- •BUSINESSES IN THE BOOK
- •Preface
- •Brief Contents
- •CONTENTS
- •Why Study Strategy?
- •Why Economics?
- •The Need for Principles
- •So What’s the Problem?
- •Firms or Markets?
- •A Framework for Strategy
- •Boundaries of the Firm
- •Market and Competitive Analysis
- •Positioning and Dynamics
- •Internal Organization
- •The Book
- •Endnotes
- •Costs
- •Cost Functions
- •Total Cost Functions
- •Fixed and Variable Costs
- •Average and Marginal Cost Functions
- •The Importance of the Time Period: Long-Run versus Short-Run Cost Functions
- •Sunk versus Avoidable Costs
- •Economic Costs and Profitability
- •Economic versus Accounting Costs
- •Economic Profit versus Accounting Profit
- •Demand and Revenues
- •Demand Curve
- •The Price Elasticity of Demand
- •Brand-Level versus Industry-Level Elasticities
- •Total Revenue and Marginal Revenue Functions
- •Theory of the Firm: Pricing and Output Decisions
- •Perfect Competition
- •Game Theory
- •Games in Matrix Form and the Concept of Nash Equilibrium
- •Game Trees and Subgame Perfection
- •Chapter Summary
- •Questions
- •Endnotes
- •Doing Business in 1840
- •Transportation
- •Communications
- •Finance
- •Production Technology
- •Government
- •Doing Business in 1910
- •Business Conditions in 1910: A “Modern” Infrastructure
- •Production Technology
- •Transportation
- •Communications
- •Finance
- •Government
- •Doing Business Today
- •Modern Infrastructure
- •Transportation
- •Communications
- •Finance
- •Production Technology
- •Government
- •Infrastructure in Emerging Markets
- •Three Different Worlds: Consistent Principles, Changing Conditions, and Adaptive Strategies
- •Chapter Summary
- •Questions
- •Endnotes
- •Definitions
- •Definition of Economies of Scale
- •Definition of Economies of Scope
- •Economies of Scale Due to Spreading of Product-Specific Fixed Costs
- •Economies of Scale Due to Trade-offs among Alternative Technologies
- •“The Division of Labor Is Limited by the Extent of the Market”
- •Special Sources of Economies of Scale and Scope
- •Density
- •Purchasing
- •Advertising
- •Costs of Sending Messages per Potential Consumer
- •Advertising Reach and Umbrella Branding
- •Research and Development
- •Physical Properties of Production
- •Inventories
- •Complementarities and Strategic Fit
- •Sources of Diseconomies of Scale
- •Labor Costs and Firm Size
- •Spreading Specialized Resources Too Thin
- •Bureaucracy
- •Economies of Scale: A Summary
- •The Learning Curve
- •The Concept of the Learning Curve
- •Expanding Output to Obtain a Cost Advantage
- •Learning and Organization
- •The Learning Curve versus Economies of Scale
- •Diversification
- •Why Do Firms Diversify?
- •Efficiency-Based Reasons for Diversification
- •Scope Economies
- •Internal Capital Markets
- •Problematic Justifications for Diversification
- •Diversifying Shareholders’ Portfolios
- •Identifying Undervalued Firms
- •Reasons Not to Diversify
- •Managerial Reasons for Diversification
- •Benefits to Managers from Acquisitions
- •Problems of Corporate Governance
- •The Market for Corporate Control and Recent Changes in Corporate Governance
- •Performance of Diversified Firms
- •Chapter Summary
- •Questions
- •Endnotes
- •Make versus Buy
- •Upstream, Downstream
- •Defining Boundaries
- •Some Make-or-Buy Fallacies
- •Avoiding Peak Prices
- •Tying Up Channels: Vertical Foreclosure
- •Reasons to “Buy”
- •Exploiting Scale and Learning Economies
- •Bureaucracy Effects: Avoiding Agency and Influence Costs
- •Agency Costs
- •Influence Costs
- •Organizational Design
- •Reasons to “Make”
- •The Economic Foundations of Contracts
- •Complete versus Incomplete Contracting
- •Bounded Rationality
- •Difficulties Specifying or Measuring Performance
- •Asymmetric Information
- •The Role of Contract Law
- •Coordination of Production Flows through the Vertical Chain
- •Leakage of Private Information
- •Transactions Costs
- •Relationship-Specific Assets
- •Forms of Asset Specificity
- •The Fundamental Transformation
- •Rents and Quasi-Rents
- •The Holdup Problem
- •Holdup and Ex Post Cooperation
- •The Holdup Problem and Transactions Costs
- •Contract Negotiation and Renegotiation
- •Investments to Improve Ex Post Bargaining Positions
- •Distrust
- •Reduced Investment
- •Recap: From Relationship-Specific Assets to Transactions Costs
- •Chapter Summary
- •Questions
- •Endnotes
- •What Does It Mean to Be “Integrated?”
