SUMMARY BESANKO

CHAPTER 2 : ECONOMIES OF SCALE AND SCOPE Economies of scale are the key determinant of a firms horizontal o!n"ari#$ (the quantities and varieties of products and services that a firm produces. E%ono&i#$ o' $%al# : when average costs (cost-unit) decrease as output increases fixed costs are spread over increasing output. Di$#%ono&i#$ o' $%al#: when average costs increase as output increases production runs up against capacity constraints or encounters coordination or other agency pro lems. !-shaped "# curve: in the short run. $-shaped "# curve: in the long run firms can expand their capacity y uilding new facilities. %irms expand their output until the &ini&!& #''i%i#nt $%al# (MES)*

E%ono&i#$ o' $%o+#: firm achieves savings as it increases the variety of goods and services it produces. $everaging core competencies& competing on capa ilities& mo ili'ing indivisi le assets. (efined in terms of: the relative total costs of producing a variety of goods and services together in one firm versus separately in ) or more firms. *# (+,+-) . *#(+,) / *#(+-) *# (+,+-) - *#(+,) . *#(+-) *he incremental cost of producing good ,& is lower when the firm if producing good - than if it doesnt produce good -. 0ources of economies of scale and scope: 1. In"i,i$i iliti#$ an" th# $+r#a"in- o' 'i.#" %o$t$. %ixed costs arise when an input cannot e scaled down elow a certain minimum si'e& even when the level of output is very small (e.g. is indivisi le). 2eductions in "# due to increased in capital utili'ation are short-run economies of scale (occur within a plant of a given si'e)3 reductions due to adoption of a technology that has high fixed costs ut lower varia le costs are long-run economies of scale. 4n different levels: - Pro"!%t l#,#l: spreading of product-specific fixed costs such as special equipment& 25( expenses& training expenses& costs necessary to set up a production process. - Plant l#,#l: firms chose the production technology (fully vs. partially automated) that minimi'es "# (fig. ).6). - M!lti+lant l#,#l: capital intensive industries are more likely to display economies of scale than material 7or la our intensive industries ecause capital is indivisi le and materials and la our are divisi le (costs increase with increasing output).

). S+#%ialization: increased productivity of varia le inputs. 0miths *heorem states that speciali'ation is limited to the si'e of the market. 8ndividuals will only make the
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speciali'ation investment if the market is ig enough to support them. *hus& larger markets will support a more speciali'ed array of activities than smaller markets can. 9. In,#ntori#$. %irms carry inventories to minimi'e the chance of running out of stock. " stock-out can cause lost usiness and loss of confidence of customers. #osts of holding inventories are: interest on the expenses orne in producing the inventory and the risk of depreciation. *hey drive up the average costs of the goods sold 1:1. *he need to carry inventories creates economies of scale ecause firms doing a high volume of usiness can usually maintain a lower ratio of inventory to sales while achieving a similar level of stock-outs. 6. Engineering principle of the %! #/$0!ar# r!l#: as the volume (: production capacity) of a vessel (: production process) increases y a given proportion& the surface area (: total production costs) increases y less than this proportion. *hus& "# decrease. 0ources of economies of scale and scope related to other areas than production: 1. P!r%ha$in-: ig usinesses that make large purchases from their suppliers may o tain discounts& ena ling them to en;oy a cost advantage over their smaller rivals. 2easons for a supplier to give these discounts: - $ess contraction-costs to sell to a single uyer. - " ulk purchaser has more to gain from getting the est price and therefore will e more price sensitive. - "ssure a steady flow of usiness. 0mall firms may form purchasing alliances that uy in ulk in order to o tain quantity discounts. ). A",#rti$in-: "dvertising costs per consumer < (costs of sending a message = no of potential consumers receiving the message) = (no of actual consumers as a result of the message = no of potential consumers receiving the message). $arger firms may en;oy lower advertising costs per consumer either ecause they have: - $ower costs of sending messages per potential consumer: ecause the fixed costs of advertising (preparation costs& negotiation with pu lisher) get spread over a larger ase of potential customers. - >igher advertising reach: more shops where you can uy the rand3 easier to reach for customers. Umbrella branding: consumers use the information in an advertisement a out one product to make inferences a out other products with the same rand name& there y reducing advertising costs per effective image. (0ometimes firms prefer to keep rand identities separate to avoid tarring its luxury market with a mass-market reputation.) 9. R1D: scale economies ecause it is a su stantial indivisi le investment which implies that "# will decline as output increases3 scope economies when the ideas developed in one research pro;ect create positive spillovers to another pro;ect. ?ut: smaller firms may have more incentive to innovate. Effect of si'e on 25( is am iguous. @ractices display %o&+l#&#ntariti#$ when the enefits of introducing one practice are enhanced y the presence of others. "ka $trat#-i% 'it: the whole of a firms strategy exceeds the sum of the parts of its organi'ational processes. 8t is necessary to firms seeking a longterm competitive advantage over their rivals since it is difficult to copy each individual process.

0ources of "i$#%ono&i#$ o' $%al#: 1. Hi-h#r la or %o$t$ than small firms <A wage gap <A large firms have to pay a compensating differential because: - *heir work is less en;oya le than the work in small firms. - Beed to draw workers form greater distances 7 compensate transportation costs. - Beed workers with unique and highly valued skills. >owever& there are factors that work in favor of large firms: - $ower worker turnover. - Core attractive to highly qualified& upwardly mo ile workers who want to move up the corporate ladder without changing employers. ). S+r#a"in- $+#%ializ#" r#$o!r%#$ too thin: if a speciali'ed input is a source of competitive advantage for a firm& and a firms attempts to expand its operations without duplicating the input& the expansion may over urden the speciali'ed resource. 9. Con'li%tin- o!t: the possi ilities for conflict place a natural limit on the market share that any one professional services firm can achieve e.g. accounting& consulting& law. 6. In%#nti,# an" %oor"ination #''#%t$: in large firms compensation is less likely to e tied to the workers contri ution toward firm profit. "nd more difficult to monitor and communicate with workers. L#arnin- %!r,# (experience curve): refers to advantages that flow from accumulating experience and know-how. *he enefits of learning manifest themselves in lower costs& higher quality& and more effective pricing and marketing. Expressed in terms of the slope of how far "# decreases as cumulative output dou les. %igure ).D. Ehen a firm en;oys the enefits of a learning curve: C# of increasing current production < expected C# of the last unit of the firm expects to sell. <A $earning firms should e willing to accept short-run prices that are elow short-run costs. Canagers who are rewarded on the asis of short-run profits may ignore this3 firms could solve this pro lem y directly accounting for learning curve enefits when assessing profits and losses. BC2 -ro3th4$har# &atri.: figure ).F. 0trategy for successfully managing a portfolio of usinesses was ased on taking advantage of the learning curve and the +ro"!%t li'# %5%l#: product demand is thought to move through 6 stages: - @hase 1: 8ntroduction3 low sales and low growth - @hase ): Growth3 demand grows rapidly - @hase 9: Caturity3 sales level off as demand ecomes increasingly driven y replacement sales rather than sales to new customers - @hase 6: (ecline3 demand declines as superior su stitute products emerge 8n phase 1 firms should use funds from cash cows to increase production and exploit learning economies3 eventually these markets will ecome mature and turn into cash cows. Remarks: learning curves are not uniform3 @$#s are easier to identify once they have een completed than during the panning process3 role of the firm as anker is questiona le when other sources of capital are easily availa le. *o maximi'e the enefits of learning3 the correct alance etween sta ility and change has to e found. #odifying work rules and reducing worker turnover facilitates retention of knowledge ut may stifle creativity. 4n the other hand& worker-specific learning can ecome too complex to transmit across the firm.

Task-specific knowledge: workers can shop around with their talents and capture the value of learning for themselves y asking higher wages. Firm-specific knowledge: worker knowledge is tied to their current employment and the firm will not have to raise the wages if workers ecome more productive. (ecreasing "# in two ways: - 8n simple capital-intensive activities: large ec of scale and low learning ec. #ut acks in production increase unit costs3 less concerned a out la our turnover. - 8n complex la our-intensive activities: low ec of scale (no decrease in "# in a given year) and large learning ec ("# decrease across several years): figure ).1H. #ut acks in production do not increase unit costs. Canagers should carefully distinguish etween the two in order to make correct inferences a out the si'e in a market. 6* A2ENCY AND COORDNATION Or-anizational +ro l#&$ 7 agency and coordination - remain an important potential diseconomy of scale. "n a-#n%5 r#lation$hi+ occurs when one party (the agent) is hired y another party (the principal) to take actions that affect the payoff of the principal. "n a-#n%5 +ro l#& (motivation pro lem) arises when two conditions are met: 1. *he o ;ectives of the principal and the agent are different. - Principals objective: max the value it receives as a result of the agents actions and the payment to the agent. gents objective: max the value it receives from the principal minus the costs incurred in doing so. ). *he actions taken y the agent (hidden action) or the information possessed (hidden information) y the agent is hard to o serve. *ools to com at agency pro lems: 1. Monitorin-: expend resources watching employees or gathering information that employees use to make decisions. >owever& there are some limitations: - 8mperfect due to the complexity of the organi'ation. - >iring monitors can e quite costly. - >iring a monitor often introduces another layer to the agency relationship. ). P#r'or&an%# a$#" in%#nti,#$: the principal offers to link the agents pay to the payoff the principal receives from the agents action. - %igure 9.1: convex cost of effort function (marginal cost of effort increase as the employee works harder). - %igure 9.): the employee increases effort until C# of effort (the slope of a line tangent to the effort cost curve) is equal to C? (commission on sales) and the firms profits increase. Eith a higher commission rate& the employees C? approaches the total C?. 0o the employee has full ownership of the value he creates and will therefore make the effort-decision that will maximi'e overall value. *he firm can capture this value y reducing the fixed salary. - %igure 9.9: if the firm offers a lower fixed salary& the employees effort choice is unchanged since C? and C# are unchanged.

