© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 8: Economics of Strategy Creating and capturing value Brickley, Smith, and Zimmerman,

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Chapter 8: Economics of StrategyCreating and capturing value

Brickley, Smith, and Zimmerman, Managerial Economics and

Organizational Architecture, 4th ed.

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Creating and capturing valuelearning objectives

Students should be able to• Distinguish between value creation and

value capture and provide examples of each

• Define transactions costs and apply to strategic decision making

• Identify and provide meaningful examples of Porter’s “five factors”

• Differentiate between industry and firm effects on organizational success

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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

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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

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Ways to create valuereduction of transaction costs

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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

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Pricing complementsexample

• CompuInc produces personal computers• PrintCo produces complementary printer• Demand for each product is

Q=12-(Pc+Pp) when (Pc+Pp)12, 0 otherwise• Profit-maximization yields reaction curves

Q)P(P ji 12

ji P.P 56

• Each will view its demand curve as

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Noncooperative pricing CompuInc & PrintCo

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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

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Capturing value

• Firms in competitive markets are price takers

• Market power and superior resources can lead to economic profit

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Market power comparison

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Market powerPorter’s five forces

• Potential rivals• Existing rivalry• Substitute products• Buyer power• Supplier power

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Porter’s Five Forces

Potential Rivals

Current Rivals

Substitute Products

BuyersSellers

Value/supply Chain

Competitive

Environment

Upstream Downstream

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Superior factors of production

• People– special talents or skills

• Physical assets– prime real estate– unique equipment

• But bidding for specialized assets may erode profits

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Producer surplus captured by superior assets

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Superior factors of production

again• 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

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Increasing demand

• Increase expected product quality– “value added” > cost increase

• Reduce price of complements

• Raise price of substitutes– limit entry of competitors

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Other value-enhancing strategies

• Introduce new products and services

• Cooperation with other firms

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Diversification

• Benefits– Economies of scope– Promoting complements

• Costs– Bureaucracy– Incompatible cultures

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Diversification and management

• Diversification for earnings volatility– may not increase value

• Related diversification– can increase value

• Capturing the gains– does the firm bring some special

resource to bear?

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Strategy formulation• Understanding resources and

capabilities– physical, human, and organizational capital

• Understanding the environment– markets, technology, regulation, economic

conditions• Combining environmental and internal

analyses• Strategy and organizational

architecture

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Framework for strategic planning

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To think about...

Can a firm capture value on a sustained basis?

Discuss.