- •The Property Rights Theory of the Firm
- •Alternative Forms of Organizing Transactions
- •Governance
- •Delegation
- •Recapping PRT
- •Path Dependence
- •Making the Integration Decision
- •Technical Efficiency versus Agency Efficiency
- •The Technical Efficiency/Agency Efficiency Trade-off
- •Real-World Evidence
- •Double Marginalization: A Final Integration Consideration
- •Alternatives to Vertical Integration
- •Tapered Integration: Make and Buy
- •Franchising
- •Strategic Alliances and Joint Ventures
- •Implicit Contracts and Long-Term Relationships
- •Business Groups
- •Keiretsu
- •Chaebol
- •Business Groups in Emerging Markets
- •Chapter Summary
- •Questions
- •Endnotes
- •Competitor Identification and Market Definition
- •The Basics of Competitor Identification
- •Example 5.1 The SSNIP in Action: Defining Hospital Markets
- •Putting Competitor Identification into Practice
- •Empirical Approaches to Competitor Identification
- •Geographic Competitor Identification
- •Measuring Market Structure
- •Market Structure and Competition
- •Perfect Competition
- •Many Sellers
- •Homogeneous Products
- •Excess Capacity
- •Monopoly
- •Monopolistic Competition
- •Demand for Differentiated Goods
- •Entry into Monopolistically Competitive Markets
- •Oligopoly
- •Cournot Quantity Competition
- •The Revenue Destruction Effect
- •Cournot’s Model in Practice
- •Bertrand Price Competition
- •Why Are Cournot and Bertrand Different?
- •Evidence on Market Structure and Performance
- •Price and Concentration
- •Chapter Summary
- •Questions
- •Endnotes
- •6: Entry and Exit
- •Some Facts about Entry and Exit
- •Entry and Exit Decisions: Basic Concepts
- •Barriers to Entry
- •Bain’s Typology of Entry Conditions
- •Analyzing Entry Conditions: The Asymmetry Requirement
- •Structural Entry Barriers
- •Control of Essential Resources
- •Economies of Scale and Scope
- •Marketing Advantages of Incumbency
- •Barriers to Exit
- •Entry-Deterring Strategies
- •Limit Pricing
- •Is Strategic Limit Pricing Rational?
- •Predatory Pricing
- •The Chain-Store Paradox
- •Rescuing Limit Pricing and Predation: The Importance of Uncertainty and Reputation
- •Wars of Attrition
- •Predation and Capacity Expansion
- •Strategic Bundling
- •“Judo Economics”
- •Evidence on Entry-Deterring Behavior
- •Contestable Markets
- •An Entry Deterrence Checklist
- •Entering a New Market
- •Preemptive Entry and Rent Seeking Behavior
- •Chapter Summary
- •Questions
- •Endnotes
- •Microdynamics
- •Strategic Commitment
- •Strategic Substitutes and Strategic Complements
- •The Strategic Effect of Commitments
- •Tough and Soft Commitments
- •A Taxonomy of Commitment Strategies
- •The Informational Benefits of Flexibility
- •Real Options
- •Competitive Discipline
- •Dynamic Pricing Rivalry and Tit-for-Tat Pricing
- •Why Is Tit-for-Tat So Compelling?