#omplications: (1) sales are likely to e affected y a variety of factors hat are eyond the salespersons control3 individuals tend to e risk averse will accept the (risk of) performance ased incentives only when they are compensated for earing such risk& which makes performance ased incentives more expensive3 ()) employees can have a multitude of tasks which makes it difficult to alance incentives of employees3 (9) employees sometimes work as a team not possi le to give each employee full ownership of the value he creates. 9. B!r#a!%ra%5: limit the set of actions that employees are allowed to take (red tape& paperwork& hierarchy)3 ut might limit employee productivity and make it difficult to control for agency pro lems. Coor"ination +ro l#&$ arise from the o servation that the est action for one person to take& will often depend on the actions taken y others or on the information held y others. 8t is important for individuals to find ways to coordinate their actions. !a"ek emphasi'ed the role that prices and markets play in solving coordination pro lems. *hese do not solve intraorgani'ational coordination pro lems (if coordination among a group of individuals is easily accomplished through prices& there is little reason for individuals to e part of the same firm). *ools to com at coordination pro lems address two questions: (1) >ow is information communicated within the firmI ()) Eho has the authorit"I " firms organi#ational structure is a key determinant of how it resolves coordination pro lems. 1. C#ntralization: concentrating decision-making authority to tighten coordination. Eeaknesses: - #ommunication pro lems make it difficult to respond to local information. - $imited in processing large amount of information. ). D#%#ntralization: dispersing decision-making authority& hence more communication etween decision makers and more responsive to local information. Eeaknesses: - Gives rise to agency pro lems. - #an cause coordination opportunities to e missed. 8n reality firms use a mixture of oth. Jey features that always remain are that coordination is likely to e imperfect3 and that coordination pro lems get more severe as the si'e of the organi'ation grows. 7* THE PO8ER OF PRINCIPLES: A HISTORICAL PERSPECTI9E " hi$tori%al +#r$+#%ti,# demonstrates that while the nature of the usiness has changed dramatically since 1K6H& successful usinesses have always applied the consistent principles to their usiness conditions. $efore %&'(: limited transportation and communications constrained firms to operate in small locali'ed markets. $etween %&'( ) %*%(: changes in infrastructure and production technology encouraged the growth of national and international markets3 however still constrained y pro lems of coordination and control. +ince %*%(: changes in communications& data processing and networking have revolutioni'ed firms a ilities to control their operations and interact with suppliers& customers& competitors and other stakeholders.

:* THE 9ERTICAL BOUNDARIES OF THE FIRM 9#rti%al %hain: process that egins with the acquisition of raw materials and ends with the distri ution and sale of finished goods and services. *he ,#rti%al o!n"ari#$ of a firm define the activities that the firm itself performs as opposed to purchases from independent firms in the market &a;#/or/ !5 decision figure L.1: - ,ntegrate everything in one firm: integrate forward (acquire downstream firm) or integrate ackward (acquire downstream firm). Early steps in the vertical chain are upstream in the production process and later steps are downstream. - -isintegrate (outsource to independent su contractors): arms-length market transactions. %or example: market firms: firms speciali'ing in specific activities such as marketing& distri ution. B#n#'it$ o' !$in- th# &ar;#t = reasons to bu": 1. Carket firms exploit economies of scale and the learning curve. - Cay possess propriety information or patents that ena le them to produce at lower cost. - Cight e a le to aggregate the needs of many firms ec of scale and $-shaped "# curves. %igure L.9: " has too high "# and "M is not of competitive advantage3 "N is CE0. - Cight exploit their experience in producing for many firms learning ec. ). Eliminate bureaucrac": - "gency costs: leads to loss of profits and may go unnoticed ecause (1) large firms often have overhead costs so that it is difficult to measure and reward an individuals contri ution3 ()) in-house divisions in large firms often serve as cost centers that perform activities solely for their own firms and generate no outside revenue3 (9) managers ignore them ecause it is going well with the firm anyway. - 8nfluence costs: the way the manager influences the allocation of internal capital (1) direct costs (time wasted to make the decision)3 ()) the making of a ad decision. 9. Carket firms are su ;ect to the discipline of the market and must e efficient and innovative to survive. 4verall corporate success may hide the inefficiencies and lack of innovativeness of in-house departments. Contra%t$ are written to protect parties to a transaction from opportunistic ehavior. *heir effectiveness depends on: 1. *he %o&+l#t#n#$$: (1) contemplate all relevant contingencies and agree on a set of actions fro every contingency3 ()) what constitutes satisfactory ehavior and e a le to measure performance3 (9) must e enforcea le y an outside third party. %actor that make contracting always incomplete: - $ounded rationalit": limits on the capacity of individuals to process information& deal with complexity& and pursue rational aims. - -ifficulties with specif"ing.measuring performance: open-ended specifications3 hard to measure. s"mmetric information: if one party knows more than the other and the knowledgea le party may distort or misinterpret the information.

). *he availa le ody of %ontra%t la3: ensures that transactions can occur smoothly when contracts are incomplete. Eliminate the need to specify certain provisions in every single transaction. >owever& not perfect su stitute for complete contracting: - (octrines are phrased in road language (open to interpretation). - $itigation is costly and can destroy usiness relations. #ontracts are an imperfect way to ensure that trading partners perform as desired. 8f the resulting inefficiencies are large enough& than it makes sense to make rather than to uy. Co$t$ o' !$in- th# &ar;#t = reasons to make all depend on the costs associated with writing and enforcing contracts. %/ 0osts of poor coordination etween the steps in the vertical chain. "ll dimensions of production need to e well fit: timing fit3 si#e fit3 color fit3 se1uence fit. #oordination is especially important with design attributes (attri utes that need to relate to each other in a precise fashion otherwise they lose a significant portion of their economic value). 2/ 2eluctance of trading partners to develop and share private 3valuable4 information ecause they run the risk of losing control over it. Eell-defined and well-protected +at#nt$ can protect this& ut they are not foolproof however. @rofessional services often require new workers to sign non-compete clauses (when leaving the firm& he may not compete with it for several years). 5/ Transaction costs6 (opportunistic ehavior and the costs in trying to prevent it): arise ecause contracting is never fully complete. Falla%i#$ when making make or uy decisions: 8f an asset is cheaper to uy than to make& you should do so& even if it is a source of competitive advantage for you. (ont uy ;ust to eliminate the cost of making the product uying does not eliminate the expenses of the associated activity (can affect the efficiency with which he activity is carried out). (ont make ;ust to avoid paying a profit margin to independent firms. ccounting profit< revenues 7 expenses. 7conomic profit< accounting profit from activity , 7 accounting profit from investing the same resources in the most lucrative alternative activity. Even if an upstream supplier is making accounting profits& it does not mean that it is making economic profits or that the downstream manufacturing firm could increase its own economic profits y internali'ing the activity (due to the expertise eing difficult& or ec of scale). (ont make ;ust to avoid paying high market prices for the input during periods of peak demand and scarce supply (to eliminate income fluctuations). #ould also uy and enter into long-term (futures) contracts with suppliers3 hedging. (ont make ;ust to tie up a distri ution channel to try to gain market share at the expense of rivals. - Cay run afoul antitrust laws which permit forms of vertical foreclosure. - !pstream firm must e careful not to pay too much for the acquisition. - *he acquirer must consider how difficult it is for competitors to open new channels of distri ution. NR#lation/$+#%i'i% a$$#t: asset that cannot e redeployed to another transaction without some sacrifice in the productivity of the asset or some cost in adapting the asset to the new transaction. 8t locks parties into the relationship. %our forms: - +ite specificit": assets that are located side- y-side to economi'e on transportation or inventory costs or to take advantage of processing efficiencies.

