- •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
136 • Chapter 4 • Integration and Its Alternatives
GOVERNANCE
In our example above, we assumed that after firm 1 acquired firm 2, the managers of firm 1 could dictate what actions the managers of firm 2 should take. But integration does not turn managers into marionettes or eliminate self-interest. The same managers at firm 2 who sought to gain at the expense of firm 1 when transacting at arm’s length may also behave selfishly when working in the same firm. It is often taken for granted that contracting inefficiencies disappear when decision makers are joined in the same organization. But this is not necessarily so. Whether integration reduces or eliminates holdup and coordination problems depends on governance arrangements. If we think of contracts as delegating decision rights and control of assets between firms, then governance arrangements delegate decision rights and the control of assets within firms.
An analogy with contracts suggests a useful way to think about governance. When independent trading partners disagree about the proper course of action or division of rewards, they rely on contracts and the courts to sort things out. When individuals within a firm disagree, they rely on the guidance and authority of the central office to sort things out. The central office must be aware that employees, like independent firms, are tempted to act in their own selfish interests. Through the judicious use of carrots and sticks (i.e., bonuses, promotions, and job terminations) the central office can tame that self-interest and get employees to act in the firm’s best interests. The success of integration therefore depends on the central office’s ability to reward and punish workers in ways that contracts cannot.
Contracts are effective when rewards and punishments can be based on objective criteria. Thus, it is important for the central office to use excellent judgment in implementing subjective criteria. (Otherwise, there would be no benefit from integration.) Moreover, the central office should be sensitive to those aspects of production that are most likely to break down because of selfishness and contractual incompleteness. Thus, the central office should reward workers who sacrifice to assure coordination of design attributes; the central office should not exploit workers who make firm-specific investments (for example, by withholding salary increases relative to workers who have more general human capital); and the central office should punish workers who hold up coworkers (for example, by demanding resources) to extract quasi-rents.
Delegation
Another critical role of the central office is delegation—determining which decisions will be made by the central office and which will be left to workers. PRT helps clarify which decisions should be delegated. Consider two types of decisions that a worker can make—decisions about how to use physical assets (e.g., equipment) and decisions about how to use human capital (e.g., the time and effort devoted to work). The central office may gain control over physical assets, but it can never gain full control over human capital—it is up to each employee to decide how hard to work. As we previously discussed, PRT concludes that the central decision-making rights for an activity should be given to those managers whose decisions will have the greatest impact on the performance of that activity. Bearing this in mind, if a manager’s investment in human capital is essential to the productive use of physical assets, then control over the physical assets should be delegated to the manager. Through delegation, the manager is encouraged to make the necessary human capital investments.
Governance • 137
We conclude that when human and physical capital are highly complementary within a given application, then delegate authority. When physical capital is complementary across applications, then centralize. For example, consider a hospital with a surgery suite. If all surgeons in the hospital can benefit from upgrades to the surgery suite, then the hospital should maintain control over upgrade decisions. If the surgery suite has specialized equipment so that it is only suitable for heart surgery, then control of the suite could be delegated to the cardiac surgery team.
Recapping PRT
To summarize, PRT says that the central decision-making rights for an activity should be given to those managers whose decisions will have the greatest impact on the performance of that activity. This leads to several possible merger scenarios:
•If the success of a merger between firms A and B depends on the specialized knowledge of the managers of firm B, then decision authority should be given to the managers of firm B. This would typically mean that firm B should acquire firm A, giving B ownership and control of A’s assets. The merger could also succeed if A acquired B, provided that A delegated decision rights to B’s managers.
•If success depends on synergies associated with the combined assets of firms A and B, such as through the resolution of coordination or holdup problems between a buyer and a supplier, then A and B should merge and the decision-making authority should be centralized.
•If success depends equally on the specialized knowledge of both firms’ managers and there are no synergies from combining assets, then A and B should remain independent.
Path Dependence
Of course, governance arrangements are not always optimal. Often, the process by which governance develops exhibits path dependence. That is, past circumstances could exclude certain possible governance arrangements in the future. For example, if the period following a merger is marked by conflict, an efficient governance structure requiring cooperation between acquired and acquiring firm managers might not be feasible. These same considerations will also apply to disintegration. One might expect a business unit that was spun off to the market to act as an independent market firm. Initially, however, managers in that unit will not be used to making decisions as an autonomous market actor and may continue to rely on associations with managers in the former parent firm. This would make the relationship between the two firms after a spinoff not a market transaction, but rather a long-term informal association, which is somewhere between being part of an integrated firm and a specialized market actor.
The path-dependent nature of the processes by which firms develop can also affect the firm’s capacity to sell the products of a unit to other downstream buyers besides itself. In Chapter 3, we suggested that market specialists could gain economies of scale by selling to multiple downstream buyers. Firms manufacturing for internal use do not typically sell excess output to other firms because this would be both a distraction and an activity for which the firm lacked the requisite skills. If a firm acquired rather than built its supply capacity, however, the situation would be different. The acquired firm would know how to sell to multiple buyers. This marketing capacity would presumably be one of the resources acquired by the parent through the