The Economics of OrganizationJoe Mahoney

The Sources Of Competitive AdvantageSome Industries Are More Profitable Than Others. ROE & ROA - Selected Industries, 19890%5%10%15%20%25%30%PharmaceuticalsTires / RubberHome AppliancesROEROA

Profitability of US Industries, 1985-97

INDUSTRY

RETURN ON EQUITY (1985-'97)

Drugs

20.3

Food and kindred products

14.8

--of which Tobacco products

19.6

Instruments and related products

11.2

Electrical, and electronic equipment

11.0

Rubber and misc. plastics products

10.7

Printing and publishing

10.6

Fabricated metal products

9.9

Aircraft, guided missiles, and parts

9.7

Petroleum and coal products

9.6

Retail trade corporations

8.9

Paper and allied products

8.5

Textile mill products

7.6

Wholesale trade corporations

6.5

Stone, glass and clay products

6.8

Machinery, exc. electrical

6.0

Nonferrous metals

5.6

Motor vehicles and equipment

5.5

Iron and Steel

2.6

Mining corporations

2.7

Airlines

1.1

4

The Sources Of Competitive AdvantageWithin Industries, Some Competitors Perform Better Than Others.ROE - Pharmaceutical Industry 19890%10%20%30%40%50%60%AmgenAMPEli LillyMerckMylanPfizer

Three Factors Determining Company Performance:Industry Contexte.g., during the last two decades, companies in the airlines industry have been less profitable than those in the pharmaceutical industry

National Contexte.g., worlds most successful consumer electronics firms are in Japan

Company Capabilities and Strategiese.g., Wal-mart and Southwest Airlines

Structure-Conduct-Performance

Industry Structure Number of buyers and sellers Degree of product differentiation Barriers to entry Cost structures Vertical integration Alliances

Firm Conduct Pricing Advertising R&D Investment in plant and equipment

Performance Econ profits Accounting profits (ratios)

NPV/DCF

MVA/EVA Tobins Q

Forces Driving Industry PerformancePorters Five Forces Framework

Industry Analysis Supports The Identification of Threats & OpportunitiesStrengths, Weaknesses, Opportunities, & Threats - SWOT AnalysisObjectivesDriversIndustryAnalysis

Efficient MarketsAn efficient market (e.g., in financial markets) is one in which prices reflect information instantaneously and one in which extra-ordinary profit opportunities are thus rapidly dissipated by the action of profit-seeking individuals in the market.

(e.g.: The value of the stock should reflect the earnings ability of the firm.)To outperform the stock market you need (1) Luck or (2) Asymmetric information.

Barriers To EntryThe free entry and free exit assumption that works reasonably well for describing financial markets seems to be a premise that strays so far from our world of experience that the assumption impedes our understanding of real-world product competition.

Thus, empirical evidence suggests that (risk-adjusted) ROE does NOT equalize in the long run.

A Taxonomy of Barriers to Entry: (1) Economies of ScaleProduct-specific economies of scalelower setup costs as a percentage of total costsmore specialized machinery and tooling (e.g., Honda)Plant-specific economies of scaleEngineers 2/3 rule: Since the area of a sphere or cylinder varies as two-thirds power of volume, the cost of constructing process industry plants can be expected to rise as two thirds power of their output capacity. (This rule applies to petroleum refining, cement making, iron ore reduction and steel conversion).Also economies of massed reserves

Economies of Scale: The Long-Run Cost Curve for a Plant

Cost Advantage 6

Units of outputper period

MinimumEfficientPlant Size

Cost perunit ofoutput

Southern Methodist University

14

Minimum Efficient Scale

Minimum efficient scale (MES) is the point of minimum average cost.It reveals the lowest output at which the firm can operate at the lowest cost.

MES

Q

ATC(Q)

Q

MES

ATC(Q)

ATC(Q)

MES

Q

A Taxonomy of Barriers to Entry:Economies of ScaleMulti-product economies of scale (economies of scope)Example: Cost (Iron, Steel) < Cost (Iron) + Cost (Steel)Key idea: Shareable input (In this case, thermal economies in the production of iron and steel)Modern examples: Aircraft, Automobiles, Consumer electronics, Household Appliances; Personal Computers, Software, Power ToolsMulti-plant economies of scaleEconomies of multi-plant production, investment, and physical distribution.