- Ph"sical asset specificit": assets whose physical or engineering properties are specifically tailored to a particular transaction. - -edicated assets: investment in plant and equipment made to satisfy a particular uyer. Eithout the promise of that particular uyers usiness& the investment would not e profita le. - !uman asset specificit": worker has acquired skills& know-how and information that are more valua le inside a particular relationship than outside it. F!n"a&#ntal tran$'or&ation: once the parties have invested in relation-specific assets& the relationship changes from a large-num ers argaining to a small-num ers argaining situation. R#nt: the profit you expect to get when you uild the plant& assuming that everything goes as planned. *he investment is a sunk cost and does not affect your decision making. " firm must expect positive rents to induce to invest in an asset. <!a$i/r#nt: the e8tra profit that you get if the deal goes ahead as planned& versus the profit you would get if you had to turn to your next est alternative. 8nforms a out the possi le magnitude of the hol"/!+ +ro l#& when a trading partner attempts to renegotiate the terms of the deal (when contracts are incomplete). *his raises the costs of arms-length market exchanges in 6 ways: - Core difficult contract negotiations and more fre1uent renegotiations. - 8nvestment to improve e8 post bargaining positions: manufacturer may acquire a stand y production facility for a key input as a hedge against contractual holdup y the input supplier. *he facility stands idle much of the time costly. - -istrust: (1) higher direct costs of contract negotiation as parties insist that more formal safeguards are uilt in3 ()) impedes sharing information to achieve production efficiencies or quality improvements. - 2educed investment in relation-specific investments: leads to lower productivity and higher production costs ( ecause firms now only have the option of making generalpurpose investments). Do! l# &ar-inalization: upstream firm exploits market power y setting @ A C# downstream firm purchases these marked-up inputs and exploits its own market powers y also setting @ A C# product is marked-up twice. *hrough integration& the downstream firm can set @<C# which will lead to lower @ and higher profits for the integrated firm. =* DI9ERSIFICATION Di,#r$i'i%ation (%on-lo&#ration): produce for numerous markets exploit ec of scale and scope (diversification for other reasons tends to e less successful) reduces costs and improves efficiency. Eays to diversify: internal growth& strategic alliances& ;oint ventures& mergers and acquisitions. 9easures of diversification: difficult. Cost approaches consider some measure of technological or market relatedness: similarity in products sold or consumers served. - Botion of r#lat#"n#$$& developed y Rumelt: depends on how much of a firms revenues are attri uta le to product market activities that have shared technological characteristics& production characteristics or distri ution channels. 2umelt focused on 9 characteristics: the proportion of a firms revenues derived from (1) its largest usiness3 ()) its largest group of related usinesses3 (9) the stages of a vertically integrated production process. %our types of firms: - +ingle-business firm: AKLO of usiness in a single activity or line of usiness. - -ominant-business firm: DH-KLO of revenues from a principal activity.
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Related- usiness firm: .DHO of revenues from a principal activity ut has other lines of usinesses related to the principal activity. - Unrelated-business firm: .DHO of revenues from a principal activity and has no other lines of usinesses related to the principal activity. - Entro+5: <H for a firm that derives all of its sales from a single four digit 08# category and increases as the firms sales are spread across more categories. - M#r-#r$ an" a%0!i$ition$. 2easons for diversification: 1. E''i%i#n%5/ a$#" reasons: - 7conomies of scale and scope: ased on market factors3 technological factors3 managerial synergies3 or financial synergies. #an only e exploited when operations display synergies. #an also come from spreading a firms underutili'ed organi'ational resources to new areas. -ominant general management logic: managers who develop specific skills (incorrectly) rely on these skills for success in other unrelated usiness areas. - 7conomi#ing on transaction costs: the multi-product firm is an efficient choice when *# complicate coordination among independent firms. - ,nternal capital markets: it might e costly for firms to raise capital from external sources due to (1) incomplete information3 ()) existing de t3 (9) high monitoring expenditures& which prevents the execution of profita le pro;ects. #om ining (unrelated) usinesses to perform cross-subsidi#ation requires one firm to have cashAinvestment opportunities and the other firm to have cash.investment opportunities. - -iversif"ing shareholders portfolios: a shareholder seeking to avoid large swings in value can invest in a single diversified firm and achieve the enefits of portfolio diversification. - ,dentif"ing undervalued firms: managers may o serve a target firm that is undervalued in the stock market and uy it cheap. 2emarks: (1) unlikely that no other investors have noticed this3 ()) announcements of mergers attract attention leading other potential acquirers to id up the price (price wars)3 (9) winners curse. ). Mana-#rial reasons (do not generate enefit for the shareholders): - Canagers may en;oy running larger firms or are more likely to e appointed to other firms oard of directors when undertaking the acquisition. - 8ncrease their compensation ecause the si'e of the firm increases. - *o reduce the risk of ;o -loss: performances of highly diversified firms are likely to mirror that of the overall ec less likely that shareholders will fire management. #osts of diversification: 1. ,nfluence costs: costs of lo ying of managers for their division3 misallocation of resources. ). 9onitoring and disciplining costs: from the corporate management to control division managers. 9. 8nternal capital market may not serve its intended purpose of facilitating profita le investment in cash-poor usinesses ecause managers have a strong preference for corporate growth even if it is unprofita le and hence may over-invest when the firm has a lot of cash.

Canagerial motives are caused y pro lems in %or+orat# -o,#rnan%#: the mechanisms through which corporations and their managers are controlled y shareholders. 0hareholders cannot easily determine which acquisitions are profita le and which are not. 0hareholders are una le to change (wrong) management decisions: (1) formally this is done y the oard of directors ut the #E4 might exercise control over the selection for new directors3 ()) they form a dispersed group. Canagers who undertake acquisitions that do not serve the interests of the shareholders 'ir&>$ $har# +ri%# 3ill 'all& ecause: (1) if a manager overpays for the acquisition& the value of the firm will fall y the amount that was overpaid3 ()) if the stock market expects the firm to overpa" ac1uisitions in the future& the market price of the firm will fall in expectation of these events. (isparity etween the firms actual and potential share prices presents an opportunity for another entity to try a takeover. *his &ar;#t 'or %or+orat# %ontrol serves as a disciplining mechanism for managers (without actual takeovers taking place) and makes sure they keep the firms share price near its potential value. "ssessing the $!%%#$$ o' "i,#r$i'i%ation y using stock prices3 two methods: - :aluation studies: compares market valuation of diversified firms to those of undiversified firms lower in diversified firms. - 7vent studies: looks at the changes in market valuations in response to the announcement of diversifying acquisitions (1) returns to acquirers are on average negative3 ()) shares of target firms tend to rise when an acquisition in announced. (iversified firms need to reduce the scope of their activities in order to reach a point at which profita le diversification is possi le. ?* COMPETITORS AND COMPETITION Co&+#titor$: firms whose strategic choices directly affect one another3 or indirectly via a third firm. "pproaches to %o&+#titor i"#nti'i%ation: "ntitrust agencies: all the competitors ina market have een identified if a merger among them would lead to a small ut significant non-transitory increase in price (++;,P). %irms are competitors if they produce $! $tit!ta l# -oo"$ goods that have: - 0imilar product performance characteristics: descri e what the product does for consumers. - 0imilar occasions for use: when& where and how is a product to e used. - "re sold in the same geographical market: in the same location& with low transportation costs for the good 5 consumers. Cro$$/+ri%# #la$ti%it5: P-, < (Q+-=+-) = (Q@,=@,) is positive. #lose correlation etween prices over time. 0tandard 8ndustrial #lassification (SIC): codes that identify products and services y a D-digit num er with each digit representing a finer degree of classification. 2#o-ra+hi%all5: y examining the flow of goods and services across geographic regions. 0atchment area: contiguous area from which a firm draws most of its customers. Flow anal"sis: examines data on consumer travel patterns. Mar;#t $tr!%t!r#: the num er and distri ution of firms in a market measured y:

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;-firm concentration ratio: com ined market share (sales revenue) of the B largest firms in the market. >owever: invariant to changes in the si'es of the largest firms. H#r'in"ahl in"#. (H): sum of the squared market shares (0) of all the firms in the market. ConopolyAH.R and perfect competition.H.).

