that compete in serving the
  island.