Eco chapter 8

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Econ Chapter 8

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Eco chapter 8

  1. 1. 1Competition and StrategyChapter 8 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  2. 2. 2• How competition is rivalry to obtain a distinct advantage• Categorizing and analyzing competitive strategies• How mergers and lawful agreements among competitors can sometimesincrease economic value created in a market• How restrictive vertical agreements between manufacturers and dealersor parent companies and franchisees can increase competition and benefitconsumers• Strategies for protecting profits• costs and benefits of attempting to compete by influencing publicopinion or government policy• How a business can identify tangible and intangible competitiveresources and formulate strategies that make the best use of them. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  3. 3. 3 The SupermarketSupermarkets that dominated grocery retailing in the twentieth century are losing their customers in the twenty-first. Managements of chains large and small are searching for strategies to restore their former dominance. Individual stores andbrands have some market power, but competition rules at all levels of the industry. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  4. 4. 4What’s Next? This chapter builds on earlier models to redirect our thinking about competition and business decisions. Rivalry among the grocers is nearly the polar opposite of the passive price-taking we saw in perfect competition. Each supplier is actively strategizing to earn and protect profits above opportunity cost, and each is subject to constant threats from innovators and imitators. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  5. 5. 5(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  6. 6. 6Competition: A Quest to BeExceptional – Competitive IdeasCompetition starts with ideas. Asked how he had produced so many good ideas over his career, Nobel Prize–winningchemist Linus Pauling responded that “the best way to have a good idea is to have lots of ideas.” Even the most original ideas build on a foundation of other ideas. A competitive idea is not necessarily a scientific one—it may be as simple as opening a business in an underserved location, keeping it open all night, or outrightly imitating the success of a competitor. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  7. 7. 7Competition: A Quest to BeExceptional - The Paradox: Competingto Acquire Market Power• Businesses compete to distinguish themselves in the eyes ofcustomers, and by becoming distinctive they acquire some marketpower.• A business implements a risky competitive idea in order to reap highreturns.• The possibility of high returns induces risk-taking.• But entry will erode profits (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  8. 8. 8 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or inCompeting to Acquire Market Power part.• The competition that now interests us is quite unlike what we saw in the model of a perfectly competitive market.• In actual markets, businesses often compete by discounting prices rather than taking the equilibrium price as given and unalterable.• Business try to bind customers to themselves using techniques like frequent-flier miles or other loyalty programs.• In real markets advertising is valuable to offer information
  9. 9. 9 Competition: A Quest to Be Exceptional - The Risks of Competition• Competition is risky, particularly for small startups.• Only about 40 percent of startups show accounting profits over theirlifetimes, which may not cover their opportunity costs.• Thirty percent break even and 30 percent are losers. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  10. 10. 10Competition and Deception• Competitive conditions constrain the freedom of all producers, whetherthey face many competitors or few.• In this chapter we continue to assume that buyers and sellers actrationally on information that is available to them.• In particular we rule out strategies that only succeed if one side candeceive the other (the sale of loss-leaders e.g).• (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  11. 11. 11Pitfalls in Studying Competition -Selection Bias, Again In studying competitive strategies we are often given the information that Company X used Strategy A and prospered. Even if the author mentions several firms thatsucceeded with Strategy A, the reader is likely to remain in the dark about (1) those that used Strategy A and failed, and (2) those that rejected Strategy A and succeeded. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  12. 12. 12 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessibleSelection Bias, Again website, in whole or in part.• People recall successes more easily than failures.• They give more weight to more recent events.• Our recall is biased and we often must use data that are not random samples of an underlying population.• Now to the success of Wal-Mart
