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Chapter 1
The Evolution of the Modern Firm

Chapter Contents 1) Introduction 2) The World in 1840 • Doing Business in 1840 • Conditions of Business in 1840: Life Without a Modern Infrastructure Example 1.1: The Emergence of Chicago 3) The World in 1910 • Doing Business in 1910 Example 1.2: Responding to the Business Environment: The Case of American Whaling • Business Conditions in 1910: A "Modern" Infrastructure Example 1.3: Evolution of the Steel Industry 4) The World Today • Doing Business Today • The Infrastructure Today Example 1.4: Economic Gyrations and Traffic Gridlock in Thailand 5) Three Different Worlds: Consistent Principles, Changing Conditions, and Adaptive Strategies Example 1.5: Infrastructure and Emerging Markets: The Russian Privatization Program Example 1.6: Building National Infrastructure: The Transcontinental Railroad 6) Chapter Summary
7) Questions

Chapter Summary

This chapter analyses the business environment in three different time periods: 1840, 1910 and the present. It looks at the business infrastructure, market conditions, the size and scope of a firm’s activities and a firm’s response to changes. This historical perspective shows that all successful businesses have used similar principles to adapt to widely varying business conditions in order to succeed.
Businesses in the period before 1840 were small and operated in localized markets. The size of a business was restricted by the lack of production technology, professional managers, capital and large-scale distribution networks. The limited transportation and communication infrastructures made it risky for businesses to expand and restricted them to small local markets. Owners ran their own businesses and depended on market specialists to match the products with the needs of the buyers. There were forces in place, however, that would enable businesses to expand their economic activity over a larger geographic area.
The infrastructure for conducting business expanded tremendously by 1910. New technologies permitted the higher volume of standardized production. The expansion of the rail system permitted the reliable distribution of manufactured goods to a wider geographic area. The telegraph enabled businesses to monitor and control suppliers, distributors and factories. Finally, the growth of financial institutions allowed businesses to raise capital and transact on a global scale. Businesses expanded in size and market-reach by making investments to capture the benefits of these innovations.
Businesses which invested in these new technologies needed a sufficient flow of throughput to keep productions level high. That is, even the largest and best-managed firms of that time were still constrained by the problem of control—how to gain sufficient information on a timely enough basis to adapt to change. As a result, manufacturing firms vertically integrated into raw materials acquisition, distribution, and retailing—eliminating the need to rely on independent factors, suppliers and agents. The growth in the size and enhancement of functional responsibilities, or horizontal integration, was critical to manage these large organizations. Price wars drove weaker rivals out of the market as the firms tried to build volume and spread the fixed costs. Businesses established managerial hierarchies to administrate and coordinate the various functions being performed within the organization. These hierarchies gave rise to a class of professional managers who became experts in certain functions performed by the firm and they became a source of competitive advantage. But the goals of these managers had to be aligned with that of the firm. Large hierarchical firms would dominate the first half of the 20th century.
The entire business infrastructure has undergone massive changes over the last 30 years. Improvements in transportation, communication and financial infrastructures have facilitated the globalization of markets increasing competition and have placed a premium on quickness and flexibility. Innovations in technology have minimized the advantages of large-scale production facilities and have made it possible for firms to coordinate extremely complex tasks over large distances without being vertically integrated. Smaller and flatter organizations are the preferred way of structuring firms to take advantages of these changes.
These changes have created opportunities as well as constraints. They have made the modern marketplace a global one but they have also increased the number of competitors at the same time. Technological innovations have given firms more control and decreased the geographic distances but they have also allowed smaller nimble firms to compete with big firms in meeting the rapid changes in consumer needs. Well-developed financial markets have lowered the cost of capital but these same markets have made large firms targets for potential hostile takeover.
The three periods, with widely different business practices and infrastructure, illustrate that a consistent set of principles have to be applied to changing business conditions in order to implement a successful business strategy. The business tactics used by firms varied from one period to another to meet the different business circumstances but the economic principles and the behavioral relationships used to form the tactics are general. These principles and relationships haven't changed and can be applied to wide variety of business circumstances. By judiciously applying these principles, managers can successfully adapt their firm’s business strategy to their competitive environment.
Approaches to Teaching this Chapter

This chapter encourages students to be cognizant of the most “bird’s eye” view one can adapt of the context in which firms compete – what are the opportunities and constraints that result from current state of the world’s development? This chapter is intended to shed light on some key strategic concepts developed later in this book including: the fluidity of firm boundaries, the importance of scale and scope, the importance of throughput, and how technology and infrastructure affect strategic choices.

Infrastructure: assets that assist in the production or distribution of goods and services that an individual firm can not provide, such as transportation (roads, bridges, etc.), telecommunications, financing.

Throughput: the movement of inputs and outputs through a production process

Vertical integration: the act by which firms choose to produce raw materials and/or distribute finished goods themselves, rather than rely on independent suppliers, etc.

Horizontal integration: growth in size and enhancement of functional responsibilities in a business area.

Path Dependence: the dependence of an actor's position on its starting conditions, initial decisions, and history.

You might want to discuss that the key business issues in 1840 (riskiness, large number of owner-operators, inefficiency, etc.) and their causes (poor communications, lack of technology etc.) can be seen today in many emerging markets (for example Tanzania, Ivory Coast, and Poland). You could also raise issues of the mistakes that Western firms could make in "emerging markets" if they misunderstand basic business conditions.

The Chicago example is a terrific illustration of how technological changes can change the environment under which firms operate. It would be interesting to ask students why Chicago emerged as the center of distribution if grain elevator technology was available throughout the Midwest at the time. It will come out that Chicago's location, with access to the Great Lakes and Mississippi River, created the advantage. It was essentially a "hub" as in the airline industry today. Furthermore, improvements in communications favored Chicago as a location for distribution activity. Distributors in Chicago had begun the practice of grading grain and were willing to buy and sell grain at guaranteed prices in Chicago before the price was actually set in NY. This was the beginning of a futures market, now called the Chicago Board of Trade (CBOT). Superior information transfer allowed grain traders to bear the risk and still profit. Conclusion: the confluence of technology development allowed Chicago to outperform those who vied for its position at the time.

Today there are still distinct infrastructure changes and new organizational forms emerging. You might discuss the media's current attention on mergers in the telecommunications, financial services, entertainment, and health care industries and the opposing fact that most industries are experiencing quite a different trend, i.e., the virtual corporation. Mention the largest manufacturers of athletic footwear in the world (Nike, Boss, Benetton, and Trek) which are "network" firms. Explain the concept of "network" firms. You could also mention how "global" firms are facing simultaneous pressures to both coordinate on a worldwide scale and pass more decisions down to local managers.

In addition to these examples, it may be helpful to encourage your students to draw on their own life/work experiences and think of the following:

1) An industry that is dominated by a few large companies. Why might that be?
2) An industry that consists of many small companies. Why might that be?
3) An industry that is highly government-regulated. How has it affected industry structure and the size and scope of the firm?
4) A company that is vertically integrated. Why is that?
5) How would you describe the industry that you most recently (or currently) worked in? What functions did it perform in-house? What functions did it outsource?
6) Can you think of an invention that dramatically changed the way business was conducted in a particular industry? Can you think of a deregulation effort that dramatically changed the way business was conducted in a particular industry?
7) Pick one industry and talk about the role of finance, transportation, government, and technology within that industry.

Suggested Harvard Case Studies[1]

Prochnik: Privatization of a Polish Clothing Manufacturer, HBS 9-394-038 Rev. 1/5/94. This case brings to life the concept that key business issues in 1840 (riskiness, large number of owner-operators, inefficiency, etc.) and their causes (poor communications, lack of technology etc.) exist today in many emerging markets, such as Poland. While this case can be an interesting first introduction to case analysis, it is also a particularly good example of value creation and a strategic turnaround based on a differentiation strategy, which will be discussed in Chapter 11.

House of Tata, HBS 9-792-065. This case traces the evolution of the largest business group in India. Its primary focus is on the organizational structure of the group and how it changed in response to internal and external forces. The instructor can link the absence of infrastructure as well as governmental policies to firm activities and overall performance. This chapter is useful for illustrating some of the concepts in the following chapters: 1, 2, 5, 14, 15 and 16.
Extra Reading

Business history is an academic field in its own right, with a large volume of sources to choose from for additional reading. Instructors wishing to provide additional reading or supplemental lectures should consult the following sources:

Atack, J. and P. Passell. A New Economic View of American History, 2nd Ed., Norton, 1994.

Chandler, A.D., Amatori, F. and T. Hikino (eds), Big Business and the Wealth of Nations. Cambridge, U.K.: Cambridge University Press, 1997.

Chandler, A.D. and H Daems (eds.). Managerial Hierarchies: Comparative Perspectives on the Rise of the Modem Industrial Enterprise. Cambridge: MA: Harvard University Press, 1980.

Chandler, A.D. and R.S. Tedlow. The Coming of Managerial Capitalism. Homewood, IL: Irwin, 1985.

Chandler, A.D. The Visible Hand. Cambridge, MA: Belknap, 1977

Chandler, A.D. Scale and Scope: The Dynamics of Industrial Capitalism. Cambridge, MA: Belknap, 1990.

Cochran, T.C. and W. Miller. The Age of Enterprise: A Social History of Industrial America. New York; Harper and Row, 1961.

Galenson, D. W. (ed.). Markets in History: Economic Studies of the Past. Cambridge, U.K.: Cambridge University Press, 1989.

Krugman, P. Geography and Trade. Cambridge, MA: MIT Press, 1991.

Lamoreaux, N. R. and D. Raff (eds). Coordination and Information: Historical Perspectives on the Organization of Enterprise. NBER Chicago: University of Chicago Press, 1995.

Lamoreaux, N. R. and Raff, D. and P. Temin (eds), Learning by Doing in Markets, Firms and Countries, NBER Chicago, University of Chicago Press, 1999

Pollard, S. "Industrialization and the European Economy," Economic History Review, 26, November 1973: 636-648.

Temin, P. (ed), Inside the Business Enterprise: Historical Perspective on the Use of Information, NBER Chicago, University of Chicago Press, 1991.
Answers to End of Chapter Questions

1. Why is infrastructure essential to economic development?
Infrastructure includes those assets that assist in the production or distribution of goods and services that firms themselves cannot easily provide. Infrastructure facilitates transportation, communication, and financing. It includes basic research, which can enable firms to find better production techniques. The government also has a key role, both because the government affects the conditions under which firms do business (e.g. regulations) and because the government is a direct supplier of infrastructure (e.g. interstate highways). Infrastructure reduces the costs associated with business transactions, thereby making these transactions feasible.
2. What is throughput? Is throughput a necessary condition for success of modern business?
Throughput is the movement of inputs and outputs through a production process. Without access and assurance of a supply of inputs, a successful business enterprise would not be possible.
3. In light of recent downsizing and restructuring of Corporate America, was Chandler’s explanation of benefits of size incorrect?
In the early part of the twentieth century, the prevailing business infrastructure made it efficient for a firm to produce in a large scale and achieve a favorable cost structure through economies of scale. This made it imperative that if a firm built up production capacity it had to expand and capture all of the market’s demand. By doing so a firm would assure a throughput of sufficient volume and generate profits. The amount of administrative coordination required within firms increased with their expansion in size since firms were performing a wider variety of functions more frequently. The firms developed large managerial hierarchies that were responsible for coordination and monitoring all the tasks of a firm in this business environment.
Market conditions and the business infrastructure have changed significantly in the last 30 years. Innovations in technology have eliminated the advantages of large-scale production. Advances in communications enables firms to coordinate complex transactions over large distances and with a large number of other institutions. This has reduced the need for firms to be large in size or be vertically integrated. The globalization of the marketplace has intensified competition and has placed a premium on quickness and flexibility. Nowadays, firms are able to serve a larger number of customers better by being smaller in size and more flexible to shifts in consumer needs. This has been made possible by the changes in technology and in the ways of doing business. A firm’s size is no longer measured by its overhead size but by the length and breadth of its reach. Chandler’s benefit of size still holds in this current marketplace. Only now, the virtual size of a firm is more important than its physical size.
4. The technology to create a modern infrastructure is more widely available today than at any time in history. Do you think this will make it easier for developing nations to create modern economies that can compete with the economies of developed nations?
Yes, the widely available technology for creating modern infrastructure will make it easier for developing nations to create modern economies that can compete with the economies of developed nations. The changes in capital markets have made it possible for developing nations to acquire the huge amounts of capital needed to build infrastructure at competitive prices quite easily. There are a large number of global firms that have the expertise for building transportation, communication and production infrastructure from scratch at a large scale. The biggest stumbling block preventing the creation of modern infrastructure in a developing nation is the government of that country. If the government of a developing nation does not focus on modernizing the infrastructure and spends its resources elsewhere, the developing nation will not have a modern economy.
5. Two features of developing nations are an absence of strong contract law and limited transportation networks. How might these factors affect the vertical and horizontal boundaries of firms within these nations?
A well developed body of contract law makes it possible for transactions to occur smoothly when contracts are incomplete, while extensive transportation networks allow better coordination and faster flow of goods and services across geographic markets. Developing nations face weaknesses in both of these aspects of modern infrastructure. Extensive vertical integration occurs in these countries because firms face extraordinarily high transaction and coordination costs. To fully exploit production opportunities, firms needing to make significant sunk investments will also need a reliable supply of inputs and distribution channels. The lack of contract law makes the firm’s relationship with its suppliers and distributors more vulnerable to holdup problems than are firms in industrialized nations. At the same time, the lack of transportation networks forces firms to coordinate their distribution and allocation activities within the firm’s boundaries to ensure smooth functioning of the value chain. To ensure reliability and overcome high transaction and coordination costs, firms have the incentive to vertically integrate. The lack of transportation networks, however, also will effectively reduce the size of a firm’s market and the scale and scope economies that are attainable. This will reduce the firm’s ability to effectively integrate vertically.
Regarding horizontal boundaries, firms in developing nations face two competing forces. On the one hand, without the support of a transportation infrastructure, firms are unable to transport their outputs to geographically distant consumers. This force reduces the scale of a firm’s production of a particular good. However, since consumers’ coordination and transaction costs are lowered by doing business with a firm that offers a wide selection of goods, firms in developing countries have an incentive to offer multiple products as opposed to specializing in a single product. Indeed, many of these firms are conglomerates with business activities encompassing almost an entire vertical chain as well as products across many different sectors. For instance, some large South Asian companies own their natural resources, processing plants and distribution networks, as well as banks and transportation companies, while producing goods from financial products to soap.
6. Many analysts say that the infrastructure of Eastern Europe today resembles that of the United States at the start of the twentieth century. If this is true, then what patterns of industrial growth might you expect in the next decade in the context of contemporary competitive forces?
The current business infrastructure in Eastern Europe lacks a modern financial, communication or transportation infrastructure. This has forced firms to operate in localized markets and increased the risks of any business enterprise operating on a large scale. Small, family-operated firms that rely on distribution specialists and market makers to match the buyers with the sellers dominate the market. Most business is conducted locally with trades being provided for small towns by one small, independent market provider.
The governments of these countries have a major role to play. If they open up their countries to the efficient market forces and invest in modern infrastructure, then the firms in these markets will leapfrog the era of big businesses that United States went through in the first part of the twentieth century. These firms will adopt the latest changes in technologies, communications and financial engineering. The firms will be small and nimble in order to meet the rapid shifts in the market place. The successful ones although small in size will be big virtually due to their extensive reach across their countries as well as the world. There will be no difference between a successful firm from U.S or Eastern Europe. On the other hand, if the governments of the Eastern European countries do not open up their markets or fail to develop their infrastructures, small family-operated firms in localized markets will dominate the economy. The economies of these countries will not see any significant growth.
7. How might U.S industry have evolved differently if strong anti-trust laws had been in place as of 1900?
In the first half of the twentieth century, the prevailing business environment led to the growth of vertically and horizontally integrated firms. The firms had rapidly expanded production capacities to reach the minimum efficient scale. The expansion of production facilities culminated in over-capacities in most industries, which led to destructive price rivalry as firms tried to build volume and spread their fixed costs. The weaker firms were driven out of an industry. The reduced number of firms then had an opportunity to collude and increase profits.
Stronger anti-trust laws in that period would have prevented a few firms from dominating a single industry (e.g. Standard Oil) and reduced the incidence of collusion among the firms, thereby providing consumers with more economic surplus. Firms may have spent more resources on innovation instead of spending their resources on acquiring their rivals. Firms probably would also have begun diversifying outside of their traditional product lines sooner in the century than they did. Acquisitions would have been more of a financial decision than an industry strategy one. In turn, the role of corporate headquarters would have become the role of financial advisor and portfolio manager a lot sooner than it actually did. Indeed, Chandler discusses the constraining effects of “stronger” antitrust environments (in Germany, Great Britain) in his 1990 book Scale and Scope: The Dynamics of Industrial Capitalism.
8. In the past half-century, several cities have been identified with specific industries: Akron/tires; Macon/carpets; Sunnyvale/computer chips; Orlando/tourism. Why do such centers emerge? Given evolving technology, what is their future?
A cluster of firms all based in the same region/city and whose fortunes are integrally linked to one another is a recent worldwide economic phenomenon. The firms in one of these “clusters” are in related industries oriented to selling outside their region, they are interdependent and they compete with each other internationally. The firms in a “cluster” have similar production technologies, material and resource needs, they sell into similar markets and rely on the same economic foundations for their competitiveness. This “clustering” phenomenon occur due to the following reasons: • These regions have diverse firm bases i.e. large firms operating at the efficient scale and small firms competing on flexibility and speed of reaction. • By being in these regions, firms have access to global markets, the latest technology, and resources that are unavailable elsewhere. • The firms are able to create company linkages (e.g. buyer-supplier relationship or strategic alliances) with fewer coordination problems since they are located close to each other. • There is a rapid diffusion of innovation among the firms since their close location allows employees to move from one firm to another. This movement of employees stimulates competition and allows all the firms in the area to share the fruits of technological innovations. Since most of the innovations are concentrated within a region, it allows the firms in this region to dominate the global market. • These regions all have a self-sufficient value-added chain that minimizes the chances of success of a firm located outside the region. Support industries develop around the core-industries to complete the value chain. The reasons why any cluster develops are complex and colored by idiosyncratic conditions and historical developments. Some localized industries develop into clusters while others become highly concentrated. Some clusters are very stable while others change frequently.

It is quite likely that similar regions will continue to appear in the future since this “clustering” phenomenon creates a “feedback” loop that strengthens the competitive advantages of the firms located in these regions. However, current innovations in communication and transportation technologies are reducing the importance of the dynamics of being in a “clustered” region. The trend is toward virtual corporations or a networked firm and the importance of geographic proximity for determining success is shrinking.

9. The advent of professional managers was accompanied by skepticism regarding their trustworthiness and ethics in controlling large corporate assets on behalf of shareholders. Today this skepticism remains and has changed little since the founding of the managerial class a century ago. Why has it remained so strong?

The growth of managerial hierarchies fostered the emergence of a class of professional managers, many of whom owned little or no share of the business. Hence, primary cause of the skepticism is this separation of ownership and control—similar to the skepticism one might feel upon hearing a parking valet claim that “s/he treat’s the cars as her/his own”. These individuals tended not to have worked their way up in a particular business, but rather have been trained as engineers or in business school. On behalf of the owners these managers applied their expertise in control and coordination to the firm and its business units. In doing so, they pioneered the standardized collection of data on a firm’s operations, and with it the beginnings of cost accounting. These changes in the nature of the firm and its managers caused problems and conflicts. Since there was little precedent for the rapid growth of firms at this time, growth of volume and expansion into new markets could easily lead to overexpansion and overcapacity. The development of internal controls needed for coordination and efficiency could easily turn into excessive bureaucracy. The very skill that new professional managers exhibit in guiding the growth of their firms raises the problem of ensuring that these managers continue to work in the best interest of owners rather than for their own ends. Ironically, these problems become particularly acute when management well aligned with shareholder interests is most needed – during downturns in the firm’s product market. 10. The Internet boom of the late 1990’s was hailed as the advent of a “new economy” that would radically alter the face of business firms. By 2002, however, it was clear that the new economy had not arrived on schedule. With the advent of the Internet, digitization, and related innovations, what fundamental aspects of the economy have changed? Which aspects have remained the same? Why has the “new economy” been so slow to arrive?
While many hailed the Internet as having a revolutionary impact on global infrastructure, events so far suggest the affect of the Internet on global infrastructure is more accurately coined evolutionary –albeit pretty significantly so. The Internet has affected each component of infrastructure. Clearly affected has been communications: examples of the affect are too many to enumerate here, but consider the increased ease with which consumers can be matched with sellers. Among the many affects of this is to make feasible business opportunities that once could not expect to find enough consumers to achieve a sufficient scale of operation – i.e., a boutique specializing in the sale of sunglasses for pets. Put succinctly, the Internet has reduced the costs of search for buyers of everything from pet sunglasses to industrial inputs. Furthermore, the Internet has spawned a wide range of industries whose role is to support the use and development of the Internet. For this one could credit the Internet with potentially increasing the volume of trade. One should resist hastily concluding that this increase in volume means higher profits for enterprises. Material covered in subsequent chapters will introduce the idea that growth in demand coupled with an increase in competition among sellers has an ambiguous outcome on profitability. Finance is similarly affected by, for example, the increased ease with which providers of capital might find seekers of capital and information about the firms and industries they might invest in. Production Technologies that were less feasible without a mechanism for sharing information in real time are feasible using the Internet. Transportation is also improved as a result of the availability of real time information. The government has a myriad of uses for the Internet, from information dissemination, criminal investigations, etc.
While the Internet has clearly impacted the costs associated with transactions among firms and individuals, and this reduction in costs has had nontrivial affects, the Internet has not altered the principles of microeconomics that predict with high accuracy the outcome of economic interactions in reasonably free markets such as in the U.S.

Chapter 2

The Horizontal Boundaries of the Firm: Economies of Scale and Scope

Chapter Contents
1) Introduction
2) Where do Economies of Scale Come From? • Definition of Economies of Scale • Definition of Economies of Scope
3) Where do Scale Economies Come From? • Indivisibilities and the Spreading of Fixed Costs • Spreading Product-Specific Fixed Costs • Tradeoffs Among Alternative Technologies • Indivisibilities Are More Likely When Production Is Capital Intensive • “The Division of Labor is Limited by the Extent of the Market” Example 2.1: Hub-And-Spoke Networks and Economies of Scope in the Airline Industry Example 2.2: The Division of Labor in Medical Markets • Inventories • The Cube-Square Rule and Physical Properties of Production
4) Special Sources of Economies of Scale and Scope • Economies of Scale and Scope in Purchasing • Economies of Scale and Scope in Advertising • Economies of Scale in Research and Development Example 2.3: The Ace Hardware Corporation Example 2.4: The Fall and Rise of Pharmacia and Upjohn • Complimentarities and Strategic Fit
5) Sources of Diseconomies of Scale • Labor Costs and Firm Size • Incentive and Bureaucracy Effects • Spreading Resources Too Thin • "Conflicting Out" Example 2.5: The AOL Time Warner Merger and Economies of Scope
6) The Learning Curve
The Concept of the Learning Curve • Expanding Output to Obtain a Cost Advantage Example 2.6: The Boston Consulting Group Growth/Share Paradigm • Learning and Organization • The Learning Curve versus Economies of Scale
7) Chapter Summary
8) Questions
Chapter Summary

This chapter intends to help the student understand how to more fully answer the following questions in strategy: How do we define our firm? What activities do we do; what are our firm’s boundaries? While the vertical boundaries of the firm (discussed in Chapter 3) illustrate which activities the firm would perform itself and which it would leave to the market, the horizontal boundaries of the firm refer to the size (how much of the total product market will the firm serve) and scope (what variety of products and services does the firm produce). This chapter argues that the horizontal boundaries of the firm depend critically on economies of scale and scope.

Economies of scale and scope are present whenever large-scale production, distribution, or retail processes provide a cost advantage over small processes. Economies of scale exist whenever the average cost per unit of output falls as the volume of output increases. Economies of scope exist whenever the total cost of producing two different products or services is lower when a single firm instead of two separate firms produces them. In general, capital intensive production processes are more likely to display economies of scale and scope than are labor or materials intensive processes. By offering cost advantages, economies of scale and scope not only affect the sizes of firms and the structure of markets, they also shape critical business strategy decisions, such as whether independent firms should merge and whether a firm can achieve long-term cost advantages in the market through expansion.

Approaches to Teaching this Chapter
Product-Level Economies of Scale: reductions in unit cost attributable to producing more of a given product in a given plant.
Short-run Economies of Scale: reductions in unit cost attributable to spreading fixed costs for a plant of a given size. These arise because of increased utilization of a plant of a given capacity.

Long-run Economies of Scale: reductions in unit costs attributable to a firm switching from a low fixed/high variable cost plant to a high fixed/low variable cost plant. These arise due to adoption of technologies or larger plants that have higher fixed costs but lower variable costs. The distinction between long and short-run scale is very important---mistaking short-run economies of scale for long-run economies could lead a firm to the false conclusion that its unit costs will continue to fall if it expands capacity once its existing capacity is full.

Product-Level Economies of Scope: reductions in unit cost attributable to a firm’s diversification into several products produced in the same plant. Examples include any process in which there are chemical by-products from the same reaction such as crop rotation and oil refining. Another example is a product that shares a key component or set of components whose production is characterized by economies of scale, such as digital watches and electronic calculators. A final example is a firm that utilizes off peak capacity such as ski resorts, garden stores, and sporting goods stores.

Plant-Level Economies of Scope: reductions in unit cost attributable to a firm’s diversification into several products produced in different plants. Examples include airline hub-and-spoke systems.

Purchasing Economies: reductions in unit cost attributable to volume discounts. Large volume buyers may be able to achieve quantity discounts that are not available to smaller-volume buyers. Examples include hospital and hardware store purchasing groups.

R&D Economies: reductions in unit cost due to spreading R&D expenses. For example, R&D labs require a minimum number of scientists and researchers whose labor is indivisible. As the output of the lab expands, R&D costs per unit may fall.

Marketing Economies: 1) economies of scale due to spreading advertising expenditures over larger markets and 2) economies of scope due to building a reputation of one product in the product line benefiting other products as well. For example, Budweiser’s cost per effective message is lower than Anchor Steam’s since Bud is widely available and its ads would thus have a higher impact. Also think of Coke/Diet Coke economies.
Horizontal Boundaries: related to the variety of related products or services the firm sells.
Fixed Costs: costs that do not vary with output.
Indivisibility: some inputs cannot be scaled down below a certain minimum size, even as output shrinks to zero. Examples include railroad and airline service.
Learning Curve: reductions in unit costs that result from the accumulation of know-how and experience.
Progress Ratio: the slope of the learning curve; the percentage by which AC declines as the firm doubles cumulative output.
Core Competency: the collective know-how within an organization about how to work with particular technologies or particular types of product functionality (e.g. 3M in coatings and adhesives and Canon in precision mechanics, fine optics, and microelectronics).

Horizontal Boundaries

Horizontal boundaries are those that define how much of the total product market the firm serves (size) and what variety of related products the firm offers (scope). The basic question is: “What strategic advantages are conferred on a firm by being large or by having a broad scope of products?” Size/scope can represent an advantage for three reasons. The first two reasons below will be discussed later in the text. Reason #3 below is the focus of Chapter 2. • Size = Market Power. Larger/diversified firms may be able to exercise monopoly power or set the terms of competition for other firms in the industry. • Size = Entry Barriers. Once a firm owns a large position in the market, it may be very difficult to dislodge it. That is, potential entrants and existing firms may be deterred from attacking this firm’s core business. A good example of this is brand proliferation in breakfast cereals. • Size = Lower Unit Costs. A large firm may be able to produce at a lower cost per unit than a small firm may.

Learning Curve
Make certain students can distinguish the difference between economies of scale and the learning curve which speaks to cumulative output, not levels of output. For example, Lockheed pursued a learning curve strategy in building its L10-11 class of aircraft. The firm anticipated that it would lose money by producing a lot of aircraft, gain experience, and finally achieve cost competitiveness in the industry. The firm initially priced below its average cost and eventually cost fell to below price. Lockheed was hard hit then with a “cheap to produce” aircraft when oil prices rose dramatically. This particular firm lost this gamble because it banked on demand remaining high; the OPEC oil embargo changed the environment significantly enough so that they couldn’t benefit from their cost advantage.

There are certainly limits to how big a firm can be and still produce efficiently. For example, labor costs increase as firms get bigger (unionization, employees are less satisfied with their jobs, commuting time increases as the firm gets bigger because it draws from further away). Smaller firms sometimes have an easier time motivating employees; moreover, rewards are much more closely linked to profits. The trick is for the big firm to create the right motivations for workers. Finally the source of your advantage may not be “spreadable.” That is, a patent is not spreadable nor are personal services such as in restaurants.

Economies of Scale/Scope Determine Market Structure
By studying the history of an industry and examining the characteristics of successful firms, managers can assess the importance of size and other firm characteristics.

Ask students to prepare thoughts on the following questions before the lecture: • Consider the industry you worked in before coming to school. What role, if any, did economies of scale or scope play in determining the number and size of firms in this industry? Did economies of scale or scope affect the ease with which new firms could enter the industry?

• Prahalad and Hamel talk about “core competencies” by which they mean special skills firms have in working with particular technologies. They argue that in making diversification decisions, firms should exploit their core competencies. Explain what this means using the concept of economies of scope. Can you think of an example of where the firm you worked for leveraged its core competencies?

• Examples 2.1 and 2.4 discuss the hub-and-spoke system and make the point that it leads to economies of scope and has had an important effect on the structure of the U.S. airline industry. Yet, the most profitable firm in the industry (Southwest) does not have such a system. Explain how an industry could have a production technology characterized by economies of scale or scope, yet a small firm could be more profitable in the long run.

Suggested Harvard Case Study[2]
De Beers Consolidated Mines, HBS 9-391-076. Describes the problems facing De Beers at the start of 1983. De Beers had, since its formation in 1888, exercised a large measure of control over the world supply of diamonds. In 1983, the company itself mined over 40% of the world’s natural diamonds and, through marketing arrangements with other producers, distributed over 70%. For 50 years up to 1983 the company never lowered its prices and, overall, had raised them significantly ahead of the rate of inflation. However, in 1983 the company was faced with a series of problems that threatened the structure it had so carefully built. First a large producing nation had stopped selling through De Beers. Second, new discoveries meant that the annual supply of mined diamonds would double by 1986. Finally, the industry was experiencing its worst slump since the 1930’s, resulting in a significant deterioration in the company’s financial position. Describes the structure and economics of the diamond industry and asks the student to decide whether or not De Beers should abandon the business strategy it had pursued for nearly a century. This case can be taught with some combination of the following chapters: 2, 7, 9, 10 and 13. You may want to ask students to think of the following questions in preparation for the case:

a) What are the characteristics of rough diamonds that create challenges in sustaining a monopoly of this trade?
b) Why does De Beers require different countries to pay different commission to participate in the syndicate?
c) Why might diamond producers agree to participate in the syndicate as opposed to selling their output on their on?
d) What forces prompt diamond producers to exit the syndicate?

House of Tata, HBS 9-792-065 (see earlier chapters)

Hudepohl Brewing Company HBS 9-381-092. Hudepohl is a private company. Presents the problem of how an established regional brewer can survive the onslaught of national breweries, some of which are being cross-subsidized by diversified parent companies. Requires detailed analysis of what operations are profitable and unprofitable for Hudepohl, in addition to industry and competitive analysis. This chapter can be taught with some combination of the following chapters: 2, 5, 11, and 12. You may want to ask students to think of the following questions in preparation for the case:

a) How well is H doing? Is Bob Pohl’s optimism about H’s future justified?
b) How have the fundamental economics of the beer business changed over the 20-30 years prior to the time of the case? Have these changes helped or hurt H?
c) What are the markets that H competes in? Which are H’s strongest markets? Which are its most profitable markets?
d) How efficient are H’s manufacturing and distribution facilities in comparison with other beer companies? Which activities need to be changed or dropped?
e) What are H’s strengths? What resources or assets does H have that its competitors do not have? Does Pohl’s strategy exploit H’s resources, capabilities, and competitive advantages?
f) What alternative strategies might Pohl adapt? More generally, how would you recommend that H position itself in the beer market, given H’s resources and assets and given the strategies of its rivals in the beer industry?
g) Profit Analysis by Segment: Calculate or estimate H’s production costs and profit margins for each of its four “product lines” shown in Table B: (1) draft beer sold to independent distributors, (2) draft beer distributed by H, (3) packaged beer sold to independent distributors, (4) packaged beer distributed by H.
h) Value Added: Using the above profit calculations, calculate the value added at each stage of H’s vertical chain. Can you explain the differences in the profitability across these product lines?
i) Segment Analysis: To the extent possible, calculate H’s market share in each of its market segments. (What are the criteria you are using to distinguish H’s different market segments?)

Sime Darby Berhad—1995, HBS 9-797-017. Sime Darby is one of South Asia’s largest regional conglomerates. At the time of the case, 1995, it is contemplating entry into the fast growing financial services sector in Malaysia through acquisition of a Malaysian bank. This is in keeping with its activities mirroring those of the Malaysian economy. Presents a discussion of whether to proceed with the acquisition. Gets at the underlying sources of value creation of the conglomerate in the institutional context, which affect the costs and benefits of broad corporate scope, especially the evolving capital market and the tight interrelationship between business and politics. This chapter can be taught with some combination of the following chapters: 2, 3, 4, 10 and 16. You may want to ask students to think of the following questions in preparation for the case:

a) What are the sources of competitive advantage for a firm that is affiliated with Sime Darby?
b) Evaluate the quote in the beginning of the case: “You need to carry a fair amount of weight to make an impression in Asian markets”.
c) Why is opportunistic behavior a concern? Does reputation matter more in Malaysia than in the U.S. (or in other advanced economies)? How does Sime Darby address these concerns?
d) What are some of the institutional voids filled by Sime Darby through acting as an intermediary in the financial markets? To what extent is being diversified important for filling these institutional voids?
e) Should Sime Darby have a common brand name used in all its companies?
f) Why might a talented individual prefer to work at Sime Darby rather that at an undiversified company?
g) Is Sime Darby’s relationship with the government anything but an asset?
h) How is Sime Darby doing relative to other Malaysian companies?
i) Should Sime Darby acquire UMBC?

Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Boston Consulting Group. Perspectives on Experience. Boston: Boston Consulting Group, 1970.

Chandler, A.. Scale and Scope: The Dynamics of Industrial Capitalism. Cambridge, MA: Belknap, 1990.

Stigler, George J. The Organization of Industry. Homewood, IL: Richard D. Irwin, 1968.

Answers to End of Chapter Questions

1. A firm produces two products, X and Y. The production technology displays the following costs, where C(i,j) represents the cost of producing i units of X and j units of Y:

C(0,50) = 100 C(5,0) = 150

C(0,100) = 210 C(10,0) = 320
C(5,50) = 240 C(10,100) = 500
Does this production technology display economies of scale? Of scope?
This technology does not display economies of scale. The cost per unit of making 50 units of Y is $2, and the cost of making 100 units of Y is $2.10. Since the cost per unit does not decrease as the quantity of Y increases, this technology does not display economies of scale in the production of Y. The result is analogous in looking at the costs of making X, as well as looking at the costs of making X and Y together in greater quantities.
This technology does display economies of scope in the production of X and Y. The cost of making 5 units of X is $150 and the cost of making 50 units of Y is $100. Made separately, the total cost of making 5 units of X and 50 units of Y is $250. The cost of making 5 units of X and 50 units of Y together is $240.
2. Economies of scale are usually associated with the spreading of fixed costs, such as when a manufacturer builds a factory. But the spreading of fixed costs is also important for economies of scale associated with marketing, R&D, and purchasing. Explain.
Fixed costs are those costs that do not vary directly with output. Fixed costs must be expended in order to initiate production, but also for activities such as selling the output or developing improvements to the output. As the firms scale of operation increases in terms of volume of output and number of products produced, functions related to marketing, R&D and purchasing are spread over more units—hence reducing the cost of each of these activities per unit sold. For example, once a firm invests in developing a new product, those R&D costs are fixed regardless of the scale of that product.
3. What is the difference between economies of scale and learning economies?
Economies of scale are said to exist if average costs decrease as output increases. Learning economies, a source of economies of scale, refer to a reduction in average costs due the accumulation of experience and know-how.
5. A firm contemplating entering the market would need to invest $100 million in a production plant (or about $10 million annually on an amortized basis). Such a plant could produce about 100 million pounds of cereal per year. U.S. breakfast cereal makers sell about 3 billion pounds of cereal. What would be the average fixed costs if the cereal maker captured a 2 percent market share? What would be the disadvantage if it achieved only a 1 percent share?
The averaged fixed cost is $10million/100 million pounds or $0.10.
2 percent market share would be .02* 3 billion pounds or 60 million pounds. The average fixed cost would be $10 million/60 million pounds or $0.167. If the firm captured only 1 percent share, average fixed cost would be $10 million/30 million pounds or $0.333, so the firm would be disadvantaged by $.23 per pound relative to a plant that ran at capacity.
6. Historically, product markets were dominated by large firms and service markets by small firms. This seems to have reversed itself somewhat in recent years. What factors might be at work?
Product markets have traditionally been capital intensive businesses, with a large portion of total costs tied up in fixed and semi-fixed costs. Applying the cube-square rule to product markets, we know that the physical properties of production traditionally allowed firms to expand capacity without comparable increases in cost. Increased utilization of production facilities allowed firms to spread fixed costs over additional units and lower average costs. Further, the divisibility of labor allowed for task specialization and energy costs tended to decline as capacity increased. Firms doing higher volume business usually need to carry proportionately less stock in inventory and therefore reduced average cost. Other factors contributing to economies of scale in product markets include umbrella branding and advertising. Consequently, these significant economies of scale allowed larger firms to dominate.
Over time, shifting environmental factors have altered the environment of product markets. The observation that firms in product markets are shrinking indicates the aforementioned economies of scale may no longer be the most pervasive contributor to firm success. Some explanations would include the development of cost saving technologies such as computers and communications developments that reduce coordination costs. Large firms’ advantage with respect to inventory may have diminished due to the development of stronger vendor/customer relationships via JIT arrangements or joint ventures, as well as advanced production planning techniques/software. Further, consumer elasticities may have relaxed such that brand loyalty has declined for certain products. As traditional economies of scale diminish in importance the barrier to entry is lowered and new entrants of smaller size, more equipped to adapt to change, may enter the market.
The shift from small to larger firm dominance in service markets is primarily due the reliance of these firms on labor as the principal factor of production. Traditional theory posits that labor does not exhibit properties of indivisibility. As such, smaller firms were unable to dedicate employees to clients within a specific industry, or with similar needs. Doing so allows employees to scale the learning curve more rapidly and improves productive efficiency. Larger firms are more capable of supporting such focused activities, allowing them to spread overhead costs over increased volume. Further, service firms rely heavily on reputation to attract new business. Therefore, economies of scale may be achieved due to reputation and branding effects.

7. Explain why the advent of ATMs has contributed to bank consolidation. Note: an important fact about ATMs is that it is costly for someone with an account at bank A to use an ATM that is owned by bank B.

Banks provide convenient ATMs to their customers who open an account and regularly pay for the bank’s services. To offer these convenient ATMs, a bank must purchase the machines and the infrastructure necessary to integrate all of them. From the bank’s standpoint, both the ATMs and the overall infrastructure represent large indivisible fixed costs. On the other hand, each time a customer uses one of the bank’s ATMs, the bank incurs only a nominal variable cost for each transaction. Likewise, the cost of serving bank customers through a network of ATMs is less expensive then building more branches of the bank. As the bank serves more paying customers with its existing ATMs, the bank’s average cost declines because the fixed cost of the ATMs and infrastructure are spread across more customer transactions.
However, the prime locations where a bank can install an ATM are limited. By establishing a greater presence of ATMs in these prime locations, the bank can secure a slight competitive advantage over its competitors by improving the benefits (lowering transaction costs) to its customers. The strength of a bank’s competitive advantage is reflected by the premium the bank can extract from non-bank customers who use the bank’s ATM machines. Therefore, when two banks consolidate, they are likely to achieve greater economies of scale and a competitive advantage by attracting more customers through a larger network of ATMs. If two banks agreed to allow reciprocal use of their machines (that is, bank A and bank B allow each other’s customers to use their machines at no charge) the outcome would not be the same as is achieved through a merger. If the two banks were separate, each bank’s investment in a new ATM location would provide a benefit not just to the bank making the investment, but also to the bank which has reciprocal rights to the machine. As a result, two separate banks would invest in fewer ATM locations than would the consolidated bank—therefore, the consolidated bank would attract more customers.
8. In the past few years, several American and European firms opened “hypermarts”, enormous stores that sold groceries, household goods, hardware, and other products under one roof. What are the possible economies of scale that might be enjoyed by hypermarts? What are the potential diseconomies of scale?
“Hypermarts” could conceivably achieve several economies of scale by offering a wide array of consumer products in one store. First, if the firm has already purchased expensive real estate and could build a slightly larger building, it can enjoy economies of scale by effectively spreading these high fixed costs across a wider array of products. Second, a firm that already has a strong reputation with consumers could enjoy marketing economies of scale using their existing branding umbrella. Third, the firm could achieve greater economies of scale by using its current distribution systems to deliver more products to fewer large stores. Finally, a “hypermart” may realize purchasing economies because it turns over products quickly, buys in bulk, and becomes a desirable channel in the eyes of product manufacturers.
Despite these potential benefits, there are some limits to economies of scale. For instance, a “hypermart” could spread specialized labor such as talented store managers so thinly that they have a difficult time managing and monitoring the entire store. Because the store has lost its niche focus, both the store’s old and new services may be adversely impacted. Additionally, the firm may damage its reputation with core consumers by expanding its products well beyond the range for which it is known.
9. Suppose you wanted to quantify a firm’s learning experience. One possible measure is the firm’s lifetime cumulative output. What are the advantages and disadvantages of this measure? Can you offer a superior alternative measure?
The magnitude of learning benefits is often expressed in terms of a slope. The slope for a given production process is calculated by examining how far average costs decline as cumulative production output doubles. It is important to use cumulative output rather than output during a given time period to distinguish between learning effects and other scale effects.
10. During the 1980s, firms in the Silicon Valley of Northern California experienced high rates of turnover as top employees moved from one firm to another. What effect do you think this turnover had on learning-by-doing at individual firms? What effect do you think it had on learning by the industry as a whole?
Employees may be viewed as assets of the firm. However, unlike other firm assets (e.g. capital equipment, buildings, etc.) human assets walk out the door on a daily basis and may take with them the knowledge that they acquired while at the firm. Both employer and employee are exposed to risks within their relationship. While firms must invest both time and dollars to provide employees with formal and experiential training in order to maximize productive efficiency, firms are exposed to the risk of their assets going elsewhere. Conversely, employees must invest time in learning firm-specific skills and forgo alternate employment opportunities to remain at the firm.
As turnover increases, firms are less inclined to invest in extensive training, as they cannot retain the benefit of learning over time. This is compounded by the adverse consequences of sharing valuable information with employees that can be passed on to competitors. Productive efficiency is further hampered as there are fewer experienced employees available to provide on-the-job training for new employees. Additionally, firms have little incentive to incur the substantial cost of training more individuals. Finally, high turnover can serve as an indicator to employees that the firm is a short-term career option. Consequently, employees may be less inclined to make a relationship-specific investment in developing skills applicable to the firm, and the industry as a whole. Overall, internal learning is reduced.
Conversely, high turnover contributes greatly to learning by the industry as a whole as it allows industry participants to free-ride off the skills and knowledge workers acquired at a given firm since employees take their expertise with them. Industry learning is enhanced further if the knowledge and skills acquired are transferable rather than firm specific. Additionally, as employees move between firms, their network of professionals with whom to share ideas expands, therefore promoting the flow of information between firms.

Chapter 3

The Vertical Boundaries of the Firm

Chapter Contents
1) Introduction
2) Make Versus Buy • Upstream, Downstream Example 3.1: Vertical Disintegration in the Pharmaceutical Industry • Defining Boundaries • Some Make-or-Buy Fallacies
3) Reasons to "Buy" • Tangible Benefits of Using the Market: Exploiting Scale and Learning Economies Example 3.2: Self-Insurance by British Petroleum • Intangible Benefits of Using the Market: Agency and Influence Effects • The Economic Foundations of Contracts • Complete versus Incomplete Contracting • The Role of Contract Law • Coordination of Production Flows Through the Vertical Chain Example 3.3: Make Versus Buy: Pepsi-Cola and Its Bottlers • Leakage of Private Information Example 3.4: An Application of the Make-or-Buy Framework to Children’s Memorial Hospital • Transaction Costs • Relationship-Specific Assets Example 3.5: The Fundamental Transformation in the U.S. Automobile Industry • Rents and Quasi-Rents Example 3.6: Floating Power Plants • The Holdup Problem Example 3.7: Hostile Takeovers and Relationship-Specific Investments at Trans Union • The Holdup Problem and Transactions Costs Example 3.8: Underinvestment in Relationship-Specific Assets by British Subcontractors • Recap: From Relationship-Specific Assets to Transaction Costs
4) Summarizing Make-or-Buy Decisions: The Make-or-Buy Decision Tree
5) Chapter Summary
6) Questions

Chapter Summary

The production of any good or service usually requires a wide range of activities organized in a vertical chain. Production activities are said to flow from upstream suppliers of raw inputs to downstream manufacturers, distributors and retailers. Activities in the chain include processing and handling activities, which are associated directly with the processing and distribution of inputs and outputs, and professional support activities, such as accounting and planning. This chapter intends to help the student understand how to answer some fundamental questions in strategy, namely: How do we define our firm? What activities do we do? What do we leave to the market? This is known as the “make-or-buy” problem.
The chapter presents several make-or-buy fallacies: • Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for that firm. This argument fails if it is more efficient for a firm to obtain an asset from the market than to produce it internally, the firm should do the former (furthermore, the firm should reevaluate its beliefs about its true source of advantage). • A firm should buy to avoid incurring associated costs. This argument ignores the fact that the firm it buys from will have to incur these costs and will charge accordingly. • A firm should make in order to keep associated profits. This argument ignores the fact that these profits usually represent the return necessary to attract investments and would be required of the firm that makes, just as they are required of independent firms. • Vertically integrated firms can produce an input at cost and, thus, have an advantage over nonintegrated firms who must buy inputs at market prices, especially at times of peak demand or scarce supply. This argument ignores hidden opportunity costs to the vertically integrated firm. By having the input to produce its final output, it forgoes outside sales in the open market. The chapter contains a numerical example to illustrate the point. • Firms should make to tie up a distribution channel. They will gain market share at the expense of rivals. While it is possible this argument could stand up to scrutiny in some cases, the costs of using integration to foreclose competition are often prohibited. Furthermore, since the costs can be difficult to determine ex ante, proceeding hastily with a plan of foreclosure makes little sense.
The solution to the make-or-buy decision depends on which decision leads to the most efficient production. This is determined by assessing the benefits and costs of using the market.

Benefits of Using the Market (Reasons to Buy)

• Tangible benefits: Market firms are often able to achieve economies of scale and learning economies in production of an input that are unattainable to firms that choose to make the input themselves. Market firms have other advantages: while a division within a hierarchical firm may hide its inefficiencies behind complex monitoring and reward systems, independent firms must survive the discipline of market competition. This encourages productive efficiency and innovation. • Intangible benefits: Vertically integrated firms can try to replicate market incentives but may encounter problems associated with motivation (agency costs) and internal lobbying for resources (influence costs).

