11

STR 421STR 421

Economics of Economics of

Competitive StrategyCompetitive Strategy

Michael RaithMichael Raith

Spring 2007Spring 2007

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Today’s classToday’s class

0. Introduction0. Introduction

0.1 Course overview0.1 Course overview0.2 Organizational information0.2 Organizational information

1. Competition and markets1. Competition and markets

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StrategyStrategy

We will be concerned with major, often irreversible We will be concerned with major, often irreversible

decisions such asdecisions such as

– entry in a market and product positioningentry in a market and product positioning

– acquisitions and make-or-buy decisionsacquisitions and make-or-buy decisions

– strategies to deter competitors, strategies to enter a marketstrategies to deter competitors, strategies to enter a market

– technological competitiontechnological competition

Objective: to achieve and maintain above-normal returnsObjective: to achieve and maintain above-normal returns

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CompetitiveCompetitive strategy strategy

All of these decisions take place in a competitive All of these decisions take place in a competitive

environmentenvironment Understanding of short- and long-run competition Understanding of short- and long-run competition

among firms is essential among firms is essential Strategic interaction: one company’s moves lead to Strategic interaction: one company’s moves lead to

responses by othersresponses by others need to understand and anticipate theseneed to understand and anticipate these

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EconomicsEconomics of Competitive Strategy of Competitive Strategy

See “Why economics has been fruitful…“ articleSee “Why economics has been fruitful…“ article Economic perspective introduced by Michael Porter in 1980Economic perspective introduced by Michael Porter in 1980

– Can learn a lot about what firms Can learn a lot about what firms shouldshould do by observing what firms do by observing what firms

are doingare doing But real progress in “economics of strategy” after 1980: application But real progress in “economics of strategy” after 1980: application

of Game Theory to the field of Industrial Organization.of Game Theory to the field of Industrial Organization. Better understanding of Better understanding of

1.1. Competitive advantageCompetitive advantage

2.2. Strategic interactionStrategic interaction One main takeaway from course: Business environments change, One main takeaway from course: Business environments change,

but the principles underlying good strategic decisions don’t.but the principles underlying good strategic decisions don’t.

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What to expectWhat to expect

Course is heavily case-based: case discussions take up Course is heavily case-based: case discussions take up

2/3 of class time 2/3 of class time You will spend most of your time outside class on You will spend most of your time outside class on

analyzing cases (reading, discussions in teams, case analyzing cases (reading, discussions in teams, case

writeups)writeups) In class, your active participation is expectedIn class, your active participation is expected Focus on “big picture”, not on details of implementationFocus on “big picture”, not on details of implementation Cases almost never have “right answers”Cases almost never have “right answers” Be sure to attend next Tues to see what course is like!Be sure to attend next Tues to see what course is like!

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Part I: Obtaining and Sustaining a Part I: Obtaining and Sustaining a Competitive AdvantageCompetitive Advantage

1.1. Markets and competition, industry analysisMarkets and competition, industry analysis– Coors: Coors: Intro to major themes of the course, Market dynamicsIntro to major themes of the course, Market dynamics– Crown, Cork & Seal: Crown, Cork & Seal: Industry analysis (5 forces)Industry analysis (5 forces)

2.2. Value creation and competitive advantageValue creation and competitive advantage– Dell: Dell: Quantification of cost advantageQuantification of cost advantage– Enterprise: Enterprise: Competitive advantage and organizational Competitive advantage and organizational

structure, sustainabilitystructure, sustainability

3.3. The scope of the firm The scope of the firm – Choice Hotels: Choice Hotels: Horizontal scopeHorizontal scope– Birds Eye in the U.K.: Birds Eye in the U.K.: Vertical integrationVertical integration

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Part II: Strategic InteractionPart II: Strategic Interaction

4. Dynamics of price competition:4. Dynamics of price competition:– American Airlines: American Airlines: How can firms avoid price wars?How can firms avoid price wars?

5. Strategic commitments, entry & exit: 5. Strategic commitments, entry & exit: – Dupont: Dupont: Strategic commitments, entry deterrenceStrategic commitments, entry deterrence

– Cereal industry: Cereal industry: Dealing with new market entrantsDealing with new market entrants

– ValuJet Airlines: ValuJet Airlines: How to succeed as an entrantHow to succeed as an entrant

6. Technological competition: 6. Technological competition: – EMI: EMI: Managing innovationManaging innovation

– Instant messaging: Instant messaging: StandardsStandards

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Today’s classToday’s class

0. Introduction0. Introduction0.1 Course overview0.1 Course overview

0.2 Organizational info0.2 Organizational info

1.1. Competition and marketsCompetition and markets

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Read the information on the web/ Read the information on the web/ in the handout!in the handout!

