1. Managerial Economics and Organizational Architecture, 5e Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved. Managerial Economics and Organizational Architecture, 5e Chapter 8: Economics of Strategy: Creating and Capturing Value McGraw-Hill/Irwin

2. Managerial Economics and Organizational Architecture, 5e Strategy General policies intended to generate profits –Choice of industry –Combination of products and services –Competitive and cooperative behaviors Strategies evolve as circumstances change Strategies must create and capture value 8-2

3. Managerial Economics and Organizational Architecture, 5e Transaction Costs Consumer transaction costs –product search –learning product characteristics and quality –negotiating terms of sale –enforcing agreements Producer transaction costs –negotiating terms –legal expenses 8-3

4. Managerial Economics and Organizational Architecture, 5e Ways to Create Value reduction of transaction costs Price (in dollars) Quantity Consumer-borne transaction costs Consumer surplus Producer surplus Producer-borne transaction costs Effective supply given transaction costs Potential supply if no Transaction costs Potential demand if no Transaction costs Effective demand after Transaction costs Q 8-4

5. Managerial Economics and Organizational Architecture, 5e Value Creation Reduce production costs or producer transaction costs –shift supply curve to the right Reduce consumer transaction costs –shift demand curve to the right Shift demand to the right by other means Devise new products and services 8-5

6. Managerial Economics and Organizational Architecture, 5e Other Ways to Increase Demand Improve product quality Price complements so consumers will buy more –printers and ink cartridges, razors and razor blades Change the price of substitutes –Theaters ban patrons from bringing food into the theater, no liquids are allowed past the security gates at airports 8-6

7. Managerial Economics and Organizational Architecture, 5e Pricing Complements Example CompuInc produces computers PrintCo produces complementary printers Demand for each product is Q=12-(P c +P p ) when (P c +P p )  12, 0 otherwise Profit-maximization yields reaction curves Each will view its demand curve as 8-7

8. Managerial Economics and Organizational Architecture, 5e Noncooperative Pricing CompuInc & PrintCo Price of PrintCo printers Price of personal computers Compulnc’s reaction curve in choosing P C PrintCo’s reaction curve in choosing P p 6 612 PpPp PcPc P c = 4 P p = 4 12 8-8

9. Managerial Economics and Organizational Architecture, 5e Advantage of Coordination Failure to coordinate yields combined profits of 32 Jointly setting MC = MR yields combined profits of 36 –customers better off as product prices fall, quantity purchased rises 8-9

10. Managerial Economics and Organizational Architecture, 5e Converting Organizational Knowledge into Value Hardware – physical assets Wetware – employee brainpower Software – formulas or recipes for creating value Implications - allow employees to experiment and innovate 8-10

11. Managerial Economics and Organizational Architecture, 5e Capturing Value Firms in competitive markets are price takers Firms with market power choose price and quantity –They can capture value if they exploit their market power 8-11

12. Managerial Economics and Organizational Architecture, 5e Market Power Comparison Producer surplus S D $ $ $ Price (in dollars) DiDi P* DjDj QiQi QjQj Q Q* Quantity: Firm i Quantity: Firm j Quantity: Industry P* MARKET POWER COMPETITIVE INDUSTRY 8-12

13. Managerial Economics and Organizational Architecture, 5e Market Power Rests In Entry barriers –Economies of scale, patents, brand names, high exit costs Degree of rivalry –Number and size of competitors Threat of substitutes –Outside products (satellite dish vs. cable) Buyer and supplier power –Number and size matters 8-13

14. Managerial Economics and Organizational Architecture, 5e Other Value-Enhancing Strategies Introduce new products and services Cooperation with other firms 8-14

15. Managerial Economics and Organizational Architecture, 5e Superior Factors of Production People –special talents or skills Physical assets –prime real estate –unique equipment 8-15

16. Managerial Economics and Organizational Architecture, 5e Superior Factors of Production Bidding for specialized assets may erode profits If a resource is adding value to a firm, other firms will attempt to bid this resource away The price of this resource will rise, raising costs Initial profits will fall 8-16

17. Managerial Economics and Organizational Architecture, 5e Superior Factors of Production Bidding for specialized assets may erode profits If a resource is adding value to a firm, other firms will attempt to bid this resource away The price of this resource will rise, raising costs Initial profits will fall 8-17

18. Managerial Economics and Organizational Architecture, 5e Superior Factors of Production Bidding for specialized assets may erode profits If a resource is adding value to a firm, other firms will attempt to bid this resource away The price of this resource will rise, raising costs Initial profits will fall 8-18

19. Managerial Economics and Organizational Architecture, 5e Superior Factors of Production Bidding for specialized assets may erode profits If a resource is adding value to a firm, other firms will attempt to bid this resource away The price of this resource will rise, raising costs Initial profits will fall 8-19

20. Managerial Economics and Organizational Architecture, 5e Producer Surplus Captured by Superior Assets Cost per unit (in dollars) P*1P*1 P*0P*0 Q*0Q*0 Q*1Q*1 Quantity: Firm i LRMC LRAC 1 LRAC 0 QiQi $ $ Quantity: Market Q*0Q*0 Q*1Q*1 D0D0 Q D1D1 S 8-20

21. Managerial Economics and Organizational Architecture, 5e Superior Factors of Production Team production –interdependencies among workers increase value beyond the “sum of the parts” –luck or foresight may endow firms with unique team production capabilities Rivals may be unable to pinpoint source of advantage and unable to capture equivalent value 8-21

22. Managerial Economics and Organizational Architecture, 5e Diversification Benefits –Economies of scope –Promoting complements Costs –Bureaucracy –Incompatible cultures 8-22

23. Managerial Economics and Organizational Architecture, 5e Diversification and Management Diversification for earnings volatility –may not increase value Investors can diversify on their own Related diversification –can increase value Capturing the gains –Target firms often obtain the largest gains in a takeover 8-23

24. Managerial Economics and Organizational Architecture, 5e Strategy Formulation Understanding internal resources and capabilities –physical, human, and organizational capital Understanding the environment –markets, technology, and government regulation Combining environmental and internal analyses Strategy and organizational architecture 8-24

25. Managerial Economics and Organizational Architecture, 5e Framework for Strategic Planning STRATEGY INTERNAL RESOURCES AND CAPABILITIES Physical Capital Human Capital Organizational Capital BUSINESS ENVIRONMENT Markets Input Output Technology Production Information Communication Government Regulation 8-25

26. Managerial Economics and Organizational Architecture, 5e Capturing Value Can a firm capture value on a sustained basis? Market will bid prices of resources up Environments change Normal rates of return will be earned in the long run 8-26