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

2. 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

3. 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?

4. 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

5. 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

6. 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

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

8. 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

9. 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

10. 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

11. 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

12. 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.

13. 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

14. 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

15. 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

16. 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

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

18. Market power comparison

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

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

21. Capturing Value: What Works?
Barriers to entry
Degree of rivalry
Number of competitors
Relative size of competitors
Threat of substitutes
Example: and fax pose serious threats to profits for Federal Express and UPS
Buyer and Supplier Power
Example: Microsoft and Intel in Personal Computers

22. 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

23. Producer surplus captured by superior assets

24. 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

25. 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

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

27. 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

28. 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

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

30. 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?

31. 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.

32. 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

33. Framework for strategic planning

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

35. 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.

36. 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.

37. 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.