Chapter 8: Economics of Strategy Creating and capturing value

1. Chapter 8: Economics of StrategyCreating and capturing value Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture, 4th ed.

2. Creating and capturing valuelearning objectives Students should be able to • Distinguish between value creation and value capture and provide examples of each • Define transactions costs and apply to strategic decision making • Identify and provide meaningful examples of Porter’s “five factors” • Differentiate between industry and firm effects on organizational success

3. Strategy • General policies intended to generate profits • Choice of industry • Combination of products and services • Competitive and cooperative behaviors • Strategies evolve as circumstances change • Strategies must create and capture value

4. Transaction costs • Consumer transaction costs • product search • learning product characteristics and quality • negotiating terms of sale • enforcing agreements • Producer transaction costs • negotiating terms • legal expenses

5. Ways to create valuereduction of transaction costs

6. Value creation • Reduce production costs or producer transaction costs • shift supply curve to the right • Reduce consumer transaction costs • shift demand curve to the right • Shift demand to the right by other means • Devise new products and services

7. Pricing complementsexample • CompuInc produces personal computers • PrintCo produces complementary printer • Demand for each product is Q=12-(Pc+Pp) when (Pc+Pp)12, 0 otherwise • Profit-maximization yields reaction curves • Each will view its demand curve as

8. Noncooperative pricingCompuInc & PrintCo

9. Advantage of coordination • Failure to coordinate yields combined profits of 32 • Jointly setting MC = MR yields combined profits of 36 • customers better off as product prices fall, quantity purchased rises

10. Capturing value • Firms in competitive markets are price takers • Market power and superior resources can lead to economic profit

11. Market power comparison

12. Market powerPorter’s five forces • Potential rivals • Existing rivalry • Substitute products • Buyer power • Supplier power

13. Porter’s Five Forces Potential Rivals Upstream Downstream Current Rivals Buyers Sellers Substitute Products Value/supply Chain Competitive Environment

14. Superior factors of production • People • special talents or skills • Physical assets • prime real estate • unique equipment • But bidding for specialized assets may erode profits

15. Producer surplus captured by superior assets

16. Superior factors of productionagain • Team production • interdependencies among workers increase value beyond the “sum of the parts” • luck or foresight may endow firms with unique team production capabilities • Rivals may be unable to pinpoint source of advantage and unable to capture equivalent value

17. Increasing demand • Increase expected product quality • “value added” > cost increase • Reduce price of complements • Raise price of substitutes • limit entry of competitors

18. Other value-enhancing strategies • Introduce new products and services • Cooperation with other firms

19. Diversification • Benefits • Economies of scope • Promoting complements • Costs • Bureaucracy • Incompatible cultures

20. Diversification and management • Diversification for earnings volatility • may not increase value • Related diversification • can increase value • Capturing the gains • does the firm bring some special resource to bear?

21. Strategy formulation • Understanding resources and capabilities • physical, human, and organizational capital • Understanding the environment • markets, technology, regulation, economic conditions • Combining environmental and internal analyses • Strategy and organizational architecture

22. Framework for strategic planning

23. To think about... Can a firm capture value on a sustained basis? Discuss.