Besanko Summary

8/13/2019 Besanko Summary

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SUMMARY BESANKO

CHAPTER 2 : ECONOMIES OF SCALE AND SCOPE

Economies of scale are the key determinant of a firms horizontal o!n"ari#$ (the quantities

and varieties of products and services that a firm produces.

E%ono&i#$ o' $%al# : when average costs (cost-unit) decrease as output increases fixed

costs are spread over increasing output.

Di$#%ono&i#$ o' $%al#: when average costs increase as output increases production runs

up against capacity constraints or encounters coordination or other agency prolems.

- !-shaped "# curve: in the short run.

- $-shaped "# curve: in the long run firms can expand their capacity y uilding new

facilities. %irms expand their output until the &ini&!& #''i%i#nt $%al# (MES)*

E%ono&i#$ o' $%o+#: firm achieves savings as it increases the variety of goods and services itproduces. $everaging core competencies& competing on capailities& moili'ing indivisile

assets. efined in terms of: the relative total costs of producing a variety of goods and

services together in one firm versus separately in or more firms.

*# (+,+) *#(+,) / *#(+)

*# (+,+) - *#(+,) *#(+)

*he incremental cost of producing good ,& is lower when the firm if producing good than if

it doesnt produce good .

0ources of economies of scale and scope:

1. In"i,i$iiliti#$ an" th# $+r#a"in- o' 'i.#" %o$t$. %ixed costs arise when an input

cannot e scaled down elow a certain minimum si'e& even when the level of output

is very small (e.g. is indivisile). 2eductions in "# due to increased in capital

utili'ation areshort-runeconomies of scale (occur within a plant of a given si'e)3

reductions due to adoption of a technology that has high fixed costs ut lower

variale costs are long-run economies of scale. 4n different levels:

- Pro"!%t l#,#l: spreading of product-specific fixed costs such as special

equipment& 25 expenses& training expenses& costs necessary to set up a

production process.

- Plant l#,#l: firms chose the production technology (fully vs. partially

automated) that minimi'es "# (fig. .6).

- M!lti+lant l#,#l: capital intensive industries are more likely to display

economies of scale than material 7or laour intensive industries ecause

capital is indivisile and materials and laour are divisile (costs increase

with increasing output).

. S+#%ialization: increased productivity of variale inputs. 0miths *heorem states that

speciali'ation is limited to the si'e of the market. 8ndividuals will only make the

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speciali'ation investment if the market is ig enough to support them. *hus& larger

markets will support a more speciali'ed array of activities than smaller markets can.

9. In,#ntori#$. %irms carry inventories to minimi'e the chance of running out of stock.

" stock-out can cause lost usiness and loss of confidence of customers. #osts ofholding inventories are: interest on the expenses orne in producing the inventory and

the risk of depreciation. *hey drive up the average costs of the goods sold 1:1. *he

need to carry inventories creates economies of scale ecause firms doing a high

volume of usiness can usually maintain a lower ratio of inventory to sales while

achieving a similar level of stock-outs.

6. Engineering principle of the %!#/$0!ar# r!l#: as the volume ( production capacity)

of a vessel ( production process) increases y a given proportion& the surface area (

total production costs) increases y less than this proportion. *hus& "# decrease.

0ources of economies of scale and scope related to other areas than production:

1. P!r%ha$in-: ig usinesses that make large purchases from their suppliers may otain

discounts& enaling them to en;oy a cost advantage over their smaller rivals. 2easons for a

supplier to give these discounts:

- $ess contraction-costs to sell to a single uyer.

- " ulk purchaser has more to gain from getting the est price and therefore will emore price sensitive.

- "ssure a steady flow of usiness.

0mall firms may form purchasing alliances that uy in ulk in order to otain quantity

discounts.

. A",#rti$in-: "dvertising costs per consumer < (costs of sending a message = no of

potential consumers receiving the message) = (no of actual consumers as a result of the

message = no of potential consumers receiving the message).

$arger firms may en;oy lower advertising costs per consumer either ecause they have:

- $ower costs of sending messages per potential consumer: ecause the fixed costs ofadvertising (preparation costs& negotiation with pulisher) get spread over a larger

ase of potential customers.

- >igher advertising reach: more shops where you can uy the rand3 easier to reachfor customers.

Umbrella branding: consumers use the information in an advertisement aout one

product to make inferences aout other products with the same rand name& therey

reducing advertising costs per effective image. (0ometimes firms prefer to keep randidentities separate to avoid tarring its luxury market with a mass-market reputation.)

9. R1D: scale economies ecause it is a sustantial indivisile investment which implies that

"# will decline as output increases3 scope economies when the ideas developed in one

research pro;ect create positive spillovers to another pro;ect. ?ut: smaller firms may have

more incentive to innovate. Effect of si'e on 25 is amiguous.

@ractices display %o&+l#ntariti#$when the enefits of introducing one practice are

enhanced y the presence of others. "ka $trat#-i% 'it: the whole of a firms strategy exceeds

the sum of the parts of its organi'ational processes. 8t is necessary to firms seeking a long-

term competitive advantage over their rivals since it is difficult to copy each individual

process.

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0ources of "i$#%ono&i#$ o' $%al#:

1. Hi-h#r laor %o$t$than small firms


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Task-specific knowledge: workers can shop around with their talents and capture the value of

learning for themselves y asking higher wages.

Firm-specific knowledge: worker knowledge is tied to their current employment and the firm

will not have to raise the wages if workers ecome more productive.

ecreasing "# in two ways:

- 8n simple capital-intensive activities: large ec of scale and low learning ec. #utacksin production increase unit costs3 less concerned aout laour turnover.

- 8n complex laour-intensive activities: low ec of scale (no decrease in "# in a givenyear) and large learning ec ("# decrease across several years): figure .1H.

#utacks in production do not increase unit costs.

Canagers should carefully distinguish etween the two in order to make correct inferences

aout the si'e in a market.

6* AENCY AND COORDNATION

Or-anizational +rol#&$7 agency and coordination - remain an important potential

diseconomy of scale.

"n a-#n%5 r#lation$hi+occurs when one party (the agent) is hired y another party (the

principal) to take actions that affect the payoff of the principal. "n a-#n%5 +rol#&

(motivation prolem) arises when two conditions are met:

1. *he o;ectives of the principal and the agent are different.

- Principals objective: max the value it receives as a result of the agents actions andthe payment to the agent.

- gents objective: max the value it receives from the principal minus the costs

incurred in doing so.. *he actions taken y the agent (hidden action) or the information possessed (hidden

information) y the agent is hard to oserve.

*ools to comat agency prolems:

1. Monitorin-: expend resources watching employees or gathering information that

employees use to make decisions. >owever& there are some limitations:

- 8mperfect due to thecomplexity of the organi'ation.

- >iring monitors can e quite costly.

- >iring a monitor often introduces another layer to the agency relationship.

. P#r'or&an%# a$#" in%#nti,#$: the principal offers to link the agents pay to the

payoff the principal receives from the agents action.

- %igure 9.1: convex cost of effort function (marginal cost of effort increase as theemployee works harder).

- %igure 9.: the employee increases effort until C# of effort (the slope of a linetangent to the effort cost curve) is equal to C? (commission on sales) and the firms

profits increase. ith a higher commission rate& the employees C? approaches the

total C?. 0o the employee has full ownership of the value he creates and will

therefore make the effort-decision that will maximi'e overall value. *he firm can

capture this value y reducing the fixed salary.

- %igure 9.9: if the firm offers a lower fixed salary& the employees effort choice is

unchanged since C? and C# are unchanged.

