SUMMARY BESANKO

CHAPTER 2 : ECONOMIES OF SCALE AND SCOPE

Economies of scale are the key determinant of a firms horizontal boundaries (the quantities
and varieties of products and services that a firm produces.
Economies of scale : when average costs (cost-unit) decrease as output increases fixed
costs are spread over increasing output.
Diseconomies of scale: when average costs increase as output increases production runs
up against capacity constraints or encounters coordination or other agency problems.
-

U-shaped AC curve: in the short run.

L-shaped AC curve: in the long run firms can expand their capacity by building new
facilities. Firms expand their output until the minimum efficient scale (MES).

Economies of scope: firm achieves savings as it increases the variety of goods and services it
produces. Leveraging core competencies, competing on capabilities, mobilizing indivisible
assets. Defined in terms of: the relative total costs of producing a variety of goods and
services together in one firm versus separately in 2 or more firms.
TC (QXQY) < TC(QX) + TC(QY)
TC (QXQY) - TC(QX) < TC(QY)
The incremental cost of producing good X, is lower when the firm if producing good Y than if
it doesnt produce good Y.
Sources of economies of scale and scope:
1. Indivisibilities and the spreading of fixed costs. Fixed costs arise when an input
cannot be scaled down below a certain minimum size, even when the level of output
is very small (e.g. is indivisible). Reductions in AC due to increased in capital
utilization are short-run economies of scale (occur within a plant of a given size);
reductions due to adoption of a technology that has high fixed costs but lower
variable costs are long-run economies of scale. On different levels:
- Product level: spreading of product-specific fixed costs such as special
equipment, R&D expenses, training expenses, costs necessary to set up a
production process.
- Plant level: firms chose the production technology (fully vs. partially
automated) that minimizes AC (fig. 2.4).
- Multiplant level: capital intensive industries are more likely to display
economies of scale than material or labour intensive industries because
capital is indivisible and materials and labour are divisible (costs increase
with increasing output).
2. Specialization: increased productivity of variable inputs. Smiths Theorem states that
specialization is limited to the size of the market. Individuals will only make the
specialization investment if the market is big enough to support them. Thus, larger
markets will support a more specialized array of activities than smaller markets can.

3. Inventories. Firms carry inventories to minimize the chance of running out of stock.
A stock-out can cause lost business and loss of confidence of customers. Costs of
holding inventories are: interest on the expenses borne in producing the inventory and
the risk of depreciation. They drive up the average costs of the goods sold 1:1. The
need to carry inventories creates economies of scale because firms doing a high
volume of business can usually maintain a lower ratio of inventory to sales while
achieving a similar level of stock-outs.
4. Engineering principle of the cube-square rule: as the volume (~ production capacity)
of a vessel (~ production process) increases by a given proportion, the surface area (~
total production costs) increases by less than this proportion. Thus, AC decrease.
Sources of economies of scale and scope related to other areas than production:
1. Purchasing: big businesses that make large purchases from their suppliers may obtain
discounts, enabling them to enjoy a cost advantage over their smaller rivals. Reasons for a
supplier to give these discounts:
- Less contraction-costs to sell to a single buyer.
- A bulk purchaser has more to gain from getting the best price and therefore will be
more price sensitive.
- Assure a steady flow of business.
Small firms may form purchasing alliances that buy in bulk in order to obtain quantity
discounts.
2. Advertising: Advertising costs per consumer = (costs of sending a message / no of
potential consumers receiving the message) / (no of actual consumers as a result of the
message / no of potential consumers receiving the message).
Larger firms may enjoy lower advertising costs per consumer either because they have:
- Lower costs of sending messages per potential consumer: because the fixed costs of
advertising (preparation costs, negotiation with publisher) get spread over a larger
base of potential customers.
- Higher advertising reach: more shops where you can buy the brand; easier to reach
for customers.
Umbrella branding: consumers use the information in an advertisement about one
product to make inferences about other products with the same brand name, thereby
reducing advertising costs per effective image. (Sometimes firms prefer to keep brand
identities separate to avoid tarring its luxury market with a mass-market reputation.)
3. R&D: scale economies because it is a substantial indivisible investment which implies that
AC will decline as output increases; scope economies when the ideas developed in one
research project create positive spillovers to another project. But: smaller firms may have
more incentive to innovate. Effect of size on R&D is ambiguous.
Practices display complementarities when the benefits of introducing one practice are
enhanced by the presence of others. Aka strategic fit: the whole of a firms strategy exceeds
the sum of the parts of its organizational processes. It is necessary to firms seeking a longterm competitive advantage over their rivals since it is difficult to copy each individual
process.
Sources of diseconomies of scale:
1. Higher labor costs than small firms => wage gap => large firms have to pay a
compensating differential because:

Their work is less enjoyable than the work in small firms.

Need to draw workers form greater distances compensate transportation costs.
Need workers with unique and highly valued skills.

However, there are factors that work in favor of large firms:

- Lower worker turnover.
- More attractive to highly qualified, upwardly mobile workers who want to move
up the corporate ladder without changing employers.
2. Spreading specialized resources too thin: if a specialized input is a source of competitive
advantage for a firm, and a firms attempts to expand its operations without duplicating the
input, the expansion may overburden the specialized resource.
3. Conflicting out: the possibilities for conflict place a natural limit on the market share that
any one professional services firm can achieve e.g. accounting, consulting, law.
4. Incentive and coordination effects: in large firms compensation is less likely to be tied to
the workers contribution toward firm profit. And more difficult to monitor and communicate
with workers.
Learning curve (experience curve): refers to advantages that flow from accumulating
experience and know-how. The benefits of learning manifest themselves in lower costs,
higher quality, and more effective pricing and marketing.
Expressed in terms of the slope of how far AC decreases as cumulative output
doubles. Figure 2.7.
When a firm enjoys the benefits of a learning curve: MC of increasing current production =
expected MC of the last unit of the firm expects to sell. => Learning firms should be willing
to accept short-run prices that are below short-run costs.
Managers who are rewarded on the basis of short-run profits may ignore this; firms could
solve this problem by directly accounting for learning curve benefits when assessing profits
and losses.
BCG growth/share matrix: figure 2.8. Strategy for successfully managing a portfolio of
businesses was based on taking advantage of the learning curve and the product life cycle:
product demand is thought to move through 4 stages:
- Phase 1: Introduction; low sales and low growth
- Phase 2: Growth; demand grows rapidly
- Phase 3: Maturity; sales level off as demand becomes increasingly driven by
replacement sales rather than sales to new customers
- Phase 4: Decline; demand declines as superior substitute products emerge
In phase 1 firms should use funds from cash cows to increase production and exploit learning
economies; eventually these markets will become mature and turn into cash cows.
Remarks: learning curves are not uniform; PLCs are easier to identify once they have been
completed than during the panning process; role of the firm as banker is questionable when
other sources of capital are easily available.
To maximize the benefits of learning; the correct balance between stability and change has to
be found. Codifying work rules and reducing worker turnover facilitates retention of
knowledge but may stifle creativity. On the other hand, worker-specific learning can become
too complex to transmit across the firm.
Task-specific knowledge: workers can shop around with their talents and capture the value of
learning for themselves by asking higher wages.