Organizational info: details on almost everythingOrganizational info: details on almost everything Schedule: info on assigned readings, cases to be Schedule: info on assigned readings, cases to be

discussed, assignments duediscussed, assignments due Case questionsCase questions I must be able to reach you by emailI must be able to reach you by email Please fill out questionnaire on course web page!Please fill out questionnaire on course web page!

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Course materialsCourse materials

1.1. Textbook: Besanko, Dranove, Shanley, Schaefer:Textbook: Besanko, Dranove, Shanley, Schaefer:

Economics of StrategyEconomics of Strategy, Wiley, 4th Edition (2007)., Wiley, 4th Edition (2007).

2.2. Course packet with casesCourse packet with cases

3.3. Additional readings and lecture notes that I will hand Additional readings and lecture notes that I will hand

out in class and/or post on the webout in class and/or post on the web

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GradingGrading

Class participation:Class participation: 20%20%

5 Case write-ups:5 Case write-ups: 20%20%

3 Assignments:3 Assignments: 15% 15%

Final exam:Final exam: 45%45%

(No midterm)(No midterm)

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Case discussions - preparationCase discussions - preparation

Use only the information provided in the caseUse only the information provided in the case Do not discuss cases with students who have taken this Do not discuss cases with students who have taken this

course, or conduct web or library research on casescourse, or conduct web or library research on cases You should know the facts of the case and have You should know the facts of the case and have

thought through the assigned case questionsthought through the assigned case questions See organizational info for detailsSee organizational info for details

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Case discussions – in classCase discussions – in class

Please bring name card; Please bring name card;

card up = prepared, card down = unpreparedcard up = prepared, card down = unprepared I’ll open by calling on someone to give brief overview of I’ll open by calling on someone to give brief overview of

casecase You carry the discussions! I’ll mainly ask questions.You carry the discussions! I’ll mainly ask questions.

– I cold-call occasionallyI cold-call occasionally Pay attention to flow of discussion, build on previous Pay attention to flow of discussion, build on previous

contributionscontributions Take notes!Take notes!

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Case write-upsCase write-ups

5 in total, best 4 will count towards grade5 in total, best 4 will count towards grade Choose from Choose from bold-facedbold-faced case questions case questions Up to 2 pages + additional calculations Up to 2 pages + additional calculations You may form teams of up to You may form teams of up to 44 students students Submit Submit electronically by 6pm on day before classelectronically by 6pm on day before class, ,

to: STR421@simon.rochester.edu to: STR421@simon.rochester.edu See write-up guidelines for detailsSee write-up guidelines for details

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Problem sets and finalProblem sets and final

Problem setsProblem sets– 3 in total, see schedule3 in total, see schedule

– Individually, or in your teamIndividually, or in your team

– Mix of quantitative theoretical, essay-style, true-false, Mix of quantitative theoretical, essay-style, true-false,

quantitative case-relatedquantitative case-related

Final examFinal exam– One half based on HBS case (available a week before exam)One half based on HBS case (available a week before exam)

– Other half: same style of questions as on problem setsOther half: same style of questions as on problem sets

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Finally, please treat classes like Finally, please treat classes like business meetings:business meetings:

Attend each class.Attend each class. Be on time.Be on time. Keep electronic devices off.Keep electronic devices off. Raise your hand and wait for me to call on you.Raise your hand and wait for me to call on you.

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Today’s classToday’s class

0. Introduction0. Introduction

1.1. Competition and marketsCompetition and markets

1.1 Starting point1.1 Starting point1.2 Basics of game theory1.2 Basics of game theory

Next week:Next week:

1.3 Oligopoly1.3 Oligopoly

1.4 Industry analysis1.4 Industry analysis

1.5 Market dynamics1.5 Market dynamics

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Efficient marketsEfficient markets

Where there is an opportunity to make a profit, it will be Where there is an opportunity to make a profit, it will be

seized by someone, diminishing or eliminating the seized by someone, diminishing or eliminating the

opportunity.opportunity. On average and in the long run, all investment On average and in the long run, all investment

opportunities have the same (risk-adjusted) returnopportunities have the same (risk-adjusted) return In principle, it’s same in industries as in financial In principle, it’s same in industries as in financial

markets!markets!

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The zero-profit equilibriumThe zero-profit equilibrium

Profits attract entry, entry reduces profits In the long run, all firms in all industries make zero profit!

