1 - Analysis of the Environment

Learning objectives:- How industry life cycle can transform competitive environment- Implications of life cycle for competitive strategy- Implications of five forces on strategy- User five forces to analyse context- Contribution and limitation of game theory- How strategic moves help gain advantage

1.1 Introduction 1/1

Rulebook for competitive strategy is not clear nor commonly agreed

1.2 Industries and the Life Cycle 1/3

Seek some position that is difficult or impossible to imitateUniqueness poses problem for analysisLifecycle analogous to biological organism

- But decline not inevitable or statistically predictable

Growth rate not passive, firm may influence:- Pricing strategies in the introductory phase (penetration, skimming)- Life cycle stretching and renewal (innovation and marketing improvements)

Some cycles more erratic than others- Professional wrestling, cinema have had multiple wax/wane phases

1.2.1 Critical turning Points- A – growth begins to slow

o If unexpected then there will be overcapacity due to overproductiono => destructive competitiono Even wise firms may still be under pressure

Rivals continue to invest Difficult to identify timing Intensified competition, price wars, market share

o Start of shake-out phase- B – market growth ends

o Could be zero growth or simply same growth as economyo Increased growth only by increasing market share

Decrease number or rivals or their share- C – market growth negative

o Maintain current levels only by taking market shareo Fierceness of struggle depends on how many firms exit

Turning points are almost impossible to predict

1.2.2 The Stages of the Life Cycle

Growth Stage- Relatively low price elasticity of demand for each brand

o Limited substitutability; user unfamiliarity- Relatively high price

o Problems: profit signal (to prospective entrants), slow growth, delay economies of scale, experience curve

- High level of advertising to create demando Informative then persuasive

- Profits low initially then increasingo Ability of firm to sustain a loss is important

- Variety of product designs- Radical product and process innovation- Major demands for new investment

o Equipment; human (training)- Frequent bugs and defects- Capacity shortages

o Buyers may vertically integrate backwards- Easy of market entry- Few firms- Patchy or limited distribution

Maturity Stage- Increasing price elasticity of demand

o Informed consumers, increased competition, standardisation- Falling price

o Economies of scale, experience curve, process improvements, competitive pressures- Brand advertising important- Profitability begins to decline- Increased standardisation

o Erosion of patent protection, better information on best design/practises, tightening competition- Incremental innovation, emphasis on process innovation- Replacement investment- Improved quality / reliability- Capacity matches demand- Entry more difficult / less attractive- Many firms- Well established distribution channels

Decline Stage- May be triggered by external event (e.g. technological substitution) or government regulation- High price elasticity of demand- Falling prices- Lack of differentiation and growth reduces need for advertising- Low profits- Further standardisation- Little innovation, investment- Overcapacity- Unattractive entry- Fewer firms- Distribution increasingly important- Porter: strategies in decline

o Dominance and leadership High market share may lead to cost advantage Credible commitment (investment, aggressive pricing)

o Niche exploitationo Harvest

Cut investment, maintenance, serviceo Exit

Best before decline sets ino Internalise threat

Need residual strengths and competences that contribute to competitive advantage in new regime

1.3 The Five Forces Framework 1/15

Prior to framework strategic management was based primarily on checklists and case studies

Considerations- Framework is not static but evolving- Doesn’t lead to clear and unambiguous conclusions, integrates major influences some quantitative, some

qualitative- After identifying forces clearly, still variety of competitive strategies possible

1.3.1 Threat of Entry- Economies of scale

o Minimum Efficiency Scale (MES) – point at which firm achieves lowest average cost (AC)o Cost gradient: steepness of slope of average cost (versus output)o High MES (high hurdle) and steep gradient (big advantage) => strong entry barrier

Natural monopoly (possible to separate ownership from operation, e.g. telco, rail)- Economies of scope

o “Synergies”o Increased output can lead to fuller exploitation of indivisible resources (plant)o Opportunities for specialisation and direction of labouro Shift down long-run AC cost curve for each product (scale economy move along curve)

- Experience curveo Unit cost falls in relation to accumulated outputo E.g. complex technological products

- Differentiationo Strongest barrier in areas of health, safety and welfare

- Risky and costly capital requirementso Plant & Equipment, Intangibles (Research & Development)

- Switching costs

o Loyalty cards, air miles- Access to supplies and suppliers- Other cost advantages

o Patented low cost process, ...- Government policy

o Regulated industries, licensed operators- Exit barriers- Expected retaliation

1.3.2 RivalryMultiple dimensions

- Objectives: profitability, market share, growth- Channels: price competition, advertising, innovation- Strength: weak/strong

Factors:- Relatively high fixed costs => marginal costs relatively low- Low growth => zero sum game- High exit barriers => no escape route- Weak differentiation and switching costs- Absence of dominant firm

1.3.3 Bargaining Power of Buyers- One or few major buyers- Buyers earn low profits

o May be signalling low profits to sellers- Product is high proportion of buyers’ purchases

o Increased price sensitivity- Standardised product, low switching costs- Buyers’ threat of backward integration

1.3.4 Bargaining Power of Suppliers- One or fewer suppliers- No close substitutes- Product is important input to buyers’ business- Buyer is not an important customer- Supplier products are differentiated- High switching costs- Supplier threat of forward integration

1.3.4 Pressure from substitutes- Similarity of function- Price/performance characteristics

1.4 Game Theory Perspectives 1/30

1.4.1 Prisoner’s dilemma

Associated with variety of strategic situations- Advertising- Pricing- Innovation- Investment

Theoretically sound but uncommon in realityPreconditions:

- Simultaneous decision-making- Accurate knowledge of pay-offs- No communication- No social ties and obligations- No history: no past or future (one-off decision)

Even when situation looks superficially like prisoner’s dilemma actual behaviour often different than predicted- Repetition, familiarity, negotiation, trust, loyalty, kinship, social pressure, personality

Caution against game theory models but valuable lessons from reasoning

1.4.2 Strategic Moves

Intended to alter beliefs and expectations of others in a favourable directionCentral issue in game theory: Credibility (e.g. empty threats and promises)Means of achieving intangible asset of credibility:

- Reputation – communicating a determination to protect reputation at all costs- Contracts – difficult to specify fully, room for misrepresentation

- Specialisation – deliberately restricting options (burning your bridges)- Investment – form is important: sunk costs- Incrementalism – build up credibility/trust over time- Hostages – cooperative agreements, decrease opportunistic behaviour- Social context – range between diamond dealer and Hollywood producers...

