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If everyone can do it, its difficult to create and capture value from it.
or, alternatively

In In a perfectly competitive market, no firm realizes economic profits (rents).

(Industrial Organization View)

Monopoly Rents

(Resource Based View)

Ricardian Rents

Schumpeterian Rents
(Dynamic ( y Capabilities p View) )

S P S MC 1MC 2 P AC 1 q1 q2 AC 2

D Q

-Barriers to entry -Industry structure matters

-Barriers to imitation -Firm structure matters

-Markets are dynamic -Innovation matters

The Industrial Organization Perspective:

Premise

that industry structure matters most rents due to barriers to competition (i.e. (i monopoly l rents) ) industries are more profitable than others
P

S S

Economic

Some

D Q

Source: Fortune 500 2009, money.cnn.com m

Threat of Entry Bargaining Power of Suppliers Bargaining Power of Buyers

Intensity of y Rivalry

Threat of Substitutes

Threat of Entry Bargaining Power of Suppliers Bargaining Power of Buyers

Intensity of y Rivalry

Threat of Substitutes

Entry is less likely when ...

1. Entrant faces high sunk costs
sunk costs are investments that cannot be recovered

2. Incumbents have a competitive advantage

potential entrants are at a competitive disadvantage compared to existing players, simply not profitable to enter

3. Entrant faces retaliation

potential entrants are likely to be forced out of business by strategic (pricing) behavior of incumbents

Point: For sunk costs, emphasize non-recoverability (vs. large recoverable capital investment) Ex: R&D, hotel vs. big box Counter Example:Leasing airplanes Slide: Potential Barriers Ex: Patents, etc: Taxis, Doctors, Lawyers Ex: Pioneering Brands: Quicken, Coke & Pepsi, Nike Ex: Pre-commitment: SWA in Detroit

Foundations of Strategy

Entry is less likely when ...

1. Entrant faces high sunk costs
sunk costs are investments that cannot be recovered

2. Incumbents have a competitive advantage

potential entrants are at a competitive disadvantage compared to existing players, simply not profitable to enter

3. Entrant faces retaliation

potential entrants are likely to be forced out of business by strategic (pricing) behavior of incumbents

Patents & licenses Pioneering brands Pre-commitment contracts (e.g., distribution) Large economies of scale (relative to demand) Steep learning (experience) curves Others

Slide: Economies of scale Point: C = q : calculate using regression ln C = ln + ln q Point: Talk about slope Slide: MES Point: Expressed as market share, could change as market grows Slide: Learning curves Point: Similar to EOS, could be quality Ex: Far better at working with team by Term 2!

Foundations of Strategy

AC

MES

Output

Minimum efficient firm size (% of Industry Capacity - 1979)

Canning (fruit) Oil Refining Meat Packing Fountain Pens Copper Typewriters Flour Milling Steel S l Gypsum Products 0.5 20.0 33.0 0.5 1.75 0.20 10.0 10.0 30.0 Metal Containers Rayon Farm Machinery Automobiles Tractors Shoes Cement Liquor Distilling Tires 1.75 3.0 2.5 10.0 3.0 6.0 6.0 10.0 15.0

Source: K. Lancaster and R. Dulaney, Modern Economics: Principles and Policy (1979)

Patents & licenses Pioneering brands Pre-commitment contracts (e.g., distribution) Large economies of scale (relative to demand) Steep learning (experience) curves Others

Unit cost

Cumulative output over time

Entry is less likely when ...

1. Entrant faces high sunk costs
sunk costs are investments that cannot be recovered

2. Incumbents have a competitive advantage

potential entrants are at a competitive disadvantage compared to existing players, simply not profitable to enter

3. Entrant faces retaliation

potential entrants are likely to be forced out of business by strategic (pricing) behavior of incumbents

Excess capacity p y of incumbents Economies of scale or other cost advantage Substantial exit costs
Exit costs are payments that must be made upon exit Exit costs provide an incentive to fight

Aggressive reputation of incumbents

Must be credible Suffers from free-riding problem

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Slide:

Likelihood of retaliation (for example, price cutting) recession Ex: Excess Capacity: airlines during recession, semiconductor cycles & PC memory prices, fiber optic lines Ex: EOS: Wal*Mart (war of attrition) Ex: Exit Costs: polluters, pensions Ex: Reputation: Microsoft (Simpson s example = (Simpsons CompuGlobalHyperMegaNet)

Foundations of Strategy

Threat of Entry Bargaining Power of Suppliers Bargaining Power of Buyers

Intensity of y Rivalry

Threat of Substitutes

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Substitute products are less of a threat when ...

