- •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
Applying the Five Forces: Some Industry Analyses • 271
•Employers, payers, regulators, and patients are demanding and getting more information about hospital quality. This could allow the best hospitals to command premium prices but could also increase the willingness of patients and their doctors to switch from hospitals whose quality is merely satisfactory.
Commercial Airframe Manufacturing
The firms that build airplanes are called airframe manufacturers. Airbus Industries and the Boeing Company have been in an effective duopoly since Lockheed pulled out in 1986 and Boeing acquired McDonnell Douglas in 1997. Despite limited competition, Airbus and Boeing still face threats from each other, as well as from some key fringe players.
Market Definition
We confine our analysis to companies that make airplanes for commercial aviation. Business jets, such as Citations and Gulfstreams, are not considered relevant since their prices have no bearing on the market for big jet airplanes. Three other companies, Montreal-based Bombardier and Brazil-based Embraer, and European joint venture ATR manufacture small-capacity (50 seats) and medium-capacity (50 to 100 seats) turboprop and jet aircraft for commercial use. Taken together, these fringe players have a combined market share of about 20–30 percent by aircraft and a much lower share by revenue. If we restrict attention to planes with more than 125 seats, then Boeing and Airbus have the entire market to themselves. Thus, we will largely pay attention to the competitive battle between Boeing and Airbus. These two firms compete globally; there are no meaningful geographic submarkets in which other companies compete.
Internal Rivalry
Boeing was established in 1917 and built military aircraft for the better part of 40 years. It delivered its first commercial aircraft in 1958. Airbus was established in 1967 by a consortium representing the governments of Great Britain, France, and Germany. Airbus did not deliver its first plane until 1974. In part because it is an older company, Boeing has produced many more airplanes than has Airbus—15,000 compared to 7,000. Airplanes are built to last—25 years or longer—and most of the planes that Boeing has built are still flying. Boeing’s market dominance seems to be waning, however. In the past few years, both Boeing and Airbus have each delivered about 400 new planes annually. (New aircraft deliveries are much more stable than orders, which can range from under 200 to over 1,000 airplanes per manufacturer per year.)
European governments heavily subsidized Airbus during its early years. These subsidies enabled Airbus to undercut Boeing’s prices and build market share. Boeing remained price competitive, in part, because it enjoys scope economies from its military aircraft division. Several factors tempered Airbus’s incentives to reduce prices. Demand for air travel grew steadily throughout the 1990s. Although air travel declined during the 2001 recession (and particularly after the September 11 attacks), it quickly recovered. Many airlines are investing to renew their fleets, which has spiked demand for new generations of the Boeing 737 and Airbus 320. At the same time, the emergence of new carriers in the Middle East and Asia, and ever-increasing demand by business for comfortable transoceanic travel, has fueled demand for the new Airbus 380 and Boeing 787. But nothing is guaranteed. Following the financial collapse in 2008, Boeing saw new orders plummet by over 80 percent.
272 • Chapter 8 • Industry Analysis
Airbus and Boeing cope with demand volatility by limiting production capacity. During good times, Airbus and Boeing run at capacity, maintaining order backlogs that can take years to fulfill. This helps reduce rivalry to some extent, as neither firm can rapidly expand market share at the other’s expense. However, backlogs decline or even disappear during downturns. Neither Boeing nor Airbus has seemed willing to shed productive capacity (through large-scale layoffs and plant closings), with the result that marginal costs decline dramatically during downturns. Not surprisingly, Boeing and Airbus are both willing to renegotiate deals at these times. The fact that a single deal with a major carrier can account for nearly 15 percent of Boeing or Airbus’s business intensifies the willingness to shave prices when times are bad.
Historically, Boeing and Airbus enjoyed little product differentiation. Flag carriers British Airways and Air France preferred Airbus, for obvious reasons. Otherwise, the airlines feel that the two manufacturers offer virtually identical products. For example, the Boeing 737 and Airbus A320 have similar seating capacities, performance, fuel economy, and flying range. Even so, airlines have developed loyalties. Southwest and Ryan Air exclusively fly Boeing 737s, allowing the carriers to economize on parts and maintenance. Boeing and Airbus have exploited this trend by making parts interchangeable across different models. The result is that a few carriers buy exclusively from Airbus while others rely on Boeing. This may limit incentives to reduce prices on airplanes in the future, for it will be increasingly difficult for Airbus and Boeing to steal each other’s customers.