- •Coordinating on the Right Price
- •Impediments to Coordination
- •The Misread Problem
- •Lumpiness of Orders
- •Information about the Sales Transaction
- •Volatility of Demand Conditions
- •Facilitating Practices
- •Price Leadership
- •Advance Announcement of Price Changes
- •Most Favored Customer Clauses
- •Uniform Delivered Prices
- •Where Does Market Structure Come From?
- •Sutton’s Endogenous Sunk Costs
- •Innovation and Market Evolution
- •Learning and Industry Dynamics
- •Chapter Summary
- •Questions
- •Endnotes
- •8: Industry Analysis
- •Performing a Five-Forces Analysis
- •Internal Rivalry
- •Entry
- •Substitutes and Complements
- •Supplier Power and Buyer Power
- •Strategies for Coping with the Five Forces
- •Coopetition and the Value Net
- •Applying the Five Forces: Some Industry Analyses
- •Chicago Hospital Markets Then and Now
- •Market Definition
- •Internal Rivalry
- •Entry
- •Substitutes and Complements
- •Supplier Power
- •Buyer Power
- •Commercial Airframe Manufacturing
- •Market Definition
- •Internal Rivalry
- •Barriers to Entry
- •Substitutes and Complements
- •Supplier Power
- •Buyer Power
- •Professional Sports
- •Market Definition
- •Internal Rivalry
- •Entry
- •Substitutes and Complements
- •Supplier Power
- •Buyer Power
- •Conclusion
- •Professional Search Firms
- •Market Definition
- •Internal Rivalry
- •Entry
- •Substitutes and Complements
- •Supplier Power
- •Buyer Power
- •Conclusion
- •Chapter Summary
- •Questions
- •Endnotes
- •Competitive Advantage Defined
- •Maximum Willingness-to-Pay and Consumer Surplus
- •From Maximum Willingness-to-Pay to Consumer Surplus
- •Value-Created
- •Value Creation and “Win–Win” Business Opportunities
- •Value Creation and Competitive Advantage
- •Analyzing Value Creation
- •Value Creation and the Value Chain
- •Value Creation, Resources, and Capabilities
- •Generic Strategies
- •The Strategic Logic of Cost Leadership
- •The Strategic Logic of Benefit Leadership
- •Extracting Profits from Cost and Benefit Advantage
- •Comparing Cost and Benefit Advantages
- •“Stuck in the Middle”
- •Diagnosing Cost and Benefit Drivers
- •Cost Drivers
- •Cost Drivers Related to Firm Size, Scope, and Cumulative Experience
- •Cost Drivers Independent of Firm Size, Scope, or Cumulative Experience
- •Cost Drivers Related to Organization of the Transactions
- •Benefit Drivers
- •Methods for Estimating and Characterizing Costs and Perceived Benefits
- •Estimating Costs
- •Estimating Benefits
- •Strategic Positioning: Broad Coverage versus Focus Strategies
- •Segmenting an Industry
- •Broad Coverage Strategies
- •Focus Strategies
- •Chapter Summary
- •Questions
- •Endnotes
- •The “Shopping Problem”
- •Unraveling
- •Alternatives to Disclosure
- •Nonprofit Firms
- •Report Cards
- •Multitasking: Teaching to the Test
- •What to Measure
- •Risk Adjustment
- •Presenting Report Card Results
- •Gaming Report Cards
- •The Certifier Market
- •Certification Bias
- •Matchmaking
- •When Sellers Search for Buyers
- •Chapter Summary
- •Questions
- •Endnotes
- •Market Structure and Threats to Sustainability
- •Threats to Sustainability in Competitive and Monopolistically Competitive Markets
- •Threats to Sustainability under All Market Structures
- •Evidence: The Persistence of Profitability
- •The Resource-Based Theory of the Firm
- •Imperfect Mobility and Cospecialization
- •Isolating Mechanisms
- •Impediments to Imitation
- •Legal Restrictions
- •Superior Access to Inputs or Customers
- •The Winner’s Curse
- •Market Size and Scale Economies
- •Intangible Barriers to Imitation
