Economics of Strategy / Edition 4

Economics of Strategy / Edition 4

ISBN-10:
0471679453
ISBN-13:
9780471679455
Pub. Date:
08/07/2006
Publisher:
Wiley

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Overview

Economics of Strategy / Edition 4

Sound strategic management is dependent on a set of business principles that apply to all sectors of the economy. Besanko, Dranove, Shanley, and Schaefer's highly acclaimed Economics of Strategy, now in its Fifth Edition, gives you grounding in those fundamental strategic concepts that will serve you throughout your career, in any economic circumstances.

This book focuses on the economic principles that form the building blocks of strategy and details the tools you'll need to perform comprehensive analysis of a firm's economic strategy. This Fifth Edition features new and expanded discussion of topics, such as:

Demand, costs, pricing, and game theory

Economics of scale, a concept fundamental to competition, entry, positioning and sustainability

The interface between the theory of the firm, organization design, and business strategy

Incentives-vital for understanding integration and organization structure

The boundaries of the firm

Positioning and sustaining advantage

Competition

New examples, drawn from real-world cases from the eighteenth century to present day, use the lens of business history to illustrate how these principles play out in the actual corporate arena.

Product Details

ISBN-13: 9780471679455
Publisher: Wiley
Publication date: 08/07/2006
Edition description: REV
Pages: 632
Product dimensions: 8.33(w) x 10.18(h) x 1.05(d)

Table of Contents

Introduction Strategy and Economics 1

Why Study Strategy? 1

Why Economics? 2

The Need for Principles 3

So What's the Problem? 3

A Framework for Strategy 5

Boundaries of the Firm 6

Market and Competitive Analysis 6

Position and Dynamics 6

Internal Organization 6

Endnotes 7

Part 1 Economic Foundations of Strategy 9

1 Basic Microeconomic Principles 11

Costs 12

Cost Functions 12

Total Cost Functions 12

Fixed and Variable Costs 14

Average and Marginal Cost Functions 15

The Importance of the Time Period: Long-Run versus Short-Run Cost Functions 18

Sunk versus Avoidable Costs 20

Economic Costs and Profitability 21

Economic versus Accounting Costs 21

Economic Profit versus Accounting Profit 22

Demand and Revenues 22

Demand Curve 23

The Price Elasticity of Demand 24

Brand-Level versus Industry-Level Elasticities 26

Total Revenue and Marginal Revenue Functions 26

Theory of the Firm: Pricing and Output Decisions 28

Perfect Competition 30

Game Theory 34

Games in Matrix Form and the Concept of Nash Equilibrium 35

Game Trees and Subgame Perfection 36

Chapter Summary 38

Questions 39

Endnotes 39

2 Economics of Scale and Scope 41

Where Do Economics of Scale Come From? 41

Definition of Economies of Scale 42

Definition of Economies of Scope 43

Where Do Scale Economies Come From? 45

Indivisibilities and the Spreading of Fixed Costs 45

Economics of Scale Due to Spreading of Product-Specific Fixed Costs 45

Economics of Scale Due to Tradeoffs among Alternative Technologies 46

Example 2.1: Hub-and-Spoke Networks and Economics of Scope in the Airline Industry 48

Indivisibilities Are More Likely When Production IsCapital Intensive 49

"The Division of Labor Is Limited by the Extent of the Market" 49

Example 2.2: The Division of Labor in Medical Markets 50

Inventories 52

The Cube-Square Rule and the Physical Properties of Production 52

Example 2.3: The Ace Hardware Corporation 53

Special Sources of Economies of Scale and Scope 54

Economics of Scale and Scope in Purchasing 54

Economics of Scale and Scope in Advertising 55

Costs of Sending Messages per Potential Consumer 55

Advertising Reach and Umbrella Branding 56

Economies of Scale in Research and Development 56

Example 2.4: The Pharmaceutical Merger Wave 57

Complementarities and Strategic Fit 58

Sources of Diseconomies of Scale 58

Labor Costs and Firm Size 59

Spreading Specialized Resources Too Thin 59

"Conflicting Out" 59

Incentive and Coordination Effects 60

Example 2.5: The AOL Time Warner Merger and Economics of Scope 60

The Learning Curve 61

The Concept of the Learning Curve 61

Expanding Output to Obtain a Cost Advantage 62

The Boston Consulting Group Growth/Shara Paradigm 63

Learning and Organization 63

The Learning Curve versus Economies of Scale 65

Example 2.6: Learning by Doing in Medicine 66

Chapter Summary 67

Questions 68

Appendix Using Regression Analysis to Estimate the Shapes of Cost Curves and Learning Curves 69