Examples of Economies of Scope(a) Aircraft

Common wing, nose, and tail components allow several models to be leveraged using different numbers of fuselage modules to create aircraft of different lengths and passenger freight capacities by Boeing and Airbus Industries.

Examples of Economies of Scope (b) Automobiles

The Taurus platform is leveraged to provide the basis for Taurus and Mercury Sable sedans and wagons and the Ford Windstar.(see Tully, February, 1993 Fortune article, The Modular Corporation)

Examples of Economies of Scope(c) Consumer Electronics

Over 160 variations of the Sony Walkman were leveraged by mixing and matching modular components in a few basic system designs.

Several upgraded models of Sony HandyCam video cameras were leveraged from an initial system design by successively introducing improved (modular) components. (Legos)

Examples of Economies of Scope(d) Personal Computers

Personal computers typically consist largely of modular components like hard drives, flat screen displays, and memory chips, coupled with some distinctive components like a micro-processor chip and enclosure.

Examples of Economies of Scope(e) Software

Software designers are creating modules of routines which can be combined to create customized applications programs.

(The term modularity gained wide currency by software designers in the 1960s.)

A Taxonomy of Barriers To Entry: (2) Experience Curve Advantages

Marvin Lieberman, a management professor at UCLA, found that in the chemical industry, on average, each doubling of plant scale over time was accomplished by an 11% reduction in unit costs. Thus, there is an 89% learning curve.

(Note: The mere presence of an experience curve does not insure an entry barrier. Another critical prerequisite is that the experience be kept proprietary, and not available to competitors and potential entrants.)

5-*

Production and Efficiency: Learning Effects

Copyright 1998 by Houghton Mifflin Company. All rights reserved.

Unit Costs

Economies of Scale

B

Output

Average Costs

Average Costs

.

.

.

LearningEffects

A

C

Economies of Scale and Learning Effects

7

A Taxonomy of Barriers To Entry:Limits of Learning Curve Advantages:

Copying and reverse engineering of products;Hiring a competitors employees;Purchasing the know-how from consultants;Obtaining the know-how from customers;Experience advantages are often nullified by innovations.

A Taxonomy of Barriers To Entry:(3) Intended Excess Capacity

Building extra capacity for the intended purpose of deterring entrants from entering the industry. (note: potential free-rider problems)Excess capacity deters entry by increasing the credibility of price cutting as an entry response by incumbents.Innocent excess capacity: Demand is cyclical; Demand falls short of expectations; Demand is expected to grow.

A Taxonomy of Barriers To Entry:(4) Reputation

A history of incumbent firms reacting aggressively to entrants may play a role in current market interactions.

A firms past decisions and standard operating procedures are important considerations for predicting a firms actions in the near-term future.

A Taxonomy of Barriers To Entry:(5) Product Differentiation

Brand identification and customer loyalty to incumbent products may be a barrier to potential entrants (e.g. Coca-Cola). Product differentiation appears to be an important entry barrier in the market for over-the counter drugs and in the brewing industry.

(6) Capital Requirements

A Taxonomy of Barriers To Entry:(7) High Switching Costs of Buyerse.g., changing may require employee retraining (e.g., IV solutions, computer software).

(8) Access to Distribution ChannelsThe manufacturer of a new food product, for example, must persuade the retailer to give it space on the fiercely competitive supermarket shelf via promises of promotion, and intense selling efforts to retailers.