1.5 Conclusions 1/39

2 - Strategies for Competitive Advantage2.1 Introduction 2/1

Scope for designing and developing competitive strategy in practice

2.2 Generic Strategies 2/2

Strategies have large variety of objectives and outcomes. - Some not directly related to profitability, but may help anticipate problems

o Vertical integration (protect against being cut off from suppliers)

Three generic strategies (Porter)- Cost leadership- Differentiation- Focus (niche)

o Cost focus / Differentiation focus

Problems in implementation:- Trade-off between cost and differentiation

o Seek parity/proximity with competitors that are not sources of competitive advantage- Stuck in the middle

o Confusing message to customer in case of multiple strategies- Single cost leader- Sustainability

o Continual adaptation and innovationo Entry barriers

2.3 The Value Chain 2/4

Breakdown of firm into component activities - Actual or potential sources of competitive advantage- Applied at SBU level- Physically and technologically separable activities- Identify activities with impact on cost or differentiation

Generic Value Chain:- R&D, Production, Marketing, Distribution- Look at linkages within chain to determine competitive advantage- Look at linkages between chains to see if shared activities can contribute value- Links to value chains of other firms:

o Vertical: suppliers/buyerso Horizontal: collaborative arrangements with other firms

Clusters:- Vertical/horizontal interactions of geographically concentrated firms

Caution: mechanistic trawl may miss crucial activities- May look mundane individually, value is in interactions

Capabilities:- Sets of related activities where firm does relatively well- Analysis does not rely on bottom-up approach- Should be firm specific, difficult to imitate- Should not be application specific (reusable in other market contexts)

Problems with simplistic approach:- Competitive advantage may reside in entire value chain, not compoenents- Identified capabilities may be too general (e.g. Innovation)

- Highly subjective- Competence can turn into liability (obsolescence)- Industry capabilities (e.g. oil firms successful but not unique)- Distinctive capabilities provide few direct lessons

Vertical links shift intermediate product Horizontal links share resources

Value chains with many strong horizontal links between them may be treated as single chain

Divisional structure: appropriate when value chains are independentFunctional structure: may be more appropriate when there are significant linkages

Resources may have dual role- Within value chain (vertical links to other resources)- Connection with other value chains (horizontal)

Hybrid- Example three values selling to same market: divisional structure with combined Marketing- Problem in recognising profit

Matrix widely adopted by large diversified firms

2.4 Cost Leadership 2/10

Cost drivers:- Economies of scale- Learning and experience curve- Capacity utilisation

o High degree of price discrimination (e.g. airlines)- Vertical links in value chain- Horizontal links with other value chains – economies of scope- Timing

o First to market versus learning from others’ mistakes- Location

o Land, labour, capital costs- Government regulation, taxes and subsidies- Discretionary policies

o Direct sales, limiting product variety, standardisation- External economies

o E.g. well-qualified labour pool in area

Cost leadership more sustainable when standardised product combines with economies of scale, and experience curve

- High market share- Attract and retain buyers on basis of price. Most likely:

o Early stages: first mover advantageo Later stages: high price-elasticity

Game theory:- Credible threat that leader will maintain strategy irrespective of competitor actions- Dominant strategy must be visible to competitor

o Credible commitments (e.g. shut down R&D, reduce product variety, move production to low-cost location)

Porter steps to cost analysis:1. Identify value chain and elements2. Identify relevant cost drivers3. Identify competitor value chains, costs, advantages4. Develop strategy to reduce costs5. Guard against eroding differentiation6. Test for sustainability (competitor emulation)

2.5 Differentiation 2/17

2.3.1 Sources of Differentiation

- Policy choiceso E.g. Kelloggs doesn’t allow rebranding

- Linkageso Just-in-time (Kanban)

- Timingo Early entry: Hoover

- Locationo E.g. bureaux de change in airport terminals

- Interrelationships with other value chainso Share cost elements, reputation

- Learningo Quality, reliability, service

- Vertical integration and controlo Control over reliability and quality

- Scaleo E.g. Interflora

Reduced indirect costs for buyer:- Long-life bulbs, batteries (replacement)- Corner shop (location)- Car leasing (breakdowns)- Chopped wood (effort)- Interior design (reduced search costs)

Kinds of purchase criteria (Porter):- Use criteria: actual impact on buyer performance or cost

o Can be intangible (style, prestige)- Signalling criteria: inferred quality

o Advertising: Advertising spend is a crude indicator of quality (credible commitment)

Asymmetric information- Adverse selection: distorts trading in favour of sellers who misrepresent- Lemons:

o If product of variable quality ando Buyers cannot distinguish quality, theno Market will be dominated by lemons

Market will underestimate real worth of superior products and sellers will remove from market

o Complex, non-standardised product of variable qualityo Trading relationship is occasional or one-off

- Mechanisms to offset Lemons problemo Reputation and word-of-mount recommendationso Warranties and guarantees

Signal quality, but guarantee may also be lemon (restrictive clauses...)o Industrial and professional associationso Brand name recognition

Chains and franchisingo Consumer guides and reviews

May be subjectiveo Intermediaries

Professional expertise – may also be lemono Government

Licensing, regulation, anti-trust policy

2.5.3 Steps in differentiation- Identify relevant buyer- Identify firm’s impact on buyer’s value chain- Identify buyer’s purchase criteria- Identify actual and potential sources of uniqueness- Identify cost of actual and potential sources of differentiation- Assess benefit versus cost of differentiation alternatives- Test for sustainability- Reduce costs that do not affect differentiation

2.6 Focus 2/26

Strategy depends on differences between segments of same market- Start with needs of segment- Tailor strategy- Optimise value chain for segment- Strategy may refer to entire firm or part of firm

o Advantages of firm-wide focus Whole value chain can be dedicated

o Disadvantages Limited opportunities for economies of scope

Limited growth opportunity Vulnerability to external threats

o Usually just part of firm Still links with other value chains

Focus should add value (linkage to other value chains) or else it may be destroying value- Fallacy of free focus

o Opportunity cost of managerial and financial resources- Linkages cost

o Cost of coordinationo Cost of compromise (quality signals)o Cost of inflexibility