1. Cross-price elasticity of demand is low 2. Switching costs are high

one-time costs customers incur when switching to a new product or service

Slide:

Note: Slide:

Cross-Price Elasticity vs landline, landline 10 yrs ago & now; more Ex: Cellular vs. generally, digital convergence Ex: butter vs. margarine VS gas vs. alternatives Negative CPE implies complements Switching Costs Ex: Cellular vs. landline & number portability Ex: car rentals vs. public transport

Foundations of Strategy

12

The ratio of the % change in demand for one good given a 1% increase in price of another good good.
P1 P1 P1

Q2 Perfectly /Infinitely Elastic Demand Moderately Elastic Demand

Q2 Perfectly Inelastic Demand

Q2

The ratio of the % change in demand for one good good given a 1% increase in price of another good.
P1 P1 P1

Q2 Perfectly /Infinitely Elastic Demand Moderately Elastic Demand

Q2 Perfectly Inelastic Demand

Q2

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Substitute products are less of a threat when ...

1. Cross-price elasticity of demand is low 2. Switching costs are high

one-time costs customers incur when switching to a new product or service

Threat of Entry Bargaining Power of Suppliers Bargaining Power of Buyers

Intensity of y Rivalry

Threat of Substitutes

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Slide: Buyer BP, point 1 (buyers not concentrated) Counter example -- McDonald McDonalds Ex: s & Coke Slide: Relative Concentration Ex: Monopoly = Wintel Competitive = PC Monopsony = Hops in mass beer Mutual = military aircraft

Foundations of Strategy

Buyers have less power when ...

1. Buyers are not concentrated (no monopsony)

Many potential buyers Each accounts for a small fraction of sales

2. Buyers have few options

Products are differentiated (low intra-industry CPE) High switching costs (relationship-specific assets) Buyer cannot backward integrate Price information is not widely available Price discrimination possible Bundling possible

3. Buyers are segmented

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Many

Monopoly Power

Competitive

Buyer
Few Mutual Dependence Few Monopsony Power Many

Supplier

Slide: Buyer BP, point 2 (few buyer options) Ex: Differentiation: Coke & Pepsi E S i hi costs: M l contract Ex: Switching Mac vs. Wi Wintel, manufacturers Ex: B. Integration: large industrial customers & electricity Slide: Ex: Slide: Ex: Buyer BP, point 3 (segmentation) Information not widely available: Mattress models Price Discrimination 1st degree: Auto sales, college tuition, auctions 2nd degree: Airlines w/ travel dates

Foundations of Strategy

16

Buyers have less power when ...

1. Buyers are not concentrated (no monopsony)

Many potential buyers Each accounts for a small fraction of sales

2. Buyers have few options

Products are differentiated (low intra-industry CPE) High switching costs (relationship-specific assets) Buyer cannot backward integrate Price information is not widely available Price discrimination possible Bundling possible

3. Buyers are segmented

Buyers have less power when ...

1. Buyers are not concentrated (no monopsony)

Many potential buyers Each accounts for a small fraction of sales

2. Buyers have few options

Products are differentiated (low intra-industry CPE) High switching costs (relationship-specific assets) Buyer cannot backward integrate Price information is not widely available Price discrimination possible Bundling possible

3. Buyers are segmented

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P
Consumer Surplus Producer Surplus

pc

D
qc

Pi Price

$60 $40

Profits = $60M

Profits = $100M

$20
Profits = $60M

Demand (Millions)

18

Consumer Type HR Engineers Sales Consultants Min. WTP for product

A $100 $60 $100 $70 $60

WTP for Product B C $90 $120 $80 $100 $80 $70 $70 $140 $60 $60

D $20 $70 $60 $80 $20

Type Total $280 $290 $380 $310 $220

Threat of Entry Bargaining Power of Suppliers Bargaining Power of Buyers

Intensity of y Rivalry

Threat of Substitutes

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Suppliers are less of a threat when ...

