Lecture - Simon Business School
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Transcript Lecture - Simon Business School
STR 421
Economics of
Competitive Strategy
Michael Raith
Spring 2007
3. The scope of the firm
Horizontal scope: to what extent should a firm expand into new
products or businesses?
– CCS: diversify into plastics?
– Choice Hotels: pros and cons of covering full quality spectrum
Vertical scope: To what extent should a firm be involved in activities
further upstream or downstream in the production chain?
– Coors: backward integration into everything
– Reynolds, beverage producers: integration into metal cans
– Dell vs. Compaq: resellers
Closely related but not focus here: mergers within industry
Today’s class
3. The scope of the firm
3.1 Expanding scope: problems and
challenges
3.2 Expanding scope to realize synergies
3.3 Expanding scope to increase market power
Bad/questionable
reasons to diversify
“We need to grow”
– Profitability often leads to growth, but growth for its own sake is
rarely profitable
– Agency problem: managers want growth because their
influence & compensation depends on it
– Managers often prefer to spend “free cash flow” on growth
strategies and pet projects than pay it out to shareholders
– Similar: diversification efforts in industries with declining
profitability
Metal cans
More questionable reasons
Diversify in production to reduce financial risk?
– Shareholders can instead diversify in financial markets
Diversified firm as source of investment funds?
– Assumes financial market failure that can be overcome
internally
…and one more:
Spread unique skills & capabilities into new industries?
– “Superior skills” exist but are hard to assess/verify
– Managers of successful firms often overestimate scope and
uniqueness of their capabilities
– Probably one of the major reasons why many acquisitions fail
Many empirical studies document a “diversification
discount”, suggesting that firms often diversify for the
wrong reasons
Bad reasons to vertically integrate
“Produce in-house to avoid paying a profit margin to
independent firms”
– If input market is competitive, “profit margin” is expected return
on invested capital = part of economic cost
– Examples: resellers in PC industry; car rental: fees for
reservation systems
“Outsource to avoid certain costs of production”
– E.g. outsource transportation to avoid maintenance &
depreciation of trucks
See BDSS for other make-or-buy fallacies
Organizational costs of integration/
expansion in scope
Dilution of incentives of division managers
Specialized resources spread too thin
Management too complex, problems more difficult to
detect
Many additional problems when two existing firms with
different organizations, cultures are merged
– CCS-Continental Can
Two main ways to expand scope
1. Internal development = Integration by developing own
capabilities in target industry/market
– This is like an entry decision
– What are the barriers to entry?
– Do we have a competitive advantage?
2. Acquisition of existing company
– Current owners must be compensated for profits they give up
– Acquisition must increase total value created between the two
companies!
Compare Choice Hotels: new brand introductions vs.
acquisitions
What if several bidders compete
for acquisition target?
Suppose firm A thinks of selling its unit X.
A is worth $50M when it owns X; worth only $30M
without X.
Two bidders:
– Firm B is worth $40M without X but $65M if acquires X
– Firm C is worth $70M without X but $100M if acquires X
Who will buy X and at what price?
Winning makes sense only if acquisition leads to larger
increase in total value than for any other bidder!
“Winner’s curse” if value of target is overestimated
Today’s class
3. The scope of the firm
3.1 Expanding scope: problems and challenges
3.2 Expanding scope to realize synergies
3.3 Expanding scope to increase market power
3.2 Integration to realize synergies
Parallel discussion of horizontal and vertical scope
because central questions are the same:
– What are the synergies/sources of economies of scope?
– Is integration better than contractual solutions?
The main good reason to expand scope is to take
advantage of lower costs or a higher benefit.
Economies of Scope:
1. Efficient use of resources
Production facilities and people
– Hollywood studios: movies and TV shows
– Pharmaceuticals: lab equipment
– Sales forces to sell different products
Related: benefits of geographical proximity; e.g.
beverage bottling and can production
Umbrella branding: Sony, Disney, Virgin, Choice Hotels
Through transfer of organizational capabilities
– Philip Morris’ marketing skills applied to Miller Brewing Co.
– IBM’s Engineering and Technology Services division
2. Benefits from bundling
for buyers
Convenience for buyers of buying multiple products
through same channels:
– Disney: movies, parks, toys, cruises etc.
– Masco Corp.: consumer brands for home
improvement/construction market
Convenience of choice: Choice Hotels
Lower costs of purchasing complementary goods:
Starbucks and Hear Music stores
3. Coordination and other
externalities in production
Knowledge spillover:
– Pharmaceuticals: knowledge spillover
– Reynolds in aluminum cans
– Intel: microprocessors and ProShare videoconferencing?
Product design and quality control
–
–
–
–
Hardware and software: Apple, Nintendo vs. Atari in 80s
PC Resellers: hardware and software support
Coors’ own trucking subsidiary to transport beer
Business school course packets
Advances in IT (making coordination easier) are one
reason for general trend towards outsourcing
4. Externalities in pricing of
complementary products
Recall oligopoly pricing: firms cutting price don’t take
negative effect on competitors into account
Complementary products: firms don’t take positive
effect of cutting price on competitors into account
Charge prices that are too high!
Less business for both firms
Integration may be only way to solve problem
Careful, though: argument assumes some degree of
market power in both markets!
Examples
Cars and financing: GMAC (est. 1919, divested 2006),
Ford Motor Credit (est. 1959), founded when credit
markets were less competitive/efficient
– Also possibly: transaction costs for buyers
Michelin: tires and guidebooks?