Difficult to divest of close down an unprofitable business

2.7 The Dangers of Hybrid Strategies 2/30

Not advisable to pursue both costs advantage and differentiation strategies in same segment (Porter)- Incompatible demands on firm- Worst outcome is to transfer inappropriate competencies into both sides of the market

o False economies on quality-conscious end; unnecessary differentiation for cost-conscious segmento Mixed strategy must at least set up distinctive unitso Some opportunities

Competitors are also stuck in the middle Cost is strongly related to scale First to innovate

2.8 Conclusions 2/33

3 - The Evolution of Competitive Advantage3.1 Introduction 3/1

Fallacies:- Innovators must be first with new idea- Inferior products will lose in the market (survival of the fittest)- If you can convince public that product is good and affordable they will buy

o E.g. network effects

3.2 The Innovative Process 3/3

Invention: act of devising/creating new ideaInnovation: commercialisation of the idea

- Product innovation: new good or service- Process innovation: development of new production technique

Research and development- Articulable knowledge: can be sent down a telephone wire (e.g. specifications- Tacit knowledge: built up through experience, experimentation, learning (how to ride a bicycle- Basic research: no specific commercial objective- Applied research: directed commercial targets (products/processes)- Development: conversion of research findings into actual products/processes

Virtual / vicious circles protect successful design - and prevent better design from challenging leader- Economies of scale- Learning effects- Network effects

Network effects: raise question of bootstrap:- Expectations- Sold below cost initially- Small user groups with strong need for connection

3.3 The Characteristics of the Innovative Process 3/6

Specificity: range of eventual commercial outcomes (products/processes)- Low degree of specificity may provide high degree of synergies- Externalities: benefit/cost that impacts someone else (e.g. competitor)

- Apprpriabjlity: ability for inventor to retain control

Uncertainty (whether project will solve problem, market will materialise, production will be cost-effective)- Reduced with fixed target, budget- Typically cumulative (reverse chronologically)

Timing- Delays cumulative

Cost of stage- Costs typically rise as development proceeds- Scale models, prototypes

Cumulative cost- Total (remaining) cost of a project being commercialised

3.4 Why Innovation can be Squeezed off the Firm’s Agenda 3/10

Hurdles (in M-Form, which is most common for large organisations)1. Appropriability problems: if benefits accrue to rival then may represent a net cost2. Neglect of potential internal spin-offs: rivalry between divisions, capital budgeting prioritisation3. Duplicated research efforts: M-form encourages compartmentalisation4. Uncertainty: risk avoidance means downside risk weighs more heavily than upside

- Also median may be much lower than the mean, distorting the expected value5. Cost: capital budgeting restrictions6. Long time horizons: managers judged on short-term performance7. Asymmetric information: scientist know more than management

- But gross underestimates, misaligned objectives8. Machiavelli’s problem : those who profit from old order will oppose the innovators, supporters tepid9. Compartmentalisation and need for integration

U-form even worse:- More specialised means spin-offs will benefit others- Smaller means less likely to afford up-front development costs

Must find balance between creativity and control

3.5 Solutions 3/16

Solutions in one dimension (e.g. reduce uncertainty through evaluation) may exacerbate others (delays)- Most obvious price to be paid is managerial time

1. Conduct R&D In-houseo Keep secret to avoid appropriability problems

2. Internal funding of R&Do Avoid capital market (appropriability)o Improper external valuation: asymmetric information, uncertainty, long-time horizons

3. Corporate level R&Do Enable spinoffs for other division, avoid duplicated research, absorb failures, long-time horizonso Problems:

o Difficult to evaluate divisional performanceo Distance from market means less sensitivity to opportunitieso Divisional managers less aware of technological developmentso Unfocused entity with disparate expertise

4. Top-down budgetingo Fund allocation using rank orderingo Address unmeasurable uncertainty, long-time horizon, principal-agent problem

5. Split the R&D functiono Research: corporate; Development: divisionalo Difficult to coordinate and integrate R&D activity

6. Split budgets for operations and innovationo Solution to: spin-offs, uncertainty, high-cost, long-term, Machiavelli’s problemo Problem: divisional managers still inclined to spend more effort on short-termo Problem: muddles assessment criteria

7. Targets for new product generationo Similar to 6 but focus on outputs rather than inputs

8. Parallel R&D approacheso In some case additional effort may reduce timeo Balance of cost versus long-time horizon

9. Second-in strategieso Turn appropriability into an opportunityo Accelerated research programme to catch up to leadero Reduces uncertainty and high cost.

10. Licensing and joint ventureo Smaller firms can innovate more easily (Machiavelli’s problem) but larger firms have more

resources for commercializationo Problem: managerial and transaction costs

11. Research clubo Deeper pocketo Administration costs, inconsistent objectives, anti-trust

12. Corporate diversificationo Larger firms can absorb cost, delays and uncertainty more easilyo Outcomes are often unpredictable => diversified firm can leverage more easilyo Problem: loss of focus

13. R&D diversificationo Multiple simultaneous projects spreads uncertainty risko Economies of scopeo Problem: cost

14. Matrix organisation - Divisional and Research reportingo Cross-divisional spin-offs while eliminating research duplicationo Problem: confusion of lines of responsibility

15. Organic structureso In contrast to rigid hierarchies, formalised M and U structures with demarcated taskso Encourage flexible responses, lateral communication, minimal job differentiation, o Trade-off between imposing control and stimulating creativity

16. Quasi-autonomyo Spin-off team with idea into separate companyo Problem: reduced control of parent company

17. Product championso Counteract natural tendency toward organisational inertia, overcome departmentalisationo Difficult to institutionalise; can only create favourable environment

18. Fixed-price versus cost-plus R&D contractingo Transfers uncertain between R&D and funding organisationo Often customer (e.g. government) can accommodate risk more easily

19. Public funding of basic researcho Appropriability, uncertainty, long-time horizons: strong disincentives for private firmso Still some incentives: scientist fulfilment, serendipity (unexpected commercial applicability)o Delays from basic to applied research are shortening

3.6 Conclusions 3/32

4 - Vertical Links and Moves4.1 Introduction 4/1

Interest in vertical integration is only recent but one of the most dynamic topics in strategy.