A Taxonomy of Barriers To Entry:(9) Favorable Access to Raw Materials and to Markets

Alcoa --> bauxiteExclusive dealing arrangementsFavorable geographic locations

A Taxonomy of Barriers To Entry:(10) Proprietary Technology

Product know howLow cost product designPatents (and other government restrictions)

(11) Exit barriers (of incumbents) can be entry barriers (to potential entrants)

A Taxonomy of Barriers To Entry:High exit costs:

high exogenous and endogenous sunk costs (not just high fixed costs!)high asset specificityhighly illiquid assetslow salvage value if exit occurshigh switching costslow mobility of assetscredible commitmentsirreversible investmente.g., Alaskan pipeline built in 1977 at a cost of $10 billion

Bargaining Power of BuyersBuyers compete within the industry by forcing down prices, bargaining for higher quality or more services, and playing competitors against each other. A buyer group is powerful when:

The buyer group is concentrated (potential collusion)The buyer group purchases large volumes relative to seller sales (e.g., HMO power buying drugs)The product is standard and undifferentiatedFew switching costs on the part of the buyerHigh switching costs on the part of the sellerBuyers pose a credible threat of backward integration

Threat From SubstitutesSubstitute products increase the industrys overall elasticity of demand and limit the potential returns of the industry by placing a ceiling on the prices that firms in the industry can profitably charge.Companies in the coffee industry compete indirectly in the tea and soft-drink industries (all three industries serve consumer needs for drinks).

Bargaining Power of SuppliersSuppliers can be broadly defined as the supplier of any input: Labor, Management, Technology, Physical MaterialsThe bargaining power of suppliers is high when:It is dominated by a few companies and is more concentrated than the industry it sells to;It does not contend with substitute products;The suppliers product is an important input to the buyers business;Suppliers products are differentiated (high switching costs for the buyer).

Degree Of Rivalry Increases When:Industry Concentration LowerIndustry Growth SlowerFixed Costs / Total Costs GreaterProduct Differentiation LowerOver-capacity HigherExit Barriers HigherPrice competition is highly unstable. Price cuts are quickly and easily matched by rivals, and once matched, they lower revenues for all firms (unless price elasticity of demand is high enough)

Degree Of RivalryAdvertising battles, on the other hand, may well expand or enhance the level of product differentiation in the industry for the benefit for all firms.

Advertising is not necessarily a zero-sum game.

The Uses of Industry Analysis

Static Analysis -How Do We Explain Current Rivalry and Profitability?

Dynamic Analysis -Where Is The Industry Headed In The Future?

Industries Evolve Over Time As The Relationships Between The Five Forces ChangeDynamic 5-Forces Analysis

SUPPLIERS

POTENTIALENTRANTS

SUBSTITUTES

BUYERS

INDUSTRYCOMPETITORS

Rivalry amongexisting firms

Bargaining power of suppliers

Bargaining power of buyers

Threat of

new entrants

Threat of

substitutes

COMPLEMENTS

The suppliers of complements create value for the industry and can exercise bargaining power

Five Forces or Six? Introducing Complements

7

A Sixth Force - The Presence of ComplementorsComplementors Industry Participants whose businesses enhance the value of yoursThe Opposite of SubstitutesThe Emergence of Networks of OrganizationsExamplesComputer Manufacturers & Software MakersConsumer Electronics & Entertainment CompaniesThe Central IssueHow to get complementors to make strategic investments which mutually benefit both companies

A Sixth Force -The Presence of ComplementorsThe biggest benefit of considering complementors is that they add a cooperative dimension to Porters competitive forces model.

Thinking [about] complements is a different way of thinking about business. Its about finding ways to make the pie bigger rather than fighting with competitors over a fixed pie. To benefit from this insight, think about how to expand the pie by developing new complements or making existing complements more affordableBrandenburger and Nalebuff Co-opetition

1999 Pankaj Ghemawat

The Value Net

Competitors

Complementors

Company

Customers

Suppliers

Source: Adam Brandenburger and Barry Nalebuff, Co-opetition(New York: Currency Doubleday, 1996), p. 17

Empirical Testing of Structure-Conduct (Strategy)- PerformanceROE(j) = 6.3 + .050 CR4(j) + .119 [CAP/S](j) + (2.08) (1.98)

1.30 [A/S](j) +1.40 [R&D/S](j) +0.26 [GROW](j) (7.20) (2.95) (2.90)

t-statistics in parenthesesR-squared = .43

CR4 = 4-firm concentrationROE = return on equityR&D/S = R&D/SalesA/S = advertising/salesCAP/S = capital expenditures/SalesGROW = demand growth

