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Research Part I: Decision Making – Business Strategy (MBA Ohio University – 2006/2009)
Part I.1: Prescriptive Theory – Managerial Economics Part I.2: Descriptive Theory – Behavioral Economics/Finance Part I.3: Strategic Management
Research Part II: Strategy Dynamics (PhD- at Chicago University ??? – 2009/2012)
by Ney M. Vasconcellos Jr. Purchasing & Logistics Director Mercosul Email: email@example.com October 2007
DMP and Business Strategy Overview
Most of managers make many decisions that involve questions of resource allocation within the organization in the short and long run. In the short run, managers may be interested in estimating demand and cost relationships to make decisions about product price and the quantity of output to produce. The areas of microeconomics dealing with demand theory and with the theory of cost and production for sure are useful in making decisions on such matters. Macro economic theory also plays an important role on decision making when managers attempts to forecast future demand based on forces influencing the overall economy. In the long run, Business Strategies/Decisions must be made about expanding or contracting production and distribution facilities, developing and marketing new products, and possibly acquiring other firms. Another important issue we must consider is that some incumbent firms have been observed to face challenges in maintaining impactful innovative streams and responding to technological changes over time. Many companies have one approach which has been actively pursued to address these challenges over the past decades is the acquisition of other companies to supplement internal innovation efforts in rapidly changing high-technology industries. In this case, certain risks may arise when using this strategy, which is to buy novel products, technologies, and capabilities. Basically, these decisions require the organization to make capital expenditures, that is, expenditures made in the current period that are expected to yield returns in the future periods. For example, if a manager of an automotive manufacturing plant note, that their problem is the use of technologically inefficient equipment, two possible solutions are (1) updating and replacing the plant’s equipment, or (2) building a completely new plant. The choice between these alternatives depends on the relative costs and benefits, as well as other organizational and societal constraints (as culture, government regulations, etc.) that may make one alternative more preferable than the other. Economists have developed prescriptive (normative) theories to support decision making process. In this case, there are many theories and one that is used the most is The Expected Utility Theory (EU) that defines the conditions of perfect utility-maximizing rationality in a world in which the probability distributions of all relevant variables can be provided by the
decision makers, in other words, a certain world. (It might be compared with a theory of ideal gases or of frictionless bodies sliding down inclined planes in a vacuum – ideal state). What distinguishes the descriptive (behavioral) research on decision making from the prescriptive approaches derived from EU theory is the attention that the former gives to the human rationality limits. These limits are imposed by the complexity of the world in which we live, the incompleteness and inadequacy of human knowledge, the inconsistencies of individual preference and belief, the conflicts of value among people and groups of people, and the inadequacy of the computations we can carry out.
I have decided – I mean, I have allowed myself to be seduced by the decision making process theory to support business strategy– that includes rational and behavioral influence – to engage in a research for my Master’s Degree in Business Administration at Ohio University. Lately, I had the opportunity to discuss with several remarkable researchers and to read some research material about Behavioral Finance/Economics and have also taken very interesting courses related to Business Strategy - Management Science/Managerial Economics and Quantitative Methods. I must confess that they are all fascinating fields, which I intend to research, focusing on important issues for our society and human behavior. In my previous research (from 1995 to 1997) – Quantitative Approach – at Systems Engineering Department, Kyoto University (Japan), I have developed a probabilistic model to evaluate the total cost of Systems’ Active Life Cycle (which includes systems acquisition, installation, operation, and retirement). This research was published by the International Journal of Operation Research, under the title Life Cycle Model for Acquisition of Automated Systems – Volume 37 – Number 9 – June 15th, 1999 – pages 2077-2092. I find this quantitative method/ research very interesting, because besides having a theoretical background it can be used in our daily business activities. In this new research at Ohio University, my main goal is to contribute to the field of Decision Making Process (DMP) – Under Risk and
Uncertainty, to support Business Strategy. I am very much inclined to take this research in a specific direction, which is the study of Rational Decision Making and Behavioral Economics/Finance to support Business Strategy. At this point, I am considering three options to write my thesis:
Option (1): Take Benteler Automotive Corporation and formulate a