i ( +i ) )
;umbers-e1uivalent of firms: 1=>erfindahl < num er of firms in market& when you assume equal market share. %our classes of market structure: @* P#r'#%t %o&+#tition: @<C#. Carket conditions will tend to drive down prices when two or more of the following conditions are met: *here are many sellers: a. (iversity of pricing is likely. b. @rice increase will lead to fewer purchases y consumers some sellers will have to reduce production its difficult to get a lot of sellers to agree on whom that should e. c. Even if sellers appear willing to cut production& especially small firms will e tempted to cheat in order to increase their market share and secure learning enefits and ec of scale that will enhance their long-run competitive position. #onsumers perceive the products to e homogeneous. *here is e8cess capacit": in the long run& competition can drive @.C#. 8f this persists& firms can chose to exit the market rather than sustain long-run economic losses. ?ur if capacity is industry-specific& firms will have to remain in the industry until the plant reaches the end of its useful life or until demand recovers. 2. Mono+ol5: can set @ without regard to how other firms will respond monopolist profits come at the expense of consumers. 4nly faces Scompetition from fringe firms: small firms that collectively account for 9H-6HO market share. 9onopsonist: firm that faces little=no competition in one of its input markets and can therefore reduce input prices. Cost monopolies result when firms discover more efficient manufacturing techniques or create new products that fulfill unmet consumer needs. Even at monopoly prices& the enefits that these innovations ring to consumers may e enormous. @olicies that limit monopoly power may discourage innovation. Cart#l: several firms acting in concert as to mimic the ehavior of a monopolist prohi ited y antitrust laws. 6* Mono+oli$ti% %o&+#tition: there are many sellers and each seller offers a slightly differentiated product (consumers make choices among competing products on the asis of factors other than ;ust price). :ertical differentiation: when a product is unam iguously etter=worse than competing products. !ori#ontal differentiation: when only some consumers prefer the product over competing products& for ex: geography allows firms to raise prices while customers remain loyal. - ,dios"ncratic preferences: tastes differ remarka ly from one person to the next. - *he degree of hori'ontal differentiation depends on the magnitude of consumer search costs: how easy=hard it is for consumers to get information a out alternatives.

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 @AC# fixed costs are covered and firms will earn positive economic profits entry will reduce prices and reduce market shares until economic profits equal 'ero. >owever: there may e arriers to entry that keep B down. 7* Oli-o+ol5: market in which the actions of individual firms materially affect the overall market. %irms produce identical goods. Co!rnot 0!antit5 %o&+#tition: (@AC#)each firm selects a quantity to produce (and ther y guesses what + the other firm will chose)& and the resulting total output determines market price. - 8n 0ournot e1uilibrium: (1) the market price& @N& is the @ at which oth firms sell all their output& +1 and +)3 ()) +1 is firm 1s profit-maximi'ing output& given that it guesses firm ) will choose +)3 (9) +) is firm )s profitmaximi'ing output& given that it guesses firm 1 will choose +1. Each firms guess a out its rivals production level is correct. - 0ournot reaction functions: 21: shows firm 1s profit maximi'ing output for any output produced y firm ). 0imilar: 2). "t the point of intersection: +1N and +)N. R#,#n!# "#$tr!%tion #''#%t: when one firm expands +& it reduces @N and thus lowers the sales revenues for all the firms in the market. *he smaller a firms share of industry sales& the greater the divergence etween its private gain and the revenue destruction effect from output expansion smaller firms are more willing to rock the oat in order to gain market share: they en;oy the full enefits of each additional unit sold& ut suffer only a small O of the revenue destruction effect which is mainly orne y their larger rivals. 8n 0ournot e1uilibrium& @N falls as more firms enter the market each firm has a smaller share and is less concerned with the revenue destruction effect. @#C < >=elasticity less concentrated smaller > lower @#C (price-cost margin). B#rtran" +ri%# %o&+#tition: each firm selects a price that maximi'es its own profits given the price it elieves the other firm will select. Each firm also elieves that its pricing practices will not affect the pricing of its rival (considered fixed). @rice competition is fierce ecause the products of the two firms are perfect su stitutes3 hence @ is driven down to C#. -ifferences etween #ournot and ?ertrand: - *ake place over different time frames. - #ournot: markets where firms must make production decisions in advance and are committed to selling all of their output and unlikely to react to fluctuations of their rivals output markets that involve a lot of sunk costs or where it is costly to hold inventories. - ?ertrand: pertains to more flexi le markets. Di''#r#ntiat#" B#rtran" &o"#l : similar to #ournot ut firms chose @ in stead of +. @roducts are hori#ontall" differentiated: softens price competition ecause lowering @ is less effective for stealing a rivals usiness. - Reaction functions: 21: shows firm 1s profit maximi'ing price for any price charged y firm ). 0imilar: 2). "t the point of intersection: @1N and @)N. Mini&!& #''i%i#nt $%al# (MES): level of output& qNN& that minimi'es costs. @roduction processes often display U-shaped 0 curves. CE0 is larger when sunk costs are large relative to ongoing varia le costs of production. Ehen +NN is total industry demand& the num er of firms in the market& BNN& can e determined: NAAB<AA40AA.
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 Ehen sunk costs are large qNN is large small num er of firms in the market. S!tton: in most consumer goods markets& the num er of large firms and the overall num er of firms does not seem to depend on the costs of production& ut more on the costs of advertising. *he sunk cost that limits he num er of firms is not the up-front cost of production& ut the sunk cost of esta lishing a credi le rand name: #n"o-#no!$ $!n; %o$t. Endogenous ecause market leaders can influence he level of investment in rand awareness that rivals must achieve to e competitive& y setting the level of their own investment in rand name capital. C* STRATE2IC COMMITMENT Strat#-i% %o&&it&#nt: decisions that have long-term impacts and are difficult to reverse. #an influence the choices made y rival firms firms must anticipate market rivalry. %irms must alance the enefits that come from preempting or altering competitors ehavior with the loss in flexi ility that comes from making competitive moves that may e hard to undo once made. #ommitments must have three characteristics: 1. 9i$i l#. ). Un"#r$tan"a l#. 9. Cr#"i l#: enhanced y irreversi ility3 making contracts3 put reputation at stake. #oncepts that capture how competitors react when one competitor changes a tactical varia le such as @ or +. Strat#-i% %o&+l#&#nt$: upward-sloping reaction functions3 the more of the action one firm chooses& the more of the action the other firm will also optimally choose3 prices in the ?ertrand model. Strat#-i% $! $tit!t#$: downward-sloping reaction functions3 the more of the action one firm chooses& the less of the action the other firm will also optimally choose3 quantities in the #ournot model. Effect of commitments on a firms profita ility: - -irect effect: impact on the present value of the firms profits assuming that the firm ad;usts its own tactical decisions in light of this commitment and that its competitors ehavior doesnt change. - +trategic effect: takes into account the competitive side effects of the commitment& either positive or negative3 dependant on whether the varia les affected are strategic complements or su stitutes. #oncepts that capture whether a commitment y one firm places its rivals at a disadvantage: To!-h %o&&it&#nt$: ad for competitors. - #ournot: capacity expansion. - ?ertrand: price reduction. So't %o&&it&#nt$: good for competitors. - #ournot: capacity constraint. - ?ertrand: price increase. S! -a&# +#r'#%t Na$h #0!ili ri!& (SPNE): two stage game (1) firm 1 makes a strategic commitment and there y anticipates the effects of this on the market equili rium (forwardlooking)3 ()) oth firms simultaneously choose + (#ournot) or @ (?ertrand). %irm 1 should thus evaluate whether competition in stage ) is #ournot or ?ertrand. 0tage ) < 0ournot: - *ough commitment: +1 increases 21 shifts right in figure K.) in new equili rium +1 is higher and +) is lower (< strategic effect for firm 1).

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0oft commitment: +1 decreases 21 shifts left in figure K.9 in new equili rium +1 is lower and +) is higher (< strategic effect for firm 1). 0tage ) < $ertrand: - *ough commitment: @1 decreases 21 shifts left in figure K.6 in new equili rium @1 has decreased more than @) has decreased (< strategic effect for firm 1). - 0oft commitment: @1 increases 21 shifts right in figure K.L in new equili rium @1 has increased more than @) has increased (< strategic effect for firm 1). 2emark: when making a commitment& the effect of it does not only depend on whether the competition is #ournot or ?ertrand& ut also on industry conditions and the characteristics of the firms competitors: - 8s the competitor currently in the industry or has it not yet enteredI - #apacity-utili'ation rates in the industry. - (egree of hori'ontal differentiation among the firm making the commitment and its competitors: in ?ertrand: (1) high differentiation steep 2s small strategic effect3 ()) vice versa. 0trategic commitments are almost always made under conditions of !n%#rtaint5: competitors moves are hard to predict. %urthermore: strategic commitments are hard to reverse (in'l#.i l#). Eays to preserve flexi ility when making a strategic commitment: 9odif" the commitment as future conditions change. -ela" the commitment to some future point in time when its more profita le. Cake an unprofita le commitment today in order to make a profita le follow-up commitment in the future commitments are linked through time. %lexi ility gives rise to r#al o+tion$: when a decision maker has the opportunity to tailor a decision to information that will e received in the future. 2eal options can e created y altering the way in which firms configure their internal processes (important to spot them) and often do not come for free (involve a trade-off). Eaiting with executing the real option& increases the risk of preemption (that someone else takes it). 0trategic decisions involve investments in $ti%;5 'a%tor$: dura le assets& speciali'ed to the particular strategy3 un-trada le3 difficult to transform or redeploy elsewhere. %ramework fro analy'ing commitments: 1. Po$itionin- anal5$i$: direct effect of the commitment3 determines *# and *2. ). S!$taina ilit5 anal5$i$: strategic effect of the commitment3 determines time hori'on efore economic profits are returned to 'ero. 3. Fl#.i ilit5 anal5$i$: incorporates uncertainty into (1) and ()). <earn-to-burn ratio: ratio of the learn rate (rate at which the firm receives new information that allows it to ad;ust strategic choices) and urn rate (rate at which the firm invests in the sunk assets to support the strategy). " high ratio high flexi ility low option value of delay. 6. D!"-&#nt anal5$i$: takes into account organi'ational and managerial factors that might distort the firms incentive to chose an optimal strategy. T"pe % errors: re;ecting an investment that should have een made high chance when decision making occurs hierarchical. T"pe 2 errors: accepting an investment that should not have een made high chance when decision making occurs decentrali'ed. @2* INDUSTRY ANALYSIS

