International Business: Lecture 2 Professor Simon J. Evenett www.evenett.com

Plan for this afternoon’s session. Non market strategies: Baron's Integrated Strategy. Main lessons learnt from Topic 1. Topic 2: Public Policies and Firms—Insights from Competitive Markets.. Topic 3: Does Nationality Matter? Firms in industrialised countries.

Adapting Porter’s Five Forces to take account of governments, courts, and NGOs

Why Porter’s approach must be adapted Porter urges us to analyse the causes of the five forces yet emphasises a limited set of actors (principally firms, their actual or potential rivals, customers, and suppliers.) Incomplete characterisation of relevant fora. International dimension is not well developed—are we to take on trust that this approach to strategy works in all capitalist countries? Baron extended Porter’s framework to include the non-market environment and so-called Integrated Strategies—but at some cost in terms of prescriptive power.

Businesses operate in two environments simultaneously (Baron). 4 I’s Non-market environment Market environment Issues: threats to profits or opportunities. Regulations, proposed laws, court judgments. Porter’s 5 forces. Institutions: relevant decision-maker and their processes. Regulators, legislatures, courts, etc. Collective or non-unanimous decisions. Arms length market transactions. Voluntary decision-making. Interests: identity and goals of those with a stake in the issue. Goals can include “fairness”, “harmony”, and inclusion. Firms seek to maximize profits. Information: beliefs, knowledge of actors, and what is persuasive. Prejudices, rumor, state reports, press coverage, etc. Market research, reputation, advertizing.

Baron on non-market strategies Lets think more systematically about the implications for strategic analysis and firm strategies. Analysis: “Nonmarket forces and the institutional arenas in which they are manifested are sufficiently different from market forces that they require a nonmarket strategy system for effectively managing interactions with the nonmarket environment.” Strategy formation: “A nonmarket strategy...is the concerted action of an interested party directed at a non-market issues that is a subject of competition in the cognizant institutions where information typically plays an important role.”

Examples of non-market strategies. Two main objectives: creating and exploiting opportunities and countering threats. Create opportunities for self—opening foreign markets. Alter rival’s current opportunities—raising rivals costs through impact of differential regulation. Block rival’s opportunities altogether—opposing rival’s M&A plans. Reducing threats from rivals—blocking entry by imports, patents. Reducing threats from the state—self regulation in financial services. Mitigating threats—state bail outs and insurance. Creating threats and uncertainty—threatening legal action.

Important characteristics of trade-related non-market strategies. Appropriability: Are the gains from pursuing non-market strategy only appropriated by those firms pursuing such strategies? If not, what are the implications for the desirability of a non-market strategy? Collective versus individual action: Would collective action be preferable to individual approaches? Credibility and Reversibility: Does precedent matter? Can a particular strategy be reversed? If not, does it matter? Sustainability and Retaliation. What are the sources of distinctive—that is, hard to copy yet effective—non-market strategy? Can the strategy be copied abroad, leading to possible retaliation? Can non-market strategy be a source of long term competitive advantage?

A multi-step approach to creating Integrated Strategies Need not involve a change in the objectives of the firm. Effective strategy formation involves: Identifying the relevant 4I’s and 5 forces. Identifying a set of strategic options which may have market and non-market components. Anticipating strategies of actors in market and non-market environment. Given 1-4, evaluating strategic options: decision, implementation needs, and coherence in both spheres. Mitigation of risks associated with chosen strategy. Implementation. Evaluation of prior decision. Start of feedback loop.

Case Study: Taking The Cake. Should Peter tell CEO Ed Malanga that Southland needs to recast its product lines?

Working through the case study. What are the 4 I’s here? Which of the Five Forces threatens Southland’s profits the most? What are the critical pieces of information you need to formulate and evaluate strategic options? What are the options available to this firm? What is your evaluation of these options? At present, how effective do you think this firm would be in implementing your recommendations? How could the firm do better in this respect? In what way would you conduct an ex-post review of your decision?