Firm-specific knowledge: worker knowledge is tied to their current employment and the firm
will not have to raise the wages if workers become more productive.
Decreasing AC in two ways:
- In simple capital-intensive activities: large ec of scale and low learning ec. Cutbacks
in production increase unit costs; less concerned about labour turnover.
- In complex labour-intensive activities: low ec of scale (no decrease in AC in a given
year) and large learning ec (AC decrease across several years): figure 2.10.
Cutbacks in production do not increase unit costs.
Managers should carefully distinguish between the two in order to make correct inferences
about the size in a market.
3. AGENCY AND COORDNATION
Organizational problems agency and coordination - remain an important potential
diseconomy of scale.
An agency relationship occurs when one party (the agent) is hired by another party (the
principal) to take actions that affect the payoff of the principal. An agency problem
(motivation problem) arises when two conditions are met:
1. The objectives of the principal and the agent are different.
- Principals objective: max the value it receives as a result of the agents actions and
the payment to the agent.
- Agents objective: max the value it receives from the principal minus the costs
incurred in doing so.
2. The actions taken by the agent (hidden action) or the information possessed (hidden
information) by the agent is hard to observe.
Tools to combat agency problems:
1. Monitoring: expend resources watching employees or gathering information that
employees use to make decisions. However, there are some limitations:
- Imperfect due to the complexity of the organization.
- Hiring monitors can be quite costly.
- Hiring a monitor often introduces another layer to the agency relationship.
2. Performance based incentives: the principal offers to link the agents pay to the
payoff the principal receives from the agents action.
- Figure 3.1: convex cost of effort function (marginal cost of effort increase as the
employee works harder).
- Figure 3.2: the employee increases effort until MC of effort (the slope of a line
tangent to the effort cost curve) is equal to MB (commission on sales) and the firms
profits increase. With a higher commission rate, the employees MB approaches the
total MB. So the employee has full ownership of the value he creates and will
therefore make the effort-decision that will maximize overall value. The firm can
capture this value by reducing the fixed salary.
- Figure 3.3: if the firm offers a lower fixed salary, the employees effort choice is
unchanged since MB and MC are unchanged.
Complications: (1) sales are likely to be affected by a variety of factors hat are beyond
the salespersons control; individuals tend to be risk averse will accept the (risk of)
performance based incentives only when they are compensated for bearing such risk,
which makes performance based incentives more expensive; (2) employees can have a

multitude of tasks which makes it difficult to balance incentives of employees; (3)

employees sometimes work as a team not possible to give each employee full
ownership of the value he creates.
3. Bureaucracy: limit the set of actions that employees are allowed to take (red tape,
paperwork, hierarchy); but might limit employee productivity and make it difficult to
control for agency problems.
Coordination problems arise from the observation that the best action for one person to take,
will often depend on the actions taken by others or on the information held by others. It is
important for individuals to find ways to coordinate their actions. Hayek emphasized the role
that prices and markets play in solving coordination problems. These do not solve intraorganizational coordination problems (if coordination among a group of individuals is easily
accomplished through prices, there is little reason for individuals to be part of the same firm).
Tools to combat coordination problems address two questions:
(1) How is information communicated within the firm?
(2) Who has the authority?
A firms organizational structure is a key determinant of how it resolves coordination
problems.
1. Centralization: concentrating decision-making authority to tighten coordination.
Weaknesses:
- Communication problems make it difficult to respond to local information.
- Limited in processing large amount of information.
2. Decentralization: dispersing decision-making authority, hence more communication
between decision makers and more responsive to local information. Weaknesses:
- Gives rise to agency problems.
- Can cause coordination opportunities to be missed.
In reality firms use a mixture of both. Key features that always remain are that coordination is
likely to be imperfect; and that coordination problems get more severe as the size of the
organization grows.
4. THE POWER OF PRINCIPLES: A HISTORICAL PERSPECTIVE
A historical perspective demonstrates that while the nature of the business has changed
dramatically since 1940, successful businesses have always applied the consistent principles
to their business conditions.
Before 1840: limited transportation and communications constrained firms to
operate in small localized markets.
Between 1840 1910: changes in infrastructure and production technology
encouraged the growth of national and international markets; however still
constrained by problems of coordination and control.
Since 1910: changes in communications, data processing and networking
have revolutionized firms abilities to control their operations and interact
with suppliers, customers, competitors and other stakeholders.

5. THE VERTICAL BOUNDARIES OF THE FIRM

Vertical chain: process that begins with the acquisition of raw materials and ends with the
distribution and sale of finished goods and services. The vertical boundaries of a firm define
the activities that the firm itself performs as opposed to purchases from independent firms in
the market make-or-buy decision figure 5.1:
- Integrate everything in one firm: integrate forward (acquire downstream firm) or
integrate backward (acquire downstream firm). Early steps in the vertical chain are
upstream in the production process and later steps are downstream.
- Disintegrate (outsource to independent subcontractors): arms-length market
transactions. For example: market firms: firms specializing in specific activities such
as marketing, distribution.
Benefits of using the market / reasons to buy:
1. Market firms exploit economies of scale and the learning curve.
- May possess propriety information or patents that enable them to produce at lower
cost.
- Might be able to aggregate the needs of many firms ec of scale and L-shaped AC
curves. Figure 5.3: A has too high AC and A is not of competitive advantage; A* is
MES.
- Might exploit their experience in producing for many firms learning ec.
2. Eliminate bureaucracy:
- Agency costs: leads to loss of profits and may go unnoticed because (1) large firms
often have overhead costs so that it is difficult to measure and reward an individuals
contribution; (2) in-house divisions in large firms often serve as cost centers that
perform activities solely for their own firms and generate no outside revenue; (3)
managers ignore them because it is going well with the firm anyway.
- Influence costs: the way the manager influences the allocation of internal capital (1)
direct costs (time wasted to make the decision); (2) the making of a bad decision.
3. Market firms are subject to the discipline of the market and must be efficient and
innovative to survive. Overall corporate success may hide the inefficiencies and lack
of innovativeness of in-house departments.
Contracts are written to protect parties to a transaction from opportunistic behavior. Their
effectiveness depends on:
1. The completeness: (1) contemplate all relevant contingencies and agree on a set of
actions fro every contingency; (2) what constitutes satisfactory behavior and be able
to measure performance; (3) must be enforceable by an outside third party. Factor that
make contracting always incomplete:
- Bounded rationality: limits on the capacity of individuals to process information,
deal with complexity, and pursue rational aims.
- Difficulties with specifying/measuring performance: open-ended specifications; hard
to measure.
- Asymmetric information: if one party knows more than the other and the
knowledgeable party may distort or misinterpret the information.
2. The available body of contract law: ensures that transactions can occur smoothly
when contracts are incomplete. Eliminate the need to specify certain provisions in
every single transaction. However, not perfect substitute for complete contracting:
- Doctrines are phrased in broad language (open to interpretation).
- Litigation is costly and can destroy business relations.
6

Contracts are an imperfect way to ensure that trading partners perform as desired. If the
resulting inefficiencies are large enough, than it makes sense to make rather than to buy.
Costs of using the market / reasons to make all depend on the costs associated with
writing and enforcing contracts.
1. Costs of poor coordination between the steps in the vertical chain. All dimensions of
production need to be well fit: timing fit; size fit; color fit; sequence fit. Coordination
is especially important with design attributes (attributes that need to relate to each
other in a precise fashion otherwise they lose a significant portion of their economic
value).
2. Reluctance of trading partners to develop and share private (valuable) information
because they run the risk of losing control over it. Well-defined and well-protected
patents can protect this, but they are not foolproof however. Professional services
often require new workers to sign non-compete clauses (when leaving the firm, he
may not compete with it for several years).
3. Transaction costs* (opportunistic behavior and the costs in trying to prevent it): arise
because contracting is never fully complete.
Fallacies when making make or buy decisions:
If an asset is cheaper to buy than to make, you should do so, even if it is a source of
competitive advantage for you.
Dont buy just to eliminate the cost of making the product buying does not
eliminate the expenses of the associated activity (can affect the efficiency with which
he activity is carried out).
Dont make just to avoid paying a profit margin to independent firms. Accounting
profit= revenues expenses. Economic profit= accounting profit from activity X
accounting profit from investing the same resources in the most lucrative alternative
activity. Even if an upstream supplier is making accounting profits, it does not mean
that it is making economic profits or that the downstream manufacturing firm could
increase its own economic profits by internalizing the activity (due to the expertise
being difficult, or ec of scale).
Dont make just to avoid paying high market prices for the input during periods of
peak demand and scarce supply (to eliminate income fluctuations). Could also buy
and enter into long-term (futures) contracts with suppliers; hedging.
Dont make just to tie up a distribution channel to try to gain market share at the
expense of rivals.
- May run afoul antitrust laws which permit forms of vertical foreclosure.
- Upstream firm must be careful not to pay too much for the acquisition.
- The acquirer must consider how difficult it is for competitors to open new channels of
distribution.
*Relation-specific asset: asset that cannot be redeployed to another transaction without some
sacrifice in the productivity of the asset or some cost in adapting the asset to the new
transaction. It locks parties into the relationship. Four forms:
-Site specificity: assets that are located side-by-side to economize on transportation or
inventory costs or to take advantage of processing efficiencies.
-Physical asset specificity: assets whose physical or engineering properties are
specifically tailored to a particular transaction.
-Dedicated assets: investment in plant and equipment made to satisfy a particular buyer.
Without the promise of that particular buyers business, the investment would not be
profitable.