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#omplications: (1) sales are likely to e affected y a variety of factors hat are eyond

the salespersons control3 individuals tend to e risk aversewill accept the (risk of)

performance ased incentives only when they are compensated for earing such risk&

which makes performance ased incentives more expensive3 () employees can have a

multitude of taskswhich makes it difficult to alance incentives of employees3 (9)

employees sometimes work as a team

not possile to give each employee fullownership of the value he creates.

9. B!r#a!%ra%5: limit the set of actions that employees are allowed to take (red tape&

paperwork& hierarchy)3 ut might limit employee productivity and make it difficult to

control for agency prolems.

Coor"ination +rol#&$arise from the oservation that the est action for one person to take&

will often depend on the actions taken y others or on the information held y others. 8t is

important for individuals to find ways to coordinate their actions.!a"ekemphasi'ed the role

that prices and markets play in solving coordination prolems. *hese do not solve intra-

organi'ational coordination prolems (if coordination among a group of individuals is easily

accomplished through prices& there is little reason for individuals to e part of the same firm).

*ools to comat coordination prolems address two questions:

(1) >ow is information communicatedwithin the firmI

() ho has the authorit"I

" firms organi#ational structure is a key determinant of how it resolves coordination

prolems.

1. C#ntralization: concentrating decision-making authority to tighten coordination.

eaknesses:

- #ommunication prolems make it difficult to respond to local information.- $imited in processing large amount of information.

. D#%#ntralization: dispersing decision-making authority& hence more communication

etween decision makers and more responsive to local information. eaknesses:

- Gives rise to agency prolems.

- #an cause coordination opportunities to e missed.

8n reality firms use a mixture of oth. Jey features that always remain are that coordination is

likely to e imperfect3 and that coordination prolems get more severe as the si'e of the

organi'ation grows.

7* THE PO8ER OF PRINCIPLES: A HISTORICAL PERSPECTI9E

" hi$tori%al +#r$+#%ti,#demonstrates that while the nature of the usiness has changed

dramatically since 1K6H& successful usinesses have always applied the consistent principles

to their usiness conditions.

$efore %&'(: limited transportation and communications constrained firms to

operate in small locali'ed markets.

$etween %&'( ) %*%(: changes in infrastructure and production technology

encouraged the growth of national and international markets3 however still

constrained y prolems of coordination and control.

+ince %*%(: changes in communications& data processing and networking

have revolutioni'ed firms ailities to control their operations and interact

with suppliers& customers& competitors and other stakeholders.

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* THE 9ERTICAL BOUNDARIES OF THE FIRM

9#rti%al %hain: process that egins with the acquisition of raw materials and ends with the

distriution and sale of finished goods and services. *he ,#rti%al o!n"ari#$of a firm define

the activities that the firm itself performs as opposed to purchases from independent firms in

the market&a;#/or/!5decision figure L.1:

- ,ntegrateeverything in one firm: integrate forward (acquire downstream firm) orintegrate ackward (acquire downstream firm). Early steps in the vertical chain are

upstreamin the production process and later steps are downstream.

- isintegrate(outsource to independent sucontractors): arms-length markettransactions. %or example: market firms: firms speciali'ing in specific activities such

as marketing& distriution.

B#n#'it$ o' !$in- th# &ar;#t= reasons to bu":

1. Carket firms exploit economies of scaleand the learning curve.

- Cay possess propriety information or patents that enale them to produce at lowercost.

- Cight e ale to aggregate the needs of many firms ec of scale and $-shaped "#curves. %igure L.9: " has too high "# and "M is not of competitive advantage3 "N

is CE0.

- Cight exploit their experience in producing for many firms learning ec.

. Eliminate bureaucrac":

- "gency costs: leads to loss of profits and may go unnoticed ecause (1) large firmsoften have overhead costs so that it is difficult to measure and reward an

individuals contriution3 () in-house divisions in large firms often serve as cost

centers that perform activities solely for their own firms and generate no outside

revenue3 (9) managers ignore them ecause it is going well with the firm anyway.

- 8nfluence costs: the way the manager influences the allocation of internal capital (1)direct costs (time wasted to make the decision)3 () the making of a ad decision.

9. Carket firms are su;ect to the discipline of the market and must e efficient and

innovative to survive. 4verall corporate success may hide the inefficiencies and lack

of innovativeness of in-house departments.

Contra%t$are written to protect parties to a transaction from opportunistic ehavior. *heir

effectiveness depends on:

1. *he %o&+l#t#n#$$: (1) contemplate all relevant contingencies and agree on a set of

actions fro every contingency3 () what constitutes satisfactory ehavior and e ale

to measure performance3 (9) must e enforceale y an outside third party. %actor that

make contracting always incomplete:

- $ounded rationalit": limits on the capacity of individuals to process information&deal with complexity& and pursue rational aims.

- ifficulties with specif"ing.measuring performance: open-ended specifications3 hardto measure.

- s"mmetric information: if one party knows more than the other and theknowledgeale party may distort or misinterpret the information.

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. *he availale ody of %ontra%t la3: ensures that transactions can occur smoothly

when contracts are incomplete. Eliminate the need to specify certain provisions in

every single transaction. >owever& not perfect sustitute for complete contracting:

- octrines are phrased in road language (open to interpretation).

- $itigation is costly and can destroy usiness relations.

#ontracts are an imperfect way to ensure that trading partners perform as desired. 8f the

resulting inefficiencies are large enough& than it makes sense to make rather than to uy.

Co$t$ o' !$in- th# &ar;#t= reasons to makeall depend on the costs associated with

writing and enforcing contracts.

%/ 0osts of poor coordinationetween the steps in the vertical chain. "ll dimensions of

production need to e well fit: timing fit3si#efit3 colorfit3se1uencefit. #oordination

is especially important with design attributes(attriutes that need to relate to each

other in a precise fashion otherwise they lose a significant portion of their economic

value).

2/ 2eluctance of trading partners to develop and shareprivate 3valuable4 information

ecause they run the risk of losing control over it. ell-defined and well-protected+at#nt$can protect this& ut they are not foolproof however. @rofessional services

often require new workers to sign non-compete clauses(when leaving the firm& he

may not compete with it for several years).

5/ Transaction costs6 (opportunistic ehavior and the costs in trying to prevent it): arise

ecause contracting is never fully complete.

Falla%i#$ when making make or uy decisions:

8f an asset is cheaper to uy than to make& you should do so& even if it is a source of

competitive advantage for you.

ont uy ;ust to eliminate the cost of making the product uying does not

eliminate the expenses of the associated activity (can affect the efficiency with which

he activity is carried out).

ont make ;ust to avoid paying a profit margin to independent firms.ccounting

profit< revenues 7 expenses.7conomic profit< accounting profit from activity , 7

accounting profit from investing the same resources in the most lucrative alternative

activity. Even if an upstream supplier is making accounting profits& it does not mean

that it is making economic profits or that the downstream manufacturing firm could

increase its own economic profits y internali'ing the activity (due to the expertise

eing difficult& or ec of scale).

ont make ;ust to avoid paying high market prices for the input during periods of

peak demand and scarce supply (to eliminate income fluctuations). #ould also uyand enter into long-term (futures) contracts with suppliers3 hedging.

ont make ;ust to tie up a distriution channel to try to gain market share at the

expense of rivals.

- Cay run afoul antitrust laws which permit forms of vertical foreclosure.

- !pstream firm must e careful not to pay too much for the acquisition.

- *he acquirer must consider how difficult it is for competitors to open new channels of

distriution.

NR#lation/$+#%i'i% a$$#t: asset that cannot e redeployed to another transaction without some

sacrifice in the productivity of the asset or some cost in adapting the asset to the new

transaction. 8t locks parties into the relationship. %our forms:

-+ite specificit": assets that are located side-y-side to economi'e on transportation orinventory costs or to take advantage of processing efficiencies.

