What is Economics of Strategy?

1. What is Economics of Strategy? • Economics of Strategy develops a set of guiding principles to apply so that one can conclude which strategies are best for which situations

2. Top News Stories: April/May 2008 • Mar’s Takeover of Wrigley Creates Global Powerhouse (WSJ 4/29) • Starbucks to Unveil New Drinks (WSJ 4/30) • Cablevision May Bid As Much As $650 Million for Newsday (WSJ 5/1) • Coke, Pepsi Bottlers Try New Sizes to Boost Sales (WSJ 5/2)

3. What is Strategy? • Planning and Directing to gain an advantage

4. What is Strategy? • Planning and Directing to gain an advantage • Planning involves not just simple decision making • allow for responses and reactions of others • involves a long range view

5. What is Economics of Strategy? • Economics concerns the costs and benefits of an action

6. What is Economics of Strategy? • Economics concerns the costs and benefits of an action • Economics emphasizes “analytical” over “functional”

7. What is Economics of Strategy? • Economics concerns the costs and benefits of an action • Economics emphasizes “analytical” over “functional” • Economics of Strategy analyzes the costs and benefits of a strategic decision

8. Costs and Benefits Example • If B(X) > C(X) , then do X Issues- opportunity cost, sunk cost, non-monetary issues, externalities, time value, risk

9. Organization of the Course • Internal Strategy • Production of a product or service typically requires a joint effort between resource owners • How do these resource owners deal with each other?

10. Organization of the Course • External Strategy • Production of a product or service is often undertaken by many competing firms • How do these competing firms deal with each other?

11. Chapter 3 The Vertical Boundaries of the Firm

12. The Vertical Chainof Tire Production • Raw Inputs • Intermediate Goods • Final Manufacturing • Warehouse Inventory • Distribute to the Final Consumer

13. Integration at Bridgestone-Firestone

14. Tires are the largest part of our business, accounting for approximately 75 percent of annual revenues. Bridgestone/Firestone, Inc. develops, manufactures and markets tires for almost every kind of vehicle. In fact, we sell more than 8,000 different types and sizes of tires - from a 13-foot-tall giant radial for earthmoving equipment to a kart tire that stands only 10 inches high. In addition to tires, Bridgestone/Firestone is recognized internationally for producing a variety of quality products, including air springs, building materials, synthetic and natural rubber, and industrial fibers and textiles.

15. We sell tires for passenger, light truck, truck, bus, off-the-road, agricultural, motorcycle and kart applications through more than 12,000 outlets, including independent dealers, discount retailers, warehouse clubs and our company-owned stores. We operate Firestone Tire & Service Centers, Mark Morris, Expert Tire and Tire Station retail outlets for automotive tires and service. Our GCR Truck Tire Centers serve the commercial trucking industry with truck tire service and retreading. Webco offers agricultural, forestry and flotation tire service and Cobre Tire services our off-the-road customers with tires and service for the mining and construction industries.

16. Make or Buy • Which activities should Bridgestone perform themselves and which should be outsourced?

17. What type of relationship should our Manufacturer have with other Resource Owners? • Employer- Employee (Firm) • Contractor-Client (Market)

18. Benefits of Using the Market to Obtain Needed Resources • Market firms can achieve Economies of Scale • Market firms are subject to the discipline of the market

19. Costs of Using the Market to Obtain Needed Resources • Coordination of Production may be compromised • Private Information may be leaked • Transaction Costs

20. Benefits of Using the Market to Obtain Needed Resources • Economies of Scale: As inputs increase by a given proportion, output increases by a greater proportion • Result: As output increases, average cost decreases

21. Returns to Scale • If increasing all inputs by a given proportion causes output to increase by the same proportion – Constant • If increasing all inputs by a given proportion causes output to increase by a greater proportion – Increasing (Economies of Scale) • If increasing all inputs by a given proportion causes output to increase by a lesser proportion – Decreasing

22. Cost Relationships • TC = f(Q) = wL + rK • MC = dTC / dQ (d= change in) • AC = TC /Q

23. Cost Relationships • If MC = AC, AC constant • If MC > AC, AC rises • If MC < AC, AC falls

24. Cost Relationships • As Q rises • CRS – AC constant • IRS – AC falls • DRS – AC rises

25. Cube-Square Rule • A 1 cubic foot oven has a surface area of 1X1X6=6 sq ft • If we double all sides, then surface area becomes 2X2X6= 24. Surface area (which dictates cost of the oven increases by factor of 22. • Volume of oven becomes 2X2X2 =8. Volume (which dictates productivity) increases by factor of 23.