4.2 Defining Vertical Relations 4/2

Shift or transfer of some intermediate product between states in the value chainVertical relations are compulsory, horizontal are optionalCan involve firms in activities that are very different from core businessThere may be some discretion over supplier (cost versus quality) and customer (international or home market)

Range of relations:- Spot market- Long-term contract- Vertical integration- Franchising- Tapered integration – mixed market exchange and vertical integration- Vertical quasi-integration – long-term contract with dominant partner- Value-adding partnership – cooperation by independent companies

Two categories: market exchange, organisation within firmForms of relationship: Mixes of contracts and administrative devices

4.3 Trends in Vertical Relations 4/6

Lead US, early 20th century, food and drink, forward integration (marketing and sales), and some backward integration

Expanded to: Oil, rubber, electrical machinery, primary metals, instruments- High volume, capital intensive, needed coordination and scheduling of input/output flows

Less integration in: furniture, paper, printing, leather, lumber, apparel, textiles- Labour intensive, product variety, shorter production runs

IBM: semiconductors to services

Complementary forces drive toward outsourcing:- If activities are standard then competition will eliminate excess profits- Firms need wide variety of inputs/services to operate. Focus managerial resources on core competencies

4.4 What Vertical Integration is Not 4/8

Not justified because potential acquisition is profitable- Profitability will be reflected in market valuation

Not obviously anti-competitive- As long as there is competition at each stage

Not justified solely on technological grounds- Technological interaction (stealmaking/reheating) does not preclude a business boundary- Transaction cost rather than technology is important

4.5 The Costs of Markets 4/10

Two forms of costs- Firms acting in own interest against contract partner- Reliance on market exchange

4.5.1 The Invisible Hand and Some Problems

Invisible hand of resource allocation (Adam Smith)Problems:Inelastic demand/supply curves (demand and supply vary little with price)

- E.g. commodity market- Problem: instability: small change in demand/supply will lead to price volatility

- Solution: Forward integration by sellers / Backward integration by buyers- Disadvantage: locks firm into internal arrangement when market exchange may be better (change in other

direction)

Vertical integration replaced continuous market bargaining with planning and administrative process4.5.2 Visible Relations and the Market

Suppliers of specialised components/productsTransaction costs:

- Search for trading partner- Negotiate deal- Monitor/police agreementAlso potential loss of intellectual property

Transaction cost economics:- Bounded rationality – individuals have limited knowledge and cognitive abilities- Opportunism – individuals may cheat/misrepresent- Asset specificity – some assets have little use outside present application

o Site specificity - physical assets cannot be redeployedo Physical assets specificity – e.g. moulds for statueo Human asset specificity – skills/knowledge not easily transferredo Dedicated assets – expanding plant for particular buyer

Hold-up problem- Once buyer and seller have built equipment (committed to transaction) may be vulnerable to hold up- Even contract may not be sufficient protection

o Court settlements are costly and lengthy- Combination of factors is problem:

o No Bounded rationality – would know whom to trusto No Opportunism – would be sensible resolutiono No Assets specificity – would be able to withdraw and find alternative

- Dangers greatest when only one party suffers from asset specificityo First glance: most favourable when firm not exposed to asset specificity but partners are

But: hard to find partner without robust contracts/guaranteesFundamental transformation – the reduction from a large number of partners (e.g. suppliers before contract)

Hold-up strategy- Increases profits at expense of reputation- Good short-term tactic but possibly disastrous long-term implications- Attitudes toward opportunism may vary between sectors, regions- Not necessarily always extreme case of extortion

o Potentially just different prioritisation of objectives

Solutions to hold-up- Repeated contracting: same preferred partner

o Advantage: other party will be conscious of potential loss of future contractso Disadvantage: reduces flexibility

- Exhaustive contracting: tighten contracto Expensive, only partly effective, legalistic climate

- Standardised assetso Advantage: readily available alternativeso Disadvantage: loss of distinctiveness

- Hostages:o E.g. penalty clauses for late completiono Multiple transactionso Advantage: threat of retaliationo Disadvantage: lock-in, less choice

- Multiple sourcing:o Advantage: Reduce asset specificityo Disadvantage: multiple contracts => increased costs

- Vertical integration: internal expansion, merger, acquisitiono Advantage: synchronised and aligned objectives

- Tapered integration: partial integration (produce and purchase)o Advantage: limits threat of hold-up; increased competitive incentive for internal organisationo Disadvantage: sacrificed economy of scale; two separate organisation methods

4.6 The Costs of Vertical Integration 4/23

Most obvious alternative to market exchangeAdministrative costs of bureaucracy:

- Difference competences: sacrificing gains of specialisation- Dangers of specialisation: vulnerability increased through additional dependency

- Lack of flexibility: in choice of sources and outletso Insulated from competitive pressures but inefficient and anti-competitiveo Industry wide vertical integration (silos) may impede entry of better performerso Not fit to deal with radical changes when they do occur

- Sacrifice economies of scale (of target)- Dampened performance incentives

o Guaranteed future irrespective of performanceo Principal-agent problem

- Large sizeo Indivisibilitieso Vertically integrated system may not be watertight

- Vertical integration with rivalso Bounded rationality & opportunism

Rival will expect to be at disadvantageo Vertical integration may spread once triggered

4.7 Choice of Strategy 4/28

4.7.1 Features Encouraging Market Alternatives

1. Stable and predictable demand and supply conditions2. Standardised product3. Many firms at each stage4. Few other vertically integrated firms5. Transaction-specific investments not required6. Well established and widely distributed knowledge of technology7. Slow-changing or static technology8. Easy to monitor contractual obligations being fulfilled9. Little chance of being cut off from supplies or inputs10. Different scales of production necessary at each stage11. Different competences required at each stage12. Reputation important in this sector13. High chance of repeated buyer–seller relationship

4.7.2 Features Encouraging Vertical Integration

Not sufficient for transaction costs to exist:- May be possible to patch up market alternative (e.g. with solutions to hold-up problem)- May still be cheaper than administrative costs of vertical integration