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-Ph"sical asset specificit": assets whose physical or engineering properties arespecifically tailored to a particular transaction.

-edicated assets: investment in plant and equipment made to satisfy a particular uyer.ithout the promise of that particular uyers usiness& the investment would not e

profitale.

-!uman asset specificit": worker has acquired skills& know-how and information thatare more valuale inside a particular relationship than outside it.

F!n"antal tran$'or&ation: once the parties have invested in relation-specific assets& the

relationship changes from a large-numers argaining to a small-numers argaining

situation.

R#nt: the profit you expect to get when you uild the plant& assuming that everything goes as

planned. *he investment is asunk costand does not affect your decision making. " firm must

expect positive rents to induce to invest in an asset.

you would get if you had to turn to your next est alternative. 8nforms aout the possilemagnitude of the hol"/!+ +rol#&when a trading partner attempts to renegotiate the

terms of the deal (when contracts are incomplete). *his raises the costs of arms-length market

exchanges in 6 ways:

- Core difficult contract negotiations and more fre1uent renegotiations.

- 8nvestment to improve e8 post bargaining positions: manufacturer may acquire astandy production facility for a key input as a hedge against contractual holdup y

the input supplier. *he facility stands idle much of the time costly.

- istrust: (1) higher direct costs of contract negotiation as parties insist that moreformal safeguards are uilt in3 () impedes sharing information to achieve

production efficiencies or quality improvements.

- 2educed investment in relation-specific investments: leads to lower productivity andhigher production costs (ecause firms now only have the option of making general-purpose investments).

Do!l# &ar-inalization: upstream firm exploits market power y setting @ A C#

downstream firm purchases these marked-up inputs and exploits its own market powers y

also setting @ A C# product is marked-up twice. *hrough integration& the downstream

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- Related-usiness firm: DHO of revenues from a principal activity ut hasother lines of usinesses related to the principal activity.

- Unrelated-business firm: DHO of revenues from a principal activity and hasno other lines of usinesses related to the principal activity.

- Entro+5:


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Canagerial motives are caused y prolems in %or+orat# -o,#rnan%#: the mechanisms

through which corporations and their managers are controlled y shareholders.

0hareholders cannot easily determine which acquisitions are profitale and which are

not.

0hareholders are unale to change (wrong) management decisions: (1) formally this

is done y the oard of directors ut the #E4 might exercise control over theselection for new directors3 () they form a dispersed group.

Canagers who undertake acquisitions that do not serve the interests of the shareholders

'ir&>$ $har# +ri%# 3ill 'all& ecause: (1) if a manager overpays for the acquisition& the value

of the firmwill fall y the amount that was overpaid3 () if the stock market expects the firm

to overpa" ac1uisitions in the future& the market price of the firm will fall in expectation of

these events. isparity etween the firms actual andpotentialshare prices presents an

opportunity for another entity to try a takeover. *his &ar;#t 'or %or+orat# %ontrolserves as

a disciplining mechanism for managers (without actual takeovers taking place) and makes

sure they keep the firms share price near its potential value.

"ssessing the $!%%#$$ o' "i,#r$i'i%ationy using stock prices3 two methods:

- aluation studies: compares market valuation of diversified firms to those of

undiversified firmslower in diversified firms.

- 7vent studies: looks at the changes in market valuations in response to the

announcement of diversifying acquisitions (1) returns to acquirers are on

average negative3 () shares of target firms tend to rise when an acquisition in

announced.

iversified firms need to reduce the scope of their activities in order to reach a point at which

profitale diversification is possile.

?* COMPETITORS AND COMPETITION

Co&+#titor$: firms whose strategic choices directly affect one another3 or indirectly via a

third firm.

"pproaches to %o&+#titor i"#nti'i%ation:

"ntitrust agencies: all the competitors ina market have een identified if a merger

among them would lead to a small ut significant non-transitory increase in price

(++;,P).

%irms are competitors if they produce $!$tit!tal# -oo"$goods that have:

- 0imilarproduct performance characteristics: descrie what the product does

for consumers.- 0imilar occasions for use: when& where and how is a product to e used.

- "re sold in the samegeographical market: in the same location& with lowtransportation costs for the good 5 consumers.

Cro$$/+ri%# #la$ti%it5: P,< (Q+=+) = (Q@,=@,) is positive.

#lose correlation etween prices over time.

0tandard 8ndustrial #lassification (SIC): codes that identify products and services y

a D-digit numer with each digit representing a finer degree of classification.

#o-ra+hi%all5: y examining the flow of goods and services across geographic

regions. 0atchment area: contiguous area from which a firm draws most of its

customers.Flow anal"sis: examines data on consumer travel patterns.

Mar;#t $tr!%t!r#: the numer and distriution of firms in a market measured y:

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- ;-firm concentration ratio: comined market share(sales revenue) of the Blargest firms in the market. >owever: invariant to changes in the si'es of the

largest firms.

- H#r'in"ahl in"#. (H): sum of the squared market shares (0) of all the firmsin the market. ConopolyAH.R and perfect competitionH..

;umbers-e1uivalent of firms: 1=>erfindahl < numer of firms in market&

when you assume equal market share.

%our classes of market structure:

@* P#r'#%t %o&+#tition: @


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@AC#fixed costs are covered and firms will earn positive economic profits

entry will reduce prices and reduce market shares until economic profits equal 'ero.

>owever: there may e arriers to entry that keep B down.

7* Oli-o+ol5: market in which the actions of individual firms materially affect the

overall market. %irms produce identical goods.

Co!rnot 0!antit5 %o&+#tition: (@AC#)each firm selects a quantity to produce (and

thery guesses what + the other firm will chose)& and the resulting total output

determines market price.

- 8n 0ournot e1uilibrium: (1) the market price& @N& is the @ at which oth firmssell all their output& +1and +3 () +1is firm 1s profit-maximi'ing output&

given that it guesses firm will choose +3 (9) +is firm s profit-

maximi'ing output& given that it guesses firm 1 will choose +1. Each firms

guess aout its rivals production level is correct.

- 0ournot reaction functions: 21: shows firm 1s profit maximi'ing output forany output produced y firm . 0imilar: 2. "t the point of intersection: +1N

and +N.

R#,#n!# "#$tr!%tion #''#%t: when one firm expands +& it reduces @N and thus lowers

the sales revenues for all the firms in the market. *he smaller a firms share of

industry sales& the greater the divergence etween its private gain and the revenue

destruction effect from output expansion smaller firms are more willing to rock the

oat in order to gain market share: they en;oy the full enefits of each additional unit

sold& ut suffer only a small O of the revenue destruction effect which is mainly

orne y their larger rivals. 8n 0ournot e1uilibrium& @N falls as more firms enter the

marketeach firm has a smaller share and is less concerned with the revenue

destruction effect. @#C < >=elasticity less concentrated smaller >lower

@#C (price-cost margin).

B#rtran" +ri%# %o&+#tition: each firm selects a price that maximi'es its own profits

given the price it elieves the other firm will select. Each firm also elieves that its

pricing practices will not affect the pricing of its rival (considered fixed). @rice

competition is fierce ecause the products of the two firms are perfect sustitutes3

hence @ is driven down to C#.

ifferencesetween #ournot and ?ertrand:

- *ake place over different time frames.

- #ournot: markets where firms must make production decisions in advanceand are committed to selling all of their output and unlikely to react to

fluctuations of their rivals output markets that involve a lot of sunk costsor where it is costly to hold inventories.

- ?ertrand: pertains to more flexile markets.

Di''#r#ntiat#" B#rtran" &o"#l: similar to #ournot ut firms chose @ in stead of +. @roducts

are hori#ontall" differentiated: softens price competition ecause lowering @ is less effective

for stealing a rivals usiness.