Costs of Using the Market (Economic Foundations of Contracts)

The costs of using the market stem from the unlikelihood of writing a complete contract. The chapter contains a discussion of the role of contracts and contract law in market exchange and introduces the important concept of incomplete contracts. Contracts are needed because all but the simplest of transactions will expose each party to the risk of opportunistic behavior by their trading partner. A complete contract -- one that provides a complete and thorough specification of the responsibilities and rights of each party in the relationship -- would completely protect the parties from opportunistic behavior. However, the requirements of complete contracting are extremely rigorous; therefore, most real-world contracts are incomplete to some degree. An incomplete contract involves some ambiguity or open-endedness about the rights and responsibilities of each party in the relationship. A contract may be incomplete for several reasons: bounded rationality, difficulties in specifying or measuring performance, and asymmetric information. Incomplete contracts result in potential market failures: • Using the market often presents coordination problems. This is especially problematic for inputs with design attributes that require a careful fit between different components. The chapter details 5 examples of “misfit” that might result from using the market, relative to the outcome of coordinating internally: timing, size, color, sequence, R&D. • Using the market might result in leakage of private information. When separate firms contract with each other to engage in exchange, they learn about each other’s sales, growth plans, etc. • Using the market generates transactions costs. This chapter develops the concept of transaction costs in great detail and discusses how they work to determine the vertical boundaries of the firm. The main emphasis in this section of the chapter is the cost of arm’s length market transactions.
The following section develops three important concepts that are needed to understand why market exchange can entail transaction costs: relationship-specific assets, quasi-rents, and the holdup problem. Relationship-specific assets are physical, site-related, or human assets that are intended specifically for use with a given trading partner. These assets, because of their specificity, have lower value in alternative uses. Once investments have been made in relationship-specific assets, the difference between actual revenue and the next best alternative revenue creates quasi-rents.
The situation when one party extracts quasi-rents from the other is called the holdup problem. Quasi-rents can be extracted by renegotiating the contract or by taking advantage of incomplete aspects of the contract. The hold up problem raises the costs of exchange in several ways; it may: 1) increase the amount of time and money spent in negotiations, 2) lead to distrust, 3) encourage “overinvestment” by inducing the parties to safeguard their positions through investing in standby facilities or other suppliers, and 4) lead to one party threatening to refrain from making relationship-specific investments, thereby lowering productivity.
The above suggests why vertical integration might be a good alternative to market contracting when the exchange involves incomplete contracting and relationship-specific assets. There are three reasons why vertical integration may be a good alternative: vertical integration may 1) result in governance arrangements that provide more powerful dispute resolution and greater flexibility in adapting to changing circumstances, 2) introduce a “repeated relationship” that reduces uncertainty and makes relationship-specific investment more profitable, and 3) allow organizational culture to promote an atmosphere of cooperation.
Approaches to Teaching this Chapter

In the past, the material in chapter 3 and 4 (a good combination) has constituted two- three hours of lecture material.

Accounting profit: the simple difference between revenues and expenses.

Arms-length transactions: one in which autonomous parties, each acting in their own self-interest, exchange goods and services.
Contract: an agreement that defines the conditions of an exchange.
Dedicated assets: those made for one specific transaction.
Economic profit: the difference between the profits earned by investing resources in a particular activity and the profits that could have been earned by investing the same resources into the most lucrative alternative activity (opportunity costs).
Fundamental transformation: the change in the nature of a relationship from a “large number bidding” situation to a “small numbers bargaining” situation between parties which make relationship-specific investments.
Handling activities: all associated transportation and warehousing activities.
Holdup Problem: opportunistic behavior by one party to exploit the other’s vulnerability due to RSIs.
Human asset specificity: human assets who have developed specific expertise or know-how, relevant to a particular transaction.
Incomplete contract: a contract involving some ambiguity or open-endedness about what each party to the contract is required to do and what rights each has in the relationship.
Minimum efficient scale: smallest output at which average cost is minimized.
Physical asset specificity: assets whose physical or engineering properties are specifically tailored to a particular transaction.
Processing activities: raw materials acquisition, goods processing, and assembly.
Quasi-Rents: the difference between the revenue the seller actually receives and what it must receive to be induced not to exit the relationship (ex post). QRs occur when contract negotiations directly benefit one party at the expense of the other or when one party can take actions that the other cannot stop because of incomplete contracts and/or being locked into a relationship.
Relationship-specific investment: one made to support a specific transaction. RSI cannot be redeployed to another transaction without some loss of productivity of the asset or by incurring additional cost.
Rent: the difference between the revenue the seller actually receives and the minimum amount of revenue the seller must receive to make it worthwhile to enter the relationship (ex ante). Rent is equivalent to economic profit.
Site specificity: assets located side-by-side.

Support activities: accounting, finance, human resources management, strategic planning (activities that support each step along the chain).
Transaction Costs: costs of organizing and transacting exchanges.

Transfer Price: an internal price between divisions of a vertically integrated firm. When there is a highly competitive market outside for the internally produced activity or input, the transfer price should be equal to this outside market price.

Vertical Boundaries: activities that define what the firm performs itself as opposed to purchasing from the market. Early steps in the vertical chain are upstream in the production process; later steps are downstream.

Value Chain: the identification of steps in the vertical chain where the most value is added. This process takes the vertical chain and puts dollar values to it.

Vertical Chain: the process that begins with the acquisition of raw materials and ends with the distribution and sale of finished goods.

As students know from Chapter 1, the firm's boundaries are fluid. Hierarchical firms were dominant for a while; today a wide variety of firms exist within industries. How do firms decide which activities to perform and which to leave to the market? There are two dimensions to a firm's boundaries: horizontal and vertical. Discuss the differences in these two definitions.

The following outline provides information useful for lecturing about this material:

The Value Chain
Michael Porter introduced the concept of the value chain in 1985. His scheme takes the vertical chain and puts dollar values to it. This helps to identify those steps in the vertical chain where the most value is added. The value chain is critical to the concept of positioning (how the firm chooses to create value/differentiate itself for customers) which will be discussed later. The value chain is a tool that portrays the firm as being made up of a set of value-creating activities. The value of a good as it moves through the value chain is equal to the price it can be sold for in the market. When the chain consists of independent firms, these prices are easily identified. When the chain consists of consecutive steps done within the same firm, these prices may or may not be identified. These are called transfer prices--a price that tries to measure what a fair market price would be for a good passed through an internal market. These prices are often based on comparisons with similar goods sold in the outside market.

Porter's chain has five primary activities: 1) purchasing/inventory handling, 2) production, 3) distribution, 4) sales/marketing, and 5) customer service and three support activities: 1) human resources management, 2) research and development/design, and 3) corporate infrastructure. Whether you or your students wish to use Porter's classification or not, the value chain is a useful way of systematically thinking about the various ways in which the firm creates value.

The value chain concept here previews a major theme of the book: value added depends on consumer value, cost/efficiency, and the ability of the firm to extract some of the difference between the two.

Most Common Make-or-buy Fallacies

1. Buy to avoid the costs of making.
This argument ignores the fact that the firm it buys from will have to incur these costs and will charge accordingly. That is, whoever manufactures the product bears the risk of fluctuating volumes; if it's costly for you, then it is probably costly for others as well. Moreover, an outside firm may be able to have a greater number of suppliers for its product or it may simply be more efficient than your firm.
Example: Intel licenses production to outside firms. Does this avoid cost? Only if the outside firms offer some advantage. In this case, the outside firms can better handle capacity due to scope economies.

2. Make to avoid paying profits to others.
It is useful to consider where profits are coming from: 1) Profit may be the normal risk adjusted return to the "maker." That is, profits may represent the return necessary to attract investments and would be required of the firm that makes internally just as they are required of independent firms; or 2) Profit may come from monopoly power. If a supplier charges $300,000 for a product that costs $200,000 to produce, why doesn't someone else enter the market? Without an answer to this question, you can't be so sure of the savings of making yourself.

3. Assure supply and avoid fluctuating prices during peak demand or short supply.
If you start to manufacture, you actually start to play the role of commodity speculator.

Reasons to Buy
1. A market specialist sells to many buyers and can better take advantage of economies of scale and scope than an in-house department could if it produced only for its own needs. If there are economies of scale then, the make-or-buy decision can be resolved by determining whether the firm or its independent suppliers are better able to achieve them. Economies of scale are present whenever costs fall as volume increases (this is discussed in the Primer). These economies are usually associated with fixed investments.

• If Q > Minimum Efficient Scale (MES), then make. This situation can be seen in Campbell's decision to backward integrate into soup can production.

• If Q < MES, then buy. Costs can be decreased if there is additional production. Who is more likely to take on added production, the firm or its partner? We generally observe that it is easier and more likely for the independent partner to grow.

The importance of economies of scale in defining the boundaries of the firm also extend to individual activities (The division of labor is limited ...). Adam Smith wrote about a pin factory in which some workers only made straight parts, some made the crowns, and some put them together. This process made sense because 1) Economies of Scale--routinization of two factors improved the productivity of the specialists, and 2) Large Demand--there was enough demand for pins that each worker could be kept busy doing just one task. Smith described this division of labor as natural in any market as volume increases enough to justify specialists. Ask students where this plays in today's business environment. Some examples include specialists in software problems, restaurants in Chicago (as discussed in the text), specialized law firms (personal injury, divorce, corporate, etc.), and specialists in medicine.

2. Efficiency and Incentives. Independent firms may have more incentive to innovate than a division within a firm because departments can never be sure if they are making /losing money. That is, the owner of an independent firm faces stern discipline from the market and keeps every dollar he makes. Conversely, it is harder to match pay to performance for individual managers of internal divisions. Efficiency and incentive concerns include:

• Transfer pricing--it is hard to determine the appropriate prices to charge internal divisions. For example, how should we charge for IT in each division? • Equity concerns--see Houston/Tenneco example • Influence costs--lobbying for resources may lead to biased information and destructive competition within the firm; internal divisions may lobby each other, raising the cost of production. Using independent firms allows you to keep these issues distinct.

3. Culture. Consolidation of independent firms can also create legendary culture clashes. • Houston Oil and Minerals/Tenneco example of pay equity • Examples include IBM and Rolm, Sony and Columbia/Tri-Star, Bank of America and Continental Bank.

In summary, the market is a powerful force for technical efficiency and independence/autonomy is a powerful motivator. These forces must be weighed against those that favor integration (outlined below).

Reasons to Make
1. Coordination Costs. The steps in the vertical chain must fit together. Fit can be along any number of dimensions: • Time: movies should be released to theaters at same time as advertising • Size: O rings on space shuttle, stamped parts for automobiles • Color: Bennetton's spring line-up • Sequence: Curriculum within a university

Fit can be attained through either doing tasks in-house or through contract. Contracts often stipulate bonuses for performance exceeding expectations or penalties for failing to meet specified criteria. • Highway construction on Chicago's Dan Ryan Expressway: bonuses were given to construction firms to finish the job early • Silicon chip production: tolerance penalties assessed

Contracts do not always obtain perfect fit. The limitations of contracts are especially problematic when there are "design attributes" involved in a product. Design attributes are those for which failure to obtain a precise fit is very costly. Ask students for examples: fashion (Bennetton color match), computer software (operating system code), etc.

It is not obvious that you want contracts to be perfect: 1) Tighter contracts may be more costly to write and enforce. 2) Stiff penalties for poor performance can create risks for contractors and certainly can drive up the cost of the contract. Moreover, you may not be able to accurately compute the costs and benefits associated with making or buying and may therefore not accurately negotiate with the independent firm.

1a. Numerical Example on Coordination Costs
A buyer needs a perishable item delivered exactly on time. Any time lost will dramatically escalate the buyer's costs (or reduce its benefits). The supplier's costs decrease the slower it is delivered (faster delivery is more costly). Total Cost to Marginal Cost Total Marginal Cost Buyer of Delay to Buyer of 1 Production Savings to more Day of Cost of Seller of 1 more Delay Seller Day of Delay

3 days early $0 $0 $1,000 $73
2 days early $0 $0 $927 $72
1 day early $0 $0 $855 $71
On-Time $0 $70 $784 $70
1 day late $70 $1,130 $714 $69
2 days late $1,200 $1,800 $645 $68
3 days late $3,000 $7,000 $577 $67
4 days late $10,000 $510

• When item is delivered on time, MC to buyer of delay = MC savings to seller of delay • A contractual solution can work in this example if a penalty on the seller of slightly more than $70 per extra hour of delay will deter the producer from delaying delivery beyond the due date. • But small mistakes in pricing have significant consequences. Suppose the buyer and seller strike a contract with "mistakenly" stipulates a penalty of $67.50 per day. Under this penalty, the seller saves more in production costs than it pays in penalties if it delivers the item 3 days late (cost savings of $784-577=207 versus penalty of 3*$67.50=$202.50). The seller wouldn't deliver four days late because the cost savings from 1 more day late ($67) is less than the penalty. • Delivery 3 days late has disastrous consequences for the buyer. • Because on-time delivery is essential, marginal cost of delay to buyer rises rapidly. • Centralized coordination between buyer and seller is needed to ensure on-time delivery. If we imagine the buyer and seller as departments within the same vertically integrated firm, we could imagine this coordination being done by a manager whose job is to ensure on-time performance of time-sensitive components (see the article on Microsoft in Extra Reading).

1b. Example
Each year professors order case packets to be copied and delivered to the university bookstore. When packets are delivered late, this is an example of "hold-up" because there is nothing the professors can do when packets are late. What would professors do to remedy this problem? (Professors could write contracts with the vendors that included a penalty for each day late. Professors could also move the copying in-house to have more control over the process.) What are the costs of doing this? (Students come unprepared to class, etc.) This example will remind students of the example used in Chapter 3.

2. Leakage of private information. This cost may seem obvious to students, but it is certainly worth discussing. Dealing with independent market specialists may require divulging proprietary product information. You may be able to constrain the use of certain information gained in a deal through contracting or patent protection, but such protection is not ironclad. • Examples: "Relying on outside suppliers is not a game for the naive player. It demands careful study. If you bungle a relationship with the Japanese, you can lose your technology, your business." Roger Levin, VP of Technology and Development, Xerox • There was also an issue with Intel's loss of patent protection from foundry licenses. You may wish to poll the class for other examples.

3. Transactions costs. A common theme in discussing costs of using the market is the inadequacy of contracts and other legal protections in securing the desired-relationship between partners. Transactions costs generally refer to the cost of organizing and transacting exchanges between arms-length partners in the market. An important element of transactions costs is the cost of negotiating, writing, and enforcing contracts. These costs, in turn, depend on the possibility of costs resulting from the hold-up problem (and relationship-specific assets).

Alternatives to Make-or-buy
It may be useful to ask students what they would consider alternatives to either making or buying. One such alternative is long-term contracting. This option eliminates some flexibility that is especially important in declining economies (where you may not know if the firm will be around in the long-term). Such flexibility is not as critical in growing economies where all the players are expected to continue to do well (Japanese Keiretsu).


Contracting and Transactions Costs

The limitations of relationships guided by contract are mostly critically exposed in the third cost of relying on the market (as presented in Chapter 3) -- transaction costs. Transaction costs generally refer to the cost of organizing and transacting exchanges between arms-length partners in the market. An important element of transaction costs is the cost of negotiating, writing, and enforcing contracts. These costs, in turn, depend on the possibility of costs resulting from the holdup problem. To understand the holdup problem, it is necessary to describe incomplete contracts, relationship-specific assets, rents and quasi-rents.

Incomplete Contracts

Contracts cannot entirely eliminate opportunism; they cannot always be complete for the following reasons:
• Bounded rationality-there are limits to our capacity to process information, deal with complexity, and rationally pursue our objectives. Contracts, therefore, often include such terms as “acceptable to publisher” rather than spelling out exactly what is acceptable. Ask the students whether they have any experience with contracts that left out things because they were simply too difficult to work through.

• Difficulty specifying/measuring performance-another reason why many contracts use such terms as “acceptable” is that it may be difficult to specify a set of objective criteria that constitute “acceptable”. Ask the students whether they can identify any examples of contracts where performance is difficult to specify or measure.

• Hidden information-occurs when one party knows more than the other about the conditions under which the transaction will occur. These conditions might determine the optimal contract, but the party with privileged information may choose not to divulge it. Ask the class if they have any examples of contracts that would have been different if both parties had the same information.

• Hidden Action-actions that affect performance but can’t be observed. Ask the class if they have any examples of market relationships that may be distorted by hidden action (e.g. CEO compensation contracts, franchise relationships)

Relationship-Specific Investments
Assets can be relationship-specific for many reasons:
Site specificity-locating grain elevator next to rail lines
Physical asset specificity-dyes, molds made specifically for one use
Human asset specificity-specialized knowledge of ones client’s project

Knowing that a partner has made an RSI, a firm may exploit contractual incompleteness by attempting holdup. This can be illustrated with a numerical example.

Example: Suppose that a leading computer software firm holds the copyright to a statistical software package. It wished to hire an expert statistician to develop a new module that it will then market as an independent add-on to the basic package. It hires Dr. Smith, a statistician at a local university. To motivate Smith to write a powerful and user-friendly program, it offers an upfront fee of $10,000 plus royalties representing 50% of gross sales.

Before agreeing to the contract, Smith computes the expected profits. She estimates that developing the software will take 250 hours. She routinely consults at $300 per hour, so she estimates the cost of her time to be $75,000. Based on sales of a similar module for a competing statistical package, she believes that the software will gross about $160,000. Thus, she expects to receive $80,000 in royalties, plus the upfront fee of $10,000 for a total expected payment of $90,000. Based on these calculations, she believes that the expected revenue exceeds the expected costs by $15,000 and agrees to develop the software.

It turns out that the project requires only 200 hours to complete. Yet, Smith faces a problem when she delivers her finished product: the firm informs her that one of its employees in his spare time has developed a software package almost as good as hers and does not want to her the 50% royalty she was promised. If she does not re-negotiate with them, the firm will market this other program at a lower price and her package will not reap the level of sales she had predicted.

She reluctantly agrees to a 25% royalty on the condition that the firm does not market the other product. Even if her package reaches a sales level of $160,000, she will end up losing $10,000 ($60,000[3](expenses) - $10,000(upfront payment) - $40,000(royalties)).

Smith has been “held-up”. She made an RSI of $60,000 worth of her time when she developed the software that could only be used with this firm’s statistical package. Her work has no independent value. The firm reneged on its initial agreement with Smith by bringing out the alternative package at the last minute.

You can walk students through the numbers: When the contract was first offered, Smith calculated an expected profit of $15,000. This is her rent from the deal. Smith could also have computed that after she sinks $60,000 of time into a project that has no alternative market value and provides only $10,000 in upfront fees, she will look forward to revenues of $80,000. This $80,000 represents her quasi-rent. Because QR>R, Smith is in a position to be heldup.

Ask students to think of examples from their own experiences.

Suggested Harvard Case Study[4]

Nucleon (HBS 4 9-692-041 and Teaching Note # 5-692-095): This case brings to life the concepts from Chapters 3 and 4 by illustrating how one company struggled with the make-or-buy decision. It shows how one company weighed the costs of relying on the market versus vertical integration. It also discusses the difficulties of contracting when there are relationship-specific assets and introduces potential coordination problems. It also illustrates that there is a strong interrelationship between the make-or-buy decision and corporate strategy.

This case relies on decision tree and NPV analysis. If you use this case, it might be useful to review/introduce these techniques. The value of these tools is not that they give the "right" answer, but that they force students to confront the hidden assumptions of their qualitative analyses and the vulnerabilities of the information they process.

You may want to ask students to think of the following thought questions in preparation for the case:

a) Describe the vertical chain for biotechnology productions. What "make" decisions has Nucleon already made? What "buy" decisions has it already made? Evaluate these decisions.
b) What make or buy decisions confront Nucleon in this case? Are there any other options besides those mentioned in the case that Nucleon might explore?
c) Assume that the cost and revenue projections in the case are correct. Based on these figures, can you assess the relative merits of the various proposals? Do you have any reason to question the cost and revenue projections in the case?
d) What other factors must Nucleon consider before reaching a final decision? When all factors are taken together, what should Nucleon do?

Pepsi-Cola Beverages HBS Case 9-390-034 A: Responding to changes in Pepsi-Cola’s competitive environment, Roger Enrico, president and CEO of PepsiCo Worldwide Beverages, formed a task force to investigate a possible reorganization of Pepsi’s domestic soft drink business. The task force recommends reorganizing along geographic lines. The group has put forth two options: 1) full decentralization, or 2) a matrix organization. Ask students to analyze the options and make their own proposals for carrying out a reorganization. They should also be asked to consider other options to deal with Pepsi’s problems that don’t center on reorganization. This case can be assigned with some combination of chapters: 3, 4, 7, 8, 9, 12, 13, 15, 16, and 18.

You may want to ask students to think of the following thought questions in preparation for the case:

a) Perform a five forces analysis on the soft drink industry. What is your qualitative assessment of this industry?
b) Why are concentrate producers like Coke and Pepsi so profitable?
c) Why do concentrate producers have an incentive to buy bottlers?
d) Why are bottlers given the right to bottler Coke or Pepsi in perpetuity?

Philips Compact Disc Introduction, HBS 9-792-035. Presents the perspective of Philips in 1979, after technical development of the CD was complete, but three years before it was introduced commercially. At that time, Philips’ management had to decide whether to attempt to establish a CD standard through an alliance with another consumer electronics firm. Raises questions regarding the costs and benefits of standardization, optimal pricing of CD players and discs (given their complementarity), optimal pricing of a durable good, and the effects of proprietary information on entry strategies. Also requires analysis of several related industries, with special attention to opportunities to invest in product specific capital. This case can be assigned with some combination of chapters: 3, 9, and 14. You may want to ask students to think of the following questions in preparation for the case:

a) What are the cost and benefits to Philips in having its standard accepted as the industry-wide format (in the hardware)?How does the degree of Philips vertical integration effect its incentives in the development of the hardware? How does its vertical integration effect its chances of having its standard being adapted? How does its vertical integration effect how profitable Philips will be in the hardware.
b) How does Philips ownership in a record company effect its position in the market for hardware?
c) Will hardware manufacturers be able to successfully engage in product differentiation? What factors effect your answer?
d) Under what conditions should Philips build extensive disc pressing capacity n the U.S. and under what condition should Philips wait one year?

Tombow Pencil Co., Ltd. (HBS # 9-692-011 and Teaching Note # 5-693-027): This case illustrates how another firm (in another country!) struggles with a similar make-or-buy problem. While the most prominent issues in the case are the "boundaries of the firm" questions, the case also raises issues related to product market competition and the role of product variety, marketing channels, and organizational issues involving the coordination of marketing, sales, and production inside Tombow. The case also presents the differences between Keiretsu (networks of long-term relationships) and arms-length market contracting. It introduces students to the idea that assignment of ownership rights can solve problems that arise due to physical asset specificity (hold-up, human asset specificity). As with Nucleon (see chapter 3), it shows that there are strong relationships between production strategy, product market strategy, and the make-or-buy decision. This case can be taught with some combination of the following chapters: 3, 4, 11, 12, 15, and 16. You may want to ask students to think of the following questions in preparation for the case:

a) What is Tombow Pencil’s current financial position? Look at Tombow’s financial statement, and compare their financial ratios to Mitsubishi’s. In particular what would the impact be on Tombow’s profits if they could reduce their inventory/sales ratio to Mitubishi’s level?
b) Is the Japanese pencil industry profitable? Are there some segments that are more profitable than others?
c) Compare the vertical chains for wooden pencils and the Object EO pencil (which will be our metaphor for mechanical pencils in general). Are the differences in the vertical scope/vertical boundaries in these two chains consistent with the underlying economics of make or buy decisions? Why does Ogawa feel the need to reexamine the production system for the EO pencil, given that Tombow’s vertical relationship have served them well for so long?
d) What recommendations would you make for Tombow? Consider both the market position (product line, quality, price point, etc.) the horizontal and vertical scope, and the organization of the company. Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Coase, Ronald, “The Nature of the Firm,” Economica, 4, 1937: 386-405

Easterbrook, F.H. and D.R. Fischel, The Economic Structure of Corporate Law, Cambridge, MA: Harvard University Press, 1991.

Klein, B., R. Crawford, and A. Alchian, “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,” Journal of Law and Economics, 21, 1978: 297-326.

Milgrom, P. and J. Roberts. Economics, Organization, and Management. Englewood Cliffs, NJ:Prentice-Hall, 1992.

Muris, T., D. Scheffman, and P. Spiller. "Strategy and Transactions Costs: The Organization of Distribution in the Carbonated Soft Drink Industry." Journal of Economics and Management Strategy, 1, Summer 1992: 83-128.

Nelson, R. and S. Winter. An Evolutionary Theory of Economic Change. Cambridge, MA: Belknap Press of the Harvard University Press, 1982.

Porter, Michael. Competitive Advantage. New York: Free Press, 1985.

Stuckey, John, Vertical Integration and Joint Ventures in the Aluminum Industry, Cambridge, MA: Harvard University Press, 1983.

Teece, D. "Towards an Economic Theory of the Multiproduct Firm." Journal of Economic Behavior and Organization, 3, 1982: 39-63.

Tully, Shawn. "You'll Never Guess Who Really Makes." Fortune. October 3, 1994, pages 124-128.

Williamson, Oliver and Sifnay G. Winter (eds.), The Nature of the Firm: Origins, Evolution, and Development, Oxford, U.K.: Oxford University Press, 1993.

Williamson, Oliver, Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press, 1975.

Williamson, Oliver, The Economics Institutions of Capitalism, New York: Free Press, 1985.

Zachary, G. Pascal. "Climbing the Peak: Agony and Ecstasy of 200 Code Writers Beget Windows NT. The Wall Street Journal, May 26, 1993, page Al.

Answers to End of Chapter Questions
1. Describe the vertical chain for the production of computer games.
Students have a great deal of leeway in answering this question, which is designed to get students to think about the complexities of an actual vertical chain.
2. A manufacturer of pencils contemplates backward integration into production of rape seed oil, a key ingredient in manufacturing the rubber-like material (called factice) that forms the eraser. Rape seed oil is traded in world commodity markets and its price fluctuates as supply and demand conditions change. The argument has been made in favor of vertical integration: “Pencil production is very utilization sensitive, i.e., a plant that operates at full capacity can produce pencils at a much lower cost per unit than a plant that operates at less than full capacity. Owning our own source of supply of rape seed oil insulates us from short-run supply-demand imbalances and therefore will give us a competitive advantage over rival producers.” Explain why this argument is wrong.

Ensuring supply might be a valid argument for vertical integration if the market for rape seed oil were extremely illiquid and inefficient, but it is traded freely on world commodity exchanges. In this case, there are no economic benefits to vertical integration that cannot be achieved through market exchange – an arms-length transaction is simply internalized within the firm if transfer prices are set at the market level. However, if transfer prices are held constant, this will lead to inefficient use of rape seed oil. The firm will fail to use the optimal quantity of rape seed oil in downstream production and would subsidize its upstream division when market prices were low or support its downstream division when market prices were high.

3. Matilda Bottlers, by virtue of a lifetime contract, has exclusive rights to distribute Big Gator products in several Australian states. Big Gator has a seven percent share of these states., similar to its nationwide share. Matilda uses its monopsony power to pay a lower price for Big Gator products than does any other distributor in the U.S. Is this sufficient justification for Big Gator to buy out Matilda Bottlers?
Big Gator should not automatically buy out Dixie simply because Dixie is able to pay a lower price for Big Gator’s products. Rather, Big Gator should determine whether there is a vertical market failure that would justify a decision to vertically integrate.
Reasons Big Gator should not vertically integrate: • The profits earned by Matilda Bottlers (which incorporate the discounted price for Big Gator Products) will be incorporated in the price that Big Gator pays for Matilda’s bottling operation. Therefore, Big Gator cannot avoid giving Matilda some or all of the benefit of Matilda’s current monopsony position. • Supplier and distributor goals are aligned – sell output for maximum profits. • Performance is easy to observe and output is measurable. • Transactions are frequent and simple and are easy to contract. • By allowing the distributor to keep profits, the manufacturer is ensuring that the distributor will continue to make relationship specific investments and to run an efficient distribution operation. • The distributor controls the amount of effort to put into distribution, so it may be good to allow the distributor to share some profit in order to provide incentives.
Reasons Big Gator should vertically integrate: • Relationship specific investment is required from the distributor, so the relationship may be subject to a hold up problem. • If product prices are driven so low that hold up is causing vertical market failure or that excessive costs are incurred (from distrust, frequent contract renegotiations, less relationship specific investing, or investing to ensure ex-post bargaining power), then the manufacturer may consider integrating into the distributor. The manufacturer should own the distributor because it ultimately commands most of the surplus in the national arena.

4. In each of the following situations, why are firms likely to benefit from vertical integration?

a. A grain elevator is located at the terminus of a rail line.

A grain elevator owner would benefit from vertical integration for several reasons:

• Coordination Costs: The use of market firms often present coordination problems. This is problematic for inputs with design attributes that require a precise fit between different components. It may be that storage bins and railcars need to be so designed. Timing is another important factor with grain. The grain operator would want to ship the grain as soon as possible to avoid spoilage, etc. Since only one rail line operator is likely to exist, it will have few incentives to closely coordinate with the grain elevator owner. Having centralized administrative control as an integrated firm would solve these coordination problems. • Transactions Costs: Arranging for timely pick-up and delivery through contracts could be extremely difficult and costly to enforce if the rail line operator lacks competition and can act opportunistically. Furthermore, the rail line operator can charge a higher fee for its services. (holdup problem) • Processing Efficiencies: Locating assets side-by-side may allow the operators to economize on transportation or inventory costs or to take advantage of processing efficiencies. (This is a concept called site specificity, which is discussed in Chapter 3.) • Economies of Scale: The grain operator may be able to achieve distribution economies of scale by having its own rail operation as opposed to contracting with individual transportation providers. b. A manufacturer of a product with a national brand name reputation uses distributors that arrange for advertising and promotional activities in local markets.

The manufacturer would benefit from vertical integration for several reasons: • Coordination Costs: The manufacturer will be better able to coordinate national and local advertising and promotions, thus conveying a consistent message/brand image across local markets and maximizing the impact of advertising and promotions on sales. (Sequencing). • The manufacturer can better coordinate the release of new products with local advertising and promotional activities. (Timing). • A manufacturer’s own distributors/sales force will be focused on selling only its products, whereas independent distributors have competing interests since they will also be selling products from rival manufacturers. May even be that the distributor’s promotional activities violate the manufacturer’s intended image of the product. (This is related to transactions/contracting costs, which is discussed in Chapter 3.) c. A biotech firm develops a new product that will be produced, tested, and distributed by an established pharmaceutical company.

The biotech firm would benefit from vertical integration for several reasons:

• Coordination Costs: Given the level of importance of the design attributes (mix of component chemicals, performance specifications, etc.) for a new biotech product, the coordination of these activities is critical for the pharmaceutical company to avoid potentially costly mistakes. • Leakage of Private Information: The biotech firm will likely have to divulge proprietary product information in order for the pharmaceutical company to manufacture the new product. As a result, the biotech firm risks giving up valuable product design information that could be used by the pharmaceutical company to develop a competing product. • Transaction Costs: In order to prevent the pharmaceutical company from producing or distributing a competing product, the biotech firm would have to incur significant contracting costs. Enforcement, in particular, could be difficult given the complexity of the product.

5. Consider the following pairs of situations. In each pair, which situation is more likely to be susceptible to coordination problems?

The key to analyzing coordination problems is in estimating how costly small errors are.

a. Maintenance of a homeowner’s lawn by a gardening company versus maintenance of a football or soccer stadium’s grass turf by a gardening company.

The maintenance of a stadium’s turf is more susceptible to coordination problems. There could be several reasons for this, including:

• The specific design attributes associated with a competitive playing field, such as the particular type of grass, the length of grass, etc., require significant attention to ensure the field meets playing standards. The existence of these types of design attributes would necessitate careful contracting to avoid the risk of coordination breakdowns.

• Timing – the gardening company must perform its tasks in advance of and between games and the watering and chalking of the stadium. Performing maintenance after a specified time would have a significant negative impact on the stadium owner. That is, the stadium owner has a very steep marginal cost curve and may have to impose significant penalties/incentives to counteract potential coordination problems.

b. Design of a toolbox to hold tools versus design of a wafer to hold the wires of a microscopic silicon chip.

The design of a wafer to hold a silicon chip would be most susceptible to coordination problems. As above, you could argue that design attributes and timing could be two of the reasons for this:

• Design Attributes – The chip manufacturer will have to specify the particular dimensions, wafer attributes, manufacturing processes, etc. to ensure the proper manufacturing of the wafers. Using a market firm to manufacture the wafer will increase coordination costs since these specifications will have to be detailed in the contract. Failure to meet these specifications will increase costs for the chip manufacturer.

• Timing – Production of the wafer will have to be scheduled to coincide with the chip manufacturer’s schedule. Failing to coordinate the schedules (i.e., missing a shipping deadline) would result in increased costs.

6. Universities tend to be highly integrated – many departments all belong to the same organization. There is not a technical reason why a university could not consist of freestanding departments linked together by contracts, much in the same way that a network organization links freestanding businesses. Why do you suppose that universities are not organized in this way?

The underlying reasons behind the existence of “integrated” universities include:

• Coordination Costs: There are several issues with regard to coordination, including: 1) timing – individual departments must coordinate around a common academic calendar and 2) sequencing – a common sequence of courses towards degree requirements needs to exist. Arranging these elements through contracts would be extremely difficult and costly to achieve.

• Organizational Issues: The university departments are bound by ties of social similarity such that they value their association with each other in addition to any monetary issues involved in their departments. This commitment supplements the more formal governances inside the university making internal governance more effective than market governance. Culture can also complement formal governance mechanisms within the university making the internal organization more effective than the market could be. Contracting a common culture for a “networked” university promises to be virtually impossible.

• Economies of Scale: By remaining integrated, a university can take advantage of several economies of scale, including: 1) purchasing economies of scale, 2) marketing economies of scale in attracting both students and professors, 3) the spreading of fixed investments such as real estate, information technology and sports-related investments, and 4) the spreading of administrative overhead. These activities could not be accomplished as efficiently through contracting.

7. Why does assymetric information lead to inefficient actions?

Contracting is not feasible when actions and information are not verifiable. Parties who are unable to contract may forgo the opportunity to maximize the value of their combined outputs.

8. Some contracts, such as those between municipalities and highway construction firms, are extremely long with terms spelled out in minute detail. Others, such as between consulting firms and their clients, are short and fairly vague about the division of responsibilities. What factors might determine such differences in contract length and detail?

Factors that might determine differences in contract length and detail include verifiability and measurability of performance. In the case of the highway construction contract, it may be easier to specify the terms of performance than in the case of the consulting project. That is, it may be easier to specify design specifications, timing, acceptable road quality, etc. When performance under a contract is extremely complicated to specify, as one would expect in the case of the consulting contract, it may be difficult to elaborate each party’s rights and responsibilities within a written contract. The language in such contracts is often left vague and open-ended because it is not clear what constitutes fulfillment of the contract. This question is similar to the car-leasing example used in the text.

9. “If the corporate govenerance function can not protect specific assets, then firms may as well transact at arms-length.” Discuss.

The firm acquiring the assets of another firm acquires, with those assets, the right to deploy the assets as the firm sees fit. Through integration, a firm can use its rights over acquired assets to adjust, for example, the level of investment in relationship specific investments to maximize the value of the integrated firm. The firm relies on its internal governance function to execute its rights over acquired assets. If internal governance cannot facilitate the desired outcome because the parties involved with the transaction believe internal governance is not strong enough to insure that all parties will recover at least the opportunity cost of their own efforts (that is, parties still fear expost hold up), then the firm may not see an increase in its value after integration.

10. Suppose that Arnold Schwarzenegger (AS) pays Besanko, Dranove, and Shanley (BDS) an advance of $5 million to write the script to Incomplete Contract, a movie version of their immensely popular text on business strategy. The movie contract includes certain script requirements, including the stipulation that AS gets to play a strong, silent business strategist with superhuman analytic powers. BDS spend $100,000 worth of their time to write a script that is tailor-made for the ex-Terminator (AS, that is). After reviewing the script, AS claims that it fails to live up to the contractual requirement that he have several passionate love scenes, and he attempts to renegotiate. Given the ambiguity over what constitutes passion, BDS are forced to agree. a. What was BDS’s rent?
BDS Rent = Actual Revenue – Minimum Revenue BDS requires to enter the contract = $5,000,000 – $100,000 = $4,900.000 b. What was their quasi-rent? What assumptions did you make to compute the latter?
Ex Post Opportunity Cost of the Script = 0

Minimum Revenue BDS Requires to Prevent Exit = Ex Post Opportunity Cost + Variable Costs < 0 + $100,000 = $100,000
Quasi-rent = Actual Revenue – Minimum Revenue to Prevent Exit > $5,000,000 - $0 = $5,000,000

To compute quasi-rent, we assume that the script is tailor-made for Schwartzeneggar and hence has no alternative value (ignoring the recycling value of the actual paper used).
11. In many modern U.S. industries the following patterns seem to hold:
What factors might explain these patterns?

a. Small firms are more likely to outsource production of inputs than are large firms;

Small firms are more likely to outsource the production of inputs because they are unable to reach the necessary scale efficiencies in-house. Vertical integration would leave them uncompetitive.

b. Standard inputs (such as a simple transistor that can be used by several electronics manufacturers) are more likely to be outsourced than “tailor-made” inputs (such as a circuit board designed for a single manufacturer’s specific needs).

Complex inputs are more likely to be made in-house than standard inputs because the specificity of these products and the assets required to produce them leads to the ‘hold-up’ problem. The upstream firm is at risk from the expropriation of the profits it makes from the production of the inputs, which are worth less in alternative uses. As a result the upstream firm will underinvest and fail to produce the inputs at the optimal level of quality and efficiency for the downstream firm, which may also be exposed to high costs if there is any supply disruption. Therefore it is often more efficient for the downstream firm to take control of the production of complex inputs themselves.

Chapter 4

Organizing Vertical Boundaries: Vertical Integration and its Alternatives

Chapter Contents 1) Introduction 2) Technical Efficiency versus Agency Efficiency • Economizing • The Technical Efficiency/Agency Efficiency Tradeoff and Vertical Integration • Real-World Evidence Example 4.1: The Virtual Corporation • Vertical Integration and Asset Ownership Example 4.2: Vertical Integration of the Sales Force in the Insurance Industry 1) Process Issues in Vertical Mergers 2) Alternatives to Vertical Integration • Tapered Integration: Make and Buy Example 4.3: Tapered Integration in Gasoline Retail • Strategic Alliances and Joint Ventures Example 4.4: Pfizer, Microsoft, and IBM Come to the Aid of Physicians Example 4.5: Millennium Pharmaceuticals: Strategic Alliances • Collaborative Relationships: Japanese Subcontracting Networks and Keiretsu Example 4.6: Interfirm Business Networks in the United States: The Women’s Dress • Implicit Contracts and Long-Term Relationships 5) Chapter Summary 6) Questions

Chapter Summary

This chapter examines why vertical integration differs across industries, across firms within the same industry, and across different transactions within the same firm. The first part of this chapter assesses the merits of vertical integration as a function of the industry, firm, and transactions characteristics. It then presents evidence on vertical integration from studies of a number of specific industries including automobiles, aerospace, and electric utilities.

The next section examines whether there might be other factors apart from those discussed in Chapter 3 that might drive a firm’s decision to vertically integrate. This chapter focuses on two alternative classes of explanation. One is theory offered by Sanford Grossman and Oliver Hart that stresses the role of asset management and its effect on investments in relationship specific assets as a key determinant of vertical integration. The second theory analyzes “market imperfections” motivations for vertical integration.

The final purpose of this chapter is to explore other ways of organizing exchange besides arm’s length market contracting and vertical integration. The alternatives discussed include: 1) tapered integration (i.e. making and buying) 2) joint ventures and strategic alliances 3) Japanese keiretsu, and 4) implicit contracts supported by reputational considerations.

Approaches to teaching this chapter

Agency Efficiency: The extent to which a firm’s administration and/or production costs are raised due to transaction and coordination costs of arm’s length market exchanges or agency and influence costs of internal organization.

Technical Efficiency: The extent to which a firm uses least-cost production techniques.

Tapered Integration: A combination of vertical integration and market exchanges. Under this process, the firm makes some quantity of the input internally and buys the rest from independent firms.

Strategic Alliance: Two or more firms agree to collaborate on a project or to share information or productive resources.

Joint Venture: A particular type of strategic alliance where two or more firms create and jointly own a new independent organization.

Keiretsu: Close semiformal relationships among buyers and suppliers, best embodied by the Japanese.

Implicit Contract: Unstated understanding between parties in a business relationship.

This chapter covers different segments, which can be taught separately. The first section is an extension of Chapter 3. This section discusses the trade-offs that go into a decision of whether or not to vertically integrate. Figures 4.1 and 4.2 illustrate theses trade-offs and yield three powerful conclusions about the relationship between the attractiveness of vertical integration and the conditions of input production and the product market scale of the firm.

• Scale and scope economics: A firm gains less from vertical integration the greater the ability of outside market specialists to take advantage of economics of scale and scope relative to the firm.

• Product market scale and growth: A firm benefits more from vertical integration the larger the scale of its product market activities.

• Asset Specificity: A firm benefits more from vertical integration when production of inputs involves investments in relationship-specific assets.

At the end of this section real world firms are examined to see if they behave according to this theory; much evidence suggests that they do.

The next section introduces an alternative theory, developed by Sanford Grossman and Oliver Hart, for comparing vertical integration with market exchange. The main point of this section is that in comparing vertical integration with market exchange, it is important to understand who has the residual rights of control. Residual rights of control are defined as the rights of control that are not explicitly stated in the contract. If one thinks of vertical integration as the changing rights of control over key assets, it affects the efficiency of exchange. The economic value created is quite different and it has an important effect on the efficiency of transactions. The third section discusses the instances where companies might want to vertically integrate due to market imperfections. It examines situations where vertical integration is aimed at undoing the effects of market imperfections or increasing market power. This section may be skipped without loss of continuity.

The last section discusses alternatives to vertical integration and arm’s length market exchange. It introduces four alternatives, namely: tapered integration, joint ventures, the Japanese Keiretsu and long-term implicit contracts. The main point is that some economic trade-offs are useful in thinking about decisions and desirability of these organizations.

Technical vs. Agency Efficiency
The relationship between Technical and Agency efficiency is one of the main themes of this chapter. Figure 4.1 illustrates the trade off between Technical and Agency efficiency and is related to the discussion in chapter 3 about the benefits and costs of using the market. Agency vs. trade-off concepts should be explained by means of graphs because MBA students find these concepts difficult. ΔT = cost of producing the activity in-house – cost of producing the activity by a market specialist, assuming that both produce as efficiently as possible.

"Transactions" cost when activity is performed by a market specialist is defined broadly to include:

• direct costs of negotiating contracts costs of safeguards against hold-up • costs of safeguards against hold-up. • inefficiencies due to under-investment in relationship-specific assets and lost opportunities for cost savings due to mistrust. • costs associated with breakdowns in coordination and synchronization when activity is purchased.

ΔA = "transactions" cost when activity is produced in-house – "transactions" cost when activity is provided by a market specialist.

"Transactions" cost when activity is produced in-house include:

• agency and influence costs that arise when hard-edged market incentives are replaced by soft-edged incentives of internal organization.

ΔC = ΔT + ΔA = the full cost difference between vertical integration and reliance on market specialist. When Δ C is positive, in-house production is more costly than reliance on market specialists; when Δ C is negative, in-house production is less costly than reliance on market specialists.

Managerial Implications
Below are four general rules for managers of when to rely on the market and when to perform tasks in-house.

1. Rely on market for routine items; produce in-house items that require specific investments in design, engineering or production know-how. • Asset specificity is high --- vertical integration is best. • Asset specificity is low --- reliance on market is best

2. Rely on market for items that require large up front investments in physical capital or organizational capabilities that outside firms already have.

• When outside specialist benefit from significant economies of scale, reliance on the market is best. • When in-house division can capture nearly all economies of scale in activity, vertical integration is best.

3. Vertical integration is usually more efficient for bigger firms than for smaller.

• Larger scale of product market activities --- vertical integration is best. • Smaller scale of product market activities --- reliance on market is best.

4. Technological advances in telecommunications and data processing have tended to lower coordination costs, making reliance on the market more attractive.

• Low coordination costs --- reliance on market is best. • High coordination costs --- vertical integration is best.
Suggested Harvard Case Studies

Hudepohl Brewing Company HBS 9-381-092 (see earlier chapters)
Pepsi-Cola Beverages HBS Case 9-390-034 A (see earlier chapters)
Philips Compact Disc Introduction, HBS 9-792-035 (see earlier chapters)
Tombow Pencil Co. Ltd. HBS 9-692-011 (see earlier chapters)

Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Anderson, E. and D.C. Schmittlein, "Integration of Sales Force: An Empirical Examination," RAND Journal of Economics, 15, Autumn 1984, pp. 385-395.

Arrow, K., "Vertical Integration and Communication," Bell Journal of Economics, 6, Spring1975, pp.173-182.

Borenstein, S. and R. Gilbert, "Uncle Sam at the Gas Pump: Causes and Consequences of Regulating Gasoline Distribution," Regulation, 1993, pp. 63-75.

Caves, R. and D. Barton, Efficiency in US Manufacturing Industries, Cambridge: MIT Press, 1990. Chandler, A.D., Jr., Scale and Scope: the Dynamics of Industrial Capitalism, Cambridge, MA: Belknap,1990.

Clark, R., The Japanese Company, New Haven: Yale University, 1979.

Davidow, W.H. and M.S. Malone, The Virtual Corporation, New York: Harper Business, 1992.

Grossman, S. and 0. Hart, "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Journal of Political Economy, 94, 1986, pp.691-719.

Joskow, P., "Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generating Plants," Journal of Law, Economics and Organization, 33, Fall 1985, pp. 32-80.

Klein, B., "Vertical Integration as Organizational Ownership," Journal of Law, Economics, and Organization, 1989 pp. 199-213.

Machlup, F. and M. Taber, "Bilateral Monopoly, Successive Monopoly, and Vertical Integration," Economist, 27, 1950, pp. 101 -119.

Masten, S., "The Organization of Production: Evidence from the Aerospace Industry," Journal of Law and Economics, 27, October 1984, pp. 403-417.

Masten, S., J.W. Meehan and E.A. Snyder, "Vertical Integration in the U.S. Auto Industry: A Note on the Influence of Transactions Specific Assets," Journal of Economic Behavior and Organization, 12, 1989, pp. 265-273.

McKenzie L.W., "Ideal Output and the Interpendence of Firms," Economic Journal, 61, 1951, pp.785-803.

Monteverde, K. and D. Teece, "Supplier Switching Costs and Vertical Integration in the Automobile Industry," Bell Journal of Economics, 13, Spring 1982, pp. 206-213.
Ohmae, K., "The Global Logic of Strategic Alliances," Harvard Business Review, March-April 1989, pp.143-154.

Perry, M.K., "Forward Integration by Alcoa: 1888-1930," Journal of Industrial Economics, 29, 1980. pp.37-53.

Perry, M., "Price Discrimination by Forward Integration", Bell Journal of Economics, 9, 1978, pp.209-217.

Peters, T., Liberation Management. Necessary Disorganization for the Nanosecond Nineties, New York:Knopf, 1992.

Spengler, J.J., "Vertical Integration and Antitrust Policy," Journal of Political Economy, 53, 1950,pp.347-352.

Wallace, D.H., Market Control in the Aluminum Industry, Cambridge: Harvard University Press, 1937.

Williamson, O.E., Antitrust Economics, Oxford, UK: Basil Blackwell, 1987, chaps. 1 through 4, for a discussion of the role of transactions cost considerations in antitrust policy.

Williamson, O., "Strategizing, Economizing and Economic Organization," Strategic Management Journal, 12, Winter 1991: 75-94. Answers to End of Chapter Questions

1. Why is the “technical efficiency” line in Figure 4.1 above the x-axis? Why does the “agency efficiency” line cross the x-axis?

The technical efficiency line represents the minimum cost of production under vertical integration minus the minimum cost of production under arm’s-length market exchange. The technical efficiency line is above the x-axis indicating that the minimum cost of production under vertical integration is higher than the minimum cost of production under arm’s length market exchange, irrespective of the level of asset specificity. The reason costs are higher under internal organization is that outside suppliers can aggregate demands from other buyers and thus can take better advantage of economies of scale and scope to lower production costs.

The agency efficiency line represents the transactions costs when production is vertically integrated minus the transactions costs when it is organized through an arm’s-length market exchange. The agency efficiency line is positive for low levels of asset specificity and negative for high levels of asset specificity. When asset specificity is low, the probability of hold up is low. In the absence of a significant risk of hold up, market exchange is likely to be more agency efficient than vertical integration because independent firms often face stronger incentives to innovate and to control production costs than divisions of vertically integrated firms (see chapter 3). Agency costs of market exchange increase with the level of asset specificity—above some threshold of asset specificity, using the market entails higher transactions costs than using an internal organization.

