what is economics of strategy? economics of strategy develops a set of guiding principles to apply...

What is Economics of Strategy?

• Economics of Strategy develops a set of guiding principles to apply

so that one can conclude which strategies are best for which situations

Top News Stories: April/May 2008

• Mar’s Takeover of Wrigley Creates Global Powerhouse (WSJ 4/29)

• Starbucks to Unveil New Drinks (WSJ 4/30)• Cablevision May Bid As Much As $650 Million

for Newsday (WSJ 5/1)• Coke, Pepsi Bottlers Try New Sizes to Boost Sales

(WSJ 5/2)

What is Strategy?

• Planning and Directing to gain an advantage

What is Strategy?

• Planning and Directing to gain an advantage

• Planning involves not just simple decision making – allow for responses and reactions of others– involves a long range view


• Economics concerns the costs and benefits of an action



• Economics emphasizes “analytical” over “functional”



• Economics emphasizes “analytical” over “functional”

• Economics of Strategy analyzes the costs and benefits of a strategic decision

Costs and Benefits Example

• If B(X) > C(X) , then do X

Issues- opportunity cost, sunk cost, non-monetary issues, externalities, time value, risk

Organization of the Course

• Internal Strategy– Production of a product or service typically

requires a joint effort between resource owners

– How do these resource owners deal with each other?

Organization of the Course

• External Strategy– Production of a product or service is often

undertaken by many competing firms

– How do these competing firms deal with each other?

Chapter 3

The Vertical Boundaries of the Firm

The Vertical Chainof Tire Production

• Raw Inputs

• Intermediate Goods

• Final Manufacturing

• Warehouse Inventory

• Distribute to the Final Consumer

Integration at

Bridgestone-Firestone

Tires are the largest part of our business, accounting for approximately 75 percent of annual revenues. Bridgestone/Firestone, Inc. develops, manufactures and markets tires for almost every kind of vehicle. In fact, we sell more than 8,000 different types and sizes of tires - from a 13-foot-tall giant radial for earthmoving equipment to a kart tire that stands only 10 inches high.

In addition to tires, Bridgestone/Firestone is recognized internationally for producing a variety of quality products, including air springs, building materials, synthetic and natural rubber, and industrial fibers and

textiles.

We sell tires for passenger, light truck, truck, bus, off-the-road, agricultural, motorcycle and kart applications through more than 12,000 outlets, including independent dealers, discount retailers, warehouse clubs and our company-owned stores.

We operate Firestone Tire & Service Centers, Mark Morris, Expert Tire and Tire Station retail outlets for automotive tires and service. Our GCR Truck Tire Centers serve the commercial trucking industry with truck tire service and retreading. Webco offers agricultural, forestry and flotation tire service and Cobre Tire services our off-the-road customers with tires and service for the mining and construction industries.

Make or Buy

• Which activities should Bridgestone perform themselves and which should be outsourced?

What type of relationship should our Manufacturer have with other

Resource Owners?

• Employer- Employee (Firm)

• Contractor-Client (Market)

Benefits of Using the Market to Obtain Needed Resources

• Market firms can achieve Economies of Scale

• Market firms are subject to the discipline of the market

Costs of Using the Market to Obtain Needed Resources

• Coordination of Production may be compromised

• Private Information may be leaked

• Transaction Costs


• Economies of Scale: As inputs increase by a given proportion, output increases by a greater proportion

• Result: As output increases, average cost decreases

Returns to Scale

• If increasing all inputs by a given proportion causes output to increase by the same proportion – Constant

• If increasing all inputs by a given proportion causes output to increase by a greater proportion – Increasing (Economies of Scale)

• If increasing all inputs by a given proportion causes output to increase by a lesser proportion – Decreasing

Cost Relationships

• TC = f(Q) = wL + rK

• MC = dTC / dQ (d= change in)

• AC = TC /Q

Cost Relationships

• If MC = AC, AC constant

• If MC > AC, AC rises

• If MC < AC, AC falls

Cost Relationships

• As Q rises

• CRS – AC constant

• IRS – AC falls

• DRS – AC rises

Cube-Square Rule

• A 1 cubic foot oven has a surface area of 1X1X6=6 sq ft

• If we double all sides, then surface area becomes 2X2X6= 24. Surface area (which dictates cost of the oven increases by factor of 22.

• Volume of oven becomes 2X2X2 =8. Volume (which dictates productivity) increases by factor of 23.