Worldwide Strategy Business Model/Case for the next 5-10 years – considering all Benteler’s five regions: Northern Europe, Southern Europe, North America Operations, Mercosul, and Asia. This Real Model/Case would be a complete application of rational and behavioral decision making in the process of formulating corporate business strategy. Main points to be considered should be (choose one or all Benteler’s business units: chassi, structures, exhaust systems and engine applications): - Technology trend in the automotive market has become one of the most important issues in the last decades. For example, electronics are becoming a very important component in the automobile market. Its application varies for each country/region, and we must define the right time to start its application, and where to use them. - Understand new entrants and the current competitors. What are they doing? Are they investing in a particular business? Are they planning and/or acquiring new businesses? What directions are they taking? Be global or concentrate in a particular business or region? Are they willing to be Tier 1, Tier 2, or/and Tier 3? Study the latest Tier one’s joint ventures. What is behind it ? - What kind of relationship with suppliers is desired? Have a long term relationship with suppliers as the Japanese OEMs do, or as the American OEMs do? Have long term agreements? Have a cooperation agreement? Have a hybrid approach? Work with low cost countries (LCC)? Make or buy decision making is becoming an important issue. Are we willing to share our technology with our suppliers? Do we have a choice? How long can we keep our technology just for ourselves and few others? - Customer relationship must be well defined. Work with OEMs alone or also supply to Tier one customers? What would be the right split? Does this choice minimize business risk? Price sensitive analysis and policy must also be well performed and defined, respectively. Are we willing to accept lower margins and take higher risks with projects with lower volumes than
initially planed? Or concentrate in keeping our current profit level? Or may be try to improve the profit level, with the penalty of loosing business? Can we do it without loosing business with more value engineering and value analysis? - Company marketing is needed? If yes, how to do it? - What kind of supplier are we willing to be? Take more responsibility on design, or make to print? What is the market trend? What are our customers requesting? What would be more profitable and lower risk? - New plants, investments, projects, etc. – what king of tool we must use to make the right decisions on those issues? - Laws and regulation are also important players in our business environment. Each country has its own laws and regulations, so it is important to understand them. That is what means being a global company. - Cultural values/customs/history/economy system for the countries we are willing to have business. - When making the right decision, we must prepare an alternative risk analysis and understand well the consequences of each decision (not necessarily a pure rational decision). Rational and behavioral analyses are the right way to go. - This research work is considering all Benteler’s business units as described above. Decisions made for a particular business unit will affect the others. This interaction, among business units, must be also investigated as part of the Strategy Model/Case.
Option (2) Work on a research that will combine the rational and
emotional decision making process to support business strategy. The idea would be to prepare a complete general business strategy guide to support the business strategist, and at the same time, try to find a solution for some topics as: decision making over time (discounting); aggregation, i.e., individual impact x the market; and limited/bounded rationality.
Try to combine both (1) and (2). In this case, I will work heavily on the theoretical part of prescriptive and descriptive theories, and prepare a complete strategy business case for Benteler Automotive.
An Introduction to Decision Making Process (DMP)
Today, investors, managers, entrepreneurs, scientists, engineers, lawyers, doctors, professors, economists, philosophers, politicians, and others are the ones responsible for the development and the course of society and its economic and governmental organizations. Their job is pretty much related to making decisions, under risk and uncertainty, and solving problems related to others/society. It is very important that the decisions, that they have to make in such uncertain environment, are made according to society needs, and thinking of the long term perspective. To perform effectively, the decision maker must be well prepared to understand the whole DMP, and I mean the variables related to each phase of the process of making decision, such as: (i) rational decision making/management science/managerial economics: decision making based on the scientific method; (ii) behavioral decision making (behavioral economics): decision making based on human behavior, i.e., decision maker own instinct, intuition, fears, cognitive biases (are distortions in the way humans perceive reality), their rational limitation (bounded rationality), etc. Each decision is extremely important for the well-being of society, since they are related to several problems at the national level and at the level of business organizations (e.g., new product development, choice of investments, merger and acquisitions, etc.), and at the level of our individual lives (e.g., choosing a career or a school, buying a house, get married, have children, deciding what kind of investment, etc.). In areas as psychology, economics, mathematical statistics, operations research, political science, and cognitive science, major research gains have been achieved, during the last decades, in understanding decision making. The progress already achieved is substantial, but we still need new advances that will contribute substantially to the world capacity for dealing intelligently (not necessarily being rational) in the process of making decision.
