Chapter 8: Economics of Strategy: Creating and capturing value Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture, 4th ed.

Creating and capturing value learning objectives Students should be able to Explain methods to create and capture value Define transactions costs and apply to strategic decision making Identify and provide meaningful examples of Porter’s “five factors”

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

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

Value creation Reduce production costs or producer transaction costs Reduce consumer transaction costs Increase expected product quality –“value added” > cost increase

Value creation Decrease price of complements Raise price of substitutes –limit entry of competitors Introduce new products and services Cooperation with other firms

Capturing value Firms in competitive markets are price takers Market power and superior resources can lead to economic profit

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

Superior factors of production People –special talents or skills Physical assets –prime real estate –unique equipment But bidding for specialized assets may erode profits

Superior factors of production 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

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

Management Implications Diversification to reduce earnings volatility –may not increase value Related diversification –can increase value Capturing the gains –does the firm bring some special resource into the transaction?

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 (Figure 8.5)