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Port#r: developed framework for exploring L economic factors that affect the profits of an industry. 0trategic analysis must account for oth cooperation and competition. $imitations of the 'i,#/'or%#$ 'ra&#3or;: - @ays little attention to factors that might affect demand. - %ocuses on a whole industr" rather than on individual firms that may occupy unique positions. - (oes not account for the government. - 4nly 1ualitative3 not quantitative. @* Int#rnal ri,alr5: ;ockeying for shares y firms within a market. 8mportant: definition of the market (product market vs. geographical market). %irms may compete on mainly ) dimensions: - ;on-price: erodes profits y driving up fixed costs (new product development) and C# (adding product features) these higher costs can however e passed on to consumers which increases profits. - Price: erodes profits y driving down @#Cs. the potential for price competition depends on the extent to which a price-cutting firm expects its market share to increase and how it expects its rivals to respond. #onditions that heat up price competition: Man5 $#ll#r$ in th# &ar;#t. Sta-nant4"#%linin- in"!$tr5: firms cannot easily expand their output without stealing form their competitors. %irms have "i''#r#nt %o$t$: low-cost firms can ask lower prices. 0ome firms have #.%#$$ %a+a%it5: want to oost sales and can often expand output rapidly to steal usiness from competitors. @roducts are !n"i''#r#ntiat#" = uyers have lo3 $3it%hin- %o$t$: firms are tempted to undercut their rivals prices ecause this can generate a su stantial increase in market share. Pri%#$ %annot # a"E!$t#" 0!i%;l5. Lar-#4in'r#0!#nt $al#$ or"#r$: firm may e tempted to temporarily undercut a rivals price to secure a particular large order. Bo %oo+#rati,# +ri%in-. 0trong #.it arri#r$: prolongs price wars as firms struggle to survive in stead of exiting. Hi-h #la$ti%it5 o' "#&an". 2* Entr5: erodes incum ents profits in ) ways: - Entrants divide market demand among more sellers. - Entrants decrease market concentration and heat up internal rivalry. %actors that affect the threat of entry: Lar-# MES relative to the si'e of the market. 2o,#rn&#nt +rot#%tion of incum ents. #onsumers are ran" lo5al. "ccess of entrants to ;#5 in+!t$ (technology& raw materials& distri ution& locations). E.+#ri#n%# %!r,#. N#t3or; #.t#rnaliti#$: installed ase. Expectations a out +o$t#ntr5 %o&+#tition.

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6* S! $tit!t#$ an" %o&+l#&#nt$: availa ility3 price value3 price elasticity of industry demand. 7F:* S!++li#r an" !5#r +o3#r: can erode industry profits when they are (1) concentrated3 ()) customers are locked into relation-specific investments with them. - ,ndirect power: can sell their services to the highest idder price they charge depends on supply and demand in the target market. - -irect power: raise prices when their target market is faring well and vice versa. %actors to consider: Co&+#titi,#n#$$ of the input market. Con%#ntration of the (upstream=downstream) industry. P!r%ha$# ,ol!&# of downstream firms. "vaila ility of $! $tit!t# in+!t$. R#lation/$+#%i'i% in,#$t&#nt$ y the industry and its suppliers (hold-up). *hreat of 'or3ar" int#-ration y suppliers. " ility of suppliers to +ri%# "i$%ri&inat#. 0trategies of firms to cope with the five forces: - -ifferentiate themselves from rivals or outperform. - 8dentify a segment of the industry in which the L forces are less severe. - 7liminate the forces y (1) esta lishing facilitating practices or creating switching costs3 ()) pursue entry-deterring strategies3 (6)(L) integrating. 2emark: @orter views all other firms as threats to profita ility ut also +o$iti,# int#ra%tion$ etween firms in a ,al!# n#t: Efforts y competitors to set t#%hnolo-5 $tan"ar"$ that facilitate industry growth. Efforts y competitors to promote 'a,ora l# r#-!lation$. #ooperation among firms and their suppliers to improve +ro"!%t 0!alit5 or oo$t "#&an". #ooperation among firms and their suppliers to improve +ro"!%ti,# #''i%i#n%5. @rofit from participating in the value net (competitors& supplier& uyers) < overall value of the value net when firm 8 participates 7 overall value of the value net when it doesnt participate.

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@6* STRATE2IC POSITIONIN2 FOR COMPETITI9E AD9ANTA2E Co&+#titi,# a",anta-#: when a firm earns a higher rate of economic profit than the average rate of economic profit of other firms competing within the same market. 8mportant: definition of the market. 7conomic profitabilit" depends on: 9arket economics (across industries): the five forces. :alue created relative to competitors (within the industry): - ?enefit position relative to competitors. - #ost position relative to competitors. Con$!&#r $!r+l!$: ? 7 @ consumer will only purchase the good if #0 A H and will chose the good that has the highest #0 (low @ and high +). Con$!&#r>$ &a.i&!& 3illin-n#$$ to +a5 (B): "t which @ is the consumer ;ust indifferent etween uying the product and going without itI seek est availa le su stitute. In"i''#r#n%# %!r,#: @& + com inations that yield the same consumer surplus. *he steepness indicates the trade-off etween @ and + a consumer is willing to make. Con$!&#r $!r+l!$ +arit5: when firms offer the same #0 @&+ com inations lie on the same indifference curve. Ehen a firm moves from this position (or from the position of consumer surplus advantage) to one which is less than its competitors& sales and market share will fall. Pro"!%#r $!r+l!$: @ 7 # producers profit margin. # < cost incurred in making the product. 9al!# %r#at#" < consumer surplus / producer surplus < (? 7 #) / (@ 7 #) < B G C. *he price determines how much of the value-created sellers capture as profit and how much uyers capture as #0. ?A#: necessary condition for a product to e economically via le. Entrepreneurs can strike win-win deals with input suppliers and consumers all parties are etter off if they trade& rather than dont trade win-win trade opportunities -ain$ 'ro& tra"#. ?A# is no guarantee that a firm will make a positive profit. *he threat of entry and fierce competition erode profits y idding down prices consumers capture all the economic value that the product creates. %or a firm to earn positive profits it must create more economic value than its rivals: must generate a hi-h#r l#,#l o' B G C than its rivals. - ?ecause consumers have different preferences& it is possi le that different firms have a higher ?-# in different market segments. 9al!# %hain (vertical chain): each activity of the value chain can potentially add to the enefit ? that consumers get from the product and each can add to the cost # that the firm incurs to produce and sell the product.

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 :alue-added anal"sis: when different stages produce finished or semi-finished goods that can e valued using market prices& we can estimate the incremental value that the distinctive parts of the value chain create. *wo ways in which a firm can %r#at# &or# #%ono&i% ,al!# than the other firms in its industry: 1. 0onfigure its value chain differently from those of competitors. ). @erform activities more effectivel" than its rivals within the same value chain. *o do so& the firm must possess resources and capa ilities that its competitors lack. R#$o!r%#$: firm-specific assets (trademarks& ase& know-how) that cannot easily e duplicated and indirectly affect the value creation ecause they are at the asis of a firms capa ilities. Ca+a iliti#$: activities that a firm does especially well compared with other firms3 common characteristics of capa ilities: Talua le across multiple products or markets. Em edded in organi#ational routines: well-honed patterns o performing activities inside an organi'ation capa ilities can persist even though individuals leave the organi'ation. Tacit: difficult to reduce to simple guidelines. 2#n#ri% $trat#-5 of a firm descri es how it positions itself to compete in the market it serves. @orters generic strategies: Co$t l#a"#r$hi+ ( road scope): companys products can e produced at lower cost per unit than competitors products: - Catch rivals prices and attain higher @#Cs: benefit parit" (same ?) or benefit pro8imit" (slightly lower ?). - !ndercut rivals prices and sell more than they do y offering a product that is 1ualitativel" different from that of its rivals. (espite the quality disadvantage& the cost leader achieves a higher profit margin than its high-cost competitors due to lower #. B#n#'it l#a"#r$hi+ ( road scope): companys products are capable of commanding a price premium relative to competitors: - Catch rivals prices and sell more than they do: offer su stantially higher ? and #. - #harge price premium and attain higher @#Cs: cost parit" (same #) or cost pro8imit" (slightly higher #). (espite the cost disadvantage& the enefit-leader achieves higher profit margins than its low- enefit competitors due to higher ?. Fo%!$A (narrow scope): company configures its value chain so as to create superior economic value within a narrow set of industry segments. Eithin these segments& the firm may have lower cost per unit than its road-scope competitor& or it may e capa le of commanding a price premium relative to these competitors& or oth. #onsumers have identical preferences in'init# #la$ti%it5 o' "#&an" : - #ost leader with enefit parity can lower its price ;ust elow the unit cost of the firm with the next-lowest unit cost. *his makes it unprofita le for highcost competitors to respond with price cuts of their own and thus allows the firm to capture the entire market. - ?enefit leader with cost parity can raise @ ;ust elow its unit cos plus the additional enefit it creates relative to the competitor with the next higher ?. to top this consumer surplus is& a competitor would have to cut @ elow its

