© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 8: Economics of Strategy Creating and capturing value Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture, 4th ed.

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Creating and capturing value learning objectives Students should be able to Distinguish between value creation and value capture and provide examples of each Define transactions costs and apply to strategic decision making Identify and provide meaningful examples of Porter’s “five factors” Differentiate between industry and firm effects on organizational success

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Ways to create value reduction of transaction costs

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Pricing complements example CompuInc produces personal computers PrintCo produces complementary printer Demand for each product is Q=12-(P c +P p ) when (P c +P p )  12, 0 otherwise Profit-maximization yields reaction curves Each will view its demand curve as

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Noncooperative pricing CompuInc & PrintCo

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Advantage of coordination Failure to coordinate yields combined profits of 32 Jointly setting MC = MR yields combined profits of 36 –customers better off as product prices fall, quantity purchased rises

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Capturing value Firms in competitive markets are price takers Market power and superior resources can lead to economic profit

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Market power comparison

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Market power Porter’s five forces Potential rivals Existing rivalry Substitute products Buyer power Supplier power

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Porter’s Five Forces Potential Rivals Current Rivals Substitute Products Buyers Sellers Value/supply Chain Competitive Environment UpstreamDownstream

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Superior factors of production People –special talents or skills Physical assets –prime real estate –unique equipment But bidding for specialized assets may erode profits

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Producer surplus captured by superior assets

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Increasing demand Increase expected product quality –“value added” > cost increase Reduce price of complements Raise price of substitutes –limit entry of competitors

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Other value-enhancing strategies Introduce new products and services Cooperation with other firms

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Diversification Benefits –Economies of scope –Promoting complements Costs –Bureaucracy –Incompatible cultures

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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?

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Framework for strategic planning

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. To think about... Can a firm capture value on a sustained basis? Discuss.