2. Explain why the following patterns seem to hold in many industries:

a. Small firms are more likely to outsource production of inputs than are large firms.

Figure 4.2 illustrates that a firm gains less from vertical integration the greater the ability is of outside market specialists to take advantage of economies of scale and scope relative to the firm itself. A small firm might not be able to take advantage of the economies of scale and scope because its level of production would not offset the significant, up-front setup costs or meet the demands of a large market outside the firm. A large firm might be able to produce a sufficient level of output and achieve the same economies of scale and scope that an outside firm would have.

b. “Standard” inputs (such as a simple transistor that could be used by several electronics manufacturers) are more likely to be outsourced than “tailor-made” inputs (such as circuit board designed for a single manufacturer’s specific needs).

“Standard” inputs are more likely to be outsourced than “tailor-made” inputs for two reasons. First, an outside firm can reach economies of scale and scope if it is producing standard inputs for several different electronic manufacturers. An outside firm might not be able to produce a higher level of inputs to take advantage of economies of scale and scope with tailor-made inputs because it is only producing for one firm, not several firms. By increasing the scale of production, outside firms will be able to take advantage of decreased fixed and exchange costs.
Second, when outsourcing tailor-made inputs, it is difficult to monitor performance and quality. Furthermore, specifying performance and quality expectations in a contract is usually not feasible. The outside firms would incur higher transactions costs. In addition, the increase in design specifications and complex components would accentuate the advantages of vertically integrating, according to the asset-specificity hypothesis. For example, Scott Masten’s study of the aerospace industry (chapter 5) highlights the make-or-buy decision associated with producing complex components and encountering potential hazards related to incomplete contracting. See Chapter 4 for further details about incomplete contracting.

3. Use the arguments of Grossman and Hart to explain why stockbrokers are permitted to keep their client lists (i.e. continue to contact and do business with clients) if they are dismissed from their jobs and find employment at another brokerage house.

Assuming incomplete contracts, Grossman and Hart’s argument is summed as follows: • Ownership rights determine the resolution of the make-or-buy decision. The owner of an asset has residual rights of control not specified in the contractual agreement. • When ownership is transferred, these residual rights are purchased. They are lost by the selling party, which fundamentally changes the legal rights of that party. • There are two types of decisions: contractible (verifiable operating decisions) and noncontractible (unverifiable up-front investments in relationship specific assets). When negotiations break down, control over operating decisions reverts to the party with residual right of control over relevant assets. • The power in the relationship is determined by the nature of the vertical integration. • Ownership should be given to the unit whose investments have the strongest impact on the total profits of the venture.
A brokerage firm’s assets are tied to each of its clients, and clients are the largest source of total profits of the firm. The nature of the relationship between a stock-broker and client is relationship-specific. The broker has ownership of each of his/her clients. The broker is investing the time and information into developing these relationships. Therefore, the broker has the ownership of those assets. Accordingly, the broker has residual rights to the ownership and control of clients. When ownership of the broker changes, the broker’s relationship-specific assets, the selling party, the original brokerage firm, loses the clients. While ownership of specialized physical assets can be transferred, ownership of specialized human capital can’t be. The brokerage house simply provides products. It is the broker who sources and services their clientele.

The nature of the product (stock trades) dictates that brokerage houses allow the stock brokers to keep client lists. Customers often have an incentive to switch their brokerage business to obtain better value for money. This is particularly true for clients doing high volume of trades. In these circumstances it becomes important for the broker to generate extra effort to keep the client. If the broker has the ownership of the asset (client list), he is not subject to 'hold-up' by the brokerage house. If he did not own the client list, the brokerage house could force the broker to accept lower commissions. This would reduce the incentive for the broker to try hard to generate business for the brokerage house.

4. Analysts often array strategic alliances and joint ventures on a continuum that begins with “using the market” and ends with “full integration”. Do you agree that these fall along a natural continuum?

No. Alliances and joint ventures fall somewhere between arm’s-length market transactions and full vertical integration. As in arm’s length market transactions, the parties to the alliance remain independent business organizations. But a strategic alliance involves much more coordination, cooperation, and information sharing than an arm’s length transaction. A joint venture is a particular type of strategic alliance in which two or more firms create, and jointly own, a new independent organization. The firms involved with a joint venture integrate a subset of their firms assets with the assets of one or more other firms.

5. What does the Keiretsu system have in common with traditional strategic alliances and joint ventures? What are some of the differences?
Keiretsu are closely related to subcontractor networks, but they involve a somewhat more formalized set of institutional linkages. Usually the key elements of the vertical chain are represented in a keiretsu. The firms in a keiretsu exchange equity shares, and place individuals on each other’s boards of directors—U.S. firms are in many cases prohibited from these practices under the U.S. antitrust laws. 6. The following is an excerpt from an actual strategic plan (company and product names have been changed to protect the innocent):
Acme’s primary raw material is PVC sheet that is produced by three major vendors within the United States. Acme, a small consumer products manufacturer, is consolidating down to a single vendor. Continued growth by this vendor assures Acme that it will be able to meet its needs in the future.
Assume that Acme's chosen vendor will grow as forecast. Offer a scenario to Acme management that might convince them that they should rethink their decision to rely on a single vendor. What do you recommend that Acme do to minimize the risk(s) that you have identified? Are there any drawbacks with your recommendation?

Acme must have a valid reason for using a single supplier. A key merit of Acme's approach is asset specificity on the vendor's side, when the vendor might be encouraged to make specific investments.

However, there is the potential of hold-up problems created by decreasing the number of vendors down from three to one. The likelihood of hold-up problems would depend on the degree of asset specificity and switching costs. The amount of implicit and explicit costs related to hold-up problems would depend on the level of inventory, customers' expectations and brand reputation. For example, if Acme can only produce its product with Company X's component and Company X ceases shipments, unless Acme has sufficient amount in inventory of the components, Acme will incur significant losses immediately due to lack of sales.
In order to minimize its risks, Acme could second source or backward integrate (partially or fully). Second sourcing or backward integration protects the firm from hold-up but may drive costs by reducing purchasing discounts, increasing production coordination and requiring additional investments by the second source. An alternative solution would be for Acme to consider tapered integration. Tapered integration poses the usual make-or-buy problems, such as high costs, coordination problems and poor incentives.
7. Shaefer Electronics is a medium-size producer (about $18 million in sales in 1993) of electronic products for the oil industry. It makes two main products - capacitors and integrated circuits. Capacitors are standardized items. Integrated circuits are more complex, highly customized items made to individual customer specifications. They are designed and made to order, they require installation, and sometimes require post-sale servicing. Shaefer's annual sales are shown in the table below.
Shaefer relies entirely on manufacturers' representatives (MR's) located throughout the United States to sell its products. MR's are independent contractors who sell Shaefer's products in exchange for a sales commission. The company's representatives are not exclusive - they represent manufacturers of related but non-competing products such as circuit breakers, small switches, or semiconductors. Often a customer will buy some of these related products along with integrated circuits or an order of capacitors. MR's have long experience within local markets, close ties to the engineers within the firms that buy control systems, and deep knowledge of their needs. In the markets in which they operate, MR's develop their own client lists and call schedules. They are fully responsible for the expenses they incur in selling their products.
Once the MR takes an order for one of Shaefer’s products, Shaefer is then responsible for any installation or post-sale servicing that is needed.
Shaefer recently hired two different marketing consultants to study its sales force strategy. Their reports contained the conclusions reported below. Please comment on the soundness of each conclusion. a. "Shaefer should continue to sell through MR's. Whether it uses MR's or an in-house sales force, it has to pay sales commissions. By relying on MR's, it avoids the variable selling expenses (e.g., travel expenses for salespeople) it would incur if it had its own sales force. As a result, Shaefer's selling expenses are lower than they would be with an in-house sales force of comparable size, talent, and know-how."
The conclusion of this marketing consultant is unsound - it is make-or-buy fallacy #1 - the fallacy states that a firm should buy rather than make because by doing so it avoids setup and production costs associated with making. In this particular case, Shaefer does not avoid variable selling expenses by relying on MR's. Presumably the MR’s will negotiate a commission rate that will allow them (over some reasonable period of time) to cover their variable selling expenses, such as travel costs. This rate will be higher than the rate that Shaefer would pay to otherwise equally talented, knowledgeable and productive in-house sales people, whose selling expenses will be reimbursed directly by Shaefer, rather than indirectly through the commission. b. "Selling through MR's made sense for Shaefer when it was first getting started and specialized in capacitors. However, given its current product mix, it would not want to set itself up the way it is now if it were designing its sales force strategy from scratch. But with what it has got, Shaefer should be extremely cautious about changing."
Initially, Shaefer utilized outside sales representatives to market its standardized products in 1980. Historically, firms relied on independent marketing agents to sell and distribute fairly standardized products. This strategy made sense because the selling process did not require specialized know-how or expertise to sell, according to the asset-specificity hypothesis. However, there are limits to economies of scale and scope in selling and distributing customized products.
If Shaefer was developing its sales force strategy in 1993, it would make sense for Shaefer to establish an internal sales force from scratch. Shaefer is selling standardized and customized products which do not hold similar sales strategies. MR's are probably not the best way to sell customized product, such as the ICs. First with the increase in capital intensity, independent wholesaling and marketing agents are no longer able to benefit from the economies of scale and scope. Consistent with the asset-specificity hypothesis, Shaefer should begin to forward integrate into marketing and distribution, especially when dealing with customized products requiring specialized investments in human capital or in equipment and facilities.
Another factor against having the MR's selling the ICs is coordination costs. Under the current arrangement, an MR, who then has to communicate with Shaefer’s design and manufacturing people to develop the specs for the customer’s order, makes the sale. And after the sale has been completed, the MR would have to arrange with Shaefer for installation and post-sale servicing. Using MR’s sales staff may compromise coordination between design, manufacturing, sales and installation and post-sale customer service. This situation leaves Shaefer vulnerable to competitors who can perform the order taking, design manufacture, delivery and installation more quickly than Shaefer.
In addition, the salesperson's personal relationship with the customer is particularly important for developing a long-term sales strategy. In this "relationship-specific" situation, Shaefer will need to provide post-sale servicing and potentially, sell future products. If the sales process begins with an MR, a customer's primary loyalty may belong to the MR, rather than to Shaefer. The MR's "ownership" of the client list would provide it with considerable bargaining power over Shaefer which would make it difficult for Shaefer to: (1) keep costs and sales commission low; (2) enforce sales quotas; and (3) control the time the MR's spend pushing Shaefer's products versus other products. We don’t know for sure that any of these problems are actually occurring, but one slight bit of evidence that may be suggestive of a problem is that since 1990, Shaefer’s sales of integrated circuits have grown less rapidly than the industry as a whole would predict. Using contracts and/or commission schedules would assist in monitoring performance; however, this arrangement would become relatively more costly. Therefore, when transactions involve relationship-specific assets, "making" is often preferred to "buying."
Overall, in the IC business, Shaefer is not just selling a physical product; it is selling its capabilities to custom design, produce and install a device that will solve a particular need for a prospective customer. An in-house sales person is likely to have more specific knowledge of Shaefer's ability to adapt its designs to solve particular customer needs than an MR who would be unable to provide similar and extensive details due to its various products. While it is true that MR’s know a lot about their clients' needs, and probably know something about the capabilities of the manufacturers, the key question is: is the MRs' knowledge about Shaefer's products sufficient enough to allow Shaefer to compete effectively against rivals who are aggressively pushing their abilities to solve specific customer problems.
Of course, this line or argument begs the question of why Shaefer could not provide training for its MR's to enhance their knowledge about Shaefer's products. A possible answer relates to the earlier discussion of asset specificity. Providing an MR with training about the capabilities and technological specifications of Shaefer's products creates relationship-specific assets that further cement the dependence of Shaefer on its manufacturer reps. The possibility that its MR’s might engage in hold-up reduces the marginal value of any investment Shaefer might make in its relationship with them. Thus, while providing training to the MR's may seem like a good idea in principle, it is far from clear that its benefits outweigh the costs.
The above considerations would argue against using MR’s in the first place when starting a sales force from scratch. However, note that if Shaefer needed to decide whether to alter its current situation, then other considerations would affect Shaefer's decision. Primarily, the irony of relationship-specific assets is that they can create dependency relationships that are difficult or costly to break. Despite the potential hold up problems for higher commissions and working less with MR's, the up front costs of developing relationships with clients and learning how to sell Shaefer's products are less than starting an in-house sales force from scratch at this time. The level of attractiveness of MR’s is higher at this current point than it would have been if Shaefer were designing its sales force strategy from scratch.

Chapter 5


Chapter Contents 1) Introduction Example 5.1: Changes in Diversification, From American Can to Primerica 2) Why do Firms Diversify? • Efficiency-based Reasons for Diversification Example 5.2: Acquiring for Synergy: BankAmerica Buys Continental • Potential Costs of Diversification 3) Managerial Reasons for Diversification • Benefits to Managers from Acquisitions • Problems of Corporate Governance • The Market for Corporate Control and Recent Changes in Corporate Governance 4) Performance of Diversified Firms • Studies of Operating Performance • Valuation and Event Studies Example5.3: Pepsi’s Fast-Food Troika • Long-Term Performance of Diversified Firms Example 5.4: Diversification and Corporate Performance of Philip Morris 5) Chapter Summary 6) Questions

Chapter Summary

This chapter provides a logical continuation of the discussion on vertical and horizontal boundaries. Chapters 2,3 and 4 looked at the benefits and costs of integration. The current chapter examines the numerous rationales for diversification. We argue that while all reasons for diversification may logically follow the manager’s perspective as an agent to company shareholders, some reasons make more economic sense than do others.

Diversification has, no doubt, played an important role in shaping the landscape for American businesses. Over the last century, firms have experienced four waves of diversification.
The first wave started at the turn of the 20th century, with the creation of trusts and later holding companies that provided structure to optimize decisions, reduce competition, and achieve economies of scale for a group of firms.
With antitrust laws in place, the second wave occurred during the 1920s, when numerous companies integrated to create mammoth corporations, which ultimately turned many industries into oligopolies.
The 1960s experienced the third wave, when conglomerates grew by acquiring unrelated businesses.
The final and fourth wave, in the 1980s, saw heavily leveraged investments as a way to bring undervalued businesses into conglomerate organizations.
Economies of scope provide the primary rationale for diversification. These economies can be derived by selling similar products. For example, products with similar production technology, similar raw materials, or similar engineering fit into this group. Economies can also be derived by selling to similar markets, such as selling products in different geographical regions.
Dominant general management logic can also motivate diversification. Some business analysts argue that the way in which managers conceptualize business and make critical resource allocations can generate economies of scope in merged companies. This argument is typically difficult to defend, however, since many variables may contribute to the differences and scale and scope economies found in merged companies.
Some argue that financial synergies between firms can also inspire diversification. This is a weak argument since the market can usually better serve the synergies. First, mergers and acquisitions for reasons of financial diversification alone add little value to shareholder wealth, since shareholders themselves can diversify through capital markets as or even more efficiently. Likewise, diversification aimed at redistributing capital from one business to another can be more efficiently performed in the financial markets, since financial institutions generally have expertise in providing banking functions. Lastly, if a firm is undervalued, then efficient takeover markets will bid-up the “bargain” target firm until the unrealized value is bid away.
Diversification can economize on transaction costs if coordination among the independent firms have higher transaction costs or holdup problems due to relationship-specific investments. However, the merged firm will face influence costs and more incentive effects than independent firms normally face. Alternative approaches to mergers, such as joint ventures, strategic alliances, or minority participation, can improve on the transaction costs problems of integration but have their own governance issues.
Managerial incentives that are not aligned with the objectives of the shareholders may prompt executives to pursue unrelated acquisitions, many of which do not create value. Such diversification carries agency costs. Managers may diversify as a means to maintaining executive positions. For example, managers may create providing job security by diversifying a firm in order to mirror the performance of the economy; avoid hostile takeovers that may result in lost executive positions; and exploit new or expanded opportunities for management.

Hostile takeovers assume that the value of the corporation is greater than the current market value if a more efficient management team is in place. Shleifer and Summers studied how the wealth generated by this takeover may accrue to the new owners, leaving the stakeholders in the firm with a value less than the original market value. The new owners can extract this quasi-rent because the new owners do not recognize the implicit contracts between a firm and its stakeholders. They believe this affects the entire economy because stakeholders in other firms observe the redistribution of wealth and become hesitant to make firm-specific investments. This lack of investment decreases the value of firms throughout the economy.

Keeping agency costs in mind, it is little surprise that several studies have shown that diversified firms generally perform poorly in the long run. Michael Porter found that nearly one-third of all acquisitions between 1950 and 1985 eventually chose to divest. Larry Lang and Rene Stultz provide further evidence that overdiversification can lead to corporate inefficiency. Since the 1980s, businesses have begun to focus more on acquisition of more closely related businesses. The result has been more positive returns on investment.

In sum, diversification can create value, although the benefits per se relative to nondiversification remain nebulous and easy to mismanage. The lack of clear association between simple measures of diversity within a business portfolio and overall corporate performance contributes to the challenges of defending or advocating diversification.

Approaches to Teaching this Chapter

Diversification: The act of producing in more than one product market.

Conglomerates: Firms that are broadly diversified.

Relatedness: A concept measuring the degree of similarity across the portfolio of a firm’s products, technologies, and markets.

Single Business: A firm with a single primary activity or line of business.

Dominant business: A firm with the largest percentage of its annual revenues resulting from a single activity

Related Business: A firm that derives most of its revenues from a primary area and that has other nontrivial lines of business tangibly related to the primary.

Unrelated Business: A firm deriving less than the majority of its business from a primary area and having no other substantial number of related businesses.

Dominant Logic: A theory that managers of diversified firms may see themselves as deriving economies of scope through their proficiency in spreading top management skills across nominally unrelated business areas (Prahalad and Hamel).

Why Diversify?

Economies/Synergies • Economies of Scope (from Chapter 2): the idea is that it is less costly or more valuable to consumers for two activities to be pursued jointly than separately • Economies of scale in an input • One-stop shopping to reduce the cost to the consumer • Leveraging core competencies • Leveraging a brand name or reputation • Efficient use of waste products • Utilizing off-peak capacity

Financial Reasons • Reduces the risk of performance • Internal Capital Markets • Reduce Risk of bankruptcy • Tax Advantages

Managerial Reasons • Managers like empire building • Personal stock ownership • Hostile Takeovers (Shleifer/Somers argument) • Career concerns (reducing risk of getting fired, better career paths, incentives) • Managerial entrenchment

Other Reasons • Managerial economies (recruiting top management, benchmarking managers) • Market Power • Generally not that important to broadly diversified firms. However, there are interesting points to discuss. • Multi-point contact may be a way of sustaining collusion. If a firm is especially large, it may establish multi-market contact. Since a large diversified company will face rivals in many markets, there are lots of strategic options available if it can sustain collusion. This is essentially a repeated prisoner’s dilemma game, since the large firm will face-off in many markets and can retaliate/make moves in many markets. (See Disney article referenced under extra reading) • Deep pockets may facilitate predatory behavior. By diversifying, a firm may be able to achieve “deep pockets” and become a fiercer competitor and engage in predatory pricing. An example of this is the Microsoft/Intuit deal. • Entry barriers

Ask students to prepare thoughts on the following before the lecture:

• Examples of conglomerates • The unrelated diversification of ITT-ITT Sheraton, ITT Holdings, ITT Industries (hotels, insurance, automotive parts) • Strengths that Anheuser Busch is leveraging with Eagle Snack Foods, beer, and Busch Garden?

Questions you may want to ask:

• Under what circumstances is a company’s strategy of reducing risk valuable for shareholders? • Under what circumstances is it valuable for managers? • When would it make sense to tie the bonus for a CEO not only to the performance of the company but also to the performance of other firms in the industry?

Suggested Harvard Case Study[5]

Bank One - 1993 HBS 9-394-043. This case expores geographic and product diversification of a U.S. “super-regional” bank during a period of industry deregulation. It also deals with acquisition as a mode of diversification.

Cooper Industries’ Corporate Strategy (A), 9-391-095. This case describes the development of a successful corporate strategy based on the acquisition and subsequent consolidation of low-technology manufacturing companies.

House of Tata HBS 9-792-065 (see earlier chapters)
PepsiCo: A View from the Corporate Office, HBS 9-693-078. This case describes the three business segments of PepsiCo (beverages, snack foods and restaurants). It then explores the competitive environment within each segment and the responses of PepsiCo’s businesses. The case is useful for motivating a discussion about whether or not the synergies within this organization merit the firm continuing as is, or is a change to the organization is warranted. The case will also generate a discussion about what organization encourages or discourages the synergies among segments.
Sime Darby Berhad—1995, HBS 9-797-017 (see earlier chapters)

Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Boston Consulting Group, Perspectives on Experience. Boston: Boston Consulting Group, 1970.

“Clash of Titans: Disney, Time Warner Just Keep Bumping Up Against Each Other,” Wall Street Journal, April 14, 1993.

Collis, D.J. and C.A. Montgomery. Corporate Strategy: A Resource Based-Approach, Boston, MA: Irwin McGraw-Hill, 1998.

Goold, M., Campbell, A. and M. Alexander. Corporate Level Strategy: Creating Value in the Multibusiness Company. New York: John Wiley and Sons, Inc., 1994.

Hoskisson, R.E. and M. A. Hitt. Downscoping: How to Tame the Diversified Firm.Oxford, U.K.: Oxford University Press, 1994.

Jensen, M.C. “Eclipse of the Public Corporation,” Harvard Business Review, September-October, 1989.

Mortgomery, C.A. “Corporate Diversification,” Journal of Economic Perspectives, Summer 1994, pages 163-178.

Rumelt, R. P. Strategy, Structure, and Economic Performance. Boston: Division Research, Graduate School of Business Administration, 1974.

Tannebaum, J. “Diversification Gives New Spice to Restaurants.” Wall Street Journal, May 8, 1995.

Answer to End of Chapter Questions

1. The main reason that firms diversify is to achieve economies of scope. Discuss.

The exploitation of economies of scope is a traditional efficiency enhancement rationale for diversification. If economies of scope exist, it is less costly for a producer of product A to move into the production of product B than it would be for a new firm to enter the market for product B. The sources of scope economies were explored in chapter 2. However, the empirical evidence on diversification does not appear to be well explained by the pursuit of traditional scope economies. Prahalad and Bettis argue that managers of diversified firms may see themselves as deriving economies of scope though their proficiency in spreading scarce top management skills across nominally unrelated business areas— so called dominant general management logic. This logic applies most directly when managers develop specific skills and seemingly unrelated businesses rely on these skills for success. However, the dominant general management logic is mistakenly applied when managers develop particular skills but diversify into businesses that do not require them, or managers perceive themselves as possessing above-average general management skills with which they can justify any diversification.

In addition to economies scope, three broad rationales for diversification are financial synergies, economizing on transactions costs and pursuit of managerial (over firm) objectives. The financial synergies rationale argues that the long-term success of a growing firm requires it to develop a portfolio of businesses that assures an adequate and stable cash flow with which to finance its activities. Although portfolio strategies may smooth cash flows and prop up expanding or troubled businesses, they do not necessarily create additional value for the owners of the firms.

Economist David Teece argues that the multiproduct firm is an efficient choice when coordination among independent firms is complicated by transactions costs and the associated hold up problems. A transactions costs explanation for horizontal diversification is analogous to the explanation for vertical integration presented in chapters 4 and 5. Both vertical and horizontal relationships often involve relationship-specific investments. When the self-interested behavior of independent firms jeopardize the value of these investments, integration is a solution.

Finally, managerial reasons for diversification are oriented toward maintaining or enhancing the position of executives making diversification decisions, rather then efficiency or enhancing shareholder wealth. Motives might include job security or growing sales or revenues relatively effortlessly.

2. Is relatedness necessary for success in the market for corporate control?
Henry Manne has argued for the existence of a market for corporate control. According to Manne, corporate control is a valuable asset that exists independently of economies of scale and scope. If this is so, then a market for this control exists and operates such that the main purpose of a merger is to replace one management team with another. The management team in charge of a firm must continually generate maximal value for shareholders. If a team fails to generate sufficient value, observers of the firm will notice this poor performance, and competing management teams can displace the incumbents via takeover. The potential for competitive bidding once a tender offer has been made will ensure the highest valuation for firms and the largest return for shareholders. However, the successful bidder may need specialized knowledge and/or resources to bring to a combination or else the expected benefits from the takeover may not be achieved due to poor implementation or may even have been bid away in the auction that followed the initial tender offer. The implication is that the market for corporate control argument needs to be supplemented by a scope or “relatedness” argument. Richard Rumelt measured “relatedness” according to how much of a firm’s revenues were attributable to product market activities that had shared, or related, technological characteristics, production characteristics, or distribution channels. If the bidder does not possess assets that can be combined with the assets of the acquisition that together would generate more value than these assets would generate separately, it is likely that the acquirer has overpaid for the acquisition.

3. How is expansion into new and geographically distinct markets similar to diversification? How is it different?

Geographic expansion may be motivated by reasons similar to those for diversification:

Economies of Scope. Expansion may allow the firm to spread the cost of tasks, such as development, research, establishing brand equity, or financial systems. By expanding into a market with similar requirements as the established market, a firm needs little additional investments to develop skills in these tasks to reap benefits in the firm’s expanded market. For example, Nordstrom’s national expansion gains economy of scope from the its established brand equity.

Financial Risk. Expansion reduces the risk realized by the firm servicing a restricted market. Continuing with Nordstrom’s, their success was originally tied to the economic performance of the Pacific Northwest. By expanding nationally, Nordstrom’s diversifies their risk across different geographic regions.

Economizing on Transaction Costs. It is less costly for an existing (successful) firm to expand into a new area than for a new firm to be formed. The existing firm has routines for conducting transaction and a reputation that will make it less expensive to establish relationships, even with parties they have not dealt with before.

Expansion into new and geographically distinct markets is different from diversification in the following ways:

Implied Contracts. Under diversification through acquisition, the buyer may change organizational routines of the acquired firm, and may have no commitment to maintain the existing implied contracts. In geographical expansion, the firm remains one, and thus more likely perpetuates (or even reinforces) routines and implied contracts already established.

Tax Advantages. Diversification through acquisition of a highly leverage firm can provide a tax shelter for a buyer with excess cash flow. International expansion, in addition to tax shelter advantages, can use differences in tax and tariff rates to take exploit more profitable transfer pricing schemes.

Learning Curve. Diversification naturally leads managers to learn new lines of business or industry practices. Geographical expansion, on the other hand, allows managers to learn local conditions that help them further entrench in the same business line. Managers in other geographical regions accelerate the firm’s learning overall learning curve by sharing information regarding the same business.

Culture. The nature of cultural barriers may differ significantly and hence influence coordination costs. Diversification may lead to issues regarding how to mesh differing management styles and firm cultures. Geographic expansion, particularly those into international territories, may need to face issues in addition to those mentioned above, such as language and ethnic differences. Firms without strong integrating mechanisms in their organizational structure may not have the ability to fully exploit scale and scope economies.

5. The following is a quote from a GE Medical Systems web site: “Growth Through Acquisition—Driving our innovative spirit at GE Medical Systems is the belief that great ideas can come from anyone, anywhere, at any time. Not only from within the company, but from beyond as well…This belief is the force behind our record number of acquisitions.” Under what conditions can growth-through-acquisition” strategy create value for shareholders?

The first part of this answer draws from Gans and Stern, “The Product Market and the Market for “Ideas”: Commercialization Strategies for Technology Entrepreneurs”

Consider the target firm as an “idea” (that is, a set of intellectual property). Suppose the “idea” can be protected (kept proprietary) AND the specialized complementary assets (infrastructure needed for full commercialization) are difficult to replicate. Here the suggestion is that the innovator might be acquired by a firm who owns the complementary assets. Both firms (target and acquirer) are empowered in the negotiation process: the innovator is empowered by the proprietary nature of their idea and the owner of the complementary assets is empowered by the necessity and scarcity of these assets.[6] The acquiring firm earns a return on their ownership of specialized complementary assets and innovators earn a return on their ideas. Here there is a gain from the acquisition. Another scenario in which acquiring might pay off: the idea is difficult to keep proprietary the specialized complementary assets are difficult to replicate (reputation-based ideas trading): Here if the firms with specialized and difficult to replicate assets also have excess capacity in those assets, it would be in their interest to build a reputation for NOT “stealing” ideas that are pitched to them, but rather licensing or acquireing these ideas (again, even though the idea is difficult to keep proprietary and would be easy to copy, resist this temptation). The firm who develops a reputation for acquiring idea firms rather than hijacking ideas will get a good idea flow and keep their complementary assets used at capacity rather than facing potential idle times.

Going along another path: Diversification may maintain some value to a firm that has the potential for catastrophe, such as bankruptcy. For example, Phillip Morris runs the risk that cigarette litigation may bankrupt the company. However, the non-tobacco businesses within Phillip Morris provide protection from complete bankruptcy should the firm lose its tobacco business. Another line of reasoning that assumes that capital markets are not efficient, a firm can help diversify shareholder risk by identifying undervalued assets. Some companies may have particularly strong skills in finding undervalued assets and thus make better diversification decisions than shareholders could find otherwise.

Looking at the broad definition of diversification to include vertical integration, there exist situations when a firm may create shareholder value by acquiring:

• Consider a vertical market failure for a scarce resource that constitutes a critical input for the survival of a company. A firm may want to backward integrate should a holdup problem relevant to the firm or common to the industry threaten the firm’s ability to compete.
• Backward integration can exploit market power necessary to obtain inputs critical to the company. The Australian ready-mix concrete industry illustrates this idea. Several players in this highly competitive industry chose to vertically integrate with suppliers in the quarry industry, which for a long time held oligopoly power. While such acquisitions may not create shareholder wealth, as economic gains from integration may be included in the acquisition price, these concrete companies safeguard their businesses. In fact, three firms now dominate the Australian ready-mix concrete industry. By exploiting market power through diversification, these firms mitigate the chances for failure of their firms, and thus reduce the risk borne by their shareholders.
• Closely held companies are not required to disclose information to the same extent as public companies. Hence, closely held companies may have additional information about the riskiness of their investments that their shareholders may not have. Thus, asymmetric information enables privately held firms to understand to a greater extent how to diversify on behalf of its shareholders.

5. With the growing number of firms that specialize in corporate acquisitions (e.g., Berkshire Hathaway, KKR), there appears to be a very active market for corporate control. As the number of specialist firms expands, will control arguments be sufficient to justify acquisitions? Do you think that relatedness will become more or less important as competition in the market for corporate control intensifies?

Control arguments propose that firms specializing in corporate acquisitions have unique skills in identifying an undervalued firm, and that these specialists extract undetected value by replacing a firm’s existing management with a more efficient one. As the number of specialists increase, it becomes more likely that more than one specialist will detect the undervalued firm. With intensified competition follows the exposure of the originally undetected value, which then gets bid away. (In fact, the winner’s curse argues that the firm may be purchased for more than its value.) Therefore, as the number of specialist firms expands, it will be less likely that control arguments will be valid. Thus, the control argument will not sufficiently explain why management teams would continue to bid. For bidding to continue, the specialists will need to target firms where synergies will create value.

Mergers make economic sense when the value of the merged firms exceeds the sum of the values of the separate firms. While replacing management with more efficient management can improve financial profits, these actions per se generally do not create value but rather simply reduce the costs of inefficiency. In order to create shareholder value, the merged firms must exploit synergies, including scale and scope economies. Synergies most likely exist between management teams that have developed complementary knowledge bases. Therefore, as the market for corporate control intensifies, in search of creating value, relatedness will become more important.

6. Professor Dranove’s son has been shoveling snow for his neighbors at $5 per hour since last year, using his dad’s shovel for the job. He hopes to save up for a bicycle. The neighbors decided to get a snow blower, leaving the boy a few dollars short and sorely disappointed (he knows that his dad will not contribute a penny!) How is this situation different from that described by Shleifer and Summers? Is there an efficiency loss as a result of the neighbors’ actions?
Shleifer and Summers’ argument is summed as follows: • Wealth redistribution may adversely affect economic efficiency when the acquired wealth is in the form of quasi-rents extracted from stakeholders having relationship-specific investments in the target firm. • Employees developing firm-specific assets are vulnerable to having quasi-rents taken by new owners, who are not bound to honor the implicit contracts made with old owners. Employees cannot readily sell firm-specific assets to other employers at a comparable price to that which they currently receive.
The employee of this example differs in that he has no sunk or fixed costs. Because he uses his father’s shovel, his quasi-rents are identical to his total pay. Additionally, his service is not restricted to the relationship with this client.

There is no efficiency loss in this case. The neighbors have elected to vertically integrate, purchasing a means of snow removal and doing it in-house instead of renting the service. The boy did not have a relationship-specific investment in the neighbor’s yard. He can easily transfer his service to other homes on the block so long as they do not have the time or desire to remove their snow in-house. Ultimately, in order to remain in this business long-term, the boy or his dad would have to increase their technological capacity and purchase a snowblower.

7. Suppose you observed an acquisition by a diversifying firm and that the aftermath of the deal included plant closings, layoffs, and reduced compensation for some remaining workers in the acquired firm. What would you need to know about this acquisition to determine whether it would be best characterized by value creation or value redistribution?

Value creation occurs if the result of the acquisition generates more value to the stakeholders of the firm than how much they held before the acquisition. Suppose, for example, the buyer introduces new technology to the acquired firm, and that this new technology reduces operations costs for the acquired firm. Consequently, the cost reduction enables the acquired firm compete more aggressively in its traditional market and earn higher profits. In this case, even if the new technology leads to layoffs and reduced compensation the merger creates value.

Value redistribution occurs when a party breaks an implied commitment with the creator of value in order to exploit quasi-rents. Suppose employees were to develop firm-specific skills that increase the profitability, and thus the value, of the firm. Subsequently, the firm reduces their salaries to increase operating margins. In this case, the firm expropriates the rents from the source that created the value. The acquiring firm takes the value owed the employees in their implied contracts.

Hence, in order to determine whether an acquisition creates value or redistributes value, you will need to know: (1) whether the value of the merged companies exceeds the sum of the values of the individual companies, (2) who or what constitutes the creative source of added value, and (3) whether that source receives the economic quasi-rents attributed to the new value added.

As a follow up to this question, can a divestiture—the opposite of diversification—involving significant layoffs creates value? Consider the case of defense contractor General Dynamics in 1991. Following the lead of William Anders, the new Chairman and CEO, the company ignited controversy when executives tied their compensation to shareholder wealth creation while implementing a strategy of drastic divestitures and downsizing that cut the number employee from 98,000 to 26,800 by 1993. Despite immediate negative attention from the media and union workers, analysts later admitted that the divestiture and downsizing had created over $4.5 billion in shareholder wealth.

8. How can you tell whether the businesses owned by a firm are better off than they would be under different forms of ownership?

It is difficult to evaluate how a firm performs under different forms of ownership. An approach would be to compare the firm to other firms in their industry before and after they have completed similar restructuring. However, since even direct competitors may embody different sets of critical resources and since many variables affect performance, some systemic and others idiosyncratic, these comparison provide limited value beyond speculation. In industries with localized product markets (i.e. hospitals, radio stations, newspapers), comparisons of different ownership patterns across markets may shed light on this question.
Chapter 6
Competitors and Competition

Chapter Contents 1) Introduction 2) Competitor Identification and Market Definition • The Basics of Competitor Identification • Putting Competitor Identification to Practice Example 6.1: Substitutes and Competition in the Postal Service • Geographic Competitor Identification 3) Measuring Market Structure Example 6.2: Defining Coca-Cola’s Market 4) Market Structure and Competition • Perfect Competition Example 6.3: A Dog-Eat-Dog World: The Demise of the Online Pet Supply Industry • Monopoly Example 6.4: The OPEC Cartel • Monopolistic Competition Example 6.5: Pricing in the Airline Industry • Oligopoly Example 6.6: Cournot Equilibrium in the Corn Wet Milling Industry 5) Evidence on Market Structure and Performance • Price and Concentration • Other Studies of the Determinants of Profitability 6) Chapter Summary
7) Questions

Chapter Summary
This chapter explores the link between market structure and competition. The chapter begins with a discussion of how to identify competitors, define markets, and describe market structure. First, the chapter discusses a qualitative way to define a market: two products are in the same market if they are substitutes. After defining substitutes, this chapter considers several approaches to defining markets and identifying competitors: demand elasticities, price correlations and trade flows. The chapter also introduces two ways to measure how concentrated the market is: the N-firm concentration ratio and the Herfindal Index.
This chapter then considers competition and financial performance within four broad classes of market structure: perfectly competitive markets; monopolistically competitive markets; oligopolistic markets; and monopoly markets. A market is perfectly competitive (see Economics Primer) if there are many sellers. In this market, consumers perceive the product to be homogeneous, and excess capacity exists. The chapter discusses how each of these characteristics discourages any one firm from raising its prices and why industry profits are driven to zero. Monopolistic competition describes markets in which there are many sellers and each seller is slightly differentiated from the rest. An oligopoly is a market in which the actions of individual firms materially affect the industry price level. The chapter introduces two theories on how firms behave in an oligopolistic market – the Cournot quantity competition model and the Bertrand price competition model, which are further elaborated on in chapters 7 and 8.
The above examination suggests that market structure is related to the level of prices and profitability that prevail in any given market. The chapter concludes with a discussion of evidence on the relationship of market structure and firm and industry performance. Specifically, the last sections of this chapter summarize the results of research on the relationship between price and concentration; the effects of advertising on price; the link between economies of scale and market structure; and connection between concentration and profitability. For the most part, these confirm that prices and profits are systematically related to industry structure.

Approaches to Teaching the Chapter


Market Structure: number and size of firms that compete within a market.

Market Definition: process of identifying the market or markets in which a firm competes.

Monopsonist: a firm is a monopsonist if it faces little or no competition in one of its input markets. In other words, monopsony is a market with many sellers, but only one buyer.

Substitutes: products tend to be close substitutes if a) they have the same or similar product performance characteristics; b) they have the same or similar occasions for use; c) they are sold in the same geographic market. Two products are substitutes if an increase (decrease) in the price of one leads to an increase (decrease) in the quantity demanded of the other.

Price Correlations: a way of determining whether two sellers are in the same market. If two sellers are in the same market, their price changes should be highly correlated.

Trade Flows: a method for defining a geographic market. A geographic market is properly identified if (1) the firms in that market must draw most of their customers from that area; (2) the customers residing in that market make most of their purchases from sellers in that market. Standard Industry Classification (SIC) System: The SIC system is used by the U.S. Bureau of the Census to analyze and report on U.S. business activity. The SIC system is a set of arbitrary definitions for product markets. SIC codes identify different products and services by a seven-digit identifier, with each digit representing a finer degree of classification.

Vertical Differentiation: making a product "better than" the products of competitors. Note that what constitutes "better than" or "higher quality" is often difficult to determine. In theory, products A and
B would be vertically differentiated if all consumers agreed that product A is higher quality.

Horizontal Differentiation: making a product distinctive from those of competitors. If products A and B were horizontally differentiated, some consumers would prefer product A and other consumers would prefer product B.

Cournot Price Competition: a model designed to explain how firms will behave in an oligopoly, based on the assumption that each firm selects a quantity to produce, and the resulting total output determines market price.

Bertrand Price Competition: a model which explains how firms will behave in an oligopoly, based on the assumption that each firm selects a price and meets all demand for that product at that price.

N-firm Concentration Ratio: a way to measure how concentrated an industry is by giving the combined market share of the N largest firms in the market. (4,8, and 20-firmconcentration ratios are common.)

Herfindahl Index: a way to measure how concentrated an industry is by summing the squared market shares of all the firms in the market.

As a means of introducing many of the topics in this chapter, ask students to draw on their own work experience and identify the competitors in an industry with which they are familiar:

• What were the key forces shaping the nature of competition and the opportunities for making profit in that industry? • What, if anything, did firms do to insulate themselves from these forces? • Was the product or service that their firm sold homogenous or heterogeneous? • What were some of the substitutes for the product or service that (your) firm produced? • Do the substitutes that come to mind fit the definition of substitute given in the chapter? • Is geography a factor in defining this market? • Were there many competitors or is this industry dominated by a few firms? • What was the pricing competition like in this industry? • Did your firm have control over pricing? • Was this industry government-regulated and what effect did government regulation have on pricing and competition? • Would you characterize this industry as perfectly competitive, monopolistically competitive, an oligopoly or monopoly? • Can you think of industries that have Bertrand or Cournot dynamics? Industries that produce agricultural products or commodities tend to have Bertrand dynamics, while industries with high fixed costs are more likely to have Cournot dynamics.

The above discussion should generate plenty of examples, which will help students understand some of the ways to define a market.

Examples: Defining a Market
A key learning point of this chapter is that there are many possible ways to define a market and the definition of market is often highly contested. Out of all possible definitions of a market, some are better than others and it is important to realize which definition of a market is more appropriate. The chapter provides two great examples of market definition and competition, the postal service and the soft drink industry.

The following examples will help students understand how there are many possible definitions of a market and how your competitive analysis of a market will change depending upon what market definition you adopt:

1) The beer industry: One can define the beer industry nationally, regionally, or locally. On a national level, micro-breweries do not represent a significant percentage of the beer sold in the US. However, in certain local markets, micro-breweries represent a fairly large market share and it would be a mistake to ignore their presence.

2) The airline industry: In certain routes/markets, airlines are not only competing with other airlines for customers; they may be competing with other forms of transportation or even other forms of communication. • For example, would you consider the train from New York to Philadelphia to be a substitute for the airplane? (yes) Clearly, it would be a huge mistake for United to use a narrow definition of market and not check how much a train or bus ticket costs to go from Philadelphia to New York. • What about the train from New York to California vs. flying from New York to California? (no) • What are some other substitutes for air travel? (i.e. fax, telephone, videoconferencing, etc.) • How close to substitutes are they? • How close to substitutes are they likely to become as technology evolves?

Quantitative Ways to Define a Market
To understand the quantitative ways to define a market, it is useful to have the students prepare some cases in conjunction with this chapter. Antitrust cases, such as the proposed merger of Pepsi and Dr. Pepper, are useful because they often provide data necessary to apply the quantitative techniques to define a market and measure market structure, like the Herfindahl index and n-firm concentration ratio. When reviewing quantitative ways to define a market, it is important to point out the difference between the n-firm concentration ratio and the Herfindahl index. The n-firm concentration ratio is not sensitive to variations in dispersions between the market shares, while the Herfindahl index takes these variations into account.

Market Structure
This chapter discusses four broad types of markets: perfect competition, monopolistic competition, oligopoly and monopoly. Although the theory of perfect competition was introduced in the Economics Primer, it may be helpful to review the characteristics of a perfectly competitive market…

1) there are many sellers
2) consumers perceive the product to be homogenous
3) excess capacity exists

…and how each of these features contribute to fierce pressure to reduce prices. Sellers have no control over prices and P=MC. Examples of perfectly competitive markets include commodities and agricultural products (which are often traded on exchanges), like silver, gold, barley, sugar, coffee, etc. Although few markets are perfectly competitive in the sense that each firm faces a perfectly horizontal demand curve for a homogenous product, many markets are almost perfectly competitive.

The key difference between monopolistic competition and perfect competition is that under monopolistic competition the goods produced by each seller are horizontally differentiated. As a result, some buyers are willing to pay slightly more for a good produced by one seller than another. It does not mean that one product is better than another for all consumers. Rather, one class of consumers prefers a good with a certain characteristic while another class of consumers would prefer something else. The text points out that geography is an important source of differentiation. Monopolistic competition encompasses a huge number of markets today, as companies constantly try to differentiate their products from their competitors. Examples of monopolistic competitive markets include: dry cleaners, toothpaste, shampoo, laundry detergent, peanut butter, jeans, rollerblades, etc. Branded products and restaurants are great examples of monopolistically competitive markets.

In perfectly competitive and monopolistically competitive markets, entry is a constant threat and sellers disregard the choices of specific competitors. In an oligopoly, however, the pricing and production strategies of individual firms in a market affect the industry price. Here, it may be helpful to work through the Cournot and Bertrand model example provided in the chapter. The example in the chapter also illustrates that profits of these firms are less in an oligopoly than if they acted as a monopoly; in other words, firms in an oligopoly do not work to maximize industry profits. The athletic footwear industry (Nike, LA Gear, and Converse) is a great example of an oligopoly and one to which most students can relate.

Unlike in a perfectly competitive market, a monopoly firm has complete control over pricing and the quantity it chooses to produce. A monopolist will produce until marginal revenue = marginal cost. If marginal revenue > marginal cost, then the monopolist could still produce more and increase profits. If marginal revenue < marginal cost, the monopolist could cut back on production and increase profits. A monopolist produces less than firms in an oligopoly, and can charge higher prices as a result. There are very few firms that have monopoly power and there is anti-trust legislation in the US designed to break up firms that have monopoly power. However, a firm might have monopoly power because of the following reasons: patent, copyrights, government license, or economies of scale. There are instances where monopolies are deemed efficient and acceptable. For example, until recently, due to the large fixed costs in the utility industry, electric, phone, and gas utilities were run as monopolies and were regulated by the government. Patent and copyright laws reward innovation and investments in R&D. Examples of monopolies include: Wal-Mart in mass merchandising in many small towns; Baxter in surgical gloves and Xerox in copiers in the 1960s and early 1970s.

Suggested Harvard Case Study[7]

Caterpillar HBS 9-385-276 . Describes the structure and evolution of the earth moving equipment industry worldwide in the post war era, particularly focusing on developments in the 1980’s and 1970’s. Describes Caterpillar’s strategy in becoming the dominant worldwide competitor with industry market share exceeding 50%. Includes details on CAT’s manufacturing, marketing research and development and organizational policies. Concludes with a description of some environmental changes occurring in the early 1980’s, and raises the question of how these might effect Caterpillar Tractor Co.’s record 1981 performance and require changes in its highly successful strategy. You may want to ask students to think of the following questions in preparation for the case:

a) Describe the key drivers to Caterpillar’s historical success.
b) Describe changes in the competitive environment and explain how these changes might impact CAT.

De Beers Consolidated Mines, HBS 9-391-076 (see earlier chapters)

Harnischfeger Industries: Portal Crains (HBS #9-391-130): This case further explores the link between market structure and competition. Harnischfeger, the market share leader, is facing increasing competition in the portal crane industry and wants to regain market share without engaging in a price war.

The Oil Tanker Shipping Industry in 1983: (HBS #9-384-034): This case provides an example of industry capacity overexpansion in the shipping industry in 1983.

The U.S. Airline Industry in 1995, J. Dana, Northwestern University (HBS also has a case with the same title): This case focuses on the US airline industry and serves as an introduction to industry analysis. Discussion typically covers horizontal boundaries of the firm, economies of scale and scope, exit and entry decisions and the long run dynamics of industry, and simple strategic positioning. The case also discusses yield management and other operations aspects of the industry.

Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Baker, J. and T. Bresnahan, '"The Gains from Merger or Collusion in Product-Differentiated Industries,"Journal of Industrial Economics, 33, 1988: pp.427-444.

Baumol, W., J. Panzar, and R. Willig, Contestable Markets and the Theory of Industry Structure, New York: Harcourt Brace Jovanavich, 1982.

Bresnahan, T. and P. Reiss, "Entry and Competition in Concentrated Markets," Journal of Political Economy, 99, 1989: 997-1009

Chamberlin, E.H., The Theory of Monopolistic Competition, Cambridge, MA: Harvard University Press, 1933.

Eizinga, K. and T. Hogarty, "The Problem of Geographic Market Definition Revisited: The Case of Coal,"Antitrust Bulletin, 23, 1978:1-18.

Porter, M. and A.M. Spence, "'The Capacity Expansion Decision in a Growing Oligopoly: The Case of Corn Wet Milling," in McCall, J.J. (ed.), The Economics of Information and Uncertainty, Chicago, IL: University of Chicago Press, 1982, pp. 259-316.

Schmalensee, R., "Interindustry Studies of Structure and Performance," in Schmalensee, R. and R. Willig (eds.), The Handbook of Industrial Organization, Amsterdam: North Holland, 1989.