I do believe that business executives would do better if they adjusted their thinking about the context of strategic decisions, rather than trying to find for ready to use formulas. That is a very difficult task. First of all, they should understand that the business world is constantly under risk and uncertainty. We all know that people in general want the world to make sense, to be predictable, and to follow clear rules of cause and effect. Managers are not different, when dealing in their business world. They want to believe that their business world is also predictable, that specific decision or action will lead to a certain outcome. Yet strategic choice is inevitably an exercise in decision making under uncertainty. Another source of uncertainty involves customers: will they embrace or reject a new product or service? Even if a company accurately anticipates what customers will do, it has to contend with the unpredictable actions of new and old competitors. A third source of uncertainty comes from technological change. Whereas some industries are relatively stable, with products that don’t change much, and customer demand that remains fairly steady, others change rapidly and in unpredictable ways. A final source of uncertainty concerns internal capabilities. Managers can’t tell exactly how a company—with its particular people, skills, and experiences—will respond to a new course of action. Our best efforts to isolate and understand the inner workings of organizations will be moderately successful at best. Combining these factors becomes clear why strategy involves decisions made under uncertainty. A strategy is a long term plan of action designed to achieve a particular goal, most often "winning". Strategy is differentiated from tactics or immediate actions with resources at hand by its nature of being extensively premeditated. Strategies are used to make the problem or problems easier to solve, and also for us to understand it more. The strategy word derives from the Greek word stratēgos, which derives from two words: stratos (army) and ago (ancient Greek for leading). Stratēgos referred to a 'military commander' during the age of Athenian Democracy.
Contents 1 Interpretation 2 Tactics 2.2Military usage 2.2 Other Usages 3 Strategic Management
Strategy is dynamic/adaptable by nature rather than rigid set of rational instructions. The simplest explanation of this is the analogy of a sports scenario. If a football team were to organize a plan in which the ball is passed in a particular sequence between specifically positioned players, their success is dependent on each of those players both being present at the exact location, and remembering exactly when, from whom and to whom the ball is to be passed; moreover that no interruption to the sequence occurs. By comparison, if the team were to simplify this plan to a strategy where the ball is passed in the pattern alone, between any of the team, and at any area on the field, then their vulnerability to variables is greatly reduced, and the opportunity to operate in that manner occurs far more often. This manner is a strategy.
Tactic (<greek taktiké or téchne = art of troops maneuver) is any component element of a strategy, with the objective of achieving any goal for a corporation, for example. Strategy searches for a more broad vision, and tactic searches for the micro part of the whole process. Tactic worries with how a task is performed, and strategy with what must be done.
2.1 Military usage
The terms tactics and strategy are often confused: tactics are the actual means used to gain a goal, while strategy is the overall plan, which may involve complex patterns of individual tactics. The United States
Department of Defense Dictionary of Military Terms defines the tactical level as ...The level of war at which battles and engagements are planned and executed to accomplish military objectives assigned to tactical units or task forces. Activities at this level focus on the ordered arrangement and maneuver of combat elements in relation to each other and to the enemy to achieve combat objectives. If, for example, the overall goal is to win a war against another country, one strategy might be to undermine the other nation's ability to wage war by preemptively annihilating their military forces. The tactics involved might describe specific actions taken in a specific location, like surprise attacks on military facilities, missile attacks on offensive weapon stockpiles, and the specific techniques involved in accomplishing such objectives.
2.2 Other usages
Referring to non-military uses of the term, in his work The Practice of Everyday Life, French scholar Michel de Certeau suggests strategy and tactics are alike and they both operate in space and time. However, unlike strategy, which inherently creates its own autonomous space, “a tactic is a calculated action determined by the absence of a proper locus. … The space of a tactic is the space of the other”. A tactic is deployed “on and with a terrain imposed on it and organized by the law of a foreign power.” One who deploys a tactic “must vigilantly make use of the cracks that particular conjunctions open in the surveillance of the proprietary powers. It creates surprises in them”. Tactics, then, are isolated actions or events that take advantage of opportunities offered by the gaps within a given strategic system, although the tactician never holds onto these advantages. Tactics cut across a strategic field, exploiting gaps in it to generate novel and inventive outcomes. Tactics are usually used to spoil the running context.
3. Strategic management
Strategic management is the art and science of formulating, implementing and evaluating cross-functional decisions that will enable an organization to achieve its objectives. It is the process of specifying the organization's objectives, developing policies and plans to achieve these objectives, and allocating resources to implement the policies and plans to achieve the
organization's objectives. Strategic management, therefore, combines the activities of the various functional areas of a business to achieve organizational objectives. It is the highest level of managerial activity, usually formulated by the Board of directors and performed by the organization's Chief Executive Officer (CEO) and executive team.
