Economics and Business Strategy Howard Davies

What Is Strategy?  Strategy as purposive action – the resource allocations that firms plan and implement in order to position themselves in markets and to compete with other  Strategy as the ‘fit’ between a firm’s use of resources and its environment  Strategy as an ongoing, unplanned and ‘unintended’ process of interaction between the firm’s internal structures and its environment

The Four Components n Strategy - in its various interpretations n Structure – the internal resources and organisation of the firm n Environment – the external circumstances in which the firm operates n Performance – the outcomes achieved

Performance as the Central Focus n WHAT IS PERFORMANCE? –Financial performance - ROI, ROS, ROE, Tobin’s Q - the most common interpretation in strategy, almost the only interpretation in Economics –Financial and Operational performance - market share, new products, productivity increase –Organisational Effectiveness - the ‘ultimate criterion’

Two Approaches n ‘System performance’ - organisational effectiveness n ‘Goal performance’ - achievement of specific lower level objectives

SWOT Analysis as an Overall Framework n Normative and Prescriptive n Firms should begin with two kinds of appraisal –Internal Appraisal of Strengths and Weaknesses –External Appraisal of Opportunities and Threats n Both Internal and External Factors are Important

Strategy and the S-C-P Approach n In the 1980s the strategy literature was heavily influenced by economic thinking, especially Porter’s re-working of the Structure-Conduct-Performance approach n The 5-forces analysis - the key to high performance lies in finding an ‘attractive’ sector to operate in or taking action to improve the attractiveness of your current environment –high barriers to entry, low threat of substitutes, less intense rivalry, low power of buyers, low power of suppliers

The Key Task of the Senior Executive? n To find attractive new environments or take action to improve existing ones n Market conditions and technology determine the 5-forces n Emphasis placed almost entirely on the OT part of SWOT.

But Does Industry Matter? n Does performance vary most within industries or across industries? n Studies differ somewhat –Schmalensee (1985) found industry effects important but no corporate effects –Rumelt (1991) used longer term data and found major business unit effects, reversing Schmalensee’s finding –McGahan (1999) much longer term data - confirmed greater importance of firm effects BUT found stable and significant industry effects

The Strategic Group Approach n At what level should industry be defined? n Within industries some groups of firms seem to compete in similar ways while others are different -e.g. cost leaders or differentiators n ‘Strategic groups’ are groups within the same industry

The Strategic Group Approach n In one sense, the strategic group approach simply re-defines industries into smaller groupings n But the groups are determined by firms choice, not an exogenous factor n From entry barriers to ‘mobility barriers’ - factors that prevent firms from copying the strategies of successful strategic groups n Emphasis shifts to what firms are able to do

The Resource-Based Perspective n Edith Penrose (1959) - The Theory of the Growth of the Firm n The firm is a collection of resources n There are differences between firms in the same industry because they access different resources n Superior performance - earning ‘rents’ - requires that a resource has certain characteristics

What Characteristics Must a Resource Have In Order to Earn Rents? n Heterogeneity - it must differ from the resources owned by other firms - ‘first-mover’ advantages - commitments n Ex post limits to competition - it must not be possible for others to access the same resource –imperfect imitability through isolating mechanisms property rights like patents and copyrighted brand names  time lags and learning effects  information asymmetries  buyer search and switching costs  reputation  channel crowding economies of scale in specialized assets causal ambiguity

What Characteristics Must a Resource Have In Order to Earn Rents? n Imperfectly mobile –non-tradeable needs co-specialised assets high switching costs or transactions costs n Limited ‘ex ante’ competition - before acquiring the resource, competition for it must have been limited. Otherwise the full value would have been paid, yielding no net benefit

What Kind of Resources Have These Characteristics? n Knowledge - routines, cultures, structures n The ‘core competence’ of the corporation n Prahalad and Hamel (1990) define the ‘core competence’ of the corporation as “the collective learning of the organisation, especially how to co- ordinate diverse production skills and integrate multiple streams of technology”. n ‘Capabilities’ (Langlois) ‘’Combinative Capabilities” (Kogut and Zander) n BUT PHYSICAL FACILITIES MIGHT BE KEY IN SOME CASES

Major Themes in RBP n Growth takes place around the key resources –economies of scope arise from being able to use the same competence in different sectors (but beware the hubris effect - the CEO may think he has a ‘dominant logic’ which allows him to succeed everywhere - Jimmy Lai?) n Differentiation takes place on the basis of the key resources

Note the Central Influence of Economics in the RBP n Penrose’ seminal influence n Rents and ‘equilibrium’ thinking - if there are no barriers then rents are competed away n Entry barriers to mobility barriers to isolating mechanisms

But Have We Forgotten the Lessons of SWOT? n BOTH Internal and External Factors MATTER n Industry matters - market attractiveness - O, T n Firm-level specifics matter - resources -S,W n Capon, Farley and Hoenig’s meta-analysis of 100’s of performance studies confirms that internal and external factors both matter n Child, Chung and Davies on Business and China - managerially controllable factors and environmental factors both count n NO REASON TO TAKE SIDES

The NEWApproach to Industrial Organisation: Game Theory and Strategy n Ghemawat (1997) - there has been relatively little interest in the strategy literature - surprisingly? –Entry deterrence –Commitments giving advantage –Reputation effects

Why Has Game Theory Economics Not Had More Influence on Strategy? n Game theory piecemeal and detailed n Not directly about performance n The general weaknesses of game theory –too many equilibria,or no equilibria, even on quite narrow issues - high/low price –commonsense solutions sometimes perform better than very complex explanations n questionable relationship to empirical data. The case study method is interesting but Ghemawat’s own book shows that for any case a dozen game-theoretic solutions may fit the facts, with no means of choosing