  13. 13. 13Pitfalls in Studying Competition –What’s Wal-Mart’s Secret?• Here is a partial list of explanations that have been offered for Wal-Mart’s success:• decentralized decision-making,• centralized decision-making,• decision-making between the center and the stores,• regional relationships,• relationships with employees• using economics to determine strategy.• Like it or not, no one really knows why Wal-Mart has attained itsstardom.• Why have Sears and K-Mart been underperformers? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  14. 14. 14Pitfalls in Studying Competition – Self-Serving Recommendations• The structure of corporate business further complicatesthe analysis of strategy.• A corporation’s executives and board of directors might makechoices that are in their personal interests rather than those of theirshareholders, who would prefer decisions that maximize the valuesof their stock.• As will be seen later, managers whose firms produce substantialfree cash flows may prefer to spend them on questionableacquisitions that often fail to benefit shareholders.• This tactic increases the size of the firm which usually meanshigher pay and prestige. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  15. 15. 15• Both seller and buyer benefit from a transaction if the seller earnsmore than his opportunity cost and the buyer pays a price belowmaximum willingness to pay.• Economic value is the difference between cost and valuation. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  16. 16. 16The Basics: One Seller and One BuyerBuyer and seller both benefit from exchanging some good if the seller gets more than his opportunity cost (i.e., the value of the best forgone alternative), and the buyer paysless than her valuation (maximum willingness to pay for it before going elsewhere). Economic value is the difference between the cost and valuation that they share. In this example there is $4 worth of value to be shared. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  17. 17. 17 The Basics: One Seller and One Buyer – Raising the Purchaser’s Valuation Here, the seller chooses to incur a cost of $1 to alter his good’scharacteristics (possibly improving quality or making the good available closer to the purchaser’s home). In so doing, he raises the purchaser’s valuation by $2 to $13, increasing the economic value from $4 to $5. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  18. 18. 18 The Basics: One Seller and One Buyer – Lowering the Seller’s CostsHere the seller devises a way to lower costs by $2, from $7 to $5. with the purchaser’s valuation constant at $11, this will increase the economic value available from $4 to $6. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  19. 19. 19 The Basics: One Seller and One Buyer – Lowering Transaction Costs Here is a situation that includes transaction costs. Seller’sopportunity cost is $5 plus $2 in transaction costs. Purchaser’s valuation is $16 plus $3 in transaction costs. Even aftertransaction costs, there remains $6 in economic value available to be shared. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  20. 20. 20 The Basics: One Seller and One Buyer – Lowering Transaction CostsIf the seller cuts his transaction costs by $1, the economic value available to be shared rises to $7. Similarly, the purchaser could reduce her transaction costs and increase the economic value available. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  21. 21. 21The Basics: One Seller and One Buyer –Lowering Transaction Costs Here, the seller spends $1 in order to lower the purchaser’stransaction costs by $2. This will increase the economic value available from $6 to $7. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  22. 22. 22 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessibleOne Seller, Many Buyers website, in whole or in part.• Sellers can distinguish themselves in hopes that buyers will pay a premium for their product.• Distinguishing implies establishing market power and a greater slope to the demand curve for their product.• Depending on the substitutes available a seller may be able to charge a higher price for his differentiated good.
  23. 23. 23 One Seller, Many Buyers - Raising Buyers’ Valuations – Altering Variable costs Here the seller increases variable cost to improve the product and increase buyer valuation. Marginal costs increases to MC’ and demandshifts to D’. Price increases to $9.50 and profit rises. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  24. 24. 24One Seller, Many Buyers - Raising Buyers’Valuations – Altering Fixed Costs• Here the seller invests in fixed cost inorder to increase buyer valuation,perhaps building a new plant thatproduces fewer defective units ofoutput from the same variable inputsas before.• This will increase the seller’s presentand future profit but that increase inthe profit stream must be compared tothe cost of the new plant to determinewhether to build. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  25. 25. 25 One Seller, Many Buyers – Lowering Production Costs Here, lowering production costsfrom MC to MC’, increases annual profit by $9 from $16 to $25. Aseller Be willing to invest up to $9 per year to achieve such a reduction in production costs. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  26. 26. 26 One Seller, Many Buyers – Lowering Transaction Costs• Here, buyers and sellers both facetransaction costs.• Including transaction costs, demand is D’(not D) and marginal cost is MC’ (not MC).• Incurring additional cost (MC”), to reducebuyer transaction costs shifts demandcurve to D and increases profit.• If the seller can cheaply reduce buyerstransactions costs output and profitincrease as do benefits to buyers. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  27. 27. 27 Many Buyers and Many SellersThis shows what happens in a competitive market when a single firm initiallyadopts a cost-saving innovation. Other firms will follow and a new long-run equilibrium will be restored where firms once again earn zero economic profit. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  28. 28. 28Many Buyers and Many Sellers Four points emerge from this model:1. as the innovation spreads among producers the earlier adopters will see longer-lived streams of profit before the market reaches its new long-run equilibrium.2. the number of firms that survive after the innovation depends on the direction in which the innovation shifts the minimum point of average costs.3. as the percentage of sellers that use the innovation increases, those who are slower to innovate will take losses if they cannot shut down temporarily or leave the market quickly.4. any newcomer to the market will only survive if it uses the innovation. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  29. 29. 29 Many Buyers and Many Sellers – Upward Sloping Supply CurvesSupply curve S’ and demand curve D’ include a $3 transaction cost for sellers and a $2 transaction cost for buyers. The market equilibrium price is $10 with 75 units traded.Suppose that all transaction costswere costlessly eliminated. Marketprice will fall to $9 with 110 units traded. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  30. 30. 30 Many Buyers and Many Sellers – Outsider Reduces Transaction Costs D1 would be the demand curve with no transaction costs. Withtransportation costs of $18 to buyers, the demand curve is D2. Market price will be $13 and 19 units will be traded.Imagine an intermediary reduces the buyer transportation costs to $8,making the demand curve D3. Marketprice rises to $16.33 and the number of units traded increases to 25.67. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  31. 31. 31(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  32. 32. 32Horizontal Mergers and Agreements -Mergers Mergers and acquisitions can be important elements of strategy. A horizontal merger puts the assets of two firms that operate in the same market under the same ownership. The consequences depend on market structure and on how the merger affects costs. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  33. 33. 33 Horizontal Mergers and Agreements - Mergers• Suppose the diagram to the rightdepicts a perfectly competitive market inequilibrium.• If two of the firms merge to reducecosts, nothing happens.• But, if this sets off a merger wave wemay end up with an oligopoly whoseequilibrium looks like a monopoly (12,000units at $10).• This would create a deadweightloss equal to the small red triangle.• The net benefit of mergers is the algebraicsum of cost savings and deadweight loss.• Here it is positive but it could be negative.• This is what anti-trust regulators assess. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  34. 34. 34 Horizontal Mergers and Agreements - Agreements U.S. antitrust law says that a “naked” agreement whose only goal is to fix prices is per se illegal—its very existence is unlawful. Other agreements among competitors can be both legal and economically desirable. For example, members of the Recording Industry Association of America(RIAA) long ago agreed on common technical specifications for music CDs. Such a standard allows CDs from any RIAA member (or nonmember who uses the format) to work on many different players and computers. Antitrust law treats agreements like these under a ruleof reason standard that balances their favorable and unfavorable effects on competition. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  35. 35. 35Vertical Mergers and Agreements• An industry’s output is often produced in stages.• For example, oil is first extracted from the ground, thenrefined, and finally the refined products are retailed.• A firm is vertically integrated if it subsumes multiplestages.• Integration can produce savings if it improvescoordination among the stages.• But it also might raise costs if there are difficulties inmanaging dissimilar activities. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  36. 36. 36 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessibleVertical Mergers and Agreements website, in whole or in part.• The degree of integration matters because costs and revenues can vary with the number of stages in which a firm operates.• Costs may increase if there are problems managing dissimilar operations.• Vertical mergers are hardly ever strongly scrutinized by anti-trust regulators.• A firm will merge vertically to improve its competitiveness.
  37. 37. 37 Vertical Mergers and Agreements - Mergers• D is the market demand fordiamonds.• A is DeBeers’ MC for mining and B isthe MC for independent retailers.• C would be the sum of A & B whichmeans 9 diamond rings would be sold at$15 each.Should DeBeers extend into the Retailbusiness?Only if it can retail rings at lower costthan jewelry stores. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  38. 38. 38 Vertical Mergers and Agreements - Agreements• Two firms in different stages of a vertical chain might reach an agreementthat makes them a better competitor when they act as a team.• An agreement will be preferable to a merger if a single managementcannot monitor both stages as well as separate managements can.• Independent retail store managers searching for profit might have betterincentives than salaried employees of an integrated firm.• Vertical agreements in apparel and textiles – integrated firms in thisindustry are rare. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  39. 39. 39Vertical Mergers and Agreements –Restrictive Agreements• Many vertical agreements greatly restrict the futurechoices of both parties.• A franchise contract between a carmaker and a dealeroften prohibits the manufacturer from opening anotheroutlet close by, that is, it specifies an exclusive territory.• Fast-food franchises often require the owner of an outletto buy all its food through the parent organization, and theparent organization promises to always have food on handto fulfill its side of the requirements contract. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  40. 40. 40 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied orVertical Mergers and Agreements – duplicated, or posted to a publicly accessible website, in whole or in part.Restrictive Agreements• Manufacturers and retailers may have exclusive dealing contracts.• All these contracts contain vertical restrictions that limit the parties choices.• Often a parent will franchise outlets and hire employees to run others.• McDonald’s only owns 15% of its stores.• Starbucks Coffee has no individual franchises.
