1 - Analysis of the Environment

Learning objectives: How industry life cycle can transform competitive environment Implications of life cycle for competitive strategy Implications of five forces on strategy User five forces to analyse context Contribution and limitation of game theory How strategic moves help gain advantage 1.1 Introduction 1/1 Rulebook for competitive strategy is not clear nor commonly agreed 1.2 Industries and the Life Cycle 1/3 Seek some position that is difficult or impossible to imitate Uniqueness poses problem for analysis Lifecycle analogous to biological organism But decline not inevitable or statistically predictable Growth rate not passive, firm may influence: Pricing strategies in the introductory phase (penetration, skimming) Life cycle stretching and renewal (innovation and marketing improvements) Some cycles more erratic than others Professional wrestling, cinema have had multiple wax/wane phases 1.2.1 Critical turning Points A growth begins to slow o If unexpected then there will be overcapacity due to overproduction o => destructive competition o Even wise firms may still be under pressure Rivals continue to invest Difficult to identify timing Intensified competition, price wars, market share o Start of shake-out phase - B market growth ends o Could be zero growth or simply same growth as economy o Increased growth only by increasing market share Decrease number or rivals or their share C market growth negative o Maintain current levels only by taking market share o Fierceness of struggle depends on how many firms exit Turning points are almost impossible to predict 1.2.2 The Stages of the Life Cycle Growth Stage Relatively low price elasticity of demand for each brand o Limited substitutability; user unfamiliarity Relatively high price o Problems: profit signal (to prospective entrants), slow growth, delay economies of scale, experience curve High level of advertising to create demand o Informative then persuasive Profits low initially then increasing o Ability of firm to sustain a loss is important Variety of product designs Radical product and process innovation Major demands for new investment o Equipment; human (training) Frequent bugs and defects Capacity shortages o Buyers may vertically integrate backwards Easy of market entry Few firms Patchy or limited distribution

Maturity Stage Increasing price elasticity of demand o Informed consumers, increased competition, standardisation Falling price o Economies of scale, experience curve, process improvements, competitive pressures Brand advertising important Profitability begins to decline Increased standardisation o Erosion of patent protection, better information on best design/practises, tightening competition Incremental innovation, emphasis on process innovation Replacement investment Improved quality / reliability Capacity matches demand Entry more difficult / less attractive Many firms Well established distribution channels Decline Stage May be triggered by external event (e.g. technological substitution) or government regulation High price elasticity of demand Falling prices Lack of differentiation and growth reduces need for advertising Low profits Further standardisation Little innovation, investment Overcapacity Unattractive entry Fewer firms Distribution increasingly important Porter: strategies in decline o Dominance and leadership High market share may lead to cost advantage Credible commitment (investment, aggressive pricing) o Niche exploitation o Harvest Cut investment, maintenance, service o Exit Best before decline sets in o Internalise threat Need residual strengths and competences that contribute to competitive advantage in new regime 1.3 The Five Forces Framework 1/15 Prior to framework strategic management was based primarily on checklists and case studies Considerations Framework is not static but evolving Doesnt lead to clear and unambiguous conclusions, integrates major influences some quantitative, some qualitative After identifying forces clearly, still variety of competitive strategies possible 1.3.1 Threat of Entry Economies of scale o Minimum Efficiency Scale (MES) point at which firm achieves lowest average cost (AC) o Cost gradient: steepness of slope of average cost (versus output) o High MES (high hurdle) and steep gradient (big advantage) => strong entry barrier Natural monopoly (possible to separate ownership from operation, e.g. telco, rail) Economies of scope o Synergies o Increased output can lead to fuller exploitation of indivisible resources (plant) o Opportunities for specialisation and direction of labour o Shift down long-run AC cost curve for each product (scale economy move along curve) Experience curve o Unit cost falls in relation to accumulated output o E.g. complex technological products Differentiation o Strongest barrier in areas of health, safety and welfare Risky and costly capital requirements o Plant & Equipment, Intangibles (Research & Development)

Switching costs o Loyalty cards, air miles Access to supplies and suppliers Other cost advantages o Patented low cost process, ... Government policy o Regulated industries, licensed operators Exit barriers Expected retaliation

1.3.2 Rivalry Multiple dimensions Objectives: profitability, market share, growth Channels: price competition, advertising, innovation Strength: weak/strong Factors: Relatively high fixed costs => marginal costs relatively low Low growth => zero sum game High exit barriers => no escape route Weak differentiation and switching costs Absence of dominant firm 1.3.3 Bargaining Power of Buyers One or few major buyers Buyers earn low profits o May be signalling low profits to sellers Product is high proportion of buyers purchases o Increased price sensitivity Standardised product, low switching costs Buyers threat of backward integration 1.3.4 Bargaining Power of Suppliers One or fewer suppliers No close substitutes Product is important input to buyers business Buyer is not an important customer Supplier products are differentiated High switching costs Supplier threat of forward integration 1.3.4 Pressure from substitutes Similarity of function Price/performance characteristics 1.4 Game Theory Perspectives 1/30 1.4.1 Prisoners dilemma Associated with variety of strategic situations Advertising Pricing Innovation Investment Theoretically sound but uncommon in reality Preconditions: Simultaneous decision-making Accurate knowledge of pay-offs No communication No social ties and obligations No history: no past or future (one-off decision) Even when situation looks superficially like prisoners dilemma actual behaviour often different than predicted Repetition, familiarity, negotiation, trust, loyalty, kinship, social pressure, personality Caution against game theory models but valuable lessons from reasoning 1.4.2 Strategic Moves Intended to alter beliefs and expectations of others in a favourable direction Central issue in game theory: Credibility (e.g. empty threats and promises) Means of achieving intangible asset of credibility: Reputation communicating a determination to protect reputation at all costs

Contracts difficult to specify fully, room for misrepresentation Specialisation deliberately restricting options (burning your bridges) Investment form is important: sunk costs Incrementalism build up credibility/trust over time Hostages cooperative agreements, decrease opportunistic behaviour Social context range between diamond dealer and Hollywood producers...