- •Causal Ambiguity
- •Dependence on Historical Circumstances
- •Social Complexity
- •Early-Mover Advantages
- •Learning Curve
- •Reputation and Buyer Uncertainty
- •Buyer Switching Costs
- •Network Effects
- •Networks and Standards
- •Competing “For the Market” versus “In the Market”
- •Knocking off a Dominant Standard
- •Early-Mover Disadvantages
- •Imperfect Imitability and Industry Equilibrium
- •Creating Advantage and Creative Destruction
- •Disruptive Technologies
- •The Productivity Effect
- •The Sunk Cost Effect
- •The Replacement Effect
- •The Efficiency Effect
- •Disruption versus the Resource-Based Theory of the Firm
- •Innovation and the Market for Ideas
- •The Environment
- •Factor Conditions
- •Demand Conditions
- •Related Supplier or Support Industries
- •Strategy, Structure, and Rivalry
- •Chapter Summary
- •Questions
- •Endnotes
- •The Principal–Agent Relationship
- •Combating Agency Problems
- •Performance-Based Incentives
- •Problems with Performance-Based Incentives
- •Preferences over Risky Outcomes
- •Risk Sharing
- •Risk and Incentives
- •Selecting Performance Measures: Managing Trade-offs between Costs
- •Do Pay-for-Performance Incentives Work?
- •Implicit Incentive Contracts
- •Subjective Performance Evaluation
- •Promotion Tournaments
- •Efficiency Wages and the Threat of Termination
- •Incentives in Teams
- •Chapter Summary
- •Questions
- •Endnotes
- •13: Strategy and Structure
- •An Introduction to Structure
- •Individuals, Teams, and Hierarchies
- •Complex Hierarchy
- •Departmentalization
- •Coordination and Control
- •Approaches to Coordination
- •Types of Organizational Structures
- •Functional Structure (U-form)
- •Multidivisional Structure (M-form)
- •Matrix Structure
- •Matrix or Division? A Model of Optimal Structure
- •Network Structure
- •Why Are There So Few Structural Types?
- •Structure—Environment Coherence
- •Technology and Task Interdependence
- •Efficient Information Processing
- •Structure Follows Strategy
- •Strategy, Structure, and the Multinational Firm
- •Chapter Summary
- •Questions
- •Endnotes
- •The Social Context of Firm Behavior
- •Internal Context
- •Power
- •The Sources of Power
- •Structural Views of Power
- •Do Successful Organizations Need Powerful Managers?
- •The Decision to Allocate Formal Power to Individuals
- •Culture
- •Culture Complements Formal Controls
- •Culture Facilitates Cooperation and Reduces Bargaining Costs
- •Culture, Inertia, and Performance
- •A Word of Caution about Culture
- •External Context, Institutions, and Strategies
- •Institutions and Regulation
- •Interfirm Resource Dependence Relationships
- •Industry Logics: Beliefs, Values, and Behavioral Norms
- •Chapter Summary
- •Questions
- •Endnotes
- •Glossary
- •Name Index
- •Subject Index
Creating Advantage and Creative Destruction • 385
possess unique resources and capabilities, they will be competing against others for the same potential profit. Competition intensifies until there are no profits to be had. This occurred when the dot-com bubble of the 1990s sobered overly optimistic investors. A few of the firms from that era survived, but most did not. Likewise, some investors made a bundle, but most did not. Health information technology is supposed to be the “next big thing,” so it too is attracting hundreds of start-up businesses and the expected profits of a start-up are close to zero. The same story has been retold in countless markets. To reiterate, competition eliminates overall industry profits, even though some firms prosper and a handful reap fortunes.
