Download Strategy Creating and capturing value objectives

ECON 308 Week 8-9
Chapter 8: Economics of Strategy
Creating and capturing value
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Case: Wal-Mart
• Wall Mart
– Most profitable retailer in the world, 5,170 stores,1.6 million emp.
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1962: First store opens rural Arkansas, small towns
1993 q2 – 1997: stock value dropped
Slow growth in value till 1997.
2005: $220 billion in sales, $10.3 billion net income
– Responses to problems in mid 1990’s
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New international super-centers
E-commerce sites
Experimented with traditional sized grocery stores in Arkansas
By 1998 the stock was performing well again
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Superior Performance?
• Beating the market over a long period
– What accounts for the success of these firms?
– Should all properly managed firms expect
superior performance?
– What actions can managers take to generate
superior performance?
– Can managers enhance financial returns by
diversification?
– Do all firms eventually drop back to the pack?
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Strategy
• General policies intended to generate profits
– Choice of industry
– Combination of products and services
– Competitive and cooperative behaviors
• Strategies evolve as circumstances change
• Strategies must create and capture value
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Economic Strategy
Maximizing long-run profitability
• Economic Profit : Total Revenue – Total Cost
• Increase Total Revenue ( Price x Quantity)
– How to Increase Price?
– Price is Demand determined
– Increase Value of the product to customer
– How to increase Quantity?
• Decrease Total Economic Cost
– Efficiency in purchase
– Efficiency in production
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Transaction costs
• Consumer transaction costs
– product search
– learning product characteristics and quality
– negotiating terms of sale
– enforcing agreements
• Producer transaction costs
– negotiating terms
– legal expenses
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Creating Value
$ Price
Supply
Consumer
Surplus
P*
Producer
Producer
Surplus
Surplus
Demand
Q*
Quantity/Time
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Creating Value: Reduce Transaction Costs
$ Price
Supply with Producer Transaction Costs
Producer-borne transaction costs
Consumer
Surplus
P*
Producer
Surplus
Consumer-borne transaction costs
Demand with Consumer Transaction costs
Q*
Quantity/Time
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Value creation
• Reduce production costs or producer
transaction costs
– shift supply curve to the right
• Reduce consumer transaction costs
– shift demand curve to the right
• Shift demand to the right by other
means
• Devise new products and services
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Transaction Cost & Creating Value
• Consumer Transaction Costs
– Costs of search
– Costs of learning about product quality
– Costs of Negotiation
• Producer Transaction Costs
– Costs of negotiation
– Attorney fees to draft sales agreements
• Examples
– Dell eliminates the middle man in direct web-site PC sales and splits the
gain between themselves and the buyer
– Early Wall Marts were in rural areas reducing transportation costs by
opening stores closer to customers.
– Kraft Lunchables
– Terrorist Attacks and the Airline Industry
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Creating Value: Advertising
• Major economic function: Provide information
about the product.
– Lowers Search Cost
– Lowers Quality Identification Costs
• Second Function: Create value in the minds of
consumers
– Lowenbrau
– Perfumes
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Creating Value
Reducing Consumer Waiting Time
• Cable Installation:4 hour window
• Doctors Office Patients Waiting
• How to value your time:
– Salary: $ 50,000
– Employee Cost to firm: $ 50,000
– $ 100,000 / 2000 hours = $ 50 per hour.
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Creating Value
Alternative Product Pricing
• Pricing Complements
– Cut the price of the complement and increase the sales of both
products
– Applications
• Printers and Personal Computers
• Razors & Blades
• Pepsi & Frito, and Lays Potato Chips
• Pricing Substitutes
– Raise the price of a substitute
– Applications
• Don’t allow people to bring food into a theater
• Airlines restrict the use of cell phones
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Creating Value: Product Quality
• Product Quality
– Profit is increased if MR > MC
– Marginal Revenue depends on value created for
Customer
• Product Quality Examples
– Titanium Golf Clubs
– Parabolic Skis
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Technology and Value
• Rapidly falling cost of information
processing
– Streamline: Order processing, shipments,
payables, receivables
– Create custom products for smaller groups of
customers
– Reduce transaction costs with suppliers and
customers
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Converting Organizational
Knowledge into Value
• Hardware: physical Assets
• Software: Soft Assets, formulas, recipes for
creating value (can be replicated)
• Wetware: Employees brainpower
(biological computer)
• Firm owns 1,2 but only rents Wetware.