RESEARCH PART I.1: Prescriptive Theory – Managerial Economics (MBA at Ohio University)
A Rational Decision Making Model is a model which emerges from Organizational Behavior. The process is one that is logical and follows the orderly path from problem identification through solution. A Rational Decision Making Model can consist of seven step model for making rational and logical reasons: 1. Define the problem: The very first step which is normally overlooked by the top level management is defining the exact problem. Although we think that the problem identification is obvious, many times it is not. The rational decision making model is a group-based decision making process. If the problem is not identified properly then we may face a problem as each and every member of the group might have a different definition of the problem. Hence, it is very important that the definition of the problem is the same among all group members. Only then it is possible for the group members to find alternative sources or problem solving in an effective manner. 2. Generate all possible solutions: The next step in the rational decision making process is, after defining the exact problem, to generate all the possible solutions of the problem. This activity is to be done in groups, as different people may have different ideas or alternatives to the problem. If you are not able to explore more and more solutions to then there is a chance that you might not arrive at an optimal or a rational decision. For exploring the alternatives it is necessary to gather information. To gather this information the use of technology is a must. 3. Generate objective assessment criteria: After going thoroughly through the process of defining the problem, exploring for all the possible alternatives for that problem and gathering information the third step says evaluate the information and the possible options to anticipate the consequences of each and every possible alternative that is thought of. At this point of time we have to also think over for optional criteria on which we will measure the success or failure of our decision taken.
4. Choose the best solution which we have already generated: Based on the criteria of assessment and the analysis done in step 3 choose the best solution which we have generated. Once we go through the above steps thoroughly, implementing the fourth step is easy job. These four steps form the core of the Rational Decision Making Model. 5. Implement the chosen decision 6. Evaluate the “success” of the chosen alternative 7. Modify the decisions and actions taken based on the evaluation of step 6.
The Research – Rational Decision Making (MBAMaster’s Degree at Ohio University- USA)
Contents: 1 Introduction 2 Rational DM topics 3 Critical conclusions of Management Science
4 My Comments
Management science, or MS, is the discipline of using a mathematical model, and other analytical methods, to help make better business management decisions. The field is also known as Operations research (OR) in the United States or Operational Research in the United Kingdom. Some of the fields that are englobed within Management Science include: decision analysis, optimization, simulation, forecasting, game theory, network/transportation forecasting models, mathematical modeling, data mining, probability and statistics, morphological analysis, resources allocation, project management as well as many others. The management scientist's task is to use rational, systematic, sciencebased techniques to inform and improve decisions of all kinds. Of course, the techniques of management science are not restricted to business applications but may be applied to military, medical, public administration, political groups, etc. MS is also concerned with so-called ”soft-operational analysis”, which concerns methods for strategic planning, strategic decision support, and problem structuring methods. At this level of abstraction, mathematical modeling and simulation will not suffice. Therefore, during the last decades, a number of non-quantified modeling methods have been
developed. This topic is discussed in the Research I.2, Behavioral Economics/Finance.
2. Management Science Topics
A few examples of applications in which management science/operations research is currently used include: - designing the layout of a factory for efficient flow of materials - make or buy analysis - M&A decisions - Private Equity decisions - investing in new plants or reinvesting in current plants - introduction/development of new products - making decisions regarding Oligopoly and Monopoly markets - constructing a telecommunications network at low cost while still guaranteeing QoS (quality of service) or QoE (Quality of Experience) if particular connections become very busy or get damaged - road traffic management and 'one way' street allocations i.e. allocation problems. - determining the routes of school buses (or city buses) so that as few buses are needed as possible - designing the layout of a computer chip to reduce manufacturing time (therefore reducing cost) - managing the flow of raw materials and products in a supply chain based on uncertain demand for the finished products - efficient messaging and customer response tactics - roboticizing or automating human-driven operations processes - globalizing operations processes in order to take advantage of cheaper materials, labor, land or other productivity inputs
- managing freight transportation and delivery systems (Examples: LTL Shipping, intermodal freight transport) - scheduling: - personnel staffing - manufacturing steps - project tasks - network data traffic: these are known as queuing models or queuing systems. - sports events and their television coverage - blending of raw materials in oil refineries Management Science/Operations research is also used extensively in government where evidence-based policy is used.
3. Critical Conclusions on Management Science (The
Bounded Rational Decision Making Model)
The Rational Decision Making Model, amongst its many assumptions assumes that there is a single, best solution that will maximize the desired outcomes. The bounded rationality model says that the problems and the decisions are to be reduced to such a level that they will be understood. In other words, the model suggests that we should interpret information and extract essential features and then within these boundaries we take a rational decision. The model turns towards compromising on the decision making process though it is a structured decision making model. The decision maker takes the decision or is assumed to choose a solution though not a perfect solution but “good enough” solution based on the limited capacity of the group leader to handle the complexity of the situation, ambiguity and information. The steps involved in such decision making are alike to the rational decision making process. The model assumes that the perfect knowledge about all the alternatives is not possible for a human being to
know. Hence, based on the limited knowledge he takes a good enough knowledge though not a perfect decision. In short, we can say that the decision that is taken is rational but is taken in a bounded area and the choice of alternatives is though not perfect is nearer to the perfect decision. In rational process the assumption is that the exact problem, all the alternatives, should be thoroughly known to the decision maker. However, the realistic approach of human limitation is overlooked in rational decision making, but the same approach is considered mainly in the bounded rational decision making process. Hence, it is also called as a Realistic Approach for Rational Decision Making Process.