1.5 Conclusions 1/39

2 - Strategies for Competitive Advantage

2.1 Introduction 2/1 Scope for designing and developing competitive strategy in practice 2.2 Generic Strategies 2/2 Strategies have large variety of objectives and outcomes. - Some not directly related to profitability, but may help anticipate problems o Vertical integration (protect against being cut off from suppliers) Three generic strategies (Porter) Cost leadership Differentiation Focus (niche) o Cost focus / Differentiation focus Problems in implementation: Trade-off between cost and differentiation o Seek parity/proximity with competitors that are not sources of competitive advantage Stuck in the middle o Confusing message to customer in case of multiple strategies Single cost leader Sustainability o Continual adaptation and innovation o Entry barriers 2.3 The Value Chain 2/4 Breakdown of firm into component activities Actual or potential sources of competitive advantage Applied at SBU level Physically and technologically separable activities Identify activities with impact on cost or differentiation Generic Value Chain: R&D, Production, Marketing, Distribution Look at linkages within chain to determine competitive advantage Look at linkages between chains to see if shared activities can contribute value Links to value chains of other firms: o Vertical: suppliers/buyers o Horizontal: collaborative arrangements with other firms Clusters: Vertical/horizontal interactions of geographically concentrated firms Caution: mechanistic trawl may miss crucial activities May look mundane individually, value is in interactions Capabilities: Sets of related activities where firm does relatively well Analysis does not rely on bottom-up approach Should be firm specific, difficult to imitate Should not be application specific (reusable in other market contexts) Problems with simplistic approach:

Competitive advantage may reside in entire value chain, not compoenents Identified capabilities may be too general (e.g. Innovation) Highly subjective Competence can turn into liability (obsolescence) Industry capabilities (e.g. oil firms successful but not unique) Distinctive capabilities provide few direct lessons

Vertical links shift intermediate product Horizontal links share resources Value chains with many strong horizontal links between them may be treated as single chain Divisional structure: appropriate when value chains are independent Functional structure: may be more appropriate when there are significant linkages Resources may have dual role Within value chain (vertical links to other resources) Connection with other value chains (horizontal) Hybrid Example three values selling to same market: divisional structure with combined Marketing Problem in recognising profit Matrix widely adopted by large diversified firms 2.4 Cost Leadership 2/10 Cost drivers: Economies of scale Learning and experience curve Capacity utilisation o High degree of price discrimination (e.g. airlines) Vertical links in value chain Horizontal links with other value chains economies of scope Timing o First to market versus learning from others mistakes Location o Land, labour, capital costs Government regulation, taxes and subsidies Discretionary policies o Direct sales, limiting product variety, standardisation External economies o E.g. well-qualified labour pool in area Cost leadership more sustainable when standardised product combines with economies of scale, and experience curve High market share Attract and retain buyers on basis of price. Most likely: o Early stages: first mover advantage o Later stages: high price-elasticity Game theory: Credible threat that leader will maintain strategy irrespective of competitor actions Dominant strategy must be visible to competitor o Credible commitments (e.g. shut down R&D, reduce product variety, move production to low-cost location) Porter 1. 2. 3. 4. 5. 6. steps to cost analysis: Identify value chain and elements Identify relevant cost drivers Identify competitor value chains, costs, advantages Develop strategy to reduce costs Guard against eroding differentiation Test for sustainability (competitor emulation)

2.5 Differentiation 2/17 2.3.1 Sources of Differentiation Policy choices o E.g. Kelloggs doesnt allow rebranding

Linkages o Just-in-time (Kanban) Timing o Early entry: Hoover Location o E.g. bureaux de change in airport terminals Interrelationships with other value chains o Share cost elements, reputation Learning o Quality, reliability, service Vertical integration and control o Control over reliability and quality Scale o E.g. Interflora

Reduced indirect costs for buyer: Long-life bulbs, batteries (replacement) Corner shop (location) Car leasing (breakdowns) Chopped wood (effort) Interior design (reduced search costs) Kinds of purchase criteria (Porter): Use criteria: actual impact on buyer performance or cost o Can be intangible (style, prestige) Signalling criteria: inferred quality o Advertising: Advertising spend is a crude indicator of quality (credible commitment) Asymmetric information Adverse selection: distorts trading in favour of sellers who misrepresent Lemons: o If product of variable quality and o Buyers cannot distinguish quality, then o Market will be dominated by lemons Market will underestimate real worth of superior products and sellers will remove from market o Complex, non-standardised product of variable quality o Trading relationship is occasional or one-off Mechanisms to offset Lemons problem o Reputation and word-of-mount recommendations o Warranties and guarantees Signal quality, but guarantee may also be lemon (restrictive clauses...) o Industrial and professional associations o Brand name recognition Chains and franchising o Consumer guides and reviews May be subjective o Intermediaries Professional expertise may also be lemon o Government Licensing, regulation, anti-trust policy 2.5.3 Steps in differentiation Identify relevant buyer Identify firms impact on buyers value chain Identify buyers purchase criteria Identify actual and potential sources of uniqueness Identify cost of actual and potential sources of differentiation Assess benefit versus cost of differentiation alternatives Test for sustainability Reduce costs that do not affect differentiation 2.6 Focus 2/26 Strategy depends on differences between segments of same market Start with needs of segment Tailor strategy Optimise value chain for segment Strategy may refer to entire firm or part of firm o Advantages of firm-wide focus

Whole value chain can be dedicated Disadvantages Limited opportunities for economies of scope Limited growth opportunity Vulnerability to external threats Usually just part of firm Still links with other value chains