26. Cobb-Douglas Production • Y = LaKb • If a+b =1, Constant Returns to Scale • If a+b < 1, Decreasing Returns to Scale • aka Diseconomies of Scale • If a+b > 1, Increasing Returns to Scale • aka Economies of Scale

27. Benefits of Using the Market to Obtain Needed Resources • Economies of Scale: Examples • Transportation of Intermediate Goods • Advertising a National Brand • Laundering Restaurant Linens • Payroll Book-keeping • Beer

28. Benefits of Using the Market to Obtain Needed Resources • Market Discipline: Survival of the Fittest • In the long-run, firms that do not operate cost efficiently will die. • Employees, however, may be be able to keep their jobs without being efficient (Agency Cost)

29. Benefits of Using the Market to Obtain Needed Resources • Market Discipline: Evidence • Baumol, Heim,Malkiel, Quandt (1970) found that Investments made out of new equity earned higher returns than investments made out of retained earnings • Grabowski and Mueller (1973) argue it’s not the source of funds that determines profitability but the market discipline

30. Benefits of Using the Market to Obtain Needed Resources • Market Discipline: Evidence • Manne (1965): Maybe it doesn’t matter - there is a market for corporate control • Inefficient management will be bought out and booted (at least in the long-run)

31. Costs of Using the Market to Obtain Needed Resources • Coordination of Production may be compromised • Painter waits for the drywaller • Drywaller waits for plumber and electrician • Plumber and Electrician wait for carpenter • Carpenter waits for concrete truck to pour the foundation

32. Costs of Using the Market to Obtain Needed Resources • Private Information may be leaked to: • Marketing Studies • Clinical Labs • Financiers • Suppliers

33. Costs of Using the Market to Obtain Needed Resources • Transaction Costs -

34. Transaction Costs • Example: • H contracts with Z to develop an input that H will use to produce product. The price of the input is agreed upon based on the amount of time they both feel that Z needs to complete the work

35. Transaction Costs • Example: • Z completes the work in the amount of time he thought would be necessary. H does not know how to properly incorporate Z’s work into H’s • Z now spends extra time assisting H

36. Transaction Costs • Example: • Z bills H for a price over and above the original agreement • H refuses to pay the extra arguing that Z agreed to have the input ready and the assistance was part of it

37. Transaction Costs • Completing Production of Our Product has three key problems • Strong mutual reliance among the resource owners

38. Transaction Costs • Completing Production of Our Product has three key problems • Strong mutual reliance among the resource owners • each party tries to maximize its own utility (before during and after the contract is written)

39. Transaction Costs • Completing Production of Our Product has three key problems • Strong mutual reliance among the resource owners • Each party tries to maximize its own utility (before during and after the contract is written) • Difficult to cover all possible contingencies and penalize shirking when writing the contract

40. Transaction Costs • Extra negotiations • Delays and Disruptions • Efforts by both parties to secure their positions

41. Complete Contract • Stipulates all rights, responsibilities • Considers all contingencies

42. Factors Preventing Complete Contracting • Bounded Rationality • Performance measurement • Asymmetric Information

43. Asset Specificity as a Source of Transaction Costs • Types of Specificity • Site Specificity • Physical Asset Specificity • Dedicated Assets • Human Asset Specificity

44. The Investment in a Relationship Specific Asset • Leads to a • FUNDAMENTAL TRANSFORMATION • of the relationship

45. Relationship Specific Assets • Example: 1920’s GM asked Fisher Body to build a body plant near its assembly line

46. Relationship Specific Assets • Example: 1920’s GM asked Fisher Body to build a body plant near its assembly line • Fisher refused - What if GM’s sales dry up, we’re stuck

47. Relationship Specific Assets • Example: 1920’s GM asked Fisher Body to build a body plant near its assembly line • Fisher refused - What if GM’s sales dry up, we’re stuck • Solution: GM buys Fisher body

48. Fisher Body’s Problem • Before the plant is built (ex ante) • Suppose Fisher must spend $40,000 to build the plant • Total Revenue: $100,000 • Variable Cost: 60,000 • Opportunity Cost: 40,000 • Economic Rent: 0

49. Fisher Body’s Problem • Once the plant is built (ex post): • Assuming that the plant (NOW BUILT) has no other uses: • Total Revenue: $100,000 • Variable Cost: 60,000 • Opportunity Cost: 0 • Economic Rent: 40,000

50. Fisher Body’s Problem • Once the plant would be built, GM knows that only $60,000 would be required to keep Fisher there • The $40,000 is ex-post “extra” that GM could try to renegotiate partly toward itself • Fearing it would be held-up, Fisher declined the offer