4 My Comments
There are a lot of assumptions, requirements without which the rational decision model is a failure. Therefore, they all have to be considered. The model assumes that we have or should or can obtain adequate information, both in terms of quality, quantity and accuracy. This applies to the situation as well as the alternative technical situations. It further assumes that you have or should or can obtain substantive knowledge of the cause and effect relationships relevant to the evaluation of the alternatives. In other words, it assumes that you have a thorough knowledge of all the alternatives and the consequences of the alternatives chosen. It further assumes that you can rank the alternatives and choose the best of it. The following are the limitations for the Rational Decision Making Model: It requires a great deal of time. It requires great deal of information It assumes rational, measurable criteria are available and agreed upon. It assumes accurate, stable and complete knowledge of all the alternatives, preferences, goals and consequences. It assumes a rational, reasonable, non – political world.
Several rational theories and methods are limited, but very much useful when making business decisions. What one can say is that in other to
improve the outcome, we must combine the rational and irrational methods. That means, we must implement the prescriptive/rational and descriptive/irrational/behavioral methods and theories.
Bernoulli, D (1954) "Exposition of a New Theory on the Measurement of Risk" (original: 1738), "Econometrica" 22:23-36. Schoemaker PJH (1982) "The Expected Utility Model: Its Variants, Purposes, Evidence and Limitations", "Journal of Economic Literature", 20:529-563. Scott Plous (1993) "The psychology of judgment and decision making", Chapter 7 (specifically) and 8,9,10, (to show paradoxes to the theory). Paul Anand, "Foundations of Rational Choice Under Risk", Oxford, Oxford University Press (an overview of the philosophical foundations of key mathematical axioms in subjective expected utility theory - mainly normative) 1993 repr 1995 2002 Sven Ove Hansson, "Decision Theory: A Brief Introduction", http://www.infra.kth.se/~soh/decisiontheory.pdf (an excellent nontechnical and fairly comprehensive primer) Paul Goodwin and George Wright, Decision Analysis for Management Judgment, 3rd edition. Chichester: Wiley, 2004 ISBN 0-470-86108-8 (covers both normative and descriptive theory) Robert Clemen. Making Hard Decisions: An Introduction to Decision Analysis, 2nd edition. Belmont CA: Duxbury Press, 1996. (covers normative decision theory) D.W. North. "A tutorial introduction to decision theory". IEEE Trans. Systems Science and Cybernetics, 4(3), 1968. Reprinted in Shafer & Pearl. (also about normative decision theory) Glenn Shafer and Judea Pearl, editors. Readings in uncertain reasoning. Morgan Kaufmann, San Mateo, CA, 1990. Howard Raiffa Decision Analysis: Introductory Readings on Choices Under Uncertainty. McGraw Hill. 1997. ISBN 0-07-052579-X
Lev Virine and Michael Trumper. Project Decisions: The Art and Science, Vienna, VA: Management Concepts, 2008. ISBN 978-1567262179 Morris De Groot Optimal Statistical Decisions. Wiley Classics Library. 2004. (Originally published 1970.) ISBN 0-471-68029-X. Khemani , Karan, Ignorance is Bliss: A study on how and why humans depend on recognition heuristics in social relationships, the equity markets and the brand market-place, thereby making successful decisions, 2005. J.Q. Smith Decision Analysis: A Bayesian Approach. Chapman and Hall. 1988. ISBN 0-412-27520-1 Akerlof, George A. and Janet L. YELLEN, Rational Models of Irrational Behavior Arthur, W. Brian, Designing Economic Agents that Act like Human Agents: A Behavioral Approach to Bounded Rationality James O. Berger Statistical Decision Theory and Bayesian Analysis. Second Edition. 1980. Springer Series in Statistics. ISBN 0-387-96098-8.