Estimating Cost Curves 69

Estimating Learning Curves 70

Endnotes 71

3 Agency and Coordination 73

Where Do Agency Problems Come From? 73

Example 3.1: Differences in Objectives in Agency Relationships: Yahoo! and English Fruit 75

Example 3.2: Hidden Action and Hidden Information in Garment Factory Fire Insurance 77

Where Do Coordination Problems Come From? 78

Example 3.3: Offsboring and Coordination 80

Combating Agency Problems 81

Monitoring 81

Performance-Based Incentives 182

Example 3.4: Performance-Based Incentives: The Case of Franchising 81

Bureaucracy 89

Example 3.5: Corporate Risk Management at Goldman Sachs 90

Combating Coordination Problems 91

Centralization 91

Decentralization 92

Chapter Summary 93

Questions 94

Endnotes 95

4 The Power of Principles: A Historical Perspective 97

The World in 1840 98

Doing Business in 1840 98

Conditions of Business in 1840: Life without a Modern Infrastructure 99

Example 4.1: The Emergence of Chicago 100

Summary 103

The World in 1910 103

Doing Business in 1910 103

Example 4.2: Building National Infrastructure: The Transcontinental Railroad 104

Business Conditions in 1910: A "Modern" Infrastructure 106

Example 4.3: Evolution of the Steel Industry 107

Summary 109

The World Today 109

Doing Business Today 109

Modern Infrastructure 110

Summary 112

Example 4.4: the Gaizhi Privatization Process in China 112

Infrastructure in Emerging Markets 113

Three Different Worlds: Consistent Principles, Changing Conditions, and Adaptive Strategies 113

Chapter Summary 114

Questions 115

Endnotes 115

Part 2 Firm Boundaries 117

5 The Vertical Boundaries of the Firm 119

Make versus Buy 120

Upstream, Downstream 120

Example 5.1: Licensing Biotechnology Products 121

Defining Boundaries 122

Some Make-or-Buy Fallacies 123

Example 5.2: Employee Skills: Make or Buy? 126

Reasons to "Buy" 127

Exploiting Scale and Learning Economies 127

Bureaucracy Effects Avoiding Agency and Influence Costs 129

Agency Costs 129

Example 5.3: Disconnection at Sony 130

Influence Costs 131

Reasons to "Make" 131

The Economic Foundations of Contracts 131

Complete versus Incomplete Contracting 132

Bounded Rationality 133

Difficulties Specifying or Measuring Performance 133

Asymmetric Information 133

The Role of Contract Law 134

Coordination of Production Flows through the Vertical Chain 134

Leakage of Private Information 136

Transaction Costs 136

Relationships-Specific Assets 137

Forms of Asset Specificity 137

Rents and Quasi-Rents 138

Example 5.4: The Fundamental Transformation in the U.S. Automobile Industry 139

The Holdup Problem 140

The Holdup Problem and Transactions Costs 141

Contract Negotiation and Renegotiation 141

Example 5.5: Power Barges 142

Example 5.6: A Game of Chicken? Specificity and Underinvestment in the Broiler Industry 143

Investments to Improve Ex Post Bargaining Positions 143

Distrust 144

Reduced Investment 144

Recap: From Relationship-Specific Assets to Transactions Costs 144

Double Marginalization: A Final Consideration 144

Summarizing Make-or-Buy Decisions: The Make-or-Buy Decision Tree 145

Chapter Summary 146

Questions 147

Endnotes 148

6 Organizing Vertical Boundaries: Vertical Integration and Its Alternatives 150

Technical Efficiency versus Agency Efficiency 150

Economizing 150

The Technical Efficiency/Agency Efficiency Tradeoff and Vertical Integration 151

Example 6.1: Vertical Integration in a Mountain Paradise 154

Real-World Evidence 155

Example 6.2: Gone in a Heartbeat: The Allegbeny Health Education and Research Foundation Bankruptcy 157