-Human asset specificity: worker has acquired skills, know-how and information that
are more valuable inside a particular relationship than outside it.
Fundamental transformation: once the parties have invested in relation-specific assets, the
relationship changes from a large-numbers bargaining to a small-numbers bargaining
situation.
Rent: the profit you expect to get when you build the plant, assuming that everything goes as
planned. The investment is a sunk cost and does not affect your decision making. A firm must
expect positive rents to induce to invest in an asset.
Quasi-rent: the extra profit that you get if the deal goes ahead as planned, versus the profit
you would get if you had to turn to your next best alternative. Informs about the possible
magnitude of the hold-up problem when a trading partner attempts to renegotiate the
terms of the deal (when contracts are incomplete). This raises the costs of arms-length market
exchanges in 4 ways:
- More difficult contract negotiations and more frequent renegotiations.
- Investment to improve ex post bargaining positions: manufacturer may acquire a
standby production facility for a key input as a hedge against contractual holdup by
the input supplier. The facility stands idle much of the time costly.
- Distrust: (1) higher direct costs of contract negotiation as parties insist that more
formal safeguards are built in; (2) impedes sharing information to achieve
production efficiencies or quality improvements.
- Reduced investment in relation-specific investments: leads to lower productivity and
higher production costs (because firms now only have the option of making generalpurpose investments).
Double marginalization: upstream firm exploits market power by setting P > MC
downstream firm purchases these marked-up inputs and exploits its own market powers by
also setting P > MC product is marked-up twice. Through integration, the downstream
firm can set P=MC which will lead to lower P and higher profits for the integrated firm.
7. DIVERSIFICATION
Diversification (conglomeration): produce for numerous markets exploit ec of scale and
scope (diversification for other reasons tends to be less successful) reduces costs and
improves efficiency. Ways to diversify: internal growth, strategic alliances, joint ventures,
mergers and acquisitions.
Measures of diversification: difficult. Most approaches consider some measure of
technological or market relatedness: similarity in products sold or consumers served.
- Notion of relatedness, developed by Rumelt: depends on how much of a firms revenues are
attributable to product market activities that have shared technological characteristics,
production characteristics or distribution channels. Rumelt focused on 3 characteristics: the
proportion of a firms revenues derived from (1) its largest business; (2) its largest group of
related businesses; (3) the stages of a vertically integrated production process. Four types of
firms:
- Single-business firm: >95% of business in a single activity or line of business.
- Dominant-business firm: 70-95% of revenues from a principal activity.
- Related-business firm: <70% of revenues from a principal activity but has
other lines of businesses related to the principal activity.
- Unrelated-business firm: <70% of revenues from a principal activity and has
no other lines of businesses related to the principal activity.

- Entropy: =0 for a firm that derives all of its sales from a single four digit SIC category and
increases as the firms sales are spread across more categories.
- Mergers and acquisitions.
Reasons for diversification:
1. Efficiency-based reasons:
- Economies of scale and scope: based on market factors; technological factors;
managerial synergies; or financial synergies. Can only be exploited when
operations display synergies. Can also come from spreading a firms
underutilized organizational resources to new areas.
Dominant general management logic: managers who develop specific
skills (incorrectly) rely on these skills for success in other unrelated business
areas.
- Economizing on transaction costs: the multi-product firm is an efficient
choice when TC complicate coordination among independent firms.
- Internal capital markets: it might be costly for firms to raise capital from
external sources due to (1) incomplete information; (2) existing debt; (3) high
monitoring expenditures, which prevents the execution of profitable projects.
Combining (unrelated) businesses to perform cross-subsidization requires
one firm to have cash>investment opportunities and the other firm to have
cash<investment opportunities.
- Diversifying shareholders portfolios: a shareholder seeking to avoid large
swings in value can invest in a single diversified firm and achieve the
benefits of portfolio diversification.
- Identifying undervalued firms: managers may observe a target firm that is
undervalued in the stock market and buy it cheap. Remarks: (1) unlikely that
no other investors have noticed this; (2) announcements of mergers attract
attention leading other potential acquirers to bid up the price (price wars); (3)
winners curse.
2. Managerial reasons (do not generate benefit for the shareholders):
- Managers may enjoy running larger firms or are more likely to be appointed
to other firms board of directors when undertaking the acquisition.
- Increase their compensation because the size of the firm increases.
- To reduce the risk of job-loss: performances of highly diversified firms are
likely to mirror that of the overall ec less likely that shareholders will fire
management.
Costs of diversification:
1. Influence costs: costs of lobbying of managers for their division; misallocation of
resources.
2. Monitoring and disciplining costs: from the corporate management to control division
managers.
3. Internal capital market may not serve its intended purpose of facilitating profitable
investment in cash-poor businesses because managers have a strong preference for
corporate growth even if it is unprofitable and hence may over-invest when the firm
has a lot of cash.
Managerial motives are caused by problems in corporate governance: the mechanisms
through which corporations and their managers are controlled by shareholders.
Shareholders cannot easily determine which acquisitions are profitable and which are
not.

 Shareholders are unable to change (wrong) management decisions: (1) formally this
is done by the board of directors but the CEO might exercise control over the
selection for new directors; (2) they form a dispersed group.
Managers who undertake acquisitions that do not serve the interests of the shareholders
firms share price will fall, because: (1) if a manager overpays for the acquisition, the value
of the firm will fall by the amount that was overpaid; (2) if the stock market expects the firm
to overpay acquisitions in the future, the market price of the firm will fall in expectation of
these events. Disparity between the firms actual and potential share prices presents an
opportunity for another entity to try a takeover. This market for corporate control serves as
a disciplining mechanism for managers (without actual takeovers taking place) and makes
sure they keep the firms share price near its potential value.
Assessing the success of diversification by using stock prices; two methods:
- Valuation studies: compares market valuation of diversified firms to those of
undiversified firms lower in diversified firms.
- Event studies: looks at the changes in market valuations in response to the
announcement of diversifying acquisitions (1) returns to acquirers are on
average negative; (2) shares of target firms tend to rise when an acquisition in
announced.
Diversified firms need to reduce the scope of their activities in order to reach a point at which
profitable diversification is possible.
8. COMPETITORS AND COMPETITION
Competitors: firms whose strategic choices directly affect one another; or indirectly via a
third firm.
Approaches to competitor identification:
Antitrust agencies: all the competitors ina market have been identified if a merger
among them would lead to a small but significant non-transitory increase in price
(SSNIP).
Firms are competitors if they produce substitutable goods goods that have:
- Similar product performance characteristics: describe what the product does
for consumers.
- Similar occasions for use: when, where and how is a product to be used.
- Are sold in the same geographical market: in the same location, with low
transportation costs for the good & consumers.
Cross-price elasticity: YX = (QY/QY) / (PX/PX) is positive.
Close correlation between prices over time.
Standard Industrial Classification (SIC): codes that identify products and services by
a 7-digit number with each digit representing a finer degree of classification.
Geographically: by examining the flow of goods and services across geographic
regions. Catchment area: contiguous area from which a firm draws most of its
customers. Flow analysis: examines data on consumer travel patterns.
Market structure: the number and distribution of firms in a market measured by:
- N-firm concentration ratio: combined market share (sales revenue) of the N
largest firms in the market. However: invariant to changes in the sizes of the
largest firms.

