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Which of the following is a characteristic of economies of scale? What is the minimum efficient scale MES of production? Which of the following is generally a way that LBOs can help a firm realize its potential value? Which of the following best describes economies of scope? Which of the following is not a product specific fixed cost?
Measuring Capabilities in the Pharmaceutical Industry Strategic Positioning in the Airline Industry: Warranteeing Surgery Nonprofit Firms Example Teaching to the Test Example Exploiting Resources: Differences in Objectives in Agency Relationships: Managing Trade-offs between Costs Example Multinational Firms: Strategy and Infrastructure?
Power and Poor Performance: Power in the Boardroom: Preserving Culture in the Face of Growth: To answer this question, we first have to understand what strategy is. Consider how three leading contributors to the field define the concept of strategy: The objective of this book is to study and analyze strategy primarily though not exclusively from the perspective of economics.
Our central theme is that much can be learned by uncover-ing durable economic principles that are applicable to many different strategic situations. This value shows up in two fundamental ways: One can approach the study of strategy in many ways. One could study strategy from the perspective of mathematical game theory, seeking to discover the logic of choice in situations that involve rivalry. Strategy could also be studied from the perspective of psychology, focusing on how the motivations and behaviors of individual decision makers shape the direction and the performance of their organizations.
One could study strategy-related questions from an organizational perspective, political science, or even anthropology. There is much to be said for viewing strategy from the perspective of multiple disciplinary lenses.
But depth of strategic knowledge is as important as breadth. Deep knowledge of a discipline permits the formulation of subtle and powerful hypotheses that generate rich strategies. An advantage of economics, and one reason for its wide-spread use for analyzing individual and institutional decision making, is that it requires the analyst to be explicit about the key elements of the process under consideration.
Economic models must carefully identify each of the following: Who are the active players? What are the decision makers trying to accomplish? Are they profit maxi-mizing, or do they have nonpecuniary interests?
What actions are under consideration? What are the strategic variables? What is the time horizon over which decisions can be made? What is the mechanism by which specific decisions translate into specific outcomes? Is the mechanism complicated by uncertainty regarding such factors as taste, technology, or the choices of other decision makers?
While other social sciences often address the same questions, economic theory is distinctive, we think, in that the answers to these questions are nearly always explicitly obtained as part of the development of the theory. The advantage to this is that there is clear linkage between the conclusions one draws from the application of economic reasoning and the assumptions used to motivate the analysis.
But we will provide the intuition behind each of the propositions that we advance. Economic modeling, by its very nature, abstracts from the situational complexity that individuals and firms face. Thus, the application of economic insights to specific situations often requires creativity and a deft touch. It also often requires explicit recognition of the constraints imposed on firms by mistakes, history, and organiza-tional and political factors.
Nor does economics fully address the process by which choices are made and translated into actions and outcomes. Our emphasis on eco-nomics in this book is not intended to downgrade the importance of process; it is simply beyond the scope of our expertise to say much about it.
Observers of business often leap uncritically to the conclusion that the keys to success can be identified by watching and imitating the behaviors of successful firms. A host of management pre-scriptions by consultants and in the popular business press are buttressed by allusions to the practices of high-performing firms and their managers.
A classic example of this type of analysis is provided by the famous book, In Search of Excellence, by Thomas Peters and Robert Waterman. The average annual return for investors in these firms was 48 percent. New market leaders are close to their customers and skilled at segmenting markets. They develop new products, advertise intensively, and outsource all but core activities, so as to better concentrate on what they do best. A final seminal work is Good to Great, by Jim Collins.
Only 11 firms met this demanding hurdle, including such well-known firms as Walgreens, Wells Fargo, Philip Morris, and Abbott. These firms possess leaders who shun the spotlight and work for the firm. The firms use technology to support their strategies, not determine them. The traditional approach to strategy, one that is embodied in best-selling strategy trade books including the three classic books cited above, has at least two key features.
First, these books derive their recommendations by studying the past performance of successful firms. Second, their recommendations seem to make sense. When these assertions also carry the weight of common sense, it would be foolish for the average manager to ignore them.
But in the book Everything Is Obvious, Duncan Watts warns against basing decisions on common-sense arguments. Strategy and Economics few successful firms, makes so much sense that readers take it as a proven fact.
While many of the ideas in Economics of Strategy may seem obvious upon reflection, they are supported by more than just the assertions of the authors or a few casual observational studies.
