Economics of Strategy

Sources of Diseconomies of Scale 68
Labor Costs and Firm Size 69
Spreading Specialized Resources Too Thin 69
Bureaucracy 69
Economies of Scale: A Summary 70
The Learning Curve 70
The Concept of the Learning Curve 70
Expanding Output to Obtain a Cost Advantage 71
Example 2.3 Learning by Doing in Medicine 72
Learning and Organization 73
The Learning Curve versus Economies of Scale 74
Example 2.4 The Pharmaceutical Merger Wave 75
Diversification 75
Why Do Firms Diversify? 76
Efficiency–Based Reasons for Diversification 76
Scope Economies 76
Internal Capital Markets 77
Problematic Justifications for Diversification 78
Diversifying Shareholders Portfolios 78
Identifying Undervalued Firms 78
Reasons Not to Diversify 79
Managerial Reasons for Diversification 79
Benefits to Managers from Acquisitions 79
Problems of Corporate Governance 80
The Market for Corporate Control and Recent Changes in Corporate Governance 81
Example 2.5 Activist Investors in Silicon Valley 82
Performance of Diversified Firms 83
Example 2.6 Haier: The World s Largest Consumer Appliance and Electronics Firm 84
Chapter Summary 85
Questions 86
Endnotes 88

3 The Vertical Boundaries of the Firm 90
Make versus Buy 90
Example 3.1 What Apple Makes and what It Buys for the iPhone3 91
Upstream, Downstream 92
Example 3.2 Licensing Biotechnology Products 93
Defining Boundaries 94
Some Make–or–Buy Fallacies 94
Avoiding Peak Prices 95
Tying Up Channels: Vertical Foreclosure 96
Reasons to Buy 98
Exploiting Scale and Learning Economies 98
Example 3.3 Employee Skills: Make or Buy? 100
Bureaucracy Effects: Avoiding Agency and Influence Costs 101
Agency Costs 101
Influence Costs 102
Example 3.4 Disconnection at Sony13 103
Organizational Design 104
Reasons to Make 104
The Economic Foundations of Contracts 104
Complete versus Incomplete Contracting 105
Bounded Rationality 105
Difficulties Specifying or Measuring Performance 106
Asymmetric Information 106
The Role of Contract Law 106
Coordination of Production Flows through the Vertical Chain 107
Example 3.5 Nightmares at Boeing: The 787 Dreamliner 108
Leakage of Private Information 109
Transaction Costs 110
Relationship–Specific Assets 111
Forms of Asset Specificity 111
The Fundamental Transformation 112
Rents and Quasi–Rents 112
The Holdup Problem 113
Example 3.6 Power Barges 114
Holdup and Ex Post Cooperation 115
The Holdup Problem and Transaction Costs 115
Contract Negotiation and Renegotiation 115
Example 3.7 A Game of Chicken? Specificity and Underinvestment in the Broiler Industry 116
Investments to Improve Ex Post Bargaining Positions 116
Distrust 116
Reduced Investment 117
Recap: From Relationship–Specific Assets to Transaction Costs 117
Summarizing Make–or–Buy Decisions: The Make–or–Buy Decision Tree 118
Chapter Summary 119
Questions 119
Endnotes 122

4 Integration And Its Alternatives 124
What Does It Mean to Be Integrated ? 124
The Property Rights Theory of the Firm 124
Alternative Forms of Organizing Transactions 125
Example 4.1 Vertical Integration in a Mountain Paradise 126
Governance 127
Delegation 128
Recapping PRT 128
Path Dependence 129
Making the Integration Decision 129
Technical Efficiency versus Agency Efficiency 130
The Technical Efficiency/Agency Efficiency Trade–off 130
Example 4.2 Accountable Care Organizations 133
Real–World Evidence 134
Double Marginalization: A Final Integration Consideration 136
Example 4.3 Vertical Integration of the Sales Force in the Insurance Industry 137
Alternatives to Vertical Integration 138
Tapered Integration: Make and Buy 138
Franchising 138
Example 4.4 Franchise Heat in China 139
Strategic Alliances and Joint Ventures 140
Example 4.5 Joint Ventures in Sub–Saharan Africa 141
Implicit Contracts and Long–Term Relationships 143
Example 4.6 Interfirm Business Networks in the United States: The Women s Dress Industry in New York City19 144
Business Groups 145
Keiretsu 145
Chaebol 147
Business Groups in Emerging Markets 148
Chapter Summary 149
Questions 150
Endnotes 151