10

Herfindahl index (H): sum of the squared market shares (S) of all the firms
in the market. Monopoly>0.6 and perfect competition<0.2.

i ( Si ) 2
Numbers-equivalent of firms: 1/Herfindahl = number of firms in market,
when you assume equal market share.
Four classes of market structure:
1. Perfect competition: P=MC. Market conditions will tend to drive down prices when
two or more of the following conditions are met:
There are many sellers:
a. Diversity of pricing is likely.
b. Price increase will lead to fewer purchases by consumers some sellers will
have to reduce production its difficult to get a lot of sellers to agree on
whom that should be.
c. Even if sellers appear willing to cut production, especially small firms will be
tempted to cheat in order to increase their market share and secure learning
benefits and ec of scale that will enhance their long-run competitive position.
Consumers perceive the products to be homogeneous.
There is excess capacity: in the long run, competition can drive P<MC. If this
persists, firms can chose to exit the market rather than sustain long-run economic
losses. Bur if capacity is industry-specific, firms will have to remain in the industry
until the plant reaches the end of its useful life or until demand recovers.
2. Monopoly: can set P without regard to how other firms will respond monopolist
profits come at the expense of consumers. Only faces competition from fringe firms:
small firms that collectively account for 30-40% market share. Monopsonist: firm that
faces little/no competition in one of its input markets and can therefore reduce input
prices. Most monopolies result when firms discover more efficient manufacturing
techniques or create new products that fulfill unmet consumer needs. Even at
monopoly prices, the benefits that these innovations bring to consumers may be
enormous. Policies that limit monopoly power may discourage innovation. Cartel:
several firms acting in concert as to mimic the behavior of a monopolist prohibited
by antitrust laws.
3. Monopolistic competition: there are many sellers and each seller offers a slightly
differentiated product (consumers make choices among competing products on the
basis of factors other than just price).
Vertical differentiation: when a product is unambiguously better/worse than
competing products.
Horizontal differentiation: when only some consumers prefer the product over
competing products, for ex: geography allows firms to raise prices while
customers remain loyal.
- Idiosyncratic preferences: tastes differ remarkably from one person to the
next.
- The degree of horizontal differentiation depends on the magnitude of
consumer search costs: how easy/hard it is for consumers to get information
about alternatives.
P>MC fixed costs are covered and firms will earn positive economic profits
entry will reduce prices and reduce market shares until economic profits equal zero.
However: there may be barriers to entry that keep N down.

11

4. Oligopoly: market in which the actions of individual firms materially affect the
overall market. Firms produce identical goods.
Cournot quantity competition: (P>MC)each firm selects a quantity to produce (and
therby guesses what Q the other firm will chose), and the resulting total output
determines market price.
- In Cournot equilibrium: (1) the market price, P*, is the P at which both firms
sell all their output, Q1 and Q2; (2) Q1 is firm 1s profit-maximizing output,
given that it guesses firm 2 will choose Q2; (3) Q2 is firm 2s profitmaximizing output, given that it guesses firm 1 will choose Q1. Each firms
guess about its rivals production level is correct.
- Cournot reaction functions: R1: shows firm 1s profit maximizing output for
any output produced by firm 2. Similar: R2. At the point of intersection: Q1*
and Q2*.
Revenue destruction effect: when one firm expands Q, it reduces P* and thus lowers
the sales revenues for all the firms in the market. The smaller a firms share of
industry sales, the greater the divergence between its private gain and the revenue
destruction effect from output expansion smaller firms are more willing to rock the
boat in order to gain market share: they enjoy the full benefits of each additional unit
sold, but suffer only a small % of the revenue destruction effect which is mainly
borne by their larger rivals. In Cournot equilibrium, P* falls as more firms enter the
market each firm has a smaller share and is less concerned with the revenue
destruction effect. PCM = H/elasticity less concentrated smaller H lower
PCM (price-cost margin).
Bertrand price competition: each firm selects a price that maximizes its own profits
given the price it believes the other firm will select. Each firm also believes that its
pricing practices will not affect the pricing of its rival (considered fixed). Price
competition is fierce because the products of the two firms are perfect substitutes;
hence P is driven down to MC.
Differences between Cournot and Bertrand:
- Take place over different time frames.
- Cournot: markets where firms must make production decisions in advance
and are committed to selling all of their output and unlikely to react to
fluctuations of their rivals output markets that involve a lot of sunk costs
or where it is costly to hold inventories.
- Bertrand: pertains to more flexible markets.
Differentiated Bertrand model: similar to Cournot but firms chose P in stead of Q. Products
are horizontally differentiated: softens price competition because lowering P is less effective
for stealing a rivals business.
- Reaction functions: R1: shows firm 1s profit maximizing price for any price
charged by firm 2. Similar: R2. At the point of intersection: P1* and P2*.
Minimum efficient scale (MES): level of output, q**, that minimizes costs. Production
processes often display U-shaped AC curves. MES is larger when sunk costs are large relative
to ongoing variable costs of production. When Q** is total industry demand, the number of
firms in the market, N**, can be determined: N**=Q**/q**.
When sunk costs are large q** is large small number of firms in the market.
Sutton: in most consumer goods markets, the number of large firms and the overall number
of firms does not seem to depend on the costs of production, but more on the costs of
12

advertising. The sunk cost that limits he number of firms is not the up-front cost of
production, but the sunk cost of establishing a credible brand name: endogenous sunk cost.
Endogenous because market leaders can influence he level of investment in brand awareness
that rivals must achieve to be competitive, by setting the level of their own investment in
brand name capital.
9. STRATEGIC COMMITMENT
Strategic commitment: decisions that have long-term impacts and are difficult to reverse.
Can influence the choices made by rival firms firms must anticipate market rivalry. Firms
must balance the benefits that come from preempting or altering competitors behavior with
the loss in flexibility that comes from making competitive moves that may be hard to undo
once made. Commitments must have three characteristics:
1. Visible.
2. Understandable.
3. Credible: enhanced by irreversibility; making contracts; put reputation at stake.
Concepts that capture how competitors react when one competitor changes a tactical variable
such as P or Q.
Strategic complements: upward-sloping reaction functions; the more of the action
one firm chooses, the more of the action the other firm will also optimally choose;
prices in the Bertrand model.
Strategic substitutes: downward-sloping reaction functions; the more of the action
one firm chooses, the less of the action the other firm will also optimally choose;
quantities in the Cournot model.
Effect of commitments on a firms profitability:
- Direct effect: impact on the present value of the firms profits assuming that
the firm adjusts its own tactical decisions in light of this commitment and that
its competitors behavior doesnt change.
- Strategic effect: takes into account the competitive side effects of the
commitment, either positive or negative; dependant on whether the variables
affected are strategic complements or substitutes.
Concepts that capture whether a commitment by one firm places its rivals at a disadvantage:
Tough commitments: bad for competitors.
- Cournot: capacity expansion.
- Bertrand: price reduction.
Soft commitments: good for competitors.
- Cournot: capacity constraint.
- Bertrand: price increase.
Subgame perfect Nash equilibrium (SPNE): two stage game (1) firm 1 makes a strategic
commitment and thereby anticipates the effects of this on the market equilibrium (forwardlooking); (2) both firms simultaneously choose Q (Cournot) or P (Bertrand). Firm 1 should
thus evaluate whether competition in stage 2 is Cournot or Bertrand.
Stage 2 = Cournot:
- Tough commitment: Q1 increases R1 shifts right in figure 9.2 in new
equilibrium Q1 is higher and Q2 is lower (= strategic effect for firm 1).
- Soft commitment: Q1 decreases R1 shifts left in figure 9.3 in new
equilibrium Q1 is lower and Q2 is higher (= strategic effect for firm 1).
Stage 2 = Bertrand:

13

Tough commitment: P1 decreases R1 shifts left in figure 9.4 in new

equilibrium P1 has decreased more than P2 has decreased (= strategic effect
for firm 1).
Soft commitment: P1 increases R1 shifts right in figure 9.5 in new
equilibrium P1 has increased more than P2 has increased (= strategic effect
for firm 1).