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unit costs& which would e unprofita le. *hus at this @& the firm with the enefit advantage captures the entire market. Horizontal "i''#r#ntiation: strong when there are many product attri utes that consumers weigh in assessing overall enefit and when consumers disagree a out the desira ility of those attri utes. Price elasticit" is not infinite and influences the choice etween two polar strategies of exploiting competitive advantage. >igh price elasticity of demand $ow price elasticity of demand #ost advantage Shar# $trat#-5: under-price competitors to gain share. Mar-in $trat#-5: maintain price parity with competitors (let #-advantage drive higher margins)& ?enefit advantage Shar# $trat#-5: maintain price parity with competitors (let ?-advantage drive share increases). Mar-in $trat#-5: charge price premium relative to competitors.

P#r%#i,#" price elasticity of demand: O change in + for 1O change in @& taking into account likely pricing reactions y competitors. #-advantages are more profita le than ?-advantages when the following are true: *he nature of the product limits opportunities for enhancing $. #onsumer indifference curves are flat. @roduct is a $#ar%h -oo" (quality attri utes can e assessed prior to the point of purchase) rather than an #.+#ri#n%# -oo" (quality attri utes can only e assessed after purchase and usage) ecause it raises the risk that the enhancements will e imitated. ?-advantages are more profita le than #-advantages when the following are true: 0teep indifference curves. Economies of learning are significant. @roduct is an experience good rather than a search good. St!%; in th# &i""l#: etween #-leader and ?-leader less profita le. #lear choices a out how to compete are critical ecause economically powerful strategic positions typically require trade-offs: - ?-leader must incur higher costs to do so. - #-leader must deliver a undant levels of quality. %actors that might 3#a;#n thi$ tra"#/o'': %irm might achieve low # and high ? when: they offer products that have a slightly higher ? increase market share lower "# ecause of ec of scale or experience curve. *he rate at which accumulated e8perience reduces costs is often greater for higherquality products than for lower-quality products. >igh ? is not necessarily high # firm may e producing more efficientl". %igure 19.1L: achieving enefit and cost advantage simultaneousl". ?ecause of the ?advantage the demand curve shifts right and the "# curve shifts up (higher ? is associated with higher #). Even if the firm raises its price& ecause of the movement of the demand curve& unit costs go down.

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E''i%i#n%5 'ronti#r: indicates the lowest level of cost that is attaina le to achieve a given level of quality& given the availa le technology and know-how. %irms that are closer to the frontier are more profita le than those further away. 8f all firms were producing as efficiently as possi le& their positions would line up along an upward sloping frontier (fig 19.1R). In"!$tr5 $#-&#ntation &atri.: characteri'es an industry along two dimensions: vertically the variety of products that industry participants offer for sale and hori'ontally the different types of uyers that purchase those products ( customer groups uyers with similar tastes& needs and market responses). In"!$tr5 $#-&#nt: differences among (the structural attractiveness of) segments arise due to differences in uyer economics& supply conditions and si'e of the industry (fig 19.1D). Broa" %o,#ra-# $trat#-5: seeks to serve all customer groups in the market y offering a full line of related products. 7conomic logic: scale and scope economies. Fo%!$ $trat#-5: a firm offers either a narrow set of product varieties& serves a narrow set of customers& or does oth. #an insulate the focuser from competition. C!$to&#r $+#%ialization (column): firm offers an array of related products to a limited class of customers. 7conomic logic: rests on the extent to which road-coverage competitors under or over-serve the focusers target group. Pro"!%t $+#%ialization (row): firm produces a limited set of product varieties for a potentially wide class of customers. 7conomic logic: a ility of the focuser to exploit economies of scale or learning economies. 2#o-ra+hi% $+#%ialization: firm offers a variety of related products within a narrowly defines geographic market. @7* SUSTAININ2 COMPETITI9E AD9ANTA2E *hreats to $!$tainin- a %o&+#titi,# a",anta-#: 2ivalry: existing competitors and entry. 8mitation. @owerful uyers=suppliers: can use their argaining leverage to extract profits from thriving firms and will often give ack some of their gains when the firm is struggling. P#r'#%tl5 %o&+#titi,# "5na&i% (fig 16.1): perfect competitive equili rium occurs at the point where the lowest possi le indifference curve is tangent to the efficiency frontier. "t this point economic profits are 'ero and no other @&+-com ination simultaneously results in greater #0 and higher profit. R#-r#$$ion to3ar"$ th# &#an : extreme performances of firms& whether good or ad& are not sustaina le in the long run these are evened out ut they do not converge to the same mean. 9arket forces are a threat to profits& ut only up to some point. *he five forces protect profita le firms. *o achieve a %o&+#titi,# a",anta-# a firm must create more value than its competitors a ility to do so depends on: 1. +tock of resources (patents& rand-name& ase). ). -istinctive capabilities: activities that the firm does etter than its competitors.

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"ccording to the r#$o!r%#/ a$#" th#or5 o' th# 'ir&3 for a competitive advantage to e sustaina le& these resources and capa ilities must e scarce and imperfectl" mobile (untrada le3 trada le& ut not useful for others3 co-speciali'ed: only useful in com ination with something else)& otherwise all firms could create the Sadvantage. I$olatin- &#%hani$&$: economic forces that limit the extent to which a competitive advantage can e duplicated or neutrali'ed through resource-creation activities of other firms. *wo kinds: @* I&+#"i&#nt$ to i&itation: L#-al r#$tri%tion$: patents& trademarks etc are trada le highly mobile hence the price of it is determined y demand and supply. #ompetitive only when the firm has superior knowledge a out how to est utili'e the asset3 possess scare complementary resources that enhance the value of the asset. S!+#rior a%%#$$ to in+!t$ or %!$to&#r$ : locations3 long-term contracts that give firms control over scarce inputs or distri ution channels. #ompetitive only if the firm can secure these at elow-market prices3 if other firms do not recogni'e the value of these assets or are una le to exploit them ( ut: winners curseU). Mar;#t $iz# an" $%al# #%ono&i#$: economies of scale limit the num er of firms that fit into the market& hence arrier to entry. #ompetitive only if demand does not grow to large (otherwise: entryU). Intan-i l# arri#r$ to imitating a firms distinctive capa ilities: - 0ausal ambiguit": causes of a firms competitive advantage are o scure an imperfectly understood ecause the knowledge is often tacit. - -ependence on historical circumstances. - +ocial comple8it": complex interpersonal relationships within the firm3 with the firm and its suppliers= uyers. 2* Earl5/&o,#r a",anta-#: once a firm acquires a competitive advantage& these isolating mechanisms increase the economic power of that advantage over time. L#arnin- %!r,#: firms with the greatest cumulative experience can under id rivals for usiness. R#+!tation an" !5#r !n%#rtaint5: rand name and experience goods. B!5#r $3it%hin- %o$t$: arise when uyers develop rand-specific know-how that is not fully transfera le to su stitute rands = also arise when sellers develop specific know-how a out uyers that other sellers cannot quickly replicate or provides aftersale services to uyers. Eays for sellers to increase switching costs: - %re1uent customer points: tie discounts to the completion of a series of transactions with customers. - 4ffer a bundle of complementar" products that fit together in a product line. N#t3or; #''#%t$ (n#t3or; #.t#rnaliti#$) : consumers often place a higher value on a product if other consumers also use it. *wo kinds of networks: ctual networks: consumers are physically linked (telephone). Core users greater opportunities from communication greater value of the network. - :irtual networks: consumers are linked via complementary goods ((T( players). *he first firm that esta lishes a large installed ase of customers has an advantage ecause new customers will o serve the si'e of the network and gravitate towards the same firm. Cany networks evolve around $tan"ar"$. 4nce a standard is esta lished it is difficult to replace (even if it has lost its initial advantage) hence powerful source of sustaina le