Our ideas were developed from fundamental principles of economic theory and debated by the profession, often for decades. Moreover, most of the ideas in this book have been subject to rigorous empirical testing that has survived peer review. Most trade books do not undergo such scrutiny. Most trade strategy books do not provide an audit trail of assumptions and conclu-sions, but they seem to offer empirical support through extensive case studies.
For one thing, the reasons for success are often unclear and also are likely to be complex.
We can think of no better example than Enron. Enron was once held up as an exemplar of how to conduct business in the new economy, but was ultimately revealed to be a company that relied on accounting shell games and lacked any real sustainable advantage.
There are many other, less pernicious, examples of this complexity. The internal manage-ment systems of a firm may spur product innovation particularly well but may not be apparent to individuals who are unfamiliar with how the firm operates. In addition, the industry and market conditions in which successful firms operate may differ greatly from the conditions faced by would-be imitators.
Success may also be due in part to a host of idiosyncratic factors that will be difficult to identify and impossible to imitate. Finally, there may be a bias resulting from trying to understand success solely by examining the strategies of successful firms.
Strategies associated with many successful firms may have been tried by an equally large number of unsuccessful firms. In addition, successful firms may pursue several strategies, only some of which contribute toward their success.
Finally, successful firms may possess proprietary assets and know-how that allow them to succeed where imitators would fail. To further understand the potential bias, consider that the choices of successful firms always seem correct in hindsight. But managers want to determine which strategic choices will work in advance. To appreciate the distinction, consider a firm investing in a risky new technology.
But if it chooses incorrectly, the firm will struggle. The gurus will say that the firm is struggling because it has let technology determine its strategy. But the real mistake was in selecting the wrong technology to begin with, not its ongoing application. In fact, economics teaches us that it may still be optimal to stick with the chosen technology, especially if the costs cannot be recovered and the firm has no better alternative.
This is what makes managerial work risky. We do believe that it is useful to study the behaviors of firms. The value of this study, however, lies in helping us identify the general principles behind why firms behave as they do, not in trying to develop lists of characteristics that lead to automatic success.
There is no such list. A strategy textbook can provide the general principles that underlie strategic decisions. Success depends on the manager who must match principles with conditions.
Trek, Usiminas, and Wal-Mart. Trek performs few of the functions traditionally associated with large industrial firms and instead uses independent contractors for much of its production, distribution, and retailing.
Usiminas is a traditional, vertically integrated steel firm best known for its operational excellence in manufacturing. Unlike the first two, Wal-Mart is a distributor and retailer. It relies on the initiative of its local store managers, combined with sophisticated downloading and inventory management, to keep its retailing costs below those of its rivals. Making sense of this variety of strategies can be frustrating, especially because, within most industries, we see poorly performing firms employing the same strategies and management practices as industry exemplars.
For every Trek, there is a Raleigh. For every Usiminas, there is a Bethlehem Steel. For every Wal-Mart, there is a Kmart. If we find this variety of management practices bewildering, imagine the reactions of a manager from , or even , who was transported ahead in time. The large hier-archical firm that dominated the corporate landscape throughout most of the twentieth century seems out of place today.
General Motors received its share of criticism in the wake of the oil shortages and Japanese invasion of the s, but its structure and strategy were models for manufacturing from the s through the s. United States Steel, the first firm in the world to achieve annual sales of one billion dollars at the time of its inception in , is no longer ranked among the Fortune and has struggled to make money in recent years.
The list of once-admired firms that today are struggling to survive is a long one. There are two ways to interpret this bewildering variety and evolution of management practice. The first is to believe that the development of successful strate-gies is so complicated as to be essentially a matter of luck. The second interpretation presumes that successful firms succeeded because the strategies best allowed them to exploit the potential profit opportunities that existed at the time or to adapt to chang-ing circumstances.
If you are reading this book, then it is likely that you or your profes-sor believe in this second interpretation. We certainly do. While there is no doubt that luck, both good and bad, plays a role in determining the success of firms, we believe that success is often no accident. We believe that we can better understand why firms succeed or fail when we analyze decision making in terms of consistent principles of market economics and strategic action.
And we believe that the odds of competitive success increase when managers try to apply these principles to the varying conditions and opportunities they face. While these principles do not uniquely explain why firms succeed, they should be the basis for any systematic examination of strategy.