Evaluating the expert advice. McClain: Unnevehr: Martaugh: Berman:

Main lessons. Integrated Strategy is about systematic, informed, decision-making using multiple-steps to analyze the global business situation confronting a manager. This approach can be usefully applied to non-market as well as market environments, both of which affect the performance of the firm. The non-market environment differs across countries and is likely to be even more significant in markets with lots of government intervention and important non-firm actors. The characteristics of many non-market strategies are different from market strategies. Implementation and evaluation of non-market strategies often requires different resources and approaches than market strategies.

Public Policies and Firms: Insights from Competitive Markets Simon J. Evenett www.evenett.com

Purpose of this presentation To show how straightforward economics tools can be used to provide useful rules of thumb when analysing the impact of certain government policies. These tools also provide insights into why some firms pursue certain non-market strategies. To show how these tools underlie some of the fundamental ideas in corporate strategy. This is not meant to be a review of microeconomics—here we will use the tools for very different purposes.

Supplemental reading If you need to review any of this material, take a look at Pindyck and Rubinfeld’s textbook Microeconomics (especially Chapters 2-4, 6-9.) This accessible book has plenty of good examples to illustrate the key points.

What is a competitive market? It is an institution where a large number of potential purchasers and a large number of suppliers buy and sell a given good. Each agent is said to have their own individual objectives, not collective goals. No one coordinates the trade between buyers and sellers.

Determining sales and revenues in the short run P MS P1 MD Q1 Q

Producer surplus is directly related to profits in the short run. MS P1 MD Q1 Q

What happens to the industry if production costs fall? MS P1 P2 MD Q1 Q

Some of the producer surplus increase is lost due to the price fall MS P1 P2 MD Q1 Q

Now for some counterintuitive findings…

The farmers’ dilemma: does productivity growth always pay? MS P P1 - P2 + MD Q1 Q2 Q

The farmers’ dilemma: does productivity growth always pay? MS P P1 - P2 MD + Q1 Q2 Q

Does the polluter always pay for pollution taxes? MS P1+t P2 P1 MD Q2 Q1 Q

Turning fixed costs into variable costs—outsourcing, relaxing employment laws etc MS: high variable costs P P2 MS: low variable costs P1 MD Q1 Q2 Q

Turning fixed costs into variable costs—the effects of liberalising rigid employment laws MC: high variable costs P MC: low variable costs Old MS P1 MD Q1 Q

Turning fixed costs into variable costs—the effects of liberalising rigid employment laws MC: high variable costs P New MS MC: low variable costs P2 Old MS P1 MD Q1 Q2 Q

The Ultimate Application: Rationalising Porter’s Five Forces Approach

Porter’s Five Forces Model Did you ever wonder where Porter got the conceptual ideas for his Five Forces Model? The simple answer is that the supply-and-demand framework that you have been using can rationalise Porter’s approach. You just have to make one change: don’t think of the factors that determine equilibrium price—think instead of the factors that determine the producer surplus in an industry. Porter’s five forces all reduce the producer surplus in an industry—let’s take one example.

Threat of new entrants: Before…and After P MS P1 P2 MD Q1 Q

New entrants erode incumbents producer surplus. MS P1 P2 MD Q1 Q

What about the other four forces? Let’s discuss each in turn Bargaining power of suppliers. Bargaining power of customers. Threat of substitute products or services. Rivalry among current producers. The straightforward supply-and-demand framework, when used to explain producer surplus, shows why four of the five forces are indeed threats to industry profitability.

Summary: Understanding a lot out from a straightforward framework. The own price elasticity of demand is a critical determinant of how industry sales respond to most changes. This analysis can be used to analyse the impact of government policies and reforms—essential for understanding a firm’s interests and incentive to engage in non-market strategies. This analysis also helps rationalise much of Porter’s approach to industry performance and strategy. Remember that supply-and-demand analysis tells you have a competitive industry would respond, not how an individual firm would respond to new circumstances.

Topic 3: Does Nationality Affect Firm Performance? Simon J. Evenett www.evenett.com

A motivating example: Not every exporter "prices to market" Studies have found that, in response to exchange rate changes, US and UK firms tend adjust their export prices in the near term. German firms, in contrast, do not engage in such “pricing to market.” Why does the nationality of the firm matter for pricing decisions? Should this factor be taken into account when formulating firm strategy?