RESEARCH PART I.2: Descriptive Theory – Behavioral Economics/Finance (MBA at Ohio University)
Expected Utility Theory
The center of prescriptive knowledge (for some wrongly descriptive) about decision making has been the theory of expected utility (EU). EU theory defines the conditions of perfect utility-maximizing rationality in a world of certainty or in a world in which the probability distributions of all relevant variables can be provided by the decision makers. (As mentioned earlier, it might be compared with a theory of ideal gases or of frictionless bodies sliding down inclined planes in a vacuum – ideal state – by Herbert Simon). Prescriptive/rational theories of choice such as EU are complemented by empirical research that shows how people actually make decisions (purchasing a pension plan, voting for political candidates, buying an insurance package, or investing in stocks).This research demonstrates that people make decisions by selective, heuristic search through large problem spaces and large data bases, using means-ends analysis as a principal technique for guiding the search. What distinguishes the descriptive/irrational research on decision making from the prescriptive/rational approaches derived from EU theory is the attention that the former gives to the limits on human rationality. These limits are imposed by the complexity of the world in which we live, the incompleteness and inadequacy of human knowledge, the inconsistencies of individual preference and belief, the conflicts of value among people and groups of people, and the inadequacy of the computations we can carry out, even with the aid of the most powerful computers. The real world of human decisions is not a world of an ideal state as mentioned earlier. The descriptive/irrational theory of decision making is centrally concerned with all those point mentioned above and also how people cut problems down to size: how they apply approximate heuristic techniques to handle
complexity that can not be handled exactly. Prospect Theory, after reviewed as Cumulative Prospect Theory, emerges to take account of the gaps and elements of unrealism in EU theory.
Cumulative Prospect Theory
Shefrin (2000), p 108 "A theory that incorporates such framing effects has been proposed by Kahneman and Tversky (1979). Termed prospect theory, it has been extraordinarily influential. It is based on the idea that people evaluate gains or losses in prospect theory from some neutral or status quo point, an assumption consistent with the adaptation-level findings that occur not just in perception but in virtually all experience. That is, we adapt to a constant level of virtually any psychological dimension and find it to be neutral. In a similar way, we adapt to the reduced light in a movie theater when we enter it—finding it not particularly dark after a few seconds—and then readapt to the much brighter light outside when we leave the theater—finding it not to be unusually bright after a few seconds. Thaler (1980) "First, individuals do not assess risky gambles following the precepts of von NeumannMorgenstern rationality. Rather, in assessing such gambles, people look not at the levels of final wealth they can attain but at gains and losses relative to some reference point, which may vary from situation to situation, and display loss aversion—a loss function that is steeper than a gain function. Such preferences—first described and modeled by Kahneman and Tversky (1979) in their ‘Prospect Theory’—are helpful for thinking about a number of problems in finance. One of them is the notorious reluctance of investors to sell stocks that lose value, which comes out of loss aversion (Odean 1998). Another is investors' aversion to holding stocks more generally, known as the equity premium puzzle (Mehra and Prescott 1985, Benartzi and Thaler 1995)." Plous (1993) p 95-96 "Unlike expected utility theory, prospect theory predicts that preferences will depend on how a problem is framed. If the reference point is defined such that an outcome is viewed as a gain, then the resulting value function will be concave and decision makers will tend to be risk averse. On the other hand, if the reference point is defined such that an outcome is viewed as a loss, then the value function will be convex and decision makers will be risk seeking."
Cumulative Prospect Theory is a model for descriptive/irrational decisions under risk which has been introduced by Amos Tversky and Daniel Kahneman in 1992 (Tversky, Kahneman, 1992). It is a further development and variant of prospect theory. The difference from the original version of prospect theory is that weighting is applied to the cumulative probability distribution function, as in rank-dependent expected utility theory, rather
than to the probabilities of individual outcomes. In 2002, Daniel Kahneman received the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel for his contributions to behavioral economics, in particular to the development of Cumulative Prospect Theory (CPT).
Outline of the model
FIGURE 1 Figure 1 is a typical value function in Prospect Theory and Cumulative Prospect Theory. It assigns values to possible outcomes of a lottery.
FIGURE 2 Figure 2 is a typical weighting function in Cumulative Prospect Theory. It transforms objective cumulative probabilities into subjective cumulative probabilities. The main observation of CPT (and its predecessor Prospect Theory) is that people tend to think of possible outcomes usually relative to a certain reference point (often the status quo) rather than to the final status, a phenomenon which is called framing effect. Moreover, they have different risk attitudes towards gains (i.e. outcomes above the reference point) and losses (i.e. outcomes below the reference point) and care generally more about potential losses than potential gains (loss aversion). Finally, people tend to overweight extreme, but unlikely events, but underweight "average“ events. The last point is a difference to Prospect Theory which assumes that people overweight unlikely events, independently of their relative outcomes.
CPT incorporates these observations in a modification of Expected Utility Theory by replacing final wealth with payoffs relative to the reference point, by replacing the utility function with a value function, depending on this relative payoff, and by replacing cumulative probabilities with weighted cumulative probabilities. In the general case, this leads to the following formula for the subjective utility of a risky outcome described by the probability measure p:
where v is the value function (typical form shown in Figure 1), w is the weighting function (as sketched in Figure 2) and , i.e. the integral of the probability measure over all values up to x, is the cumulative probability. This formula is a generalization of the original formulation by Tversky and Kahneman which allows for arbitrary (continuous) outcomes, and not only for finitely many distinct outcomes.
