Transcript Top News Stories: Jan 13, 1999

What is Economics of Strategy?
• Economics of Strategy develops a set of
guiding principles to apply
so that one can conclude which strategies
are best for which situations
Top News Stories:
April/May 2008
• Mar’s Takeover of Wrigley Creates Global
Powerhouse (WSJ 4/29)
• Starbucks to Unveil New Drinks (WSJ 4/30)
• Cablevision May Bid As Much As $650 Million
for Newsday (WSJ 5/1)
• Coke, Pepsi Bottlers Try New Sizes to Boost Sales
(WSJ 5/2)
What is Strategy?
• Planning and Directing to gain an advantage
What is Strategy?
• Planning and Directing to gain an advantage
• Planning involves not just simple decision
making
– allow for responses and reactions of others
– involves a long range view
What is Economics of Strategy?
• Economics concerns the costs and benefits
of an action
What is Economics of Strategy?
• Economics concerns the costs and benefits
of an action
• Economics emphasizes “analytical” over
“functional”
What is Economics of Strategy?
• Economics concerns the costs and benefits
of an action
• Economics emphasizes “analytical” over
“functional”
• Economics of Strategy analyzes the costs
and benefits of a strategic decision
Costs and Benefits Example
• If B(X) > C(X) , then do X
Issues- opportunity cost, sunk cost, nonmonetary issues, externalities, time value,
risk
Organization of the Course
• Internal Strategy
– Production of a product or service typically
requires a joint effort between resource owners
– How do these resource owners deal with each
other?
Organization of the Course
• External Strategy
– Production of a product or service is often
undertaken by many competing firms
– How do these competing firms deal with each
other?
Chapter 3
The Vertical Boundaries of the Firm
The Vertical Chain
of Tire Production
• Raw Inputs
• Intermediate Goods
• Final Manufacturing
• Warehouse Inventory
• Distribute to the Final Consumer
Integration at
Bridgestone-Firestone
Tires are the largest part of our business,
accounting for approximately 75 percent of
annual revenues. Bridgestone/Firestone,
Inc. develops, manufactures and markets
tires for almost every kind of vehicle. In fact,
we sell more than 8,000 different types and
sizes of tires - from a 13-foot-tall giant
radial for earthmoving equipment to a kart
tire that stands only 10 inches high.
In addition to tires, Bridgestone/Firestone is
recognized internationally for producing a
variety of quality products, including air
springs, building materials, synthetic and
natural rubber, and industrial fibers and
textiles.
We sell tires for passenger, light truck,
truck, bus, off-the-road, agricultural,
motorcycle and kart applications through
more than 12,000 outlets, including
independent dealers, discount retailers,
warehouse clubs and our company-owned
stores.
We operate Firestone Tire & Service
Centers, Mark Morris, Expert Tire and Tire
Station retail outlets for automotive tires
and service. Our GCR Truck Tire Centers
serve the commercial trucking industry with
truck tire service and retreading. Webco
offers agricultural, forestry and flotation tire
service and Cobre Tire services our
off-the-road customers with tires and
service for the mining and construction
industries.
Make or Buy
• Which activities should Bridgestone
perform themselves and which should be
outsourced?
What type of relationship should
our Manufacturer have with other
Resource Owners?
• Employer- Employee (Firm)
• Contractor-Client (Market)
Benefits of Using the Market to
Obtain Needed Resources
• Market firms can achieve Economies of
Scale
• Market firms are subject to the discipline of
the market
Costs of Using the Market to
Obtain Needed Resources
• Coordination of Production may be
compromised
• Private Information may be leaked
• Transaction Costs
Benefits of Using the Market to
Obtain Needed Resources
• Economies of Scale: As inputs increase by a
given proportion, output increases by a
greater proportion
• Result: As output increases, average cost
decreases
Returns to Scale
• If increasing all inputs by a given proportion
causes output to increase by the same proportion –
Constant
• If increasing all inputs by a given proportion
causes output to increase by a greater proportion –
Increasing (Economies of Scale)
• If increasing all inputs by a given proportion
causes output to increase by a lesser proportion –
Decreasing
Cost Relationships
• TC = f(Q) = wL + rK
• MC = dTC / dQ (d= change in)
• AC = TC /Q
Cost Relationships
• If MC = AC, AC constant
• If MC > AC, AC rises
• If MC < AC, AC falls
Cost Relationships
•
•
•
•
As Q rises
CRS – AC constant
IRS – AC falls
DRS – AC rises
Cube-Square Rule
• A 1 cubic foot oven has a surface area of
1X1X6=6 sq ft
• If we double all sides, then surface area
becomes 2X2X6= 24. Surface area (which
dictates cost of the oven increases by factor
of 22.
• Volume of oven becomes 2X2X2 =8.
Volume (which dictates productivity)
increases by factor of 23.
Cobb-Douglas Production
• Y = LaKb
• If a+b =1, Constant Returns to Scale
• If a+b < 1, Decreasing Returns to Scale
– aka Diseconomies of Scale
• If a+b > 1, Increasing Returns to Scale
– aka Economies of Scale
Benefits of Using the Market to
Obtain Needed Resources
• Economies of Scale: Examples
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–
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Transportation of Intermediate Goods
Advertising a National Brand
Laundering Restaurant Linens
Payroll Book-keeping
Beer
Benefits of Using the Market to
Obtain Needed Resources
• Market Discipline: Survival of the Fittest
– In the long-run, firms that do not operate cost
efficiently will die.
