Chapter 8: Economics of Strategy Creating and capturing value ECON 308 Week 9 Chapter 8: Economics of Strategy Creating and capturing value

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 1990’s New international super-centers E-commerce sites Experimented with traditional sized grocery stores in Arkansas By 1998 the stock was performing well again

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?

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

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

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

Creating Value $ Price Supply Consumer Surplus P* Producer Surplus Demand Q* Quantity/Time

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

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

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

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

Creating Value Reducing Consumer Waiting Time Cable Installation:4 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.

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 Don’t allow people to bring food into a theater Airlines restrict the use of cell phones

Creating Value: Product Quality Profit is increased if MR > MC Marginal Revenue depends on value created for Customer Product Quality Examples Titanium Golf Clubs Parabolic Skis

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

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 Macdonald’s: Fillet of Fish

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

Market power comparison

Market power Porter’s five forces that affect Market Power Potential rivals Existing rivalry Substitute products Buyer power Supplier power

Porter’s Five Forces Affecting Market Power Potential Rivals Upstream Downstream Current Rivals Buyers Sellers Substitute Products Value/supply Chain Competitive Environment

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

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

Producer surplus captured by superior assets

Superior factors of production again 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

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

Increasing demand Increase expected product quality “value added” > cost increase Reduce price of complements Raise price of substitutes limit entry of competitors

Diversification Benefits Economies of Scope Promoting Complements 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

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

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

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?

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.

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

Framework for strategic planning

To think about... Can a firm capture value on a sustained basis? Discuss.

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.

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.

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.