- Reaction functions: 21: shows firm 1s profit maximi'ing price for any pricecharged y firm . 0imilar: 2. "t the point of intersection: @1N and @N.

Mini&!& #''i%i#nt $%al# (MES): level of output& qNN& that minimi'es costs. @roduction

processes often display U-shaped 0 curves. CE0 is larger when sunk costs are large relativeto ongoing variale costs of production. hen +NN is total industry demand& the numer of

firms in the market& BNN& can e determined: N


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hen sunk costs are large qNN is large small numer of firms in the market.

S!tton: in most consumer goods markets& the numer of large firms and the overall numer

of firms does not seem to depend on the costs of production& ut more on the costs of

advertising. *he sunk cost that limits he numer of firms is not the up-front cost of

production& ut the sunk cost of estalishing a credile rand name: #n"o-#no!$ $!n; %o$t.Endogenous ecause market leaders can influence he level of investment in rand awareness

that rivals must achieve to e competitive& y setting the level of their own investment in

rand name capital.

* STRATEIC COMMITMENT

Strat#-i% %o&&itnt: decisions that have long-term impacts and are difficult to reverse.

#an influence the choices made y rival firms firms must anticipate market rivalry. %irms

must alance the enefits that come from preempting or altering competitors ehavior with

the loss in flexiility that comes from making competitive moves that may e hard to undo

once made. #ommitments must have three characteristics:

1. 9i$il#.. Un"#r$tan"al#.

9. Cr#"il#: enhanced y irreversiility3 making contracts3 put reputation at stake.

#oncepts that capture how competitors react when one competitor changes a tactical variale

such as @ or +.

Strat#-i% %o&+l#nt$: upward-sloping reaction functions3 the more of the action

one firm chooses& the more of the action the other firm will also optimally choose3

prices in the ?ertrand model.

Strat#-i% $!$tit!t#$: downward-sloping reaction functions3 the more of the action

one firm chooses& the less of the action the other firm will also optimally choose3

quantities in the #ournot model.

Effect of commitments on a firms profitaility:

- irect effect: impact on the present value of the firms profits assuming thatthe firm ad;usts its own tactical decisions in light of this commitment and that

its competitors ehavior doesnt change.

- +trategic effect: takes into account the competitive side effects of thecommitment& either positive or negative3 dependant on whether the variales

affected are strategic complements or sustitutes.

#oncepts that capture whether a commitment y one firm places its rivals at a disadvantage:

To!-h %o&&itnt$: ad for competitors.

- #ournot: capacity expansion.- ?ertrand: price reduction.

So't %o&&itnt$: good for competitors.

- #ournot: capacity constraint.

- ?ertrand: price increase.

S!-a +#r'#%t Na$h #0!iliri!& (SPNE): two stage game (1) firm 1 makes a strategic

commitment and therey anticipates the effects of this on the market equilirium (forward-

looking)3 () oth firms simultaneously choose + (#ournot) or @ (?ertrand). %irm 1 should

thus evaluate whether competition in stage is #ournot or ?ertrand.

0tage < 0ournot:

- *ough commitment : +1increases

21shifts right in figure K.

in newequilirium +1is higher and +is lower (< strategic effect for firm 1).

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- 0oft commitment: +1decreases21shifts left in figure K.9 in new

equilirium +1is lower and +is higher (< strategic effect for firm 1).

0tage


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Port#r: developed framework for exploring L economic factors that affect the profits of an

industry. 0trategic analysis must account for oth cooperation and competition.

$imitations of the 'i,#/'or%#$ 'raor;:

- @ays little attention to factors that might affectdemand

.

- %ocuses on a whole industr"rather than on individual firms that may occupyunique positions.

- oes not account for thegovernment.- 4nly 1ualitative3 not quantitative.

@* Int#rnal ri,alr5: ;ockeying for shares y firms within a market. 8mportant: definition of

the market (product market vs. geographical market). %irms may compete on mainly

dimensions:

- ;on-price: erodes profits y driving up fixed costs (new product

development) and C# (adding product features) these higher costs can

however e passed on to consumers which increases profits.

- Price: erodes profits y driving down @#Cs. the potential for pricecompetition depends on the extent to which a price-cutting firm expects its

market share to increase and how it expects its rivals to respond.

#onditions that heat up price competition:

Man5 $#ll#r$ in th# &ar;#t.

Sta-nant4"#%linin- in"!$tr5: firms cannot easily expand their output without

stealing form their competitors.

%irms have"i''#r#nt %o$t$: low-cost firms can ask lower prices.

0ome firms have#.%#$$ %a+a%it5: want to oost sales and can often expand output

rapidly to steal usiness from competitors.

@roducts are !n"i''#r#ntiat#"= uyers have lo3 $3it%hin- %o$t$: firms are temptedto undercut their rivals prices ecause this can generate a sustantial increase in

market share.

Pri%#$ %annot # a"!$t#" 0!i%;l5.

Lar-#4in'r#0!#nt $al#$ or"#r$: firm may e tempted to temporarily undercut a

rivals price to secure a particular large order.

Bo %oo+#rati,# +ri%in-.

0trong #.it arri#r$: prolongs price wars as firms struggle to survive in stead of

exiting.

Hi-h #la$ti%it5 o' "#&an".

2* Entr5: erodes incuments profits in ways:- Entrants divide market demand among more sellers.

- Entrants decrease market concentration and heat up internal rivalry.

%actors that affect the threat of entry:

Lar-# MESrelative to the si'e of the market.

o,#rnnt +rot#%tion of incuments.

#onsumers are ran" lo5al.

"ccess of entrants to ;#5 in+!t$(technology& raw materials& distriution& locations).

E.+#ri#n%# %!r,#.

N#t3or; #.t#rnaliti#$: installed ase.

Expectations aout +o$t#ntr5 %o&+#tition.

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6* S!$tit!t#$ an" %o&+l#nt$: availaility3 price value3 price elasticity of industry

demand.

7* S!++li#r an" !5#r +o3#r: can erode industry profits when they are (1) concentrated3

() customers are locked into relation-specific investments with them.

- ,ndirect power: can sell their services to the highest idder

price theycharge depends on supply and demand in the target market.

- irect power: raise prices when their target market is faring well and viceversa.

%actors to consider:

Co&+#titi,#n#$$ of the input market.

Con%#ntrationof the (upstream=downstream) industry.

P!r%ha$# ,ol!of downstream firms.

"vailaility of $!$tit!t# in+!t$.

R#lation/$+#%i'i% in,#$tnt$y the industry and its suppliers (hold-up).

*hreat of 'or3ar" int#-rationy suppliers.

"ility of suppliers to +ri%# "i$%ri&inat#.

0trategies of firms to cope with the five forces:

- ifferentiatethemselves from rivals or outperform.

- 8dentify a segment of the industry in which the L forces are less severe.

- 7liminate the forcesy (1) estalishing facilitating practices or creatingswitching costs3 () pursue entry-deterring strategies3 (6)(L) integrating.

2emark: @orter views all other firms as threats to profitaility ut also +o$iti,#

int#ra%tion$etween firms in a ,al!# n#t:

Efforts y competitors to set t#%hnolo-5 $tan"ar"$that facilitate industry growth.

Efforts y competitors to promote 'a,oral# r#-!lation$. #ooperation among firms and their suppliers to improve +ro"!%t 0!alit5 or oo$t

"#&an".

#ooperation among firms and their suppliers to improve +ro"!%ti,# #''i%i#n%5.

@rofit from participating in the value net (competitors& supplier& uyers) < overall value of the

value net when firm 8 participates 7 overall value of the value net when it doesnt participate.