Part Two Market and Competitive Analysis 153
5 Competitors and Competition 155
Competitor Identification and Market Definition 156
The Basics of Market Definition and Competitor Identification 156
Putting Competitor Identification into Practice 157
Example 5.1 The SSNIP in Action: Defining Hospital Markets 157
Empirical Approaches to Competitor Identification 158
Geographic Competitor Identification 160
Example 5.2 Whole Foods Attempts to Acquire Wild Oats 161
Measuring Market Structure 162
Market Structure and Competition 163
Perfect Competition 163
Many Sellers 164
Homogeneous Products 164
Excess Capacity 165
Example 5.3 The Bottom Drops Out on Cubs Tickets 166
Monopoly 166
Monopolistic Competition 168
Demand for Differentiated Goods 168
Entry into Monopolistically Competitive Markets 169
Oligopoly 170
Example 5.4 Capacity Competition in the U.S. Beef Processing Industry13 171
Cournot Quantity Competition 171
The Revenue Destruction Effect 174
Cournot s Model in Practice 175
Bertrand Price Competition 175
Example 5.5 Cournot Equilibrium in the Corn Wet Milling Industry 176
Why Are Cournot and Bertrand Different? 177
Example 5.6 Electric Markets, Bertrand Competition, and Capacity Constraints 178
Bertrand Price Competition When Products Are Horizontally Differentiated 179
Evidence on Market Structure and Performance 181
Price and Concentration 181
Chapter Summary 182
Questions 182
Endnotes 184

6 Entry and Exit 186
Some Facts about Entry and Exit 187
Entry and Exit Decisions: Basic Concepts 188
Barriers to Entry 188
Bain s Typology of Entry Conditions 189
Analyzing Entry Conditions: The Asymmetry Requirement 189
Example 6.1 How the Japanese Broke into the U.S. Car Market 190
Structural Entry Barriers 191
Control of Essential Resources 191
Economies of Scale and Scope 192
Example 6.2 Emirates Air8 193
Marketing Advantages of Incumbency 194
Barriers to Exit 195
Entry–Deterring Strategies 196
Limit Pricing 196
Example 6.3 Limit Pricing by Brazilian Cement Manufacturers 197
Is Strategic Limit Pricing Rational? 198
Example 6.4 Entry Barriers and Profitability in the Japanese Brewing Industry 199
Predatory Pricing 200
The Chain–Store Paradox 200
Example 6.5 Predatory Pricing in the Laboratory 201
Rescuing Limit Pricing and Predation: The Importance of Uncertainty and Reputation 202
Wars of Attrition 203
Example 6.6 Walmart Enters Germany . . . and Exits 204
Predation and Capacity Expansion 204
Strategic Bundling 205
Judo Economics 206
Evidence on Entry–Deterring Behavior 207
Contestable Markets 208
An Entry Deterrence Checklist 208
Entering a New Market 208
Preemptive Entry and Rent–Seeking Behavior 210
Chapter Summary 211
Questions 212
Endnotes 213

7 Dynamics: Competing Across Time 214
Microdynamics 215
The Strategic Benefits of Commitment 215
Strategic Substitutes and Strategic Complements 216
The Strategic Effect of Commitments 217
Example 7.1 Committed to a Settlement 218
Tough and Soft Commitments 219
A Taxonomy of Commitment Strategies 219
The Informational Benefits of Flexibility 220
Example 7.2 Commitment at Nucor and USX: The Case of Thin–Slab Casting9 221
Real Options 222
A Framework for Analyzing Commitments 223
Competitive Discipline 224
Dynamic Pricing Rivalry and Tit–for–Tat Pricing 225
Example 7.3 What Happens When a Firm Retaliates Quickly to a Price Cut: Philip Morris versus B.A.T. in Costa Rica 21 226
Why Is Tit–for–Tat So Compelling? 227
Coordinating on the Right Price 227
Impediments to Coordination 229
The Misread Problem 229
Example 7.4 Forgiveness and Provocability: Dow Chemicals and the Market for Reverse Osmosis Membranes 230
Lumpiness of Orders 230
Information about the Sales Transaction 231
Volatility of Demand Conditions 231
Asymmetries among Firms and the Sustainability of Cooperative Prices 232
Price Sensitivity of Buyers and the Sustainability of Cooperative Pricing 233
Market Structure and the Sustainability of Cooperative Pricing: Summary 233
Facilitating Practices 234
Price Leadership 234
Advance Announcement of Price Changes 234
Most Favored Customer Clauses 234
Example 7.5 Are Most Favored Nation Agreements Anticompetitive? 235
Uniform Delivered Prices 236
Where Does Market Structure Come From? 237
Sutton s Endogenous Sunk Costs 238
Example 7.6 The Evolution of the Chinese Down Apparel Industry 239
Innovation and Market Evolution 240
Learning and Industry Dynamics 241
Chapter Summary 241
Questions 242
Endnotes 244

