Economics of Strategy

University of VictoriaSummer 2011Pascal Courty

Economics of StrategyObjectives for today

• Discuss course outline• Introduction to economics of strategy• Academic influences

• Course objectives: learn how market environment and firm’s strategy influence firm performance

• Learning approach: mix of formal lectures (1/2), discussion of research articles (1/4), and class discussion(1/4)

• Material: book, slides, weekly emails, research articles• Pre-requisites: Micro, IO, game theory• Expectations: read book chapters, read research articles,

follow instructions in weekly emails• Grading: pb sets (40%), midterm (30%), essay (30%)

Course outline

– Part I. Incentives, Firms, and Markets• Chapters 3, 5, 6, 16, 17• Performance measurement and incentives within firms• Vertical boundaries of the firm

– Part II. Markets and Competitive Analysis• Chapters 9, 10, 11, 12• Thinking strategically and strategic commitment• Pricing rivalry• Entry• Industry analysis

– Part III. Competitive Advantage and Industry Dynamics• Chapters 13, 14, 15• Competitive advantage• Innovation and industry dynamics

Course Contents

Economics of StrategyAcademic Influences

• Industrial organization (analysis of market competition)

• Game theory (strategic interactions)• Economics of organization (transaction cost

economics, contract theory)• Incentive theory (personnel economics,

information theory)

• Focus can be on managerial ability to change firm position (organizational behaviour) or market environment (competition economics)

Research articlesPart I. Incentives, Firms, and Markets• The Dynamics of Franchise Contracting: Evidence from Panel Data. Francine Lafontaine and Kathryn L. Shaw. The Journal of Political Economy. Vol.

107, No. 5 (October 1999) (pp. 1041-1080)• Peers at Work. Alexandre Mas and Enrico Moretti. American Economic Review 2009, 99:1, 112–145.• Competition and Business Strategy in Historical Perspective. Pankaj Ghemawat. The Business History Review, Vol. 76, No. 1 (Spring, 2002), pp. 37-

74• Performance Pay and Top-Management Incentives. Michael C. Jensen and Kevin J. Murphy. Journal of Political Economy, 98. Page 225 of 225-264Part II. Markets and Competitive Analysis• How Much Does Industry Matter, Really? by Anita M McGAHAN, Michael E Porter. Strategic Management Journal (1997) Volume: 18, Issue: S1,

Publisher: John Wiley \& Sons, Pages: 15-30• Commitment to a Process Innovation: Nucor, USX, and Thin-Slab Casting. Pankaj Ghemawat. Journal of Economics & Management Strategy

Volume 2, Issue 1, pages 135–161, March 1993.• Entry, Exit, Growth, and Innovation over the Product Life Cycle. Steven Klepper. American Economic Review. 1996, vol 86, 562-58.• Klepper, S., and K. Simons, "The Making of an Oligopoly: Survival and Technological Change in the Evolution of the U.S. Tire Industry," Journal of

Political Economy 108 (2000), 728-760.• What do we know about entry? P. A. Geroski International Journal of Industrial Organization. Volume 13, Issue 4, December 1995, Pages 421-440Part III. Competitive Advantage and Industry Dynamics• Managing with Style: The Effect of Managers on Firm Policies. Marianne Bertrand and Antoinette Schoar. Quarrterly Journal of Economics, Nov

2003, vol 143. Page 1169 of 1169-1208• Does management matter? Evidence from India. Nicholas Bloom, Benn Eifert, Aprajit Mahajan, David McKenzie and John Roberts. Mimeo 2011. • Measuring and Explaining Management Practices Across Firms and Countries. Nick Bloom and John Van Reenen. Quarterly Journal of Economics,

November 2007.• Architectural innovation: The reconfiguration of existing product technologies and the failure of established firms. Rebecca M. Henderson and

Kim B. Clark. Administrative science quarterly, 1990, 35, 9-30. • Measuring Competence? Exploring Firm Effects in Pharmaceutical Research. Rebecca Henderson and Iain Cockburn. Strategic Management

Journal. 1994, vol 15, 63-84. • Exploiting a Cost Advantage and Coping with a Cost Disadvantage. David Besanko, David Dranove, Mark Shanley. Management Science, Vol. 47,

No. 2 (Feb., 2001), pp. 221-235• On the evolution of the firm size distribution: Facts and theory. Luis Cabral and Jose Mata. American Economic Review, 2003. 93, 1075-90.

Slides by: Richard Ponarul, California State University, Chico

Copyright 2010 John Wiley Sons, Inc.

Chapter 4

The Power of Principles: A Historical Perspective

1840, 1910, and Today

• The years 1840, 1910 and 2009 represent widely disparate business conditions.

• The general economic principles behind business strategy are enduring.

• Business practices evolve with changing environment.