Remark: when making a commitment, the effect of it does not only depend on whether the
competition is Cournot or Bertrand, but also on industry conditions and the characteristics of
the firms competitors:
- Is the competitor currently in the industry or has it not yet entered?
- Capacity-utilization rates in the industry.
- Degree of horizontal differentiation among the firm making the commitment
and its competitors: in Bertrand: (1) high differentiation steep Rs small
strategic effect; (2) vice versa.
Strategic commitments are almost always made under conditions of uncertainty:
competitors moves are hard to predict. Furthermore: strategic commitments are hard to
reverse (inflexible). Ways to preserve flexibility when making a strategic commitment:
Modify the commitment as future conditions change.
Delay the commitment to some future point in time when its more profitable.
Make an unprofitable commitment today in order to make a profitable follow-up
commitment in the future commitments are linked through time.
Flexibility gives rise to real options: when a decision maker has the opportunity to tailor a
decision to information that will be received in the future. Real options can be created by
altering the way in which firms configure their internal processes (important to spot them) and
often do not come for free (involve a trade-off). Waiting with executing the real option,
increases the risk of preemption (that someone else takes it).
Strategic decisions involve investments in sticky factors: durable assets, specialized to the
particular strategy; un-tradable; difficult to transform or redeploy elsewhere. Framework fro
analyzing commitments:
1. Positioning analysis: direct effect of the commitment; determines TC and TR.
2. Sustainability analysis: strategic effect of the commitment; determines time horizon
before economic profits are returned to zero.
3. Flexibility analysis: incorporates uncertainty into (1) and (2).
Learn-to-burn ratio: ratio of the learn rate (rate at which the firm receives new
information that allows it to adjust strategic choices) and burn rate (rate at which the
firm invests in the sunk assets to support the strategy). A high ratio high flexibility
low option value of delay.
4. Judgment analysis: takes into account organizational and managerial factors that
might distort the firms incentive to chose an optimal strategy.
Type 1 errors: rejecting an investment that should have been made high chance when
decision making occurs hierarchical.
Type 2 errors: accepting an investment that should not have been made high chance when
decision making occurs decentralized.
12. INDUSTRY ANALYSIS
Porter: developed framework for exploring 5 economic factors that affect the profits of an
industry. Strategic analysis must account for both cooperation and competition.

14

Limitations of the five-forces framework:

- Pays little attention to factors that might affect demand.
- Focuses on a whole industry rather than on individual firms that may occupy
unique positions.
- Does not account for the government.
- Only qualitative; not quantitative.
1. Internal rivalry: jockeying for shares by firms within a market. Important: definition of
the market (product market vs. geographical market). Firms may compete on mainly 2
dimensions:
- Non-price: erodes profits by driving up fixed costs (new product
development) and MC (adding product features) these higher costs can
however be passed on to consumers which increases profits.
- Price: erodes profits by driving down PCMs. the potential for price
competition depends on the extent to which a price-cutting firm expects its
market share to increase and how it expects its rivals to respond.
Conditions that heat up price competition:
Many sellers in the market.
Stagnant/declining industry: firms cannot easily expand their output without
stealing form their competitors.
Firms have different costs: low-cost firms can ask lower prices.
Some firms have excess capacity: want to boost sales and can often expand output
rapidly to steal business from competitors.
Products are undifferentiated / buyers have low switching costs: firms are tempted
to undercut their rivals prices because this can generate a substantial increase in
market share.
Prices cannot be adjusted quickly.
Large/infrequent sales orders: firm may be tempted to temporarily undercut a
rivals price to secure a particular large order.
No cooperative pricing.
Strong exit barriers: prolongs price wars as firms struggle to survive in stead of
exiting.
High elasticity of demand.
2. Entry: erodes incumbents profits in 2 ways:
- Entrants divide market demand among more sellers.
- Entrants decrease market concentration and heat up internal rivalry.
Factors that affect the threat of entry:
Large MES relative to the size of the market.
Government protection of incumbents.
Consumers are brand loyal.
Access of entrants to key inputs (technology, raw materials, distribution, locations).
Experience curve.
Network externalities: installed base.
Expectations about postentry competition.
3. Substitutes and complements: availability; price value; price elasticity of industry
demand.

15

4,5. Supplier and buyer power: can erode industry profits when they are (1) concentrated;
(2) customers are locked into relation-specific investments with them.
- Indirect power: can sell their services to the highest bidder price they
charge depends on supply and demand in the target market.
- Direct power: raise prices when their target market is faring well and vice
versa.
Factors to consider:
Competitiveness of the input market.
Concentration of the (upstream/downstream) industry.
Purchase volume of downstream firms.
Availability of substitute inputs.
Relation-specific investments by the industry and its suppliers (hold-up).
Threat of forward integration by suppliers.
Ability of suppliers to price discriminate.
Strategies of firms to cope with the five forces:
- Differentiate themselves from rivals or outperform.
- Identify a segment of the industry in which the 5 forces are less severe.
- Eliminate the forces by (1) establishing facilitating practices or creating
switching costs; (2) pursue entry-deterring strategies; (4)(5) integrating.
Remark: Porter views all other firms as threats to profitability but also positive
interactions between firms in a value net:
Efforts by competitors to set technology standards that facilitate industry growth.
Efforts by competitors to promote favorable regulations.
Cooperation among firms and their suppliers to improve product quality or boost
demand.
Cooperation among firms and their suppliers to improve productive efficiency.
Profit from participating in the value net (competitors, supplier, buyers) = overall value of the
value net when firm I participates overall value of the value net when it doesnt participate.

16

13. STRATEGIC POSITIONING FOR COMPETITIVE ADVANTAGE

Competitive advantage: when a firm earns a higher rate of economic profit than the average
rate of economic profit of other firms competing within the same market. Important:
definition of the market. Economic profitability depends on:
Market economics (across industries): the five forces.
Value created relative to competitors (within the industry):
- Benefit position relative to competitors.
- Cost position relative to competitors.
Consumer surplus: B P consumer will only purchase the good if CS > 0 and will chose
the good that has the highest CS (low P and high Q).
Consumers maximum willingness to pay (B): At which P is the consumer just
indifferent between buying the product and going without it? seek best available
substitute.
Indifference curve: P, Q combinations that yield the same consumer surplus. The
steepness indicates the trade-off between P and Q a consumer is willing to make.
Consumer surplus parity: when firms offer the same CS P,Q combinations lie on
the same indifference curve. When a firm moves from this position (or from the
position of consumer surplus advantage) to one which is less than its competitors,
sales and market share will fall.
Producer surplus: P C producers profit margin. C = cost incurred in making the
product.
Value created = consumer surplus + producer surplus = (B C) + (P C) = B C. The price
determines how much of the value-created sellers capture as profit and how much buyers
capture as CS.
B>C: necessary condition for a product to be economically viable. Entrepreneurs can
strike win-win deals with input suppliers and consumers all parties are better off if
they trade, rather than dont trade win-win trade opportunities gains from
trade.
B>C is no guarantee that a firm will make a positive profit. The threat of entry and
fierce competition erode profits by bidding down prices consumers capture all the
economic value that the product creates.
For a firm to earn positive profits it must create more economic value than its rivals:
must generate a higher level of B C than its rivals.
- Because consumers have different preferences, it is possible that different
firms have a higher B-C in different market segments.
Value chain (vertical chain): each activity of the value chain can potentially add to the benefit
B that consumers get from the product and each can add to the cost C that the firm incurs to
produce and sell the product.
Value-added analysis: when different stages produce finished or semi-finished goods
that can be valued using market prices, we can estimate the incremental value that the
distinctive parts of the value chain create.