ACMC

Q

q

P

D

S

q*

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Industry and firm profitability differencesIndustry and firm profitability differences

High performers Low performers

Industry Firm

Return on invested capital minus cost of capital (%), 2000-2004 Firm

Return on invested capital minus cost of capital (%), 2000-2004

Computer hardware Dell 21.57 Apple Computer -14.41Computer software Microsoft 20.25 Siebel Systems -22.78Steel Nucor 7.75 U.S. Steel -1.58Building supplies Home Depot 6.9 Lowe's 3.78Mass merchandising Wal-Mart 5.02 Target 1.54Personal Care Estee-Lauder 2.53 Revlon -6.27Appliances Whirlpool 1.22 Maytag 0.93Cellular/wireless Borders Group -1.94 Amazon.com -14.26Satellite radio XM -26.54 Sirius -28.88

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Differences in performance over Differences in performance over time: Dell vs. Gatewaytime: Dell vs. Gateway

Relative share price performance of Dell, Gateway and the S&P 500 (Jan. 1995 - Dec. 2006)

1

10

100

1000

10000

1/3

/1995

7/3

/1995

1/3

/1996

7/3

/1996

1/3

/1997

7/3

/1997

1/3

/1998

7/3

/1998

1/3

/1999

7/3

/1999

1/3

/2000

7/3

/2000

1/3

/2001

7/3

/2001

1/3

/2002

7/3

/2002

1/3

/2003

7/3

/2003

1/3

/2004

7/3

/2004

1/3

/2005

7/3

/2005

1/3

/2006

7/3

/2006

Month

Clo

sin

g p

rice a

dju

ste

d f

or

div

iden

ds a

nd

sp

lits

(Jan

. 1996 =

100)

GTW

Dell

SP500

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Persistent above-normal returns?Persistent above-normal returns?

Some companies seem to be consistently more Some companies seem to be consistently more

profitable than othersprofitable than others Central question of this course: Why do some Central question of this course: Why do some

companies succeed in making profits in the long run, companies succeed in making profits in the long run,

while others fail?while others fail? Two main sources of above-normal returns:Two main sources of above-normal returns:

1.1. Returns from unique resources and capabilities that are difficult Returns from unique resources and capabilities that are difficult

to imitateto imitate

2.2. Market power due to a position in the market that others cannot Market power due to a position in the market that others cannot

profitablyprofitably get into (aka first-mover advantages). get into (aka first-mover advantages).

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We need tools that go beyond We need tools that go beyond STR 401STR 401

STR 401: understand perfect competition and STR 401: understand perfect competition and

monopolymonopoly In most markets, we have neither: markets that are In most markets, we have neither: markets that are

dominated by a small number of firms = “oligopoly”dominated by a small number of firms = “oligopoly” Roadmap for this week and next: Roadmap for this week and next:

– Need a bit of game theory to understand interaction of firms in Need a bit of game theory to understand interaction of firms in

oligopolyoligopoly– Link oligopoly theory to traditional industry analysisLink oligopoly theory to traditional industry analysis– Finally, look at market dynamics: what determines market Finally, look at market dynamics: what determines market

structure in the long run?structure in the long run?

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Today’s classToday’s class

1.1. Competition and marketsCompetition and markets1.1 Starting point1.1 Starting point

1.2 Basics of game theory1.2 Basics of game theory

Next week:Next week:

1.3 Oligopoly1.3 Oligopoly

1.4 Industry analysis1.4 Industry analysis

1.5 Market dynamics1.5 Market dynamics

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Game theory Game theory

Set of tools to analyze situations of Set of tools to analyze situations of strategic strategic

interdependenceinterdependence, i.e. where A’s best decision depends , i.e. where A’s best decision depends

on what B doeson what B does A A gamegame consists of: consists of:

1.1. Players: Which decision makers are involvedPlayers: Which decision makers are involved

2.2. Strategies: What are the options available to each?Strategies: What are the options available to each?

3.3. Outcomes: What is the outcome for each player, depending Outcomes: What is the outcome for each player, depending

on which strategies are chosen? on which strategies are chosen? What will happen if each player pursues his own What will happen if each player pursues his own

interests? interests?

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Example: Example: TimeTime and and NewsweekNewsweek

choose a cover story choose a cover story

Two options: Two options: A: Discovery of a new cure for AIDSA: Discovery of a new cure for AIDS

B: A battle between House and Senate over the budget B: A battle between House and Senate over the budget

Suppose: Suppose: – 30% of readers buy only if budget story on cover. 30% of readers buy only if budget story on cover.

– 70% of readers buy only if AIDS story on cover. 70% of readers buy only if AIDS story on cover.

– If magazines run same story, then 60% buy If magazines run same story, then 60% buy TimeTime, 40% buy , 40% buy

NewsweekNewsweek..

Suppose both magazines decide independently. Suppose both magazines decide independently.

What will happen?What will happen?