Cobb-Douglas Production

• Y = LK

• If + =1, Constant Returns to Scale

• If + < 1, Decreasing Returns to Scale

– aka Diseconomies of Scale

• If + > 1, Increasing Returns to Scale

– aka Economies of Scale


• Economies of Scale: Examples– Transportation of Intermediate Goods– Advertising a National Brand– Laundering Restaurant Linens– Payroll Book-keeping– Beer


• Market Discipline: Survival of the Fittest– In the long-run, firms that do not operate cost

efficiently will die.– Employees, however, may be be able to keep

their jobs without being efficient (Agency Cost)


• Market Discipline: Evidence– Baumol, Heim,Malkiel, Quandt (1970) found

that Investments made out of new equity earned higher returns than investments made out of retained earnings

– Grabowski and Mueller (1973) argue it’s not the source of funds that determines profitability but the market discipline


• Market Discipline: Evidence– Manne (1965): Maybe it doesn’t matter - there

is a market for corporate control• Inefficient management will be bought out and

booted (at least in the long-run)


• Coordination of Production may be compromised– Painter waits for the drywaller – Drywaller waits for plumber and electrician– Plumber and Electrician wait for carpenter– Carpenter waits for concrete truck to pour the

foundation


• Private Information may be leaked to:– Marketing Studies– Clinical Labs– Financiers– Suppliers


• Transaction Costs -

Transaction Costs

• Example:– H contracts with Z to develop an input that H

will use to produce product. The price of the input is agreed upon based on the amount of time they both feel that Z needs to complete the work

Transaction Costs

• Example:– Z completes the work in the amount of time he

thought would be necessary. H does not know how to properly incorporate Z’s work into H’s

– Z now spends extra time assisting H

Transaction Costs

• Example:– Z bills H for a price over and above the original

agreement

– H refuses to pay the extra arguing that Z agreed to have the input ready and the assistance was part of it

Transaction Costs

• Completing Production of Our Product has three key problems– Strong mutual reliance among the resource

owners

Transaction Costs


owners– each party tries to maximize its own utility

(before during and after the contract is written)

Transaction Costs


owners– Each party tries to maximize its own utility

(before during and after the contract is written)– Difficult to cover all possible contingencies and

penalize shirking when writing the contract

Transaction Costs

– Extra negotiations

– Delays and Disruptions

– Efforts by both parties to secure their positions

Complete Contract

• Stipulates all rights, responsibilities

• Considers all contingencies

Factors Preventing Complete Contracting

• Bounded Rationality

• Performance measurement

• Asymmetric Information

Asset Specificity as a Source of Transaction Costs

• Types of Specificity– Site Specificity– Physical Asset Specificity– Dedicated Assets– Human Asset Specificity

The Investment in a Relationship Specific Asset

• Leads to a

• FUNDAMENTAL TRANSFORMATION

• of the relationship

Relationship Specific Assets

• Example: 1920’s GM asked Fisher Body to build a body plant near its assembly line



• Fisher refused - What if GM’s sales dry up, we’re stuck



• Fisher refused - What if GM’s sales dry up, we’re stuck

• Solution: GM buys Fisher body

Fisher Body’s Problem

• Before the plant is built (ex ante)

• Suppose Fisher must spend $40,000 to build the plant

• Total Revenue: $100,000

• Variable Cost: 60,000

• Opportunity Cost: 40,000

• Economic Rent: 0


• Once the plant is built (ex post):

• Assuming that the plant (NOW BUILT) has no other uses:

• Total Revenue: $100,000

• Variable Cost: 60,000

• Opportunity Cost: 0

• Economic Rent: 40,000


• Once the plant would be built, GM knows that only $60,000 would be required to keep Fisher there

• The $40,000 is ex-post “extra” that GM could try to renegotiate partly toward itself

• Fearing it would be held-up, Fisher declined the offer

The Holdup Problem

• Each party to a contract worries about being forced to accept disadvantageous terms later after it has sunk an investment

Cupholder Example

• The issue is: Should we make the investment at all.

• Ex ante: Before making the investment

• Ex post: After making the investment

Rent

• (P* -C)1,000,000 - I = Ex Ante Rent

• Once I is sunk:

• (P*-C)1,000,000 - next best alternative = Ex Post Quasi Rent

The Fear

• If Quasi Rent is Positive,

• Then Ford might try to renegotiate the price

Assumption

• Suppose Ford and Cupholder Maker have equal bargaining power

• Then, Cupholder expects to lose 1/2 the Quasi Rents.

Added Questions

• 1. What must Pm be so that the cupholder maker goes ahead and spends the $8.5 million?

• 2. How low must I be (when Pm = 4) so that cupholder maker will invest I even though there is specificity?

• 3. Interpret!

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