Vertical Integration and Asset Ownership 158

Example 6.3: Vertical Integration of the Sales Force in the Insurance Industry 160

Governance Issues in Vertical Mergers 161

Alternatives to Vertical Integration 162

Tapered Integrations: Make and Buy 162

Example 6.4: Tapered Integration in Clinical Research 163

Strategic Alliances and Joint Ventures 164

Example 6.5: Toys "R" Us Enters Japan 165

Collaborative Relationships 167

Subcontractor Networks 167

Example 6.6: Interfirm Business Networks in the United States: The Women's Dress Industry in New York City 168

Keiretsu 169

Implicit Contracts and Long-Term Relationships 169

Chapter Summary 171

Questions 172

Endnotes 173

7 Diversification 175

A Brief History 175

Example 7.1: Changes in Diversification, from American Can to Primerica 177

Why Do Firms Diversify? 178

Efficiency-Based Reasons for Diversification 179

Economies of Scale and Scope 179

Economizing on Transaction Costs 180

Internal Capital Markets 181

Diversifying Shareholders' Portfolios 181

Example 7.2: Acquiring for Synergy: Procter & Gamble Buys Gillette 182

Identifying Undervalued Firms 183

Potential Costs of Diversification 184

Managerial Reasons for Diversification 185

Benefits to Managers from Acquisitions 186

Problems to Corporate Governance 187

Example 7.3: Managerial Motives for Diversification: The Strange Case of Tyco International 188

The Market for Corporate Control and Recent Changes in Corporate Governance 188

Performance of Diversified Firms 191

Studies of Operating Performance 192

Valuation and Event Studies 192

Example 7.4: The Search for Synergy in New Markets: eBay's Acquisition Binge 194

Long-Term Performance of Diversified Firms 195

A Conglomerate with a Record of Success 196

Chapter Summary 197

Questions 198

Endnotes 199

Part 3 Market and Competitive Analysis 203

8 Competitors and Competition 205

Competitor Identification and Market Definition 206

The Basics of Competitor Identification 206

Example 8.1: The SSNIP in Action: Defining Hospital Markets 207

Putting Competitor Identification into Practice 207

Empirical Approaches to Competitor Identification 208

Geographic Competitor Identification 209

Measuring Market Structure 210

Example 8.2: Defining Coca-Cola's Market 211

Market Structure and Competition 212

Perfect Competition 213

Many Sellers 213

Homogeneous Products 214

Excess Capacity 214

Example 8.3: Competition among U.S. Health Insurers 215

Monopoly 217

Monopolistic Competition 218

Entry into Monopolistically Competitive Markets 220

Oligopoly 221

Cournot Quantity Competition 222

Example 8.4: Capacity Competition in the U.S. Beef-Processing Industry 223

Bertrand Price Competition 226

Example 8.5: Cournot Equilibrium in the Corn Wet Milling Industry 227

Why Are Cournot and Bertrand Different? 228

Bertrand Price Competition When Products Are Horizontally Differentiated 229

Where Does Market Structure Come From? 231

Sutton's Endogenous Sunk Costs 232

Example 8.6: A Dog-Eat-Dog World: The Demise of the Online Pet Supply Industry 233

Evidence on Market Structure and Performance 233

Price and Concentration 233

Chapter Summary 234

Questions 235

Endnotes 236

9 Strategic Commitment 238

Why Commitment Is Important 239

Example 9.1: Loblaw versus Wal-Mart Canada 240

Example 9.2: Strategic Commitment and Preemption in the Global Airframe Market: Airbus versus Boeing 242