Schmalensee, R., "Studies of Structure and Performance," in Schmalensee R. and R. Willig (eds.), The Handbook of Industrial Organization, Amsterdam: North-Holland, 1989.

Shapiro, C. "Theories of Oligopoly Behavior," in chap. 6 in Willig, R. and R. Schmalensee (eds.), The Handbook of Industrial Organization, Amsterdam: North Holland, 1989.

Stigler, G. and R. Sherwin, "The Extent of the Market," Journal of Law and Economics, 28, 1985: pp. 555-585.

Weiss, L. (ed.), Concentration and Price, Cambridge, MA: MIT Press, 1989.
Answers to End of Chapter Questions

Why are the concepts of own and cross-price elasticities of demand essential to competitor identification and market definition?

The magnitude of consumer responses to changes in a product market’s (or industry’s) price is measured by the own-price elasticity of demand, which equals the percentage change in a product market’s sales that results from a 1 percent change in price. If an industry raises price and consequently loses most of its customers to another industry (or industries), we conclude that the market under consideration faces close substitute products (or the product market competes with other product markets). Measuring the own-price elasticity of demand tells us whether a product faces close substitutes, but it does not identify what those substitutes might be. We can identify substitutes by measuring the cross-price elasticity of demand between two products. The cross-price elasticity measures the percentage change in demand for good Y that results from a 1- percent change in good X. The higher is the cross-price elasticity, the more readily consumers substitute between two goods when the price of one good is increased.

In a recent antitrust case, it was necessary to determine whether certain ‘elite’ schools (mainly the Ivy League schools and MIT) constituted a separate market. How would you go about identifying the market served by these schools?

The market can be identified in part by the customers and by residual demand analysis. To determine if the ‘elite’ schools comprised a separate market, we could conduct a survey to uncover who the applicants to these schools (consumers) were and which other schools did these applicants apply to. If the applicants were from the same pool of high-school students and if they did not apply outside the ‘elite’ schools, this would tend to identify the ‘elite’ schools as a separate market.
In addition, we could study the pricing and enrollment history of these schools to see if their pricing decisions were constrained by the possibility that consumers will switch to sellers outside the market. If these schools collectively raised their prices compared to other schools (controlling for changes in demand) and did not see a drop in their enrollment (revenues), then they may constitute a separate market.

How would you characterize the nature of competition in the restaurant industry? Are there submarkets with distinct competitive pressures? Are there important substitutes that constrain pricing? Given these competitive issues, how can a restaurant be profitable?

The restaurant industry can be described as exhibiting monopolistic competition as there are many sellers in the market but each seller is slightly differentiated from the rest. A restaurant can be horizontally differentiated by the type of cuisine its serves, the quality of the food, the service, the ambience and décor and the location. The prices that can be charged for these differentiating features are constrained in large part by the geographic location of the restaurant and the local competition. Consumers will tend to not travel long distances for their meal, no matter how differentiated the product. The consumers will weigh the convenience of the location against the price of the meal and so cross-price elasticity of demand may be high. Substitutes to restaurant meals are home prepared meals and frozen dinners. The restaurant will be profitable if it has a superior location. Failing that, a restaurant can be profitable by creating a loyal following for its horizontally differentiated product, so that consumer demand is relatively inelastic.

How does industry-level price elasticity of demand shape the opportunities for making profit in an industry? How does firm-level price elasticity of demand shape the opportunities for making profit in an industry?

The industry price elasticity of demand indicates the percentage change in quantity demanded per percentage change in price when all firms simultaneously change price. It determines the limits on firms' abilities to profit from collective price increases and thus shapes profit opportunities in environments where firms are able to coordinate their pricing behavior to more closely resemble that of a monopolist.
The firm level price elasticity of demand indicates the percentage change in a firms quantity demanded per percentage change in price when that firm changes its price but other competing firms do not. This elasticity will determine the perceived benefits from a price cut aimed at stealing business from competitors. The larger the elasticity is (in absolute value), the stronger the temptation is on the part of a firm to cut price. This elasticity thus shapes industry profitability by influencing the likelihood of destabilizing price-cutting behavior by firms. Thus, the greater the firm-level elasticity of demand, the greater is the potential for price wars and reductions in overall profits.

What is the “revenue destruction effect”? As the number of Cournot competitors in a market increases, the price generally falls. What does this have to do with the revenue destruction effect? Smaller firms often have greater incentives to reduce prices than do larger firms. What does this have to do with the revenue destruction effect?

When a firm expands its output, it reduces the market price and thus lowers the sales revenue of its rivals—this is referred to at the “revenue destruction effect”. Each firm seeks to maximize its own profit and not total industry profit. The smaller is a firm’s share of industry sales, the greater the divergence between its private gain and the revenue destruction effect from output expansion. This suggests that as the number of firms in an industry exhibiting Cournot competition increases, the greater is the divergence between the Cournot equilibrium and the collusive outcome.

How does the calculation of demand responsiveness in Linesville change if customers rent two videos at a time? What intuition can you draw from this about the magnitude of price competition in various types of markets?

Recall from the chapter that there is a video store at each end of Straight Street, which is 10 miles long. Each store carries identical inventory. There are 100 video rental customers in Linesville, and their homes are equally spaced along the street.
When customers decide which store to visit, they take two factors into account: the price that each store charges for a video and the cost of travelling to the store. Intuitively, if customers rent two videos at a time, transportation costs would be a smaller percentage of their total costs and customers would be willing to travel further if one video store charged less than the other did. As transportation costs decrease as a percentage of total costs, they would become less important in the transaction and a store could gain more from the price decrease.
If you think of ‘transportation costs’ as ‘horizontal differentiation’, then you can apply this reasoning to a variety of markets. As product differentiation declines in importance, consumers are more willing to switch to another product.

5. Numerous studies have shown that there is usually a systematic relationship between concentration and price. What is this relationship? Offer two brief explanations for this relationship.

Leonard Weiss summarized he results of price and concentration studies in over 20 industries, including cement, railroad freight, supermarkets, and gasoline retailing. He finds that with few exceptions, prices tend to be higher in concentrated markets. Consider an industry with a high concentration ratio because there are a small number of Cournot competitors. If each firm’s share of industry sales is large, the divergence between a firm’s private gain and the revenue destruction effect from output expansion is small. Hence, total industry output and price are closer to the levels that would be chosen by a profit-maximizing monopolist. Alternatively, an industry with a high concentration ratio that has a small number of sellers is able to engage more successfully in tacit collusion.

6. The relationship described in question 7 does not always appear to hold. What factors, besides the number of firms in the market, might affect margins?
An important source of variations in price-cost margins across industries is due to regulation, product differentiation, the nature of sales transactions, and the concentration of buyers.
Also, it is difficult to control for the way in which price cost margins are calculated. Since the predictions of economic theory pertain to the market between price and marginal cost, price-cost margins should be computed using marginal cost. However, accounting cost data usually allow the researcher to infer average cost rather than marginal cost.
7. The following are the approximate market shares of different brands of soft drinks during the 1980’s: Coke—40%; Pepsi—30%; 7-Up—10%; Dr. Pepper—10%; All other brands—10%. a. Compute the Herfindahl for the soft drink market. Suppose Pepsi acquired 7-Up. Compute the most merger Herfindahl. What assumptions did you make?
.4^2 + .3^2 + .1^2 + .1^2 = Herfindahl index = .16+.09+.01+.01 = 0.27
If Pepsi and 7-Up merged:
.4^2 + .4^2 + .1^2 = Herfindahl index = .16+.16+.01 = 0.33
The assumptions of the above include that the market shares of firms in the industry do not change as a result of the merger of two players (Pepsi and 7-Up). b. Federal antitrust agencies would be concerned to see a Herfindahl increase of the magnitude you computed in (a), and might challenge the merger. Pepsi could respond by offering a different market definition. What market definitions might they propose? Why would this change the Herfindahl?
Pepsi should consider a market definition that would cause the market shares of firms to appear more fragmented. That is, Pepsi should attempt to increase the size of the denominator that determines its market share. For example, Pepsi might argue that the market definition is the “junk food market” – which includes chips and candy. This would have the affect of making the market Pepsi competes in more fragmented.
8. The dancing machine industry is a duopoly. The two firms, Chuckie B Corp. and Gene Gene Dancing Machines, compete through Cournot quantity-setting competition. The demand curve for the industry is P=100 – Q, where Q is the total quantity produced by Chuckie B and Gene Gene. Currently, each firm has marginal cost of $40 and no fixed cost. Show that the equilibrium price is $60, with each firm producing 20 machines and earning profits of $400.
(1) (1 = P1Q1 – TC1 = (100 - Q1 - Q2 ) Q1 -40 Q1
(2) (2 = P2Q2 – TC2 = (100 - Q1 - Q2 ) Q2 -40 Q2
Now take the derivative of each of the above with respect to Q:
(1) Max (1 = 100 - 2Q1 - Q2 -40
Q1 = 30 - .5Q2
(2) Max (2 = 100 - 2Q2 - Q1 -40
Q2 = 30 - .5Q1
Now solve the above simultaneously:
Q1 = 30 - .5Q2 = Q1 = 30 - .5(30 - .5Q1)
Q1 = 20 and so by symmetry Q2 = 20
To find P we use the market demand curve:
P = 100 – Q = 100 – Q1 – Q2 = 100 – 20 – 20 = $60
And finally each firm’s profits:
(1 = P1Q1 – TC1 = (60*20) – (40*20) = 1200 – 800 = $400 and so by symmetry
(2 = P2Q2 – TC2 = (60*20) – (40*20) = 1200 – 800 = $400

9. Consider a market with two horizontally differentiated firms, X and Y. Each has a constant marginal cost of $20. Demand functions are:
Qx = 100 – 2Px + 1Py
Qy = 100 – 2Py + 1Px
Calculate the Bertrand equilibrium in prices in the market:
Notice the form of the demand function – the quantity X sells increases as the price Y charges increases. Hence, the each firm improves its profits by undercutting its rival and capturing a windfall in sales. The only stable price combination is at the point when both firms are charging MC. Prices would not necessarily fall to MC if the firms faced capacity constraints.

Chapter 7
Strategic Commitment

Chapter Contents

1) Introduction 2) Why Commitment is Important Example 7.1: Strategic Commitment and Preemption in the Global Airframe Market: Airbus versus Boeing Example 7.2: Commitment and Irreversibility in the Airline Industry 3) Strategic Commitment and Competition • Strategic Complements and Strategic Substitutes • Tough versus Soft Commitments • A Taxonomy of Commitment Strategies Example 7.3: Commitment at Nucor and USX: The Case of Thin-Slab Casting 4) Flexibility and Real Options Example 7.4: Commitment versus Flexibility in the CD Market Example 7.5: Corning’s Nuclear Winter 5) A Framework for Analyzing Commitments 6) Chapter Summary 7) Questions

Chapter Summary

Decisions such as investment in new capacity or introduction of new products are examples of strategic commitment. Strategic commitments are decisions that have long term impact and are difficult to reverse. These decisions are different from tactical decisions, which have a short-term impact and are easier to reverse. For example, Philips, N.V. of the Netherlands faced a critical choice in 1982: whether to build a disk pressing plant or wait until the commercial appeal of the CD market became certain.

Strategic commitments influence the nature of competition in the industry. The decision to build a new plant with substantial capacity in the above example would discourage other firms from making investments in similar plants. Firms making commitments need to balance the benefits of commitments with the loss of flexibility that come in by making irreversible decisions.

The next section illustrates the importance of commitment and its effect on profits with a simple example. Imagine two firms in an oligopolistic industry. Firm 1 is considering two options, 1) Aggressive - increase capacity to gain market share and, 2) Soft - no change in firm’s capacity. Table 7.1 shows payoffs of each firm under different options that each of them can choose. We can see that if firm 1 makes a preemptive move of expanding capacity, it can improve its profits irrespective of what firm 2 chooses. This also makes another point--by choosing an aggressive strategy firm 1 becomes more inflexible, but firm 1 is also better off.

In order to be effective a commitment must be visible, understandable and credible. The key to credibility is irreversibility; i.e. a competitive move must be hard or costly to reverse once it is set in motion. Relationship specific investments, most favored customer clauses in contracts, and public statements of intention of taking actions are examples of competitive moves that become irreversible commitments. This section ends with an airline industry example. Ming-jer Chen and Ira Macmillan’s study of this industry shows that: M&A, investment in creation of hubs, and feeder alliances have highest perceived irreversibility while promotions, decisions to abandon a route, and increasing commission rates of travel agents are seen as easiest to reverse.

The next section uses product market competition models to discuss how strategic commitments alter competition between firms. Both Cournot and Bertrand models use the concept of reaction functions. When reaction functions are upward sloping the firm’s actions are strategic complements. In the Bertrand model prices are strategic complements, because the profit-maximizing response to a competitor’s price cut is price reduction. In the case of downward sloping reaction functions the firm’s actions are strategic substitutes. In the Cournot model, quantities are strategic substitutes because an increase in quantity is the profit maximizing response to a competitor's reduction in quantity. To illustrate the Cournot model, the chapter describes how the world market for memory chips follows the Cournot model of quantity setting. The price drops of 1984 caused American firms to not invest in new capacities; Japanese firms responded by increasing their investments in new capacity. In the 90s the same situation is occurring with South Korean’s expanding their capacity when major Japanese firms have scaled back production due to soft local economy.

The next section analyzes the commitment process in two stages; the firm makes a strategic commitment in stage 1 and then both firms make tactical decisions in stage 2. Commitment decisions have a direct effect and a strategic effect. The direct effect assumes that the competitor’s behavior is constant and analyzes the incremental NPV of the decision. The strategic effect factors in the competitive side effects that occur when the competitor reacts to the firm’s investment. Figure 7.2 illustrates effects of making a “tough” decision in a Cournot market. By making a “tough” decision, Firm 1 forces Firm 2 to reduce its output, which in turn makes firm 1 better off or has a positive strategic side effect of commitment (its rival is producing less output). Similarly a “soft” decision on Firm 1’s part induces Firm 2 to increase its output or behave more aggressively, thus a negative side effect of commitment.

Incentives for strategic commitment are different when stage 2 competition is Bertrand. If the commitment makes Firm1 tough, the firm charges a lower price, which corresponds to an inward shift in Firm 1’s reaction function. As a result, the Bertrand equilibrium moves to the southwest and involves a lower price for both Firm 1 and Firm 2 (Fig 7.4). On the other hand, if the commitment makes Firm 1 soft, the firm’s reaction function shifts outward. As a result, the Bertrand equilibrium moves to the northwest and involves a higher price for Firm 1 and Firm 2 (Fig 7.5). The strategic effects of the commitment may also depend on the degree of horizontal differentiation among the firm making the commitment and its competitors. Figure 7.6 shows that in a Bertrand market the magnitude of the strategic effect depends on the degree of horizontal differentiation.

Table 7.2 summarizes the taxonomy by Fudenberg and Tirole—that is, the effect of Cournot and Bertrand competitions or soft vs. tough. The main components of the taxonomy are the “Puppy-Dog Ploy”, “Top-Dog Strategy”, “Fat-Cat Effect” and “Lean and Hungry Look”. The main point that comes out is that a commitment that induces competitors to behave less aggressively will have a beneficial strategic effect on the firm making the commitment. By contrast, a commitment that induces competitors to behave more aggressively will have a harmful strategic effect. Other factors may affect the degree of a competitor’s reaction, like capacity utilization rates and the degree of a firm’s horizontal differentiation.

Example 7.3 describes Nucor’s decision to adopt this slab casting in the steel industry and illustrates how previous commitments by a firm can limit its ability to take advantage of new commercial opportunities. Example 7.4 explores the link between a firm’s financial structure and product market competition, and concludes that increased leverage encourages a firm to behave more aggressively.

The final section is about the flexibility that a firm gives up by making a strategic commitment and the option value that a firm gains when it can wait before making a decision. This section introduces Pankaj Ghemawat’s four-part framework for analyzing major strategic decisions: positioning analysis, sustainability analysis, flexibility analysis, and judgment analysis.

Approaches to teaching this chapter

The student must become familiar with the following definitions and concepts as described in this chapter:
Strategic Commitment: decision by a firm that has a long-term impact and is difficult to reverse.

Tactical Decision: decision by a firm that can easily be reversed and whose impact persists only in the short run.

“Aggressive” Strategy: strategy that involves a large and rapid increase in capacity and is aimed at increasing the firm’s market share.

“Soft” Strategy: a firm’s strategy that involves no change in capacity.

Strategic Complements: occurs when reaction functions of firms are upward sloping. The more of a certain action one firm chooses the more of the same action the other firm will optimally choose. In the Bertrand model, prices are strategic complements.

Strategic Substitutes: Occurs when reaction functions of firms are downward sloping. The more of a certain action that one firm takes, the less of that same action the other firm optimally chooses. In the Cournot model quantities are strategic substitutes.

Direct Effect: is the commitment’s impact on the present value of the firms profits, assuming that the firm adjusts it own tactical decisions in light of this commitment, but that its competitors behavior does not change.

Strategic Effect: takes into account the competitive side effects of the commitment; i.e. how does the commitment alter the tactical decisions of the rival and ultimately, the Cournot or Bertrand equilibrium.

Option Value: of a delay is the difference between the expected net present value if the firm invests today and the expected net present value if the firm waits until the uncertainty resolves itself. Option value is the outcome of preserving flexibility or future options open after a commitment has been made.

Learn-to-burn Ratio: This is the ratio of the “learn rate” – the rate at which new information is received by the firm that allows it to adjust its strategic choices – and the “burn rate” – the rate at which the firm is investing in the sunk assets to support the strategy.

Positioning Analysis: One of the steps in Ghemawat’s four-step framework for analyzing commitment-intensive choices. This analysis determines the direct effect of the strategic commitment. It involves the analysis of whether the firm’s commitment is likely to result in a product market position in which the firm delivers superior consumer benefits or operates with lower costs than competitors.

Sustainability Analysis: Second step in Ghemawat’s four-step framework for analyzing commitment-intensive choices. This analysis determines the strategic effect of the commitment, which could involve a formal analysis of the net present value of alternative strategic commitments.

Flexibility Analysis: Another step in Ghemawat’s four-step framework for analyzing commitment-intensive choices. This analysis incorporates uncertainty into positioning and sustaining strategic commitments.

Judgement Analysis: The last step in Ghemawat’s four-step framework for analyzing commitment-intensive choices. The analysis involves taking stock of the organizational and managerial factors that might distort the firm’s incentive to choose an optimal strategy.

For students to get the full benefit of this chapter, it is important that they understand the following concepts:

The concept of a Nash equilibrium and how commitment can move the market outcome away from Nash equilibrium, which, from the perspective of the committing firms, is inferior. The best way to illustrate this theory is through a simple example, like the one given in table 7.1 of this chapter. The game theory section of the primer also introduces the basic elements of game theory and the concept of Nash Equilibrium. To illustrate the value of commitment, consider the example from the text:

| | | |Firm 2 | |
| | |Aggressive | |Soft |
|Firm 1 |Aggressive |12.5, 4.5 | |16.5, 5 |
| |Soft |15, 6.5 | |18, 6 |

If both firms act simultaneously, Firm 1 will choose “soft” and Firm 2 will choose “aggressive” which will not be the best outcome for Firm 1. The two firms have reached Nash equilibrium because each firm is doing the best it can give what the other firm is doing. However, if Firm 1 acts first and chooses “aggressive”, then Firm 2's best option is to choose “soft”. Therefore, Firm 1 will increase its profits to 16.5 from 15. This example illustrates the power of making a “strategic” commitment” and how a strategic commitment can alter competition and profits between firms.

This chapter also relies heavily on the concepts of Cournot and Bertrand equilibriums developed in chapter 6. A key point made in this chapter is that expected form of competition can have a major influence on whether the commitment is ultimately beneficial to the committing firm. In this regard, it is helpful to walk through example in the text, in which firm 1 makes a commitment in stage 1, and both firms maneuver tactically in stage 2. This discussion concludes the impact of strategic commitment on the market equilibrium depends on whether the stage 2 tactical variables are strategic complements (Bertrand) or strategic substitutes (Cournot) and whether firm 1 makes the firm soft or tough (see figure 7.6 - A Taxonomy of Strategic Commitments).

• A natural question students may ask is how can one access whether a market is Cournot or Bertrand so that the forgoing theory can be applied to a real market. We would consider that to be an overly literal interpretation of the key learning points from this section. In our view what is critical in any real world application of this theory is that analyst be able to access whether the commitment is a tough one or a soft one and whether that, in turn, will induce competitors or potential entrants to act more aggressively then they would have had the form not made the commitment.

• To help students understand the impact of “strategic commitments” in real markets the examples in the chapter of Nucor, world market for memory chips, and Airline industry studies are very useful. The following case studies will give students hands on experience in analyzing strategic commitments.

Suggested Harvard Case Study[8]

De Beers Consolidated Mines, HBS 9-391-076 (see earlier chapters)

Du Pont in Titanium Dioxide HBS 9-385-140: This case illustrates the strategic logic and risks of preemption. This case examines Du Pont's decision to add 500,000 tons of capacity to its titanium dioxide plant in 1972 in order to "preempt" the market.

Gillette’s Launch of Sensor HBS 9-792-028: This case discusses Gillette’s launch of its Sensor shaving system. One of the biggest product launches ever, and examines Gillette’s decision to position sensor razor as a cartridge rather than as disposable in order to blunt potential price competition with disposable razors.

Leading the Charge: The Launch of the GM Card (HBS 9-385-140): This case discusses General Motors’ launch of the GM credit card in 1992. The incentives under the GM card can be interpreted as a kind of targeted rebate, one of whose effects may be to soften price competition in the automotive business.

Nucor at a Crossroads HBS 9-793-039. Nucor is a minimill deciding whether to spend a significant fraction of its net worth on a commercially unproven technology in order to penetrate a market. This case is an integrative one designed to facilitate a full blown analysis of a strategic investment decision. This case can be prepared with some combination of the following chapters: 9, 10, 13, 14, and 15. You may want to ask students to think of the following questions in preparation for the case:

a) How attractive do the economics of thin slab casting look?
b) Is thin slab casting likely to afford Nucor a sustainable competitive advantage in flat rolled products?
c) How should Nucor think about the uncertainties surrounding thin slab casting.

Philips Compact Disc Introduction, HBS 9-792-035 (see earlier chapters)

Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Avinash Dixit and Barry Nalebuff, Thinking strategically: The Competitive Edge in Business, Politics and Everyday Life, (New York: Norton), 1991.

Bulow, J., Geanakopolos, and P. Klemperer, “Multimarket Oligopoly: Strategic Substitutes and Complements” Journal of Political Economy”, 93, 1985: 488-511.

Chen, M.-J. and I.C. MacMillan, “Nonresponse and Delayed Response to Competitive Moves”

Dixit, A.K. and R.S. Pindyck, Investments under Uncertainty, Princeton, N.J.: Princeton University Press, 1994.

The Roles of Competitive Dependence and Action Irreversibility, Academy of Management Journal, 35, 1992: 539-570.

Ghemawat, P. “Commitment to a Process Innovation: Nucor, USX and Thin Slab Casting,” Journal of Economics and Management Strategy,2, spring 1993: 133-161.

Ghemawat, P. “Commitment: The Dynamics of Strategy, New York; Free Press, 1991.

McGahan, A.M. “ The Incentive not to Invest: Capacity Commitments in Compact Disk Introduction,” Research on Technological Innovation, Management and Policy, 5, 1993: 177-197

Answers to End of Chapter Questions 1. What is the difference between a soft commitment and no commitment?
In making no commitment, a firm has not taken an action or made an investment that alters its own and/or its rivals competitive responses. In contrast, a soft commitment is one that, no matter what its competitors do, the firm will behave less aggressively than if it had not made the commitment. Thus, in a Cournot game a soft commitment will cause the firm to produce relatively less output, while in a Bertrand game a soft commitment will induce the firm to charge a higher price than if it had not made the commitment. 2. How are commitments related to sunk costs?
A commitment is a difficult to reverse action or investment that alters the subsequent competitive interaction between a firm and its rivals, presumably to the advantage of the firm making the commitment. A sunk cost is a cost that has already been incurred and cannot be recovered. In order for an action or investment to serve as a commitment, rival firms must believe the firm who made the investment will, indeed, alter their future behavior. The key to the credibility of the firm’s strategic commitment is irreversibility. If a firm could recover the cost of its strategic commitment after it was set in motion, much credibility would be lost. Therefore, the higher the proportion of an investment that is sunk, the more likely that investment would serve as a strategic commitment. 3. Explain why prices are usually strategic complements and capacities are usually strategic substitutes.
If an increase (decrease) in a particular action on the part of one firm is met by an increase (decrease) in the same action on the part of another firm, than the actions are said to be strategic complements. If two firms sell identical products and one firm lowers its price, the other firm will lose many of its customers. Most likely, a firm can partially restore profits by responding to the price cut of its rival by a price cut of its own. Hence price-cutting often elicits price-cutting and so prices are usually strategic complements.
If an increase (decrease) in a particular action on the part of one firm is met by a decrease (increase) in the same action on the part of another firm, than the actions are said to be strategic substitutes. If a firm expands capacity, it is profit maximizing for the firm’s rivals to choose lower capacities. Since a choice of high capacity by a firm often elicits a response of lower capacity by rival firms, capacity is usually a strategic substitute. 4. Why did Fudenberg and Tirole only identify four of the eight possible strategic commitment strategies? Of the four they did not identify, which do you think firms might actually adopt?
The following are four strategic commitment possibilities that Fudenberg and Tirole did not identify.
1. Strategic Complements: Commitment makes the firm tough, and the firm makes the investment.
2. Strategic Complements: Commitment makes the firm soft and the firm does not make the investment.
3. Strategic Substitutes: Commitment makes the firm tough and the firm does not make the investment.
4. Strategic Substitutes: Commitment makes the firm soft and the firm makes the investment.
The reason Fudenberg and Tirole did not identify these strategies is that the strategies above reduce the value of the firm if the strategic effect is larger than the direct effect.
Firms whose tactical variable is price often do not make investments that commit them to raising price (in other words they employ strategy 2 from above). 5. Use the logic of the Cournot equilibrium to explain why it is more effective for a firm to build capacity ahead of its rival than it is for that firm to merely announce that it is going to build capacity.
The purpose of a commitment is to alter the future behavior of the firm and of the firm’s rivals in such a way as to improve the net present value of the profits of the firm making the commitment. If a firm announces a capacity expansion, but the firm’s announcement is not credible, the behavior of rival firms will not be effected by the announcement. Hence the announcement has no strategic effect whatsoever if the firm’s credibility is in doubt. If the firm actually builds the capacity, rival firms have no choice but to alter their behavior in response to the expansion of capacity. If the firms are Cournot competitors, firms will react by choosing a lower capacity if their rival has expanded their capacity. Had the firm simply made an announcement rather than actually building the capacity, rival firms could have chosen higher capacity forcing the announcing firm to “reneg” on its announcement as its best response to its rivals ignoring its initial announcement. 6. An established firm is considering expanding its capacity to take advantage of a recent growth in demand. It can do so in two ways. It can purchase fungible, general-purpose assets that can be resold close to their original value, if their use in the industry proves unprofitable. Or it can invest in highly specialized assets that, once they are put in place, have no alternative uses and virtually no salvage value. Assuming that each choice results in the same production costs once installed, under what choice is the firm likely to encounter a greater likelihood that its competitors will also expand their capacity.

In order to be effective commitment must be visible, understandable and irreversible. The key is irreversibility. In general, a significant investment in a highly specialized relationship specific asset has a high commitment value. The value is greater because the asset has no other use. As the question states, once the plant is build the firm has no option but to utilize it within this particular industry. This sends a strong signal to the competition and they behave less aggressively. Hence if the firm invests in a fungible asset there is higher likelihood that its competitors will also expand their capacity.

7. Consider a monopoly producer of a durable good, such as a supercomputer. The good does not depreciate. Once consumers purchase the good from the monopolist, they are free to sell it in the “second hand” market. Often times in markets for new durable goods, one sees the following price pattern: the seller starts off charging high price, but then lowers the price over time. Explain why with a durable good, the monopolist might prefer to commit to keep its selling price constant over time. Can you think of a way that the monopolist might be able to make a credible commitment to do this?

Monopolist of a durable good faces a problem that can be stated in two ways::

4. Monopolist of today is in competition with monopolist of tomorrow, since the good is durable.
5. The good sold today has a substitute in form of good from the past (i.e. secondary market)

Either way, entry of firms or substitutes will erode monopoly profits. At the extreme monopolist of durable goods has no market power due to the “entry” and “substitution” effect. This causes monopolist to reduce price in the subsequent period. Hence rational consumers will expect lower prices form the monopolists and may decide to wait.

Monopolist making a credible commitment will reduce the above effect. This chapter gives an example in form of most favored customer clause (MFCC) in a contract. The monopolist can offer this clause to most of its customers, making a very credible commitment against price reductions. The monopolist can also make commitment in form of increasing B in every period, i.e. offer more features at the same fixed price, that will reduce the substitution effect.

8. Indicate whether the strategic effects of the following competitive moves are likely to be positive (beneficial to the form making them) or negative (harmful to the firm making them.)

a. Two horizontally differentiated producers of diesel railroad engines-one located in the U.S. and other located in Europe -- compete in European market as Bertrand price competitors. The U.S. manufacturer lobbies the U.S. government to give it an export subsidy, the amount of which is directly proportional to the amount of output the firm sells in the European market.

Given that the two firms are competing as Bertrand price competitors, stage 2 tactical variables are strategic complements. U.S. government subsidy would reduce U.S. firm’s marginal costs in Europe, reducing the price. This makes firm 1 tough - i.e. no matter what its European counterpart charges firm 1 would charge a lower price with the subsidy. This shifts firm 1’s reaction curve inwards (see figure 8.4) moving Bertrand equilibrium southwest. Firm 2 would follow and reduce price (though by not as much as firm 1), this hurts firm 1 and strategic effect is negative.

b. A Cournot duopolist issues new debt to repurchase shares of its stock. The new debt issue will preclude the firm from raising additional debt in the foreseeable future, and is expected to constrain the firm from modernizing existing production facilities

Since the firms are competing in a Cournot industry their actions are strategic substitutes. Firm 1’s decision to buyback its shares of stock is a “soft” move, because it constrains it from making investments in modernizing its production facilities.

Hence this kind of commitment makes Firm 1 “soft” - This means that no matter what level of output Firm 2 chooses, Firm 1 will produce less output. This corresponds to inward shift in Firm 1’s reaction curve (see Figure 8.2) and has a negative strategic effect since this allows firm 2 to respond more aggressively.

9. Consider two firms competing in a Cournot industry. One firm – Roomkin Enterprises – is contemplating an investment in a new production technology. This new technology will result in efficiencies that will lower its variable costs of production. Roomkin’s competitor, Adams, Co., does not have the resources to undertake a similar investment. Roomkin’s corporate financial planning staff has studied the proposed investment and reports that at current output levels, the present value of the cost savings from the investment is less than the cost of the project, but just barely so. Now, suppose that Roomkin Enterprises hires you as a consultant. You point out that a complete analysis would take into account the effect of the investment on the market equilibrium between the Roomkin Enterprises and Adam Co. What would this more complete analysis say about the desirability of this investment?

Roomkin’s corporate financial planning is considering only the direct effect of the investment in the new production technology. A more complete analysis would also consider the strategic effect of this project on the market equilibrium.

As summarized in Figure 8.6, the impact of a strategic commitment on the market equilibrium depends on whether the two firms are strategic complements or strategic substitutes and on whether the commitment makes the firm “tough” or “soft”. As the two firms are competing in Cournot industry, their tactical variables are strategic substitutes. In other words, if Roomkin Enterprises increases production, Adam Co.’s reaction would be to decrease production. The investment will make Roomkin Enterprises “tough” i.e. Roomkin Enterprises will produce more output than it would have had it not made the commitment. As shown in Figure 8.6, Roomkin’s investment would cause Adam Co. to react less aggressively and to decrease production. Thus, this investment would have a positive strategic effect and, since its direct effect was “barely” negative, the overall effect would probably be positive and so the investment would be desirable.

The chapter discussed a situation in which Cournot competitor would refrain from entering a geographically distinct market for its product, even though it would have a monopoly in that market. Under what circumstances would this incentive be reversed?

The chapter example and figure 8.3 discuss that a firm would refrain from entering a geographically distinct market for its product because the decision would increase its marginal cost in the Cournot market and thus would induce it to reduce its output in that market. Because output decisions are strategic substitutes and entering this new market would be a soft commitment, it would cause the firm’s competitor to increase its production and be more aggressive. Entry would thus have a negative strategic effect.

However, the situation would be reversed if entering this new market causes an increase in the total quantity of output the firm produced in the Cournot market. This would occur if the firm had a marginal cost function that decreases with its total output. In that circumstance, the firms reaction function in the Cournot market would shift outward, making the entry decision a tough commitment. In equilibrium, the competitor would decrease production and be less aggressive and this action would have a positive strategic effect.

10. The chapter discussed a situation in which a Cournot competitor would refrain from entering a geographically distinct market for its product, even though it would have a monopoly in that market. Under what circumstances would this incentive be reversed?

The above firm is considering an investment that makes the firm soft on its rivals. Using the taxonomy, when the nature of stage 2 tactical variables is strategic substitutes (Cournot competition) and the investment makes the firm soft, the strategy of proceeding with the investment is labeled “Suicidal Siberian” – this label indicates the adverse strategic affect. The capacity constrained firm will relinquish share in the market it currently competes in as a result of entering another market – hence, entering a new market is akin to handing market share over to its existing rival in its existing market.

If the direct effect of entering the new market is sufficient positive (that is, greater than the loss of profits in the firm’s existing market) then entering the new market may be reasonable.

11. This question refers to information in question 10 in Chapter 6.
Chuckie B Corp. is considering implementing a proprietary technology they have developed. The onetime sunk cost of implementing this process is $350. Once this investment is made, marginal cost will be reduced to $25. Gene Gene has no access to this, or any other cost-saving technology, and its marginal cost will remain at $40. Chuckie B’s financial consultant observes that the investment should not be made, because a cost reduction of $15 on each of the 20 machines results in a savings of only $300, which is less than the cost of implementing the technology. Is the consultant’s analysis accurate? Why or why not? Compute the strategic effect of the investment.

(1) (1 = P1Q1 – TC1 = (100 - Q1 - Q2 ) Q1 -40 Q1
(2) (2 = P2Q2 – TC2 = (100 - Q1 - Q2 ) Q2 -25 Q2
Now take the derivative of each of the above with respect to Q:
(1) Max (1 = 100 - 2Q1 - Q2 -40
Q1 = 30 - .5Q2
(2) Max (2 = 100 - 2Q2 - Q1 -25
Q2 = 37.5 - .5Q1
Now solve the above simultaneously:
Q1 = 30 - .5Q2 = Q1 = 30 - .5(37.5 - .5Q1)
Q1 = 15 and Q2 = 37.5 - .5(15) = 30
To find P we use the market demand curve:
P = 100 – Q = 100 – Q1 – Q2 = 100 – 15 – 30 = $55
And finally each firm’s profits:
(1 = P1Q1 – TC1 = (55*15) – (40*15) = 825 - 600 = $225 and
(2 = P2Q2 – TC2 = (55*30) – (25*30) = 1650 – 750 = $900

The firm who invested in the cost saving technology does save $15 on the ORIGINAL 20 units it produced. However, there are additional effects: The firm is able to use its cost advantage to take share from its rival:

The firm used to sell 20 units at $60 (revenue $1200). Now the firm sells 30 units at $55 (revenue $1,650). The firms used to jointly earn $2,400, now they jointly earn $2,475. So the consultant failed to count the gain in units (market share) the investing firm would enjoy.

Below we lay out the effects the firm who makes the investment gets:

$20 * 15 = $300 cost savings on original 20
$55 * 10 = $550 new units sold at new price as a result of having a cost advantage
$-5*20 = -$100 loss in revenue on original units as a result of selling them at a new price
$-25*10 = -$250 cost of making 10 more units total increase in profits: $500 ($900 - $400)

While the consultant acknowledged the gain of $300, the consultant did not address the other effects.
Chapter 8
The Dynamics of Pricing Rivalry

Chapter Contents
1) Introduction
2) Dynamic Pricing Rivalry • Why the Cournot and Bertrand Models Are Not Dynamic • Intuition • Competitor Responses and Tit-for-Tat Pricing • Tit-for-Tat Pricing with Many Firms Example 8.1: What Happens When a Firm Retaliates Quickly to a Price Cut: Philip Morris versus B.A.T in Costa Rica • The “Folk Theorem” • Coordinating on an Equilibrium • Why is Tit-for-Tat so Compelling? • Misreads Example 8.2: Forgiveness and Provocability: Dow Chemicals and the Market for Reverse Osmosis Membrane
3) How Market Structure Affects the Sustainability of Cooperative Pricing • Market Concentration and the Sustainability of Cooperative Pricing • Reaction Speed, Detection Lags, and the Sustainability of Cooperative Pricing • Asymmetries Among Firms and the Sustainability of Cooperative Prices Example 8.3: General Motors and Zero-Percent Financing in the U.S. Automobile Industry Example 8.4: Firm Asymmetries and the 1992 Fare War in the U.S. Airline Industry Example 8.5: Pricing Discipline in the U.S. Cigarette Industry Example 8.6: How market Structure Conditions Conspire to Limit Profitability in the Heavy-Duty Truck Engine Industry • Market Structure and the Sustainability of Cooperative Pricing: Summary
4) Facilitating Practices • Price Leadership • Advance Announcement of Price Changes • Most Favored Customer Clauses • Uniform Delivered Prices
5) Quality Competition • Quality Choice in Competitive Markets • Quality Choices of Sellers with Market Power
6) Chapter Summary
7) Questions

Chapter Summary

Through examples and theory, Chapter 8 further explores industry rivalry and examines what conditions affect the intensity of price competition in an industry. Why are some firms able to coordinate their pricing behavior to avoid costly price wars while other firms engage in vicious price wars? This chapter introduces a set of models and analytical frameworks that help explain why firms compete as they do.
These models build on the ideas introduced in Chapter 6. However, unlike Chapter 6, these models are dynamic; that is they assume firms engage in repeated interactions with each other. This chapter introduces a theory of rivalry to explain how firms act when they meet repeatedly over time—a dynamic that is not fully encompassed in the Cournot or Bertrand oligopoly models.
The first section describes a scenario where two firms - competing in the same industry with the exact same product and cost structure – could charge monopoly prices and reap monopoly profits without meeting or engaging in price collusion. This dynamic pricing rivalry theory supports this intuition and further suggests that any price between the monopoly price P and marginal cost C can be sustained as an equilibrium. The chapter uses the term “cooperative pricing” to refer to these situations in which firms are able to sustain higher profits than would be predicted by the Cournot and Bertrand model. This example and theorem prove that cooperative pricing is possible, but not guaranteed.
There are strategies that a firm can adopt to increase the likelihood that cooperative pricing will occur in their market. The chapter focuses on the pros and cons of the tit-for-tat strategy, a strategy that is appealing in its simplicity and its power.
The chapter goes on to discuss four market structure conditions and whether they help or hinder firms from achieving cooperative pricing and competitive stability: market concentration, structural conditions that affect reaction speeds and detection lags, asymmetries among firms, and multi-market contact. Although market structure strongly affects a firm’s ability to sustain cooperative pricing, this chapter discusses four ways in which firms can facilitate cooperative pricing: though price leadership, advance announcements of price changes, most favored customer clauses, and uniform delivered pricing. The chapter discusses each of these methods in turn.
The last section of this chapter addresses non-price competition, such as competition with respect to product quality. This part of the chapter explores how market structure influences a firm’s decision to choose its level of product quality. It also examines the role that consumer information plays in shaping the nature of competition with respect to quality. Specifically, if consumers do not have perfect information about product quality or if a consumer cannot gauge quality, a lemons market can emerge (i.e., cars, health insurance). When sellers have market power, the quality they provide depends on the marginal cost and marginal benefit of increasing quality. The marginal benefit of increasing quality depends on the increase in demand brought on by the increase in quality and the incremental profit earned on each additional unit sold. This implies that a firm’s price-cost margin is an important determinant of its incentives to raise quality.
Approaches to Teaching this Chapter

Chapters 8 and 9 have the most difficult microeconomics content and students with weaker microeconomic backgrounds will find these chapters especially challenging.

In teaching this chapter, one could begin by talking about the notion of price cooperation, which is the ability of firms within an industry to collectively avoid the "prisoners' dilemma" outcome of pricing, that is, to do better than they would do in a static Bertrand or Cournot equilibrium. The first section of Chapter 8 develops a theoretical framework (based on a repeated prisoners dilemma game model) for looking at firms' incentives to deviate from cooperative outcomes. This framework has very powerful implications for how market structure conditions impact the likelihood of firms to achieve pricing cooperation. Equation 8.1 sets forth a condition for the cooperative pricing outcome to bean equilibrium in a non-cooperative game of price setting. This condition can then be used to develop insights about how market structure affects the intensity of pricing rivalry.

The next section develops this point in detail. This section is the heart of the chapter. The instructor should cover carefully how market concentration, asymmetries among firms, multimarket contact, reaction speeds and detection lags affect the sustainability of cooperative pricing.

It is then natural to follow up this material with a coverage of facilitating practices: price leadership, advance announcement of price changes, most favored customer clauses, uniform delivered pricing and strategic use of inventories and order backlogs.

The "Quality Competition" section of the chapter discusses the other dimensions besides price along which competition can take place. This section does not follow directly the earlier parts of the chapter, and can easily be dropped.

Suggested Harvard Case Study

Caterpillar HBS 9-385-276 (see earlier chapters)

De Beers Consolidated Mines, HBS 9-391-076 (see earlier chapters)

Nucor at a Crossroads HBS 9-793-039 (see earlier chapters)

Philips Compact Disc Introduction, HBS 9-792-035 (see earlier chapters)

Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Axelrod, R., The Evolution of Cooperation, New York: Basic Books, 1984.

Bernheim, B.D. and M. Whinston, "Multimarket Contact and Collusive Behavior," RAND Journal of Economics, 21, Spring 1990: 1-26.

Chamberlin, E.H., Monopolistic Competition, Cambridge, MA: Harvard University Press, 1933, p. 48

Dixit, A. and B. Nalebuff, Thinking Strategically.- The Competitive Edge in Business, Politics and Everyday Life, New York: Norton, 1991.

Dranove, D. and M. Satterthwaite, "Monopolistic Competition When Price and Quality are Not Perfectly Observable," RAND Journal of Economics, Winter 1992: 518-534.

Kreps, D.M., A Course in Microeconomic Theory, Princeton, NJ: Princeton University Press, 1990, pp. 392-393.

Merrilees, W., "Anatomy of a Price Leadership Challenge: An Evaluation of Pricing Strategies in the Australian Newspaper Industry," Journal of Industrial Economics, XXXI, March 1983:291-311.

Schelling,Thomas. The Strategy of Conflict, Cambridge, MA: Harvard, 1960.

Scherer, F.M. and D. Ross, Industrial Market Structure and Economic Performance, New York: Houghton Mifflin, 1991.

Spence, A.M., "Monopoly, Quality, and Regulation," Bell Journal of Economics, 1975: 417-429.

Stigler, George J., "A Theory of Oligopoly," Journal of Political Economy, 72 (1), February 1964:44-61.
Answers to End of Chapter Questions
1. “Economic theories of how price wars begin presume that firms would prefer their industry price to be high”. Comment.
Consider a firm (firm X) whose output is only slightly differentiated from the output of other firms in the industry. If the firm X’s rivals lower their prices, than firm X will loose significant market share and will consequently suffer a reduction in profits. Collectively, the firms in the industry have lower profits after a price reduction—however, it is possible that even though the total profit pie is smaller, some firms are better off after the price reduction. However, since total industry profits are lower, more firms see their profits decline than see their profits increase—hence, we can presume that, on average, firms prefer industry price to be high.
2. Why do misreads and misjudgements encourage firms to lower prices?
Consider what might happen when two firms are playing tit-for-tat, and there is a chance that a cooperative move is misread an uncooperative one. The firm that misreads the cooperative move as an uncooperative one responds by making an uncooperative move in the next period. The firm lowers price in order to enforce the tit-for-tat strategy. It is possible that a firm mistakes the actions of its rival as aggressive and so reacts with a price cut in order to protect volume.
3. Firms operating at or near capacity are unlikely to instigate price wars. Briefly explain.
Firms who lower price earn less on every unit they sell up to the quantity they sold before the price reduction. However, this loss can be offset by an increase in units sold due to the now lower price. If a firm is at or near capacity, its ability to expand quantity sold is constrained and hence the firm cannot recover the forgone profits from selling each unit at a lower margin. The capacity constrained firm has little incentive to initiate a price reduction.

Firms are more likely to instigate price wars when excess capacity exists. For example, if a firm is experiencing excess capacity, and a new firm enters the market, the new entry will induce even greater excess capacity on the part of the incumbent. If there are economies of scale in production, the costs of idle capacity may rise with the degree of idleness. This suggests that the incumbent will fight harder to retain market share under excess capacity conditions, prices are likely to drop with entry. The firm with excess capacity may lower its price in order to retain or steal market share.
4. “Pricing cooperation is more likely to emerge in markets where, if one firm raises a price and competitors follow suit, market shares remain unchanged. It is less likely to work well in markets where price matching may not leave market shares constant.” Evaluate this statement. Can you think of circumstances under which price matching behavior could alter market share?

The relative levels of profitability from cooperating and defecting in the collusive pricing game are what will ultimately determine the stability of price cooperation. Market share is only important in so far as it is often a good proxy for profitability. Price-matching behavior will not necessarily leave market shares unchanged. For example, if products are differentiated, the relative abilities of products to support their level of benefits in the market may vary as prices change. In addition, changes in market share may also occur if movements in price allow one firm to develop a more favorable brand image or reputation, or if network externalities are at work. For example, imagine that two firms, Firm A and Firm B, share a market equally. If Firm A cuts its price, then it will steal market share from Firm B until Firm B lowers its price to the same level. Once Firm B matches Firm A, both firms are worse off than they were before Firm A lowered price. If Firm A knows it cannot increase its market share, Firm A has little incentive to initiate a price reduction. However, if Firm A is able to keep a larger market share even after Firm B matches the price cut, the deterrent effect of the tit-for-tat strategy would be reduced. If Firm A could, for example, build in some switching costs for its new users, it can retain much of its increased market share.
5. Suppose that you were an industry analyst trying to determine if the leading firms in the automobile manufacturing industry are playing a tit-for-tat pricing game. What real world data would you want to examine? What would you consider to be evidence of tit-for-tat pricing?

Circumstantial evidence of tit-for-tat pricing is relatively easy to find. Public pricing behavior like the advance announcement of price changes and the use of commitments to meet the lowest available price support price coordination and stability, as does simplified pricing behavior such as having annual pricing reviews. However, hard evidence of tit-for-tat pricing is much harder to come by, unless firms are foolish enough to put a collusive agreement in writing. You would want detailed data on historical prices and firm profits in an attempt to discern pricing patterns that support above-average industry profitability. One such telltale pattern is a punishment strategy, where all firms lower price to ‘punish’ a renegade firm that reduces its price unilaterally. Then, after a period, all firms raise their price back to the previous, higher level. However, firms can always argue that external circumstances are responsible for the price moves. Furthermore, if collusion is extremely effective, you would not observe punishment behavior at all.
6. An article on price wars by two McKinsey consultants makes the following argument.

That the (tit-for-tat) strategy is fraught with risk cannot be overemphasized. Your competitor may take an inordinately long time to realize that its actions can do it nothing but harm; rivalry across the entire industry may escalate precipitously; and as the “tit-for-tat” game plays itself out, all of a price war’s detrimental effects on customers will make themselves felt.

As the argument in the McKinsey article points out, there are risks involved in adopting the tit-for-tat strategy. Misreading pricing moves made by competitors can lead to alternating cooperative and uncooperative responses or all uncooperative responses. When the possibility of misreads exists, it may be beneficial for a firm to adopt a more forgiving strategy to reduce the likelihood of detrimental responses to a competitor’s price deviations. However, adopting the tit-for-tat strategy before a price war ensues can serve as a powerful deterrent sustaining monopoly pricing at a non-cooperative equilibrium.