8 Industry Analysis 247
Performing a Five–Forces Analysis 248
Internal Rivalry 249
Entry 250
Substitutes and Complements 251
Supplier Power and Buyer Power 251
Strategies for Coping with the Five Forces 252
Coopetition and the Value Net 253
Applying the Five Forces: Some Industry Analyses 255
Chicago Hospital Markets Then and Now 255
Market Definition 255
Internal Rivalry 255
Entry 256
Substitutes and Complements 257
Supplier Power 257
Buyer Power 258
Commercial Airframe Manufacturing 259
Market Definition 259
Internal Rivalry 259
Barriers to Entry 260
Substitutes and Complements 261
Supplier Power 261
Buyer Power 262
Professional Sports 262
Market Definition 262
Internal Rivalry 262
Entry 264
Substitutes and Complements 266
Supplier Power 267
Buyer Power 267
Conclusion 267
Professional Search Firms 268
Market Definition 268
Internal Rivalry 268
Entry 269
Substitutes and Complements 269
Supplier Power 270
Buyer Power 270
Conclusion 270
Chapter Summary 271
Questions 271
Endnotes 275

Part Three Strategic Position and Dynamics 277
9 Strategic Positioning For Competitive Advantage 279
Competitive Advantage and Value Creation: Conceptual
Foundations 280
Competitive Advantage Defined 280
Maximum Willingness–to–Pay and Consumer Surplus 281
From Maximum Willingness–to–Pay
to Consumer Surplus 282
Value–Created 284
Example 9.1 The Division of Value Creation for Gilead
Sciences Sovaldi on the Back of an Envelope 286
Value Creation and Win Win Business Opportunities 287
Value Creation and Competitive Advantage 288
Analyzing Value Creation 288
Example 9.2 Kmart versus Walmart 290
Example 9.3 The Emergence of Uber . . . and the Demise of the Taxi? 291
Value Creation and the Value Chain 292
Value Creation, Resources, and Capabilities 292
Example 9.4 Creating Value at Enterprise Rent–a–Car17 294
Example 9.5 Measuring Capabilities in the Pharmaceutical Industry 295
Strategic Positioning: Cost Advantage and Benefit
Advantage 296
Generic Strategies 296
The Strategic Logic of Cost Leadership 296
The Strategic Logic of Benefit Leadership 298
Example 9.6 Haute Pot Cuisine in China 299
Extracting Profits from Cost and Benefit Advantage 301
Comparing Cost and Benefit Advantages 302
Stuck in the Middle 304
Example 9.7 Strategic Positioning in the Airline Industry: Four Decades of Change 304
Diagnosing Cost and Benefit Drivers 306
Cost Drivers 306
Cost Drivers Related to Firm Size, Scope, and Cumulative Experience 307
Cost Drivers Independent of Firm Size, Scope, or Cumulative Experience 307
Cost Drivers Related to Organization of the Transactions 308
Benefit Drivers 308
Methods for Estimating and Characterizing Costs and Perceived Benefits 309
Estimating Costs 309
Estimating Benefits 310
Strategic Positioning: Broad Coverage versus Focus Strategies 310
Segmenting an Industry 310
Broad Coverage Strategies 311
Focus Strategies 312
Chapter Summary 314
Questions 315
Endnotes 318

10 Information and Value Creation 320
The Shopping Problem 321
Unraveling 322
Alternatives to Disclosure 323
Example 10.1 A Warranty for Surgery 324
Example 10.2 The Evolution of Branding in Appliance Retailing 326
Nonprofit Firms 327
Report Cards 327
Multitasking: Teaching to the Test 328
Example 10.3 Teachers Teaching to the Test7 329
What to Measure 331
Example 10.4 Calorie Posting in New York City Restaurants 333
Risk Adjustment 335
Presenting Report Card Results 336
Gaming Report Cards 337
Example 10.5 Hospital Report Cards 338
The Certifier Market 339
Certification Bias 340
Matchmaking 342
When Sellers Search for Buyers 343
Example 10.6 The Netflix Challenge 343
Chapter Summary 345
Questions 346
Endnotes 347