Because this is an economics book, we will necessarily gloss over if not completely ignore some possible paths to profitability. We will not discuss how firms can improve Strategy and Economics manufacturing techniques or reduce inventory costs.
We will mention advertising only insomuch as it touches other topics that are of direct interest to strategy, such as entry deterrence. We examine accounting mainly to point out that costs and profits reported on accounting statements are often poor measures of economic performance. We give short shrift to leadership and team building, not because these are unimportant, but because economics has little to say about them.
Others, including Gary Hamel and C. But how would we determine which is more important? To answer this question, imagine taking a broad sample of different firms over many years. Would we see persistent variation in profitability of firms within industries but little variation in profitability across industries?
Or would we see little variation in profitability of firms within industries but persistent variation in profitability of entire industries?
If so, the market effect is paramount, and the positioning effect is unimportant. In fact, research suggests that the profitability varies both within and across industries, and that within-industry variability is a bit bigger than across-industry variability. In other words, firms matter and markets matter, though perhaps firms matter a bit more. Note also that a large component of the variation in profitability across firms is not persistent over time. Turnover of key management personnel, or a failed product launch, new regulations, or just plain luck could cause temporary swings in profitability.
We believe that the successful strategist must master principles associated with both market competition and positioning and that this motivates the framework for strategy that we provide in this book. But what specifically does this mean? Put another way, to formulate and implement a successful strategy, what does the firm have to pay attention to?
We would argue that to successfully formulate and implement strategy, a firm must confront four broad classes of issues: What should the firm do, how large should it be, and what businesses should it be in?
What is the nature of the markets in which the firm competes and the nature of competitive interactions among firms in those markets? How should the firm position itself to compete, what should be the basis of its competitive advantage, and how should it adjust over time?
How should the firm organize its structure and systems internally? Boundaries can extend in three different directions: All three boundaries have received differing amounts of emphasis at different times in the strategy literature. Our view is that all are important and can be fruitfully analyzed through the perspectives offered by economics. Market and Competitive Analysis To formulate and execute successful strategies, firms must understand the nature of the markets in which they compete.
As Michael Porter points out in his classic work Competitive Strategy, performance across industries is not a matter of chance or accident. The nature of industry structure cannot be ignored either in attempting to understand why firms follow the strategies they do or in attempting to formulate strategies for competing in an industry.
Positioning and Dynamics Positioning and dynamics are shorthand for how and on what basis a firm competes. Position is a static concept. At a given moment in time, is the firm competing on the basis of low costs or because it is differentiated in key dimen-sions and can thus charge a premium price? Position, as we discuss it, also con-cerns the resources and capabilities that underlie any cost or differentiation advantages that a firm might have.
Dynamics refers to how the firm accumulates resources and capabilities, as well as to how it adjusts over time to changing cir-cumstances. Strategy and Economics Internal Organization Given that the firm has chosen what to do and has figured out the nature of its market, so that it can decide how and on what basis it should compete, it still needs to organize itself internally to carry out its strategies.
Organization sets the terms by which resources will be deployed and information will flow through the firm. It will also determine how well aligned the goals of individual actors within the firm are with the overall goals of the firm. How the firm organizes itself—for example, how it structures its organization, the extent to which it relies on formal incentive systems as opposed to informal influences—embodies a key set of strategic decisions in their own right.
Part One explores firm boundaries; Part Two deals with competition; Part Three addresses positioning; and Part Four examines internal organization. The principles that we present should prove useful to managers across a wide range of business conditions and situations. Chandler, A. Servaes, H. Irwin, Wittman, D. A firm produces two products, X and Y.
The production technology displays the following costs, where C i,j represents the cost of producing i units of X and j units of Y: Of scope? This technology does not display economies of scale. Since the cost per unit does not decrease as the quantity of Y increases, this technology does not display economies of scale in the production of Y.
The result is analogous in looking at the costs of making X, as well as looking at the costs of making X and Y together in greater quantities. This technology does display economies of scope in the production of X and Y. Economies of scale are usually associated with the spreading of fixed costs, such as when a manufacturer builds a factory.
Fixed costs are those costs that do not vary directly with output. Fixed costs must be expended in order to initiate production, but also for activities such as selling the output or developing improvements to the output. How does the globalization of the economy affect the division of labor? Can you give examples? The increased magnitude of the market due to globalization will increase the demand for more highly specialized labor.