– Must convert 3 into 1,2
– Macdonald’s: Fillet of Fish
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Capturing value
• Long Run Profitability in Competitive
Markets
– Economic Profit
– Accounting Profit
• Firms with Market power
– With barriers to entry
– Without barriers to entry
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Market power comparison
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Market power
Porter’s five forces that affect Market Power
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Potential rivals
Existing rivalry
Substitute products
Buyer power
Supplier power
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Porter’s Five Forces Affecting Market Power
Upstream
Sellers
Value/supply
Chain
Potential
Rivals
Current
Rivals
Substitute
Products
Downstream
Buyers
Competitive
Environment
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Capturing Value: What Works?
• Barriers to entry
• Degree of rivalry
– Number of competitors
– Relative size of competitors
• Threat of substitutes
– Example: Email and fax pose serious threats to profits
for Federal Express and UPS
• Buyer and Supplier Power
– Example: Microsoft and Intel in Personal Computers
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Superior factors of production
• People
– special talents or skills
• Physical assets
– prime real estate
– unique equipment
• But bidding for specialized assets may erode profits
• Some things are hard to copy:
– Flexible Technology
– Team Production
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Producer surplus captured by
superior assets
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Superior factors of production
again
• Team production
– interdependencies among workers increase
value beyond the “sum of the parts”
– luck or foresight may endow firms with
unique team production capabilities
• Rivals may be unable to pinpoint source
of advantage and unable to capture
equivalent value
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Sustainability?
Rank
1970
2004
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IBM
Wal-Mart
2
AT&T
Exxon-Mobil
3
General Motors
General Motors
4
Standard Oil of NJ
Ford Motor
5
Eastman Kodak
General Electric
6
Sears Roebuck
Chevron-Texaco
7
Texaco
Conoco-Phillips
8
General Electric
Citigroup
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Xerox
IBM
10
Gulf Oil
American International Group
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Increasing demand
• Increase expected product quality
– “value added” > cost increase
• Reduce price of complements
• Raise price of substitutes
– limit entry of competitors
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Diversification
• Benefits
– Economies of Scope
• Example: When one input is used in several
products you may get a better price when ordering
it.
– Promoting Complements
• Example: Ford can advertise its auto-financing when
advertising its cars
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Diversification
• Costs
– With larger firms it gets increasingly difficult to
get lower level managers to act in the interests
of the owners.
– Success in management of one area may not
apply in other products
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Diversification
• Benefits
– Economies of scope
– Promoting complements
• Costs
– Bureaucracy
– Incompatible cultures
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Diversification and management
• Diversification for earnings volatility
– may not increase value
• Related diversification
– can increase value
• Capturing the gains
– does the firm bring some special resource
to bear?
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Diversification
• When does diversification create value?
– Related Diversification
• Businesses serve common markets or use common
technologies
• Example: Disney operates theme parks, hotels, retail
shops and TV stations. All are family oriented
products. This can reduce consumer transactions
costs for people searching for safe products for
children.
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Strategy formulation
• Understanding resources and
capabilities
– physical, human, and organizational capital
• Understanding the environment
– markets, technology, regulation, economic
conditions
• Combining environmental and internal
analyses
• Strategy and organizational architecture
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Framework for strategic planning
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To think about...
Can a firm capture value on a sustained
basis?
Discuss.
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Market Power & Profits
• Airbus and Boeing are two major producers
of jumbo jets. Are these firms guaranteed to
make high profits since there are only two
large firms in the industry? Explain.
• No. Even if there are only two firms in
the industry, they may compete
vigorously to reduce prices and profits.
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Specialized Resource & Economic Profits
• The Watts Brewing Company owns valuable water rights
that allow it to produce better beer than competitors. The
company sells its beer at a premium and reports a large
profit each year. Is this firm necessarily making economic
profits?
• No. Its advantage is that it owns a valuable but
marketable asset. The firm may be only making normal
profits given the opportunity cost of keeping the water
rights itself rather than selling them to others in the
marketplace. The company is more valuable because it
owns the water rights. However, selling the rights to
others might be the best way to capture this value.
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Political Competition
• Sun Resorts has a hotel on a Caribbean Island. It
recently spent money to lobby the government to build
a better airport and expand air service. Why did they do
this? Do you think that Sun Resorts cares about how
many airlines will serve the island?
• Airline service is a complement for Sun Resorts.
Cheaper air service to the island increases the
demand for Sun Resorts. Thus, Sun Resorts wants
better airport service and lower airfares. Lower
fares are more likely to result if there are several
airlines that compete in serving the island.
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