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competitive advantage. *o knock off the dominant standard& the rival must (1) offer superior quality or new options for using the product3 ()) a le to tap into complementary goods markets. Early-mover "i$a",anta-#$ early moves can fail to achieve a sustaina le competitive advantage for the following reasons: - $ack the complementary assets needed to commerciali'e the product. - ?et on the wrong technologies or products high uncertaint" a out demand and technology when an early mover enters the market. %igure 16.L: industry equili rium with imperfect imita ility. "t @N a firms expected operating profit (revenue 7 varia le costs) < cost of entry (cost of factory x return on capital). @otential entrants are ;ust indifferent etween entering or not. Each firms rat# o' r#t!rn on in,#$t#" %a+ital (ROIC) < cost of capital. ?efore entering (e8 ante) each firms expected profit is 'ero (each firm expects to earn the cost of capital). "fter entering ( e8 post) economic profits differ. "verage profit of active firms in the market overstates e8 ante profita ility ecause it ignores unsuccessful firms that have lost money and exited the industry. @:* THE ORI2INS OF COMPETITI9E AD9ANTA2E: INNO9ATIONF E9OLUTIONF EN9IRONMENT "ccording to S%h!&+#t#r: entrepreneurship is the a ility to act on the opportunity that innovation and discoveries create. ,nnovation causes most markets to evolve in a characteristic pattern. Cr#ati,# "#$tr!%tion: evolutionary process: quit period when firms that have developed superior technologies earn positive economic profits shock or discontinuity destroys old sources of competitive advantage and replaces them with new ones the entrepreneurs who exploit the opportunities these shocks create& achieve positive economic profits in the next period of quiet. %ocus lies on "5na&i% #''i%i#n%5: the achievement of long-term economic growth and technological improvement. Di$r!+ti,# t#%hnolo-i#$: technologies that offer much higher ? 7 # than their predecessors ut do so through a com ination of lower ? and su stantially lower #. (ifferent from reakthrough technologies ecause of the emphasis on costs. / Strat#-i% int#nt: sustained o session with world dominance. / Strat#-i% $tr#t%h: gap etween am itions and resources. / H5+#r/%o&+#tition: sources of competitive advantage are eing created and eroded in an increasingly rapid rate. %orce that make firms refrain from innovating: S!n; %o$t #''#%t: a firm that has already committed to a particular technology has invested resources and organi'ational capa ilities that are specific to that technology and are thus less valua le if the firm switches to another technology inertia that favors sticking to the current technology. R#+la%#&#nt #''#%t: entrants are more willing to innovate ecause they are a le to overtake a monopoly position& whereas the monopolist gain would only e to replace itself and thus would gain less from innovating. E''i%i#n%5 #''#%t: comes into play when the incum ent monopolist reali'es that potential entrants may also have the opportunity to develop the innovation. Conopolist usually has more to lose from another firms entry than that firm has to gain from entering the market ecause entrant will not only steal usiness away3 it will also lower @.

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" new firms a ility to prosper from its inventions depends on the &ar;#t 'or i"#a$ influenced y two elements: - *he technology is not easily expropriated y others: good patent protection. - +peciali#ed assets must e8its to produce and market the new product. 8f many firms have these expertises the innovation will go to the highest idder and the innovator will reap all the enefits3 if only a few firms have these expertises& the alance of power shift away to the producers. Earl5/&o,#r a",anta-#$ of eing the first firm to innovate: e the first to get the patent3 enefit from consumer perceptions. Pat#nt ra%#: race etween firms to innovate first. " firm engaged in this race must consider the following factors when determining whether or not to increase 25( spending: - >ow much does increasing investment in crease the chance of winning the raceI (diminishing vs increasing returns on productivity) - #ompetitive response. - "mount of competitors. *wo dimensions of interest when choosing a methodolog": (1) riskiness of 25( (completion data& certainty)3 ()) correlated research strategies if one research is successful& the other one is likely to e not. E,ol!tionar5 #%ono&i%$: firms do not directly choose innovative activities to maximi'e profits3 rather key decisions concerning innovation result from organi#ational routines well-practiced patterns of activity inside the firm. %irms do not change their routines often ecause altering what worked well in the past seems unnatural. D5na&i% %a+a iliti#$: a ility of a firm to maintain and adapt the capa ilities that are at the asis of its competitive advantage. $imited ecause: *he search for new sources of competitive advantage is +ath "#+#n"#nt: depends on the path the firm has taken in the past to get to where it is now. @resence of %o&+l#&#ntar5 a$$#t$: firm-specific assets that are valua le only in connection with a particular product& technology or way of doing usiness sunk cost argument. 8in"o3$ o' o++ort!nit5: firms that do not adapt their existing capa ilities or commit themselves to new markets when these new uncertain windows of opportunities exits may find themselves eventually locked out from the market or competing at a significant disadvantage with early movers. Port#r argues that competitive advantage originates in the local environment in which the firm is ased. -iamond: four attri utes of the home market that promote or impede a firms a ility to achieve competitive advantage in glo al markets: 1. Fa%tor %on"ition$: general-purpose factors of production are often availa le locally or can e purchased in glo al markets3 the most import factors of production are highl" speciali#ed to the needs of particular industries. ). D#&an" %on"ition$: sophisticated home customers or unique local conditions stimulate firms to enhance the quality of their products and to innovate. 9. R#lat#" $!++li#r or $!++ort in"!$tri#$: although many inputs are mo ile and thus firms dont need geographical proximity to o tain them& the exchange of key inputs& certain know-how doe require such proximity. 6. Strat#-5F $tr!%t!r# an" ri,alr5: context of competition3 local management practices3 organi'ational structure3 corporate governance. "lthough rivalry may hold down profita ility in local markets& firms that survive vigorous competition in the home market are often more efficient and innovative.

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Canaging innovation creates a dilemma: formal structure and controls needed to coordinate innovation vs. looseness and flexi ility can foster innovation& creativeness and adaptiveness to changing circumstances.

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Chapter 16 The multitask principle If employees have to multi-task they will focus more on the tasks that are rewarded. Three factors that make for a performance measure 1. Less affected by random factors a. Most people are risk adverse and dislike jobs that involve risky pay. he incentive to take on the risk is very e!pensive for the firm. ". Can clearly identify all the activities a firm needs to have done. a. #tron$er incentives will make employees more focused on those activities. %. Cannot be improved by actions the firm does &' want undertaken. a. #tron$er incentives a$ainst those actions will limit employees from doin$ them. Various performance measures Absolute/Relative ( ) relative measure compares one performance with another employee*s performance. o +asin$ each employee*s pay on the difference between the individual performances will shield the employees from risk if the sources of randomness are positively correlated. o ,elative measurements have the potential to increase multitask problems. -mployees can try to sabota$e each other to $et a better pay. Broad/narrow ( &arrow measurements look at direct profits from an employee .e!/ countin$ the number of pieces of output produced by an individual employee0. +road measurements try to look direct and indirect profits. o +road measure rewards employees for improvin$ overall efficiency in a firm. o +road measure is more subject to random factors. Pay-for-performance will often reduce performance on unmeasured dimensions. It is only profitable for jobs where productivity can be measured directly. Implicit/Explicit Incentive Contracts Implicit -- ) ran$e of performance measures can be incorporated. Explicit -- 1ay is tied to a measure throu$h a predetermined formula. Types of Performance Evaluation 360-degree peer reviews ( )n employee*s supervisor2 coworkers and subordinates are all asked to provide information re$ardin$ that employee*s performance. Management-b -ob!ective s stems ( )n employee and a supervisor work to$ether to construct a set of $oals for the employee and are evaluated at the end of that period how well the employee met those $oals. Merit rating s stems ( -mployees are $iven numerical scores. Costs of Subjective ssessments .like the ones above0 of an Employee!s Performance

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1. Ratings compression ( 3hen the people who need to evaluate an employee*s performance find it personally difficult to reward one employee but not others. a. It weakens incentives. ". #ubject to influence activity a. -mployees mi$ht try to affect their evaluations by establishin$ a $ood personal relationship with supervisors. The "ays firms provi#e incentives$ 1. Promotion Tournaments -- 3here a set of employees compete to win a promotion because the hi$her pay2 etc. increases incentive. "#ree properties o$ promotion tournaments o -mployee*s effort levels increase with the difference of the salaries levels from the promotion. o If more competitors are added2 it can maintain the same incentives for effort by increasin$ the si4e of the pri4e .salary2 etc0 o If there are successive rounds of promotion tournaments2 the wa$e differentials between levels must increase in order to maintain the same incentives for effort. Advantages Circumvent the problem of supervisors who are unwillin$ to make sharp distinctions between employees. hey are a form of relative performance evaluation. %isadvantages 1romotin$ based on a $ood performance in a lower-level job mi$ht not yield the best person for the promotion because different skill sets are re5uired. ,elative performance evaluation rewards employees for sabota$in$ the performance of other employees.