  41. 41. 41(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  42. 42. 42 Barriers to Entry—Size and Commitment • Building barriers to entry that protect profits against existing and future competitors can be an important element of strategy.• Size and specificity may serve as barriers to entry.• A firm may need to be sufficiently large to achieve availableeconomies of scale. Firms may also need to invest in specific assets that are not easily redeployed to other uses and locations. A power plant for instance.• New competitors do not miraculously appear especially where economies of scale are important.• Inexperienced competitors rarely appear except in new markets.• The automobile market – incumbent disadvantages (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  43. 43. 43Intangible Assets: Trademarks andAdvertising• A seller wants to inform customers about more thanprice—consistent quality, for instance, may engendercustomer loyalty.• A producer can use a brand name or trademark to assurebuyers it will produce the quality they expect.• Signalling (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  44. 44. 44Influencing the Public and Government– Public Relations• Public recognition and approval of a firm’s practices can also be acompetitive tool.• In 2005, two hurricanes destroyed much of the New Orleans andBeaumont–Port Arthur areas.• While the relief efforts of local and national governments faltered,companies like Wal-Mart, Home Depot, and Lowe’s had stockpiled andshipped necessities to the area before the storms hit, and the firmsbypassed profits by keeping prices at pre-disaster levels.• Actions can be both charitable and competitive.• Similarly, energy and auto producers advertise their environmentalconcerns.• Campaigns for Toyota’s and Honda’s hybrid cars stress their ecologicalimpact rather than their performance. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  45. 45. 45Influencing the Public and Government– Influencing Government• Government can also help a business to advantage itself ordisadvantage competitors.• Among possible strategies, a firm might seek legislation that makescompetition illegal, as cable TV operators have done in many cities.Cable, however, has failed to suppress satellite TV, which is beyondlocal control.• Government can also make competition costly for foreigners byimposing quotas or tariffs in return for support from the domesticindustry. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  46. 46. 46• How do businesses choose a competitive strategy?• Strategy is resource-based and market-based.• Firms in the same market will have different resources leadingto different choices.• Strategy is about more than price.• It can range from product design, to mergers, to politicalactivity. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  47. 47. 47Resources and Strategies - What AreResources? The originator of the resource-based model, Birger Wernerfelt of MIT, writes: By a resource is meant anything which could be thought of as a strength or weakness of a given firm. More formally, a firm’s resources at a given time could be defined as those (tangible and intangible) assets which are tied semi-permanently to the firm. Examples of resources are: brand names, in-house knowledge of technology, employment of skilled personnel, trade contacts, machinery, efficient procedures, capital, etc. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  48. 48. 48Resources and Strategies – InnovationPro and Con • Strategy need not entail innovation or entry into new markets—some firms have resources better suited to perfecting an established product. • Properly carried out, imitation can be as profitable as innovation and sometimes less risky. • Ampex invented the VCR and Xerox invented the first office computer, but neither firm found commercial success in those areas. • Success is surprisingly short-lived. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  49. 49. 49 Competence and Sustainability - Identification of Resources and Feasible Strategies A firm’s strategy choice starts by identifying its resources and the resources of its competitors, paying attention to those resources competitors have that it does not itself, and vice versa. Discussions of strategy must go beyond simple models that treat constraints as unalterable by the decision makers.• The best choice depends on our resources and those of our competitors.• We will often wish to use or acquire resources that make our strategymore resistant to their attacks. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  50. 50. 50Competence and Sustainability - TheSearch for Strategies• The idea remains that no strategy that competitors can easily duplicatewill produce long-term profit.• The search for strategy must be a continuing one.• Having a grand strategy may not be the road to success.• Tactical moves are responses to idiosyncratic, short-lived developments.• If your competitors are flexible and unpredictable you might do betterby deemphasizing global strategy and seeking to seize more immediateopportunities.• Emphasize tactics rather than a strategic mission. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
  51. 51. 51 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied orCompetence and Sustainability - The duplicated, or posted to a publicly accessible website, in whole or in part.Search for Strategies• If competition is resource based, we will require a better understanding of the types, potential, and limitations of these and other intangible resources.• To do so, we must proceed beyond transactions in markets.• Contracts with enforceable commitments.

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