7. Studies of pricing in the airline industry show that carriers that dominate hub airports (Delta in Atlanta, USAir in Pittsburgh, American in Dallas) tend to charge higher fares, on average, for flights in and out of the hub airport than other, non-dominate, carriers flying in and out of the hub. What might explain this pattern of prices?

There are several reasons why dominant hub airlines can charge higher prices than non-dominant carriers flying in and out of the hub. First, the convenience that a hub airline provides creates a differentiated product for which the airline can charge a premium. Second, the frequency that hub airlines provide reduces the number of substitute flights available for consumers. This shifts the demand for the hub airline out, reducing the price elasticity for the hub airline’s flights. And finally, smaller airlines may reduce prices below the hub airline prices because the dominant airline has little incentive to retaliate with a price war.
8. It is often argued that price wars may be more likely to occur during low demand periods than during high demand periods. (This chapter makes that argument.) Are there factors that might reverse this implication? That is, can you think of reasons why the attractiveness of deviating from cooperative pricing might actually be greater during booms (high demand) than during busts (low demand)?

Deviation from cooperative pricing can occur during economic booms. During periods of high demand, gaining the dominant market share position will capture a higher percentage of industry profits. Also, recognizing the inevitable downturn in their market following a boom period, a firm may be tempted to capture profits to serve as a cushion during an economic downturn. Gaining a dominant market share is more profitable during a boom than during a downturn. Furthermore, if the firm can retain some of it increased share after the boom (through reputational effects, switching costs, etc.) it will be in a better position during the downturn. These factors may tempt a firm to deviate from cooperative pricing during a boom.
9. Consider a duopoly consisting of two firms, Amalgamated Electric (AE) and Carnegie-Manheim (C-M), that sell products that are somewhat differentiated. Each firm sells to customers with different price elasticities of demand, and, as a result, occasionally discounts below list price for the most price-elastic customers. Suppose, now, that AE adopts a contemporaneous most favored customer policy, but C-M does not. What will happen to AE’s average equilibrium price? What will happen to C-M’s average equilibrium price?

By adopting a contemporaneous most favored customer clause (MFCC), AE precludes itself from discriminating between price-elastic and price-inelastic customers. Whereas before it was price discriminating, now it will charge all customers the same price. Margins on inelastic customers will fall and margins on elastic customers will rise.
The common price for AE will most likely be higher than the average price without the MFCC. Presumably AE adopted the MFCC to increase its profit. This implies that the margin increase on elastic customers will be greater than the margin decrease on inelastic customers.
Now that AE will charge a higher price to the elastic customers, CM does not have to discount as aggressively in order to compete for these customers. Its profit-maximizing price to elastic customers will increase, though not as much as AE’s. As a result, CM’s average equilibrium price will increase as well.

Chapter 9
Entry and Exit

Chapter Contents

1) Introduction 2) Some Facts About Entry and Exit Example 9.1: Hyundai’s Entry into the Steel Industry 3) Entry and Exit Decisions: Basic Concepts • Barriers to Entry Example 9.2: Patent Protection in the Pharmaceutical Industry Example 9.3: Barriers to Entry in the Australian Airline Market Example 9.4: Entry Barriers and Profitability in the Japanese Brewing Industry • Barriers to Exit 4) Entry-Deterring Strategies • Limit Pricing • Predatory Pricing Example 9.5: Limit Pricing by Xerox Excess Capacity Example 9.6: Coffee Wars • “Judo Economics” and the “Puppy-Dog Ploy” 5) Exit-Promoting Strategies • Wars of Attrition Example 9.7: DuPont’s Use of Excess Capacity to Control the Market for Titanium Dioxide 6) Evidence on Entry-Deterring Behavior • Survey Data on Entry Deterrence 7) Chapter Summary 8) Questions

Chapter Summary

The focus of this chapter is on the dynamics of entry and exit in the marketplace. In general, entrants into an industry reduce the market share of firms in the industry and intensify competition through product introduction and price competition. This, in turn, reduces profits for all competing firms in the industry. Likewise, when a firm exits an industry, market share for remaining firms is increased, price and product competition is reduced, and profits increase.

A firm will enter a market if the net present value of expected post-entry profits exceed the sunk costs of entry. A firm would exit a market if the expected future losses exceed the sunk costs of exit. Factors that reduce the likelihood of entry/exit are called entry/exit barriers.

The structural entry barriers result from exogenous market forces. These are the barriers that cannot be influenced by incumbents firms. Low-demand, high-capital requirements, and limited access to resources are all examples of structural entry barriers. Exit barriers arise when firms have obligations that they must keep whether they produce or not. Examples of such obligations include labor agreements and commitments to purchase raw materials, obligations to input suppliers and relationship-specific investments.

The chapter contains a discussion of the strategies that incumbents employ to deter entry or hasten exit by competitors. Limit pricing, predatory pricing, and capacity expansion change entrants’ forecasts of the profitability of post-entry competition and thus reduce the threat of entry and/or promote exit.

Limit pricing refers to the practice whereby an incumbent firm can discourage entry by its ability to sustain a low price upon facing entry, while setting a higher price when entry is not imminent. Predatory pricing is the practice of setting a price with the objective of driving new entrants or incumbent firms out of the industry. Limit pricing and predatory pricing strategies can succeed only if the entrant is uncertain about the nature of post-entry competition.

Firms may also choose to hold excess capacity that serves as a credible commitment that the incumbent will expand output should entry occur.

The next section provides a discussion of exit-promoting strategies. In particular, the section contains an example of how Standard Oil in 1870 dominated the refining industry through predatory pricing. Standard Oil, Toyota, and Wal-Mart have all been accused of slashing prices below cost to eliminate competition. Price wars are examples of wars of attrition, where larger firms engage in price wars, harmful to the industry profits to drive out competition. Such tactics are used by firms, which believe that they can outlast their rivals.

Diversification can help or hurt entry when products are related through economies of scope. Diversified firms may enjoy economies of scope in production, distribution and marketing. Entry costs of diversified firms tend to be lower than startup firms since they are larger and have access to lower cost capital. A diversified firm can better coordinate pricing across related products, but may be vulnerable if price war in one market cuts into its profits in a substitute product market.

The last section of this chapter discusses survey of product managers about their use of entry deterring strategies. Product managers reported that they rely much more on entry-deterring strategies (aggressive price reduction, intense advertising to create brand loyalty, and acquiring patents) than strategies that affect the entrant’s perception (enhancing firms reputation through announcements, Limit pricing, and holding excess capacity). Managers also reported that they are more likely to pursue entry-deterring strategies for new products than for existing products.

Approaches to teaching this chapter

The student must be familiar with the following definitions and concepts as described in Chapter 9 :

Accommodated Entry: exists if structural entry barriers are low and either (a) entry-deterring strategies would be ineffective; or (b) the cost to incumbents of trying to deter entry exceeds the potential benefits from keeping entrants out.

Blockaded Entry: exists if incumbents need not undertake any entry-deterring strategies to deter entry. Blockaded entry may result when there are structural entry barriers, or if entrants expect unfavorable postentry competition, perhaps because the entrants’ production is undifferentiated from that of the incumbents.

Deterred Entry: exits when incumbents can keep entrants out by entry-deterring strategies.

Entry: occurs as new firms begin production and sales in a market. Entry can occur under two different situations: (a) by new firms, that were previously not in the industry, or (b) diversifying firms, which are firms that were in business, but were not previously doing business in that market.

Exit: occurs when a firm ceases to produce in a market. Exit from an industry occurs when a firm ceases to operate completely or continues to operate in other markets but withdraws its product offerings from the industry under consideration. To exit an industry, a firm stops production and either redeploys or sells off its assets.

Incumbent: firm that is already in operation in a market.

Limit Pricing: refers to the practice whereby an incumbent firm can discourage entry by charging a low price before entry occurs. The entrant, observing the low price set by the incumbent, infers that postentry price would be as low or even lower, and that entry into the market would therefore be unprofitable.

Perfectly Contestable: describes the condition when a monopolist cannot raise prices above competitive levels. In theory, the threat of entry can constrain a monopolist from raising prices.

Postentry Competition: the conduct and performance of firms after entry has occurred.

Predatory Acts: are entry deterring strategies by an incumbent that appear to reduce its profits, until one account for the additional profits that it earns because the acts deter entry or promote exit by competitors.

Predatory Pricing: refers to the practice of setting price with the objective of driving new entrants or existing firms out of business.

Strategic Entry Barriers: exists when incumbent firms take explicit actions aimed at deterring entry. Entry-deterring strategies include capacity expansion, limit pricing, and predatory pricing.

Structural Entry Barriers: result when incumbents have natural cost or marketing advantages, or benefits from favorable regulations. Low demand, high-capital requirements, and limited access to resources are all examples of structural entry barriers.

Particular attention must be paid to the following concepts: • Entry reduces share, increases competition, and reduces profits. Exit has the inverse effects. • Barriers to entry are a major factor in evaluating entry conditions into a market. The case studies and examples in the text help the student identify the different types of barriers. It is important the student be able to not only understand the barriers to entry in the examples but to also be able to apply this knowledge to other industries. • Postentry Competition is how entrants assess their willingness to enter a market. Thus Incumbent firms may use entrance-deterring strategies to avert entrance by new firms. • Students must understand the assumptions under which limit pricing will and will not work. Assuming that a firm considering entering a market has perfect market information, limit pricing would never work for an incumbent firm. It is only when the entrant is unsure about the level of postentry prices that limit pricing may work. • In order for a firm to make a successful entrance into a market it must be able to recognize a wide host barriers to entry and anticipate the many scenarios postentry behavior by the entrants competitors.

Suggested Harvard Case Studies [9]

Caterpillar HBS 9-385-276 (see earlier chapters)

De Beers Consolidated Mines, HBS 9-391-076 (see earlier chapters)

The Disposable Diaper Industry in 1974 HBS 9-380-175: This case describes the rapidly growing disposable diaper industry in 1974, a period in which Procter and Gamble’s industry leadership faced strong challenges from Kimberly Clark, Johnson and Johnson, and Union Carbide. This illustrates one of the main themes of the chapter: that a potential entrant must anticipate the likely reactions of incumbent firms when deciding whether or not to enter a market. This case also allows students to calculate the net present value of entry under a variety of possible post-entry scenarios.

Nucor at a Crossroads HBS 9-793-039 (see earlier chapters)

Sime Darby Berhad—1995, HBS 9-797-017 (see earlier chapters)

Southwest Airlines HBS 9-694-023: Southwest Airlines, a small intrastate carrier serving Dallas, Houston and San Antonio, begins service in 1971 in the face of competition by two larger, entrenched airlines. Improved quality service, lower prices, and innovative advertising and promotional strategy bring Southwest to the brink of profitability in early 1973, when its major competitor halves fares on Southwest’s major route. Management wonders what response to make. The following are good preparation questions:

a) How has Southwest been able to lower costs so much? b) How have they been able to recruit so many fliers? c) How did route selection help Southwest execute the above strategy?

Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Bain, J., Barriers to New Competition: Their Character and Consequences in Manufacturing Industries, Cambridge, MA: Harvard University Press, 1956.

Baumol, W.,J. Panzar and R. Willig, Contestable Markets and the Theory of Industrial Structure, New York: Harcourt Brace Jovanovich, 1982.

Dunne, T., Robert,M.J., and Samuelson, L., “Patterns of Firm Entry and Exit in U.S. Manufacturing Industries,” RAND Journal of Economics (winter 1988), pp. 495-515.

Fisher, F. Industrial Organization, Economics and the Law, Cambridge: MIT Press, 1991.

Isaac, R.R. and V. Smith, “In Search of Predatory Pricing,” Journal of Political Economy, 93, 1985:320 345.

Milgrom, P. and J. Roberts, “Limit Pricing and Entry Under Incomplete Information,” Econometrica, 50, 1982:443-460.

Smiley, R., “Empirical Evidence on Strategic Entry Deterrence,” International Journal of Industrial Organization, 6, 1988:167-180.

Tirole, J., The Theory of Industrial Organization, Cambridge, MA: MIT Press,1988.

Answers to End of Chapter Questions

1. Dunne, Roberts, and Samuelson found that industries with high entry rates tended to also have high exit rates. Can you explain this finding? What does this imply for pricing strategies of incumbent firms?

Production exhibiting low economies of scale (a condition that weakens entry barriers) and requiring little or no investment in specialized assets (a condition that weakens exit as well as entry barriers) is frequently observed in industries exhibiting high entry and high exit.

Consider the following scenario: Firms in an industry with no entry barrier face increased demand. If these firms begin to earn positive profits, entry occurs, especially if there are little or no exit barriers. As demand turns down, firms exit the industry. If barriers to entry or exit existed, this industry might not exhibit this pattern.

Given an industry with no entry or exit barriers is susceptible to “hit and run” entry, we would expect the firms within this industry to price closer to marginal cost to discourage some of this activity.

2. Dunne, Roberts, and Samuelson examined manufacturing industries in the 1960s to 1980s. Do you think that entry and exit rates have changed in the past two decades? Do you think that entry and exit rates are systematically different for service and retail industries?

Entry and exit rates may be affected by changes in the state of an industry’s technology. It is likely that even for service and retail industries, conditions that encourage entry in an industry also foster exit.

3. “All else equal, an incumbent would prefer blockaded entry to deterable entry.” Comment.

Entry is blockaded if the incumbent need not undertake any entry-deterring strategies to deter entry. Blockaded entry may result when there are structural entry barriers, perhaps because production requires significant fixed investments. Blockaded entry may also result if the entrant expects unfavorable postentry competition, perhaps because the entrant’s product is undifferentiated from those of the incumbents.

Entry is deterred if the incumbent can keep the entrant out by employing entry-deterring strategies, such as limit pricing, predatory pricing and capacity expansion. Moreover, the cost of the entry-deterring strategy is more than offset by the additional profits that the incumbent enjoys in the less competitive environment. However, entry-deterring strategies are generally met with various degrees of success.

Control of essential resources, economies of scale and scope, and marketing advantages of incumbency are types of entry barriers. The firm who is able to use one or a combination of these entry barriers to blockade entry does not have to actively guard itself against entry and so can focus on other activities. If entry is deterred rather than blockaded, the incumbent must actively engage in predatory acts to discourage entry. A threat of entry will most definitely constrain the incumbent. Given the incumbent might prefer to be passive rather than active about discouraging entry, blockaded entry would be preferable to deterable entry.

4. Explain why economies of scale do not protect incumbents from hit-and-run entry unless the associated fixed costs are sunk. Does the learning curve limit contestability?
If the firm’s investments are nonsunk, this suggests the firm can exit and recover the costs of its investments. This reduces the risk associated with entry and, therefore, increases the likelihood of hit-and-run entry. If the firm enjoys lower costs as a result of the learning curve, the market is less likely to be contestable. The learning firm’s enjoy as a by-product of one production process are unlikely to be applicable to other processes – hence the learning is tied to this particular activity. Since the learning cannot leave the activity, hit-and-run entry is less attractive.

5. How a firm behaves toward existing competitors is a major determinant of whether it will face entry by new competitors. Explain.

If a firm is “tough” towards existing competitors (for example, the firm is involved in price or non-price competition), the firm will face less entry because entrants will expect lower profits than if the incumbent were more tolerant of entry. However, if the incumbent has a “soft” stance towards the existing competitors, the entrant may take this a signal for some accommodation of entry and thus the entry rate could be higher. The incumbent signals what post-entry competition will be like through its current behavior toward other firms in the industry.

6. Why is uncertainty a key to the success of entry-deterrence?

Entry deterring strategies include limit pricing, predatory pricing and capacity expansions.

• Limit Pricing: If entrants operated in a world of certainty, it would be difficult to find a rational explanation for limit pricing. In general, entering firms must be uncertain about some characteristic of the incumbent firm or the level of market demand. The incumbent wants the entrant to believe that post entry prices will be low. If the entrant is sure about the factors that determine postentry pricing, it can calculate the incumbent’s payoffs from all possible postentry pricing scenarios and correctly forecast the postentry price. If the entrant is uncertain about the postentry price, however, then the incumbent’s pricing strategy could affect the entrant’s expectations. • Predatory Pricing: As with limit pricing, predatory pricing would appear to be irrational if entrants operated under certainty. If, however, entrants lack certainty, then price-cutting by an incumbent may affect the entrants expectations of the incumbent’s future pricing strategies. Operating under uncertainty makes it more difficult for the entrant to rule out a bad postentry scenario and therefore predatory pricing may, indeed, discourage entry. • Excess Capacity: Unlike predatory pricing and limit pricing, excess capacity can deter entry even when the entrant possesses full information about the incumbent’s costs and strategic direction. If the incumbent is holding an entry deterring level of capacity it is actually in the incumbent’s interest to convey this information to would be entrants. If, however, the incumbent is unable to hold an entry-deterring level of investment, then the incumbent might hope the entrant is uncertain about the level of capacity the incumbent actually holds.

7. An incumbent is considering expanding its capacity. It can do so in one of two ways. It can purchase fungible, general purpose equipment and machinery that can be resold at close to its original value. Or it can invest in highly specialized machinery that, once it is put in place, has virtually no salvage value. Assuming that each choice results in the same production costs once installed, under which choice is the incumbent likely to encounter a greater likelihood of entry and why?

The investment that is more visible, understandable and irreversible is more likely to deter entry. In general, a significant investment in a highly specialized relationship specific asset has a high commitment value. The value is greater because the asset has no other use. Essentially the firm whose investment has no outside option has increased its own exit barrier. Exit barriers can limit the incentives for the firm to stop producing even when the prevailing conditions are such that the firm, had it know with certainty that these conditions would prevail, would not have entered in the first place. Given the firm is less likely to exit during poor industry conditions, entry is less attractive as industry downturns will generate lower overall profits than if firms could redeploy their assets to other uses. As the question states, once the plant is build the firm has no option but utilize it within this particular industry. This sends a strong signal to the competition and they behave less aggressively. Hence if the firm invests in a fungible asset there is higher likelihood that entry will not be as deterred.

8. In most mode of entry deterrence, the incumbent engages in predatory practices that harm a potential entrant. Can these models be reversed, so that the entrant engages in predatory practices? If so then what are the practical differences between incumbents and entrants?

Entrants and incumbents roles can be switched in the theoretical models and the results will hold true. If the entrant has deep pockets then it can engage in predatory practices to drive incumbent out. Incumbents have an advantage in that they in most cases would have created brand loyalty or reputation, network externalities, and lower costs due to learning curve. Taking all the above factors into account, it is less likely that entrant will pursue predatory practices.

9. Recall the discussion of monopolistic competition in chapter 7. Suppose that an entrepreneur considered opening a video store along Straight Street in Linesville. Where should the entrepreneur position the store? Does your answer depend on whether additional entry is expected?

From chapter 6, the Straight Street in Linesville has video rental customers who are equally spaced along the street.

An entrepreneur who does not expect further entry should position his/her video store in the center of Linesville to minimize average “transportation cost” and to attract the most customers. The customers at equal distance from the store will have equal transportation cost to the store at the center and the average transportation cost for all customers would be the lowest.

An entrepreneur who expects additional entry should position his store in a location that balances the desire to achieve as large a market as possible against the desire to soften as much as possible the post–entry price competition. This might support the merits of locating at one end of the street, anticipating that a rival might then enter at the other end. However, by locating at one end, you take the risk that a competitor could locate right next to you.

On the other hand, one might also want to consider locating in such a way as to discourage entry. Given that a potential entrant will anticipate the severity of post-entry competition in its decision, locating at the center of the street may be the most desirable option. The entrant would want to locate as far away as possible from the entrepreneur as possible in order to soften price competition, i.e. it would locate at one end of the street or the other. But given that the incumbent is in the center, this may deny the entrant sufficient market share to allow it to be profitable.

10. Consider a firm selling two products, A and B, that substitute for each other. Suppose that an entrant introduces a product that is identical to product A. What factors do you think will affect (a) whether a price war is initiated, and (b) who wins the price war?
Given the incumbent is producing two substitute goods, the incumbent has more lose if a price war erupts. The reason is, if the incumbent lowers the price of good A to match the price of the entrant’s identical offering, the incumbent loses revenues on good B as well as on good A because customers who used to purchase B will substitute toward good A. If exit barriers are minimal, the incumbent might prefer to exit the market for good A rather than endure a price war. The incumbent is more likely to stay and fight if exit barriers are high and/or good A and B are weak substitutes. Clearly the probability of a price war decreases if the level of demand for these goods is high relative to the combined capacities of the firms.
Chapter 10

Industry Analysis

Chapter Contents

1) Introduction

2) Performing a Five-Forces Analysis

• Internal Rivalry • Entry • Substitutes and Complements • Supplier and Buyer Power • Strategies for Coping with the Five Forces
3) Coopetition and the Value Net
4) Applying the Five Forces: Some Industry Analyses • Hospital Markets Then and Now • Commercial Airframe Manufacturing • Hawaiian Coffee • Conclusion
5) Chapter Summary
6) Questions

Chapter Summary
The roots of the field of industry economics and market competition can be traced to the 1930s or earlier. However, they had little impact on business strategy until Michael Porter published a series of articles in the 1970s that culminated in his pathbreaking book Competitive Strategy. In his book, Porter presented a convenient framework for exploring the economic factors that affect the profits of an industry and classified these factors into five major forces. This chapter reviews the five-forces framework in the context of the economics of firms and industries. One assesses each force by asking “Is it sufficiently strong to reduce or eliminate industry profits?” Because the framework is comprehensive, the process of working through each of the five forces requires the systematic evaluation of all the significant economics factors affecting an industry. The five-forces framework does have several limitations: (1) it is not concerned with the magnitude or growth in demand, (2) it focuses on the entire industry, rather than on that industry’s individual firms, (3) it does not explicitly account for the role of the government, and (4) it is only qualitative. The chapter further uses the five-forces framework to analyse three specific industries: hospitals, tobacco, and Hawaiian Coffee.

Approaches to Teaching this Chapter

Purposes of the Framework

• Provides for assessment of industry profitability • Identifies opportunities for success and threats to success • Provides basis for generating strategic choices • Applies equally well to industrial and service sectors

Internal Rivalry

Internal rivalry refers to the jockeying for share by firms in the market. As was discussed in Chapters 7-9, firms may compete on a number of price and nonprice dimensions. Do firm interactions erode profits? Fierce competition between firms within an industry can force prices downward toward costs, thereby eroding profits. Internal rivalry is likely to be a problem when:

• there are numerous or equally balanced competitors • slow industry growth • high fixed costs or storage costs • lack of differentiation or switching costs • capacity augmented in large increments • diverse competitors • high strategic stakes-- how important is this industry? • high exit barriers

Barriers to Entry

Does the threat of entry erode profits? If entrants are not substantially differentiated from incumbents, then entry has two deleterious effects: 1)-market shares of incumbent firms fall and 2) competition to protect share leads to lower prices and therefore to lower profit margins. Entry is a key threat to the stability of markets in which there has been low internal rivalry. For example, an entrant may lower prices below “collusive” levels in order to penetrate the market. Earlier chapters discussed factors that affect the likelihood of entry and the ability of firms to deter entry. Entrants can be ignored if they are small, but failure to retaliate may invite more entry. Anything that makes it difficult for entry to occur is called an entry barrier. Barriers to entry are high when:

• there are economies of scale • product differentiation • capital requirements are high • there are switching costs • access to distribution channels (for example, channel crowding) • cost disadvantages independent of scale • proprietary product technology • favorable access to raw materials • favorable locations • government subsidies • learning or experience curve • government policies

Substitutes and Complements

Do substitute/complement products threaten to erode profits? Substitute products have similar “product performance characteristics”, that is, they perform a similar function, at least to a certain extent. Substitute products have the same effect as entry, the distinction is more a matter of degree. Close substitutes lead to greater price rivalry and theft of market share than do weak substitutes. Substitute products pose the greatest threat when they represent new technologies that will benefit from a learning curve and may eventually prove superior to the technologies they substitute for. Complements boost demand for the product in question, thereby enhancing profit opportunities for the industry.
One must be wary of: • trends which improve the price-performance of substitutes for the industry’s product • substitutes produced by industries with higher profits than the industry under consideration • trends which reduce the price-performance of complements to the industry’s product

Ask students for ideas on how to qualitatively describe a market. Some ideas include: 1) products have similar product performance characteristics (what the product does for the consumer), 2) products have similar occasions of use, and 3) products are sold in the same geographic market.

Ask students to give examples of substitute and complement products, i.e., What is a substitute for airline travel? Answers may include train, car, fax, depending on the distance of travel, relative prices and purpose of travel. What is a complement to airline travel? Answers may include hotels, taxis, and rental cars.

Buyer Power

Do buyers have sufficient power to threaten industry profits? High buyer power leads to intense internal rivalry since small price reductions can generate large gains in market share. Buyer power is high when:

• Buyer purchases a large volume relative to sellers’ sales • Buyer’s purchases represent a significant fraction of the buyers’ total costs • Products purchased are standard or undifferentiated • Buyer faces few switching costs • Buyers pose a threat of backward integration • Industry’s product is unimportant to the quality of the buyers’ output • Buyer has full information

Supplier Power

Do suppliers have sufficient power to threaten industry profits? Again, this is related to concentration and the ability to shop around. Supplier power is high when;

• Suppliers’ industry is dominated by few companies and is more concentrated than the industry it is selling to • Suppliers do not have to contend with other substitute products for sale to the industry • The industry is not an important customer of the supplier industry • The suppliers’ products are differentiated or it has built up switching costs • The supplier group poses threat of forward integration

The Value Net

The Value Net framework (attributed to Brandenberger and Nalebuff) addresses weaknesses of Porter’s five forces analysis. While Porter’s five forces framework focuses on the negative spillovers of a firm’s actions with respect to other firms, the Value Net captures the notion that some actions firms take have positive spillover effects on other firms in the industry. The Value Net, which consists of suppliers, customers, competitors, and complementors, assesses both threats and opportunities to the industry. The Value Net is, therefore, a complement to a five forces analysis. The chapter contains several excellent examples.

Students should be able to make the connection of buyer and supplier power to some of the concepts discussed in Chapter 3 and 4, for example:

• Contracting costs: Chapters 3 and 4 address why vertical integration might be a good alternative to market contacting. Indeed the degree to which vertical integration reduces transactions costs and improves dispute resolution, adaptability, and repeated exchanges, it is often preferable to using market specialists. When market specialists are used, however, relative buyer/supplier power affects these issues and may raise the cost of exchange. • Hold-up: As discussed in Chapter 4, the holdup problem raises the costs of exchange by increasing the amount of time and money parties spend in negotiations, reducing trust in the relationship, encouraging “overinvestment”, or leading one party to threaten to refrain from making relationship-specific investments. All of these behaviors affect the relative level of either buyer or supplier power. • Switching costs: Can buyers/sellers switch to other firms? When a relationship involves relationship-specific assets, parties cannot switch trading partners costlessly. If you buyers have no options, then, you have supplier power. If the supplier has no options, then the buyer owns the power. This is discussed in Chapter 4. • Forward or backward integration: The ability of a buyer to backward integrate or a supplier to forward integrate can reduce the power of their contracting party. Vertical integration is discussed primarily in Chapters 3 and 4.
Ask students to prepare thoughts on the following questions before the lecture: • Consider the industry you worked in before returning to (graduate) school. What were the key forces shaping the nature of competition and the opportunities for making profit in that industry? What, if anything, did firms do to insulate themselves from these forces? • A business consultant once argued that it is undesirable to enter industries that are easy to enter. Is there any wisdom in this advice? Why or why not?

Suggested Harvard Case Studies

Caterpillar HBS 9-385-276 (see earlier chapters)

Crown Cork and Seal, HBS 9-378-024, rev. 3/84. Describes the technical, economic, and competitive trends in the metal container industry. The strategy of Crown Cork and Seal is then described in relation to these trends. Potential threats to Crown’s future are outlined. This case could be used to introduce students to Porter’s five forces model, and as the case describes the production process a discussion about optimal scale is appropriate. You may want to ask students to think of the following questions in preparation for the case:

a) Perform a five forces analysis of the can manufacturing industry as of 1977. When possible, back up your analysis with information from the case. b) Identify viable strategic positions in this industry. How important are economies of scale in this industry? c) Identify the current strengths and weaknesses of CCS. What opportunities and threats does the current environment pose? d) Does CSS have a strategic position? What is it? What do you think it should be? Prepare a mission statement for CCS based on the position you think it should adopt. e) Identify concrete steps that Connelly should take to improve Crown’s position. Be sure to discuss the move to aluminum, the growth of environmentalism, and opportunities overseas. Try to develop as cohesive a plan as possible. Does your plan address the opportunities and threats identified by your economic analysis?

Hudepohl Brewing Company HBS 9-381-092 (see earlier chapters)

Ingvar Komprad and IKEA HBS 9-390-132 (see earlier chapters)

Tombow Pencil Co., Ltd. (HBS # 9-692-011 and Teaching Note # 5-693-027): This case illustrates how another firm (in another country!) struggles with a similar make-or-buy problem. While the most prominent issues in the case are the "boundaries of the firm" questions, the case also raises issues related to product market competition and the role of product variety, marketing channels, and organizational issues involving the coordination of marketing, sales, and production inside Tombow. The case also presents the differences between Keiretsu (networks of long-term relationships) and arms-length market contracting. It introduces students to the idea that assignment of ownership rights can solve problems that arise due to physical asset specificity (hold-up, human asset specificity). As with Nucleon (see chapter 3), it shows that there are strong relationships between production strategy, product market strategy, and the make-or-buy decision. This case can be taught with some combination of the following chapters: 3, 4, 5, 11, 12, 15, and 16. You may want to ask students to think of the following questions in preparation for the case:

a) What is Tombow Pencil’s current financial position? Look at Tombow’s financial statement, and compare their financial ratios to Mitsubishi’s. In particular what would the impact be on Tombow’s profits if they could reduce their inventory/sales ratio to Mitubishi’s level?
b) Is the Japanese pencil industry profitable? Are there some segments that are more profitable than others?
c) Compare the vertical chains for wooden pencils and the Object EO pencil (which will be our metaphor for mechanical pencils in general). Are the differences in the vertical scope/vertical boundaries in these two chains consistent with the underlying economics of make or buy decisions? Why does Ogawa feel the need to reexamine the production system for the EO pencil, given that Tombow’s vertical relationship have served them well for so long?
d) What recommendations would you make for Tombow? Consider both the market position (product line, quality, price point, etc.) the horizontal and vertical scope, and the organization of the company.

Extra Readings
It may be useful to distribute the following to students:

McGahan, A. “Selected Profitability Data on U.S. Industries and Companies”.

Porter, Michael, “How Competitive Forces Shape Strategy”, Harvard Business Review, March-April 1979.
Porter, Michael, A Note on the Structural Analysis of Industries, Boston: Harvard Business School, 1975.

Grant, R.M. “Notes on Key Success Factors”, excerpts from Contemporary Strategy Analysis: Concepts, Techniques, Applications, Cambridge, MA: Blackwell Business, 1991, pages 57-60.

Answers to End of Chapter Questions

1. It has been said that Porter’s five forces analysis turns antitrust law—law intended to protect consumers from monopolies—on its head. What do you think this means?
Porter frames the forces that prevent industry profits from falling to the level that would exist in a competitive industry as a “positive”. When a force is such that profits are held above the competitive level, the five forces framework suggests this force is for the good of the industry. The antitrust laws are intended to push industry profits toward the competitive floor, for the benefit of consumers (and market efficiency).
2. Comment on the following: All of Porter’s wisdom regarding the five forces is reflected in the economic identity:
Profit = (Price – Average Cost) x Quantity
The distribution of profits, as defined in the above equation, rationalizes the analysis behind Porter’s five forces. Each of the variables in the equation bears on or is affected by one or more of the five forces discussed in the Porter model. Thus, the relationships between the forces influencing an industry are captured in the simple equation for economic profits. • Rivalry: The existence of rivalry would be reflected in price as well as in quantity. The prediction is that increased rivalry would drive prices down and could also cause a redistribution of market shares. Rivalry can also increase competition for scarce input resources and drive up costs. • Substitute goods: The existence of close substitutes would limit the price producers in the industry could charge. Substitute products can also reduce quantity when those substitutes are perceived to be better at satisfying customers’ needs or when they are priced lower and demand for the product is elastic. • Buyer power: Buyers can force price down if they hold more bargaining power than producers, thereby converting producer profits to consumer surplus. • Barriers to entry: High barriers to entry will prevent competitors from entering to drive prices down, allowing the current producers to maintain higher prices as well as larger quantities. • Supplier power: If manufacturers of an input hold bargaining power, then they can increase the prices they charge for inputs – the suppliers can capture a portion of the profits in the value chain.
The existence of profits suggests that competitors will certainly attempt to enter the industry. The five forces analysis identifies the factors that affect the distribution of value creation within the industry (whether it is to buyers (consumer surplus), suppliers (producer surplus in another industry) or competitors (competition for producer surplus)), and qualifies the extent to which the capturing the profits appears feasible. The equation can act as a simple model for Porter’s paradigm.

3. How does the magnitude of scale economies affect the intensity of each of the five forces?
Economies of scale exist when the average cost of producing output declines as the absolute volume of output increases. Scale economies affect the number of competitors that can compete successfully in an industry. There are likely to be fewer firms in an industry with high scale economies relative to total industry output than in an industry where scale economies are exhausted at relatively low levels of output. Since there are fewer players, the established incumbents would each have large market share and incur low unit production cost. In this context, scale economies will affect the five forces in the following way.
Barriers to entry: Scale economies raise the entry barriers. To bring cost to a level comparable to those of existing players, an entrant would have to enter the industry with large capacity and risk strong reaction from the incumbents. An alternative would be to enter at a small scale and face a cost disadvantage. Both options are undesirable to new entrants.
Rivalry: Scale economies can have competing effects on rivalry. On the one hand, scale economies may intensify rivalry because the players have the incentive to increase their market share to sustain and deepen their scale economies. Rivalry may take the form of price competition, advertising battles and new product introductions. On the other hand, scale economies may result in fewer firms that could facilitate communication and “peaceful coexistence” among industry players.
Substitutes: Scale economies increase the threat of the substitute products. If the price-performance trade-off of a substitute product improves, firms within the industry lose share which reduces the industry’s own price-performance trade-off.
Bargaining power of suppliers: If high scale economies result in fewer firms in the industry, it is possible that the bargaining power of suppliers decreases. Fewer firms could co-ordinate their purchases from suppliers, negotiating lower prices and thereby increasing value creation in the industry.
Bargaining power of buyers: Using the same reasoning for supplier power, scale economies that lead to higher industry concentration could decrease the bargaining power of buyers. Fewer firms could co-ordinate their pricing activities, thereby reducing consumer surplus. On the other hand, however, the existence of scale economies increases the power of buyers who purchase very large quantities.
4. How does the magnitude of consumer switching costs affect the intensity of internal rivalry? The extent of entry barriers?
The presence of switching costs would reduce the intensity of internal rivalry. Switching costs are costs that consumers incur when they switch from one supplier’s product to another’s. As such, consumers when faced with switching costs would not switch product unless a competitor can offer a major improvement in either price or performance. If switching costs are low, consumers are inclined to switch products when a competitor offers better price or service. This could result in price and service competition that would intensify the rivalry among competitors.
In the presence of consumer switching costs, the bar for entrants is set higher. The entrant may have difficulty attracting consumers away for incumbents. Entrants should expect to more easily attract consumers who have yet to participate in the product vs. the customers of existing firms.
5. Consider an industry whose demand fluctuates over time. Suppose that this industry faces high supplier power. Briefly state how this high supplier power will affect the variability of profits over time.
Given an industry whose demand fluctuates over time and an input supplier with high supplier, the industry’s variability of profits would decrease. High supplier power exists when an input supplier is able to negotiate prices that extract profits from their customers. In this case, the supplier’s power would be reflected in his/her ability to change prices to reflect demand within the customer’s industry over any given period of time. For example, if the industry is doing well, the supplier could raise prices to extract a share of the industry’s profits. Conversely, if the industry was doing poorly, the supplier could lower prices. The underlying demand volatility would be reflected in the supplier’s profits rather than the industry’s profits. The industry’s profits would stabilize (at a low level). 6. What does the concept of “coopetition” add to the five forces approach to industry analysis?
Coopetition is the concept that the forces that shape industry profits are to a great extent the result of choices made by the individual firms within the industry. As these firms become more savvy regarding the reaction of rivals to their own actions, they will choose actions that reduce the likelihood of losing industry profits to price wars, consumer surplus, and/or ineffective negotiations with suppliers. As each firm comprehends its own role within the industry, firms can collectively fashion strategies which “cause” a force to have only a limited effect. If firms ignore the concept of “coopetition”, they must resign themselves to simply reacting to the industry forces. 7. The following table reports the distribution of profits(on a per disc basis) for different steps in the vertical chain for music compact discs:

|Industry |Profits |
|Artist |$.60 |
|Record Company |$1.80 |
|Retailer |$.60 |

Use the five forces to explain this pattern. (Note: The record companies, including the “Big 6” –Warner, Sony, MCA, EMI, Polygram and BMG –as well as smaller labels, are responsible for signing up artists, handling technical aspects of recording, securing distribution and promoting the recordings).
Recorded Material Industry: The industry is comprised of record labels that produce, promote and distribute recorded material mainly for home use. • Barriers to Entry: Economies of scale in marketing, reputation and established distribution networks create barriers to entry. Established firms also have brand identification and customer loyalty, which stem from past customer experiences with a particular label. Existing competitors have ties with retail channels based on long relationships. In addition, the experience curve gives existing competitors cost advantages. In sum, “knowing the right people” is a cliché that cannot be understated in this industry. Relationships between distributors and the media and retail stores determine the success of an album. As these relationships take time and are costly to develop, they pose a formidable barrier to entry. • Rivalry: Labels primarily engage in product differentiation. Record companies each have artists signed on to exclusive recording contracts. Rivalry may take the form of “competing” for the best artists, however, rivalry generally does not result in price competition. • Supplier Power: Because there are many artists in the market (just add up every waiter and waitress in the U.S.) and few record labels, supplier power is low. The record company is responsible for recording, distribution and promotion. Thus, the artist depends heavily on the record company’s activities if the artist hopes to become a hit. Initially the artist has little power to negotiate profits away from the record label. However, once the artist becomes a hit, his/her power within the relationship may increase. The extent to which the artist’s power increases depends on how confident the record label is that they can invent a new star from the large pool of “wanna bees”. If stars are difficult to emulate or replace, their share of profits along the vertical chain increases. • Buyer Power: The music industry sells its output to retailers. The retailer stocks products that appeal to the individuals who purchase the output and use the output to generate home entertainment. Reputation is an important asset in music retailing. Consumers prefer to go to retailers who have a reputation for being well stocked with a large selection of products that appeal to the consumers’ tastes. Retailers also attract more customers if they have a reputation for being knowledgeable about the artists, courteous about replacing damaged material and reasonably priced, among other attributes. As reputation may impose a moderate barrier to entry, retailers have a degree of power within the vertical chain. Higher the barriers to entry are in retailing, the more profits retailers earn along the vertical chain.

• Substitutes: Examples of substitutes for recorded material are books, magazines, television, movies, and any other form of entertainment that can be consumed in the home. How consumers collectively feel about these substitutes effects the sum of profits along the vertical chain.
Chapter 11

Strategic Positioning for Competitive Advantage

Chapter Contents 1) Introduction
2) Competitive Advantage • Competitive Advantage Defined • What Matters More for Profitability: The Market or the Firm? 3) Competitive Advantage and Value Creation: Analytical Tools and Conceptual • Maximum Willingness-to-Pay Consumer Surplus • Value-Created • Value Creation and “Win-Win” Business Opportunities Example 11.1: The Division of the Value-Created in the Sale of Beer at a Basketball Game • Value Creation and Competitive Advantage Example 11.2: Value Creation Within a Vertical Chain: Integrated Delivery Systems in Health Care • Analyzing Value Creation • Value Creation and the Value Chain • Value Creation, Resources, and Capabilities Example 11.3: Creating Value at Enterprise Rent-a-Car Example 11.4: Measuring Capabilities in the Pharmaceutical Industry • Value Creation versus Value Redistribution • Value Capture and the Role of Industry Economics 4) Strategic Positioning: Cost Advantage and Benefit Advantage • Generic Strategies • The Strategic Logic of Cost Advantage Example 11.5: Cost Advantage at Cemex • The Strategic Logic of Benefit Advantage Example 11.6: Benefit Advantage at Superquinn • Extracting Profits from Cost and Benefit Advantage: The Importance of the Price Elasticity of Demand • Comparing Cost and Benefit Advantages Example 11.7: Strategic Positions in the U.S. Credit Card Industry: Capital One versus MBNA • “Stuck in the Middle” Example 11.8: Continental Airlines: Moving to the Efficiency Frontier 5) Strategic Positioning: Broad Coverage versus Focus Strategies • Segmenting an Industry • Broad Coverage Strategies • Focus Strategies 6) Chapter Summary 7) Questions
Chapter Summary

The purpose of this chapter is to develop a conceptual framework for characterizing and analyzing a firm’s strategic position within an industry. This framework employs simple economic concepts to characterize necessary conditions for a strategic position to create a competitive advantage in the market.

This chapter is organized into the following sections. The first section explores the concept of competitive advantage and argues that a firm can achieve a competitive advantage by creating more value than its rivals create. A firm that creates more total value can simultaneously earn higher profits and deliver higher net benefits than its competitors. The ability to create value depends on both the firm’s cost position and its differentiation position relative to its competitors. Understanding how a firm creates value and how it can continue to do so in the future is a necessary first step in diagnosing a firm’s potential for securing a competitive advantage in the marketplace. Projecting a firm’s prospects for creating value into the future also involves evaluating whether changes in market demand and technology are likely to threaten how the firm (or the entire industry) creates value. This section also clarifies the distinction between redistributing existing value and creating additional value.

The next section covers the analytical tools and conceptual foundations. The concepts of maximum willingness to pay, consumer surplus and value created are defined. Examples of “win-win” business opportunities are given. The concepts of value creation and competitive advantage are linked. The section argues that in order for a firm to earn positive economic profit in an industry in which competition would otherwise drive economic profitability to zero, the firm must create more economic value than its rivals (that is, more B – C). The value chain is described and depicted in figure 11.10. The importance of distinctively different and superior resources is discussed in the context of the firm’s ability to create more value. The section goes on to discuss value redistribution and value capture.

The following section discusses the economic and organizational logic of two broad alternative approaches to positioning: cost advantage and differentiation advantage. This section compares the two strategies and discusses when a cost advantage strategy is better than a differentiation strategy, and vice versa. In general, a position based on a superior cost position is appropriate when:

• Economies of scale and learning are potentially significant, but no firm in the market seems to be exploiting them. • Opportunities for enhancing the product’s perceived benefit, B, are limited by the nature of the product. • Consumers are relatively price sensitive and are unwilling to pay much of a premium for enhanced product quality, performance, or image. • The product is a search good, rather than an experience good.

Building a competitive advantage based on superior differentiation is likely to be relatively more attractive when:

• A substantial segment of consumers is willing to pay a significant price premium for attributes that enhance B. • Economies of scale and learning are significant, and existing firms -- because of their size or cumulative experience -- are already exploiting them. • The product is an experience good, rather than a search good.

This section explores how a firm’s positioning strategy also drives its operating strategies for its functional areas, such as marketing, operations, and engineering. This section also considers whether a firm can pursue both a cost advantage and differentiation strategy simultaneously.

The final sections cover market segmentation and targeting strategies and how these strategies are tied to a firm’s approach to creating value. Also discussed is the concept of strategic groups.

Approaches to Teaching this Chapter

Chapter 11 introduces a framework to study a firm’s strategic position within an industry.

Competitive Advantage: a firm has a competitive advantage when it outperforms (i.e. earns higher rates of profitability than) competitors who sell in the same market.

Consumer Surplus: the difference between what a consumer is willing to pay for a good and what she actually pays.

Perceived Benefit: the highest price a consumer is willing to pay for a good.

Indifference Curve: a curve that illustrates price-quality combinations that yield a constant level of consumer utility. Consumers are indifferent among the different price-quality combinations offered along this curve.

Value Created: the difference between the value that resides in the finished good and the value that is sacrificed to convert raw inputs into finished products.

Consumer Purchase Parity: exists when firms’ price-quality positions line up along the same indifference curve; that is, when firms are offering a consumer the same amount of consumer surplus.

Resources: firm-specific assets, such as patents and trademarks, brand name reputation, installed base, organizational culture, and workers with firm-specific expertise or know-how.

Capabilities: clusters of activities that a firm does especially well in comparison with other firms.

Key Success Factors: key success factors refer to the skills and assets a firm must possess to achieve profitability in a market. Possessing an industry’s key success factors is a necessary condition for achieving competitive advantage, but it is not a sufficient condition.

Cost Advantage: one approach to achieving competitive advantage. A firm that pursues a cost advantage strategy seeks to attain a lower C, while maintaining a B that is comparable to competitors.

Cost Driver: source of cost advantage.

Differentiation Advantage: one approach to achieving competitive advantage. A firm that pursues a differentiation advantage strategy seeks to offer a higher B, while maintaining a C that is comparable to competitors.

Focus Strategy: a strategy whereby a firm concentrates on either offering a single product or serving a single market segment or both.

Broad Coverage Strategy: a strategy that is aimed at serving all of the segments in the market by offering a full line of related products.

Strategic Groups: set of firms within an industry that are similar to one another and different from firms outside the group on one of more key dimensions of their strategy.

The following outline provides a useful starting place for lecturing about the chapter.

Competitive Advantage
A firm has a competitive advantage when it outperforms (i.e., earns higher rates of profitability than) competitors who sell in the same market. This chapter defines competitive advantage more precisely than it is defined in traditional strategic management literature. This definition emphasizes that a firm has a competitive advantage if it is able to reap higher profits than other firms in the industry are, whereas other definitions emphasize the ability of a firm to distinguish its products in the eyes of consumers.

Consumer Surplus and Value Created
In a given transaction:

Value Created = (Buyer’s Perceived Benefit – Price) + (Price – Cost) = Consumer surplus + Profit = (B - P) + (P - C) = B – C

• B reflects the value consumers derive from consuming the product less any costs (other than purchase price) of acquiring, using or maintaining the product. Thus, it is the maximum amount consumers are willing to pay for the product. • B - P is the net benefit from consumption and is called consumer surplus (synonymous with ‘delivered value’ in marketing texts.) Think of consumers choosing from among firms offering the same product on the basis of consumer surplus. • B in relation to C determines the magnitude of value-created, but the price P determines how much of the value created is captured by the firm as profit, P - C, and how much is captured by consumers as consumer surplus, B - P. • Industry structure is a key determinant of P - C, and, thus, is a key determinant of the proportion of total surplus captured by firms. • In general, the level of B is determined by the attributes of a firm’s products (benefit drivers) and the weight that consumers give to them. • The level of C is determined by a combination of factors that we refer to as cost drivers. (e.g. economies of scale, experience, input prices.)

You might want to ask students the following questions: What is an example of an industry where there is lots of surplus created, but not much captured by firms? To achieve competitive advantage, a firm must create more value than competitors (higher B-C). Why? This leads into the next learning point.

Link between Competitive Advantage and Value Creation
As the chapter suggests, it is useful to think of competition among firms as an “auction” where firms “bid” for consumers on the basis of consumer surplus. The firm that offers the highest consumer surplus will get the consumer’s business. If a firm creates more value -- higher B - C -- than its competitors, this firm will be able to match consumer surplus bids of competitors and end up with higher profit on the sale.

This is best illustrated by a numerical example:

Firm A Firm B
Value created (B-C) = $11 Value created (B-C) = $6

If Firm B offers a price that makes consumer surplus = $4, it gets profit of $2 (Remember, CS + profit = value created, so profit = value created - CS)

If Firm A offers a price that makes consumer surplus = $4, it gets profit of $7.

For both firms to make sales, we must have consumer surplus parity. When that happens, Firm A earns a higher profit than Firm B.