11 Sustaining Competitive Advantage 349
Market Structure and Threats to Sustainability 349
Threats to Sustainability in Competitive and Monopolistically Competitive Markets 350
Threats to Sustainability under All Market Structures 351
Evidence: The Persistence of Profitability 351
The Resource–Based Theory of the Firm 353
Imperfect Mobility and Cospecialization 353
Example 11.1 Coffee, Tea, or Starbucks? 354
Isolating Mechanisms 355
Example 11.2 Sports Dynasties 357
Impediments to Imitation 358
Legal Restrictions 358
Superior Access to Inputs or Customers 359
Example 11.3 Cola Wars in Venezuela 360
The Winner s Curse 361
Market Size and Scale Economies 361
Intangible Barriers to Imitation 362
Causal Ambiguity 363
Dependence on Historical Circumstances 363
Social Complexity 363
Early–Mover Advantages 364
Learning Curve 364
Reputation and Buyer Uncertainty 364
Buyer Switching Costs 364
Network Effects 365
Networks and Standards 365
Example 11.4 Building Blocks of Sustainable Advantage 366
Competing For the Market versus In the Market 366
Knocking Off a Dominant Standard 367
Early–Mover Disadvantages 367
Imperfect Imitability and Industry Equilibrium 368
Creating Advantage and Creative Destruction 370
Disruptive Technologies 370
The Productivity Effect 371
The Sunk Cost Effect 371
The Replacement Effect 372
The Efficiency Effect 372
Disruption versus the Resource–Based Theory of the Firm 373
Innovation and the Market for Ideas 373
Example 11.5 Patent Racing and the Invention of the Integrated Circuit23 374
Evolutionary Economics and Dynamic Capabilities 375
The Environment 376
Factor Conditions 376
Demand Conditions 376
Related Supplier or Support Industries 376
Example 11.6 The Rise of the Swiss Watch Industry27 377
Strategy, Structure, and Rivalry 378
Chapter Summary 378
Questions 379
Endnotes 381

Part Four Internal Organization 383
12 Performance Measurement and Incentives 385
The Principal Agent Relationship 386
Combating Agency Problems 386
Example 12.1 Differences in Objectives in Agency Relationships: Yahoo! and English Fruit 387
Performance–Based Incentives 388
Example 12.2 Hidden Action and Hidden Information in Garment Factory Fire Insurance 391
Problems with Performance–Based Incentives 393
Preferences over Risky Outcomes 393
Risk Sharing 394
Risk and Incentives 396
Example 12.3 Target and Terror in English Hospitals14 398
Performance Measures That Fail to Reflect All Desired Actions 399
Selecting Performance Measures: Managing Trade–offs between Costs 401
Example 12.4 Herding, RPE, and the 2007 2008 Credit Crisis 403
Do Pay–for–Performance Incentives Work? 404
Implicit Incentive Contracts 405
Subjective Performance Evaluation 405
Promotion Tournaments 406
Example 12.5 Quitters Never Win32 408
Efficiency Wages and the Threat of Termination 409
Incentives in Teams 410
Example 12.6 Teams and Communication in Steel Mills42 412
Chapter Summary 413
Questions 414
Endnotes 416

13 Strategy and Structure 419
An Introduction to Structure 421
Individuals, Teams, and Hierarchies 421
Complex Hierarchy 424
Departmentalization 424
Coordination and Control 426
Approaches to Coordination 428
Example 13.1 ABB s Matrix Organization16 430
Types of Organizational Structures 431
Functional Structure (U–form) 431
Example 13.2 Organizational Structure at AT&T 432
Multidivisional Structure (M–form) 433
Matrix Structure 434
Matrix or Division? A Model of Optimal Structure 435
Network Structure 436
Why Are There So Few Structural Types? 438
Strategy–Environment Coherence 439
Technology and Task Interdependence 440
Example 13.3 Steve Jobs and Structure at Apple31 441
Information Processing 442
Structure Follows Strategy 443
Example 13.4 Strategy, Structure, and the Attempted Merger Between the University of Chicago Hospital and Michael Reese Hospital 445
Strategy, Structure, and the Multinational Firm 445
Example 13.5 Multinational Firms: Strategy and Infrastructure39 446
Example 13.6 Reorganization at Rhône–Poulenc S.A.41 447
Hybrid Organizations 449
Chapter Summary 451
Questions 452
Endnotes 453

14 Environment, Power, and Culture 456
The Social Context of Firm Behavior 456
Internal Context 458
Power 459
The Sources of Power 460
Example 14.1 The Sources of Presidential Power9 462
Structural Views of Power 463
Do Successful Organizations Need Powerful Managers? 464
Example 14.2 Power and Poor Performance: The Case of the 1957 Mercury16 465
The Decision to Allocate Formal Power to Individuals 466
Example 14.3 Power in the Boardroom: Why Let CEOs Choose Directors? 466
Culture 468
Culture Complements Formal Controls 470
Example 14.4 Corporate Culture and Inertia at ICI30 470
Culture Facilitates Cooperation and Reduces Bargaining Costs 471
Culture, Inertia, and Performance 472
A Word of Caution about Culture 473
Example 14.5 Corporate Culture at Aetna: Yoga and the CEO37 474
External Context, Institutions, and Strategies 474
Example 14.6 Corporate Culture at Ford38 475
Institutions and Regulation 477
Interfirm Resource Dependence Relationships 478
Example 14.7 Preserving Culture in the Face of Growth: The Google IPO 480
Industry Logics: Beliefs, Values, and Behavioral Norms 481
Chapter Summary 483
Questions 484
Endnotes 485

Glossary 488
Name Index
Subject Index