– Employees, however, may be be able to keep
their jobs without being efficient (Agency Cost)
Benefits of Using the Market to
Obtain Needed Resources
• Market Discipline: Evidence
– Baumol, Heim,Malkiel, Quandt (1970) found
that Investments made out of new equity earned
higher returns than investments made out of
retained earnings
– Grabowski and Mueller (1973) argue it’s not
the source of funds that determines profitability
but the market discipline
Benefits of Using the Market to
Obtain Needed Resources
• Market Discipline: Evidence
– Manne (1965): Maybe it doesn’t matter - there
is a market for corporate control
• Inefficient management will be bought out and
booted (at least in the long-run)
Costs of Using the Market to
Obtain Needed Resources
• Coordination of Production may be
compromised
–
–
–
–
Painter waits for the drywaller
Drywaller waits for plumber and electrician
Plumber and Electrician wait for carpenter
Carpenter waits for concrete truck to pour the
foundation
Costs of Using the Market to
Obtain Needed Resources
• Private Information may be leaked to:
–
–
–
–
Marketing Studies
Clinical Labs
Financiers
Suppliers
Costs of Using the Market to
Obtain Needed Resources
• Transaction Costs -
Transaction Costs
• Example:
– H contracts with Z to develop an input that H
will use to produce product. The price of the
input is agreed upon based on the amount of
time they both feel that Z needs to complete the
work
Transaction Costs
• Example:
– Z completes the work in the amount of time he
thought would be necessary. H does not know
how to properly incorporate Z’s work into H’s
– Z now spends extra time assisting H
Transaction Costs
• Example:
– Z bills H for a price over and above the original
agreement
– H refuses to pay the extra arguing that Z agreed
to have the input ready and the assistance was
part of it
Transaction Costs
• Completing Production of Our Product has
three key problems
– Strong mutual reliance among the resource
owners
Transaction Costs
• Completing Production of Our Product has
three key problems
– Strong mutual reliance among the resource
owners
– each party tries to maximize its own utility
(before during and after the contract is written)
Transaction Costs
• Completing Production of Our Product has
three key problems
– Strong mutual reliance among the resource
owners
– Each party tries to maximize its own utility
(before during and after the contract is written)
– Difficult to cover all possible contingencies and
penalize shirking when writing the contract
Transaction Costs
– Extra negotiations
– Delays and Disruptions
– Efforts by both parties to secure their positions
Complete Contract
• Stipulates all rights, responsibilities
• Considers all contingencies
Factors Preventing Complete
Contracting
• Bounded Rationality
• Performance measurement
• Asymmetric Information
Asset Specificity as a Source of
Transaction Costs
• Types of Specificity
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Site Specificity
Physical Asset Specificity
Dedicated Assets
Human Asset Specificity
The Investment in a Relationship
Specific Asset
• Leads to a
• FUNDAMENTAL TRANSFORMATION
• of the relationship
Relationship Specific Assets
• Example: 1920’s GM asked Fisher Body to
build a body plant near its assembly line
Relationship Specific Assets
• Example: 1920’s GM asked Fisher Body to
build a body plant near its assembly line
• Fisher refused - What if GM’s sales dry up,
we’re stuck
Relationship Specific Assets
• Example: 1920’s GM asked Fisher Body to
build a body plant near its assembly line
• Fisher refused - What if GM’s sales dry up,
we’re stuck
• Solution: GM buys Fisher body
Fisher Body’s Problem
• Before the plant is built (ex ante)
• Suppose Fisher must spend $40,000 to build
the plant
• Total Revenue: $100,000
• Variable Cost:
60,000
• Opportunity Cost: 40,000
• Economic Rent:
0
Fisher Body’s Problem
• Once the plant is built (ex post):
• Assuming that the plant (NOW BUILT) has
no other uses:
• Total Revenue: $100,000
• Variable Cost:
60,000
• Opportunity Cost:
0
• Economic Rent: 40,000
Fisher Body’s Problem
• Once the plant would be built, GM knows
that only $60,000 would be required to keep
Fisher there
• The $40,000 is ex-post “extra” that GM
could try to renegotiate partly toward itself
• Fearing it would be held-up, Fisher declined
the offer
The Holdup Problem
• Each party to a contract worries about being
forced to accept disadvantageous terms later
after it has sunk an investment
Cupholder Example
• The issue is: Should we make the
investment at all.
• Ex ante: Before making the investment
• Ex post: After making the investment
Rent
• (P* -C)1,000,000 - I = Ex Ante Rent
• Once I is sunk:
• (P*-C)1,000,000 - next best alternative =
Ex Post Quasi Rent
The Fear
• If Quasi Rent is Positive,
• Then Ford might try to renegotiate the price
Assumption
• Suppose Ford and Cupholder Maker have
equal bargaining power
• Then, Cupholder expects to lose 1/2 the
Quasi Rents.
Added Questions
• 1. What must Pm be so that the cupholder
maker goes ahead and spends the $8.5
million?
• 2. How low must I be (when Pm = 4) so that
cupholder maker will invest I even though
there is specificity?
• 3. Interpret!