1. Unstable unpredictable demand and supply conditions2. Differentiated product3. Few firms, at least at one stage4. Few firms not vertically integrated5. Transaction-specific investment required6. Technological knowhow concentrated in pockets in the sector7. Rapidly changing technology8. Difficult to check that contractual obligations are being fulfilled9. Real fear of being cut off from supplies or inputs10. Similar scale of production necessary at each stage11. Similar competences required at each stage12. Difficult to establish or maintain reputation and trust in this sector13. Low possibility of repeated buyer–seller relationship

4.8 The Varieties of Vertical Relations 4/30

Often expressed as: Make or Buy

Production transactions- Higher degree of assets specificity => higher probability to make

R&D transactions- Control required to prevent leakage of non-specific items and- Control focus of tasks to specific requirements

Advertising transactions- Incentive to in-source: high specificity, hold-up problem- However: also specific competencies

4.9 Conclusions 4/32

Review Questions 4/32

5 - Horizontal Links and Moves5.1 Introduction 5/1

Limits to vertical integrationCentral concepts to horizontal integration

- Value, efficiency, opportunity cost- Principal-agent problems, transaction costs, value chains

Lifecycles apply to people and products, not necessarily to firmsMost large firms survive

- Most are not conglomerates- If they are they tend to stay

5.2 The Diversification Game 5/3

Diversification is both a direction and a method- Direction: horizontal- Method: internal organisation rather than agreements

5.2.1 Horizontal Directions in the Diversification Game

Rule 1: Competitive advantage- Move mush shift at least one demand curve or one cost cruve to add value

Rule 2: Only one move at a time- Limited managerial resources

Rule 3: Fair play- No dominant position (monopoly control)

More gains through rich linkages at multiple points in value chain- Distribution, marketing, production, R&D- E.g. Duopoly => monopoly: higher price using less resources- Specialisation – linkage of all elements in value chain

5.2.2 Preferred Moves in the Diversification Game

Resource Effects- Specialisation best- Avoid unrelated diversification (opportunity cost)

Market Power- Specialisation best- Market linkage: Influence over retailers

Allergic reactions- Resources come in bundles (strategic planning team, marketing team plant facility)

o Difficult to separate elements to share- BIC diversification into perfumes; gourmet/fast-food => improve cost, damage image- Porter: Failure of synergy in corporate expansion

Rivals’ valuation- Rivals may value business more highly => excessive acquisition cost

5.2.3 Methods of Expansion in the Diversification Game

Same benefits through cooperation:

Market power: cooperative agreement- Anti-competitive regulation- Partner trust- Diluted control- Transaction costs

Expansion of single link (e.g. advertising):- Limits transaction costs to that link- Reduced risk of allergic reaction

Diversification- Allergic reaction costs increase the less related the firms

Co-operation

- Transaction costs increase the more related the firms

5.3 Why Diversify? 5/135.3.1 Market PowerDominance versus suppliers/buyers clear a benefitDepends also on other circumstances:

- Attitudes of firm- Other players- Potential entrants- Government regulations/intervention

5.3.2 SynergyCost savings through resource sharing

- Economies of scope- If businesses are similar there may be economies of scale- Indivisibilities

o Increased resource utilisation (machines, workers)o Specialisation

Individuals can specialise in area of expertise Reduced transition costs from switching Improved learning

- Spreading competencies/capabilities across more activities- Larger firms:

o Resource sharing or tangible products (plant and equipment) less importanto Intangible resources (managerial capabilities) more important

5.3.3 User Gains

Cost advantage- E.g. one-stop shopping

Differentiation- E.g. product compatibility

User gains lead to differentiation advantage that allow it do sell at premium

5.3.4 Internal MarketsInternal markets for Labour, R&D...Advantages over external markets:

- Asymmetric information- Control of opportunistic behaviour- Divisionalisation gains

Conversion from Unitary Form to Multi-divisional structureo Creation of profit centreso Collecting resources with coordination needs into unitso Separation of strategy formulation (HQ) and functional responsibilities (SBU)o Disadvantages: principal-agent problems

Opaque performance: concealed in consolidated accounts Lock-in: impedes reallocation of assets; artificial support of obsolete businesses Not-invented-here syndrome: less value placed on ideas from other businesses

- Internal capital marketo HQ has advantages over external market in: information, control, dvidisionalisation

5.3.5 Growth

Principal-agent problem- Shareholders want to maximise profits- Managers want to maximise growth

5.3.6 Risk and UncertaintyDiversification clearly reduces riskBut:

- Opportunity costs (versus related diversification)- Owners may spread business risks by diversifying portfolios

o If managers pursue risk spread => principal agent problemSimpler solutions to volatile sales:

- Liquid assets: smooth out sources of funds- Short-term finance- Stockholding: absorb surplus production during slack periods

- Insurance: not sales directly but events causing fluctuations- Long-term contracts: with buyer/retailer- Vertical integration: forward

Solutions are not free but allow firm to concentrate on core competencies

Risk of disruptive surprise (e.g. new substitute)- Linkages generate enhance value in stable environment but can be source of joint weakness in crisis- Diversification reduces risk

o Why not specialise until forced to change? Worst time to switch when forced

o Can corporate diversification also be in interest of owners (as well as managers)? Transaction costs of bankruptcy

o How can management know when to diversify? Difficult to anticipate future threats but possible to recognise environment where likely

But not always

5.4 Forms of Diversification 5/30

Most evidence suggestion expansion into closely related business most effective

Related-linked: (Richard Rumelt)- Combine linkage gains with risk-spreading of multiple markets/technologies

Forms of disruption:- Innovation: new products/processes- Change in consumer tastes: fashions, sports fads, health scares

o Often triggered by technological innovation- Changes in government restrictions: safety, deregulation, privatisation- Resource deletion

Innovation most important source

Attack on business (i.e. product) less severe than attack on competenceLinkages create shared vulnerabilitiesConglomerate most resistant to disruption

Related link: advantages of related diversification wiout dangers of exposure to single external threat- The more links the less exposed

Conglomerates usually exist for:- Synergy, deep-pocket, market power, or to absorb individual business risk- Related diversification (especially related-linked) can usually match/outdo