– Also possibly: lower production costs
The vertical counterpart:
Double marginalization
Same in vertical production chains; e.g. manufacturer, retailer
– Both provide complementary goods/services!
– Retailer’s price > wholesale price; manufacturer’s price > MC
Problem: retail price higher, and total profits lower than if prices
were coordinated/ if upstream & downstream firm were integrated
Example: Brewers and pubs in the U.K.
– In late 1980’s, many pubs were owned and managed by brewers
– Antitrust authority forces brewers to divest some of their pubs
– Slade (1998) finds that beer prices in pubs subsequently increased
and industry profits decreased
Again, argument applies only if both upstream & downstream firm
have market power!
But why integrate??
Many economies of scope can be realized through
contracts, without integration
When that is possible, it’s much easier than integration
Integration best if contracts don’t work well
– Why did Fedex buy Kinko’s in 2003? Why did Disney merge
with ABC? Both pairs had established relationships before
Think of “buy” instead of “make” as default, see if there
are reasons to “make”. Independent suppliers…
– often benefit from scale & scope economies, experience
– have better incentives to keep costs low and improve products
Examples of contracting solutions
Use of resources:
– Manufacturer’s representatives
– Reservation systems for car rental, flights
Coordination/quality
– Nintendo and external game producers
– Supply chain management at Dell
Complementary products
– Partnerships to offer discounts: Choice Hotels
Pricing in vertical chains
– Non-linear pricing in franchising
– Gasoline: retail price maintenance as upper limit on price
Contracting problems
Costs of describing and measuring quality of
performance
Costs of describing the terms of a contract
– E.g. B-school packets: costs of specifying penalties
Costs of agreeing on prices for resources to share, or
on contributions to their costs
– Underlying problem: parties have private information about
what resource is worth to them
Unwanted leakage of proprietary knowledge
Legal constraints: price fixing prohibited
The holdup problem
1. Companies often make relationship-specific investments = useful
only when dealing with a particular business partner
– E.g. setting up a can factory near Coca-Cola
2. Contracts are often incomplete for any of the above reasons
– E.g. increase in cost of aluminum may require adjustment of can price
The firm that made a specific investment may later be “held up” by
the other
– E.g. Coca-Cola might say: your past investment in your plant is your
problem; let’s look forward
– Consequence: firm making investment may not get its expected return
The firm then has less incentive to invest in the first place =>
inefficient outcome!
Integration as solution to the
holdup problem
Possible solution: vertical integration (Coke produces its own
cans), unless it’s possible to write long-term contracts
Examples:
– Automobiles (Monteverde and Teece, 1982): Components requiring
high engineering effort (specific human capital) more likely to be
produced in-house.
– Aerospace industry (Masten, 1984): components with design specific
to company more likely to be produced in-house.
– Electric utilities: “Mine-mouth” electric utility plants more likely to be
vertically integrated with mines than others (Joskow 1985).
– Electronic components (Anderson and Schmittlein, 1984): components
with greater human capital specificity ( = salespeople’s effort to learn
about it) more likely to be sold through in-house sales force.
Scale economies and
firm/market size
“The division of labor is limited by the extent of the market”
1. Make if no one else has use for the same input, or because input
is unique
– Independent suppliers would not want risk of holdup
– Integrated cell phone makers: Nokia, Ericsson, Motorola
2. Buy if independent supplier can sell to others as well
– Solves two problems: reduces holdup risk, helps realize EOS
– Small cell phone makers that purchase standard components
– Small companies selling through manufacturer’s representatives
3. Possibly make if the quantity you need is large enough to realize
all scale economies
– Big companies often prefer to have an in-house sales force
– GM more integrated than Ford
Today’s class
3. The scope of the firm
3.1 Expanding scope: problems and challenges
3.2 Expanding scope to realize synergies
3.3 Expanding scope to increase market
power
Integration and market power
So far, considered reasons to integrate that are purely
between two firms (and their buyers)
Other possible reasons are to increase market power
over other firms
Often stated as reasons for M&A in practice
But whether they are good reasons is much less clear
Horizontal scope and bargaining
power
Diversify to increase bargaining power vis-à-vis buyers
or suppliers?
– Important reason for horizontal mergers, e.g. hospitals
Choice Hotels and suppliers
– Rarely main reason for diversification
But e.g. Pepsi-Quaker Oats: influence in distribution
channels
Foreclosure
Integrate into another stage of vertical chain to make
competitors’ access to suppliers or customers difficult
or impossible => raise rivals’ costs
Examples:
– U.S. Steel’s acquisition of iron ore mining rights in early 20th
century
– Murdoch’s acquisition of DirecTV in 2003: greater control over
distribution of programming may place other producers (e.g.
Time-Warner [CNN], Disney [ESPN)] at disadvantage
Foreclosure (cont’d)
Potential problems with this strategy:
1. need barriers to entry in target industry
2. threat of antitrust intervention
3. winners might be owners of the scarce input
Not much evidence that this strategy is effective
BDSS consider this argument a make-or-buy fallacy
(#5)!
“Leveraging” market power
Can a firm “leverage” its market power into another
market through integration and tying?
Can NewsCorp, with market power in programming
(Fox), increase its power over cable companies
(=downstream firms) by buying DirecTV?
Popular argument, but hard to get to fly: works only if it
prevents entry / induces exit in target market