CREATING ADVANTAGE AND CREATIVE DESTRUCTION
Before firms can sustain advantage they must create it. Simply put, firms create advantage by exploiting opportunities that other firms either ignore or cannot exploit. Seizing such opportunities is the essence of entrepreneurship, which is often seen as synonymous with discovery and innovation. But, as Joseph Schumpeter has stated, entrepreneurship is also the ability to act on the opportunity that innovations and discoveries create:
To undertake such new things is difficult and constitutes a distinct economic function, first, because they lie outside the routine tasks that everybody understands and secondly because the environment resists in many ways that vary, according to social conditions, from simple refusal either to finance or to buy a new thing, to physical attack on the person who tries to produce it. To act with confidence beyond the range of familiar beacons and to overcome that resistance requires aptitudes that are present in only a small fraction of the population and define the entrepreneurial type as well as the entrepreneurial function. This function does not essentially consist in either inventing anything or otherwise creating the conditions which the enterprise exploits. It consists in getting things done.18
Schumpeter believed that innovation causes most markets to evolve in a characteristic pattern. Any market has periods of comparative quiet, when firms that have developed superior products, technologies, or organizational capabilities earn positive economic profits. These quiet periods are punctuated by fundamental “shocks” or “discontinuities” that destroy old sources of advantage and replace them with new ones. The entrepreneurs who exploit these shocks achieve positive profits during the next period of comparative quiet. Schumpeter called this evolutionary process creative destruction.
Schumpeter’s research was largely concerned about the long-run performance of the economy, and he criticized economists who focused exclusively on the outcomes of price competition when promoting the benefits of free markets. What really counted was not price competition, but competition between new products, new technologies, and new sources of organization.
This kind of competition is as much more effective than the other as a bombardment is in comparison with forcing a door, and so much more important that it becomes a matter of comparative indifference whether [price] competition in the ordinary sense functions more or less properly; the powerful lever that in the long run expands output and brings down prices is in any case made of other stuff.19
Disruptive Technologies
There is no end to the list of new technologies that “creatively destroyed” established markets and their dominant firms—quartz watches, cellular communication, and computer flash memory are just a few examples. In the parlance of Chapter 9, these
386 • Chapter 11 • Sustaining Competitive Advantage
technologies succeeded because they had higher B–C than did their predecessors. In the popular book, The Innovator’s Dilemma, Clay Christensen identified a special class of products that offer much higher B–C than their predecessors, but do so not through incremental improvements but with entirely new technologies that drastically lower C.20 In the spirit of Schumpeter, Christensen calls these disruptive technologies. Examples include computer workstations (replacing more powerful mainframes), ink jet printers (replacing higher visual-resolution laser printers), electronic mail (replacing more personal “snail mail” and the telephone), and downloadable MP3 recordings (replacing higher audio-resolution compact discs). Not all low C technologies are disruptive. Backers of the Segway human transporter thought for a brief moment that it would replace the automobile for urban commuting. Most commuters thought the B was too low, and so the Segway was relegated to niche status.
The concept of the innovator’s dilemma raises a fundamental question about sustainability: Are large firms doomed to be less innovative than smaller rivals? Economists have identified four factors that weigh on this question: (1) the productivity effect, (2) the sunk cost effect, (3) the replacement effect, and (4) the efficiency effect.
The Productivity Effect
Suppose that a large firm and five small firms all pursue the same research objective. The first firm to succeed obtains a patent and enjoys sustained profits. To make for a level playing field, suppose that the total size of the research effort of the small firms equals the total research effort of the large firm. Will the large firm win the race? The answer depends in part on whether the large firm will be more productive at research, or what we call the productivity effect.