The Research – Behavioral Decision Making (MBAMaster’s Degree at Ohio University- USA)
Behavioral finance and behavioral economics are very close related fields which apply scientific research on human and social cognitive and emotional biases, so we can understand economic decisions and how they affect, for example: stock market prices; the allocation of resources in new and/or current businesses, as buying/selling out companies; buying/selling stocks, etc. These two areas are mainly concerned with the economic agents’ rationality and/or the lack of it. Behavioral models typically integrate insights from psychology with neo-classical economic theory. Behavioral analyses are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases. Contents: 1 Introduction 2 Key observations 3 Behavioral finance topics 3.1 Behavioral finance models 3.2 Criticisms of behavioral finance 4 Behavioral economics 4.1 Behavioral economics topics 4.2 Critical conclusions of behavioral economics
5 My Comments
Economics and psychology had a very close link during the classical period. The economist Adam Smith wrote The Theory of Moral Sentiments, describing psychological principles of individual behavior; and Jeremy Bentham wrote heavily on the psychological foundation of utility. Economists began to distance themselves from psychology during the development of neo-classical economics as they sought to reshape the discipline as a natural science, with explanations of economic behavior deduced from assumptions about the nature of economic agents. The concept of homo economicus was developed, and the psychology of this entity was fundamentally rational. Nevertheless, psychological explanations continued to inform the analysis of many important figures in the development of neo-classical economics such as Francis Edgeworth, Vilfredo Pareto, Irving Fisher and John Maynard Keynes. A number of factors contributed to the resurgence of usage of psychology in the economy studies and the development of behavioral economics. Expected utility and discounted utility models began to gain wide acceptance, generating testable hypotheses about decision making under uncertainty and intertemporal consumption respectively. Soon a number of observed and repeatable anomalies challenged those hypotheses. Furthermore, during the 1960s cognitive psychology began to describe the brain as an information processing device (in contrast to behaviorist models). Psychologists in this field such as Ward Edwards, Amos Tversky and Daniel Kahneman began to compare their cognitive models of decision making under risk and uncertainty to economic models of rational behavior. Perhaps the most important paper in the development of the behavioral finance and economics fields was written by Kahneman and Tversky in 1979. This paper, 'Prospect theory: Decision Making Under Risk', used cognitive psychological techniques to explain a number of documented anomalies in economic decision making. Further milestones in the development of the field include a well attended and diverse conference at the University of Chicago (see Hogarth & Reder, 1987), a special 1997 edition of the Quarterly Journal of Economics ('In Memory of Amos Tversky') devoted to the topic of behavioral economics and the award of the Nobel prize to Daniel Kahneman in 2002 "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty."
Prospect theory is an example of generalized expected utility theory. Although not commonly included in discussions of the field of behavioral economics, generalized expected utility theory is similarly motivated by concerns about the descriptive inaccuracy of expected utility theory. Richard H. Thaler (b. September 12, 1945, in East Orange, NJ) is an economist perhaps best known as a theorist in behavioral finance and for his collaboration with Daniel Kahneman and others in further defining that field. Thaler has also organized a series of behavioral finance seminars along with Robert Shiller, another behavioral finance expert at the Yale School of Management. Thaler gained some attention in the field of economics for publishing a regular column in the Journal of Economic Perspectives from 1987 to 1990 titled "Anomalies", in which he documented individual instances of economic behavior that seemed to violate traditional microeconomic theory. Kahneman later cited his joint work with Thaler as a "major factor" in his receiving the Nobel Prize in Economics, saying "The committee cited me 'for having integrated insights from psychological research into economic science ….'. Although I do not wish to renounce any credit for my contribution, I should say that in my view the work of integration was actually done mostly by Thaler and the group of young economists that quickly began to form around him." Thaler also is the founder of an asset management firm that enables a select group of investors to capitalize on cognitive biases such as the endowment effect, loss aversion and status quo bias.
Thaler has also written a number of books on the subject of behavioral finance, including Quasi-rational Economics and The Winner's Curse, the latter of which contains many of his "Anomalies". Behavioral economics has also been applied to problems of intertemporal choice. The most prominent idea is that of hyperbolic discounting, in which a high rate of discount is used between the present and the near future, and a lower rate between the near future and the far future. This pattern of discounting is dynamically inconsistent (or time-inconsistent), and therefore inconsistent with some models of rational choice, since the rate of discount between time t and t+1 will be low at time t-1, when t is the
near future, but high at time t when t is the present and time t+1 the near future.