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@6* STRATEIC POSITIONIN FOR COMPETITI9E AD9ANTAE

Co&+#titi,# a",anta-#: when a firm earns a higher rate of economic profit than the average

rate of economic profit of other firms competing within the same market. 8mportant:

definition of the market.7conomic profitabilit"depends on:

9arket economics (across industries): the five forces.

alue created relative to competitors (within the industry):

- ?enefit position relative to competitors.

- #ost position relative to competitors.

Con$!r $!r+l!$: ? 7 @ consumer will only purchase the good if #0 A H and will chose

the good that has the highest #0 (low @ and high +).

Con$!r>$ &a.i&!& 3illin-n#$$ to +a5 (B): "t which @ is the consumer ;ust

indifferent etween uying the product and going without itI seek est availale

sustitute.

In"i''#r#n%# %!r,#: @& + cominations that yield the same consumer surplus. *he

steepness indicates the trade-off etween @ and + a consumer is willing to make.

Con$!r $!r+l!$ +arit5: when firms offer the same #0 @&+ cominations lie on

the same indifference curve. hen a firm moves from this position (or from theposition of consumer surplus advantage) to one which is less than its competitors&

sales and market share will fall.

Pro"!%#r $!r+l!$: @ 7 # producers profit margin. # < cost incurred in making the

product.

9al!# %r#at#"< consumer surplus / producer surplus < (? 7 #) / (@ 7 #) < B G C. *he price

determines how much of the value-created sellers capture as profit and how much uyers

capture as #0.

?A#: necessary condition for a product to e economically viale. Entrepreneurs can

strike win-win deals with input suppliers and consumers all parties are etter off if

they trade& rather than dont trade win-win trade opportunities-ain$ 'ro&

tra"#.

?A# is no guarantee that a firm will make a positive profit. *he threat of entry and

fierce competition erode profits y idding down prices consumers capture all the

economic value that the product creates.

%or a firm to earn positive profits it must create more economic value than its rivals:

must generate a hi-h#r l#,#l o' B G C than its rivals.

- ?ecause consumers have different preferences& it is possile that differentfirms have a higher ?-# in different market segments.

9al!# %hain(vertical chain): each activity of the value chain can potentially add to the

enefit ? that consumers get from the product and each can add to the cost # that the firmincurs to produce and sell the product.

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alue-added anal"sis: when different stages produce finished or semi-finished goods

that can e valued using market prices& we can estimate the incremental value that the

distinctive parts of the value chain create.

*wo ways in which a firm can %r#at# &or# #%ono&i% ,al!#than the other firms in its

industry:1. 0onfigureits value chain differently from those of competitors.

. @erform activities more effectivel"than its rivals within the same value chain. *o do

so& the firm must possess resources and capailities that its competitors lack.

R#$o!r%#$: firm-specific assets (trademarks& ase& know-how) that cannot easily e

duplicated and indirectly affect the value creation ecause they are at the asis of a firms

capailities. Ca+ailiti#$: activities that a firm does especially well compared with other

firms3 common characteristics of capailities:

Taluale across multiple products or markets.

Emedded in organi#ational routines: well-honed patterns o performing activities

inside an organi'ation capailities can persist even though individuals leave the

organi'ation. Tacit: difficult to reduce to simple guidelines.

#n#ri% $trat#-5of a firm descries how it positions itself to compete in the market it serves.

@orters generic strategies:

Co$t l#a"#r$hi+ (road scope): companys products can e produced at lower cost

per unitthan competitors products:

- Catch rivals prices and attain higher @#Cs: benefit parit"(same ?) orbenefit pro8imit"(slightly lower ?).

- !ndercut rivals prices and sell more than they do y offering a product that

is 1ualitativel" differentfrom that of its rivals.espite the quality disadvantage& the cost leader achieves a higher profit margin

than its high-cost competitors due to lower #.

B#n#'it l#a"#r$hi+ (road scope): companys products are capableof commanding a

price premiumrelative to competitors:

- Catch rivals prices and sell more than they do: offer sustantially higher ?and #.

- #harge price premium and attain higher @#Cs: cost parit"(same #) or costpro8imit"(slightly higher #).

espite the cost disadvantage& the enefit-leader achieves higher profit margins

than its low-enefit competitors due to higher ?.

Fo%!$ (narrow scope): company configures its value chain so as to create superior

economic value within a narrow set of industry segments. ithin these segments& the

firm may have lower cost per unit than its road-scope competitor& or it may e

capale of commanding a price premium relative to these competitors& or oth.

#onsumers have identical preferences in'init# #la$ti%it5 o' "#&an":

- #ost leader with enefit parity can lower its price ;ust elow the unit cost ofthe firm with the next-lowest unit cost. *his makes it unprofitale for high-

cost competitors to respond with price cuts of their own and thus allows the

firm to capture the entire market.

- ?enefit leader with cost parity can raise @ ;ust elow its unit cos plus the

additional enefit it creates relative to the competitor with the next higher ?.to top this consumer surplus is& a competitor would have to cut @ elow its

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unit costs& which would e unprofitale. *hus at this @& the firm with the

enefit advantage captures the entire market.

Horizontal "i''#r#ntiation: strong when there are many product attriutes that consumers

weigh in assessing overall enefit and when consumers disagree aout the desiraility of

those attriutes.Price elasticit"is not infinite and influences the choice etween two polar

strategies of exploiting competitive advantage.

#ost advantage ?enefit advantage

>igh price elasticity of

demand

Shar# $trat#-5: under-price

competitors to gain share.

Shar# $trat#-5: maintain

price parity with competitors

(let ?-advantage drive share

increases).

$ow price elasticity of

demand

Mar-in $trat#-5: maintain

price parity with competitors

(let #-advantage drive higher

margins)&

Mar-in $trat#-5: charge

price premium relative to

competitors.

P#r%#i,#"price elasticity of demand: O change in + for 1O change in @& taking into account

likely pricing reactions y competitors.

#-advantages are more profitale than ?-advantages when the following are true:

*he nature of the product limits opportunities for enhancing $.

#onsumer indifference curves are flat.

@roduct is a $#ar%h -oo"(quality attriutes can e assessed prior to the point of

purchase) rather than an #.+#ri#n%# -oo"(quality attriutes can only e assessed

after purchase and usage) ecause it raises the risk that the enhancements will e

imitated.

?-advantages are more profitale than #-advantages when the following are true:

0teep indifference curves.

Economies of learning are significant.

@roduct is an experience good rather than a search good.

St!%; in th# &i""l#: etween #-leader and ?-leader less profitale. #lear choices aout

how to compete are critical ecause economically powerful strategic positions typically

require trade-offs:

- ?-leader must incur higher costs to do so.

- #-leader must deliver aundant levels of quality.

%actors that might 3#a;#n thi$ tra"#/o'': %irm might achieve low # and high ? when: they offer products that have a slightly

higher ?increase market share lower "# ecause of ec of scale or experience

curve.

*he rate at which accumulated e8periencereduces costs is often greater for higher-

quality products than for lower-quality products.

>igh ? is not necessarily high # firm may e producing more efficientl".

%igure 19.1L: achieving enefit and cost advantage simultaneousl". ?ecause of the ?-

advantage the demand curve shifts right and the "# curve shifts up (higher ? is associated

with higher #). Even if the firm raises its price& ecause of the movement of the demand

curve& unit costs go down.

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E''i%i#n%5 'ronti#r: indicates the lowest level of cost that is attainale to achieve a given

level of quality& given the availale technology and know-how. %irms that are closer to the

frontier are more profitale than those further away. 8f all firms were producing as efficiently

as possile& their positions would line up along an upward sloping frontier (fig 19.1R).