Strategic Commitment and Competition 243

Strategic Complements and Strategic Substitutes 243

Example 9.3: Commitment and Irreversibility in the Airline Industry 245

Strategic Incentives to Make Commitments 246

Tough versus Soft Commitments 246

Tough and Soft Commitments in Cournot and Bertrand Equilibria 246

Stage 2 Competition Is Cournot 247

Example 9.4: Commitment at Nucor and USX: The Case of Thin-Slab Casting 249

Stage 2 Competition Is Bertrand 250

A Taxonomy of Commitment Strategies 251

Making Sense of the Taxonomy 253

Example 9.5: Commitment versus Flexibility in the CD Market 254

Flexibility and Real Options 255

Example 9.6: Corning's Nuclear Winter 257

A Framework for Analyzing Commitments 258

Chapter Summary 260

Questions 260

Endnotes 262

10 The Dynamics of Pricing Rivalry 264

Dynamic Pricing Rivalry 265

Why the Cournot and Bertrand Models Are Not Dynamic 265

Dynamic Pricing Rivalry: Intuition 266

Competitor Responses and Tit-for-Tat Pricing 267

Example 10.1: The General Motors Employee Discount Price War 269

Tit-for-Tat Pricing with Many Firms 270

Example 10.2: What Happens When a Firm Retaliates Quickly to a Price Cut: Philip Morris versus B.A.T. in Costa Rica 271

The "Folk Theorem" 272

Coordination 272

Why Is Tit-for-Tat So Compelling? 274

Misreads 274

Example 10.3: Forgiveness and Provocability: Dow Chemicals and the Market for Reverse Osmosis Membrane 275

How Market Structure Affects the Sustainability of Cooperative Pricing 276

Market Concentration and the Sustainability of Cooperative Pricing 276

Reaction Speed, Detection Lags, and the Sustainability of Cooperative Pricing 277

Lumpiness of Orders 278

Information about Sales Transactions 279

The Number of Buyers 280

Volatility of Demand Conditions 280

Asymmetries among Firms and the Sustainability of Cooperative Prices 280

Example 10.4: Pricing Discipline in the U.S. Cigarette Industry 282

Price Sensitivity of Buyers and the Sustainability of Cooperative Pricing 283

Market Structure and the Sustainability of Cooperative Pricing: Summary 284

Example 10.5: How Market Structure Conditions Conspire to Limit Profitability in the Heavy-Duty Truck Engine Industry 285

Facilitating Practices 286

Price Leadership 286

Advance Announcement of Price Changes 287

Most Favored Customer Clauses 287

Uniform Delivered Prices 288

Facilitating Practices and Antitrust 289

Quality Competition 290

Quality Choice in Competitive Markets 290

Example 10.6: Quality Competition among U.S. Health Plans 291

Quality Choices of Sellers with Market Power 292

The Marginal Cost of Increasing Quality 293

The Marginal Benefit of Improving Quality 293

Chapter Summary 295

Questions 295

Endnotes 296

11 Entry and Exit 299

Some Facts about Entry and Exit 300

Entry and Exit Decisions: Basic Concepts 301

Barriers to Entry 302

Bain's Typology of Entry Conditions 302

Analyzing Entry Conditions: The Asymmetry Requirement 302

Example 11.1: Hyundai's Entry into the Steel Industry 303

Structural Entry Barriers 304

Example 11.2: Emirates Air 306

Barriers to Exit 308

Entry-Deterring Strategies 309

Limit Pricing 310

Example 11.3: Limit Pricing by Brazilian Cement Manufacturers 311

Is Strategic Limit Pricing Rational? 312

Example 11.4: Entry Barriers and Profitability in the Japanese Brewing Industry 313

Predatory Pricing 315

The Chain-Store Paradox 315

Rescuing Limit Pricing and Predation: The Importance of Uncertainty and Reputation 315