The large firm may have the advantage of scope economies. For example, a large pharmaceutical company could maintain a biostatistics department that services all of its research activities. But these scope economies can be defeated by the sheer statistical power of the innovative process. In this example, innovation is a winner-take-all activity rewarded by a patent. Economists call this type of competition patent racing. Statistical analysis shows that if there are no scope economies, then the winner of the patent race is most likely to be one of the five small firms each pursuing an independent research agenda. This is because the large firm may not explore all possible research directions, which handicaps its effort to be the first innovator. The large firm could counter this by dividing its efforts among five smaller internal research labs. But this tactic only works if the internal labs are truly independent. If lab managers are influenced by a common corporate research philosophy, or if they mimic each other’s strategies, then the research efforts will be correlated and one of the five independent firms will be more likely to win the race.
The incentive and bureaucratic effects of vertically integrated firms also weigh on large firms seeking to motivate internal research labs. It is very difficult for large firms to provide a financial incentive for innovation that rivals the potential rewards earned by the innovative entrepreneur. Countering this, Jeremy Stein observes that investors in R&D firms often have little direct understanding of the underlying science and cannot easily evaluate research progress. 21 However, this may work to the benefit of the firms because the investors do not meddle in research decisions. The managers of small R&D firms are usually also their founders. This may work against the firms because the managers/founders might overstate the success of ongoing research rather than see the plug pulled on their projects and, therefore, on their firms. In contrast, allocation of R&D in large firms is conducted by scientists (often with the title of vice president
Creating Advantage and Creative Destruction • 387
for research). They oversee the funding of numerous projects. If one project is faltering, they can reallocate funds to another without fear of losing their jobs. In this way, larger firms may do a better job of allocating research dollars.
The Sunk Cost Effect
The sunk cost effect has to do with the asymmetry between a firm that has already made a commitment to a particular technology or product concept and one that is planning such a commitment. The sunk cost effect arises because a firm that has already committed to a particular technology has invested in resources and organizational capabilities that are likely to be specific to that technology and are thus less valuable if the firm switches to another technology. For an established firm, the costs associated with these investments are sunk and thus should be ignored when the firm considers whether to switch to a new technology. Ignoring these sunk costs creates an inertia that favors sticking with the current technology. By contrast, a firm that has not yet committed to a technology can compare the costs of all of the alternative technologies under consideration and is thus not biased in favor of one technology over another.
The Replacement Effect
Who stands to gain more from an innovation: a profit-maximizing monopolist or a new entrant? The Nobel Prize–winning economist Kenneth Arrow considered the incentives for adopting a process innovation that would lower the average variable costs of production.22 The innovation is drastic: once it is adopted, producers using the older technology will not be viable competitors. Arrow compared two different scenarios: (1) the opportunity to develop the innovation is available to a firm that currently monopolizes the market using the old technology, and (2) the opportunity to develop the innovation is available to a potential entrant who, if it adopts the innovation, will become the monopolist. Under which scenario, Arrow asked, is the willingness-to-pay to develop the innovation greatest?
Arrow concluded that assuming equal innovative capabilities, an entrant would be willing to spend more than the monopolist to develop the cost-reducing innovation. The intuition behind Arrow’s insight is this: a successful innovation for a new entrant leads to it becoming a low cost monopolist; a successful innovation by the established firm maintains its monopoly, albeit at lower cost. So the entrant gets the full benefit of being a low cost monopolist while the incumbent monopolist gets the partial benefit of increasing its monopoly profits further. Thus, the entrant has greater incentive to innovate. Put another way, through innovation an entrant can replace the monopolist, but the monopolist can only replace itself. For this reason, this phenomenon is called the replacement effect.23
The Efficiency Effect
If an incumbent monopolist anticipates that potential entrants may also have an opportunity to develop the innovation, then the efficiency effect comes into play. To understand the efficiency effect, compare the following: (1) the loss in profits when a monopolist becomes one of two competitors in a duopoly, and (2) the profits of a duopolist. Most oligopoly models, including the Cournot model discussed in Chapter 5, suggest that (1) is larger than (2). In other words, a monopolist usually has more to lose from another firm’s entry than that firm has to gain from entering the market. The reason is that the entrant not only takes business from the monopolist, but also