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Payoff matrixPayoff matrix

Players: Time, NewsweekPlayers: Time, Newsweek Strategies: each chooses between A or BStrategies: each chooses between A or B Outcomes: the shares of potential readers for eachOutcomes: the shares of potential readers for each

NewsweekNewsweek

AIDSAIDS BudgetBudget

TimeTimeAIDSAIDS , , 70, 30 70, 30

BudgetBudget ,, ,,

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Best responsesBest responses

One player’s One player’s best responsebest response = best strategy, = best strategy, givengiven the the

strategy(ies) chosen by the other player(s)strategy(ies) chosen by the other player(s) Time’s best response… Time’s best response…

……if Newsweek chooses A:if Newsweek chooses A:

……if Newsweek chooses B: if Newsweek chooses B: Newsweek’s best response…Newsweek’s best response…

……if Time chooses A: if Time chooses A:

……if Time chooses B: if Time chooses B:

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EquilibriumEquilibrium

Three equivalent definitions of a (Nash) equilibrium:Three equivalent definitions of a (Nash) equilibrium:

An An equilibriumequilibrium is a combination of strategies such that is a combination of strategies such that each player’s strategy is a best response to the each player’s strategy is a best response to the

strategies of the other playersstrategies of the other players each player maximizes his payoff, taking as given the each player maximizes his payoff, taking as given the

others’ strategiesothers’ strategies given the strategies of the others, no player has an given the strategies of the others, no player has an

incentive to deviateincentive to deviate

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The equilibrium in our example:The equilibrium in our example:

What’s the equilibrium? Here, it’s fairly easy: What’s the equilibrium? Here, it’s fairly easy: – TimeTime has a has a dominantdominant strategy strategy– NewsweekNewsweek does not have a dominant strategy, but does not have a dominant strategy, but

can anticipate can anticipate TimeTime’s choice and choose its best ’s choice and choose its best

response.response.– Each player’s strategy is best response to the Each player’s strategy is best response to the

other’s. Only one such combination.other’s. Only one such combination. Newsweek must put itself in Time’s shoes! Newsweek must put itself in Time’s shoes!

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Example 2:Example 2:

Disney and Dreamworks release new animated moviesDisney and Dreamworks release new animated movies Choice for each: Thanksgiving or ChristmasChoice for each: Thanksgiving or Christmas Christmas is larger market, but both want to avoid Christmas is larger market, but both want to avoid

head-to-head competitionhead-to-head competition

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Payoff matrix might look like this:Payoff matrix might look like this:

DreamworksDreamworks

Thanksg.Thanksg. XmasXmas

DisneyDisneyThanksg.Thanksg. 40, 4040, 40 70, 90 70, 90

XmasXmas 90, 7090, 70 50, 5050, 50

Equilibria?Equilibria?

Problem: coordination may be difficult!Problem: coordination may be difficult!

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Games with sequential moves Games with sequential moves

In many situations, one player moves before the other.In many situations, one player moves before the other. Example:Example:

– Firm 1 is a monopolist, making a profit of 10Firm 1 is a monopolist, making a profit of 10

– Firm 2 can enter market at a cost of 1, or stay outFirm 2 can enter market at a cost of 1, or stay out

– If firm 2 enters, firm 1 can eitherIf firm 2 enters, firm 1 can either accommodateaccommodate entry: both firms get 4 (not including 2’s entry: both firms get 4 (not including 2’s

cost of entry) cost of entry) fightfight: firm 1 gets 2, firm 2 gets 0 (not including 2’s cost of : firm 1 gets 2, firm 2 gets 0 (not including 2’s cost of

entry)entry)

Here, firm 2 moves Here, firm 2 moves beforebefore firm 1. What will happen? firm 1. What will happen?

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Game treeGame tree

Firm 2

Firm 1

Don’tenter

Enter

Fight

Accommodate

(10, 0)

(2, -1)

(4, 3)

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Look ahead and reason backLook ahead and reason back

Firm 2’s best strategy depends on what 1 does.Firm 2’s best strategy depends on what 1 does. Look at 1’s decision: If 2 enters, …Look at 1’s decision: If 2 enters, … 2’s simplified tree:2’s simplified tree:

Firm 2

Don’tenter

Enter

(10, 0)

(4, 3)

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Game theory in practiceGame theory in practice

Formal games capture essentials of strategic interactionFormal games capture essentials of strategic interaction In practice, In practice,

– not set up model and solve; not set up model and solve;

– rather, gain insight into the strategic interaction rather, gain insight into the strategic interaction

– What kind of game best describes the situation? What kind of game best describes the situation?

Put yourself in the shoes of others you interact with! If Put yourself in the shoes of others you interact with! If

they don’t do what you expect them to,they don’t do what you expect them to,– don’t assume they’re irrational, insteaddon’t assume they’re irrational, instead

– try to understand how they perceive the gametry to understand how they perceive the game