Focus should add value (linkage to other value chains) or else it may be destroying value Fallacy of free focus o Opportunity cost of managerial and financial resources Linkages cost o Cost of coordination o Cost of compromise (quality signals) o Cost of inflexibility Difficult to divest of close down an unprofitable business 2.7 The Dangers of Hybrid Strategies 2/30 Not advisable to pursue both costs advantage and differentiation strategies in same segment (Porter) Incompatible demands on firm Worst outcome is to transfer inappropriate competencies into both sides of the market o False economies on quality-conscious end; unnecessary differentiation for cost-conscious segment o Mixed strategy must at least set up distinctive units o Some opportunities Competitors are also stuck in the middle Cost is strongly related to scale First to innovate 2.8 Conclusions 2/33

3 - The Evolution of Competitive Advantage

3.1 Introduction 3/1 Fallacies: Innovators must be first with new idea Inferior products will lose in the market (survival of the fittest) If you can convince public that product is good and affordable they will buy o E.g. network effects 3.2 The Innovative Process 3/3 Invention: act of devising/creating new idea Innovation: commercialisation of the idea Product innovation: new good or service Process innovation: development of new production technique Research and development Articulable knowledge: can be sent down a telephone wire (e.g. specifications Tacit knowledge: built up through experience, experimentation, learning (how to ride a bicycle Basic research: no specific commercial objective Applied research: directed commercial targets (products/processes) Development: conversion of research findings into actual products/processes Virtual / vicious circles protect successful design - and prevent better design from challenging leader Economies of scale Learning effects Network effects Network effects: raise question of bootstrap: Expectations Sold below cost initially Small user groups with strong need for connection 3.3 The Characteristics of the Innovative Process 3/6

Specificity: range of eventual commercial outcomes (products/processes) Low degree of specificity may provide high degree of synergies

Externalities: benefit/cost that impacts someone else (e.g. competitor) Apprpriabjlity: ability for inventor to retain control

Uncertainty (whether project will solve problem, market will materialise, production will be cost-effective) Reduced with fixed target, budget Typically cumulative (reverse chronologically) Timing Delays cumulative Cost of stage Costs typically rise as development proceeds Scale models, prototypes Cumulative cost Total (remaining) cost of a project being commercialised 3.4 Why Innovation can be Squeezed off the Firms Agenda 3/10 Hurdles (in M-Form, which is most common for large organisations) 1. Appropriability problems: if benefits accrue to rival then may represent a net cost 2. Neglect of potential internal spin-offs: rivalry between divisions, capital budgeting prioritisation 3. Duplicated research efforts: M-form encourages compartmentalisation 4. Uncertainty: risk avoidance means downside risk weighs more heavily than upside Also median may be much lower than the mean, distorting the expected value 5. Cost: capital budgeting restrictions 6. Long time horizons: managers judged on short-term performance 7. Asymmetric information: scientist know more than management But gross underestimates, misaligned objectives 8. Machiavellis problem : those who profit from old order will oppose the innovators, supporters tepid 9. Compartmentalisation and need for integration U-form even worse: More specialised means spin-offs will benefit others Smaller means less likely to afford up-front development costs Must find balance between creativity and control 3.5 Solutions 3/16 Solutions in one dimension (e.g. reduce uncertainty through evaluation) may exacerbate others (delays) Most obvious price to be paid is managerial time 1. 2. 3. Conduct R&D In-house o Keep secret to avoid appropriability problems Internal funding of R&D o Avoid capital market (appropriability) o Improper external valuation: asymmetric information, uncertainty, long-time horizons Corporate level R&D o Enable spinoffs for other division, avoid duplicated research, absorb failures, long-time horizons o Problems: o Difficult to evaluate divisional performance o Distance from market means less sensitivity to opportunities o Divisional managers less aware of technological developments o Unfocused entity with disparate expertise Top-down budgeting o Fund allocation using rank ordering o Address unmeasurable uncertainty, long-time horizon, principal-agent problem Split the R&D function o Research: corporate; Development: divisional o Difficult to coordinate and integrate R&D activity Split budgets for operations and innovation o Solution to: spin-offs, uncertainty, high-cost, long-term, Machiavellis problem o Problem: divisional managers still inclined to spend more effort on short-term o Problem: muddles assessment criteria Targets for new product generation o Similar to 6 but focus on outputs rather than inputs Parallel R&D approaches o In some case additional effort may reduce time o Balance of cost versus long-time horizon Second-in strategies o Turn appropriability into an opportunity o Accelerated research programme to catch up to leader

4. 5. 6.

7. 8. 9.

o Reduces uncertainty and high cost. 10. Licensing and joint venture o Smaller firms can innovate more easily (Machiavellis problem) but larger firms have more resources for commercialization o Problem: managerial and transaction costs 11. Research club o Deeper pocket o Administration costs, inconsistent objectives, anti-trust 12. Corporate diversification o Larger firms can absorb cost, delays and uncertainty more easily o Outcomes are often unpredictable => diversified firm can leverage more easily o Problem: loss of focus 13. R&D diversification o Multiple simultaneous projects spreads uncertainty risk o Economies of scope o Problem: cost 14. Matrix organisation - Divisional and Research reporting o Cross-divisional spin-offs while eliminating research duplication o Problem: confusion of lines of responsibility 15. Organic structures o In contrast to rigid hierarchies, formalised M and U structures with demarcated tasks o Encourage flexible responses, lateral communication, minimal job differentiation, o Trade-off between imposing control and stimulating creativity 16. Quasi-autonomy o Spin-off team with idea into separate company o Problem: reduced control of parent company 17. Product champions o Counteract natural tendency toward organisational inertia, overcome departmentalisation o Difficult to institutionalise; can only create favourable environment 18. Fixed-price versus cost-plus R&D contracting o Transfers uncertain between R&D and funding organisation o Often customer (e.g. government) can accommodate risk more easily 19. Public funding of basic research o Appropriability, uncertainty, long-time horizons: strong disincentives for private firms o Still some incentives: scientist fulfilment, serendipity (unexpected commercial applicability) o Delays from basic to applied research are shortening 3.6 Conclusions 3/32