". Threat of Termination ( he stren$th depends on how valuable a job is to the employee. %. Teams ( 6irms can motivate employees to work to$ether by usin$ teams. &ree-rider problems ( Can occur when workin$ in teams. 6irms can help prevent that by keepin$ teams small and allowin$ employees to work to$ether repeatedly. hey can also keep an eye on each other*s actions.

Chapter 17: Strategy and Structure

(2nd chapter of Part V: internal organization) Organizational structure Organizational structure concerns the arrangements, both ormal an! in ormal, b" #hich a irm !i$i!es u% its critical tas&s, s%eci ies ho# its managers an! em%lo"ees ma&e !ecisions, an! establishes routines an! in ormation lo#s to su%%ort o%erations so as to lin& o%%ortunities in the en$ironment #ith its resources an! ca%abilities. 'l re! (han!ler) *tructure ollo#s *trateg". +anagers #ill choose the structure that matches the chosen strateg" best , a%%licable or irms o all sizes.

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-or im%lementation o strateg" its em%lo"ees must &no# it an! &no# #hat it entails or their #or&. .#o ste%s o organization !esign)

'r$ani4in$ simple tasks performed by simple wor' groups Link simple work $roups and their activities into complex #ierarc#ies(

Simple work groups *tructuring sim%le tas&s in sim%le grou%s can be !one in se$eral #a"s)

Individually/ the members of the work $roup are paid based on what they do #elf-mana$ed teams/ a $roup of individuals work to$ether to set and achieve common $oals. Individuals are rewarded in part based on team performance ( e$ 7ierarchy of authority/ 'ne $roup member speciali4es in monitorin$ and coordinatin$ the work of the other members.

*tructure !e%en!s on circumstances) #hen coor!ination is nee!e! choose teams or hierarch". /e"on! a certain size grou% sel -management becomes too costl". Organizing these sim%le tas&s o ten is not o much strategic im%ortance an! can be change! easil". Complex Hierarchy .he organization o a large irm into a com%le0 hierarch" is o much greater im%ortance) a ects more %eo%le an! allocation o assets. .#o %roblems relate! to com%le0 organization structures)

%epartmentali)ation *oordination o$ activities within and between sub$roups.

Departmentalization i!enti ies ormal grou%ings #ithin the organization, organize! along $arious !imensions, eg common tas&s1 unctions, in%uts, out%uts, geogra%hical location an! time o #or&. -or the o%timal structure economies o scale an! sco%e, transaction costs an! agenc" costs shoul! be consi!ere!. 2ach structure has its tra!eo s, re lecting managers %riorities or the irm. Coordination and control of activities becomes im%ortant once grou%s are organize!)

*oordination involves the flow of information to facilitate subunit decisions that are consistent with each other and the $oals of the or$ani4ation.
.#o a%%roaches or !e$elo%ing coor!ination #ithin irms

Autonom /sel$-containment of work units - less coordination between units needed o #tron$ lateral relations across work $roups are seen as important *ontrol involves where in the or$ani4ation decisions are made and who has the authority o )llocation of authority .control0/ Centrali4ation vs decentrali4ation ( a firm is more centrali4ed in re$ards to certain decisions when they are made at hi$her levels in or$ani4ations hierarchy. o )ffects efficiency and a$ency costs. o

Four basic types of structures for large organizations Onl" a limite! number o structural orms are e icient because the characteristics o structures share com%lementarities, ma&ing it !i icult to mi0 an! match them 3coul! result in loss o %er ormance4. 27

+( ,nitar $unctional structure -,-$orm. ) sin$le department is responsible for each of the basic business functions and tasks that are or$ani4ed in departments. he firm is or$ani4ed alon$ functional lines. )llows for speciali4ation of labor to $ain economies of scale in manufacturin$2 marketin$ and distribution. /( Multidivisional structure -M-$orm. Creates a division of labor between top mana$ers and division mana$ers2 allowin$ the former to speciali4e in strate$ic decisions and lon$-ran$e plannin$. ) corporate head5uarters and staff lead a set of autonomous divisions2 each division consistin$ of functionally or$ani4ed departments or other divisions. .e$ 3al-Mart/ each store is a division0 his structure or$ani4es by product line2 related business units2 $eo$raphy or customer type rather than function8task. 3( Matrix structure -$ig +0(3 p 1+6.
.he irm is organize! along multi%le !imensions, usuall" t#o. 'n" combination o the !imensions ma" be use!. 20am%le) irm #ith our unctional grou%s an! our %ro5ects. .he our grou%s each #or& on %articular %arts o each %ro5ect. 6n!i$i!uals #or&ing on the intersection o the matri0 re%ort to t#o hierarchies an! ha$e t#o bosses) eg the grou% manager an! the %ro5ect manager o that %articular grou% an! %ro5ect. .he matri0 structure is o ten onl" use! in %arts o an organization, not the #hole. 6t is $aluable in certain situations o economies o scale an! sco%e an! agenc" consi!erations or or s%eci ic im%ortant issues that a !i erent structure cannot a!!ress success ull", or necessar" #hen there are con licting !ecision !eman!s an! se$ere restraints on managerial resources. 6n case o %ositi$e s%illo$ers bet#een !i erent grou%s an! i acti$ities are %ro it substitutes 3%ro it increase in one area increases it in another as #ell, eg a ne# %ro!uct !esign increases sales an! re!uces costs4 matri0 is ne$er o%timal an! !i$ision is a better choice.

2( 3etwor' structure
-ocuses on in!i$i!uals rather than %ositions1tas&s an! is the most le0ible o the structural t"%es. 7or&ers can contribute to multi%le tas&s an! rearrange! as the tas&s o the organization change. 8e$elo%ments in net#or&ing technologies 3lo#er coor!ination costs4 an! mo!ular %ro!uct !esigns ha$e e0%an!e! the a%%lications o this structure. .his structure is use ul #hen its coor!ination costs are lo#er than the gains in technical e icienc" an! coo%eration. 3e0am%le) biotechnolog" in!ustr"4 .he best organizational structure or a %articular irm !e%en!s on the s%eci ic circumstances it aces. Two factors that affect the efficiency of organizational structures

Technology and task interdependence( Most firms cannot8will not do all ,9: by themselves. o "ec#nolog determines the de$ree of tas' interdependence/ the de$ree to which two or more positions depend on each other to do their own work. ,eciprocal task interdependence/ two or more workers8$roups depend on each other to do their work #e5uential/ one worker8$roup depends on another ( e$ production line2 sales. 1ooled interdependence/ not directly dependent but both are needed for the success of the firm.

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Information flows. -fficient information processin$ by lettin$ work $roups work accordin$ to clear work rules2 and have an increasin$ administrative hierarchy handle the more difficult e!ceptions. he hi$hest mana$ement handles the most difficult ones/ strate$ic decisions. he demands for faster information processin$ can overwhelm an e!istin$ hierarchy and call for reor$ani4ation of structure.

Transnational strategy: -le0ible organizations combine matri0 an! net#or& structures. +ultinationals balance res%onsi$eness to local con!itions #ith centralization to achie$e global economies. *tructure can also a ect strateg" to a certain !egree, as it !etermines ho# #ell in ormation can be gathere! an! %rocesse! or strategic %ur%oses an! ho# these !ecisions #ill be im%lemente! in lo#er le$els o the organization. (urrent !ecisions #ill also be constraine! b" %ast !ecisions. 2$olutionar" economics $ie# the actions o irms as the result o a com%le0 set o beha$ioral %atterns, or routines, that e$ol$e as the irm res%on!s to its en$ironment. *trateg" an! structure are e0am%les o high-le$el heuristics) %rinci%les1gui!e%osts that re!uce the a$erage time s%en! on certain !ecisions an! %roblems.

Chapter 18: Environment, Power, and Culture

(
rd

chapter of Part V: internal organization)

*ome as%ects o managerial !ecision ma&ing that are not tra!itionall" inclu!e! in economic anal"ses o strateg". .he summar" , % 557-558 , seems to co$er most o the cha%ter. 20tra notes) %o#er is not the same as authorit", #hich stems rom e0%licit contractual !ecision ma&ing an! !is%ute resolution rights that a irm or other source grants to an in!i$i!ual. 9o#er is then the abilit" to get things !one in the absence o contracts. 6n luence is using %o#er in a gi$en situation b" a %erson. 6n luence is an e ect o %o#er. .here are $arious sources o %o#er) *tructure o a irm can su%%ort or im%e!e %o#er *tructural holes) one actor is the crucial lin& in a net#or& bet#een other actors) bargaining %o#er :egitimate1 ormal %o#er) base! on someone;s %osition #ithin a hierarch". *ocial e0change1interactions <esource-!e%en!ence %o#er) one has resources that the other nee!s

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