There is even some differentiation in the products themselves. The Airbus A380 is a double-decker plane capable of seating over 550 passengers (but usually configured for fewer passengers with more amenities). Sales thus far are sluggish, in part because airports need to reconfigure arrival gates to accommodate the jumbo planes. Boeing’s 787 Dreamliner is smaller but more fuel efficient than the A380. Orders for the 787 double those for the A380, but Boeing has delivered just a handful of planes due to major production delays that we described in Example 3.4.
Barriers to Entry
High development costs and the experience-based advantages of the incumbents combine to make entry into the commercial airframe manufacturing industry extremely difficult. It cost Airbus an estimated $13 billion to develop the A380. Airbus hopes to make about $50 million in profit per aircraft. With discounting, Airbus will need to sell over 350 planes to break even; thus far, only about 250 have been ordered. A startup manufacturer would likely face higher development costs owing to experience effects. It could also expect smaller margins, both because airlines are reluctant to purchase from start-ups (Airbus discovered this 30 years ago) and because entry would likely engender a price response by Airbus and Boeing. Entry by a newcomer in the jumbo segment would therefore be very risky.
Incumbents are also protected by the learning curve in production. Stanford University economist Lanier Benkard used detailed data on the production of the Lockheed L1011 to estimate the learning curve for producing that plane.2 He found that with a doubling of experience, the number of personnel required to produce a plane would fall by 35 to 40 percent. However, this effect is mitigated by “forgetting” (i.e., past experience is less valuable as time goes by). In fact, the economic downturn of the early 1970s, which caused a decline in demand for the L1011, helps explain why Lockheed failed to achieve the anticipated learning benefits. Even so, learning effects are usually substantial and help further insulate incumbents from competition by newcomers.
Applying the Five Forces: Some Industry Analyses • 273
We have already noted that some airlines prefer to purchase from the same manufacturer. This poses yet another barrier to entry. One positive note for entrants— access to raw materials and labor is not a significant barrier.
Substitutes and Complements
From the perspective of the airlines, the only substitute for an airplane made by Boeing or Airbus would be an airplane made by someone else. Historically, Boeing and Airbus made the only planes that met airlines’ needs for mediumand largecapacity planes capable of flying thousands of miles. But this is no longer the case.
Passengers are weary of hub-and-spoke travel and the associated delays and lost baggage. Even so, it has not always been economically viable for airlines to replace mediumto long-haul hub-and-spoke flights with nonstop point-to-point travel. Simply put, demand for these routes has been too small to fill the smaller Boeing and Airbus jets. Around 1990, Canadian manufacturer Bombardier and Brazilian manufacturer Embraer filled this important void. The Bombardier CRJ series and Embraer ERJ series “regional jets” seat 50 to 90 passengers and are capable of flying over 2,000 miles. Both companies now offer newer and larger planes capable of seating up to 125 passengers. European joint venture ATR offers smaller turboprops to carriers looking for low-cost short-haul aircraft. Regional jets and turboprops increase the number of economically viable point-to-point routes and allow airlines to increase the frequency of flights on existing routes, for example, flying four round trips daily from Chicago to Syracuse on a small jet, instead of just twice daily on a larger plane. This is especially appealing to airlines courting the lucrative business segment.
The market response has been overwhelming, with about 3,000 regional jets sold to date and about 200–300 new deliveries annually. There is no doubt that much of this has come at the expense of Boeing 737s and Airbus 320s, the traditional workhorses of the major carriers. As demand for air travel rises, some carriers are finding it profitable to switch back to 737s and 320s; the cost per passenger mile is lower on a full 120-seat plane than on a full 50-seater.
Substitution also comes indirectly from other forms of transportation. High-speed rail may be a particularly important substitute, for it matches or exceeds the airlines’ “product performance characteristic” of high-speed transport. High-speed rail is currently operational in Japan. The Maglev (a high-speed train) is a levitating train able to reach speeds of up to 500 kilometers per hour. Although this may affect regional aircraft in certain routes, it is unlikely to affect commercial aircraft owing to the high development costs, the long time horizon for development, and their physical constraints.
Teleconferencing and other modes of business communication are probably substitutes for air travel and therefore affect the demand for airplanes.
Supplier Power
Boeing and Airbus can obtain raw materials and components from competitive supplier markets. However, most parts suppliers do more business selling replacement parts to airlines than selling original equipment to Boeing and Airbus, so the airframe makers do not have an iron grip on their suppliers. There are a few suppliers that may be in a position of strength when bargaining with Boeing and Airbus. For example, General Electric competes primarily with Pratt & Whitney and Rolls Royce in the manufacturing of jet engines. When Boeing and Airbus do well, these three firms can negotiate more favorable supplier contracts for themselves.