Economics of Strategy

Economics of StrategyUniversity of VictoriaSummer 2011Pascal CourtyEconomics of StrategyObjectives for today

Discuss course outlineIntroduction to economics of strategyAcademic influencesCourse objectives: learn how market environment and firms strategy influence firm performanceLearning approach: mix of formal lectures (1/2), discussion of research articles (1/4), and class discussion(1/4)Material: book, slides, weekly emails, research articlesPre-requisites: Micro, IO, game theoryExpectations: read book chapters, read research articles, follow instructions in weekly emailsGrading: pb sets (40%), midterm (30%), essay (30%)Course outline3Part I. Incentives, Firms, and MarketsChapters 3, 5, 6, 16, 17Performance measurement and incentives within firmsVertical boundaries of the firmPart II. Markets and Competitive AnalysisChapters 9, 10, 11, 12Thinking strategically and strategic commitmentPricing rivalryEntryIndustry analysisPart III. Competitive Advantage and Industry DynamicsChapters 13, 14, 15Competitive advantageInnovation and industry dynamicsCourse Contents4Economics 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 MarketsThe 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, 112145.Competition and Business Strategy in Historical Perspective. Pankaj Ghemawat. The Business History Review, Vol. 76, No. 1 (Spring, 2002), pp. 37-74Performance 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 AnalysisHow 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: 15-30Commitment to a Process Innovation: Nucor, USX, and Thin-Slab Casting. Pankaj Ghemawat. Journal of Economics & Management Strategy Volume 2, Issue 1, pages 135161, 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 DynamicsManaging 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 1169-1208Does 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. 221-235On 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, ChicoCopyright 2010 John Wiley Sons, Inc.Chapter 4

The Power of Principles: A Historical Perspective1840, 1910, and TodayThe 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 1840Numerous intermediaries - Farmers to factors to brokers agents to buyersSubstantial price risk for participantsInfrequent transactionsScarcity of information regarding sales and prices of comparable goodsInfrastructure in 1840Infrastructure 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 1840Railroads, 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 marketsCommunication in 1840Postal 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 1840Most 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 1840Most 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 1840Government 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 1840Technology 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 1840Without 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 1910Mass-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.18Business Conditions in 1910Manufacturing 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 1910Securities 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 1910Government 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 1910Expanded 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 TodayLarge vertically integrated firms have been declining.Alliances and joint ventures could work better than mergers and acquisitions.Firms adopt complex matrix structures.Transportation Infrastructure TodayAir, 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 TodayCapacity 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.FinanceRegulation 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 TechnologyModern 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.GovernmentIn some areas (airlines, trucking and financial services) traditional regulation has been relaxed.Regulation has increased in other areas (workplace safety, discrimination and environmental protection).GovernmentIntergovernmental treaties and agreements create regional free trade zones.Governments anti trust policy encourages in-house development of capabilities.Government policy supports basic research and the commercialization of R & D projects.Business TodayWith 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 MarketsUnlike 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 StrategyBusiness 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.