Examples of this higher demand for specialized labor would be the rise of high technology manufacturing jobs in countries like China where cell phones and computers are now assembled. Likewise the increase in specialized jobs such as accounting and computer programming now exist in countries like India due to globalization. Such a plant could produce about million pounds of cereal per year.
What would be the average fixed costs of this plant if it ran at capacity? Each year, U. What would be the average fixed costs if the cereal maker captured a 2 percent market share?
What would be its cost disadvantage if it only achieved a 1 percent share?
If prior to entering the market, the firm contemplates achieving only a 1 percent share, is it doomed to such a large cost disparity? A 2 percent market share would be. The CEO is interested in maximizing profits and wants to pursue the project or set of projects that return the highest expected profits to the firm.
Three potential alternatives have been proposed, including the following estimated financial projections: The expected revenue divided by the upfront costs provides an estimated one year return on investment. Students should realize that upfront costs are fixed costs and the variable costs of producing the expected revenues are unknown. This return on investment analysis assumes that the profit margin for all three projects is the same.
How does the digitization of books, movies and music affect inventory economies of scale? Inventory costs drive up the average costs of the goods that are actually sold. 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.
Larger firms that previously enjoyed a competitive advantage due to their high sales volume and low ratio of inventory to sales now face increased competition from smaller firms that enjoy the same average costs to sales due to inventory. First, if the firm has already downloadd expensive real estate and could build a slightly larger building, it can enjoy economies of scale by effectively spreading these high fixed costs across a wider array of products.
Second, a firm that already has a strong reputation with consumers could enjoy marketing economies of scale using their existing branding umbrella. Third, the firm could achieve greater economies of scale by using its current distribution systems to deliver more products to fewer large stores.
Despite these potential benefits, there are some limits to economies of scale. Additionally, the firm may damage its reputation with core consumers by expanding its products well beyond the range for which it is known. Explain why learning reduces the effective marginal cost of production. If firms set prices in proportion to their marginal costs, as suggested by the Economics Primer, how can learning firms ever hope to make a profit? The effect of learning allows firms to increase output at lower average costs.
The reduction in average cost can only occur if marginal costs are also declining. As firms increase employee and manager learning, output increases due to better coordination and throughput. Since the effect of learning on a firm is to reduce marginal costs, making a profit is consistent with the economic model of setting prices in proportion to those costs.
The reduced marginal costs due to learning allow for a reduced product selling price, but still one where a profit is earned. What is the dominant general manager logic? How is this consistent with the principles of scale economies? How is it inconsistent with these principles? Dominate general manager logic exists when managers develop specific skills — say in information systems or finance — and seemingly unrelated businesses rely on those skills for success. Firms often diversify to achieve economies of scale or scope.
They do this by combining similar functions across unrelated business lines — like sharing technology, distribution or accounting activities.
The ability to spread these fixed costs across multiple business lines gives each an economy of scale or scope. The same is true with management talent. The ability to spread specific skills or knowledge of managers across diverse businesses increases scale or scope economies. Dominate general manager logic is inconsistent with achieving scale or scope economies if the manager does not possess superior knowledge or skill to spread across diverse business lines. Absent other known economies of scale and scope arising from diversification, merely spreading the management talent across unrelated businesses may not lead to any advantage.
In rapidly developing economies such as India and South Korea conglomerates are far more common than they are in the US and Western Europe. In rapidly developing countries where financial markets are less well developed, this analytical process demonstrates why the conglomerate form of business is more prevalent. Economies of scope can emerge in the conglomerate structure even absent developed financial markets by utilizing the free cash flow identified in non-similar businesses lines to provide internal capital.
The following is a quote from GE Medical Systems web site: Not only from within the company, but from beyond as well…. This belief is the force behind our record number of acquisitions.
Examining which of the following is broadly considered one of the easiest ways to measure diversifying activity?
What force does Manne indicate constrains the actions of managers so that they stay focused on the goals of owners? What kind of economies come from reductions in average costs due to increases in capacity utilization? What are economies of density as referred to in the airline industry? Which of the following is not generally a potential benefit of diversification?
Which of the following benefits of diversification explains the idea that mergers are more likely when there is an expectation of positive changes in market share? How does carrying inventories contribute to economies of scale? Which of the following benefits of diversification explains the idea that combining unrelated businesses can allow firms to finance projects through cross-subsidization when they previously were unable to finance the same projects externally?
Which of the following is not a reason a supplier might seek to sell in bulk?