Diagnosing sources of competitive advantage is then a matter of diagnosing why a firm’s B - C is higher than existing or potential competitors:

Does firm offer higher B? (Differentiation Strategy)
Does firm have lower C? (Cost Position)
Or both? (Stuck in the middle)

Concepts for thinking about Value Creation

Porter’s Value Chain: As illustrated in Figure 11.10, the value chain depicts the firm as a collection of discrete, value creating activities (inbound logistics, production operations, outbound logistics, and marketing and sales) and four support activities (firm infrastructure activities, such as finance and accounting, human resources management, technology development, and procurement). The value chain is a useful tool for organizing one’s thinking when considering how different activities within a firm can help create value.
Another way to think about value creation is to identify the activities that a firm performs better than its rivals do. In other words, think about the distinctive resources and capabilities that a firm has. Resources are firm-specific assets that a firm draws upon to help create value. Examples of resources include patents, trademarks, human resources with firm-specific skills, experience, and reputation. Distinctive capabilities are clusters of activities that a firm does particularly well in comparison to other firms (for our purposes, think of these as synonymous with core competencies).
Choose a firm and ask students: What does this firm do especially well?

Alternative Approaches to Competitive Positioning: Cost vs. Differentiation

Cost Advantage: Create more value than competitors by having lower C for the same B (benefit parity) or not too much lower B (benefit proximity). A firm can exploit its cost advantage by charging a price P that is low enough to offset its B disadvantage (if any) but high enough that the firm can earn higher profits than competitors (see Figure 11.14).
Firms that achieve a competitive advantage by pursuing a low cost strategy can do so in many ways. Potential sources of cost advantage include: • Cost drivers related to firm size or scope, such as economies of scale; economies of scope, and capacity utilization. • Cost drivers related to cumulative experience, i.e. learning curve. • Cost drivers independent of firm size, scope or cumulative experience: input prices; location; economies of density; process efficiency; government policy. • Cost drivers related to organization of transactions: organization of the vertical chain, agency efficiency

Examples of firms that have built their competitive position on a cost advantage include DuPont in TiO2, Yamaha in pianos, and Frito Lay in salty snack foods.

Ask students to come up with their own examples of firms that follow a cost advantage strategy.

Differentiation Advantage: Create more value than competitors by having higher B for same B (cost parity) or not too much higher C (cost proximity). A firm can exploit its differentiation advantage by charging a price premium that is high enough to offset its C disadvantage (if any) but still low enough to maintain consumer surplus parity with competitors, even if they respond with price cuts aimed at improving the attractiveness of their products. (See Figure 11.15).

The benefit a firm creates depends on product attributes (benefit drivers) and the weights consumers put on them. Benefit drivers must always be viewed from the perspective of the consumer. Potential sources of differentiation advantages include:
9. Physical characteristics of product (e.g. performance, quality, features, aesthetics)
10. Complementary goods or services (e.g. post-scale services, spare parts)
11. Characteristics that shape consumer expectations of performance, quality or cost in use (e.g. reputation, installed base)
12. Subjective image (e.g. driven by advertising messages, packaging)

Examples of firms that have successfully pursued differentiation strategies include Honda accord vs. Domestic sedans, and Maytag in washers.

Challenge students to come up with their own examples of firms that follow a differentiation strategy.

Michael Porter has argued in his book Competitive Strategy that the pursuit of differentiation advantage is incompatible with the pursuit of cost advantage. You might want to pose the following question to the class: Can a firm have both cost & differentiation advantages? What are some examples of this? (Breyer’s ice cream) short answer, yes… but tradeoffs do exist (quality is not often free)

Suggested Harvard Case Study[10]
Hudepohl Brewing Company HBS 9-381-092 (see earlier chapters).
Prochnik: Privatization of a Polish Clothing Manufacturer HBS 9-394-038: This case examines the challenge of creating value when the environment changes dramatically. Prochnik, a Polish clothing firm, became one of the first five state enterprises to be privatized by the Polish government and to be listed in 1991 on the newly formed Polish stock exchange. Prochnik’s old ways of creating value were no longer effective and the firm had to develop new skills.
Tombow Pencil Co. Ltd. HBS 9-692-011(see earlier chapters)

Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Christensen, K. and L. Fahey, “Building Distinctive Competencies into Competitive Advantage,” Strategic Planning Management, February 1984, pp. 113-123.

Ghemawat, P., Commitment: The Dynamic of Strategy, New York: Free Press, 1991.

Porter, Michael, Competitive Advantage, New York: Free Press, 1985.

Nelson, R.R. and S.G. Winter, An Evolutionary Theory of Economic Change, Cambridge, MA: Belknap,1982.

Henderson, R. and I. Cockburn, “Measuring core Competence? Evidence from the Pharmaceutical Industry,” Massachusetts Institute of Technology, working paper, January 1994.

Stalk, G. and T. Hout, Competing Against Time: How Time-Based Competition is Reshaping Global Markets, New York: Free Press, 1990.

Miles, R. and C. Snow, Organizational Strategy, Structure and Process, New York: McGraw-Hill, 1978.

Miller, D. and P. Friesen, Organizations: A Quantum View, Englewood Cliffs, NJ: Prentice-Hall, 1984.

Answers to Questions at End of Chapter 1. How can the value chain help a firm identify its strategic position?
The value chain is a technique for describing the vertical chain of production. The value chain is also a useful device for thinking about how value is created in an organization. The value chain depicts the firm as a collection of value-creating activities, such as production operations, marketing and distribution, and logistics. Each activity in the value chain can potentially add to the benefit (B) that consumers get from the firm’s product and each can add to the cost (C) that the firm incurs in producing and selling the product. A firm creates more value than competitors only by performing some or all of these activities better than they do. We can often categorize strategic positions into two broad categories, either a cost advantage or a differentiation advantage. If a firm outperforms other firms in activities that generate superior B (differentiation) or in activities that generate a lower C (cost), the firm’s strategic position should rely on these activities. 2. Analysts sometimes suggest that firms should outsource low value-added activities. Do you agree or disagree?
A firm should outsource value-added activities that other firms can generate at lower cost than can the firm itself. However, the firm should not outsource an activity that can be performed cheaper by another firm but in giving up the activity the firm subjects itself to significant hold up and/or transactions costs. 3. Two firms, Alpha and Beta, are competing in a market in which consumer preferences are identical. Alpha offers a product whose benefit B is equal to $100 per unit. Beta offers a product whose benefit B is equal to $75 per unit. Alpha’s average cost C is equal to $60 per unit, while Beta’s average cost C is equal to $50 per unit.
a) Which firm’s product provides the greatest value created? Alpha Beta
BA = $100 BB = $75
CA = $60 CB = $50
VA = $40 VB = $25
B = perceived benefit, C = cost, and V = value created.
Firm Alpha creates more value than Beta. b) In an industry equilibrium in which the firms achieve consumer surplus parity, by what dollar amount will the profit margin, P-C, of the firm that creates the greatest amount of value exceed the profit margin of the firm that creates the smaller amount of value? Compare this amount to the difference between the value created of each firm. What explains the relationship between the difference in profit margins and the difference in value-created between the two firms?
In an industry equilibrium in which the firms achieve consumer surplus parity, the profit margin (P-C) of firm Alpha will exceed the profit margin of firm Beta by $15. Consumers will be willing to pay up to $15 more for firm Alpha’s product. Note that this amount is the same as the difference in value-created by the two firms. Firm Alpha can raise its price to the point just below where its unit price equals its unit cost plus the additional benefit it creates relative to firm Beta: PA = CA + (VA - VB) 4. Consider a market in which consumer indifference curves are relatively steep. Firms in this industry are pursuing two positioning strategies: some firms are producing a basic product that provides satisfactory performance; others are producing an enhanced product that provides performance that is superior to that of the basic product. Consumer surplus parity currently exists in the industry. Are the prices of the basic and the enhanced product likely to be significantly different or about the same? Why? How would the answer change if the consumer indifference curves were relatively flat?
Indifference curves illustrate price-quality combinations that yield the same consumer surplus. The fact that the indifference curve is steep means that consumers are willing to pay significantly more for a good that is of higher quality. Therefore, the prices of the basic and the enhanced product are likely to be significantly different. On the other hand, the prices of the two goods would be about the same if the consumer indifference curves were relatively flat. Flat indifference curves mean that consumers are not willing to pay much more money for a higher benefit. 5. Why would the role of the marketing department in capital-intensive industries (e.g., steel) differ from that in labor-intensive industries (e.g., athletic footwear)? How does this relate to positioning?
According to Chandler, capital-intensive industries enjoy economies of scale. As a result, those that can produce in volume achieve significant cost reductions. A few firms will control the market. A necessary ingredient in the success of these firms is throughput. The marketing department identifies markets, secures distribution, and determines the price at which the firm can sell its massive output.
In labor-intensive industries, there are few natural sources of scale economies, and large firms have no inherent cost advantage over small firms. There can be many firms, and, absent product differentiation, the market will be competitive, with few profit opportunities. The role of the marketing department is to differentiate the firm’s products in the mind of the consumer. The marketing department becomes a core source of value in the firm. With successful differentiation, the market becomes monopolistically competitive, or, if image differentiation is extremely successful, oligopolistic. Marketing drives this evolution of market structure. 6. In the value-creation model presented in this chapter, it is implicitly assumed that all consumers get the identical value (e.g. identical B) from a given product. Do the main conclusions in this chapter change if consumer tastes differ, so that some get more value than others do?
The main conclusions of this chapter are as relevant if consumer tastes differ as when all consumers get identical value. If every consumer obtained a different B from a particular good, there would still exist meaningful segments that would be profitably served by particular firms—rather than each consumer enjoying the same consumer surplus, each would obtain a different surplus. Consumers would purchase as long as their consumer surplus was positive—this is true whether consumers have the same valuation or not. The fact that the level of surplus consumers received was different across consumers does not fundamentally change the analysis. 7. Identify one or more experience good. Identify one or more search goods. How does the retailing of experience goods differ from the retailing of search goods? Do these differences help consumers?
An experience good is a product whose quality can be assessed only after the consumer has actually consumed the product. For example, a buyer could not decide if he likes the taste of a particular beverage until the buyer actually consumes the beverage. Sometimes the product has to be used for a while in order to understand fully how satisfying is consumption of the good. For example, a consumer may not be able to evaluate the quality of his automobile until he has driven that automobile for several weeks.
A search good is one whose objective quality attributes the typical buyer can easily access at the time of purchase. For example, a consumer could determine all the important attributes of a diamond at the time of purchase—wearing the diamond as an owner of the diamond does not generate any additional information.
With search goods, the potential for differentiation lies largely in enhancing the product’s observable features. When a firm is selling a search good that possesses attributes the seller wants the customer to know about, the customer does not have to take the seller at his word—the customer can observe the attributes. The seller must only provide an opportunity for the consumer to fully observe the good. Sellers who do not reveal the attributes of their products at the time of sale will lose sales to sellers who are willing to reveal their products fully to buyers or these sellers would have to heavily discount their prices. The seller’s reputation, however, is not in question—the attributes of the good speak for themselves.
When selling an experience good, sellers must often send signals to buyers that the good will not disappointment the buyer post-purchase. Since the buyer does not get to fully appreciate the good until after the good is consumed, the buyer buys under uncertainty. The seller’s reputation for delivering products that perform as promised becomes an important feature of the purchase process.
The selling processes associated with search and experience goods help insure that consumers purchase goods closer to their “ideal” good. Both processes reduce the risks of buying under uncertainty—the attributes of search goods are revealed at the time of purchase and reputation and other credible signals are used to guide consumers in their purchases of experience goods. 8. Recall from Chapter 2 Adam Smith’s dictum “The Division of Labor is Limited by the Extent of the Market.” How does market growth affect the viability of a focus strategy?
Under a focus strategy, a firm concentrates either on offering a single product or serving a single market segment or both. Four examples of focus strategies are: • Product specialization: the firm concentrates on producing a single type of product of a variety of different market segments. • Geographic specialization: the firm offers a variety of related products within a narrowly defined geographic market. • Customer specialization: the firm offers a variety of related products to a particular class of customers. • Niche strategy: a firm produces a single product for a single market segment
The basic economic logic of a focus strategy is that the firm is sometimes able to achieve deep economies of scale by concentrating on a particular segment or a particular product that is would be unable to exploit if it expanded beyond the segment or product it is concentrating on. The growth of a market can make a focus strategy that at one time was not feasible become a very profitable opportunity. Growth might also increase the benefits of economies of scale for the focuser. If a market grows to the point where a firm’s economies of scale are exhausted, the firm might have to worry about entry. 9. “Firms that seek a cost advantage should adopt a learning curve strategy; firms that seek to differentiate their products should not.” Comment on both of these statements.
A learning curve strategy is one in which a firm seeks to reduce costs by learning. This is but one of many ways in which a firm can achieve a cost advantage. Other cost drivers include: economies of scale, economies of scope, capacity utilization, economies of density, process efficiency, government policy, and a firm’s location.
Learning curves can also confer quality advantages. If there is a first mover advantage in establishing a particular quality position (say the goods are experience goods), then it may pay to push aggressively down the learning curve to gain that quality advantage. Therefore, pursuing a learning curve strategy could be advantageous to both firms that seek a cost advantage and firms that seek to differentiate their products. 10. Consumers often identify brand names with quality. Do you think branded products usually are of higher quality than generic products and therefore justify their higher prices? If so, why don’t all generic product makers invest to establish brand identity, thereby enabling them to raise price?
Establishing a brand name is very costly for firms. Large sums of capital must be invested continually over a long period of time before a firm earns a significant brand identity. In the sale of experience goods—goods whose quality cannot be assessed before they are purchased and used—the reputation for quality that a firm establishes can be a significant advantage. Consumers can reason that a firm who has invested continually in its brand identity is unlikely to chisel on quality and risk depreciating its precious brand image. In other words, incurring the cost of establishing a brand identity is a means for firms to signal to consumers that the firm offers quality products. Hence, the expectation is that branded products are of higher quality than generic products and should, therefore, garner higher prices.
We should not expect, however, that all sellers of experience goods would brand their goods. For certain goods consumers may be much more price sensitive than quality sensitive. A firm who incurs costly marketing may find itself unable to pass this cost on to customers who do not sufficiently value the signal that the firm is selling a higher quality product.
Also, establishing a brand identity is less attractive to sellers of search goods, or goods whose quality and other attributes can be established at the time of sale. Since the consumer can ascertain the quality of the product directly, signals of quality are not necessary. Hence, sellers of search goods might be better off selling their products under a generic label. Theoretically, a consumer should not pay a premium for a branded search good because the brand name does not confer any additional information. 11. Industry 1 consists of four firms that sell a product that is identical in every respect except for production cost and price. Firm A’s unit production costs are 10 percent less than the others are, and it charges a price that is one percent less than the others do. Industry 2 consists of four firms that sell a product that is identical in every respect except for production cost and price. Firm X’s unit production costs are 10 percent less than the others are, and it charges a price that is 8 percent less than the others do. Stable demand and comparable entry barriers characterize both industries.
The above situations have prevailed for years. The managers of the above firms are very smart and are surely acting in the best interest of their owners, whose only goal is to maximize profits. Based on this information only, can you determine which industry has the highest price-cost margin (i.e. price-unit production cost) as a percentage of price) and why?
The key here is to recognize that the firm with the cost advantage in each industry is following a different strategy for exploiting its cost advantage. In industry 1, the cost leader (Firm A) is shadow pricing. It is following a “margin” strategy, rather than a “volume” strategy for exploiting its cost advantage. In industry 2, the cost leader (Firm X) is significantly underpricing its competitor, which suggests that it is following a “volume” strategy rather than a “margin” strategy. As discussed in this chapter, a margin strategy is generally sensible in industries with high horizontal differentiation and low margins. Without knowing anything else about these two industries, a plausible inference from the information given is that industry 1 is characterized by higher horizontal differentiation, and thus higher margins, than industry 2.

Chapter 12

Sustaining Competitive Advantages

Chapter Contents

1) Introduction
2) How Hard Is It to Sustain Profits? • Threats to Sustainability in Competitive and Monopolistically Competitive Markets • Evidence: The Persistence of Profitability 3) Sustainable Competitive Advantage Example 12.1: Exploiting Resources: The Mattel Story • The Resource-Based Theory of the Firm Example 12.2: American versus Northwest in Yield Management • Isolating Mechanisms • Impediments to Imitation Example 12.3: Cola Wars: Slugging It Out in Venezuela Example 12.4: Maintaining Competitive Advantage in the On-Line Brokerage Market • Early-Mover Advantages Example 12.5: Switching Costs for the Newborn Set: Garanimals Example 12.6: The Microsoft Case • Early-Mover Disadvantages
4) Imperfect Imitability and Industry Equilibrium 5) Chapter Summary 6) Questions

Chapter Summary

Competitive advantage in a competitive market is not sustainable in the long run. The resource-based theory of the firm demonstrates how profits are reduced through competition, new market entrants and imitation among other reasons.
The resource-based theory states that for a firm to maintain long run excess profits, its resources must meet four conditions: • Resource heterogeneity: the resources and capabilities underlying firm production are heterogeneous across firms. In a particular industry, since firms are all different, there must be some whose resources are superior to other firms for competing in the industry. These firms with superior resources are able to produce their output more efficiently (lower costs) and/or are able to product goods that satisfy consumers more than the goods offered by other firms. • Ex-ante barriers to competition: other firms cannot recognize the value that the resource creates up front. If the value of the resource were common knowledge, competition to acquire the resource would have driven up the price of acquiring it initially — perhaps up to the point where the rents are completely dissipated. In other words, ex-ante barriers to competition presume imperfect information in market. • Imperfect mobility: generally means that the superior resource cannot be traded (or if the resource can be traded, there are reasons it wouldn’t be as productive in the hands of another producer). If a resource could be used just as effectively or more effectively by a competitor, the opportunity cost of utilizing the resource offsets the profits generated by the resource. Imperfect mobility implies the existence of cospecialization. • Ex-post barriers to competition: insure that the competitive advantage associated with heterogeneity is preserved. Subsequent to a firm gaining a superior position and earning rents, there must be forces that limit the competition for those rents. If another firm can obtain the same resources, there is no ex post limit. Examples include patents, experience curves, and ownership of scarce inputs.

Although the above suggests that there is a high “hurdle” to generating economic rents in the long run, research has shown that although high performance firms’ profits do decline in the long run, and those of low performance companies increase, they do not converge. This lack of convergence could arise from the fact that there are few true “competitive markets” in the world or the presence of some degree of resource-based advantage.


Regression to the Mean (Reversion to the Mean): In the case of extremely good (or poor) performance by a company, there is a high probability of this company returning to a less extreme (or average) performance in subsequent periods. This implies that firms will sometimes have the ability to generate extraordinarily high (or low) rents through unspecifiable factors, such as luck, but in the long run will revert back to average performance.
Cost of Capital: A firm specific rate of return, specified by the market’s view of a firm’s riskiness, which determines the cost of raising capital. If the firm is unable to exceed this expected return, they will be unable to attract investor’s capital.
Competitive Advantage: The ability of a firm to outperform its industry average and earn higher rents than the norm. A firm’s competitive advantage is subject to issues of sustainability, otherwise the firm’s exceptional performance will be vulnerable to a regression to the mean.
Resource-Based Theory of the Firm: Theory that sustainable competitive advantage exists only if resources and capabilities are scarce and imperfectly mobile. In a well-functioning market, where resources are plentiful, competitively priced, and not specific to a company, competitive advantages do not exist.
Imperfectly Mobile: Resources are imperfectly mobile when they are cospecialized and therefore derive higher rents for the firm with ownership of cospecialized assets, since these assets will be worth less to any other firm. The owning firm will have these quasi-rents. (Current rents less the next best option.)

Co-Specialized Assets: Assets that are more valuable and derive more rents, when used together.

Isolating Mechanisms: Mechanisms that limit the extent to which a firm’s competitive advantage can be duplicated or neutralized by competitors. They are to companies what barriers to entry are to an industry.

Causal Ambiguity: Exists if the cause of a firm’s ability to create value is obscured and only imperfectly understood. External observers, competitors, find it difficult to know why one firm can create an advantage and therefore cannot duplicate the company’s ability to extract rents.

Social Complexity: Source of a firm’s competitive advantage may lie in its interpersonal capability (such as trust with suppliers, relationships with clients). The ability to create or manage this advantage may be too complex and expensive to replicate easily, thereby leading to increase sustainability of their competitive advantage.

Network Externalities: Exist when the benefits of a product to a consumer grows as the community of users of this product increase in size. The example in the chapter is QWERTY keyboard.

Conceptual Applications

Choose a Profitable Company and Investigate
Students are familiar with dozens of companies that seem to have sustained profitability for more than a handful of years. Instructors could assign short reports about individual firms to verify and explain why profits were sustained or why sustainability changed. Which of the mechanisms discussed in the chapter were key to this profitability? How long does the student believe the firm will be able to maintain that advantage?

Choose a Barrier and Explore
None of the barriers to imitation are immutable. Technological, legal, regulatory and cultural factors continually redefine the extent and power of these advantages. Instructors might want to have the students investigate one barrier and how it has evolved in recent history. With an understanding of historical changes, the students might be able to predict what future changes would mean for industry competition. For example, if the average length of patents and copyrights were shortened by the government, which companies would win, which would lose? If changing technology dramatically reduced the economies of scale in automobile production, how would you expect the industry dynamics to change?

Talk about Industries in which Barriers Occur
Students may also investigate competition from an industry level. Which barriers occur in which industries? Does historical profitability of companies match student expectations based on the availability of these impediments? How quickly are specific industries changing? An example from the computer software world: if a universal software recognition system were to be developed that allowed seamless recognition of all software programs irrespective of operating system (such as Sun's Java 'applets' might turn out to be), how would this change Microsoft's Windows network externality advantage? Would Apple be able to gain share in this altered environment? Students could also compare industries. For example, why is imitation more of a problem for biotechnology companies than for semiconductors?
Suggested Harvard Case Studies

De Beers Consolidated Mines, HBS 9-391-076 (see earlier chapters)

Nucor at a Crossroads HBS 9-793-039 (see earlier chapters)
Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Brock, G. W. The US Computer Industry. A Study of Market Power. Cambridge, MA: Ballinger,1975.

Carroll, P. Big Blues: The Unmaking of IBM. New York: Crown, 1993.

DeLamarter, R. Big Blue: IBM's Use and Abuse of Power. New York: Dodd, Mead, 1986.

Ferguson, C.H. and C.R. Morris. Computer Wars: The Fall of IBM and the Future of Global Technology. New York: Times Books, 1994.

Ghemawat, P. Commitment.- The Dynamics of Strategy. New York: Free Press, 1991.

Greer, D. F. Industrial Organizations and Public Policy. 3rd ed., New York: Macmillan, 1992.

Mueller, D. C. Profits in the Long Run. Cambridge: Cambridge University Press, 1986.

Nelson, R. and S. Winter. An Evolutionary Theory of Economic Change. Cambridge, MA: Harvard University Press, 1982.

Penrose, E. T. The Theory of the Growth of the Firm. Oxford: Blackwell, 1959. - the pioneering work underlying the resource-based theory.

Peteraf, M. A. "The Cornerstones of Competitive Advantage: A Resource-Based View." Strategic Management Journal, 14, 1993.Polanyi, M. The Tacit Dimension. Garden City, NY: Anchor, 1967.

Scherer, F. M. and D. Ross. Industrial Market Structure and Economic Performance. 3rd ed., Boston, MA: Houghton Mifflin, 1990.

Answers to End of Chapter Questions

1. “An analysis of sustainability is similar to a five forces analysis.” Comment.
Clearly, a five forces analysis identifies many of the threats to sustainability. A five forces analysis identifies the factors which impact overall industry profits. However, the five forces does not explain why some firms in an otherwise perfectly competitive market may be able to sustain positive economic profits over long periods, even though the industry on average earns zero profits. The five forces framework is not appropriate for analyzing the differential in performance across firms. A complete analysis of sustainability must address the differences in resources and capabilities possessed by each firm. 2. Mueller’s evidence on profit persistence is 30 years old. Do you think that profits are more or less persistent today then 30 years ago? Justify your answer.
Mueller’s results suggest that firms with abnormally high levels of profitability tend, on average, to decrease in profitability over time, while firms with abnormally low levels of profitability tend, on average, to experience increases in profitability over time – but high profitability firms and low profitability firms do not converge to a common mean. Mueller’s work implies that market forces are a threat to profits, but only up to a point. Other forces appear to protect profitable firms.
While Mueller’s work is 30 years old, it is likely a similar study performed currently would yield analogous results. Many of the forces that acted to protect profits 30 years ago are still very relevant (for example, economies of scale in manufacturing and/or branding). High profit industries still currently attract entry, but many of these industries also enjoy forces that inhibit the degree of competition firms face. 3. Coke and Pepsi have sustained their market dominance for nearly a century. General Motors and Ford have recently been hard hit by competition. What is different about the product/market situation in these cases that affects sustainability?

One problem facing the auto industry is even the most popular of cars, such as Ford’s1960 Mustang faces a limited technological as well as a general product life cycle. That is, changes in technology and taste force automakers to eventually phase out even the most popular models. Coke and Pepsi, on the other hand, face no real pressure to change their formula. In short, automakers must incur huge recurring capital outlays in order to product, while Coke and Pepsi only need to continually invest in their brands.

Second Pepsi and Coke have successfully created brand equity unmatched by Detroit. Studies show that people do not necessarily think that Coke tastes better than RC. However, the image and brand equity that Pepsi and Coke have built up over the years has created a loyal following because consumers apparently value this brand equity and reward the firms with repeat purchases. GM and Ford, on the other hand, have not been able to do that with their own products. An individual’s choice of soft drink is an ad hominem decision. Once consumers have chosen a brand of beverage, they exhibit a significant amount of inertia—they are unlikely to switch brands. Individuals are more likely to choose their automobile analytically—trading off features and price.
Third, General Motors and Ford have the issue that any technological advantages or advantages rooted in economies of scale that they have are difficult to keep proprietary because of imitability or employee turnover etc., and if they have an enforceable patent, it eventually expires and becomes available to other companies, or, in some cases, it can be invented around. Coke and Pepsi’s “recipe” for creating their tastes and their images is essentially inimitable.
Finally, the “shelf space” that Coke and Pepsi rely on to sell their product is inherently more limited than the “shelf-space” on which Ford and GM rely. Car manufacturers can easily proliferate dealerships. Foreign carmakers can enter and easily open dealerships. Carmakers can sell their products over the Internet—infinite shelf space. Entrants into the beverage industry (and this applies to many consumer nondurables) are hard pressed to find available shelf space among retailers. 4. Provide an example of a firm that has co-specialized assets. Has the firm prospered from them? Why or why not?
Assets are cospecialized when they are more valuable when used together than when separated. For example, sports analysts have suggested that John Stockton and Carl Malone of the Utah Jazz basket ball team create more value as a pair then the sum of their values would be if each played for other teams. If their contracts expire at different times, it would be difficult for either of them to negotiate in salary the value they create for the Jazz. The reason is, when one contract expires the other player is still under contract and so the Jazz “owns” the other half of the dynamic duo. The player can only negotiate his value to the team who values that player the most after the Jazz. Since the players are worth more to the Jazz than the sum of their values to other teams, the Jazz gets to retain a portion of the value the players create. If the players had contracts that expired at the same time and the players were not cospecialized with the other players or with the state of Utah, they could negotiate away from the team their full value. 5. “Often times, the achievement of a sustainable competitive advantage requires an investment and should be evaluated as such. In some cases, the benefits from the investment may not be worth the costs. Rather than trying to build a sustainable position, the firm should ‘cash out,’ for example, by exiting the industry, selling the business assets to another firm, or refraining from investing additional capital in the business for future growth.”
Evaluate this statement keeping a focus on two questions: a) in light of the factors that help a firm sustain a competitive advantage, explain in what sense achieving a sustainable advantage requires an investment.” b) Can you envision circumstances under which the such an investment would not be beneficial to the firm.
a) Gaining a competitive advantage requires an investment in a factor or factors that allow the company to make profits in excess of those of their competition. However, a simple investment does not guarantee competitive advantage. Investments in factors that do not provide excess profits are a waste of money. For example, if a company wants to buy a factor and there is perfect information as to the factors future value, the purchaser will have to pay the owner the net present value of future cash flows from the factor, or even more. Thus while the company makes accounting profits, it does not make economic profits and thus has no competitive advantage. Furthermore, competitive advantage is not a guarantee of profits. Having a competitive advantage in a shrinking or tiny market could mean that the company’s advantage is not paying off in excess profits or a positive net present value.
b) Managers and shareholders often have different goals and ideas of what is best for the company. For example, a shareholder may realize that investing in order to create or maintain a competitive advantage in a small industry is a waste of capital while the manager may be undertaking the project for self-aggrandizement or “empire-building.” Equity holders may hold the company’s stock for reasons other than claiming a share of the company’s future income, such as diversification and risk-hedging and thus may be unwilling to shift the focus of the company. 6. Do you agree or disagree with the following statements about sustaining advantage? A. In a market with network externalities, the product that would potentially offer consumers the highest “B-C” inevitably comes to dominate.
In a market with network externalities, it is not necessarily true that the product that would potentially offer consumers the highest “B-C” comes to dominate. For some products, such as computer software or consumer electronics, a consumer’s benefit from purchasing the product is greater the more consumers currently use the product or are expected to use it in the near future. When a network externality exists, a firm that has made more sales than its competitors in early periods and has thus developed a large installed base has an advantage when competing against firms with smaller installed bases. B. Usually high performing firms may get that way either by outpositioning their competitors, belonging to high performing industries, or both.
High performance in the long run requires that the company outperform their competition through inimitable strategies or use of factors, such as outpositioning one’s competition. This is true for all industries, not just high performing ones.

C. If the sunk costs of entering industry A exceed the sunk cost of entering industry B, there will certainly be fewer firms in industry A than in industry B.
Higher suck costs of entering an industry will make new comers hesitate to enter the market. If all conditions other than the sunk costs are the same, the higher the sunk cost, the fewer the new entrants. However, if the net present value of entering an industry is positive, firms will enter. In other words, we cannot conclude that the level of sunk costs is perfectly negatively correlated with the number of firms in the industry without accounting for other factors such as the level of overall demand in the industries. Furthermore, if an industry has high sunk costs, firms are less likely to exit the industry—sunk costs act as a barrier to exit that may positively impact the number of firms in the industry. D. The Kronos Quartet (a popular classical string quartet) provides an example of co-specialized assets.
If the members of the quartet produce more value together than they do as soloists or as members of different groups, then they could be viewed as co-specialized assets. However, each member of the Kronos Quartet is considered tradable. If any player can quit the Kronos Quartet and join another group and the same (or more) total value is generated, then the members would not be examples of co-specialized assets. 7. Which of the following circumstances are likely to create first mover advantages:
A. Maxwell House introduces the first freeze dried coffee.
There are no network externalities or switching costs with freeze-dried coffee. A case may be made for possible reputation and buyer uncertainty effects, that is if Maxwell house can pioneer a product and establish a reputation for quality, preexisting customers may be unwilling to switch and new customers will seek out the pioneer because of its reputation. However, this effect is very uncertain. If another brand comes along that tastes better, consumers can easily switch. If Maxwell house can patent the freeze-drying process and it cannot be “invented around,” the patent may offer a sustainable first mover advantage. It is also possible that the product would offer first mover disadvantages. If Maxwell House invests all its money in one process, but another company “free-rides” on its marketing and creates a better product, Maxwell house could face a first mover disadvantage.
B. A consortium of US firms introduces the first high-definition television.
There is a potential first mover advantages to the introduction. The invention might be patentable. It is also possible that the introduction will offer the consortium the network externality advantage in that it can become the “base” for the complementary software (TV programming, providing that these programs must meet the consortium’s standard) and for future home-entertainment opportunities. Consumers will want to buy hardware that meets the standard so they can receive the TV programs and tie in to future complementary hardware, if it comes about. Another possible advantage is the learning curve effect. If the consortium successfully introduces the technology, they may be able to produce larger volumes earlier than their competition.
A disadvantage could arise if the high definition television was the wrong “bet,” i.e. it’s the wrong technology, or a different consortium introduces a different standard that dominates the US consortium’s.
C. Smith Kline introduces Tagamet, the first effective medical treatment for ulcers.
The first possible advantage would again be legal, i.e. patent protection. If Smith Kline markets the Tagament as a pioneer they may be able to gain customers and keep them through reputational effects and the fact that switching costs would be high. If physicians learn how to treat patients using Tagament and patients prefer to purchase a product with which physicians are experienced, Tagament may secure a first mover advantage. A customer who had used Tagament successfully for years may be unwilling to switch for a newer, less tested product, unless offered a strong incentive to switch. Smith Kline’s several year head start could also give them an insurmountable advantage in terms of the learning curve. However, it is possible that substitute products can “free ride” on Smith Kline’s marketing efforts.
D. Wal-Mart opens a store in Nome, Alaska.
This can be a sustainable first mover advantage if the market dynamics of Nome, Alaska are such that there are not enough potential customers in Nome to let two or more stores operate at an efficient scale. This assumes that Wal-Mart is the first store to open. 8. Each of the following parts describes a firm that was an early mover in its market. In light of the information provided, indicate whether the firm’s position as an early mover is likely to be the basis of a sustainable competitive advantage. A. An early mover has the greatest cumulative experience in a business in which the slope of the learning curve is one.

The learning curve is the decreasing marginal costs of production corresponding with an increase in volume over time. A learning curve of one means that costs do not decrease or increase as a function of volume over time and thus show that there is no learning curve advantage for this particular firm. B. A bank has issued the largest number of automated teller cards in a large urban area. Banks view their ability to offer ATM cards as an important part of their battle for depositors, and a customer’s ATM card for one bank does not work on the ATM systems of other banks.
This potentially is a sustainable advantage. Issuing a large number of cards does not give a sustainable advantage unless there is a correspondingly large number of ATM’s to use them at and if all other ATM cards don’t work at them. Having the largest number of ATM’s might grant a economy of scale advantage that other banks cannot afford to duplicate. Having the largest number of ATMs and ATM cards might also create a network externality in that firms with installed bases larger than their competitors has an advantage when competing with competitors with smaller basis.
This advantage could be easily lost. For example if customers want to use their ATM’s out of the geographic area the bank services, the bank may have to use services like Cirrus to provide this service. Thus, the externality advantage could be undermined. C. A firm has a 60 percent share of T3MP, a commodity chemical used to make industrial solvents. Minimum efficient scale is thought to be 50 percent of current market demand. Recently a change in environmental regulations has dramatically raised the price of a substitute chemical that indirectly competes with T3MP. This change undermines the market for the substitute, which is about twice the size of the market for T3MP.
This question is about first move advantage and minimum efficient scale. A firm does possess a first mover advantage if it achieves minimum efficient scale and no other firm can do so. This describes the firm in question, until the market for the substitute collapses. When the T3MP market expands, more firms can achieve economies of scale, and the first mover advantage may be lost. If, however, the firm has a well-developed brand name, it will have an advantage as these new customers launch their initial purchases of T3MP.

9. In defending his company against allegations of anticompetitive practices, Bill Gates claimed that if someone developed an operating system for personal computers that was superior to Microsoft’s Windows ’95 operating system, it would quickly become the market leader, just as Gates’ DOS system became the market leader in the early 1980’s. Opponents countered that the market situation in the late 1990’s was different than in the early 1980’s, so even a markedly superior operating system might fail to capture significant market share. Comment.
This is a great example of the power of network externalities. The installed base of Microsoft Windows operating systems increased precipitously between early 1980 and late 1990. Each of these users has purchased and learned to use software that is compatible with the Windows operating system. Each of these users has constructed worksheets and documents in their Windows compatible softwares. Furthermore, most of these users network with other individuals, at least on some level, who, in all likelihood, are Windows operating system users. If a user changed operating systems, and that operating system was not backward compatible with Windows and all the software that operates in Windows, that user would probably have limited software choices, would have to convert all his files into new programs and would be unable to network with many other users. Even an operating system with phenomenal features would be hard pressed to attract many users.

10. Super Audio CD (SACD) and DVD Audio (DVDA) are new digital audio formats. Both offer surround-sound music at a quality that approaches the original studio master recordings from which they are made. (Standard compact discs degrade sound quality due to format limitations.) Although there are few dedicated SACD or DVDA players, it is possible to manufacture DVD players with SACD and/or DVDA circuitry for an additional for an additional $50-$500 per format, depending on the quality of the playback. SACD is supported by Sony, which offers the format on some of its mid-priced DVD players. It has also won support from several classical music and jazz labels, and has released recordings from several popular acts including the Rolling Stones. DVDA is backed by the DVD consortium, and is included as a low-cost added feature in mid-priced DVD players from Denon, Panasonic, and Pioneer. However, few recording studios have embraced the format thus far.
Which format do you think is most likely to survive the nascent format war? Should Sony compete for the market or in the market?

A product is said to be standardized when some protocol is followed in its production such that users of the same product can interact with each other and/or with some set of complementary goods that follow that protocol. If a firm is considering entering a market in which a standard does exist (or is likely to emerge) there is much the firm needs to consider—more than can be addressed in answering this question! As is the case with any firm, there is a share that enables the firm to achieve sufficient profitability to continue operation. In the case of a firm whose product complies with a standard and the good is consumed with a complementary good (PC and software), the level of market share required to achieve profitability is affected not just by the firm’s own minimum efficient scale, but the minimum efficient scale in the production of the complementary goods. Within a product function, there are multiple possible standards that might emerge—sometimes only one survives (as in PCs, since Apple is really delegated to a ever decreasing niche) and sometimes multiple standards coexist for many, many years (cassettes and CDs or DVDA and SACD). When we see multiple standards, the following is often the case: o Alternative standards are not substitutable enough for many customers. That is, there is “meaningful” differentiation among the offerings—whereby one standard dominates for one set of occasions of use and another standard dominates for another set of occasions of use (for example, cassettes are portable and CDs have better sound quality). Sufficient product performance differences could justify coexistence. Sometimes these alternative standards sell to difference segments of consumers and sometimes the consumer segments overlap. o Producers of the complementary goods can cover all their costs. That is, the consumers are willing to pay for the redundant costs of producing the complementary goods for multiple standards because the consumers value the differentiation between the standards.

Whether entering a new or existing product market for which a complementary product is required the firm needs to consider the minimum efficient scale of the complementary good in setting its market share target.

The good described in the question does not seem likely to be dominated by one standard. While Sony has done a good job of getting some traction, the fact that other hardware manufacturers are currently including the feature in their products suggests that Sony’s lead will be contested.

Chapter 13
The Origins of Competitive Advantage: Innovation, Evolution, and the Environment

Chapter Contents


Creative Destruction

• Disruptive Technologies • Sustainability and Creative Destruction Example 13.1: The Sunk Cost Effect in Steel: The Adoption of the Basic Oxygen Furnace
3) The Incentive to Innovate • The Sunk Cost Effect • The Replacement Effect Example 13.2: Innovation in the PBX Market
4) Innovation Competition • Patent Races • Choosing the Technology
5) Evolution Economics and Dynamic Capabilities Example 13.3: Organizational Adaptation in the Photolithographic Alignment Equipment Industry
6) The Environment Example 13.4: The Rise of the Swiss Watch Industry
7) Managing Innovation Example 13.5: Competence, History, and Geography: The Nokia Story
8) Chapter Summary
9) Questions

Chapter Summary

Chapter 13 examines the role of innovation as a source of competitive advantage. The origins of competitive advantage accrue from the ability of firms to exploit opportunities to create profitable competitive positions that other firms are unable, or unwilling to do. In short, competitive advantage arises when a firm is willing to innovate during periods of fundamental “shocks” or discontinuities in the economy to displace existing practices and technologies.

The incentives to innovate can be attributed to three main effects: (1) the Sunk Cost Effect, (2) the Replacement Effect, and (3) the Efficiency Effect. While the first two phenomena explain the rationale for entrants to innovate, the third effect provides possible reasons for incumbents to continually innovate. In addition to the traditional theories of innovation discussed above that are rooted in neoclassical economics, the chapter also offers insight from the viewpoint of evolutionary economics. These theories examine the impact of the firm’s resources, capabilities, and history on innovation. In short, while neoclassical economics offer insights on the firm’s incentives to innovate, the evolutionary theories posit that some firms have greater abilities to innovate than do others. Additionally, the impact of a firm’s environment (particularly its local environment) on its incentive to innovate is also explored.

In addition, the chapter also examines the dynamics of innovation competition. Regardless of whether competition is modeled as deterministic or probabilistic patent races, the key is to anticipate R&D investments of competitors. Failure to do so can be very costly.

The chapter ends with an examination of empirical evidence on the process of innovation and summarizes how firms are attempting to manage innovation within the firm.

Approaches to Teaching this Chapter


Creative Destruction: An evolutionary process by which the power of entrepreneurial innovation alters radically the competitive market for the long-run betterment of consumers. This competitive advantage is achieved through the “destruction” of current sources of advantage and exploiting the new opportunities.

Sunk Cost Effect: The asymmetry that exists between a firm that has already made investments in a particular technology or product concept and a firm that is planning such a commitment. The profit maximizing decision for a firm that has committed to the technology or product may be to go ahead with its development while the firm that is still contemplating the idea may choose a different path. This is due to the fact that prior investments may have been made that are specific to a particular technology or concept that makes it cheaper for the firm to continue with it.

Replacement Effect: This belief suggests that challengers to monopolists will invest more in the next generation technology than does the monopolist. This is because the challenger stands to gain an entire market, while the monopolist would only maintain what it currently has. Through innovation, the challenger stands to gain a monopoly, while the monopolist can only replace itself.

Efficiency Effect: This theory argues that an incumbent monopolist’s incentive to innovate is stronger than that of a potential entrant because the monopolist stands to lose its monopoly. The benefit to being a sole monopolist compared to being a member of a duopoly is greater than the benefit derived from being a member of a duopoly a compared to not being in the industry at all. In short, the monopolist stands to lose more than the competitor stands to gain.

Deterministic Patent Races: This way of viewing competition to innovate suggests there is only one winner, namely the company that spends the most money on R&D.

Probabilistic Patent Races: This view of competition to innovate argues that the company’s odds of sinning the race increases with R&D spending, but are not guaranteed with superior spending.

Evolutionary Economics: Theory that posits that a firm’s decisions are determined by routines, or the well-practiced patterns of activity, adopted by that firm.

Factor Conditions: This refers to a nation’s position with regard to factors of production that are necessary to compete in a particular industry. Each country may have different factors of production that are highly specialized to the needs of a particular industry which helps firms from this country succeed.

Path Dependence: Firm-wide learning is incremental rather than revolutionary. It is therefore impossible to ignore what a firm has done in the past. The search for new sources of competitive advantage depends on the route the firm has taken to get to where it is now.

Demand Conditions: Refers to the size, growth, and characteristics of demand for a specific product. Unique markets will allow for competitive advantages to be won.

Conceptual Applications

Find a Breakthrough and Explore
This chapter offers conflicting opinions on the source of innovation and the nature of patent races. Instructors may want their students to challenge these theories.

For example, students could explore whether, for a given discovery, these academic studies of incentives and innovation could have predicted the eventual winner? Have each student investigate a different, recent innovation, and then compile his or her answers into predictable and unpredictable categories.

Investigate Specific Firms that appear to have Reduced the Cost of Innovation
Some firms like AT&T, 3M and BancOne appear to achieve economies of scale and scope in innovation. Assign (or allow students to choose) firms that have clearly discovered inexpensive ways to innovate. What are their secrets? Are they transferable? Have other firms tried to use them and were their attempts successful?

Explore Startup Firms in your Business Community
Often, business academics focus too much attention on large, multi-million dollar firms - the P&G's, Goldman Sachs', and HP's of the world. But what about the entrepreneurs? Who are the entrepreneurs in your community or among the students? What was the market opportunity exploited by the local entrepreneur? Why did s/he innovate when the large companies in your community didn't? What does it take to be one of these creative destroyers?

If Excess Profits are indeed sustainable for long periods of time, is Capitalism Failing?
Schumpeter suggested that excess profits in a market are the result of major market shifts created (usually) by entrepreneurs. He asked that the health of a market not be judged according to excess profits by a firm at any particular moment. Rather, Schumpeter suggests that economists and governments should take a long-term perceptive. Economists and politicians continue to debate these issues.

What do the students believe are the characteristics of a healthy market? Can there be too much competition (China)? Will a functioning system drive all excess profits out of the market eventually? Would twenty straight years of profits by the (same) Fortune 500 be a troublesome sign or a fantastic one? What is the role of government in these situations? What benchmarks might students suggest for government intervention?

Resource-based view of the Firm vs. Core Competencies
Professors Prahalad and Hamel have proposed an alternative to the resource-based view of competitive advantage. They suggest that winning companies do not just own superior resources, but also know how to create superior resources through strategic intent and strategic stretch. Is this distinction helpful?

In what industries does resource creation gain in importance over the firm's resource mobilization? Some example to consider: Microsoft's Windows and the Java challenge; Procter and Gamble vs. other brand management companies; Wal-Mart's move into discount warehouses; Honda and small motor technology; Sony and miniaturization capabilities.

Path Dependencies, Dynamic Capabilities and Routines
Some academic literature suggests that profit-maximizing decisions are made in a context established by the routines and previous successes of the company. Can students identify companies that were victims of their own successes, their own routines? IBM and the US auto industry are two clear examples. The world changed dramatically but the decision-making processes in these firms did not change. IBM ignored the personal computer revolution, until it was almost too late. The US auto industry did not understand the quality of their Japanese competition and paid dearly.

Porter's Environment Argument Explored
Michael Porter argues that competitive advantage originates in the local environment in which the firm is located. Firms recognize the existence of new markets or technologies and move to exploit these opportunities. Four conditions in the home market promote or impede the ability of firms to achieve worldwide competitive advantage. They are factor conditions (human resources or infrastructure available), demand conditions, related and supporting industries, and strategy, structure and rivalry.

With a basic understanding of Porters proposition, students should question whether this theory is supportable. International students in the class should be asked to take the lead on the credibility of Porter's belief. How important are factor and demand conditions? Is this worldview too deterministic? Must the best producers of tunneling equipment be from Switzerland or another mountainous country?

If Porter is right with his theory, what is the role of government policy in this macro-level discussion? For example, if firms need supporting and related industries, should government invest in whole industries rather than specific firms? If factor conditions are vital to the success of certain industries, should the government target the resources of the country for the infrastructure or human resources needs of specific industries? The country of Singapore is a strong example of how government policy has created the factors necessary for industrial development, including a large pool of computer scientists and nation-wide digital networks.

Managing Innovation at Large Companies
Can large companies innovate? What are leading companies doing to change the traditional inability of large organizations to facilitate innovation? What kinds of skills do managers need to promote and direct innovation processes?

While we do not discuss many of the innovations attempted by large companies, instructors may want to expose students to the most inventive of these techniques. Two interesting examples include the "intrapreneur" program at 3M and Motorola's "venture capital" division.

Suggested Harvard Case Studies

Caterpillar HBS 9-385-276 (see earlier chapters)

Nucor at a Crossroads HBS 9-793-039 (see earlier chapters)

Philips Compact Disc Introduction, HBS 9-792-035 (see earlier chapters)

Also consider one of several HBS cases on Microsoft, Dell computer and Apple computer.

Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

D'Aveni, R. Hypercompetition: Managing the Dynamics of Strategic Maneuvering. New York: Free Press, 1994.

Gibson, D. V. and E. M. Rodgers. R&D Collaboration on Trial. Cambridge, MA: Harvard Business School Press, 1994.

Hamel, G. and C.K. Prahalad. Competing for the Future. Cambridge, MA: Harvard Business School Press, 1994.

Jewkes, J., D. Sawers, and R. Stillerman. The Sources of Inventions. London: Macmillan, 1958.

Kamien, M. 1. and N. L. Schwartz. Market Structure and Innovation. Cambridge, UK: Cambridge University Press, 1982.

Kanter, R. M. The Change Masters. New York: Simon and Schuster, 1983.

Nelson, R. R. and S. G. Winter. An Evolutionary Theory of Economic Change. Cambridge, MA: Belkap Press, 1982.

Peters, T. and R. Waterman. In Search of Excellence. New York: Warner Books, 1982.

Prahalad, C. K. and G. Hamel. "Strategic Intent," Harvard Business Review. May-June 1989.

Prahalad, C. K. and G. Hamel. "Strategy as Stretch and Leverage," Harvard Business Review. March-April 1993.