Reasons for conglomerates:- Disguised related-linked- Restructuring of related-linked (e.g. initially related-linked but linkages very fragile, divesture of central

element)- No alternatives: some industries such as tobacco and petroleum- Rapid growth objective- Path dependency: once conglomerate it may be expensive (transaction cost) to shift- Conglomerate focus: Adapted strategy after partial failures

o Divest unprofitable businesseso Pursue related diversification of remaining businesseso There may be some disconnections: e..g independent groups of related businesses

5.5 Conclusions 5/39

Review Questions 5/39

6 - International StrategyInternational: serves foreign marketsMultinational: locates operating facilities abroad

Dunning: with exception of oil companies, most giants:- Located most assets in home country- Most sales in home country

Not necessary to be multinational to be extremely successful

6.1 The Diversification Game Goes International 6/3

Expected links from internationalisation:- Few: no shared production. separate distribution channels, separate markets- Potential with R&D- Poor comparison with domestic specialisation

Export:- Economies of scale from further expansion- Administrative economies compared to multinationalism- Resource costs: cheap labour- Transport costs: significant volume or weight

Market saturation- But why not related diversification

6.2 The Question of International Competitiveness 6/6

Factors, but neither necessary nor sufficient conditions:- Exchange rate (counterexample Germany)- Cheap labour (counterexample Sweden)- Cheap natural resources (counterexample Japan)

Countries do not compete, firms do (Porter)- For a given country, few industries perform well internationally- For a given industry, few countries perform strongly

Successful companies often come from countries with tough competitive environmentDilemma for standard economics:

- Space: territories are not isolated- Time: Standard economics long-run doesn’t consider technological upheavals

6.3 Porter’s Diamond Framework 6/9

Diamond: Factor conditions, Demand Conditions, Linked and related industries, Firm Strategy

Analysis in space and time:- Space: Home base exerts influence over each category; Cluster: typically smaller than nation, e.g. region,

city, even street- Time: Long time frame; innovation and organisational changes may be very disruptive

Factor Conditions- Degree of sophistications

o Basic factors: Natural resources, unskilled labouro Advanced factors: research scientist

- Degree of specialismo Generalised factors: village hallo Specialised factors: brain surgeon

- Selective factor disadvantage stimulates innovation to deal with problematic factoro E.g. Japan: ideographic language => faxo E.g. Sweden: short building season =?prefabricated buildingso E.g. US: great inter-city distances => telephone, railway, aircraft, caro Converse: US: Low fuel price => fuel-inefficient carso No guarantee, not all factor disadvantages are converted into competitive advantage

Difficult to forecastDemand conditions

- Paramount role of home market

o Strategic planners are based in home marketo Home market dominates quantitatively and qualitatively

- Main features (Porter)o Composition of home demand: pressures and opportunities

Segment structure of demand: distribution and variety of patterns of demand Existence of sophisticated buyers Anticipatory buyer needs: early warning system, experience, trends

o Demand size and pattern of growth Size of home market: economy of scale, learning curve Number of independent buyers: variety of information and market feedback Rate of growth: possible entry of innovative firms Domestic market saturates early: fierce rivalry

o Internationalisation of home demand Mobile, international buyers Influence on foreign needs

Linked and related industries- Internationally competitive industries/sectors don’t emerge in isolation

o Associated with other industries/sectors that are vertically or horizontally related- Spill-over benefits

o User sector firms imposing high specifications on supplier sectoro Reputational spill-overso User sector firms demanding cost competitiveness from supplier sectoro Supplier sector protecting their brands by raising user sector performance.o Technology spill-overs between related sectorso Related sectors sharing marketing and distributional channelso Spill-over of highly trained and well qualified labour pool between sectorso Best practice diffusion by example and observationo Proximity reduces transaction costs between sectors.

Firm strategy, structure and rivalry- Fukuyama: Trust can be important influence on economic activity

o Japan: Trust well distributed => diminishes principal-agent problem => larger firmsto China: Family/kin => favours family-owned businesses

- Strategy and structure of domestic firmso Germany: technical skills => optics, chemical, machineryo Italy: family/kin emphasis => fragmented sectors, e.g. furniture, footwear, woollen fabrics

- Goals and objectiveso Level of individual, company, nationo Germany: risk averse => emphasis on mature industrieso US: risk-friendly => start-ups, sectors with start-ups (e.g. biotechnology)

- Domestic rivalryo Competitive pressureo Visible examples of best practiceso Silicon Valley, Hollywood, Swiss pharmaceuticals, Scania/Volvo

- Implications for public policyo Creation of national champions may be mistakeno Cautious of advantages of domestic mergers (reduce rivalry)

Jokers in the pack- Chance: wars and invention- Government: effect may be benign but excessive intervention may be problematic

6.4 Using the Diamond Framework 6/19

Implications for governments as well as firms- Domestic clusters: any means to encourage their formations, maintain robustness

6.4.1 Identifying and Using a Diamond

Issues with approach:- Interdependence of Four Main Elements: difficult to isolate critical element- Essential Contribution of all Four Elements

o All four best, three can occasionally compensate weak 4th, two almost impossible- Continuous Upgrading and Improving

o Diamond representation static; reality dynamic- Subjectivity and Multiplicity

o Some factors subjective (cultural influence)o Some elements based on combination of elements (nature and degree of inter-firm rivalry)

o Weighting not obviouso Different individuals might construct different Diamonds for same industry/country

6.4.2 Diamond in Action: US Competitive Advantage in Economics Textbooks

Factor Conditions:- Leading authors- English language- Major university

Demand Conditions- Large domestic market- Anticipates wider trends- Sophisticated distributions channels

Linked and related industries:- Advertising and software industries

Firms’ strategy, structure and rivalry- Advertising-oriented- Glamorous industry- Risky venture (new textbook)- Numerous rivals; clusters (New York)

6.5 Framing Company Strategy 6/24

Possibility of competitive advantage depends on home Diamond- E.g. US publisher has supportive cultural and social environment, extensive resources- Non-US publisher would need to find niche market

Choice of strategy influenced by home Diamond- May facilitate certain strategies and discourage others

Continuous Innovation- Seek sophisticated buyers- Seek demanding buyers- Overshoot stringent regulations- Source from leading home-based suppliers- Seek rivals as benchmarks

Anticipate industry change- Seek buyers with anticipatory needs- Explore emerging buyer groups- Seek locations with early regulations- Identify trends in factor cots- Link with research centres- Study new competitors- Include outsiders in management teamCaution: uncritical emphasis on emerging signals can also be dangerous