Example 11.5: Predatory Pricing in the Laboratory 316

Capacity Expansion 318

"Judo Economics" and the "Puppy-Dog Ploy" 318

Exit-Promoting Strategies 319

Wars of Attrition 320

Example 11.6: Wal-Mart Enters Germany...and Exits 321

Evidence on Entry-Deterring Behavior 321

An Entry-Deterrence Checklist 322

Survey Data on Entry Deterrence 323

Chapter Summary 323

Questions 324

Endnotes 325

12 Industry Analysis 327

Performing a Five-Forces Analysis 328

Internal Rivalry 329

Entry 331

Substitutes and Complements 331

Supplier Power and Buyer Power 332

Strategies for Coping with the Five Forces 333

Coopetition and the Value Net 333

Applying the Five Forces: Some Industry Analysis 336

Chicago Hospital Markets Then and Now 336

Market Definition 336

Internal Rivalry 336

Entry 337

Substitutes and Complements 338

Supplier Power 338

Buyer Power 339

Commercial Airframe Manufacturing 340

Market Definition 340

Internal Rivalry 340

Barriers to Entry 342

Substitutes and Complements 342

Supplier Power 343

Buyer Power 343

Professional Sports 344

Market Definition 344

Internal Rivalry 344

Entry 347

Substitutes and Complements 349

Supplier Power 350

Buyer Power 350

Conclusion 350

Chapter Summary 351

Questions 351

Appendix: Template for Doing a Five-Forces Analysis 352

Endnotes 355

Part 4 Strategic Position and Dynamics 357

13 Strategic Positioning for Competitive Advantage 359

Competitive Advantage 362

Competitive Advantage Defined 362

What Matters More for Profitability: The Market or the Firm? 364

Competitive Advantage and Value Creation: Conceptual Foundations 365

Maximum Willingness-to-Pay and Consumer Surplus 365

From Maximum Willingness-to-Pay to Consumer Surplus 367

Value-Created 369

Example 13.1: The Division of the Value-Created in the Sale of Beer at a Baseball Game 371

Value Creation and Win-Win Business Opportunities 372

Value Creation and Competitive Advantage 372

Analyzing Value Creation 373

Example 13.2: Kmart versus Wal-Mart 374

Value Creation and the Value Chain 375

Value Creation, Resources, and Capabilities 376

Example 13.3: Creating Value at Enterprise Rent-a-Car 377

Example 13.4: Measuring Capabilities in the Pharmaceutical Industry 378

Strategic Positioning: Cost Advantage and Benefit Advantage 379

Generic Strategies 379

The Strategic Logic of Cost Leadership 379

The Strategic Logic of Benefit Leadership 382

Extracting Profits from Cost and Benefit Advantage: The Importance of the Price Elasticity of Demand 382

Example 13.5 Benefit Leadership by Superquinn 384

Comparing Cost and Benefit Advantages 387

"Stuck in the Middle" 388

Example 13.6: Strategic Positioning in the Airline Industry: Four Decades of Change 390

Strategic Positioning: Broad Coverage versus Focus Strategies 393

Segmenting an Industry 393

Broad-Coverage Strategies 395

Focus Strategies 395

Chapter Summary 397

Questions 399

Appendix: Cost Drivers, Benefit Drivers, and Value-Added Analysis 400

Endnotes 407

14 Sustaining Competitive Advantage 410

How Hard Is It to Sustain Profits? 411

Threats to Sustainability in Competitive and Monopolistically Competitive Markets 411

Threats to Sustainability under All Market Structures 412

Example 14.1: "Von-a-Bees" 413

Evidence: The Persistence of Profitability 414

Sustainable Competitive Advantage 415

The Resource-Based Theory of the Firm 415

Example 14.2: Exploiting Resources: The Mattel Story 416

Isolating Mechanisms 418

Example 14.3: American versus Northwest in Yield Management 419

Impediments to Imitation 421

Legal Restrictions 421

Example 14.4: Cola Wars in Venezuela 422

Superior Access to Inputs or Customers 423

Market Size and Scale Economies 424

Intangible Barriers to Imitation 425

Early-Mover Advantages 426

Learning Curve 426

Reputation and Buyer Uncertainty 427

Buyer Switching Costs 427

Example 14.5: Building Blocks of Sustainable Advantage 428

Network Effects 429

Early-Mover Disadvantages 432

Example 14.6: The Microsoft Case 433

Imperfect Imitability and Industry Equilibrium 434

Chapter Summary 436

Questions 437

Endnotes 438

15 The Origins of Competitive Advantage: Innovation, Evolution, and the Environment 441

Creative Destruction 443

Disruptive Technologies 444

Sustainability and Creative Destruction 445

The Incentive to Innovate 446

Example 15.1: The Sunk Cost Effect in Steel: The Adoption of the Basic Oxygen Furnace 447