4 - Vertical Links and Moves

4.1 Introduction 4/1 Interest in vertical integration is only recent but one of the most dynamic topics in strategy. 4.2 Defining Vertical Relations 4/2 Shift or transfer of some intermediate product between states in the value chain Vertical relations are compulsory, horizontal are optional Can involve firms in activities that are very different from core business There may be some discretion over supplier (cost versus quality) and customer (international or home market) Range of relations: Spot market Long-term contract Vertical integration Franchising Tapered integration mixed market exchange and vertical integration Vertical quasi-integration long-term contract with dominant partner Value-adding partnership cooperation by independent companies

Two categories: market exchange, organisation within firm Forms of relationship: Mixes of contracts and administrative devices 4.3 Trends in Vertical Relations 4/6 Lead US, early 20th century, food and drink, forward integration (marketing and sales), and some backward integration Expanded to: Oil, rubber, electrical machinery, primary metals, instruments High volume, capital intensive, needed coordination and scheduling of input/output flows Less integration in: furniture, paper, printing, leather, lumber, apparel, textiles Labour intensive, product variety, shorter production runs IBM: semiconductors to services Complementary forces drive toward outsourcing: If activities are standard then competition will eliminate excess profits Firms need wide variety of inputs/services to operate. Focus managerial resources on core competencies 4.4 What Vertical Integration is Not 4/8 Not justified because potential acquisition is profitable Profitability will be reflected in market valuation Not obviously anti-competitive As long as there is competition at each stage Not justified solely on technological grounds Technological interaction (stealmaking/reheating) does not preclude a business boundary Transaction cost rather than technology is important

4.5 The Costs of Markets 4/10 Two forms of costs Firms acting in own interest against contract partner Reliance on market exchange 4.5.1 The Invisible Hand and Some Problems Invisible hand of resource allocation (Adam Smith) Problems: Inelastic demand/supply curves (demand and supply vary little with price) E.g. commodity market Problem: instability: small change in demand/supply will lead to price volatility

Solution: Forward integration by sellers / Backward integration by buyers Disadvantage: locks firm into internal arrangement when market exchange may be better (change in other direction)

Vertical integration replaced continuous market bargaining with planning and administrative process 4.5.2 Visible Relations and the Market Suppliers of specialised components/products Transaction costs: Search for trading partner Negotiate deal Monitor/police agreement Also potential loss of intellectual property Transaction cost economics: Bounded rationality individuals have limited knowledge and cognitive abilities Opportunism individuals may cheat/misrepresent Asset specificity some assets have little use outside present application o Site specificity - physical assets cannot be redeployed o Physical assets specificity e.g. moulds for statue o Human asset specificity skills/knowledge not easily transferred o Dedicated assets expanding plant for particular buyer Hold-up problem Once buyer and seller have built equipment (committed to transaction) may be vulnerable to hold up Even contract may not be sufficient protection o Court settlements are costly and lengthy Combination of factors is problem: o No Bounded rationality would know whom to trust o No Opportunism would be sensible resolution o No Assets specificity would be able to withdraw and find alternative Dangers greatest when only one party suffers from asset specificity o First glance: most favourable when firm not exposed to asset specificity but partners are But: hard to find partner without robust contracts/guarantees Fundamental transformation the reduction from a large number of partners (e.g. suppliers before contract) Hold-up strategy Increases profits at expense of reputation Good short-term tactic but possibly disastrous long-term implications Attitudes toward opportunism may vary between sectors, regions Not necessarily always extreme case of extortion o Potentially just different prioritisation of objectives Solutions to hold-up Repeated contracting: same preferred partner o Advantage: other party will be conscious of potential loss of future contracts o Disadvantage: reduces flexibility Exhaustive contracting: tighten contract o Expensive, only partly effective, legalistic climate Standardised assets o Advantage: readily available alternatives o Disadvantage: loss of distinctiveness Hostages: o E.g. penalty clauses for late completion o Multiple transactions o Advantage: threat of retaliation o Disadvantage: lock-in, less choice Multiple sourcing: o Advantage: Reduce asset specificity o Disadvantage: multiple contracts => increased costs Vertical integration: internal expansion, merger, acquisition o Advantage: synchronised and aligned objectives Tapered integration: partial integration (produce and purchase) o Advantage: limits threat of hold-up; increased competitive incentive for internal organisation o Disadvantage: sacrificed economy of scale; two separate organisation methods 4.6 The Costs of Vertical Integration 4/23 Most obvious alternative to market exchange Administrative costs of bureaucracy: Difference competences: sacrificing gains of specialisation

Dangers of specialisation: vulnerability increased through additional dependency Lack of flexibility: in choice of sources and outlets o Insulated from competitive pressures but inefficient and anti-competitive o Industry wide vertical integration (silos) may impede entry of better performers o Not fit to deal with radical changes when they do occur Sacrifice economies of scale (of target) Dampened performance incentives o Guaranteed future irrespective of performance o Principal-agent problem Large size o Indivisibilities o Vertically integrated system may not be watertight Vertical integration with rivals o Bounded rationality & opportunism Rival will expect to be at disadvantage o Vertical integration may spread once triggered

4.7 Choice of Strategy 4/28 4.7.1 Features Encouraging Market Alternatives 1. Stable and predictable demand and supply conditions 2. Standardised product 3. Many firms at each stage 4. Few other vertically integrated firms 5. Transaction-specific investments not required 6. Well established and widely distributed knowledge of technology 7. Slow-changing or static technology 8. Easy to monitor contractual obligations being fulfilled 9. Little chance of being cut off from supplies or inputs 10. Different scales of production necessary at each stage 11. Different competences required at each stage 12. Reputation important in this sector 13. High chance of repeated buyerseller relationship 4.7.2 Features Encouraging Vertical Integration Not sufficient for transaction costs to exist: May be possible to patch up market alternative (e.g. with solutions to hold-up problem) May still be cheaper than administrative costs of vertical integration 1. Unstable unpredictable demand and supply conditions 2. Differentiated product 3. Few firms, at least at one stage 4. Few firms not vertically integrated 5. Transaction-specific investment required 6. Technological knowhow concentrated in pockets in the sector 7. Rapidly changing technology 8. Difficult to check that contractual obligations are being fulfilled 9. Real fear of being cut off from supplies or inputs 10. Similar scale of production necessary at each stage 11. Similar competences required at each stage 12. Difficult to establish or maintain reputation and trust in this sector 13. Low possibility of repeated buyerseller relationship 4.8 The Varieties of Vertical Relations 4/30 Often expressed as: Make or Buy Production transactions Higher degree of assets specificity => higher probability to make R&D transactions Control required to prevent leakage of non-specific items and Control focus of tasks to specific requirements Advertising transactions Incentive to in-source: high specificity, hold-up problem However: also specific competencies