In"!$tr5 $#-ntation &atri.: characteri'es an industry along two dimensions: vertically

the variety of products that industry participants offer for sale and hori'ontally the different

types of uyers that purchase those products (customer groupsuyers with similar tastes&

needs and market responses). In"!$tr5 $#-nt: differences among (the structural

attractiveness of) segments arise due to differences in uyer economics& supply conditions and

si'e of the industry (fig 19.1D).

Broa" %o,#ra-# $trat#-5: seeks to serve all customer groups in the market y offering a full

line of related products.

7conomic logic: scale and scope economies.

Fo%!$ $trat#-5: a firm offers either a narrow set of product varieties& serves a narrow set of

customers& or does oth. #an insulate the focuser from competition. C!$tor $+#%ialization (column): firm offers an array of related products to a

limited class of customers.

7conomic logic: rests on the extent to which road-coverage competitors under or

over-serve the focusers target group.

Pro"!%t $+#%ialization (row): firm produces a limited set of product varieties for a

potentially wide class of customers.

7conomic logic: aility of the focuser to exploit economies of scale or learning

economies.

#o-ra+hi% $+#%ialization: firm offers a variety of related products within a

narrowly defines geographic market.

@7* SUSTAININ COMPETITI9E AD9ANTAE

*hreats to $!$tainin- a %o&+#titi,# a",anta-#:

2ivalry: existing competitors and entry.

8mitation.

@owerful uyers=suppliers: can use their argaining leverage to extract profits from

thriving firms and will often give ack some of their gains when the firm is

struggling.

P#r'#%tl5 %o&+#titi,# "5na&i%(fig 16.1): perfect competitive equilirium occurs at the point

where the lowest possile indifference curve is tangent to the efficiency frontier. "t this point

economic profits are 'ero and no other @&+-comination simultaneously results in greater #0and higher profit.

R#-r#$$ion to3ar"$ th# an: extreme performances of firms& whether good or ad& are not

sustainalein the long run these are evened out ut they do not converge to the same

mean.9arket forcesare a threat to profits& ut only up to some point. *hefive forcesprotect

profitale firms.

*o achieve a %o&+#titi,# a",anta-#a firm must create more valuethan its competitors

aility to do so depends on:

1. +tock of resources(patents& rand-name& ase).

. istinctive capabilities: activities that the firm does etter than its competitors.

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"ccording to the r#$o!r%#/a$#" th#or5 o' th# 'ir&3 for a competitive advantage to e

sustainale& these resources and capailities must escarceand imperfectl" mobile

(untradale3 tradale& ut not useful for others3 co-speciali'ed: only useful in comination

with something else)& otherwise all firms could create the Sadvantage.

I$olatin- %hani$&$: economic forces that limit the extent to which a competitive

advantage can e duplicated or neutrali'ed through resource-creation activities of other firms.

*wo kinds:

@* I&+#"int$ to i&itation:

L#-al r#$tri%tion$: patents& trademarks etc are tradale highly mobilehence the

price of it is determined y demand and supply.

#ompetitive only when the firm has superior knowledge aout how to est utili'e

the asset3 possess scare complementary resources that enhance the value of the asset.

S!+#rior a%%#$$ to in+!t$ or %!$tor$: locations3 long-term contracts that give

firms control over scarce inputs or distriution channels.

#ompetitive only if the firm can secure these at elow-market prices3 if other firms

do not recogni'e the value of these assets or are unale to exploit them (ut: winners

curseU). Mar;#t $iz# an" $%al# #%ono&i#$: economies of scale limit the numer of firms that

fit into the market& hence arrier to entry.

#ompetitive only if demand does not grow to large (otherwise: entryU).

Intan-il# arri#r$to imitating a firms distinctive capailities:

- 0ausal ambiguit": causes of a firms competitive advantage are oscure an

imperfectly understood ecause the knowledge is often tacit.

- ependence on historical circumstances.

- +ocial comple8it": complex interpersonal relationships within the firm3 withthe firm and its suppliers=uyers.

2* Earl5/&o,#r a",anta-#: once a firm acquires a competitive advantage& theseisolating mechanisms increase the economic power of that advantage over time.

L#arnin- %!r,#: firms with the greatest cumulative experience can underid rivals

for usiness.

R#+!tation an" !5#r !n%#rtaint5: rand name and experience goods.

B!5#r $3it%hin- %o$t$: arise when uyers develop rand-specific know-how that is

not fully transferale to sustitute rands = also arise when sellers develop specific

know-how aout uyers that other sellers cannot quickly replicate or provides after-

sale services to uyers. ays for sellers to increase switching costs:

- %re1uent customer points: tie discounts to the completion of a series oftransactions with customers.

- 4ffer a bundle of complementar" productsthat fit together in a product line.

N#t3or; #''#%t$ (n#t3or; #.t#rnaliti#$): consumers often place a higher value on a

product if other consumers also use it. *wo kinds of networks:

- ctual networks: consumers are physically linked (telephone). Core users

greater opportunities from communication greater value of the network.

- irtual networks: consumers are linked via complementary goods (Tplayers).

*he first firm that estalishes a large installed ase of customers has an advantage

ecause new customers will oserve the si'e of the network and gravitate towards the

same firm.

Cany networks evolve around $tan"ar"$. 4nce a standard is estalished it is difficult toreplace (even if it has lost its initial advantage) hence powerful source of sustainale

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competitive advantage. *o knock off the dominant standard& the rival must (1) offer superior

quality or new options for using the product3 () ale to tap into complementary goods

markets.

Early-mover "i$a",anta-#$early moves can fail to achieve a sustainale competitive

advantage for the following reasons:- $ack the complementary assets needed to commerciali'e the product.

- ?et on the wrong technologies or productshigh uncertaint"aout demandand technology when an early mover enters the market.

%igure 16.L: industry equilirium with imperfect imitaility. "t @N a firms expected

operating profit (revenue 7 variale costs) < cost of entry (cost of factory x return on capital).

@otential entrants are ;ust indifferent etween entering or not. Each firms rat# o' r#t!rn on

in,#$t#" %a+ital (ROIC) < cost of capital. ?efore entering (e8 ante) each firms expected

profit is 'ero (each firm expects to earn the cost of capital). "fter entering (e8 post) economic

profits differ."verage profit of active firms in the market overstates e8 anteprofitaility

ecause it ignores unsuccessful firms that have lost money and exited the industry.

@* THE ORIINS OF COMPETITI9E AD9ANTAE: INNO9ATION

E9OLUTION EN9IRONMENT

"ccording to S%h!&+#t#r: entrepreneurship is the aility to act on the opportunity that

innovation and discoveries create.,nnovationcauses most markets to evolve in a

characteristic pattern. Cr#ati,# "#$tr!%tion: evolutionary process: quit period when firms

that have developed superior technologies earn positive economic profits shock or

discontinuity destroys old sources of competitive advantage and replaces them with new ones

the entrepreneurs who exploit the opportunities these shocks create& achieve positive

economic profits in the next period of quiet. %ocus lies on "5na&i% #''i%i#n%5: the

achievement of long-term economic growth and technological improvement.

Di$r!+ti,# t#%hnolo-i#$: technologies that offer much higher ? 7 # than their predecessors

ut do so through a comination of lower ? and sustantially lower #. ifferent from

reakthrough technologies ecause of the emphasis on costs.

/ Strat#-i% int#nt: sustained osession with world dominance.

/ Strat#-i% $tr#t%h: gap etween amitions and resources.

/ H5+#r/%o&+#tition: sources of competitive advantage are eing created and eroded in an

increasingly rapid rate.