Scherer, F. M. Innovation and Growth: Schumpeterian Perspectives. Cambridge, MA: MIT Press, 1984.

Schumpeter, J. Capitalism, Socialism, and Democracy. New York: Harper & Row, 1942.

Smith, G. S. The Anatomy of a Business Strategy: Bell, Western Electric, and the Origins of the American Telephone Industry. Baltimore, MD: Johns Hopkins, 1985.

Tirole, J. The Theory of Industrial Organization. Cambridge, MA: MIT, 1988.

Watson, J. P. The Double Helix: A Personal Account of the Discovery of the Structure of DNA. London: Weidenfeld and Nicolson, 1981.
Answers to End of Chapter Questions

1. Is the extent of creative destruction likely to differ across industries? Can the risk of creative destruction be incorporated into a five-forces analysis of an industry?

Creative destruction is the process by which innovation introduces shocks or discontinuities that destroy old sources of advantage and replace them with new ones. The entrepreneurs who exploit the opportunities these shocks create achieve positive profits during the next period of comparative quiet. Following this line of reasoning, competitive advantage based on inimitable resources or capabilities or early mover advantages can eventually become obsolete as new technologies arise, takes change, or government policies evolve.
All industries could be affected by creative destruction but the magnitude of affect certainly varies across industries. Technological change is low in some industries – while very rapid in others. The risk of creative destruction can be incorporated into a five-forces analysis by adapting a dynamic rather than a static perspective. Firms can determine how changes in their production technology (or in the technology of their suppliers) might affect minimum efficient scale in their industry and thereby affect variables like entry, differentiation, etc.

2. In many industries, such as pharmaceuticals, firms are geographically clustered. In others, such as automobile production, clustering has become less common. What factors contribute to clustering? Will the Internet and improvements in telecommunication ultimately eliminate clustering?

Clustering is essentially a result of need to be in close proximity to either Demand-side complementors(a player is your demand-side complementor if consumers have a higher willingness to pay for your product when they have that player’s product, too than when they just have your product) or Supply-side Complementors (a player is your supply-side complementor if suppliers have a lower cost of providing inputs to your when they provide inputs for that player too, than when they just provide inputs for you. We can think of R&D as an important “supplier” to the pharmaceutical industry (even though R&D is internally supplied). Since firms can benefit from each other’s learning when they are in close physical proximity, costly redundant R&D outlay’s are avoided. Auto companies can each generally keep their suppliers at minimum efficient scale all on their own. Although improvements in telecommunications reduce the need for physical proximity, individuals who share information find personal contact to be the most effective mechanism.

3. What is the difference between the efficiency effect and the replacement effect? Could both effects operate at the same time? If so, under what conditions would the efficiency effect be likely to dominate? Under what conditions would the replacement effect be likely to dominate?

The Replacement Effect: Credited to Nobel prize winning economist Kenneth Arrow. Consider a drastic innovation--once it is adopted costs are so reduced that producers using the old technology will not longer be viable competitors. Arrow pondered two scenarios: (1) the opportunity to develop the innovation is available to a firm that currently monopolizes the market using the old technology, (2) the opportunity to develop the innovation is available to a potential entrant who, if it adopts the innovation , will become monopolist. Under which scenario is the willingness to pay to develop the innovation greatest? The monopolist retains its monopoly (it replaces, or cannibalizes itself). The entrant gains a monopoly. The entrant’s GAIN is larger and hence so is its incentive to innovate.

The efficiency effect has to do with the fact that the benefit to a firm from being a monopolist as compared with being one of two competitors in a duopoly is greater than the benefit to a firm from being a duopolist as compared with not being in the industry at all (and thus earning no profit). The monopolist has more to lose from another firm's entry than the entrant has to gain from entering the market. This mainly has to do with the fact that entry will tend to drive prices down.

The replacement effect tends to dominate with the (perceived) chance of innovation from outside the industry is low. The efficiency effect may dominate when the monopolist’s failure to develop the innovation means (or is perceived to mean) that new entrants almost certainly will.

4. In their article "Strategy as Stretch and Leverage," Gary Hamel and C. K. Prahalad argue that industry newcomers have a stronger incentive to supplant established firms from their leadership positions than established firms have to maintain their leadership positions. The reason, they argue, is that a greater gap exists between a newcomer's resources and aspirations as compared to a market leader." Is Hamel and Prahalad's argument consistent with profit-maximizing behavior by both the leader and the newcomer? Is their argument consistent with ideas from evolutionary economics?

Hamel and Prahalad’s argument is consistent with profit maximizing behavior for firms, particularly when viewed from the perspective of the returns that each of these firms expect to earn from leadership positions. A leader has less incentive to expend large resources to maintain its leadership positions, because such actions only serve to maintain its current position, permitting the firm to earn monopoly profits which it has already been earning previously. On the other hand, by gaining the leadership position, the entrant would move from a position from earning low (to zero) profits to a position of monopoly profits. The entrant thus has a greater incentive to supplant the leader. This phenomenon is known as the replacement effect.
Hamel and Prahalad’s argument is also consistent with ideas from evolutionary economics. Firms typically need to engage in a continuous search for ways to improve their existing routines, thereby establishing dynamic capabilities. However, a firm’s dynamic capabilities are inherently limited. The search for new sources of competitive advantage is path dependent – it depends on the route the firm has taken in the past. Older firms are more likely to be path dependent, and thus are more limited in the possible alternatives they can pursue. This renders them less flexible when it comes to responding to external changes that might require a distinct change in routines. Younger firms, on the other hand, is less constrained by history (i.e. routines are perhaps less firmly established) and thus they are better able to respond to environmental changes in order to gain a competitive advantage.

5. Is patent racing a zero-sum game? A negative-sum game? Explain.

An extreme characterization of a patent race is that the first firm to complete the project “wins” the patent race and obtains exclusive rights to develop and market the product. The losing firms get nothing. Given this characterization, it is certainly possible that the sum of the losses is greater than the winning firm’s net gain.

6. What are a firm's dynamic capabilities? To what extent can managers create or "manage into existence" a firm's dynamic capabilities?

A firm’s dynamic capabilities refer to the firm’s ability to maintain and adapt the capabilities that are the basis for the firm’s competitive advantage. A firm that searches continuously to improve its routines – that is, makes it an institutional priority to continually search, is managing into existence dynamic capabilities. However, a firm’s dynamic capabilities are inherently limited – it can be difficult for a firm to be as liberated from its own history as it needs to be to find revolutionary as opposed to evolutionary ideas. Furthermore, firms may lack required complementary assets that they need to change the way they produce or do business. Finally, timing can cause firms to be locked out of a market because they had precommitted to another way of doing business. 7. What is meant by the concept of path dependence? What implications does path dependence have for the ability of a firm to create new sources of competitive advantage over time?

Path dependence means it depends on the path the firm has taken in the past to get where it is now. A firm that has developed significant commitment to a particular way of doing business may find it hard to adapt to seemingly minor changes in technology.

8. How does the extent of competition in a firm's domestic market shape its ability to compete globally? Why would local rivalry have a stronger effect on the rate of innovation than foreign competition?

According to Porter, local rivalry affects the rate of innovation in a market far more than foreign rivalry does. Although local rivalry may hold down profitability in local markets, firms that survive rigorous local competition are often more efficient and innovative than are international rivals that emerge from softer local conditions.

9. "Industrial or antitrust policies that result in the creation of domestic monopolies rarely result in global competitive advantage." Comment.

In his book, The Competitive Advantage of Nations, Michael Porter argues that rivalry in the home market is an important determinant of a firm’s ability to achieve competitive advantage in global markets. In particular, Porter argues that local rivalry affects the rate of innovation in a market to greater degree than global competition. If firms are shielded from such rivalry through the creation of domestic monopolies, they are less efficient and innovative compared to international rivals who emerge from environments of vigorous local competition. Since these firms are able to reap monopoly benefits in their home market without having to worry about the impending threat of new entrants, there is less incentive to innovate and be efficient. As such, these domestic monopolies are less capable of competing in the global marketplace. 10. IQ Inc. currently monopolizes the market for a certain type of microprocessor, the 666. The present value of the stream of monopoly profits from this design is thought to be $500 million. Enginola (which is currently in a completely different segment of the microprocessor market from this one) and IQ are contemplating spending money to develop a superior design that will make the 666 completely obsolete. Whoever develops the design first gets the entire market. The present value of the stream of monopoly profit from the superior design is expected to be $150 million greater than the present value of the profit from the 666.

Success in developing the design is not certain, but the probability of a firm's success is directly linked to the amount of money it spends on the project (more spending on this project, greater probability of success). Moreover, the productivity of Enginola's spending on this project and IQ's spending is exactly the same: Starting from any given level of spending, an additional $1 spent by Enginola has exactly the same impact on its probability of winning. The table in the book illustrates this. It shows the probability of winning the race if each firm's spending equals 0, $100 million, and $200 million. The first number represents Enginola's probability of winning the race, the second is IQ's probability of winning, and the third is the probability that neither succeeds.
Which company, if any, has the greater incentive to spend money to win this “R&D race”? Of the effects discussed in the chapter (sunk cost effect, replacement effect, efficiency effect), which are shaping the incentives to innovate in this example?
In order to understand the motivations of the two companies, we need to first consider what stakes are involved to these two parties. We can try to frame this problem using concepts from the chapter:
Kenneth Arrow might suggest this is the classic replacement effect. A successful innovation for a new entrant leads to a monopoly. A successful innovation by the established firm also leads to a monopoly, but since it already had a monopoly, the gain from the innovation is less than it would be for the potential entrant. Through innovation an entrant can replace the monopolist, but the monopoly can only replace itself. In this example, Enginola, in obtaining the breakthrough, would earn $650 million in total profits, while to IQ, the breakthrough would only earn them an additional $150 million, since their current technology is winning them $500 million. Since Enginola could theoretically gain a profit of $650 million if it succeeds, it would be willing to spend $200 million on research, since more money would increase the probability of success. If IQ correctly anticipates Enginola’s decision, it would have to spend $200 million as well, so as to maximize its chance of success given Enginola’s choice. But why would a firm invest $200 million to get a 50% chance of a $150 million gain? Arrow’s replacement effect suggests that Enginola, not IQ, will be the innovator in this case.
However, the efficiency effect takes a different point of view. Here the incumbent monopolist anticipates that potential entrants may also have the opportunity to develop the innovation. The efficiency effect makes an incumbent monopolist’s incentive to innovate stronger than that of a potential entrant. This is due to the fact that the benefit to a firm from being a monopolist is compared with that of being a duopolist. The benefit to the entrant from achieving a duopoly position (as compared with not being in the industry at all) is smaller, in absolute terms, than the value of the incumbent’s monopoly position. Advocates of the efficiency effect would suggest that the monopolist would lead the innovation. The company with the most to lose, as opposed to the most to gain, will drive change.
Neither the efficiency effect nor the replacement effect applies perfectly to the situation above. In this case, the probabilities given above do not support the efficiency effect. The winner is a monopolist—there is no asymmetry whereby if the incumbent wins his/her monopoly position is maintained and if the entrant wins he/she becomes a duopolist. Similarly, the replacement effect suggests that the incumbent’s marginal gain is smaller than the entrant’s marginal gain. Since the entrant’s success means the incumbent is out of the market, the incumbent’s marginal gain is not $150 million, but is equivalent to the entrant’s marginal gain. Given there is no asymmetry, the firms have equal incentive to innovate.
Chapter 14
Agency and Performance Measurement

Chapter Contents 1) Introduction 2) The Principal/Agent Framework • Using Contracts to Provide Incentives • How Employees Respond to Performance Measures in Incentive Contracts Example 14.1: Agency Contracts in Franchising Example 14.2: Pay, Performance, and Selection at Safelite Glass
3) Cost of Tying Pay to Performance • Risk Aversion and Risk Sharing • Risk and Incentives Example 14.3: Market Effects in Executive Compensation • Performance Measures That Fail to reflect All Desired Actions Example 14.4: Cardiovascular Surgery Report Cards
4) Selecting Performance Measures: Managing Tradeoffs Between Costs
5) Do Pay-for-Performance Incentives Work?
6) Chapter Summary
7) Questions

Chapter Summary
Individuals (principals) often hire others (agents) to work on their behalf. An agent, however, is simultaneously acting on in his own behalf, and so situations may arise whereby the agent might choose to promote his own interests at the expense of the principal’s interests. The problem created by this divergence in interests is called the principal-agent problem. In order to align both interests, specific contracts are used that spell out the terms of the agency relationship. This chapter examines the agency relationship, the various opportunities for solving agency problems by contracting, the characteristics of an efficient contract and the conditions that lead to inefficiencies even when best possible contracts are used.

Every contract has to satisfy two types of conditions: (1) the agent must be willing to accept the contract, and (2) the actions the principal expects the agent to take must be compatible with the incentives spelled out in the contract. Under an ideal contract the agent will not shirk and will always take the efficient action. An ideal contract that pays the agent his threshold wage (the wage at least as great as the agent's next best alternative) is first-best efficient for the principal. For first-best-efficient contracts to exist, three conditions have to be met: (1) no hidden information, (2) observable actions and/or outcomes, and (3) absence of risk considerations for agents.

However, a serious obstacle to this ideal contract is imperfect observability. Hidden actions and hidden information are nearly impossible to specify in contracts, and hence lead to moral hazard. Imperfect observability limits the principal's ability to measure the desired action and outcome. If the principal cannot adequately measure the action or outcome, he/she may instead use a proxy.

In order to reduce the principal-agent problem, principals must choose the agent’s compensation method carefully. A performance-based contract makes a payment contingent on the agent meeting some prespecified performance objectives. Two problems arise: (1) it is difficult for the principal to set a performance standard, and (2) the outcome often is uncertain and cannot be completely controlled by the agent. Uncertainty of outcome causes the problem that a principal often cannot distinguish poor performance due to shirking from poor performance due to bad luck (or due to factors outside the agent’s control). Hence, a performance-based contract imposes an element of risk on the agent. The risk-averse agent must be compensated for this risk with an expensive risk premium.

As a result of these problems, a contract usually combines a fixed, guaranteed payment and a performance-based payment. In such a contract, the principal and the agent share the risk, which explains why these contracts are called risk-sharing contracts. The principal seeks a contract that offers the most balanced split between fixed and performance-based compensation. The degree of performance-based compensation depends on four distinct factors: 1) the agent's risk aversion 2) the agent's effort aversion , 3) the marginal contribution of effort to profitability , and 4) the noisiness of the performance measure. The risk and effort averse the agent and the noisier the performance measure, the less performance based compensation should be used. The greater the marginal contribution of effort to profitability, the more performance based compensation should be used.

The structure of agency contracts used can also help the principal to find agents with desired characteristics. This mechanism is called sorting. The level of wages or the structure of the incentive contract systematically influences the characteristics of applicants. For example, more able workers are more likely to be attracted by contracts tied to performance. Similarly, firms use raises, bonuses, and promotions to motivate workers in the internal labor market. Wages tend to be backloaded in order not only to encourage loyalty and to motivate younger workers, but also to reduce agency costs.

The chapter concludes with some empirical observations about incentive based pay. There is ample evidence suggesting that employees do appear to consider the effects on the compensation when making decisions. The effect of incentive based pay on profits is less clear, as pay-for-performance compensations plans can have destructive effects.

Approaches to Teaching (Chapters 14 and 15 are combined below)


Principal/Agent Framework: Applies whenever one party (the agent) is hired by another (the principal) to take actions or make decisions that affect the payoff of the principal.
Agency Theory: Agents always act in their own interests, which might diverge from the principals’ interests. Agency theory examines the use of incentives to align the agent's and the principal's interests and describes the opportunities and pitfalls that arise in efforts to align them.
Agency Problems: Are difficulties in the principal/agent relationship. Agency problems arise because the two parties’ interests typically differ in some way. Absent of some mechanism to align the agent with the principal, the agent does not care about the value generated for the principal.
Complete Contract: A complete contract stipulates each partys’ responsibilities and rights for each and every contingency that could conceivably arise during the transaction.
Risk Preference: Variable measure that identifies an individual’s attitude toward risk. For example, a Las Vegas gambler may be very risk tolerant.

Performance-Based Contract: A performance-based contract makes payment contingent on the agent meeting some prespecified performance measure.

Hidden Action: In agency relationships with hidden actions, any contract that is contingent on all important as;ects of the agents actions will not be enforceable, since neither the principal nor a court could verify whether the agent’s action fulfilled the terms of the contract.
Hidden Information: Aspects of the productive environment that are important to the principal but cannot be observed by the principal.
Explicit Incentive Contract: An incentive contract that can be enforced by an outside third party such as a judge or an arbitrator. These contracts are based on information that can be observed and verified by this external enforcement mechanism.
Risk Averse: A risk averse person prefers a safe outcome to a risky outcome with the same expected value.
Risk Neutral: A risk neutral decision maker is indifferent between a same outcome and a risky outcome with the same expect payoff.
Certainty Equivalent: The certain amount the decision maker would be willing to accept in exchange for the risky payoff.
Risk-Premium: This quantity is the amount that a principal must compensate a risk-averse agent for accepting a performance-based contract with some degree of variability in the outcome.

Multitask Principle: When allocating effort among a variety of tasks, employees will tend to exert more effort toward the tasks that are rewarded.
Efficiency wage: Limited liability restricts punishments for non-compliance. The principal has to pay the agent more than the agent’s opportunity cost to prevent him from shirking. This payment is called efficiency wage.

Sorting: The level of wages or structure of the incentive contract can systematically influence the characteristics of the agents a principal can hire. In general, more able workers and risk takers prefer pay-for-performance arrangements, while workers with low mobility prefer compensation schemes based on job tenure. Agents with limited liability are more willing to take highly risky ventures.

As far as structuring a discussion, this chapter is an opportunity for the instructor to rely heavily on the work experience of the students:

What jobs have you had?

How was pay determined?

If pay was tied explicitly to performance, what performance measures were used?

How much of the variation in measured performance was under the control of the employee, and how much was random?

Were there any value-creating activities that did not affect the performance measure?

Were there any non-value-creating activities that did affect the performance measure?

If pay was not tied explicitly to performance, why not?

Were any performance measures available to the firm?

14 If so, what would have happened if these measures had been used?

15 Were the available measures risky?

16 Would the wrong activities have been rewarded?

Student Assignments:

Have Students Audit their Own Work Contracts
Most students will have had a wide variety of jobs and work contracts of their own. It might be useful for them to detail the compensation schemes (protecting salary information of course) and analyze whether the contracts represented the most efficient ones possible. For example, does the reliance of waiters on tips align the workers' incentives with that of management? Have students reflect on examples of shirking from their own experiences and the ways management could have reduced it. Can students recognize selection theory in practice?

Executive Salaries and Downsizing
"Downsizing' has become very common at many of the world's largest companies. Workers who thought they were under implicit contracts based on the traditional wage/tenure profile were fired in the middle of their career. There are no "above market" wages waiting as reward for their many years of service at "below market" rates. At the same time the salaries of CEO's have skyrocketed, as their stock options shoot up in value. The popular press has identified a severe backlash to Wall Street profits and Main Street instability, including the Presidential candidacy of Pat Buchanan.

What are the true effects of the destruction of the wage/tenure profile when combined with massive blue and white collar layoffs, record corporate profits and skyrocketing CEO salaries? If you were a CEO and you were "forced" to lay off 10,000 employees, would you cut your own salary? Would you cut the salaries of the "tournament" losers? What are the short-term benefits and costs? What are the long-term benefits and costs? What are the costs to businesses if everyone from employees, leadership and stockholders is thinking short-term?

Rogue Traders on Wall Street
There have been a rash of uncontrolled securities traders who have lost millions and even billions in bad bets. The most famous example is Nick Leeson who in 1995, brought down the venerable Barings Bank with a cocktail of derivatives in the Asian markets. Do students think that actions of these agents represent a breakdown of the agent/principal relationship? If so, how would students change the incentive systems to reward successes but not lead to tremendous losses?

There are also plenty of more common situations in which incentive systems can create principal/ agent problems. What examples can students identify in business situations, at school, with their families, or in their communities?

The Technology Revolution and Observability
The agent/principal relationship is supposed to improve as the observability of actions increases. Massive changes in technology have enabled managers to monitor almost as much information as they want. What are the boundaries of this observability? How would non-shirkers respond to increased observability? Do workers deserve any privacy or do only shirkers ask for privacy? How do privacy issues differ in public versus private worlds? What role does worker choice or lack of it play in this debate?

Team-based Structures and Incentives
Much of the work in the business world and at business schools is done in a group setting: several individuals contribute to a single product. When are team structures appropriate? If the process and contributions of each individual member are obscured by this structure, what happens to the incentive system? What rules could you put in place to help judge the performance of individual team members?

Performance standards in a rapidly changing environment
Many contracts are based on industry or company standards for individual performance: how many widgets produced per hour, for example. Some industries and processes are so new or have such ill-defined technologies that no accepted performance standards exist. How would you as a principal negotiate a performance standard for such a process or industry? What is the role of trust? What is the role of observability?

Big Picture Discussion Questions: • Should a firm tie an employee's pay to his or her on-the-job performance? Why or why not? • Do pay-for-performance incentives "work"? What do we mean by "work" in this sentence? • Why do people dislike random variation in their wealth? • If a firm is to tie pay to employee performance, then how should performance be measured? • What factors make one performance measure "better" than another? • What are the pros and cons of basing pay on relative comparisons of employees' performances?

The Key Point to Bring Out in Discussion are:

(1) Tying pay to performance has costs and benefits.

1) Benefits: Helps with problems relating to hidden action and hidden information.

2) Costs: All depends on the quality of the performance measure. There are three ways a performance measure can be bad: (1) exposes employee to risk, (2) includes an activity that does not create value, (3) excludes an activity that does create value.
The question of whether, and if so to what extent, to tie pay to performance depends on this cost/benefit balance.

Other examples to illustrate chapter concepts:

1) Sorting: How does the high tuition for a MBA education help sorting out the "right" students?

2) The Venture Capital Industry as an example, where contracts between investors and venture capitalist, and between venture capitalists and issuers, as well as the structure of the limited partnerships, are driven by the principal-agent problem.

Suggested Harvard Case Study (Chapter 14 and 15 combined)

Nordstrom: Dissension in the Ranks (HBS 9-191-002)
Nordstrom pays salespeople on commissions. Illustrates selection and incentive effect of pay-for-performance.

Lincoln Electric Company (HBS 9-376-028)
Lincoln is famous for paying piece rates to factory workers. Discuss Page 1potential drawbacks of piece rate based pay. Discussion the "system" Lincoln puts in place to mitigate the effects of piece rates.

Putnam Investments: Work@Home (HBS 9-803-011)
Putnam allows some employees to telecommute. Discuss effects on productivity and importance of availability of good performance measures for these employees.

Family Feud: Andersen vs. Andersen (HBS 9-800-064)
Andersen worldwide split into Arthur Andersen (the public accounting firm) and Accenture (the consultancy) in 2000. At the heart of their dispute was a performance measurement issue: should partners be compensated on the basis of firm-wide performance (in which case, the consulting partners would be subsidizing the accounting partners) or the performance of their own business unit (which would leave the accounting partners no incentive to pass potential consulting opportunities to the consultants)? There is an A and B case.
House of Tata HBS 9-792-065 (see ealier chapters).
Ingvar Komprad and IKEA HBS 9-390-132 (see ealier chapters).
Nucor at a Crossroads HBS 9-793-039 (see ealier chapters).
Tombow Pencil Co. Ltd. HBS 9-692-011 (see ealier chapters).
Extra Readings (Chapter 14 and 15 combined)
The sources below provide additional sources for the theories and examples of the chapter.

Aggarwal, Rajesh and Andrew A. Samwick, 1998, “The other side of the Tradeoff: The Impact of Risk of Executive Compensation,'' Journal of Political Economy 108, 65-105.
Alchian, A. and H. Demsetz. "Production, Information Costs, and Economic Organization," American Economic Review. 62, 1972.

Baker, George, 1992, “Incentive Contracts and Performance Measurement,'' Journal of Political Economy 100, 598-614.

Doehringer, P. and M. Piore. Internal Labor Markets and Manpower Analysis. Lexington, MA: D.C.Health, 1971.

Easterbrook, F. and D. Fischel. The Economic Structure of Corporate Law. Cambridge, MA: Harvard University Press, 1991.

Gibbons, Robert, 1998, ''Incentives in organizations,'' Journal of Economic Perspectives 12, 115-132.
Grossman, S. and 0. Hart. "The Costs and Benefits of Ownership: A Theory of Lateral and Vertical Integration," Journal of Political Economy. 94, August 1986.

Harris, M. and A. Raviv. "Optimal Incentive Contracts with Imperfect Information," Journal of Economic Theory. 20,1979.

Holmstrom, B. "Moral Hazard and Observability," Bell Journal of Economics. 10, Spring 1979. -the seminal work on the value of information in agency relationships.

Holmstrom, Bengt, and Paul R. Milgrom, 1991, ''Multi-task Principal/Agent Analyses: Incentive Contracts, Asset ownership and Job Design,' journal of Law, Economics and organization 7, 524-552.
Jensen, Michael C., “Corporate Budgeting Is Broken--Let's Fix It,'' Harvard Business Review, November 2001.
Kohn, Alfie, “Why Incentive Plans Cannot Work,'' Harvard Business Review, September 1993.
Lazear, Edward P., 2000, “Performance Pay and Productivity,'' American Economic Review 90, 1346-1361.
Milgrom, Paul R. and John Roberts, 1994, “Complementarities and Fit: Strategy, Structure, and Organizational Change in Manufacturing,'' Journal of Accounting and Economics 19, 179-208.
Nagan, Daniel S., James B. Rebitzer, Seth Sanders, and Lowell J. Taylor, 2002, ''Monitoring, Motivation and Management: The Determinants of Opportunistic Behavior in a Field Experiment'' American Economic Review 92, 850-873.
Oyer, Paul, 1998, “Fiscal Year Ends and Nonlinear Incentive Contracts: The Effect on Business Seasonality,'' Quarterly Journal of Economics 113, 149-185.

Parson, D. "The Employment Relationship: Job Attachment, Work Effort and the Nature of Contracts," in Ashenfelter, 0 and Layard (ed.), The Handbook of Labor Economics. Amsterdam: North Holland, 1986.

Post, R. and K Goodpaster. "The Administration of Policy," Harvard Business School, Case 382-034.

Ross, S. "The Economic Theory of Agency: The Principal's Problem," American Economic Review. 63, 1973.

Answers to End of Chapter 14 Questions:

Using your own experience, if possible, identify three types of hidden information that could affect an agency relationship. Identity three forms of hidden action, as well.

Suppose you were granted a "risky job" of the type studied in this chapter. The job pays $40,000 with probability 1/2, and $160,000 with probability 1/2. What is your certainty equivalent for this risky payoff? To answer this question, compare this risky job to a safe job paying $100,000 for sure. Then reduce the value of the safe job in $1,000 increments until you are indifferent between the safe job and the risky job. What is your certainty equivalent for a job paying $10,000 or $190,000, each with equal probability?

The CE of the job with a .5 probability of $40,000 and a .5 probability of $160,000 is higher than the CE associated with the job that has a .5 probability of $10,000 and a .5 probability of $190,000. The reason the CE falls as the low end drops and the high end increases is it is typical for an individual to place a higher value on incremental consumption when he is poor compared to when he is rich.`

In the United States, lawyers in negligence cases are usually paid a contingency fee equal to roughly 30 percent of the total award. Lawyers in other types of cases are often paid on an hourly basis. Discuss the merits and drawbacks of each from the perspective of the client (i.e., the principal).

In negligence cases, the client will not pay any money to the lawyer unless the suit is victorious. What is the risk profile of a lawyer who will accept such a risky project? Clearly the selection process will draw risk neutral or risk loving practitioners to these suits. Only certain people will accept this “all or nothing” proposition. The client will know that it is in the interest of the lawyer to win and win quickly because there are no other benefits other than the victory settlement.

In other cases, the client is offering hourly billing to the lawyer. A risk averse pool will be drawn to these cases; the lawyers know that there is a direct link between every hour of work and payment. The client will have the advantage of seeing the step by step work toward winning the lawsuit through detailed billing statements, but s/he may question whether the lawyer really wants to win the case. When the case is settled, the lawyer’s payments end. In these situations the client must analyze the hourly work or trust that the lawyer has the client’s best interests at heart.

Contingency incentives will also encourage more negligence suits. While the hourly payments will force the client to calculate quickly the true possibility of victory, the contingency lawyers impose no costs on the clients until victory is assured. However, plaintiffs in personal injury cases often don't know whether their claims are legally valid. Contingency arrangements solve this hidden information problem, by motivating attorneys to accept only those cases that have a shot at winning. When clients are more sophisticated (for example, a large firm with in-house attorneys who hires a law firm to handle specific matters), this selection effect is less important.

Suppose a firm offers a divisional manager linear pay-for-performance contract based on the revenues of the division the manager leads. The manager's pay is given by: Pay = F + a Revenue, where F is a fixed yearly salary and a is the fraction of the division's revenue that is paid to the manager. Suppose the labor market demand for this type of divisional manager increases, meaning the firm has to increase this manager's pay in order to retain him or her. Should the firm do this by increasing the salary F, the commission a, or both? Explain.

The content of this chapter suggests that only F should increase. The reason is nothing about the nature of the job has changed, so if the previously chosen salary plus pay-for-performance contract had struck the correct balance between risk and incentives, then there is no reason to change it.

Regulated firms, such as electric utilities, typically have limited discretion over the prices they charge. Regulators set prices to guarantee a fixed return to the firm's owners after gathering information about the firm's operating costs. Studies of executive pay practices have consistently shown that the compensation of utility CEOs is significantly less sensitive to firm performance that of non-utility CEOs. Explain why, using the tradeoff between risk and incentives.

There isn't as much scope for utility executives to benefit shareholders by, for example, reducing cost. If an executive in a non-regulated firm takes actions to reduce the firm's costs, then shareholders benefit. Hence, shareholders want to motivate executives to take these actions, and are willing to pay the executive's risk premium in order to so. If an executive in regulated firm reduces costs, the shareholders do not benefit. Hence, no reason to pay the risk premium associated with tying pay to performance.

Firms often use quotas as part of compensation contracts for salespeople. A quota-based contract may stipulate, for example, that the salesperson will receive a $10,000 bonus if yearly sales are $1 million or more, and no bonus otherwise. Identify actions a firm does not likely want taken that the employee will be motivated to take under such a contract.
The salesperson will be highly motivated to generate sales up to $1 million. However, sales over the $1 million mark do not generate additional compensation for the salesperson. Hence the structure of this compensation contract may induce the salesperson to “game” the system. For example, the salesperson may try to push current sales that would push that salesperson over the $1 million mark into the next year. Furthermore, the salesperson may simply "give up" if the quota is unlikely to be met.
While it is, in principle, feasible for business schools to write explicit pay-for-performance contracts with professors, this is rarely done. Identify drawbacks of the following performance measures for this job:
Number of research articles published
Students' ratings of professors' courses
Dollar value of research grants won
Starting salaries of students after graduation.

Professor’s compensation tied to student ratings of his/her performance:

Strength: • Innovation in the classroom that leads to better (relative) performance would be rewarded. These rewards would motivate the most innovative teachers (or teachers who perceive themselves to be innovative) to work harder. • The chance of outperforming one’s peers might motivate all teachers to work harder. • Professor’s should not object to difficult material being added to the curriculum since the teacher is only concerned with relative performance.

Weaknesses: • Professors may pander to students to get ratings (giving “easy A’s”, food, etc.) • Much of quality teaching is subjective. • Each professor would have lessened incentive to share information with other professors that might strengthen the competition. The overall quality of education would be reduced if professors were given an incentive to be uncooperative with each other. • If relative performance were affected by the quality of the students, professors would try to pass off poorer students to other professors when these students did not really belong in those courses. If the professor could not remove the poor student from the class, the professor’s attitude toward this student may be affected. • If it was necessary to alter, for example, the size of the performance differential needed in order to get the bonus, professors might become skeptical about the integrity of the system. Any change to the regime after the regime is implemented would cause much anxiety for professors and would diminish the effectiveness of the approach.

Professor’s compensation tied to number of articles published, grants, student salaries (some absolute measure of performance):

Strengths: • Professors will be compensated for and therefore perform more activities that create value (at least from the perspective of the designers of the compensation regime). • Professors do not face an immediate threat from sharing effective teaching or research techniques with other professors.

Weaknesses: • As all professors approach the performance bar, the bar will inevitably have to be moved or the bonus will become regular compensation. Professors may come to realize they are shooting for a moving target and may come to resent this approach to earning their pay. • Professors may resent the addition of difficult material to the curriculum, as an absolute performance threshold is more difficult to meet the more difficult is the material. • Professors may falsify or “game” their performance criteria. For example, change an article a small bit and attempt to have it republished. • Professors may go for volume over quality when it comes to research. • Professors may spend a suboptimally high amount of time seeking grants as opposed to teaching or other valuable activities. • Availability of grant, for example, is tied to economic conditions – not under the control of professors. • If absolute performance were affected by the quality of the students, professors would try to pass off poorer students to other classes when these students did not really belong in elsewhere. If the professor could not remove the poor student from the class, the professor’s attitude toward this student may be affected. • Student salaries are tied to economic conditions not under the control of the professors.

Suppose Minot Farm Equipment Corp. employs two salespeople. Each covers an exclusive territory; one is assigned to North Dakota and the other to South Dakota. These two neighboring plains states have similar agricultural economies and are affected by the same weather patterns. Durham Tractor Co. also employs two salespeople. One works North Carolina, while the other is assigned to Oregon. Farm products and methods vary considerably across these two states. Each firm uses the dollar value of annual sales as a performance measure for salespeople. Which of the firms do you think would benefit most from basing pay on its salespeople's relative performance? Why?

Relative performance as a basis for compensation is useful for filtering out common shocks. When conditions are good in North Dakota, they are likely to be good in South Dakota as well. Hence, using relative performance evaluation allows the firm to shield these employees from the risks associated with the quality of the local farm economy. North Carolina and Oregon are likely to be subject to differing shocks, and so using relative pay evaluation will not be appropriate.

Consider a potential employee who values wages but also values the opportunity to pursue non-work-related activities. (You may think of these non-work activities as relating to family obligations such as childcare.) Suppose other jobs available to this employee pay $100 per day, but require the employee to work at the company's facility, effectively eliminating the employee's ability to pursue non-work activities. Ignore "effort" for the purposes of this problem and assume the only agency problem pertains to how the employee allocates his or her time. Suppose that if the employee allocates all of his or her time in a day to "work", then the employee creates $150 worth of value (gross of wages) for the firm. The employee may also have access to two forms of "non-work" activities: (1) a high-value non-work activity (think of unexpected child care needs) and (2) a low value non-work activity (think of leisure - playing video games or watching TV). The employee values the ability to complete the high-value non-work activity at $200, and values the ability to complete the low-value non-work activity at $50.
a) Suppose first that the low-value non-work activity does not exist, and that the highvalue non-work activity exists with probability 0.10. (Interpretation: there is a 10% chance that the employee will need to perform an important child-care duty each day.) Suppose your firm is considering offering a telecommuting job to this employee. Assume here that if the employee telecommutes and the high-value activity arises, then the employee spends all his or her time on this activity and creates no value for the firm that day. If the high-value non-work activity does not arise, the employee spends all his or her time working on behalf of the firm. What daily wage should you offer? What will your profits be'? Is your firm better off than if it offered a non-telecommuting job to the employee? Why?
b) Suppose now that the low-value non-work activity does exist. Unlike the high-value activity (which only arises with some probability), the low-value activity is always present. Suppose also that the firm cannot pay this employee based on individual performance because the available performance measures are of insufficient quality. Suppose your firm offers a telecommuting job you described in part (a). According to the multi-task principle, how will the employee spend his or her time? Are your profits higher offering the telecommuting job, or the non-telecommuting job?
c) Now suppose that the firm does have access to a good measure of individual performance. The firm can make pay contingent on whether the employee works on the firm's activity. What job (telecommuting or non-telecommuting) and compensation arrangement (fixed, or fixed plus some variable dependent on output) maximizes firm profits? Comment on the types of jobs where one might expect to see firms offering telecommuting.

Telecommuting requires good (meaning complete and verifiable) measures of individual performance. One reason for firms to require employees to work on-site is that doing so limits employees' access to outside activities—if the employee does not have access to these alternative activities, it is more likely the employee will be occupied doing their actual job! This is useful when measures of individual performance are not available. Note this offers an alternative explanation to "power" for why higher ranking people within an organization typically have more control over their own schedules. Consider a divisional manager with P&L responsibility: the firm can use profits as a measure of performance, and allow this employee to pursue high-value non-work activities without worrying that the person will also pursue low-value non-work activities. For lower level employees, individual performance is often more difficult to measure.

Chapter 15
Incentives in Firms

Chapter Contents
1) Introduction
2) Implicit Incentive Contracts • Subjective Performance Evaluation • Promotion Tournaments • Efficiency Wages and the Threat of Termination Example 15.1: Promotion Tournament at General Electric
3) Incentives in Teams Example 15.2: Stock Options for Middle-Level Employees
4) Career Concerns and Long-Term Employment Example 15.3: Career Concerns of Mutual Fund Managers
5) Incentives and Decision Making in Organizations Example 15.4: Teams and Communications in Steel Mills
6) Chapter Summary

7) Questions

Chapter Summary

This chapter contains a survey of many different mechanisms firms use to provide incentives when explicit, pay-for-individual performance contracts are not feasible. In chapter 14, most of the performance measures are likely verifiable. However, for many jobs, the available performance measures are imperfect in some way. The measures may be affected by random factors beyond the employees control; they may reward activities the firm does not value or fail to reward activities the firm does value. Implicit incentive contracts are appropriate when it is important that a range of performance measures are incorporated. Implicit contracts allow firms to use subjective assessments as performance measures. The disadvantage of subjective assessments is the supervisor faces the unsavory task of rewarding some but not all of his/her staff and the employee has an incentive to “lobby” his supervisor for a good evaluation.

Strong incentives can be provided through the use of promotion tournaments. The size of the prize determines the intensity of the employees’ motivation.

Instead of rewarding agents for good performance, principals can prevent agents from shirking (noneffort) by punishing them for poor performance. This, however, becomes difficult when agents have limited liability that restricts the maximum penalty that can be imposed on them. In such a case, the only option the principal has, is to make the agent want to keep the agency relationship. In order to achieve this, the principal has to pay to the agent more than the agent’s opportunity cost (the threshold wage) for good performance. Such payments above the market wage are called efficiency wages. In this case, the penalty for the agent if he is caught shirking is the loss of his efficiency wage.

Firms often find the most effects means of production involves asking a group of employees to work as a team. Team-based performance measures mean that the benefits from an individual’s actions are shared with the entire team. In setting team-based goals, it is important that the free-rider problem is considered. The free-rider problem suggests that one team member may elect not to work and instead get a “free ride”. The free rider problem can be mitigated by keeping teams small, by keeping team members together for a long time (develop relationships), and by structuring teams such that members monitor one another.

Investment bankers, mutual fund managers, athletes, and actors are examples of employees whose actions are driven by a desire to keep their future prospects bright. Firms that are interested in motivating employees to develop firm-specific skills have typically accomplished this by offering long-term employment relationships. Backloaded compensation can act as an efficiency wage.

The last section of the chapter considers the link between incentives and decision making in firms. A key question facing firms is who should decide on the appropriate response to a given piece of information.

Approaches to Teaching (see above as Chapters 14 and 15 are combined)

Suggested Harvard Case Study (see above as Chapters 14 and 15 are combined)

Extra Readings (see above as Chapters 14 and 15 are combined)

Answers to End of Chapter 15 Questions:

Implicit incentive contracts can be somewhat difficult to communicate to a firm's employees. Often, firms will make available a set of rewards (raises, bonuses, or promotions) to those employees with "good" performance, but what constitutes good performance is never explicitly defined. As part of the job-interview process, potential employees often spend many hours talking to a large number of the firm's employees. While this practice helps the firm gain information about the potential employee, information is also transmitted to the potential employee about the firm. Explain, using your own experience if possible, what questions job applicants ask of interviewers, and how this may fill in important aspects of firms' implicit incentive contracts.

Interviewees are often interested in the typical career path within a firm, and frequently seek information about the characteristics of people who are viewed as successful within the firm. When the applicant learns about employee turnover, where employees who leave the firm go, and the type of employee who is content that he/she is progressing well at the firm, the applicant is more able to determine his/her own “fit” in that firm and the likelihood he/she will succeed in a career at the firm.

What kinds of value-creating actions might not be reflected in subjective performance evaluations, as performed by an employee's supervisor? Explain how 360-degree peer reviews might mitigate this problem. What are some potential drawbacks associated with 360-degree peer review as a performance measure?

It is likely that students will have many good examples as there are many actions that create value for the firm but are difficult for supervisors to observe. An analogy that may be useful for students to consider is: A project is done by a group of students – how well can the Professor give individual grades based on this group work? An example in a job context: supervisors may not be aware of how much time an individual spends mentoring a lower-level employee. Mentoring is a very important activity from the perspective of the firm as the mentoring process improves the firm’s pool of human capital.

While peer reviews mitigate the problem of supervisors being unable to observe all the employee’s actions, there are drawbacks to the peer review process. The chapter discusses issues involved with combining with any form of relative performance evaluation--there may be sabotage. Further, employees may engage in non-productive "sucking up" or lobbying their peers for good marks. Peers could collude to give each other good reviews.

Giganticorp, a large conglomerate, has just acquired Nimble, Inc., a small manufacturing concern. Putting yourself in the shoes of Nimble's employees, what concerns do you have about the implicit incentive contracts that had, until the merger, governed your relationship with Nimble? Now place yourself in the position of Giganticorp's merger integration team. How might concern over implicit incentive contracts affect your dealings with Nimble's employees?

This is a tough question. The best student answer would suggest possible details of an employee’s implicit contract with Nimble. The question is whether as an employee of Giganticorp, will the employee’s implicit contracts they had with Nimble will be honored? A good answer would cover the following points: • Does G value the same activities that did? Or is a different set of activities to be rewarded? • Does G stand to gain a large financial windfall by breaking existing implicit contracts? Is there an opportunity for G to “cherry pick” which implicit contracts to break? • As G, you may want to either (1) make clear that you intend to reward similar activities as did N, or (2) make clear what new activities are to be rewarded.

According to Example 15.1, the 2001 salary and bonus for the General Electric CEO tournament "winner," Jeffrey Immelt, was just slightly larger than that of the tournament "loser," Robert Nardelli. Does this small monetary prize mean the incentives to win were muted? Why or why not?
The salaries for these executive is so stratospheric, more money on the margin is unlikely to be an important motivating factor. The big prize is the power and prestige associated with the title of CEO of GE. Afterall, Immelt is on the cover of Fortune all the time! An individual without an appetite for the limelight would be less motivated to pursue the top spot at GE – this is a good thing as a limelight seeking CEO is likely to be valued by the board and shareholders of GE. Hence, compensation in the way of fame is a good way to sort for the type of CEO the board and shareholders of GE want.

Suppose a firm announces it is giving a $1 million raise in salary to the CEO effective immediately. In addition, the firm will keep the CEO salary higher by $1 million, even after the current CEO leaves office. Thus, the next CEO and the CEO after that, et cetera, will benefit from this raise as well. Describe the effects of this plan on the tournamentbased effort incentives for the firm's non-CEO employees.

Increasing the size of the prize makes winning more valuable. This increases the marginal return to effort, and people who believe they are likely to be considered for the position of CEO should work harder.

A firm faces a choice between two means of making it costly for an employee to shirk. The firm can invest in technology that makes it easier to detect shirking, or it could raise the employee's salary. Let the employee's salary in his or her next best job be $40,000, and suppose the cost to the employee of working hard is $5,000. If the firm invests $X in the monitoring technology, then the probability the firm finds out if the employee shirks is given by √(X/5000). Assume the firm wants to motivate the employee to work hard.

(a) What wage should it offer and how much should it invest in the monitoring technology in order to minimize its total expenditure?
(b) How should the firm adjust wages and monitoring investments if the monitoring technology becomes more effective? Compute the firm's wage and monitoring expenditure assuming the probability of catching the employee shirking is 2√(X/5000).
The key here is that the firm should offer lower wages as the monitoring technology gets more effective. To see, follow below:
If the worker works hard, his payoff is: 40 – 5 + R, where R is the increment given to induce effort.
If the worker shirks, his payoff is: 40 + R but only with probability 1 - √(X/5000)
Hence, the worker is indifferent when:
40 – 5 + R = 40 + R (1 - √(X/5000))
Which reduces to:
R = (5 + 40 √(X/5000))/ √(X/5000)
The firm would like to Min X +R or
Min (5 + 40 √(X/5000))/ √(X/5000) +X
X = 3149.8
R = 6299.6 (for a total compensation of 46299.6)
B. Change the probability to 2√X/5000
X = 1984.25
R = 3968.5 (for total compensation of 43968.5)
Offer examples (from your own experience, if possible) of three skills that qualify as general purpose human capital, and three skills that qualify as firm-specific human capital. Explain why for each.

Many good answers to this question:

General Purpose (for example):
• Good team player • Cooperates • Listens to Peers • Meets deadlines
• Good computer skill (is an expert at using all Microsoft products)
• Well educated (has an MBA or law degree)

Firm Specific (for example)
• Knows how to operate firm owned technology
• Knows how to service a particular customer • Has a good relationship with customer(s) of the firm • Knows the customers needs/buseiness very well
• Knows how to manage the relationship with a supplier to the firm

Two young partners at the consulting firm MacKenzie and Co (call them Bob and Doug) leave the firm to set up their own partnership. They agree to try the partnership for one year, and to split the profits 50/50. Profits depend on the partners' actions as follows: If both work hard, the new firm will make profits of $1,500,000. If one of the consultants works hard while the other shirks, the firm's profits will be $1,150,000. If Bob and Doug both shirk, they will make profits of $700,000. Each partner is willing to work hard only if doing so earns him an additional $250,000 in a year. Draw this "partnership game" in matrix form (using ideas from the Economics Primer). Does this game have dominant strategies? What is the the Nash Equilibrium? Is this partnership game a prisoners' dilemma? What is the relationship between the prisoners' dilemma game and incentives in teams?

|750,000, 750,000 |575,000, 575,000 |
|575,000, 575,000 |350,000, 350,000 |

The economics of team incentives are identical to the prisoner’s dilemma. The nash equilibrium of this game is to “shirk”. The reason is that even though working generates a higher payoff for each worker, working does not clear the $250,000 premium that both Doug and Bob need to induce them to work. Hence shirking is a dominant strategy – no mater what Bob expects Doug to do, shirking is preferred by Bob and the same can be said from Doug’s perspective.

Consider a monopolist firm that consists of two functional divisions. The manufacturing division produces the firm's product, and the actions of the managers in manufacturing have a large effect on the firm's costs. The sales division markets and sells the firm's product, and the actions of the managers in sales have a large effect on the firm's revenues.
a) Explain why the firm may want to use the firm's revenue as a performance measure for the sales managers instead of the firm's profit. Explain why measures of cost might be preferred to measures of profit for motivating manufacturing managers.
b) If the firm rewards sales managers on the basis of revenues, can it delegate decisions over prices and quantities to these managers? If the firm did delegate these decisions, then what price would the sales managers choose to sell?
c) Suppose that because sales managers are in constant contact with customers, they have the most accurate information about the current demand for the firm's product. What performance measure should the firm use if it is essential to delegate pricing decisions to achieve quick price responses to changes in market demand? Use your discussion to identify the cost to the firm of delegating this pricing decision.

One nice thing about revenue and cost as performance measures is that they shield employees from risk. The firm could, if it wanted, pay each manager on the basis of firm-wide performance. But this would mean the manufacturing manager's pay would vary with shifts in demand for the firm's product. This subjects the manager to risk without providing any additional incentives. Similarly, paying the sales manager based on firm performance would mean that random shocks to input prices would affect his pay, again with no effect on incentives.

One difficulty with using these more focused measures is that some decisions can't be delegated. For example, a revenue-maximizing sales manager would select the quantity where MR = 0.

Delegating this pricing decision means the firm has to use profit as a performance measure. And this imposes cost-based risk on this manager, implying a risk premium.