4.9 Conclusions 4/32 Review Questions 4/32

5 - Horizontal Links and Moves

5.1 Introduction 5/1 Limits to vertical integration Central concepts to horizontal integration Value, efficiency, opportunity cost Principal-agent problems, transaction costs, value chains Lifecycles apply to people and products, not necessarily to firms Most large firms survive Most are not conglomerates If they are they tend to stay 5.2 The Diversification Game 5/3 Diversification is both a direction and a method Direction: horizontal Method: internal organisation rather than agreements 5.2.1 Horizontal Directions in the Diversification Game Rule 1: Rule 2: Rule 3: Competitive advantage Move mush shift at least one demand curve or one cost cruve to add value Only one move at a time Limited managerial resources Fair play No dominant position (monopoly control)

More gains through rich linkages at multiple points in value chain Distribution, marketing, production, R&D E.g. Duopoly => monopoly: higher price using less resources Specialisation linkage of all elements in value chain 5.2.2 Preferred Moves in the Diversification Game Resource Effects Specialisation best Avoid unrelated diversification (opportunity cost) Market Power Specialisation best Market linkage: Influence over retailers Allergic reactions Resources come in bundles (strategic planning team, marketing team plant facility) o Difficult to separate elements to share BIC diversification into perfumes; gourmet/fast-food => improve cost, damage image Porter: Failure of synergy in corporate expansion Rivals valuation Rivals may value business more highly => excessive acquisition cost 5.2.3 Methods of Expansion in the Diversification Game Same benefits through cooperation: Market power: cooperative agreement Anti-competitive regulation Partner trust Diluted control Transaction costs

Expansion of single link (e.g. advertising): Limits transaction costs to that link Reduced risk of allergic reaction Diversification Allergic reaction costs increase the less related the firms Co-operation

Transaction costs increase the more related the firms

5.3 Why Diversify? 5/13 5.3.1 Market Power Dominance versus suppliers/buyers clear a benefit Depends also on other circumstances: Attitudes of firm Other players Potential entrants Government regulations/intervention 5.3.2 Synergy Cost savings through resource sharing Economies of scope If businesses are similar there may be economies of scale Indivisibilities o Increased resource utilisation (machines, workers) o Specialisation Individuals can specialise in area of expertise Reduced transition costs from switching Improved learning Spreading competencies/capabilities across more activities Larger firms: o Resource sharing or tangible products (plant and equipment) less important o Intangible resources (managerial capabilities) more important 5.3.3 User Gains Cost advantage E.g. one-stop shopping Differentiation E.g. product compatibility User gains lead to differentiation advantage that allow it do sell at premium 5.3.4 Internal Markets Internal markets for Labour, R&D... Advantages over external markets: Asymmetric information Control of opportunistic behaviour Divisionalisation gains Conversion from Unitary Form to Multi-divisional structure o Creation of profit centres o Collecting resources with coordination needs into units o Separation of strategy formulation (HQ) and functional responsibilities (SBU) o Disadvantages: principal-agent problems Opaque performance: concealed in consolidated accounts Lock-in: impedes reallocation of assets; artificial support of obsolete businesses Not-invented-here syndrome: less value placed on ideas from other businesses Internal capital market o HQ has advantages over external market in: information, control, dvidisionalisation 5.3.5 Growth Principal-agent problem Shareholders want to maximise profits Managers want to maximise growth 5.3.6 Risk and Uncertainty Diversification clearly reduces risk But: Opportunity costs (versus related diversification) Owners may spread business risks by diversifying portfolios o If managers pursue risk spread => principal agent problem Simpler solutions to volatile sales: Liquid assets: smooth out sources of funds Short-term finance Stockholding: absorb surplus production during slack periods

Insurance: not sales directly but events causing fluctuations Long-term contracts: with buyer/retailer Vertical integration: forward Solutions are not free but allow firm to concentrate on core competencies Risk of disruptive surprise (e.g. new substitute) Linkages generate enhance value in stable environment but can be source of joint weakness in crisis Diversification reduces risk o Why not specialise until forced to change? Worst time to switch when forced o Can corporate diversification also be in interest of owners (as well as managers)? Transaction costs of bankruptcy o How can management know when to diversify? Difficult to anticipate future threats but possible to recognise environment where likely But not always 5.4 Forms of Diversification 5/30 Most evidence suggestion expansion into closely related business most effective Related-linked: (Richard Rumelt) Combine linkage gains with risk-spreading of multiple markets/technologies Forms of disruption: Innovation: new products/processes Change in consumer tastes: fashions, sports fads, health scares o Often triggered by technological innovation Changes in government restrictions: safety, deregulation, privatisation Resource deletion Innovation most important source Attack on business (i.e. product) less severe than attack on competence Linkages create shared vulnerabilities Conglomerate most resistant to disruption Related link: advantages of related diversification wiout dangers of exposure to single external threat The more links the less exposed Conglomerates usually exist for: Synergy, deep-pocket, market power, or to absorb individual business risk Related diversification (especially related-linked) can usually match/outdo Reasons for conglomerates: Disguised related-linked Restructuring of related-linked (e.g. initially related-linked but linkages very fragile, divesture of central element) No alternatives: some industries such as tobacco and petroleum Rapid growth objective Path dependency: once conglomerate it may be expensive (transaction cost) to shift Conglomerate focus: Adapted strategy after partial failures o Divest unprofitable businesses o Pursue related diversification of remaining businesses o There may be some disconnections: e..g independent groups of related businesses 5.5 Conclusions 5/39