17

Two ways in which a firm can create more economic value than the other firms in its
industry:
1. Configure its value chain differently from those of competitors.
2. Perform activities more effectively than its rivals within the same value chain. To do
so, the firm must possess resources and capabilities that its competitors lack.
Resources: firm-specific assets (trademarks, base, know-how) that cannot easily be
duplicated and indirectly affect the value creation because they are at the basis of a firms
capabilities. Capabilities: activities that a firm does especially well compared with other
firms; common characteristics of capabilities:
Valuable across multiple products or markets.
Embedded in organizational routines: well-honed patterns o performing activities
inside an organization capabilities can persist even though individuals leave the
organization.
Tacit: difficult to reduce to simple guidelines.
Generic strategy of a firm describes how it positions itself to compete in the market it serves.
Porters generic strategies:
Cost leadership (broad scope): companys products can be produced at lower cost
per unit than competitors products:
- Match rivals prices and attain higher PCMs: benefit parity (same B) or
benefit proximity (slightly lower B).
- Undercut rivals prices and sell more than they do by offering a product that
is qualitatively different from that of its rivals.
Despite the quality disadvantage, the cost leader achieves a higher profit margin
than its high-cost competitors due to lower C.
Benefit leadership (broad scope): companys products are capable of commanding a
price premium relative to competitors:
- Match rivals prices and sell more than they do: offer substantially higher B
and C.
- Charge price premium and attain higher PCMs: cost parity (same C) or cost
proximity (slightly higher C).
Despite the cost disadvantage, the benefit-leader achieves higher profit margins
than its low-benefit competitors due to higher B.
Focus* (narrow scope): company configures its value chain so as to create superior
economic value within a narrow set of industry segments. Within these segments, the
firm may have lower cost per unit than its broad-scope competitor, or it may be
capable of commanding a price premium relative to these competitors, or both.
Consumers have identical preferences infinite elasticity of demand:
- Cost leader with benefit parity can lower its price just below the unit cost of
the firm with the next-lowest unit cost. This makes it unprofitable for highcost competitors to respond with price cuts of their own and thus allows the
firm to capture the entire market.
- Benefit leader with cost parity can raise P just below its unit cos plus the
additional benefit it creates relative to the competitor with the next higher B.
to top this consumer surplus bis, a competitor would have to cut P below its
unit costs, which would be unprofitable. Thus at this P, the firm with the
benefit advantage captures the entire market.

18

Horizontal differentiation: strong when there are many product attributes that consumers
weigh in assessing overall benefit and when consumers disagree about the desirability of
those attributes. Price elasticity is not infinite and influences the choice between two polar
strategies of exploiting competitive advantage.
High price elasticity of
demand
Low price elasticity of
demand

Cost advantage
Share strategy: under-price
competitors to gain share.
Margin strategy: maintain
price parity with competitors
(let C-advantage drive higher
margins),

Benefit advantage
Share strategy: maintain
price parity with competitors
(let B-advantage drive share
increases).
Margin strategy: charge
price premium relative to
competitors.

Perceived price elasticity of demand: % change in Q for 1% change in P, taking into account
likely pricing reactions by competitors.
C-advantages are more profitable than B-advantages when the following are true:
The nature of the product limits opportunities for enhancing B.
Consumer indifference curves are flat.
Product is a search good (quality attributes can be assessed prior to the point of
purchase) rather than an experience good (quality attributes can only be assessed
after purchase and usage) because it raises the risk that the enhancements will be
imitated.
B-advantages are more profitable than C-advantages when the following are true:
Steep indifference curves.
Economies of learning are significant.
Product is an experience good rather than a search good.
Stuck in the middle: between C-leader and B-leader less profitable. Clear choices about
how to compete are critical because economically powerful strategic positions typically
require trade-offs:
- B-leader must incur higher costs to do so.
- C-leader must deliver abundant levels of quality.
Factors that might weaken this trade-off:
Firm might achieve low C and high B when: they offer products that have a slightly
higher B increase market share lower AC because of ec of scale or experience
curve.
The rate at which accumulated experience reduces costs is often greater for higherquality products than for lower-quality products.
High B is not necessarily high C firm may be producing more efficiently.
Figure 13.15: achieving benefit and cost advantage simultaneously. Because of the Badvantage the demand curve shifts right and the AC curve shifts up (higher B is associated
with higher C). Even if the firm raises its price, because of the movement of the demand
curve, unit costs go down.
Efficiency frontier: indicates the lowest level of cost that is attainable to achieve a given
level of quality, given the available technology and know-how. Firms that are closer to the

19

frontier are more profitable than those further away. If all firms were producing as efficiently
as possible, their positions would line up along an upward sloping frontier (fig 13.16).
Industry segmentation matrix: characterizes an industry along two dimensions: vertically
the variety of products that industry participants offer for sale and horizontally the different
types of buyers that purchase those products (customer groups buyers with similar tastes,
needs and market responses). Industry segment: differences among (the structural
attractiveness of) segments arise due to differences in buyer economics, supply conditions and
size of the industry (fig 13.17).
Broad coverage strategy: seeks to serve all customer groups in the market by offering a full
line of related products.
Economic logic: scale and scope economies.
Focus strategy: a firm offers either a narrow set of product varieties, serves a narrow set of
customers, or does both. Can insulate the focuser from competition.
Customer specialization (column): firm offers an array of related products to a
limited class of customers.
Economic logic: rests on the extent to which broad-coverage competitors under or
over-serve the focusers target group.
Product specialization (row): firm produces a limited set of product varieties for a
potentially wide class of customers.
Economic logic: ability of the focuser to exploit economies of scale or learning
economies.
Geographic specialization: firm offers a variety of related products within a
narrowly defines geographic market.
14. SUSTAINING COMPETITIVE ADVANTAGE
Threats to sustaining a competitive advantage:
Rivalry: existing competitors and entry.
Imitation.
Powerful buyers/suppliers: can use their bargaining leverage to extract profits from
thriving firms and will often give back some of their gains when the firm is
struggling.
Perfectly competitive dynamic (fig 14.1): perfect competitive equilibrium occurs at the point
where the lowest possible indifference curve is tangent to the efficiency frontier. At this point
economic profits are zero and no other P,Q-combination simultaneously results in greater CS
and higher profit.
Regression towards the mean: extreme performances of firms, whether good or bad, are not
sustainable in the long run these are evened out but they do not converge to the same
mean. Market forces are a threat to profits, but only up to some point. The five forces protect
profitable firms.
To achieve a competitive advantage a firm must create more value than its competitors
ability to do so depends on:
1. Stock of resources (patents, brand-name, base).
2. Distinctive capabilities: activities that the firm does better than its competitors.
According to the resource-based theory of the firm; for a competitive advantage to be
sustainable, these resources and capabilities must be scarce and imperfectly mobile

20

(untradable; tradable, but not useful for others; co-specialized: only useful in combination
with something else), otherwise all firms could create the advantage.
Isolating mechanisms: economic forces that limit the extent to which a competitive
advantage can be duplicated or neutralized through resource-creation activities of other firms.
Two kinds:
1. Impediments to imitation:
Legal restrictions: patents, trademarks etc are tradable highly mobile hence the
price of it is determined by demand and supply.
Competitive only when the firm has superior knowledge about how to best utilize
the asset; possess scare complementary resources that enhance the value of the asset.
Superior access to inputs or customers: locations; long-term contracts that give
firms control over scarce inputs or distribution channels.
Competitive only if the firm can secure these at below-market prices; if other firms
do not recognize the value of these assets or are unable to exploit them (but: winners
curse).
Market size and scale economies: economies of scale limit the number of firms that
fit into the market, hence barrier to entry.
Competitive only if demand does not grow to large (otherwise: entry).
Intangible barriers to imitating a firms distinctive capabilities:
- Causal ambiguity: causes of a firms competitive advantage are obscure an
imperfectly understood because the knowledge is often tacit.
- Dependence on historical circumstances.
- Social complexity: complex interpersonal relationships within the firm; with
the firm and its suppliers/buyers.
2. Early-mover advantage: once a firm acquires a competitive advantage, these
isolating mechanisms increase the economic power of that advantage over time.
Learning curve: firms with the greatest cumulative experience can underbid rivals
for business.
Reputation and buyer uncertainty: brand name and experience goods.
Buyer switching costs: arise when buyers develop brand-specific know-how that is
not fully transferable to substitute brands / also arise when sellers develop specific
know-how about buyers that other sellers cannot quickly replicate or provides aftersale services to buyers. Ways for sellers to increase switching costs:
- Frequent customer points: tie discounts to the completion of a series of
transactions with customers.
- Offer a bundle of complementary products that fit together in a product line.
Network effects (network externalities): consumers often place a higher value on a
product if other consumers also use it. Two kinds of networks:
- Actual networks: consumers are physically linked (telephone). More users
greater opportunities from communication greater value of the network.
- Virtual networks: consumers are linked via complementary goods (DVD
players).
The first firm that establishes a large installed base of customers has an advantage
because new customers will observe the size of the network and gravitate towards the
same firm.
Many networks evolve around standards. Once a standard is established it is difficult to
replace (even if it has lost its initial advantage) hence powerful source of sustainable
competitive advantage. To knock off the dominant standard, the rival must (1) offer superior