Chapter 16
Strategy and Structure

Chapter Contents
1) Introduction
2) An Introduction to Structure • Individuals, Teams and Hierarchies Individuals Self-Managed Teams Hierarchy of Authority • Complex Hierarchy Departmentalization Coordination and Control Example 16.1: The Division of Labor Among Seamen: 1700-1750 • Types of Organizational Structures The Functional Structure (U-form) Multidivisional Structure (M-form) Matrix Structure Network Structure Example 16.2: Abb's Matrix Organization 3) Contingency Theory • Technology and Task Interdependence • Improving Information Processing • Balancing Differentiation and Integration Example 16.3: Organizational Structure at AT&T 4) Structure Follows Strategy Example 16.4: Strategy, Structure, and the Attempted Merger Between The University of Chicago Hospital and Michael Reese Hospital Example 16.5: Samsung: Reinventing a Corporation • Strategy, Structure, and the Multinational Firm • Structure, Strategy, Knowledge, and Capabilities Example 16.6: Transnational Strategy and Organization Structure at SmithKline-Beecham • Structure as Routine and Heuristic Example 16.7: WingspanBank.Com: A Network Organization 4) Chapter Summary 5) Questions

Chapter Summary

This chapter discusses the interrelationship between structure and strategy, and the mutual fit necessary to effectively implement business operations and change. The successful implementation of a firm’s strategy requires appropriate organizational structures within the firm. Alfred Chandler summarized this concept as structure follows strategy.
The chapter begins the discussion of firm organization at the task level. Workers can complete tasks individually. These workers receive incentives based solely on their individual outcomes. Individuals can be organized into teams. Self-managed teams are partially rewarded on team performance. This structure works well when team effort is more valuable than individual efforts—such as when there specialization exists among group members. Teams with a hierarchy of authority designate one member—a supervisor—to take charge of monitoring and coordinating the work of others. Communication and coordination requirements partially determine optimal team structure. Projects that require frequent team interaction and inter-group support benefit most from self-managed teams, as opposed to hierarchical structures.
When defining the complex hierarchical structures, firms should consider the potential problems and costs of departmentalization and coordination. Optimal departmentalization will depend on the firm’s economies of scale and scope, transaction costs, and agency costs. Designers of a complex hierarchy must also consider how to resolve conflicts resulting from departmentalization. Coordination approaches ensure the flow of information and facilitate decision making. The autonomous approach emphasizes self-containment of work units, such as profit centers and responsibility centers. Minimal information flows outside these units, which are measured by their achievement of high-level goals. The alternative approach emphasizes lateral relations across work groups, such as informal relations or more formalized matrix organizations.
The structure of large organizations usually fit into one of four categories.
The functional structure, or U-form (unitary functional), defines the unit for each basic business function of the firm, such as corporate divisions. Division of labor motivates this structure.
The multidivisional structure, or M-form, organizes the firm into groups segregated by product line, related business units, regions, or customer types. Additionally, these groupings, or divisions, will have their own internal structures. This structure addresses the limitations of a functional structure in large, diversified firms, such as coordination difficulties and agency costs.
A matrix structure organizes the firm along multiple dimensions, assigning human resources to more than one dimension simultaneously. For example, a software designer would report to the engineering division as well as a product group. This structure can exploit economies of scale or scope and address agency considerations relating to firms organized along multiple dimensions. It also helps the firm allocate scarce resources on the basis of need by specific units. The matrix structure has the disadvantage of multiple lines of authority for a worker.
A network structure organizes groups into a changing structure driven by task requirements. This structure is seen in Japanese keiretsu organizations. • Contingency theory states that since three factors affect the relative efficiency of different structures, there does not exist a “best” organizational structure that fits all circumstances of a firm. As the technology of a firm changes, the firm’s structure will also need to change, since technology defines the degree of task interdependence. Jay Galbraith proposes that advances in information processing increase the amount, complexity and speed of availability of information. This leads to firms making more difficult decisions and less routine decisions, overwhelming the firm’s decision-making structure. A firm can change its formal organization to address these changes. Alternatively, it may create teams responsible for crossing established hierarchical boundaries, creating a lateral organization to aid in decision making.
An historical perspective of firm structures provides evidence that Chandler’s thesis that structure follows strategy remains true. Large firms of the late nineteenth and early twentieth century exploited new technologies to become leaders in a single market focus. These firms successfully used the functional structure to achieve a specialization of labor that led to economies of scale in manufacturing, marketing and distribution. Such economies of scale then prompted firms to move into new businesses or markets. As firms shifted their strategy from a single business or market focus to diversification in product lines, the functional structure no longer worked well, and firms moved to the multidivisional structure. With the new structure, division managers were measured on the profit-and-loss of their division and monitored the activities of the functional units within the division. Today, firms augment the traditional structures by creating networks, outsourcing some functions to contractors. At the same time, multinational firms face the unique challenge of attaining economies of scale and scope across nations yet specializing within nations. The multinational strategy now motivates structure that combines matrices and networks.
The chapter concludes with a discussion on what other strategic or environmental factors in a firm may influence the structure of the firm. For instance, the strategy and structure of the firm can influence how information flows and how decisions are made within the firm. Beyond the formal structure, the routines of a firm provide a structure for the actions of a firm. The formal structure provides a mechanism for handing situations that fall outside of the established routines.

Approaches to Teaching this Chapter

Self-Managed Teams: Organizing on the basis of work groups, each member works with the other members to set and pursue common task objectives.

Hierarchy of Authority: The specialization of one member of the group on the monitoring and coordination of the work of the other. Less formally, employees have a boss under this hierarchy.

Span of Control: The number of subordinates of a specific supervisor. The optimal span of control is uniquely determined based on the complexity of the coordinating tasks.

Complex Hierarchies: The structure of most large firms involves multiple groups and multiple levels of groupings. This structure arises not just from the need to organize individuals into groups, but to organize groups into larger groups.

Departmentalization: Involves the division of the organization into formal groups, such as common functions, inputs, locations, or time of work.

Coordination: Involves the managing of information within an organization to facilitate sub-unit decisions that are consistent with each other and the organizational objectives.

Control: Organizing functions that involve the exercise of decision-rights and rule-making authority within the hierarchy.

Functional Form: (U-form): A structure that groups the organization into functional units that based on skill and training (e.g. finance, marketing, or manufacturing).

Multidivisional Structure (M-form): A structure that groups the organization into units other than along functional lines. These units should be chosen based upon the independence of units. For example, in some firms geographical regions can operate semi-autonomously.

Matrix Organizations: An organizational design that fosters lateral relations by organizations on multiple dimensions simultaneously. These are structures that employees are subject to two or more sets of managers at once.

Network Structures: Structure in which relationships among work groups are governed more by the often-changing implicit and explicit requirements of common tasks than by formal lines of authority. The Japanese keiretsu is a leading example of a network structure.

Contingency Theory: Approach to organizing which sees the best structure for an organization depending on the unique circumstances facing that organization.

Task Interdependence: The extent to which two or more positions depend on each other to do their own work. Thompson sees three types of interdependence: reciprocal, sequential, and pooled.

Heuristics: Principles that reduce the average time decision-makers must spend searching for solutions to difficult, non-routine problems. These principals are embedded in organizational structures and corporate cultures.
Students’ Audit of their Organizational Structures
Most of the students will have worked in organizations with complex structures and have had significant dealings with several others. Discuss some of their examples in class.
What are the structures that students have experienced? Do they believe that the structure was a conscious decision of the firm, or a result of personalities and historical circumstances? Which structures are easier to work under? For students who have experienced matrix and network systems, how did they handle reporting to two bosses with different demands? Also, do the actual structures in their organizations correspond to the organizational changes of the official structure?
Industries and Structures
Challenge students to discover the dominant structures in various industries. Why do industries differ? How does variety within different industries vary? Are some industries homogenous in the types of structures represented in that industry?
In particular, have students investigate the companies and industries that recruit at your campus. For example, how are consulting firms typically structured? Would students expect advertising agencies to be structured differently? What does structure tell students about the firms” strategy and the skills necessary for career advancement?
Business Schools and Structure
If the structure of an organization is one indication of the goals that an organization is trying to accomplish, why are business schools organized by functional experience (marketing, strategy, finance)? Does the structure of business schools reflect the structure of corporations? Does it matter?
What are the possible goals of business schools? Possible goals may include training employees for major recruiters, producing cutting-edge research, or training the next generation of professors. Are these goals internally consistent? When would industry-focused departments (real estate, transportation, consumer products) be a better structure than the functional design?

Suggested Harvard Case Study
Bank One - 1993 HBS 9-394-043 (see earlier chapters)
Booz, Allen & Hamilton: Vision 2000, HBS 9-396-031.
In 1993, Booz, Allen & Hamilton forsook its previously highly local organizational structure in order to serve multinational clients more effectively. The firm’s human resource systems were redesigned along with the structure.
House of Tata HBS 9-792-065 (see earlier chapters).
Ingvar Komprad and IKEA HBS 9-390-132 (see earlier chapters).
Nucor at a Crossroads HBS 9-793-039 (see earlier chapters).
Pepsi-Cola Beverages HBS Case 9-390-034 A
Responding to changes in Pepsi-Cola’s competitive environment, Roger Enrico, president and CEO of PepsiCo Worldwide Beverages, formed a task force to investigate a possible reorganization of Pepsi’s domestic soft drink business. The task force recommends reorganizing along geographic lines. The group has put forth two options: 1) full decentralization, or 2) a matrix organization. Ask students to analyze the options and make their own proposals for carrying out a reorganization. They should also be asked to consider other options to deal with Pepsi’s problems that don’t center on reorganization.

Extra Readings
The sources below provide additional resources for the theories and examples of the chapter.

Bowman, E. H. and B. M. Kogut (eds.). Redesigning the Firm. New York, NY: Oxford University Press, 1995.

Burt, R. S. Structural Holes. Cambridge, MA: Harvard University Press, 1992.

Burton, R.M. and B. Obel. Strategic Organizational Diagnosis and Design. Boston, MA: Kluwer, 1998.

Chandler, A. D. Scale and Scope: The Dynamics of Industrial Capitalism. Cambridge, MA: Harvard University Press, 1990.

Chandler, A.D. Strategy and Structure. Cambridge, MA: MIT Press, 1962.

Cyert, R. and J. March. A Behavioral Theory of the Firm. Englewood Cliffs, NJ: Prentice-Hall, 1963.

Fligstein, N. The Transformation of Corporate Control. Cambridge, MA: Harvard University Press, 1990.

Galbraith, J. R., E. E. Lawler, and Associates. Organizing for the Future: The New Logic for Managing Complex Organizations. San Francisco, CA: Jossey-Bass, 1993.

Galbraith, J. R. and R. K. Kazanjian. Strategy Implementation: The Role of Structure and Process. 2nd ed., St. Paul, MN: West Publishing, 1986.

Garvin, D. Managing Quality. New York: Free Press, 1988.

Jacquemin, A. The New Industrial Organization. Cambridge, MA: MIT Press, 1991.

Lawrence, P. R. and J. W. Lorsch. Organization and Environment. Boston: Harvard Business School Press, 1986.

Lieberstein, H. Beyond Economic Man. Cambridge, MA: Harvard University Press, 1980.

March, J. and H. Simon. Organizations. New York: Wiley, 1958.

Miller, G. J. Managerial Dilemmas. Cambridge, UK: Cambridge University Press, 1992.

Nelson, R. R. and S. G. Winter. An Evolutionary Theory of Economic Change. Cambridge, MA: Belknap, 1982.

Quinn, J. B. Intelligent Enterprise. New York: Free Press, 1992.

Smith, G. D. The Anatomy of a Business Strategy. Baltimore, MD: Johns Hopkins Press, 1985.

Stinchcombe, A. L. Information and Organizations. Berkeley, CA: University of California Press, 1990.

Stopford, J. and L. Wells. Managing the Multinational Enterprise. London: Longmans, 1972.

Thompson, J. D. Organizations in Action. New York: McGraw-Hill, 1967.


Answers to End of Chapter Questions

1. A team of eight individuals must fold, stuff, seal, and stamp 250 preaddressed envelopes. Offer some suggestions for organizing this team. Would your suggestions differ if, instead of 250 envelopes, the team was responsible for processing 2500 envelopes? For assembling personal computers? Why?

The task relates to interdependence, complexity, and volume. Students should look for economies of scale, scope or learning around which to create an efficient structure.

Consider the implications of the different ways to structure tasks. If each letter is already matched to its envelope and the assembly does not require specialized equipment, such as a stamp machine, then each individual can complete all tasks oneself. The pooled interdependence of tasks allows the workers to perform individually, completing the entire set of tasks for each letter allocated.

If sequential interdependence amongst the tasks exists, then the individuals may want to form a self-managed team and an assembly line. For example, if letters must be matched with envelopes before folding, or the team must share a single postage machine, the individuals may want to specialize in tasks such as sorting, folding and stuffing, sealing, and stamping. Increasing the volume from 250 to 2500 may indicate that specialization is more appropriate. Since the self-managed team will be partially rewarded on team performance, it will be motivated to distribute the labor so that no individual accumulates an appreciable amount of idle time.

Would your suggestions differ if, instead of envelopes, the team was responsible for assembling 250 personal computers? Why?

If the team were assembling 250 personal computers, then a hierarchy of authority and specialization among the individuals would be more appropriate. Since assembling computer systems requires expertise in separate tasks, team members should be assigned to the task for which they have expertise. Moreover, tasks in computer assembly involve sequential interdependence. Hence, a supervisor would help ensure the smooth flow of production. The supervisor could resolve disputes that arise within the team.

2. Consider a firm whose competitive advantage is built almost entirely on its ability to achieve economies of scale in producing small electric motors that are used by the firm to make hair dryers, fans, vacuum cleaners, and food processors. Should this firm be organized on a multidivisional basis by product (hair dryer division, food processor division, etc.) or should it be organized functionally (marketing, manufacturing, finance, etc.)?

This scenario highlights the balance between differentiation and integration explained by the contingency theory. If competitive advantage lies in product differentiation, a multidivisional basis might make sense. However, in this case, the competitive advantage lies in extensive and efficient manufacturing of motors. Therefore, firm structure should support that advantage. This structure gives manufacturing responsibility for the production of motors regardless of which products use the motors.

3. What types of structures would a firm consider if it were greatly expanding in global operations?

Contingency theory argues that there does not exist a “best” organizational structure for all firms. Rather, structure should focus on the most important task confronting the company. When determining its optimal structure, the theory suggests that a firm consider three primary issues. First, what is the technology and task interdependence seen by the firm? Are products manufactured in one facility for distribution worldwide? Do operations in one country have interdependencies with tasks in other countries? Second, what is the information flow? Does a central organization need to make decisions that affect all operations, or should the decision-making be contained within a country. Finally, does the competitive advantage of the company rely on core technology regardless of what country the firm operates in? Does the firm manufacture and market diverse products and services in one country and then distribute on a worldwide basis? Or does the firm have autonomous operations in each country?

4. Proctor and Gamble is one of the largest consumer product companies in the world. The company is organized along both product and country lines. For a specific product, such as dish soap, each country manager may select product characteristics, price, and marketing strategy. This decentralized structure has enabled P&G to be successful in many parts of the world, including Europe, where P&G’s brands frequently outperform locally produced brands. As trade barriers in Europe disappear, do you think that P&G will need to move to a more centralized structure?

As trade barriers in Europe disappear, P&G must reevaluate their structure. Domestic producers will find more opportunities for scale and scope when the meaning of the term “domestic” expands from a single country to include all of the European Union. P&G may find that managers in European countries may be duplicating tasks when each country faces the same regulation from the European Union. These are arguments for a more centralized strategy. However, decreased trade barriers may not eliminate the country differences that have made P&G products successful in Europe. If the country differentiation remains, then the current structure may remain the optimal structure.

5. In the 1980s, Sears acquired several financial services firms, including Allstate Insurance and Dean Witter Brokerage Services. Sears kept these businesses as largely autonomous divisions. By 1995, the strategy had failed and Sears had divested all of its financial service holdings. Bearing in mind the dictum that structure follows strategy, identify the strategy that Sears had in mind when it acquired these businesses, and recommend a structure that might have led to better results.

Sears’ strategy focused on becoming a one-stop shop for the core American family. Sears expected that consumers would seek traditional retail transactions and financial transactions in the same store environment. This implies a more complex organizational structure to link the diverse services. It appears, however, that Sears saw few opportunities for economies of scale or scope amongst the firms, and therefore kept the firms as autonomous divisions. The only connection among the businesses lay in the sharing of store floor space.

Given the lack of scale and scope economies, the project may have been flawed from the start. Sears may have been able to improve the situation by exploiting possible scale and scope economies through the combination of the two financial services companies. Alternatively, Sears could have formed joint ventures or other strategic alliances to target Sears’ customer base, rather than acquiring the firms.

6. Matrix organizations first sprang up in businesses that worked on scientific and engineering projects for narrow customer groups. Examples include Fluor, which built oil refineries in Saudi Arabia, and TRW, which supplied aerospace equipment to NASA. What do you suppose the dimensions of the matrix would be in such firms?

This matrix would likely have two dimensions: functional groups and project groups. Functional groups comprise of staff from a single discipline, such as engineering or marketing. Project groups include persons such as design engineers, marketing professionals, production specialists within a single, cross-functional team.

Why would these companies develop such a complex structure?

The company derives a different benefit from each dimension on the matrix. In the case of Fluor and TRW, the design engineers would report to a design engineering organization. The company gains benefits since the engineers have access to information on previous designs (for design reuse), design equipment, training opportunities, and other engineers for informal consultation. This provides economies of scale, including learning curve advantages, for the firm.

Regarding the project dimension, individuals would be rewarded for their contribution to the project. This allows the corporation to measure each major project as its own profit and loss center. The project manager aims to profitably deliver project results that meet customer specifications. The project manager thus has the greater ability to motivate and control the contributors to the project than the manager would have had in a functional organization.

7. It is sometimes argued that a matrix organization can serve as a mechanism for achieving strategic fit – the achievement of synergies across related business units resulting in a combined performance that is greater than the units could achieve if they operated independently. Explain how a matrix operation could result in the achievement of strategic fit.

Matrix organization gives the firm flexibility by organizing resources along two (or more) dimensions. Such combinations in turn enable the firm to achieve the optimal levels of staffing given specific scenarios. Stochastic demand can greatly influence the amount or skill sets required of resources. Flexibility can address such issues. For example, Amoco Corporation’s information technology department assigns experts to functional groups called Centers of Expertise. The firm staffs projects by selecting the appropriate number of experts from their respective Centers, depending on project needs. Simple projects may demand only a few experts from a given Center, whereas complex projects may require numerous experts from multiple Centers.

8. Contingency theory suggests that it is possible to organize too much to meet the needs of the environment. This would be a case of strategic misfit. Think of an example of misfit caused by an inappropriate organization design. Explain how a firm’s structure could systematically increase its costs and place it at a strategic disadvantage.

Contingency theory is the idea that there is no uniformly “best” structure for all firms in all circumstances. Contingency theory has focused on three factors that may affect the relative efficiency of different structures: • Technology and task interedependence • Example: Telecommunications advances have vastly improved the ability of engineers and product specialists located physically far apart to communicate and coordinate product design. This reduction in the costs of coordination reduces the need for members of a team to be in the same part of the firm’s formal organization or even to be part of the same firm. Hence, a firm might suffer strategic misfit if it is overly vertically integrated relative to the ability of coordination across firms. • Information flows • Example: According to the economist Galbraith, administrative hierarchy (bosses!) develop in order to handle “exceptions” – decisions that cannot be made easily by applying standard organizations routines. Successively higher levels of organization are needed to handle more difficult exceptions. What follows from this argument is that strategic misfit occurs as the amount, complexity and/or speed of information processing that a firm must undertake to make decisions changes but the firm does not change. A firm with a rigid hierarchy in an environment where responses must come more rapidly is disadvantaged. • The tension between differentiation and integration • Example: Lawrence and Lorsch note a tension in complex organizations between the benefits of creating independent specialized work groups (differentiation) and the need to integrate these groups into a corporate whole (integration). Differentiation provides the benefits of division of labor – but integration is necessary to capture the benefits of labor division. Consider a multi-product food company that silos each of its products. Here the firm may lose the benefit of using all of its products together to gain leverage over retailers.

9. While the dot-com ventures of the late 1990s failed for many reasons, lack of organization was a significant one, especially in light of the rapid growth of these ventures. Explain the organizational problems that a small Internet venture might have encountered as it grew from a 5-10 person operation into an operation 10 times as big, spanning multiple sites in multiple countries, and needing to interact regularly with multiple business stakeholders.

With a small number of employees, coordination and control are relatively easy. Coordination and control involve issues of technical and agency efficiency. Agency efficiency is affected because structures may differ in opportunities they offer to decision makers to pursue personal or unit objectives that are inconsistent with the objectives of the firm. With only a few workers, each can have a significant impact on the firm (and therefore his/her own) earnings. As the firm grows, it is more feasible for individuals to attempt to free-ride on the efforts of others. When the dot-coms were young, they were so busy trying to create their product and collect customers that many of these firms did not put in place a structure capable of handling monitoring and information flows.

Chapter 16
Strategy and Structure

Chapter Contents
1) Introduction
3) An Introduction to Structure • Individuals, Teams and Hierarchies Individuals Self-Managed Teams Hierarchy of Authority • Complex Hierarchy Departmentalization Coordination and Control Example 16.1: The Division of Labor Among Seamen: 1700-1750 • Types of Organizational Structures The Functional Structure (U-form) Multidivisional Structure (M-form) Matrix Structure Network Structure Example 16.2: Abb's Matrix Organization 3) Contingency Theory • Technology and Task Interdependence • Improving Information Processing • Balancing Differentiation and Integration Example 16.3: Organizational Structure at AT&T 4) Structure Follows Strategy Example 16.4: Strategy, Structure, and the Attempted Merger Between The University of Chicago Hospital and Michael Reese Hospital Example 16.5: Samsung: Reinventing a Corporation • Strategy, Structure, and the Multinational Firm • Structure, Strategy, Knowledge, and Capabilities Example 16.6: Transnational Strategy and Organization Structure at SmithKline-Beecham • Structure as Routine and Heuristic Example 16.7: WingspanBank.Com: A Network Organization 6) Chapter Summary 7) Questions

Chapter Summary

The chapter attempts to assess the nature of power and culture within large organizations and their effects on the goals and accomplishments of those organizations, particularly where contractual agreements fail to provide adequate structure or guidance.
Power is defined as the individual’s ability to accomplish his or her goals by means of resources obtained through noncontractual exchange relationships with other actors. There are five general bases of power: legitimate (formal) power, reward power, coercive power, and resource dependence. Power can also be based on image or reputation. Successful managers likely need to build several bases of power.
The most common view of power in organizations is based on the idea of social exchange. Power arises from persistent inequalities in the terms of repetitive social exchanges between a pair of individuals concerning access to valuable resources. The resource dependence view argues that power arises from dependence relationships based on access to these resources. Individuals and firms seek to gain power by reducing their dependence on other actors, while increasing the dependence of other actors on them. Individuals who control critical resources will gain power.
Power is difficult to measure. The resource deployment and resource mobilization perspectives on power seek to clarify the exchange of power in observed uneven exchanges, but they are not precise. Transactions costs are another way to view power, arguing that power comes from the ability to reduce the costs associated with transactions involving valuable resources. By eliminating an internal holdup problem, for example, managers can acquire great power within an organization.
Power can also be obtained by occupying particular locations within the structure of the firm. By occupying “structural holes,” individuals can create power for themselves by serving as a link between different parts of the organization that might not interact otherwise. If this linkage creates value, the person spanning the structural hole will gain power.
Firms may or may not benefit from powerful managers. Firms will benefit from an accumulation of power if the firm is relatively stable and there are high agency costs between management and lower level workers. They will be harmed if the firm’s environment is relatively unstable and there are high agency costs between levels of upper management. When power is allocated within an organization, the firm is best off when knowledgeable individuals whose interests are most aligned with the firm are given the most power.
While power is primarily concerned with the effects of certain individuals on firm performance, corporate culture refers to a set of collectively held values, beliefs, and norms of behavior that influences individual employee preferences and behaviors. These are the behavioral guideposts that are not spelled out by contract but still constrain the behavior of the firm’s employees. This constraint can be a source of sustainable competitive advantage, but only if the culture is valuable, specific to the firm and inimitable by competitors. The value created by culture can come in one (or more) of three ways: by simplifying individuals’ information-processing demands, by complementing formal control systems and by facilitating cooperation and reducing bargaining costs. For the same reasons that culture can be a source of sustainable competitive advantage, it can also be a source of inertia when the firm needs to change.
Approaching to Teaching the Chapter

Noncontractual Exchange Relationships: Business situations that offer no clear authority structures between the actors. Without a formal structure, the actors must negotiate the relationship.

Legitimate (formal) Power: Rooted in formal authority, legitimate power is received as a consequence of occupying a high-ranking position in the hierarchy of an organization. Anyone occupying that position has access to that power, regardless of personal characteristics.

Reward and Coercive Power: The corollary to legitimate power, these are located in a specific hierarchical location, and involve influencing others through rewards and punishments. They are not strong motivational devices in long-term relationships.

Expert Power: This type of power is derived from the possession of specialized knowledge that is valued by some other actor or by the organization as a whole. This power is unrelated to the position in the hierarchy of the expert, although experts often get promoted to higher positions in the structure.

Referent Power: Referent power is gained from the admiration of others. Role models or charismatic leaders have referent power. As with expert power, this power must be earned, and can be quickly lost.

Social Exchange: The transfer of resources among parties that occurs outside the terms of a market environment.

Resource Dependence: In an environment without easy contracting for exchange, individuals seek to gain power by reducing their dependence on the resources of others.

Structural Hole: Identifies a relationship in a social network in which one actor is the critical link between individuals or groups. The individual who can span that hole will gain power within the organization.

Clan Control: This system of organizational norms and values internal to a firm acts as an alternative control system to the formal power of the organizational hierarchy.

Conceptual Applications

Student Audit of their Work Histories
Instructors could ask students to bring in examples of their experiences with each of the forms of power, as well as various corporate cultures. Each student can react to the central questions of the chapter. For example, does referent power work? Does the use of formal power negate all other accrued powers? Was culture inertial or was it a competitive advantage?

Successful Companies in Similar Industries with Opposite Cultures
Hewlett-Packard and Microsoft are both wildly successful in the rapidly changing computer industry. They have developed opposite corporate cultures, however. HP is communal and consensus; Microsoft is individualistic and competitive. Why did each develop this culture? Is one more successful than another? How would you qualify the benefits or costs of each culture? Which will adapt the quickest as the industry evolves? Did these cultures drive economic success or did the economic challenges facing each company determine the most efficient culture for that market?

Regional or Industrial Norms (Boston vs. Silicon Valley)
Much has been written about the corporate and cultural differences between the computer industries in Boston, Massachusetts and in Silicon Valley, California. The Boston companies in general were more likely to vertically integrate, maintain formal environments, and retain workers for long tenures. Silicon Valley firms making similar products were in general more likely to use the market for their supply needs, foster informal environments, and swap workers among firms quite often.

Are there regional or industrial norms in your local business environment? Does the appearance of these cultures bunch in certain industries, or geographies, or sizes of firms? Are these cultures effective for the competitive challenges facing these companies today? Did the region and its economic challenges create the corporate cultures or did individual firms set the norms for the region?

Culture and the Pace of Competitive Environmental Change
The rapidity of change in various industries has increased dramatically during the 20th century. If "hypercompetition" is quickly becoming the norm in many industries, what will the future of corporate culture be? If culture necessarily drags behind the needs of the firm, is "corporate culture" destined to become pejorative? Are there examples of cultures designed to be highly sensitive to the environmental needs of the firm? Are they found by region or industry or by individual leadership? Some have suggested the Silicon Valley model described in the question above will soon jump to various other industries. Is that likely?

Suggested Harvard Case Study[11]

Bank One - 1993 HBS 9-394-043 (see earlier chapters).

Booz, Allen & Hamilton: Vision 2000, HBS 9-396-031 (see earlier chapters).

De Beers Consolidated Mines, HBS 9-391-076 (see earlier chapters).

House of Tata HBS 9-792-065 (see earlier chapters).

Ingvar Komprad and IKEA HBS 9-390-132 (see earlier chapters).

Sime Darby Berhad—1995, HBS 9-797-017 (see earlier chapters).
Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Blau, P. M. Exchange and Power in Social Life. New York: Wiley, 1964.

Coleman, J. S. Foundations of Social Theory. Cambridge, MA: Belknap, 1990.

Crozier, M. The Bureaucratic Phenomenon. Chicago: University of Chicago Press, 1964.

Deal, T. and A. A. Kennedy. Corporate Cultures The Rites and Rituals of Corporate Life. Reading, MA: Addison-Wesley, 1982.

Geertz, C. The Interpretation of Cultures. New York: Basic Books, 1973.

Kipnis, D. The Powerholders. Chicago: University of Chicago Press, 1976.

Kotler, J. "Power, Dependence, and Effective Management," Harvard Business Review, July-August 1977.

Laumann, E. and D. Knoke. The Organizational State. Madison, WI: University of Wisconsin Press, 1987.

Lukes, S.. Power., A Radical View. London, UK: Macmillan, 1974.

Lincoln, J. R. and A. L. Kalleberg. Culture, Control and Commitment. Cambridge, UK: Cambridge University Press, 1990

Miller, G. J. The Political Economy of Hierarchy. Cambridge, UK: Cambridge University Press, 1992.

Odagiri, H. Growth through Competition, Competition through Growth: Strategic Management and the Economy in Japan. Oxford, UK: Oxford University Press, 1994.

Ouchi, W.. Theory Z. How American Business Can Meet the Japanese Challenge. Reading, MA: Addison-Wesley, 1981.

Perrow, C. Complex Organizations: A Critical Essay. New York: Random House, 1986.

Pfeffer, J. Managing with Power Politics and Influence in Organizations. Boston, MA: Harvard Business School Press, 1992.

Pfeffer, J. Power in Organizations. Marshfield, MA: Pitman, 1981.

Thibaut, J. W. and H. H. Kelley. The Social Psychology of Groups. New York: Wiley, 1959.

Trice, H. M. and J. M. Beyer. The Cultures of Work Organizations. Englewood Cliffs, NJ: Prentice Hall, 1993.

Useem, M., Executive Defense: Shareholder Power and Corporate Reorganization. Cambridge, MA: Harvard University Press, 1993.

Williamson, O. The Economic Institutions of Capitalism. New York: Free Press, 1985.

Answers to End of Chapter Questions

1. How does the resource-dependence view of power differ from the perspective of transactions-costs economics? In what situations would their predictions about economic transactions be similar; in which situations would they be different?

The resource-dependence view, as expressed by Pfeffer, maintains that power develops because there are resources controlled by a certain party (an individual or group within an organization) that are important to the firm, there are no readily available substitutes or alternative suppliers for those resources and contracting for the exchange of these resources would be prohibitively costly. Therefore, other parties within the organization become dependent to the party that controls these resources. Individuals and firms seek to gain power by getting access to these resources to reduce their dependence on other parties, while increasing other parties’ dependence on them. It is control of the resource itself that creates power.

Transactions-costs economics, on the other hand, argues that power arises from the costs associated with transactions; it is the cost of exchanging the resource that creates power. Individuals, groups or firms that can reduce these costs to other affected parties will be the ones who gain power. For example, managers within a vertically integrated firm who can punish internal suppliers for holding up users of important assets will gain great power within the organization. Here it is the ability to reduce costs associated with transactions involving resources that creates power.

In situations where transaction costs are high, then we would also expect to see high resource dependencies. Thus, both theories would predict that power would arise from these situations. These situations occur when there are complex situations that cannot be contracted easily. For example, a vertically integrated firm where one division controls supply of a scarce resource for several production divisions would create power for both the supplying division and a manager who could reduce the costs of these transactions.

In situations where transactions costs are not as high, it is still possible for the exercise of power under the resource-dependence view. This could arise, for example, in the relationship between a firm’s Board of Directors and the CEO. This relationship is easily contractible, but the CEO may hide certain information that makes it difficult for the Board to fully exercise their power and gives the CEO greater power within the organization.

2. Could some actors get power just by being very effective at their jobs? If this is so, how is power different from basic competence or efficiency?

An individual who is very effective at their job in a situation where a replacement for that individual would be very difficult to secure would develop power. The degree of power would depend on whose outside options were stronger or more credible, the firm’s or the individual’s. The power an individual may derive from doing his/her job well is a result of the thin market of individuals who could replace that worker and not a result of the worker merely being competent at their job.

This question also brings out the point that there are aspects of any relationship that cannot be controlled by contract. Therefore, even if the principal writes thorough contract, there may be situations where it may be in the agent’s best interests to act in a way that is not in the best interests of the firm.

For instance, an agent’s need for recognition or respect most likely will not be covered by a contract. These needs can reduce the agent’s incentives to act in the contracted way. Both culture and power can reduce (or, in some cases, increase) these costs to the principal when a contract does not apply to a given situation. Culture can serve as a way to align the agent’s interests with the principal’s when formal contracting is not adequate.

3. What is the relationship between the degree of regulation in an industry and the competitiveness of that industry? Under what conditions could extensive regulations foster a very competitive environment?

Regulatory activity has huge influence on the strategic behavior of firms. Court decisions have defined the types of structures that firms may employ as they grow and diversity. Justice department policies and standards, along with the courts, have constrained how firms can behave, how they acquire knowledge from their environment, what types of mergers can be made, and what types of limits can be placed on corporate decisions and influence activities.

Regulations could strategically advantage regulated firms. They can restrict entry, which allows incumbents to enjoy greater scale and reduced price competition. They can also limit innovations that injure the capabilities of incumbents, while focusing competition on those aspects of the business at which incumbents excel. So regulations that encourage entry or favor new way of doing business would act to intensify competition.

4. How might favorable location within the interpersonal networks within a firm help an individual acquire and maintain additional bases of power?

Power in an organization is derived from having access to valuable resources and controlling the transactions that surround them. An individual who occupies a position that has access to these resources, or is in a position to influence the transactions that involve them, will be able to acquire power. On an interpersonal level, knowledge about the organization can be a valuable resource. Individuals can gain access to this resource by being well connected to many others in the organization. This can facilitate, for example, positive interactions between departments or divisions that might not otherwise interact. According to Burt, these individuals fill the “structural holes” within the organization that serve as links between resources and, therefore, create power. This can explain, for instance, why a manager who has access to several important functions will have more power than will a manager who has access to just one. For example, finance managers who work at headquarters serving several different divisions will typically have more power than a local plant controller, all else being equal.

5. Social-exchange views of power tend to emphasize individual abilities to make decisions and prevail in conflicts. How might power also be associated with an individual’s ability to not make decisions and avoid conflict?
While power in organizations is often a function of the ability to make tough decisions and prevailing in conflicts, there are isolated situations where these skills are not as applicable. As Fernandez and Gould found in their research, acquiring and maintaining powerful brokerage positions within an organization or group can often be predicated on the ability to remain neutral in disputes. If one party in the relationship feels that the broker is not impartial but is pursuing her own interests instead, the broker will lose her power. Therefore, individuals in these positions may find it advantageous to avoid conflict and not make decisions in order to appear impartial and retain their power. For example, mediators in labor disputes must be able to represent the views of both management and the unions without bias towards one side or the other. Should they lose their neutrality, one of the affected parties would likely refuse to bargain further and the mediator would be replaced.
6. All firms operate within an institutional environment of some kind. How do the common beliefs, values and norms of behavior that characterize the institutional environment affect the ability of firms to pursue sustainable strategies? Are institutional influences always constraining or can they ever promote competition and innovation?
While firms have their own cultures, they are also part of a large macroculture that affects a wider set of firms and differ significantly from corporate culture. Firms also act within a broader scientific and technological context that strongly influences what products and services firms offer, the performance standards that offerings must meet, and the rate of change that an industry or sector undergoes.
Out of the common beliefs come common practices regarding what managers should do, how changes should occur, how business should be transacted, and what types of innovations are worthwhile. When common beliefs about an industry are disrupted, then most everything else about the industry becomes open to change. These changes benefit some and hurt others. Institutional research has shown how these reference points themselves change as industry changes affect common beliefs and values. Values that were nonnegotiable at one time may become less important at another. Stakeholder groups may rise or fall in importance as an industry evolves.
7. Discuss the idea of structural holes in the context of value creation and value extraction. Use these ideas to identify some of the skills necessary to be a financially successful general manager.
As Burt explains, a structural hole is a function of information or social networks and is a relationship in the network in which one actor is the critical link between individuals or entire groups. To associate with each other, these individuals or groups must go through the actor occupying the structural hole; there is no other access otherwise. This position allows the individual occupying the link to use the control of information or resource flows as a source of power.
In these relationships, value is often created by the linking of resources between the groups or individuals on each side of the structural hole. That is, the combined resources’ value is greater than the sum of the resources used individually. By creating this value, each of the actors will be able to extract some of the value from it. As a consequence of bringing the groups together, the person occupying the structural hole will often be able to extract a good portion of the value created. For instance, those individuals in an organization that can link research and marketing (for instance, by understanding the practical application of a research discovery) in a way that will create a valuable end product can often reap great rewards (power, money, recognition) in the process.
This implies that certain skills may be more applicable to these individuals than other holders of power. The reason these individuals are important is that they resolve information asymmetries that have prevented the groups from interacting on their own. Among the skills applicable to these individuals might be the ability to understand the culture of both groups; the ability to gain the trust and confidence of groups with perhaps different motivations; the ability to recognize the value that each group brings to the relationship; and the ability to resolve disputes among the groups.
8. How can there be several different cultures within the same firm? If this situation occurs, what are its implications for the relationship between culture and performance?

There are several different ways for a firm to have multiple cultures within its boundaries. First, the firm may have physical boundaries that prevent divisions from interacting with each other. For example, a firm that operates internationally will likely have a different culture in the U.S. than in South Korea. Second, the firm’s divisions or units may have differing motivations that create cultural differences. For example, a finance group may be very conservative as they focus on cutting costs, while research and development may be encouraged to take risks in order to find innovative new products. Finally, each group’s management may have influence over the direction of a firm’s culture. For instance, the appointment of a new marketing chief can change the marketing group’s culture from buttoned-down to freewheeling as a firm seeks to change its image.

Ultimately, culture can drive performance only to the extent that the culture reinforces the organization’s goals. When the goals of divisions are different, such as in the finance/R&D example above, differing cultures can allow each division to operate most effectively in its given realm. Thus, R & D and finance can each remain effective in their own environment.

9. Why is culture generally inertial in its effects on firms? Why is a firm’s culture difficult to engineer or change?
Ironically, the same reasons that a firm’s culture may contribute to its sustained competitive advantage are the same reasons a firm may find its culture creating a drag on its attempts to change during periods of difficulty. This is because a firm’s cultural influence is likely to depend on intangible factors that are not easily described and that represent the accumulated history of the firm much better than a description at any point in time. Barney identifies three factors that might allow a culture to be a source of sustainable competitive advantage. One of these is that the culture must be inimitable. Rivals will imitate a successful firm’s culture that is easily imitated and the advantage gained by the firm’s culture will be negated. However, a culture that is not easily imitable must be also be very complex. This complexity would make it very difficult for internal managers to modify the culture in a short period of time. A firm whose success is related to its culture will likely find a positive alignment between its culture and its goals. When those goals change (as when the firm finds its competitive environment changes), the accumulated history that goes into comprising a culture will take much longer to change. Therefore, the firm finds its culture to be inertial in its effects in that culture represents the accumulation of history and routines of the firm. This inertia also makes culture a barrier to change when changes might be needed that sharply diverge from the firm’s history and routines.
10. How can powerful individuals influence a firm’s culture? Do “superstar” CEOs really exert the influence on firms that is claimed for them in the popular business press?
A firm’s culture is a set of values, beliefs, and norms of behavior shared by members of a firm that influences employee preferences and behaviors. A more operational view is that culture represents the behaviors guideposts and evaluative critieria in a firm that are not spelled out by contracts but nonetheless constrain and inform the firm’s managers and employees in their decisions. According to Kreps “ culture…gives hierarchical inferiors an idea ex ante how the firm will “react” to circumstances as they arise—in a very strong sense, it gives identity to the organization.” Clearly the leader of the organization can have a significant impact on the “culture” of that firm as the individual most responsible for visibly exhibiting, extolling, demonstrating and explaining the behaviorial guideposts that make up culture. However, culture must be inculcated in the employees by more than just the CEO—so the CEO alone does not determine the culture of the organization. Furthermore, culture is credible only have years of persistence. Hence, it is unlikely a “superstar” CEO can come into a firm and reengineer its culture in a very short time frame. Furthermore, a positive culture is the result of an effective collaborative effort among many individuals in the firm – hence fully crediting the CEO (or blaming the CEO) is not appropriate.
11. Are the institutional logics in an industry simply the aggregation of individual firms strategies? To what extent do these logics constrain managers in how they make strategic decisions? Once firms in an industry or sector have arrived at common approaches to a business (made strategic investments supporting those approaches), what does it take to bring about industry changes?
Institutional logics are the interrelated beliefs, values, material practices, and norms of behavior that exist in an industry at any given time. It is difficult to give a general answer to this question, but an answer that contains specific examples and uses the terminology presented in the chapter is a good answer. It is sometimes possible to link changes in industry logics to specific external stimuli, such that some event can be seen as the cause of the industry change. In other industries, however, changes in industry logics occur as a result of multiple stimuli, without a clear external push. In these conditions, the institutional logics appear to change independently of external stimuli and then lead to further changes in industry practices.

Chapter 18
Strategy and the General Manager

Chapter Contents 1) Introduction 2) A Historical Perspective on the General Manager 3) What do General Managers Do? • Case Studies of General Managers • The Roles of the General Manager • The Tensions of Managerial Work • Changing Definitions of Managerial Work
4) Chapter Summary

Chapter Summary
This concluding chapter discusses the breadth of opportunity and responsibility for modern general managers. The general manger (GM) is both a problem-solver and a visionary. As a problem solver, the GM defines and manages the boundaries of the firm, sets a competitive strategy, and oversees the firm’s internal incentives, culture, and structure. As a visionary, the GM identifies a sustainable position for long-term success. GMs use both formal and informal means to accomplish objectives. While relying on qualitative analyses as much or more than quantitative analyses, they also rely on formal agendas and information networks. The GM may play one or all of several roles: entrepreneur, organizer/implementer, contractor, facilitator, competitor, and reevaluator/changer. Tensions arise when these roles require conflicting actions. GMs have to change their roles in response to changing technological, regulatory, and competitive conditions.

Suggestions to Teaching this Chapter
This chapter, more than most, lends itself to a wide-ranging class discussion. Students should be pushed to envision themselves as general managers and explore now the issues they will face in that role.

Job Audits
Can students predict the influence, roles and responsibilities of different jobs in specific organizations? What questions would students ask (in research or of recruiters) to determine the true nature of a position?

We list several roles of managers in this chapter. Do students think they could prioritize these responsibilities? For which of these roles will formal schooling prepare students? Where do managers learn all of the other skills?

1) Does a general manager have a job description? There are two schools of thought. Some believe every job can be described. If a position cannot be defined, it may not be real. The other belief is that the general manager does whatever needs to be done. If an employer can define the limits of a general manager's job, s/he isn't a general manager. What do students think?

2) Managers' salaries have skyrocketed in the last ten years, while average wage earners have seen little or no salary increase. Have the new roles and responsibilities of today's managers sore defined these jobs that the compensation for senior managers should be 100 times more than the average worker? Can there be a market-generated salary that is too high?

While beyond the scope of this endeavor, ethical situations are crucial issues facing managers of today's corporations. Students should explore their personal understanding of morality and ethical limits. We list below several readings that might supplement an ethics discussion.

Work/Life Balance
Most employees wrestle with how to balance family and career. The old saying goes that no one says on his deathbed, "I wish I had spent more time in the office." How much of an individual's happiness comes from the fulfillment of work or the material comforts of life? As senior management positions become more and more demanding, will students have to choose between a family and a high-powered job? If so, how would they make that decision? Will the demands on senior management change in a society dominated by dual career or single parent families? Should they?

Suggested Harvard Case Study[12]

The Lyric Dinner Theater HBS 9-386-057 A, B: These cases describe the efforts of Deborah Denenberg to affect the turnaround of this ailing dinner theater. As General Manager, she faces the problem of restoring the Lyric to profitability or having the business closed by its investors. Case A describes her efforts in the first six months on the job. Students should prepare a complete action plan for Denenberg. Case B describes the actions she took.

Peter Olafson HBS 9-475-025 A-E: This case series describes the problems facing a recent MBA graduate in his job as general manager of a cable television company owned by a parent corporation. Case A raises the issues of corporate divisional relationships and the difficulties facing an inexperienced manager who seems to be receiving little support. Case B is a one-paragraph case that adds to the data presented. Cases C and D focus on the strained relationship between the new manager and his bosses. Case E presents a description from the corporate president's point of view.

Extra Readings
The sources below provide additional resources concerning the theories and examples of the chapter.

Bailyn, L.. Breaking the Mold: Women, Men and Time in the New Corporate World. New York: Free Press, 1993.

Barnard, C. The Functions of the Executive. Cambridge, MA: Belknap, 1938.

Bennis, W. and B. Nanus. Leaders: The Strategies for Taking Charge. New York: Harper and Row, 1985.

Chandler, A. The Visible Hand. Cambridge, MA: Belknap, 1977.

Donaldson, G. and J. W. Lorsch. Decision Making at the Top: The Shaping of Strategic Decisions. New York: Basic Books, 1983.

Eccles, R. G. and N. Nohria. Beyond the Hype: Rediscovering the Essence of Management. Boston: Harvard Business School Press, 1992.

Gabarro, J. J. "When a Manager Takes Charge," Harvard Business Review, article # 85308.

Hill, L. A. Becoming a Manager. New York: Penguin, 1992.

Kotter, J. The General Managers. New York: Free Press, 1982.

Lawrence, P. R. and J. Lorsch. Organization and Environment.- Managing Differentiation and Integration. Homewood, IL: Irwin, 1969. -

Leavy, B. and D. Wilson. Strategy and Leadership. London, UK: Routledge, 1994.

Mintzberg, H. The Nature of Managerial Work. New York: Harper and Row, 1973.

Quinn, J. B. Strategies for Change: Logical lncrementalisrn. Homewood, IL: Irwin, 1980.

Selznick, P. Leadership and Administration. Berkeley: University of California Press, 1957.

On Ethics and Management, these resources make good teaching tools:

Friedman, M., "The Social Responsibility of Business is to Increase its Profits," New York Times Magazine, Sept. 13, 1970.

Goodpaster, K. E. and J. S. Matthews, Jr., "Can a Corporation have a Conscience?", Harvard Business Review, #82104.

Shleifer, A. and L. H. Summers, "Breach of Trust in Hostile Takeovers," University of Chicago Press article. United Technologies and the Closing of American Bosch, Harvard Business School Case #9-386-174, R.5/96.

[1] These descriptions have been adapted from Harvard Business School's Catalog of Teaching Materials
[2] These descriptions have been adapted from Harvard Business School 1995-96 Catalog of Teaching Materials.
[3] Based on 200 hours of work, Smith’s actual expenses ($60,000) were less than her original estimate ($75,000).

[4] These descriptions have been adapted from Harvard Business School 1995-96 Catalog of Teaching Materials.
[5] These descriptions have been adapted from Harvard Business School 1995-96 Catalog of Teaching Materials.
[6] If the innovator attempted to develop these assets from scratch, it is possible s/he would not succeed and/or the creation of these assets by the innovator would not be cost effective.
[7] These descriptions have been adapted from Harvard Business School 1995-96 Catalog of Teaching Materials.
[8] These descriptions have been adapted from Harvard Business School 1995-96 Catalog of Teaching Materials.
[9] These descriptions have been adapted from Harvard Business School Catalog of Teaching Materials.
[10] These descriptions have been adapted from Harvard Business School 1995-96 Catalog of Teaching Materials.
[11] These descriptions have been adapted from Harvard Business School 1995-96 Catalog of Teaching Materials.
[12] These descriptions have been adapted from Harvard Business School 1995-96 Catalog of Teaching Materials.







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