Thinking About Strategy

Why do economists and cognitive scientists question the idea of planning? Because planning is combinatorially explosive. If ten things can happen today and for each of those ten things ten more things can happen tomorrow and so on—the possible outcomes quickly get out of hand. The Austrian view of the role of entrepreneurs—is to deal with the unexpected.

But some economists allow that there may be a role for planning in the following sense. Determine a goal e.g. to develop a new product, technology, etc. Planning is than used to determine the best way to achieve that goal. And Strategic interaction involves recognizing that your success depends upon what others (your competitors) are doing and recognizing that they will try to determine what you are doing. So your actions, in part, depend upon your best guess about what they are doing, and what they are doing is in part, dependent upon what they think you are doing and so on—which is the essence of strategic planning.

Cooperation Game Consider the Prisoner’s dilemma: Column Player Cooperate Defect Row Cooperate 15,15 5,25 Player Defect 25,5 10,10 First sum is the payoff to the row player, the second is the column player’s payoff

Coordination Game Column Player R L Row R 15,15 1,1 Player L 1,1 10,10 First sum is the payoff to the row player, the second is the column player’s payoff

What is likely to happen if the players do not know each other and play only one time in the Cooperation game? The Nash equilibrium: pick the best response to your opponent’s strategy options. What if the same players play the cooperation game may times? Reciprocity, evolves in the repeated PD game under some strategies—leads to cooperation.

Ultimatum Game: randomly pick an individual, called the proposer, give her $10, to be divided with another called the responder, if the responder rejects the offer both get nothing—what is the Nash equilibrium? Beauty Contest Game: A relatively large number of people each pick a number from the interval 1 to 100. The winner is the individual who’s number is closest to 2/3 times the average of all numbers picked—what is the Nash equilibrium?

What is the essence of strategy? What do these games say about the limits of strategy?

Porter’s Competitive Strategy

The Five Forces Substitute Products Internal Rivalry Buyer Power Supplier Power Entry

Refers to Industries and the Forces that Effect Firm Profit Within the Industry An industry refers to firms producing a similar product Are industries or markets what is important?—It depends Why think about industries? –View from the “outside” to guide investment. –View from the “inside” to guide strategy.

Firms try to maximize expected discounted of future profits П = TR - TC EPVП = Strategy refers thinking about and planning for potential responses and effects to the to various actions by your firm to increase profits for example: –increase revenue by selling more –Increase revenue by raising your price –Increase quality –Reduce costs, e.g., reducing supply price –Introduce new products

How customers affect revenue Tradeoff between higher price and more sales. Alternative opportunities for customer. –Buy from someone else in the industry. –Buy a substitute product –Do it themselves. –Do without.

Two terms for one idea Bargaining Power: ability of a buyer (seller) to negotiate a lower (higher) price. Market Power: ability to raise your price without losing all your customers. Depends on substitution opportunities (the competitiveness of the market).

How suppliers affect cost Again, bargaining power (this time, the competitiveness of the input market) Do they sell to many firms or just you? Are there other firms that you could buy from?

Competitors Other firms try to get your customers to buy from them instead of from you. New entry What does this do? –Forces you to lower your price (bad for revenue). –or make better products (bad for costs). Good for consumers!

Competition from other firms in the industry Most noticeable type of competition Competition vs. Collusion. Some things that affect competition: –Switching costs. –Fixed costs. –Legal restrictions.

Competition from potential entry of new firms Not all competitors are seen! Barriers to entry: –Economies of scale. –Network externalities –Proprietary product technology. –Government use of coercive power –Customer loyalties and brand. Strategies to deter entry.

Competition from firms making substitute products Opportunities for substitution reduce market power. How big of an effect? –How similar are the products? –How much cheaper are they? Offering substitute products is a way of competing.

Competition limits profits Firms would like to be free of competitors so that they can have higher profits. But, higher profits attract more competitors to the market.

Competitive strategies Get market power by developing a differentiated product. Have lower cost and/or lower price. Have a “focused” or niche strategy

Competition as a dynamic process Firm develops new product - makes above- average profits. Other firms follow with competitor products and lower costs. Firm continues to innovate to develop new products or to reduce costs.

Structural analysis of industries Think about sources of competition. Strategies for dealing with competitors. Overall strategy of the firm.

Examples Errors (internal rivalry): Let rivals get head start: WordPerfect—slow to switch to Windows Schwinn—slow to see the potential in mountain bikes Motorola—slow to embrace digital cell technology Music, Movies—digital format + computer + internet = file sharing

Supplier Power: California electricity market Innovation as a strategy: Why were Thomas Malthus, The Club of Rome and Paul Ehrlich all wrong—resources are not the key constraint, human material well being is limited by ideas, not by stuff.

We don’t need coal, copper wire or paper, to heat our homes, communicate with other or store information. These can be satisfied by new ideas—recipes, designs, or techniques—to rearrange existing resources to yield more: Petroleum replaces whale oil Shipping containers Margarine, Hippolyte Mege-Mourcez (1870) The combinatorial nature of ideas allows progress to be exponential—importantly ideas are public goods