21

quality or new options for using the product; (2) able to tap into complementary goods
markets.
Early-mover disadvantages early moves can fail to achieve a sustainable competitive
advantage for the following reasons:
- Lack the complementary assets needed to commercialize the product.
- Bet on the wrong technologies or products high uncertainty about demand
and technology when an early mover enters the market.
Figure 14.5: industry equilibrium with imperfect imitability. At P* a firms expected operating
profit (revenue variable costs) = cost of entry (cost of factory x return on capital). Potential
entrants are just indifferent between entering or not. Each firms rate of return on invested
capital (ROIC) = cost of capital. Before entering (ex ante) each firms expected profit is zero
(each firm expects to earn the cost of capital). After entering (ex post) economic profits differ.
Average profit of active firms in the market overstates ex ante profitability because it
ignores unsuccessful firms that have lost money and exited the industry.
15. THE ORIGINS OF COMPETITIVE ADVANTAGE: INNOVATION, EVOLUTION,
ENVIRONMENT
According to Schumpeter: entrepreneurship is the ability to act on the opportunity that
innovation and discoveries create. Innovation causes most markets to evolve in a
characteristic pattern. Creative destruction: evolutionary process: quit period when firms
that have developed superior technologies earn positive economic profits shock or
discontinuity destroys old sources of competitive advantage and replaces them with new ones
the entrepreneurs who exploit the opportunities these shocks create, achieve positive
economic profits in the next period of quiet. Focus lies on dynamic efficiency: the
achievement of long-term economic growth and technological improvement.
Disruptive technologies: technologies that offer much higher B C than their predecessors
but do so through a combination of lower B and substantially lower C. Different from
breakthrough technologies because of the emphasis on costs.
- Strategic intent: sustained obsession with world dominance.
- Strategic stretch: gap between ambitions and resources.
- Hyper-competition: sources of competitive advantage are being created and eroded in an
increasingly rapid rate.
Force that make firms refrain from innovating:
Sunk cost effect: a firm that has already committed to a particular technology has
invested resources and organizational capabilities that are specific to that technology
and are thus less valuable if the firm switches to another technology inertia that
favors sticking to the current technology.
Replacement effect: entrants are more willing to innovate because they are able to
overtake a monopoly position, whereas the monopolist gain would only be to replace
itself and thus would gain less from innovating.
Efficiency effect: comes into play when the incumbent monopolist realizes that potential
entrants may also have the opportunity to develop the innovation. Monopolist usually has
more to lose from another firms entry than that firm has to gain from entering the market
because entrant will not only steal business away; it will also lower P.
A new firms ability to prosper from its inventions depends on the market for ideas
influenced by two elements:
22

The technology is not easily expropriated by others: good patent protection.

Specialized assets must exits to produce and market the new product. If many
firms have these expertises the innovation will go to the highest bidder
and the innovator will reap all the benefits; if only a few firms have these
expertises, the balance of power shift away to the producers.

Early-mover advantages of being the first firm to innovate: be the first to get the patent;
benefit from consumer perceptions. Patent race: race between firms to innovate first. A firm
engaged in this race must consider the following factors when determining whether or not to
increase R&D spending:
- How much does increasing investment in crease the chance of winning the
race? (diminishing vs increasing returns on productivity)
- Competitive response.
- Amount of competitors.
Two dimensions of interest when choosing a methodology: (1) riskiness of R&D (completion
data, certainty); (2) correlated research strategies if one research is successful, the other
one is likely to be not.
Evolutionary economics: firms do not directly choose innovative activities to maximize
profits; rather key decisions concerning innovation result from organizational routines
well-practiced patterns of activity inside the firm. Firms do not change their routines often
because altering what worked well in the past seems unnatural.
Dynamic capabilities: ability of a firm to maintain and adapt the capabilities that are at the
basis of its competitive advantage. Limited because:
The search for new sources of competitive advantage is path dependent: depends on
the path the firm has taken in the past to get to where it is now.
Presence of complementary assets: firm-specific assets that are valuable only in
connection with a particular product, technology or way of doing business sunk
cost argument.
Windows of opportunity: firms that do not adapt their existing capabilities or
commit themselves to new markets when these new uncertain windows of
opportunities exits may find themselves eventually locked out from the market or
competing at a significant disadvantage with early movers.
Porter argues that competitive advantage originates in the local environment in which the
firm is based. Diamond: four attributes of the home market that promote or impede a firms
ability to achieve competitive advantage in global markets:
1. Factor conditions: general-purpose factors of production are often available locally
or can be purchased in global markets; the most import factors of production are
highly specialized to the needs of particular industries.
2. Demand conditions: sophisticated home customers or unique local conditions
stimulate firms to enhance the quality of their products and to innovate.
3. Related supplier or support industries: although many inputs are mobile and thus
firms dont need geographical proximity to obtain them, the exchange of key inputs,
certain know-how doe require such proximity.
4. Strategy, structure and rivalry: context of competition; local management
practices; organizational structure; corporate governance. Although rivalry may hold
down profitability in local markets, firms that survive vigorous competition in the
home market are often more efficient and innovative.

23

Managing innovation creates a dilemma: formal structure and controls needed to coordinate
innovation vs. looseness and flexibility can foster innovation, creativeness and adaptiveness
to changing circumstances.

24

Chapter 16
The multitask principle
If employees have to multi-task they will focus more on the tasks that are
rewarded.
Three factors that make for a performance measure
1. Less affected by random factors
a. Most people are risk adverse and dislike jobs that involve
risky pay. The incentive to take on the risk is very expensive
for the firm.
2. Can clearly identify all the activities a firm needs to have done.
a. Stronger incentives will make employees more focused on
those activities.
3. Cannot be improved by actions the firm does NOT want undertaken.
a. Stronger incentives against those actions will limit employees
from doing them.
Various performance measures
Absolute/Relative A relative measure compares one performance
with another employees performance.
o Basing each employees pay on the difference between the
individual performances will shield the employees from risk if
the sources of randomness are positively correlated.
o Relative measurements have the potential to increase
multitask problems. Employees can try to sabotage each
other to get a better pay.
Broad/narrow Narrow measurements look at direct profits from an
employee (ex: counting the number of pieces of output produced by
an individual employee). Broad measurements try to look direct and
indirect profits.
o Broad measure rewards employees for improving overall
efficiency in a firm.
o Broad measure is more subject to random factors.
Pay-for-performance will often reduce performance on unmeasured
dimensions.
It is only profitable for jobs where productivity can be measured directly.
Implicit/Explicit Incentive Contracts
Implicit -- A range of performance measures can be incorporated.
Explicit -- Pay is tied to a measure through a predetermined
formula.
Types of Performance Evaluation
360-degree peer reviews An employees supervisor, coworkers
and subordinates are all asked to provide information regarding that
employees performance.
Management-by-objective systems An employee and a supervisor
work together to construct a set of goals for the employee and are
evaluated at the end of that period how well the employee met
those goals.