%orce that make firms refrain from innovating:

S!n; %o$t #''#%t: a firm that has already committed to a particular technology hasinvested resources and organi'ational capailities that are specific to that technology

and are thus less valuale if the firm switches to another technology inertia that

favors sticking to the current technology.

R#+la%#nt #''#%t: entrants are more willing to innovate ecause they are ale to

overtake a monopoly position& whereas the monopolist gain would only e to replace

itself and thus would gain less from innovating.

E''i%i#n%5 #''#%t: comes into play when the incument monopolist reali'es that potential

entrants may also have the opportunity to develop the innovation. Conopolist usually has

more to lose from another firms entry than that firm has to gain from entering the market

ecause entrant will not only steal usiness away3 it will also lower @.

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" new firms aility to prosper from its inventions depends on the &ar;#t 'or i"#a$

influenced y two elements:

- *he technology is not easily expropriated y others:good patent protection.- +peciali#ed assets must e8itsto produce and market the new product. 8f many

firms have these expertises the innovation will go to the highest idder

and the innovator will reap all the enefits3 if only a few firms have theseexpertises& the alance of power shift away to the producers.

Earl5/&o,#r a",anta-#$of eing the first firm to innovate: e the first to get the patent3

enefit from consumer perceptions. Pat#nt ra%#: race etween firms to innovate first. " firm

engaged in this race must consider the following factors when determining whether or not to

increase 25 spending:

- >ow much does increasing investment in crease the chance of winning theraceI (diminishing vs increasing returns on productivity)

- #ompetitive response.- "mount of competitors.

*wo dimensions of interest when choosing a methodolog": (1) riskiness of 25 (completion

data& certainty)3 () correlated research strategies if one research is successful& the other

one is likely to e not.

E,ol!tionar5 #%ono&i%$: firms do not directly choose innovative activities to maximi'e

profits3 rather key decisions concerning innovation result from organi#ational routines

well-practiced patterns of activity inside the firm. %irms do not change their routines often

ecause altering what worked well in the past seems unnatural.

D5na&i% %a+ailiti#$: aility of a firm to maintain and adapt the capailities that are at the

asis of its competitive advantage. $imited ecause:

*he search for new sources of competitive advantage is +ath "#+#n"#nt: depends onthe path the firm has taken in the past to get to where it is now.

@resence of %o&+l#ntar5 a$$#t$: firm-specific assets that are valuale only in

connection with a particular product& technology or way of doing usiness sunk

cost argument.

8in"o3$ o' o++ort!nit5: firms that do not adapt their existing capailities or

commit themselves to new markets when these new uncertain windows of

opportunities exits may find themselves eventually locked out from the market or

competing at a significant disadvantage with early movers.

Port#rargues that competitive advantage originates in the local environmentin which the

firm is ased.iamond: four attriutes of the home market that promote or impede a firms

aility to achieve competitive advantage in gloal markets:1. Fa%tor %on"ition$: general-purpose factors of production are often availale locally

or can e purchased in gloal markets3 the most import factors of production are

highl" speciali#ed to the needs of particular industries.

. D#&an" %on"ition$: sophisticated home customers or unique local conditions

stimulate firms to enhance the quality of their products and to innovate.

9. R#lat#" $!++li#r or $!++ort in"!$tri#$: although many inputs are moile and thus

firms dont need geographical proximity to otain them& the exchange of key inputs&

certain know-how doe require such proximity.

6. Strat#-5 $tr!%t!r# an" ri,alr5: context of competition3 local management

practices3 organi'ational structure3 corporate governance. "lthough rivalry may hold

down profitaility in local markets& firms that survive vigorous competition in the

home market are often more efficient and innovative.

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Canaging innovation creates a dilemma: formal structure and controls needed to coordinate

innovation vs. looseness and flexiility can foster innovation& creativeness and adaptiveness

to changing circumstances.

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Chapter 16

The multitask principleIf employees have to multi-task they will focus more on the tasks that are rewarded.

Three factors that make for a performance measure1. Less affected by random factors

a. Most people are risk adverse and dislike jobs that involve risky pay.he incentive to take on the risk is very e!pensive for the firm.

". Can clearly identify all the activities a firm needs to have done.a. #tron$er incentives will make employees more focused on those

activities.%. Cannot be improved by actions the firm does &' want undertaken.

a. #tron$er incentives a$ainst those actions will limit employees fromdoin$ them.

Various performance measures Absolute/Relative( ) relative measure compares one performance with

another employee*s performance.o +asin$ each employee*s pay on the difference between the individual

performances will shield the employees from risk if the sources ofrandomness are positively correlated.

o ,elative measurements have the potential to increase multitask

problems. mployees can try to sabota$e each other to $et a betterpay.

Broad/narrow( &arrow measurements look at direct profits from an employee

e!/ countin$ the number of pieces of output produced by an individualemployee0. +road measurements try to look direct and indirect profits.

o +road measure rewards employees for improvin$ overall efficiency in

a firm.o +road measure is more subject to random factors.

Pay-for-performance will often reduceperformance on unmeasured dimensions.It is only profitable for jobs where productivity can be measured directly.

Implicit/Explicit Incentive Contracts

Implicit -- ) ran$e of performance measures can be incorporated.

Explicit -- ay is tied to a measure throu$h a predetermined formula.

Types of Performance Evaluation 360-degree peer reviews( )n employee*s supervisor2 coworkers and

subordinates are all asked to provide information re$ardin$ that employee*sperformance.

Management-b-ob!ective sstems( )n employee and a supervisor work

to$ether to construct a set of $oals for the employee and are evaluated at theend of that period how well the employee met those $oals.

Merit rating sstems( mployees are $iven numerical scores.

Costs of Subjective ssessments like the ones above0 of an Employee!sPerformance

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1. Ratings compression( 3hen the people who need to evaluate anemployee*s performance find it personally difficult to reward one employeebut not others.

a. It weakens incentives.". #ubject to influence activity

a. mployees mi$ht try to affect their evaluations by establishin$ a $oodpersonal relationship with supervisors.

The "ays firms provi#e incentives$1. Promotion Tournaments-- 3here a set of employees compete to win a

promotion because the hi$her pay2 etc. increases incentive.

"#ree properties o$ promotion tournamentso mployee*s effort levels increase with the difference of the salaries levels

from the promotion.o If more competitors are added2 it can maintain the same incentives for effort

by increasin$ the si4e of the pri4e salary2 etc0

o If there are successive rounds of promotion tournaments2 the wa$edifferentials between levels must increase in order to maintain the sameincentives for effort.

Advantages %isadvantages

Circumvent the problem of supervisorswho are unwillin$ to make sharpdistinctions between employees.

romotin$ based on a $ood performancein a lower-level job mi$ht not yield thebest person for the promotion becausedifferent skill sets are re5uired.

hey are a form of relative performanceevaluation.

,elative performance evaluation rewardsemployees for sabota$in$ theperformance of other employees.

". Threat of Termination( he stren$th depends on how valuable a job is tothe employee.

%. Teams( irms can motivate employees to work to$ether by usin$ teams.

&ree-rider problems( Can occur when workin$ in teams. irms can helpprevent that by keepin$ teams small and allowin$ employees to work to$etherrepeatedly. hey can also keep an eye on each other*s actions.

Chapter 17: Strategy and Structure(2ndchapter of Part V: internal organization)

Organizational structureOrganizational structure concerns the arrangements, both ormal an! inormal, b"

#hich a irm !i$i!es u% its critical tas&s, s%eciies ho# its managers an!em%lo"ees ma&e !ecisions, an! establishes routines an! inormation lo#s tosu%%ort o%erations so as to lin& o%%ortunities in the en$ironment #ith itsresources an! ca%abilities.