Evaluating the "national business climate"—Porter’s Diamond

What determines the business environment? PORTER’S DIAMOND. Context for firm strategy. Factor input conditions. Demand conditions. Related and supporting conditions. Innovation-driven economy. Factor-driven economy. Investment-driven economy.

Digging deeper… Factor (input) conditions. Context for firm strategy and rivalry. Demand conditions. Related and supporting industries. Presence of high quality and specialised inputs. Local rules and context to encourage investment and upgrading. Sophisticated and demanding local consumers. Presence of local suppliers in related fields. Not just factors, but also various infrastructures. Meritocratic incentive systems. Local specialised demand segments. Presence of clusters. Open and vigorous competition among locally based rivals.

Porter’s main conclusions A nation’s level of economic development—rather than nationality per se—dictates the national business climate and shapes firm strategy. Export prowess is stimulated by intense competition at home. Very demanding customers should be cherished. Meritocratic incentive systems spur performance. The benefits of co-location (clusters) should not be overlooked. When governments care about more than competitiveness and growth—such as stability, solidarity, and burden-sharing—then Varieties of Capitalism emerge. Understanding what that means for managers is next.

Why the role of managers differs across rich economies— Varieties of Capitalism

Rich economies differ markedly in the following four ways Financing of firms and corporate governance. Employee relations. Degree of acceptable inter-firm cooperation: With competitors. With suppliers. Across sectors. Perceived legitimate and actual role of the state (leader, regulator, arbitrator, cajoler, and rescuer.) All four are legacy items—inherited from the past. Learn to live with them. How did managers succeed with these constraints?

Different ways to solve four key challenges facing firms Managerial challenge. Alternative 1. (Anglo Saxon) Alternative 2. (Coordinated economies) Financing the company. Borrowing from capital market, frequent reporting, and evaluation. Borrowing from banks who have representatives on boards. Incenting employees. Huge rewards. Wage compression. Encouraging employees to make RS investments. Avoid if possible. Longer term contracts. Encouraging suppliers to make RS investments. If can’t be avoided, vertical integration. Long term relationship (different forms).

Preconditions for Alternative 2 to work. Bank representatives on corporate boards. Banks under less pressure to maximise short term performance. Limited competition for depositors—steady source of capital. Wage compression. Requires monitoring—feasibility and acceptability. Longer term contracts. Employees must believe in future and accept slow moves through hierarchy. Longer term relationships with suppliers. Supplier must believe in future. Geographical proximity often needed to foster cooperation.

The timing of incentives is a critical difference Incentives can be supplied immediately or over time. Supplying necessary incentives now requires an acceptance of risk and tolerance of substantial changes in the pecking order—yet preserves options for the future. Supplying incentives over time requires credible commitment—and limits some types of flexibility. Preferences of firms and societies shape these choices. Do not underestimate firms or others interest in the pecking order. Relative performance is as important for many as absolute performance in understanding the choices made.

Importance of Corporate Governance Regimes (Edwards). Shows how restructuring of European firms depends on national corporate governance and industrial relations systems. Distinguishes between insider versus outside corporate governance regimes. VW—defensive reaction to shareholder pressure; worker relations go beyond German legal requirements and have stayed there; adjustment different in subsidiaries outside Germany. Vivendi—made to adopt US financial standard when it took over Universal; restructured within French labour relations system. Corus—shifting burden of restructuring to the UK.

Key points to take away Nationality matters: State policies condition the business environment, and this in turn affects how managers solve four related incentive problems. Supplying incentives over time requires commitments and stability and this is incompatible with some Anglo-Saxon practices. Flexibility has a price—it narrows the set of incentive schemes available to firms. How societies and governments view relative performance versus absolute performance has a lot to do with acceptable managerial choices.

Recap: Key questions to ask about any economy. What metrics are used to gauge performance in an economy? What premium is placed on absolute performance versus relative performance (the pecking order)? In what ways are incentives supplied—and what does this imply for cooperation across issues, between firms, and over time? In what ways, if at all, is the capacity to adjust to new circumstances constrained by these choices? What are the mechanisms for saying “no” in an economy?