Review Questions 5/39

6 - International Strategy
International: serves foreign markets Multinational: locates operating facilities abroad Dunning: with exception of oil companies, most giants: Located most assets in home country Most sales in home country Not necessary to be multinational to be extremely successful 6.1 The Diversification Game Goes International 6/3 Expected links from internationalisation: Few: no shared production. separate distribution channels, separate markets Potential with R&D Poor comparison with domestic specialisation Export: Economies of scale from further expansion Administrative economies compared to multinationalism Resource costs: cheap labour Transport costs: significant volume or weight

Market saturation But why not related diversification 6.2 The Question of International Competitiveness 6/6 Factors, but neither necessary nor sufficient conditions: Exchange rate (counterexample Germany) Cheap labour (counterexample Sweden) Cheap natural resources (counterexample Japan) Countries do not compete, firms do (Porter) For a given country, few industries perform well internationally For a given industry, few countries perform strongly Successful companies often come from countries with tough competitive environment Dilemma for standard economics: Space: territories are not isolated Time: Standard economics long-run doesnt consider technological upheavals 6.3 Porters Diamond Framework 6/9 Diamond: Factor conditions, Demand Conditions, Linked and related industries, Firm Strategy Analysis in space and time: Space: Home base exerts influence over each category; Cluster: typically smaller than nation, e.g. region, city, even street Time: Long time frame; innovation and organisational changes may be very disruptive Factor Conditions Degree of sophistications o Basic factors: Natural resources, unskilled labour o Advanced factors: research scientist Degree of specialism o Generalised factors: village hall o Specialised factors: brain surgeon Selective factor disadvantage stimulates innovation to deal with problematic factor o E.g. Japan: ideographic language => fax o E.g. Sweden: short building season =?prefabricated buildings o E.g. US: great inter-city distances => telephone, railway, aircraft, car o Converse: US: Low fuel price => fuel-inefficient cars o No guarantee, not all factor disadvantages are converted into competitive advantage Difficult to forecast Demand conditions Paramount role of home market

o Strategic planners are based in home market o Home market dominates quantitatively and qualitatively Main features (Porter) o Composition of home demand: pressures and opportunities Segment structure of demand: distribution and variety of patterns of demand Existence of sophisticated buyers Anticipatory buyer needs: early warning system, experience, trends o Demand size and pattern of growth Size of home market: economy of scale, learning curve Number of independent buyers: variety of information and market feedback Rate of growth: possible entry of innovative firms Domestic market saturates early: fierce rivalry o Internationalisation of home demand Mobile, international buyers Influence on foreign needs

Linked and related industries Internationally competitive industries/sectors dont emerge in isolation o Associated with other industries/sectors that are vertically or horizontally related Spill-over benefits o User sector firms imposing high specifications on supplier sector o Reputational spill-overs o User sector firms demanding cost competitiveness from supplier sector o Supplier sector protecting their brands by raising user sector performance. o Technology spill-overs between related sectors o Related sectors sharing marketing and distributional channels o Spill-over of highly trained and well qualified labour pool between sectors o Best practice diffusion by example and observation o Proximity reduces transaction costs between sectors. Firm strategy, structure and rivalry Fukuyama: Trust can be important influence on economic activity o Japan: Trust well distributed => diminishes principal-agent problem => larger firmst o China: Family/kin => favours family-owned businesses Strategy and structure of domestic firms o Germany: technical skills => optics, chemical, machinery o Italy: family/kin emphasis => fragmented sectors, e.g. furniture, footwear, woollen fabrics Goals and objectives o Level of individual, company, nation o Germany: risk averse => emphasis on mature industries o US: risk-friendly => start-ups, sectors with start-ups (e.g. biotechnology) Domestic rivalry o Competitive pressure o Visible examples of best practices o Silicon Valley, Hollywood, Swiss pharmaceuticals, Scania/Volvo Implications for public policy o Creation of national champions may be mistaken o Cautious of advantages of domestic mergers (reduce rivalry) Jokers in the pack Chance: wars and invention Government: effect may be benign but excessive intervention may be problematic

6.4 Using the Diamond Framework 6/19 Implications for governments as well as firms Domestic clusters: any means to encourage their formations, maintain robustness 6.4.1 Identifying and Using a Diamond Issues with approach: Interdependence of Four Main Elements: difficult to isolate critical element Essential Contribution of all Four Elements o All four best, three can occasionally compensate weak 4th, two almost impossible Continuous Upgrading and Improving o Diamond representation static; reality dynamic Subjectivity and Multiplicity o Some factors subjective (cultural influence)

o o o

Some elements based on combination of elements (nature and degree of inter-firm rivalry) Weighting not obvious Different individuals might construct different Diamonds for same industry/country