25

Merit rating systems Employees are given numerical scores.

Costs of Subjective Assessments (like the ones above) of an

Employees Performance
1. Ratings compression When the people who need to evaluate an
employees performance find it personally difficult to reward one
employee but not others.
a. It weakens incentives.
2. Subject to influence activity
a. Employees might try to affect their evaluations by
establishing a good personal relationship with supervisors.
The ways firms provide incentives:
1. Promotion Tournaments -- Where a set of employees compete to
win a promotion because the higher pay, etc. increases incentive.
Three properties of promotion tournaments
o Employees effort levels increase with the difference of the salaries
levels from the promotion.
o If more competitors are added, it can maintain the same incentives
for effort by increasing the size of the prize (salary, etc)
o If there are successive rounds of promotion tournaments, the wage
differentials between levels must increase in order to maintain the
same incentives for effort.
Advantages
Circumvent the problem of
supervisors who are unwilling to
make sharp distinctions between
employees.
They are a form of relative
performance evaluation.

Disadvantages
Promoting based on a good
performance in a lower-level job
might not yield the best person for
the promotion because different skill
sets are required.
Relative performance evaluation
rewards employees for sabotaging
the performance of other
employees.

2. Threat of Termination The strength depends on how valuable a

job is to the employee.
3. Teams Firms can motivate employees to work together by using
teams.
Free-rider problems Can occur when working in teams. Firms can
help prevent that by keeping teams small and allowing employees
to work together repeatedly. They can also keep an eye on each
others actions.

Chapter 17: Strategy and Structure

(2nd chapter of Part V: internal organization)
Organizational structure

26

Organizational structure concerns the arrangements, both formal and informal, by

which a firm divides up its critical tasks, specifies how its managers and
employees make decisions, and establishes routines and information flows to
support operations so as to link opportunities in the environment with its
resources and capabilities.
Alfred Chandler: Structure follows Strategy. Managers will choose the structure
that matches the chosen strategy best applicable for firms of all sizes.
For implementation of strategy its employees must know it and know what it
entails for their work.
Two steps of organization design:

Organizing simple tasks performed by simple work groups

Link simple work groups and their activities into complex
hierarchies.

Simple work groups

Structuring simple tasks in simple groups can be done in several ways:

Individually: the members of the work group are paid based on what
they do
Self-managed teams: a group of individuals work together to set
and achieve common goals. Individuals are rewarded in part based
on team performance eg
Hierarchy of authority: One group member specializes in monitoring
and coordinating the work of the other members.

Structure depends on circumstances: when coordination is needed choose teams

or hierarchy. Beyond a certain size group self-management becomes too costly.
Organizing these simple tasks often is not of much strategic importance and can
be changed easily.
Complex Hierarchy
The organization of a large firm into a complex hierarchy is of much greater
importance: affects more people and allocation of assets.
Two problems related to complex organization structures:

Departmentalization
Coordination of activities within and between subgroups.

Departmentalization identifies formal groupings within the organization, organized

along various dimensions, eg common tasks/functions, inputs, outputs,
geographical location and time of work. For the optimal structure economies of
scale and scope, transaction costs and agency costs should be considered. Each
structure has its tradeoffs, reflecting managers priorities for the firm.
Coordination and control of activities becomes important once groups are
organized:

Coordination involves the flow of information to facilitate subunit

decisions that are consistent with each other and the goals of the
organization.
Two approaches for developing coordination within firms

o
o

Autonomy/self-containment of work units - less coordination

between units needed
Strong lateral relations across work groups are seen as important

27

Control involves where in the organization decisions are made and who
has the authority
o Allocation of authority (control): Centralization vs decentralization
a firm is more centralized in regards to certain decisions when they
are made at higher levels in organizations hierarchy.
o Affects efficiency and agency costs.

Four basic types of structures for large organizations

Only a limited number of structural forms are efficient because the characteristics
of structures share complementarities, making it difficult to mix and match them
(could result in loss of performance).

1. Unitary functional structure (U-form)

A single department is responsible for each of the basic business
functions and tasks that are organized in departments. The firm is
organized along functional lines. Allows for specialization of labor to
gain economies of scale in manufacturing, marketing and distribution.
2. Multidivisional structure (M-form)
Creates a division of labor between top managers and division
managers, allowing the former to specialize in strategic decisions and
long-range planning.
A corporate headquarters and staff lead a set of autonomous divisions,
each division consisting of functionally organized departments or other
divisions. (eg Wal-Mart: each store is a division) This structure
organizes by product line, related business units, geography or
customer type rather than function/task.
3. Matrix structure (fig 17.3 p 516)
The firm is organized along multiple dimensions, usually two. Any combination
of the dimensions may be used. Example: firm with four functional groups and
four projects. The four groups each work on particular parts of each project.
Individuals working on the intersection of the matrix report to two hierarchies
and have two bosses: eg the group manager and the project manager of that
particular group and project. The matrix structure is often only used in parts
of an organization, not the whole. It is valuable in certain situations of
economies of scale and scope and agency considerations or for specific
important issues that a different structure cannot address successfully, or
necessary when there are conflicting decision demands and severe restraints
on managerial resources.
In case of positive spillovers between different groups and if activities are
profit substitutes (profit increase in one area increases it in another as well,
eg a new product design increases sales and reduces costs) matrix is never
optimal and division is a better choice.

4. Network structure
Focuses on individuals rather than positions/tasks and is the most flexible of
the structural types. Workers can contribute to multiple tasks and rearranged
as the tasks of the organization change. Developments in networking
technologies (lower coordination costs) and modular product designs have
expanded the applications of this structure. This structure is useful when its
coordination costs are lower than the gains in technical efficiency and
cooperation. (example: biotechnology industry)

28

The best organizational structure for a particular firm depends on the specific
circumstances it faces.
Two factors that affect the efficiency of organizational structures

Technology and task interdependence. Most firms cannot/will not

do all R&D by themselves.
o Technology determines the degree of task interdependence: the
degree to which two or more positions depend on each other to
do their own work.
Reciprocal task interdependence: two or more
workers/groups depend on each other to do their work
Sequential: one worker/group depends on another eg
production line, sales.
Pooled interdependence: not directly dependent but both
are needed for the success of the firm.
Information flows. Efficient information processing by letting work
groups work according to clear work rules, and have an increasing
administrative hierarchy handle the more difficult exceptions. The
highest management handles the most difficult ones: strategic
decisions. The demands for faster information processing can
overwhelm an existing hierarchy and call for reorganization of
structure.

Transnational strategy: Flexible organizations combine matrix and network

structures. Multinationals balance responsiveness to local conditions with
centralization to achieve global economies.
Structure can also affect strategy to a certain degree, as it determines how well
information can be gathered and processed for strategic purposes and how these
decisions will be implemented in lower levels of the organization. Current
decisions will also be constrained by past decisions.
Evolutionary economics view the actions of firms as the result of a complex set of
behavioral patterns, or routines, that evolve as the firm responds to its
environment.
Strategy and structure are examples of high-level heuristics:
principles/guideposts that reduce the average time spend on certain decisions and
problems.

Chapter 18: Environment, Power, and Culture

(3rd chapter of Part V: internal organization)
Some aspects of managerial decision making that are not traditionally included in
economic analyses of strategy.
The summary p 557-558 seems to cover most of the chapter.
Extra notes: power is not the same as authority, which stems from explicit
contractual decision making and dispute resolution rights that a firm or other
source grants to an individual. Power is then the ability to get things done in the
absence of contracts. Influence is using power in a given situation by a person.
Influence is an effect of power.

29

There are various sources of power:

Structure of a firm can support or impede power
Structural holes: one actor is the crucial link in a network between other actors:
bargaining power
Legitimate/formal power: based on someones position within a hierarchy.
Social exchange/interactions
Resource-dependence power: one has resources that the other needs

30