Empirical Testing of Structure-Conduct (Strategy)- PerformanceModel Specification

In practice, researchers estimate a statistical model of the following form where data are aggregated to the industry level:

Industry Profit Rates = f(Concentration, Barriers to Entry, Demand )

Empirical Testing of Structure-Conduct (Strategy)- PerformanceModel Specification

Multiple regression analysis seeks to evaluate the degrees to which deviations of the dependent variable (and in this course our focus has been on profit rates as the dependent variable) from its mean are explained by or associated with variations in each of a set of independent or explanatory variables (e.g., concentration, barriers to entry, demand, etc.)

Empirical Testing of Structure-Conduct (Strategy)- PerformanceModel Specification

The nature of this association is captured by regression coefficients or parameters relating the profit rates in the industry of each independent variable, allowing us to determine the effect, for example, of a 10% increase in seller concentration on profit rates, holding all other explanatory variables constant (i.e., ceteris paribus)

Empirical Testing of Structure-Conduct (Strategy)- PerformanceModel Specification

Predicted SignReasonCR4+Higher concentration enables higher pricesCAP/S+Capital-cost Barrier to entryA/S+Advertising intensity as a product differentiation barrier to entryR&D/S+Technological know-howGROW+Demand growth leads toless likely price wars

Empirical Testing of Structure-Conduct (Strategy)- PerformanceModel Specification

Note that the multiple regression results are consistent with (but do not prove!) the structure-conduct-performance model.

As you probably are aware from your statistics classes, there are many potential problems that can interfere with the reliable estimation of regression models, leading to incorrect inference about the statistical significance and economic importance of explanatory variables.

Empirical Testing of Structure-Conduct (Strategy)- PerformanceThree Potential Problems:

(1)Mis-specification problems

(2)Measurement problems

(3)Identification problems

Empirical Testing of Structure-Conduct (Strategy)- Performance(1) Mis-specification Problems:Important Variables Omitted. In our regression, the impact of substitute products, and the power of buyers and suppliers have not been included in the model specification.Irrelevant Variables Included. If you believe fervently in perfect capital markets then you may question the idea of capital cost entry barriers and therefore you would question the inclusion of the independent variable [CAP/S] in the model.

Empirical Testing of Structure-Conduct (Strategy)- Performance(1) Mis-specification ProblemsModel assumes a linear relationship. Since the regression assumes a linear relationship, this may turn out to be a poor approximation if some of the explanatory variables (e.g., ADV/S) influence the dependent variable (i.e., ROE) in a non-linear way.

Independent variable may not be truly independent. For example, not only can increased concentration affect profit rates but profit rates may affect industry concentration.

Empirical Testing of Structure-Conduct (Strategy)- Performance(1) Mis-specification Problems

Multicollinearity. If independent variables such as (ADV/S) and {R&D/S) are highly correlated, then the validity of the t-statistics come into question.

Empirical Testing of Structure-Conduct (Strategy)- Performance (2) Measurement ProblemsFor example, CR4 may not be the best measure of industry concentration. Perhaps some performance measure other than ROE would also be better for testing the theory.Note: If the evidence is not consistent with the theory it is not necessarily the case that we abandon the theory. One of the many possibilities is that we do not have good measures of the theoretical concepts.

Empirical Testing of Structure-Conduct (Strategy)- Performance(3)Identification Problems:- These problems are related to the idea that correlation does not imply causality.

For example, you might argue that high advertising/sales is a barrier to entry (product differentiation) strategy that causes high profit rates. The regression is consistent with the Porter theory.

Empirical Testing of Structure-Conduct (Strategy)- PerformanceIdentification ProblemsHowever, you might argue that high profit rates allow more discretionary spending in marketing and thus, high profit rates cause high advertising/sales. The empirical evidence is also consistent with this theory. Thus, we have an identification problem. The data are consistent with multiple theories and we must find more refined tests and better econometric methods in order to advance our scientific knowledge in strategic management.