6.4.2 Diamond in Action: US Competitive Advantage in Economics Textbooks Factor Conditions: Leading authors English language Major university Demand Conditions Large domestic market Anticipates wider trends Sophisticated distributions channels Linked and related industries: Advertising and software industries Firms strategy, structure and rivalry Advertising-oriented Glamorous industry Risky venture (new textbook) Numerous rivals; clusters (New York) 6.5 Framing Company Strategy 6/24 Possibility of competitive advantage depends on home Diamond E.g. US publisher has supportive cultural and social environment, extensive resources Non-US publisher would need to find niche market Choice of strategy influenced by home Diamond May facilitate certain strategies and discourage others Continuous Innovation Seek sophisticated buyers Seek demanding buyers Overshoot stringent regulations Source from leading home-based suppliers Seek rivals as benchmarks Anticipate industry change Seek buyers with anticipatory needs Explore emerging buyer groups Seek locations with early regulations Identify trends in factor cots Link with research centres Study new competitors Include outsiders in management team Caution: uncritical emphasis on emerging signals can also be dangerous Difficulty replicating Diamonds advantages Creation of healthy clusters can take decades to achieve and reflect numerous interdependencies Awareness of foreign Diamonds Merits and deficiencies compared to home Diamond 6.6 Competing in International Markets 6/26 Dunning: Eclectic Paradigm (OLI Model) Ownership advantages: Technical know-how most easily transferred and shared Marketing. Purchasing knowhow Access to finance Access to resources (e.g. ownership of oil reserves) Brand recognition Location advantages: Access to cheap/high quality resources Transport costs Government impediments to imports (e.g. tariffs, quotas) Internalisation advantages: (versus cooperative agreement with local firms) Transaction costs of cooperative alternatives o Search, negotiation, policing, lack of suitable local partners, o Residual problems of opportunism o Control of ownership (IP), brand o Reduced chance of losing access to inputs/outlets Enable monopoly practices such as predatory pricing using cross-subsidisation

Without ownership advantage => no international firms Without location advantage => international trade but no foreign direct investment Without internalisation advantage => co-operative ventures but no multinationals Eclectic Paradigm assumes most attractive investments found overseas However, this is only the case after exhausting all specialisation and diversifications in home base until resources linkages unattractive 6.7 Competing Abroad: The Principles 6/32 Seek sophisticated overseas buyers Strengthen ability to compete Source basic factors globally Commodities not source of competitive advantage => best/cheapest suppliers Keep strategic assets close to home Benefit from local interactions, easier to manage, guard against unplanned leakage Selective tapping of foreign technology Potential leaks of technical knowhow also opportunity to harvest from foreign cooperation Attack rivals directly to learn from them and neutralise them Head-to-head competition valuable learning lesson; prevent rivals from further growth Locate Regional HQs at best Diamond Provide valuable information on what makes the local system work International acquisitions and alliances for access and learning Means of learning new skills Globalisation versus localisation World not homogenous: different cultures, societies, legal, political systems => products with regional technical/market characteristics 6.8 Globalisation Versus Localisation 6/33 Resource-based versus market-based approach Resource-based: Same product line, same home market If diversification is necessary (e.g. market saturation) => leverage maximum of existing resources If international expansion => leverage common information E.g. PC, Food & Drinks (Coca Cola) Market-based Different requirements in different countries Customisation required even if it implies sacrifice of scale Local market conditions dominate => incumbents can fight off challenges E.g. educational materials, confectionary Hotels, clothing are combination (Hilton, Nike... many national brands) Characteristics which encourage international firms in markets dominated by local tastes/brands: Surface differentiation: common brand but different specifications for local product Access to factors of production: lower labour costs Cultural globalisation: Convergence in tastes through international communication and contact 6.9 Conclusions 6/36 Review Questions 6/36

7 - Making The Moves

Combination options: Vertical integration, diversification, multinational expansion Internal growth, merger/acquisition, licensing, franchising, joint venture Must be compared to opportunity costs 7.1 Example of a Combination 7/3 Synergy benefits: Resource side: Economies of scope in marketing, distribution Lower the Average Cost Market-side Shifting of demand curve to right and reducing demand elasticity 7.2 Evidence on the Performance of Combinations 7/5 Perform badly, yet popular with strategic planners - Acquisitions reduce efficiency 70% of joint ventures fall short of expectations Challenges in judging: Measurement difficulties difficult to separate out and measure benefits Other motives management status, rewards, prevent rival action with supplier (no increase but prevent future decrease) Wrong criteria stated objectives of allotted life span dont reflect performance (e.g. knowhow benefits other activities) Opportunity costs true cost of failure may be higher than observed Conclusions: Frequently disappoint Motives and implications may be more complex than short-term profit 7.3 Adding Value from Combination 7/8 Combining a sales force example: Similar outlets, avoid duplication in products territories and outlets only one salesperson per outlet Similar product, eliminate competition push up price and margins Similar activities, increase sales each sales person promotes both products in assigned territory Similar activities, improve capabilities leverage best selling practices and training methods Considerations of merger/acquisition The whole value chain matters: sales, production, etc Alternative methods of combining activities o Internal expansion: Merger is faster o Cooperative agreements achieve some gains without the need for combination o Even intangible elements (brand image) can be transferred o Competition authorities will closely monitor for anti-competitive operations 7.4 Why Do Mergers and Acquisitions Perform So Badly? 7/13 Two parts: Why the gains are often so poor Why does one party do badly compared to counterparts 7.4.1 Why the Gains from Merger or Acquisition May Be So Disappointing Compatibility Problems Different skills and competencies Tangible differences can be assessed but intangible (identity, character) more difficult Standards, jargon, operating procedure; social and knowledge-based characteristics

Consequences: o Limited coordination o Attempts to harmonise may prove costly

Optimistic bias Easier to identify opportunities to enhance value than the pitfalls and problems Strategy matching, interdependent strategies Wave-feature of mergers/acquisitions: fear of being cut off triggers desire for vertical integration Conservatism: match rival strategy of acquisition to reduce relative risk Insulation from environmental surprises Avoid dependency on single market or technology with related-constrained/related-linked Objective to reduce risk not to enhance profitability Agency problems managerial motives for merger The Prisoners Dilemma Downstream move provides competitor base to foreclose on firms market Only protection is same downstream move 7.4.2. Why Do Acquirers Do Even Worse than Those Bing Acquired The Grossman-Hart Problem Dispersed share ownership means increased price for acquisition Price must increase until last critical shareholder sells; others will hold for free-ride Winners Curse High degree of uncertainty regarding present value of firm Potential bidders make errors: some overly optimistic, some overly pessimistic Winning bid likely to be based on overestimation Best defence is natural caution and risk aversion in face of uncertainty o Bidders value in risk premiums Hubris (or excessive self-confidence) Management caught up in excitement => lack of balanced judgement Reasons for M/A over internal growth Growth objectives of management Speed is important, e.g. pre-empt competitive response Gain competencies and resources No room for entry (supplier or customers locked up) Eliminate a competitor Merger may be quick fixed but questionable if sustainable Reduction of rivalry may also lead to loss of sharpness 7.5 Co-operative Activity 7/22 Forms of cooperation Licensing Franchising Informal cooperation Sub-contracting Alliances Network participation Joint venture

