1. Markets Organization and Corporate Strategy George Norman Cummings Professor of Entrepreneurship and Business Economics

2. Some Introductory Comments Textbook: The Economics of Strategy Grading:  Two sets of essays: 20% and 25% respectively  Research paper: 30%  Industry analysis and presentation: 25% Syllabus: not a legally binding description Web-site http://www.tufts.edu/~gnorman/cmba344.html

3. Objectives Focus on strategic decision-making Application of economic reasoning to develop insights necessary for a firm to deal effectively with its operating environment The central role of strategic decision-making in determining a firm’s success

4. Strategy and Economics The definition of strategy  no single definition  different from tactics - essentially short-term

5. Strategy Definition The determination of the basic long-term goals and objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary for carrying out these goals. (Chandler, 1962)

6. Strategy Definition The pattern of objectives, purposes or goals, and the major policies and plans for achieving these goals, stated in such a way as to define what business the company is in or should be in and the kind of company it is or should be. (Andrews, 1971)

7. Strategy Definition What determines the framework of a firm’s business activities and provides guidelines for coordinating activities so that the firm can cope with and influence the changing environment. Strategy articulates the firm’s preferred environment and the type of organization it is striving to become. (Itami, 1987)

8. Why an Economic Perspective? Other approaches are possible  game theory  psychology how motivation and behavior of individuals shape organizations  sociology social structures, peer networks, routines and their effects on organizational decisions and decision- making

9. Economics Requires that we be explicit about the elements that generate strategies  decision-makers  goals  choice of strategic variables  relationships between choices and outcomes Provides a clear linkage between conclusions and assumptions Cost: lose some detail

10. The Need for Principles What makes a profitable, successful business? Can general lessons be drawn from the behavior of successful organizations?  Reasons for success often unclear and complex  No list of characteristics that guarantee success  Partial data  Success stories bias interpretation No automatic or general recipe for success  Trek: outsourcing and brand-management (Raleigh)  Usiminas: excellence in manufacturing (Bethlehem)  Wal-Mart: initiative of local managers; inventory management (Kmart)

11. Principles (cont.) Successful firms adopt strategies that exploit potential profit opportunities. Adapt to changing environments Need to analyze decision making using consistent principles of market economics and strategic action

12. A Framework for Strategy The big issues:  boundaries of the firm  markets and competitive analysis  position and dynamics  internal organization

13. The boundaries of the firm These extend in three directions horizontal: how much of the product market the firm serves vertical: the set of activities that the firm performs itself and those it purchases from other firms corporate: the set of distinct businesses in which the firm operates

14. Markets and competitive analysis Understand the markets in which the firm operates Industry-specific effects constrain profitability and must be understood:  high-tech e.g. pharmaceuticals or low-tech e.g. airline travel  determinants of entry  mistakes can be made e.g. major pharmaceutical companies’ attempts to move into production of generics

15. Position and dynamics How and on what a company competes  cost  advertising  product positioning  R&D Dynamics  how the firm accumulates resources  how the firm adjusts to changing circumstances

16. Internal organization How should a firm organize itself to give effect to its strategies? Organizational structure determines information flows and alignment of individuals with the objectives of the firm  decentralized versus centralized  incentives versus culture

17. An Economics Primer

18. Some Introductory Ideas Objectives need well-defined strategies that are under the control of the decision-maker Success is determined by the economic environment within which the firm operates Strategies must be consistent with the environment  law of demand  size and profitability of price-matching is it reasonable to match a small competitor’s price cut?  Price and cost: can additional volume be sold at a profit?

19. Costs How do costs change as output changes? This is the total cost function - TC(Q) Describes the efficient relationship between output and total cost Total cost increases with output Total Cost Output TC(Q)

20. Fixed and variable costs Variable costs increase with output  labor costs  materials costs Fixed costs are independent of output  general administration costs  property taxes The distinction is fuzzy  some costs have fixed and variable components  costs may be fixed over one range and vary over another

21. Fixed and variable costs (cont.) Fixed costs are invariant with output but are affected by other decisions Whether costs are fixed or variable depends upon the time period

22. Average and marginal costs Average cost is total cost divided by output: AC(Q)=TC(Q)/Q. Marginal cost is the additional cost of producing one more unit of output: MC(Q)=dTC(Q)/dQ. They are related as follows: Cost Output AC(Q) MC(Q)