1. Sellers are not concentrated (no monopoly) 2. Firms have many alternatives

many substitutes for suppliers products firms face low switching costs supplier cannot forward integrate

3. Sellers may not treat segments differently

price information is widely available price discrimination not possible

Threat of Entry Bargaining Power of Suppliers Bargaining Power of Buyers

Intensity of y Rivalry

Threat of Substitutes

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Note: Slide: Slid Note: Note: Note:

Big issue is concentration. Economists have long been interested in this issue B t d vs C Bertrand Cournot t Both are one-shot games with simultaneous moves In the end, there is wide variance across industries. Consider duopolies, Coke vs. Pepsi (favorable) Bud vs. Miller (favorable) B i vs. Airbus Boeing Ai b ( (contentious) t ti ) More useful to think about two broad conditions.

Note:

Foundations of Strategy

Slide: Note: Ex: Slide: Point: Slide: A k Ask: Note:

Intensity of rivalry Catch 22 -- many y of the factor that lower the incentives to fight also lower barriers to entry Cyclical demand (autos, hotels in college towns, PCs) Value of coordination So reduce output, raise price Illegal forms of coordination, Crandall example Wh i Why is OPEC not anti-trust? i ? What is allowed is various forms of tacit collusion

Foundations of Strategy

21

Rivalry is less intense when ...

1. 2. The number of competitors is small !!!!! Incentives to fight are low

Substantial market growth (especially if capacity constrained) Opportunities to differentiate Low exit costs Little excess capacity (demand is not cyclical) Explicit price / market fixing (antitrust violation!) Tacit coordination (implicitly holding prices high, differentiating)

3.

Coordination is feasible

Price Taker

Monopolist (or Cartel)

MC PC

AC PM

MC

AC

MR qC qM

max MR = MC
MR = P P = MC

max MR = MC
MR = P + P / q * q P + P / q * q = MC

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Cartels are classic examples (e.g., OPEC) Such price-fixing is per se illegal in U.S.
No discussion of pricing allowed!!! Includes functional equivalents Other actions judged according to rule of reason

Examples of accused price-fixing

Ivy League financial aid U.S. airline reservation systems

Coordination is typically difficult to maintain (prisoners dilemma) Structural factors may facilitate tacit coordination
Few competitors (concentration ratio) A few dominant competitors (Herfindahl index) Similar competitors

Facilitating devices may facilitate tacit coordination

Threat of price wars (tit-for-tat) Best-price clauses

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Threat of Entry Bargaining Power of Suppliers Bargaining Power of Buyers

Intensity of y Rivalry

Threat of Substitutes

Threat of Entry Bargaining Power of Suppliers Bargaining Power of Buyers

Intensity of y Rivalry

Role of Compliments

Threat of Substitutes

Role of Institutions

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Complements are products for which a decrease in price will increase demand for the target product (i.e., p g p ( , negative cross-price elasticity) Examples: computers and software, VCRs and video tapes, bread and butter (?), guns and bullets Important issues: Who controls complementary products? Who has bargaining power power, firms in the industry

or providers of complementary products?

Institutions

set the rules of the game

Antitrust law and enforcement Legal barriers to entry, trade (natural

monopolies) Policymaking institutions (policy stability) Institutions may be influenced by players

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Raise switching costs (e.g., frequent flyer programs) Differentiate (e.g., Swatch watches) Coordinate tacitly of course (e.g., best-price clauses) Consolidate (e.g., telecoms industry) Integrate vertically, that is (e.g., M&A in media) Innovate (e.g., CFCs to HCFCs) y / Lobby y (e.g., ( g , lawyers, y , doctors) ) Certify

A key task in a strategic analysis is to identify and dd h competitive ii f h li i economic i address the forces that limit rents:
Entry is less likely when incumbent firms have a competitive

advantage and can credibly retaliate against new entrants.

Substitution is less likely when switching costs are high and

cross-price elasticity is low.

Buyer and supplier power depend on relative concentration,

the viability of alternatives, and information availability.

Rivalry is more intense when incentives to fight are large and

tacit coordination is difficult.

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