Doing Business in 1840

• Numerous intermediaries - Farmers to factors to brokers agents to buyers

• Substantial price risk for participants• Infrequent transactions• Scarcity of information regarding sales and

prices of comparable goods

Infrastructure in 1840

• Infrastructure in transportation, communication and finance were poorly developed in 1840.

• Poor infrastructure meant the dominance of small family run firms.

• Markets were local.

Transportation in 1840

• Railroads, in their infancy, were fragmented. National railway network had not yet arrived.

• Waterways were used for long distance transportation. Yet routes were limited.

• With poor transportation, producers were limited to local markets

Communication in 1840

• Postal service was the dominant mode of long distance communication.

• Postal service relied on the horse and stagecoach.

• Telegraph was expensive and was used only for important time-sensitive information.

Finance in 1840

• Most businesses were sole proprietorships or partnerships which made long term debt difficult to obtain.

• Shares of stock were not easily traded and cost of capital was high.

• No institutional mechanism existed for handling business risk.

• Futures trading to manage price risk was yet to come about.

Production Technology in 1840

• Most factories used century old methods of production.

• Textile manufacture was mechanized.• Use of standardized parts (prevalent in clocks

and guns then) was just beginning.• Scale intensive industries and high volume

production were non existent.

Government in 1840

• Government was involved in large infrastructure investments such as canals and railroads.

• Later in the century government regulation of the business environment was emerging.

• Prime Meridian Conference led to the system of standard time.

Business in 1840

• Technology limited production to traditional modes.

• Production served local markets.• Without transportation infrastructure and

access to large markets, mass production technologies would not have been useful.

Business in 1840

• Without communication infrastructure, information on prices, sellers and buyers was not readily available.

• Credit was available based on personal relationships.

• As a result businesses were small and informally organized.

Business Conditions in 1910

• Mass-production technologies made possible high volume low cost manufacture of goods.

• Railroads dominated transportation and allowed mass distributors to reach widely scattered customers.

• Telegraph and telephones greatly improved long distance communications.

Business Conditions in 1910

• Manufacturing became more vertically integrated.

• Multidivisional firms emerged in response to the size and complexity of operations.

• Industries were becoming concentrated.• As standardization increased so did labor

related conflicts.

Finance in 1910

• Securities markets traded shares of large industrial firms.

• Credit bureaus made credit related information easily accessible.

• Innovations appeared in monitoring and reporting business activities.

• Public disclosure of accounting information was in vogue.

Government in 1910

• Government regulation extended to such areas as corporate law, antitrust and worker safety.

• Increased regulation forced managers to collect a lot of data on internal operations.

• Mandatory secondary schooling provided the labor force needed by large bureaucratic organizations.

Business in 1910

• Expanded infrastructure allowed firms to expand their markets, product lines and production scale.

• New technologies allowed high volume standardized production.

• Growth of financial infrastructure made large scale firms viable.

Doing Business Today

• Large vertically integrated firms have been declining.

• Alliances and joint ventures could work better than mergers and acquisitions.

• Firms adopt complex matrix structures.

Transportation Infrastructure Today

• Air, water, rail and ground transportation have become better coordinated.

• Sophisticated communication and data processing technologies enable container shipping.

• Cities like Atlanta have grown relying on air transport in spite of poor rail and water connections.

Communications Technology Today

• Capacity for instantaneous transmission of complex information makes possible global markets for products and services.

• Technology has enhanced worker productivity.• Coordination of activities has become easier

with modern computer and communication technologies.

Finance

• Regulation of banking and securities markets resulted in a stable financial services sector.

• Capital markets and financial institutions became more active in evaluating firm performance.

• Globalization of financial markets made many mergers and acquisitions possible.

• Liquidity crisis of 2008 has slowed economic and entrepreneurial activity.

Production Technology

• Modern technologies such as CAD/CAM have made low cost tailor-made production feasible.

• Use of new technologies often means reorganizing the firm around these technologies.

Government

• In some areas (airlines, trucking and financial services) traditional regulation has been relaxed.

• Regulation has increased in other areas (workplace safety, discrimination and environmental protection).

Government

• Intergovernmental treaties and agreements create regional free trade zones.

• Government’s anti trust policy encourages in-house development of capabilities.

• Government policy supports basic research and the commercialization of R & D projects.

Business Today

• With rising demand from developing nations the market size has increased.

• Firms focus on a narrow range of activities and enjoy the economies of scale.

• Financial innovation enables faster growth of firms and the ability of new entrants to challenge the incumbents.

Infrastructure in Emerging Markets

• Unlike the advanced nations, many developing nations still lack transportation and finance infrastructures.

• Businesses are reluctant to invest in countries where corruption, cronyism and conflicts are rampant.

Business Conditions and Strategy

• Business conditions change over time and so do the optimal strategies.

• Principles needed to arrive at successful strategies do not change.

• Recipes change from period to period but principles behind the recipes do not.