23. The importance of time Distinguish between short-run and long- run costs In the long-run choose plant size that is adjusted to anticipated output In the short run may have to live with “wrong” plant SAC S (Q) SAC M (Q) SAC L (Q) Q1Q1 Q2Q2 Q3Q3 Average Cost Output If expected output is Q1 Q1 install the small scale plant If expected output is Q2 Q2 install the medium scale plant If expected output is Q3 Q3 install the large scale plant Q4Q4 If expected output is Q1 Q1 but actual output is Q4 Q4 then short-run costs will be on SAC S (Q) The long-run cost curve is the lower envelope of the short-run cost curves

24. Sunk costs When assessing the costs of a decision consider only those costs the decision affects Distinguish between sunk costs and avoidable costs  inventory already existing is a sunk cost  additions to inventory are avoidable costs Sunk costs are not the same as fixed costs  some fixed inputs can be redeployed from their existing use if conditions change

25. Sunk costs (cont.) Sunk costs affect strategy - particularly on entry and exit  change of technology with existing production versus adoption of new technology with greenfield site  existing firms generally more reluctant to adopt new technologies The existence of sunk costs makes it difficult to eliminate a competitor The existence of sunk costs is a barrier to entry

26. Demand and Revenues The demand function describes the relationship between quantity demanded and variables that affect demand  income  tastes  advertising  price The relationship between quantity and price is generally negative Price Quantity P1P1 P2P2 Q1Q1 Q2Q2 At price P 1 the quantity demanded is Q 1 At price P 2 the quantity demanded is Q 2

27. Demand and Revenues (cont.) There are exceptions to this “law of demand”  prestige goods: price confers prestige  goods where quality is not directly observable: price is taken as a signal of quality Where this is true then a cut in price may damage sales by damaging the good’s image

28. Price elasticity of demand An increase in price  generally reduces the quantity sold  has an ambiguous effect on sales revenue The relationship between a price change and sales revenue is determined by the elasticity of demand (or the sensitivity of demand to price) definition:  = % change in quantity % change in price

29. Price elasticity of demand (cont.) If price elasticity of demand is greater than unity then an increase in price reduces sales revenue If price elasticity of demand is less than unity then an increase in price increases sales revenue Price Quantity Price Quantity Reduction in sales revenue from increased price Increase in sales revenue from increased price Reduction in sales revenue from increased price Increase in sales revenue from increased price Elastic demandInelastic demand

30. Price elasticity of demand (cont.) Demand is elastic if:  close substitutes  buyers’ expenditures are a large proportion of total expenditure  product is an input to another product with elastic demand Demand is inelastic if:  comparison is difficult complex product little experience  buyers’ pay only a small proportion of total cost insurance coverage  switching costs exist  complementary with other products

31. Pricing Decisions If firm aims to maximize profit then the pricing and output rule is simple:  choose output such that marginal revenue equals marginal cost  get price from the demand function: the price that clears the market Use the standard pricing formula: P(1 - 1/  ) = MC

32. Game Theory Firms not in competitive markets must make strategic decisions When there are “few” firms these decisions are interdependent game theory is a particularly useful tool for analyzing such interdependence and strategic choice  assumes rationality

33. Matrix form and Nash equilibrium Simple example of capacity choice by two firms Alpha Do Not Expand Expand Beta Do Not ExpandExpand $18, $18 $20, $15$16, $16 $15, $20 Dominant strategy for Beta Dominant strategy for Alpha $16, $16 Nash Equilibrium

34. Nash equilibrium Need not be attractive  generally does not maximize joint profits  Prisoners’ dilemma But it is compelling  neither firm would choose to change strategy if its rival does not Timing is important:  simultaneous (or non-observable)  sequential (or observable)

35. Game trees and equilibrium Consider a modified and expanded example $18, $18 Alpha Do Not Expand Large Beta Do Not ExpandLargeSmall $15, $20 $8, $12 $0, $0 $9, $18 $20, $15 $18, $9 $16, $16

36. Sequential choice If choices are sequential the first mover can  anticipate rival’s choice  manipulate rival’s choice With sequential choice use game tree

37. A game tree Do not Expand Small Large Alpha Beta ($18, $18) ($15, $20) ($9, $18) ($20, $15) ($16, $16) ($8, $12) ($18, $9) ($12, $8) ($0, $0) Small Do not Expand Large