Licence: permission for any firm to indulge in activity otherwise prohibited Intellectual property rights, patents, designs, trademarks Usually part of business/technology Franchise: transfer of intellectual property rights for specified periods and territories - Knowhow ranging over entire business (purchasing, productions, presentation, selling) Information Cooperation Example: one engineer may ask another from rival for advice expectation of reciprocity Senior management may or may not approve Sub-contracting

Separating part of business as contract for separate firm Trend more responsibility, e.g. R&D and Design May evolve into long-term cooperation

Joint Venture Two or more parent firms agree to cooperate New entity created for specified task and duration Own decision-making capability Co-owned by parents Provision for continuing parental supervision and control Issues: o Contractual: managerial and legal resources of create, police and monitor o Complex hierarchy: conflict and confusion regarding objectives, priorities, perceptions, procedures, cultures o Appropriability problems: intellectual property leakage Parents reluctance to reveal/commit sensitive resources Why a joint venture International expansion: may be required to enter national markets Why a joint venture and not other forms of cooperation (licensing, franchising)? Other forms more appropriate where market and technical characteristics are known Where there is uncertainty: give child decision-making capabilities Why joint venture and not merger/acquisition? In can be design to cover only selected range of activity Joint venture of selected resources: Selected pieces of value chain (e..g sales only) Selected business of firm o E.g. two related-linked parents: One firm offers technical expertise, The other marketing skills Joint venture more expensive that merger over the range of activity But avoids additional problems of merging entire system - Value not in was it does to but what it does not do Joint venture not only alternative to corporate diversification: also a consequence of it Not likely to be preferred route to growth of small specialised firms Alliance: formal/informal agreement to cooperate on a variety of matters Resource-based logic: o Both sets of management teams build up familiarity with other firm I.e. would be major effort if firm selects a new partner for each agreement Transaction-cost logic: o Inhibits opportunism: jointly held hostages Cost of alliance o Partner may not be ideal choice for each constituent agreement Dull competitive edge, limits competition Networks: three or more firms directly/indirectly linked by series of cooperative agreements Access and transaction cost benefits above the 1:1 agreements Vary in scope: o Mailing list Major cooperative agreements with collective retaliation threat Encourage open information flows and reduce transaction costs Need not involve deliberate joining decision (blurred membership) May soften competitiveness o Immediate disadvantage of those excluded o Eventual disadvantage of network members 7.6 Conclusions 7/32 7.7 The Elective as a Whole: Conclusions 7/33 Review Questions 7/33

Key Points
Lifecycle influences: + Brand advertising + Standardisation - Price elasticity - Margins + Excess capacity - Entry incentive, # firms - Bugs - Innovation

Decline options: Dominance Harvest Niche Exit Internalise Cost driver (2.4) - scale/experience/utilisation - vertical/horizontal links in value chain

- timing, location, government

Diff process/strat; Identify buyer, impact, criteria; uniqueness, different, cost/benefit; sustainability, reduce cost Differentiation drivers: (2.5.1) Linkage, timing, location, learning, scale, policy (Kellog), vert int Lemons: Reputation, warranty, professional ass, brand, guides, intermediary, government, franchise Dominant design: scale/experience; network (user/supplier) Strategic Moves: Reputation, Contracts, Specialism, Investment, Incrementalism, Hostages, Social Research characteristics: Specificity, Uncertainty, Time, Cost (stage, cumul) Innovation problems: - Appropriability - Uncertainty - Asymmetric information - Long-time horizon - Neglect of spin-offs - Machiavelli - Budget - Duplicate research - Compartmentalisation Innovation Solutions + In-house + Internal funding + Corporate R&D + Split R&D + Top-down budget + New product targets

+ Split budgets + Parallel + R&D diversification + Second-in + Licensing, JV + Organic structure

+ Matrix org + Quasi-autonomy + Champions + Research club + Public funding, Fixed price versus cost-plus

Hold-up: bounded rationality, opportunism, specificity (site, physical, human, dedicated) Production, R&D, Advertising + Contracts: repeat; tapered + Multi-source exhaustive + Hostages + Integration: vertical, + Standardisation Vertical integration criteria + Unpredictable supply/demand + Differentiated product + Few firms not integrated Vertical integration

+ contracts difficult to verify + similar scale/competence + transaction-specific investments

different competencies specialisation differences inflexibility economy of scale (target)

performance incentives vertical relations with rivals Large size (mgmt) prisoner's dilemma

Demand volatility options: stock; liquid assets, short-term finance, insurance, Fwd VI, longterm contr Diversification + Market power + Economy scope/scale/experience + User gains + Internal market + Risk + Growth - agency, optimistism

Rival valuation Rival reaction Costly Opaque performance Allergic reactions Late recognition

Assessment problems: Measurement, criteria, non-profit, opportunity cost Merger failures: compatibility, optimism, strategy match, insulation, agency, prisoner Grossman Hart, Winner's curse, Hubris Multinational alternatives: Export JV, Alliance

Direct investment Acquisition

License Franchise

Move to hot diamond: + promotes innovation, efficiency; information access - May lose competitive advantage, root success factor, may not survive Cooperate with hot diamond: + potential to combine complimentary strengths - major costs and problems Multinational resource implications: Horizontal: R&D; Vertical: resource, transport costs => production Diamond issues: interdependence, minimum, cont. upgrade, subjectivity Diamond principles: seek sophisticated buyers source factors globally strategic assets close to home selective foreign technolgy

frontal attack of rivals regional HQ at best diamond acquisitions/alliances: learning & access globalisation / localisation