Difficulty replicating Diamond’s advantages- Creation of healthy clusters can take decades to achieve and reflect numerous interdependencies

Awareness of foreign Diamonds- Merits and deficiencies compared to home Diamond

6.6 Competing in International Markets 6/26

Dunning: Eclectic Paradigm (OLI Model)

Ownership advantages:- Technical know-how – most easily transferred and shared- Marketing. Purchasing knowhow- Access to finance- Access to resources (e.g. ownership of oil reserves)- Brand recognition

Location advantages:- Access to cheap/high quality resources- Transport costs- Government impediments to imports (e.g. tariffs, quotas)

Internalisation advantages: (versus cooperative agreement with local firms)- Transaction costs of cooperative alternatives

o Search, negotiation, policing, lack of suitable local partners, o Residual problems of opportunism o Control of ownership (IP), brando Reduced chance of losing access to inputs/outlets

- Enable monopoly practices such as predatory pricing using cross-subsidisation

Without ownership advantage => no international firms

Without location advantage => international trade but no foreign direct investmentWithout internalisation advantage => co-operative ventures but no multinationals

Eclectic Paradigm assumes most attractive investments found overseas- However, this is only the case after exhausting all specialisation and diversifications in home base until

resources linkages unattractive

6.7 Competing Abroad: The Principles 6/32

Seek sophisticated overseas buyers- Strengthen ability to compete

Source basic factors globally- Commodities not source of competitive advantage => best/cheapest suppliers

Keep strategic assets close to home- Benefit from local interactions, easier to manage, guard against unplanned leakage

Selective tapping of foreign technology- Potential leaks of technical knowhow also opportunity to harvest from foreign cooperation

Attack rivals directly to learn from them and neutralise them- Head-to-head competition valuable learning lesson; prevent rivals from further growth

Locate Regional HQs at best Diamond- Provide valuable information on what makes the local system work

International acquisitions and alliances for access and learning- Means of learning new skills

Globalisation versus localisation- World not homogenous: different cultures, societies, legal, political systems => products with regional

technical/market characteristics

6.8 Globalisation Versus Localisation 6/33

Resource-based versus market-based approach

Resource-based:- Same product line, same home market- If diversification is necessary (e.g. market saturation) => leverage maximum of existing resources- If international expansion => leverage common information- E.g. PC, Food & Drinks (Coca Cola)

Market-based- Different requirements in different countries- Customisation required even if it implies sacrifice of scale- Local market conditions dominate => incumbents can fight off challenges- E.g. educational materials, confectionary

Hotels, clothing are combination (Hilton, Nike... many national brands)

Characteristics which encourage international firms in markets dominated by local tastes/brands:- Surface differentiation: common brand but different specifications for local product- Access to factors of production: lower labour costs- Cultural globalisation: Convergence in tastes through international communication and contact

6.9 Conclusions 6/36Review Questions 6/36

7 - Making The Moves

Combination options:- Vertical integration, diversification, multinational expansion- Internal growth, merger/acquisition, licensing, franchising, joint venture

Must be compared to opportunity costs

7.1 Example of a Combination 7/3

Synergy benefits:Resource side:

- Economies of scope in marketing, distribution- Lower the Average Cost

Market-side- Shifting of demand curve to right and reducing demand elasticity

7.2 Evidence on the Performance of Combinations 7/5

Perform badly, yet popular with strategic planners- Acquisitions reduce efficiency- 70% of joint ventures fall short of expectations

Challenges in judging:- Measurement difficulties – difficult to separate out and measure benefits- Other motives – management status, rewards, prevent rival action with supplier (no increase but prevent

future decrease)- Wrong criteria – stated objectives of allotted life span don’t reflect performance (e.g. knowhow benefits

other activities)- Opportunity costs – true cost of failure may be higher than observed

Conclusions:- Frequently disappoint- Motives and implications may be more complex than short-term profit

7.3 Adding Value from Combination 7/8

Combining a sales force example:- Similar outlets, avoid duplication in products territories and outlets – only one salesperson per outlet- Similar product, eliminate competition – push up price and margins- Similar activities, increase sales – each sales person promotes both products in assigned territory- Similar activities, improve capabilities – leverage best selling practices and training methods

Considerations of merger/acquisition- The whole value chain matters: sales, production, etc- Alternative methods of combining activities

o Internal expansion: Merger is fastero Cooperative agreements achieve some gains without the need for combinationo Even intangible elements (brand image) can be transferredo Competition authorities will closely monitor for anti-competitive operations

7.4 Why Do Mergers and Acquisitions Perform So Badly? 7/13

Two parts:- Why the gains are often so poor- Why does one party do badly compared to counterparts

7.4.1 Why the Gains from Merger or Acquisition May Be So Disappointing

Compatibility Problems- Different skills and competencies- Tangible differences can be assessed but intangible (identity, character) more difficult- Standards, jargon, operating procedure; social and knowledge-based characteristics

- Consequences:o Limited coordinationo Attempts to harmonise may prove costly

Optimistic bias- Easier to identify opportunities to enhance value than the pitfalls and problems

Strategy matching, interdependent strategies- Wave-feature of mergers/acquisitions: fear of being cut off triggers desire for vertical integration- Conservatism: match rival strategy of acquisition to reduce relative risk

Insulation from environmental surprises- Avoid dependency on single market or technology with related-constrained/related-linked- Objective to reduce risk not to enhance profitability

Agency problems – managerial motives for merger

The Prisoner’s Dilemma- Downstream move provides competitor base to foreclose on firm’s market- Only protection is same downstream move

7.4.2. Why Do Acquirers Do Even Worse than Those Bing Acquired

The Grossman-Hart Problem- Dispersed share ownership means increased price for acquisition- Price must increase until last critical shareholder sells; others will hold for free-ride

Winners Curse- High degree of uncertainty regarding present value of firm- Potential bidders make errors: some overly optimistic, some overly pessimistic- Winning bid likely to be based on overestimation- Best defence is natural caution and risk aversion in face of uncertainty

o Bidders value in risk premiums

Hubris (or excessive self-confidence)- Management caught up in excitement => lack of balanced judgement