The Sunk Cost Effect 448

The Replacement Effect 448

The Efficiency Effect 449

Innovation and the Market for Ideas 449

Example 15.2: Innovation and Organization in the Early Auto Industry 450

Allocating Innovative Capital 451

Innovation Competition 451

Patent Races 452

Example 15.3: Patent Racing and the Invention of the Integrated Circuit 453

Choosing the Technology 454

Riskiness of R&D 454

Correlated Research Strategies 454

Example 15.4: Organizational Adaptation in the Photolithographic Alignment Equipment Industry 455

Evolutionary Economics and Dynamic Capabilities 456

Example 15.5: The Rise of the Swiss Watch Industry 457

The Environment 458

Example 15.6: Competence, History, and Geography: The Nokia Story 460

Managing Innovation 461

Chapter Summary 462

Questions 463

Endnotes 464

Part 5 Internal Organization 467

16 Performance Measurement and Incentives in Firms 469

Economics of Performance Measurement 470

Risk Aversion and Risk Sharing 470

Preferences over Risky Outcomes 470

Risk Sharing 472

Risk and Incentives 474

Example 16.1: Pay and Performance at Yakima Valley Orchards 478

Performance Measures That Fail to Reflect All Desired Actions 479

Example 16.2: Cardiovascular Surgery Report Cards 480

Selecting Performance Measures: Managing Tradeoffs between Costs 483

Do Pay-for-Performance Incentives Work? 485

Example 16.3: Herding, Relative Performance Evaluation, and the 2007-2008 Credit Crisis 486

Incentives in Firms 488

Implicit Incentive Contracts 488

Subjective Performance Evaluation 489

Promotion Tournaments 490

Efficiency Wages and the Threat of Termination 493

Example 16.4: Promotion Tournaments at General Electric 494

Incentives in Teams 496

Example 16.5: Stock Options for Middle-Level Employees 499

Example 16.6: Teams and Communication in Steel Mills 500

Chapter Summary 501

Questions 502

Endnotes 503

17 Strategy and Structure 507

An Introduction to Structure 509

Individuals, Teams, and Hierarchies 509

Complex Hierarchy 510

Departmentalization 510

Coordination and Control 511

Types of Organizational Structures 512

Functional Structure (U-Form) 513

Multidivisional Structure (M-Form) 514

Matrix Structure 515

Example 17.1: Enter the Matrix: Organizational Structure at Her Majesty's Revenue and Customs 517

Matrix or Division? A Model of Optimal Structure 518

Network Structure 519

Why Are There So Few Types? 521

Structure-Environment Coherence 521

Technology and Task Interdependence 522

Efficient Information Processing 523

Example 17.2: Organizational Structure at AT&T 525

Structure Follows Strategy 525

Example 17.3: Strategy, Structure, and the Attempted Merger between the University of Chicago Hospital and Michael Reese Hospital 527

Example 17.4: Recent Changes to Divisional Structures 528

Strategy, Structure, and the Multinational Firm 529

Structure, Strategy, Knowledge, and Capabilities 529

Example 17.5: Transnational Strategy and Organization Structure at SmithKline-Beecham 530

Structure as Routine and Heuristic 530

Chapter Summary 531

Questions 533

Endnotes 534

18 Environment, Power, and Culture 536

The Social Context of Firm Behavior 536

Internal Context 537

Power 538

The Sources of Power 539

Structural Views of Power 540

Example 18.1: The Sources of Presidential Power 541

Do Successful Organizations Need Powerful Managers? 543

Example 18.2: Power and Poor Performance: The Case of the 1957 Mercury 543

The Decision to Allocate Formal Power to Individuals 544

Example 18.3: Power in the Boardroom: Why Let CEOs Choose Directors? 545

Culture 546

Culture and Performance 546

Culture Complements Formal Controls 548

Example 18.4: Corporate Culture and Inertia at ICI 548

Culture, Facilitates Cooperation and Reduces Bargaining Costs 549

Culture, Inertia, and Performance 550

External Context, Institutions, and Strategies 550

Institutions and Regulation 551

Interfirm Resource-Dependence Relationships 552

Example 18.5: Preserving Culture in the Face of Growth: The Google IPO 554

Institutional Logics: Beliefs, Values, and Behavioral Norms 555

Chapter Summary 557

Questions 559

Endnotes 559

Glossary 563

Index 573

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