'lre! (han!ler) *tructure ollo#s *trateg". +anagers #ill choose the structurethat matches the chosen strateg" best a%%licable or irms o all sizes.

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or im%lementation o strateg" its em%lo"ees must &no# it an! &no# #hat itentails or their #or&.

#o ste%s o organization !esign)

'r$ani4in$ simple tasks performed by simple wor' groups

Link simple work $roups and their activities into complex #ierarc#ies(

Simple work groups*tructuring sim%le tas&s in sim%le grou%s can be !one in se$eral #a"s)

Individually/ the members of the work $roup are paid based on what they do

#elf-mana$ed teams/ a $roup of individuals work to$ether to set and achieve

common $oals. Individuals are rewarded in part based on team performance( e$

7ierarchy of authority/ 'ne $roup member speciali4es in monitorin$ and

coordinatin$ the work of the other members.*tructure !e%en!s on circumstances) #hen coor!ination is nee!e! choose teamsor hierarch". /e"on! a certain size grou% sel-management becomes too costl".

Organizing these sim%le tas&s oten is not o much strategic im%ortance an! canbe change! easil".

Complex Hierarchyhe organization o a large irm into a com%le hierarch" is o much greaterim%ortance) aects more %eo%le an! allocation o assets.

#o %roblems relate! to com%le organization structures)

%epartmentali)ation

*oordination o$ activitieswithin and between sub$roups.

Departmentalization i!entiies ormal grou%ings #ithin the organization, organize!along $arious !imensions, eg common tas&sunctions, in%uts, out%uts,geogra%hical location an! time o #or&. or the o%timal structure economies oscale an! sco%e, transaction costs an! agenc" costs shoul! be consi!ere!. achstructure has its tra!eos, relecting managers %riorities or the irm.

Coordination and control of activities becomes im%ortant once grou%s areorganize!)

*oordination involves the flow of information to facilitate subunit decisions that

are consistent with each other and the $oals of the or$ani4ation.#o a%%roaches or !e$elo%ing coor!ination #ithin irms

o Autonom/sel$-containmentof work units - less coordination between units

neededo #tron$ lateral relations across work $roups are seen as important

*ontrol involves where in the or$ani4ation decisions are made and who has the

authorityo )llocation of authority control0/ Centrali4ation vs decentrali4ation ( a firm is

more centrali4ed in re$ards to certain decisions when they are made at hi$herlevels in or$ani4ations hierarchy.

o )ffects efficiency and a$ency costs.

Four basic types of structures for large organizations

Onl" a limite! number o structural orms are eicient because the characteristicso structures share com%lementarities, ma&ing it !iicult to mi an! match themcoul! result in loss o %erormance.

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+( ,nitar $unctional structure ,-$orm.) sin$le department is responsible for each of the basic business functions andtasks that are or$ani4ed in departments. he firm is or$ani4ed alon$ functionallines. )llows for speciali4ation of labor to $ain economies of scale inmanufacturin$2 marketin$ and distribution.

( Multidivisional structure M-$orm.Creates a division of labor between top mana$ers and division mana$ers2allowin$ the former to speciali4e in strate$ic decisions and lon$-ran$e plannin$.) corporate head5uarters and staff lead a set of autonomous divisions2 eachdivision consistin$ of functionally or$ani4ed departments or other divisions. e$3al-Mart/ each store is a division0 his structure or$ani4es by product line2related business units2 $eo$raphy or customer type rather than function8task.

3( Matrix structure $ig +(3 p 1+6.he irm is organize! along multi%le !imensions, usuall" t#o. 'n" combination

o the !imensions ma" be use!. am%le) irm #ith our unctional grou%s an!our %roects. he our grou%s each #or& on %articular %arts o each %roect.n!i$i!uals #or&ing on the intersection o the matri re%ort to t#o hierarchies

an! ha$e t#o bosses) eg the grou% manager an! the %roect manager o that%articular grou% an! %roect. he matri structure is oten onl" use! in %arts

o an organization, not the #hole. t is $aluable in certain situations oeconomies o scale an! sco%e an! agenc" consi!erations or or s%eciic

im%ortant issues that a !ierent structure cannot a!!ress successull", ornecessar" #hen there are conlicting !ecision !eman!s an! se$ere restraintson managerial resources.n case o %ositi$e s%illo$ers bet#een !ierent grou%s an! i acti$ities are%roit substitutes %roit increase in one area increases it in another as #ell,eg a ne# %ro!uct !esign increases sales an! re!uces costs matri is ne$er

o%timal an! !i$ision is a better choice.

2( etwor' structureocuses on in!i$i!uals rather than %ositionstas&s an! is the most leible o

the structural t"%es. or&ers can contribute to multi%le tas&s an! rearrange!as the tas&s o the organization change. e$elo%ments in net#or&ing

technologies lo#er coor!ination costs an! mo!ular %ro!uct !esigns ha$ee%an!e! the a%%lications o this structure. his structure is useul #hen itscoor!ination costs are lo#er than the gains in technical eicienc" an!coo%eration. eam%le) biotechnolog" in!ustr"

he best organizational structure or a %articular irm !e%en!s on the s%eciic

circumstances it aces.

Two factors that affect the efficiency of organizational structures

Technology and task interdependence(Most firms cannot8will not do all ,9:

by themselves.o "ec#nologdetermines the de$ree of tas' interdependence/ the de$ree to

which two or more positions depend on each other to do their own work.

,eciprocal task interdependence/ two or more workers8$roupsdepend on each other to do their work

#e5uential/ one worker8$roup depends on another ( e$ productionline2 sales.

ooled interdependence/ not directly dependent but both areneeded for the success of the firm.

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Information flows. fficient information processin$ by lettin$ work $roups work

accordin$ to clear work rules2 and have an increasin$ administrative hierarchyhandle the more difficult e!ceptions. he hi$hest mana$ement handles the mostdifficult ones/ strate$ic decisions. he demands for faster information processin$can overwhelm an e!istin$ hierarchy and call for reor$ani4ation of structure.

Transnational strategy:leible organizations combine matri an! net#or&structures. +ultinationals balance res%onsi$eness to local con!itions #ithcentralization to achie$e global economies.

*tructure can also aect strateg" to a certain !egree, as it !etermines ho# #ellinormation can be gathere! an! %rocesse! or strategic %ur%oses an! ho# these

!ecisions #ill be im%lemente! in lo#er le$els o the organization. (urrent!ecisions #ill also be constraine! b" %ast !ecisions.

$olutionar" economics $ie# the actions o irms as the result o a com%le set obeha$ioral %atterns, or routines, that e$ol$e as the irm res%on!s to itsen$ironment.*trateg" an! structure are eam%les o high-le$el heuristics)%rinci%lesgui!e%osts that re!uce the a$erage time s%en! on certain !ecisions an!

%roblems.

Chapter 18: Environment, Power, and Culture(rdchapter of Part V: internal organization)

*ome as%ects o managerial !ecision ma&ing that are not tra!itionall" inclu!e! ineconomic anal"ses o strateg".

he summar" % 557-558 seems to co$er most o the cha%ter.

tra notes) %o#er is not the same as authorit", #hich stems rom e%licitcontractual !ecision ma&ing an! !is%ute resolution rights that a irm or other

source grants to an in!i$i!ual. o#er is then the abilit" to get things !one in theabsence o contracts. nluence is using %o#er in a gi$en situation b" a %erson.nluence is an eect o %o#er.

here are $arious sources o %o#er)*tructure o a irm can su%%ort or im%e!e %o#er*tructural holes) one actor is the crucial lin& in a net#or& bet#een other actors)

bargaining %o#er:egitimateormal %o#er) base! on someone;s %osition #ithin a hierarch".*ocial echangeinteractions

Besanko Summary

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