Reasons for M/A over internal growth- Growth objectives of management- Speed is important, e.g. pre-empt competitive response- Gain competencies and resources- No room for entry (supplier or customers locked up)- Eliminate a competitor

Merger may be quick fixed but questionable if sustainable- Reduction of rivalry may also lead to loss of sharpness

7.5 Co-operative Activity 7/22

Forms of cooperation- Licensing- Franchising- Informal cooperation- Sub-contracting- Alliances- Network participation- Joint venture

Licence: permission for any firm to indulge in activity otherwise prohibited- Intellectual property rights, patents, designs, trademarks- Usually part of business/technology

Franchise: transfer of intellectual property rights for specified periods and territories- Knowhow ranging over entire business (purchasing, productions, presentation, selling)

Information Cooperation- Example: one engineer may ask another from rival for advice expectation of reciprocity- Senior management may or may not approve

Sub-contracting- Separating part of business as contract for separate firm

- Trend more responsibility, e.g. R&D and Design- May evolve into long-term cooperation

Joint Venture- Two or more parent firms agree to cooperate- New entity created for specified task and duration- Own decision-making capability- Co-owned by parents- Provision for continuing parental supervision and control- Issues:

o Contractual: managerial and legal resources of create, police and monitoro Complex hierarchy: conflict and confusion regarding objectives, priorities, perceptions, procedures,

cultureso Appropriability problems: intellectual property leakage

Parent’s reluctance to reveal/commit sensitive resources

Why a joint venture- International expansion: may be required to enter national markets

Why a joint venture and not other forms of cooperation (licensing, franchising)?- Other forms more appropriate where market and technical characteristics are known- Where there is uncertainty: give child decision-making capabilities

Why joint venture and not merger/acquisition?- In can be design to cover only selected range of activity

Joint venture of selected resources:- Selected pieces of value chain (e..g sales only)- Selected business of firm

o E.g. two related-linked parents: One firm offers technical expertise, The other marketing skills

Joint venture more expensive that merger over the range of activity- But avoids additional problems of merging entire system- Value not in was it does to but what it does not do

Joint venture not only alternative to corporate diversification: also a consequence of it- Not likely to be preferred route to growth of small specialised firms

Alliance: formal/informal agreement to cooperate on a variety of matters- Resource-based logic:

o Both sets of management teams build up familiarity with other firm I.e. would be major effort if firm selects a new partner for each agreement

- Transaction-cost logic:o Inhibits opportunism: jointly held hostages

- Cost of allianceo Partner may not be ideal choice for each constituent agreement

Dull competitive edge, limits competition

Networks: three or more firms directly/indirectly linked by series of cooperative agreements- Access and transaction cost benefits above the 1:1 agreements- Vary in scope:

o Mailing list Major cooperative agreements with collective retaliation threat

- Encourage open information flows and reduce transaction costs- Need not involve deliberate joining decision (blurred membership)- May soften competitiveness

o Immediate disadvantage of those excludedo Eventual disadvantage of network members

7.6 Conclusions 7/32

7.7 The Elective as a Whole: Conclusions 7/33

Review Questions 7/33

Key PointsLifecycle influences:+ Brand advertising+ Standardisation- Price elasticity

- Margins+ Excess capacity- Entry incentive, # firms

- Bugs- Innovation

Decline options: Dominance Harvest Niche Exit Internalise

Cost driver (2.4)- scale/experience/utilisation- vertical/horizontal links in value chain

- timing, location, government

Diff process/strat; Identify buyer, impact, criteria; uniqueness, different, cost/benefit; sustainability, reduce costDifferentiation drivers: (2.5.1) Linkage, timing, location, learning, scale, policy (Kellog), vert intLemons: Reputation, warranty, professional ass, brand, guides, intermediary, government, franchiseDominant design: scale/experience; network (user/supplier)Strategic Moves: Reputation, Contracts, Specialism, Investment, Incrementalism, Hostages, Social

Research characteristics: Specificity, Uncertainty, Time, Cost (stage, cumul)Innovation problems:- Appropriability- Long-time horizon- Budget

- Uncertainty- Neglect of spin-offs- Duplicate research

- Asymmetric information- Machiavelli- Compartmentalisation

Innovation Solutions+ In-house+ Internal funding+ Corporate R&D+ Split R&D

+ Top-down budget+ New product targets

+ Split budgets+ Parallel+ R&D diversification

+ Second-in+ Licensing, JV+ Organic structure

+ Matrix org+ Quasi-autonomy+ Champions

+ Research club+ Public funding, Fixed price versus cost-plus

Hold-up: bounded rationality, opportunism, specificity (site, physical, human, dedicated) Production, R&D, Advertising+ Contracts: repeat; exhaustive+ Integration: vertical, tapered

+ Hostages+ Standardisation

+ Multi-source

Vertical integration criteria+ Unpredictable supply/demand+ Differentiated product+ Few firms not integrated

+ contracts difficult to verify+ similar scale/competence+ transaction-specific investments

Vertical integration- different competencies- specialisation differences- inflexibility

- economy of scale (target)- performance incentives- vertical relations with rivals

- Large size (mgmt) - prisoner's dilemma

Demand volatility options: stock; liquid assets, short-term finance, insurance, Fwd VI, long-term contr

Diversification+ Market power+ Economy scope/scale/experience+ User gains+ Internal market+ Risk+ Growth

- Rival valuation- Rival reaction- Costly- Opaque performance- Allergic reactions- Late recognition

- agency, optimistism

Assessment problems: Measurement, criteria, non-profit, opportunity costMerger failures: compatibility, optimism, strategy match, insulation, agency, prisoner Grossman Hart, Winner's curse, Hubris

Multinational alternatives: Export JV, Alliance

Direct investment Acquisition

License Franchise

Move to hot diamond: + promotes innovation, efficiency; information access - May lose competitive advantage, root success factor, may not surviveCooperate with hot diamond: + potential to combine complimentary strengths - major costs and problems

Multinational resource implications: Horizontal: R&D; Vertical: resource, transport costs => production

Diamond issues: interdependence, minimum, cont. upgrade, subjectivity

Diamond principles: seek sophisticated buyers source factors globally strategic assets close to home selective foreign technolgy

frontal attack of rivals regional HQ at best diamond acquisitions/alliances: learning & access globalisation / localisation