2. Key observations
There are three main themes in behavioral finance and economics (Shefrin, 2002) (three major points for research !!!!!): Heuristics: People often make decisions based on approximate rules of thumb, not strictly rational analyses (see also cognitive biases and bounded rationality). Framing (formulating): The way a problem or decision is presented to the decision maker will affect his action. Market inefficiencies: There are explanations for observed market outcomes that are contrary to rational expectations and market efficiency. These include mispricings, non-rational decision making, and return anomalies. Richard Thaler, in particular, has written a long series of papers describing specific market anomalies from a behavioral perspective.
This chart shows word counts using Lexis Nexis of the terms "behavioral finance" and "efficient markets", by year, in General News, Major Papers, Full Text, scaled by an estimate of the number of words of text on Lexis-Nexis for the year. The chart shows that "behavioral finance" has been growing exponentially starting from several years after we began our workshop series, while "efficient markets" has been declining. The chart is dramatic evidence that behavioral finance has been gaining in the marketplace for ideas.
FIGURE 3 – Behavioral Finance x Efficient Markets Recently, Barberis, Shleifer, and Vishny (1998), as well as Daniel, Hirshleifer, and Subrahmanyam (1998) have built models based on
extrapolation (seeing patterns in random sequences) and overconfidence to explain security market over - and underreactions, though such models have not been used in the money management industry. These models assume that errors or biases are correlated across agents so that they do not cancel out in aggregate (aggregation is the sum of). This would be the case if a large fraction of agents look at the same signal (such as the advice of an analyst) or have a common bias. More generally, cognitive biases may also have strong anomalous effects in aggregate if there is a social contamination with a strong emotional content (collective greed or fear), leading to more widespread phenomena such as herding and groupthink. Behavioral finance and economics rests as much on social psychology within large groups as on individual psychology (here we see how important is to understand the aggregation effect). However, some behavioral models explicitly demonstrate that a small but significant anomalous group can also have market-wide effects (eg. Fehr and Schmidt, 1999).
3. Behavioral finance topics
Key observations made in behavioral finance literature include the lack of symmetry between decisions to acquire or keep resources, called colloquially the "bird in the bush" paradox, and the strong loss aversion or regret attached to any decision where some emotionally valued resources (e.g. a home) might be totally lost. Loss aversion appears to manifest itself in investor behavior as an unwillingness to sell shares or other equity, if doing so would force the trader to realize a nominal loss (Genesove & Mayer, 2001). It may also help explain why housing market prices do not adjust downwards to market clearing levels during periods of low demand. Presently, some researchers in Experimental finance use experimental method, e.g. creating an artificial market by some kind of simulation software to study people's decision-making process and behavior in financial markets.
3.1 Behavioral finance models
Some financial models used in money management and asset valuation use behavioral finance parameters. For example: -Thaler's model of price reactions to information, with three phases, underreaction-adjustment-overreaction, creating a price trend. One
characteristic of overreaction is that the average return of asset prices following a series of announcements of good news is lower than the average return following a series of bad announcements. In other words, overreaction occurs if the market reacts too strongly or for too long (persistent trend) to news that it subsequently needs to be compensated in the opposite direction. As a result, assets that were winners in the past should not be seen as an indication to invest in as their risk adjusted returns in the future are relatively low compared to stocks that were defined as losers in the past.
3.2 Criticisms of behavioral finance
Critics of behavioral finance, such as Eugene Fama, typically support the efficient market theory (though Fama may have reversed his position in recent years). They contend that behavioral finance is more a collection of anomalies than a true branch of finance and that these anomalies will eventually be priced out of the market or explained by appealing to market microstructure arguments. However, a distinction should be noted between individual biases and social biases; the former can be averaged out by the market, while the other can create feedback loops that drive the market further and further from the equilibrium of the "fair price". A specific example of this criticism is found in some attempted explanations of the equity premium puzzle. It is argued that the puzzle simply arises due to entry barriers (both practical and psychological) which have traditionally impeded entry by individuals into the stock market, and that returns between stocks and bonds should stabilize as electronic resources open up the stock market to a greater number of traders (See Freeman, 2004 for a review). In reply, others contend that most personal investment funds are managed through superannuation funds, so the effect of these putative barriers to entry would be minimal. In addition, professional investors and fund managers seem to hold more bonds than one would expect given return differentials.
4. Behavioral economics
Models in behavioral economics are typically addressed to a particular observed market anomaly and modify standard neo-classical models by describing decision makers as using heuristics and being affected by framing effects. In general, behavioral economics sits within the neoclassical framework, though the standard assumption of rational behavior is often challenged.
4.1 Behavioral Economics topics Heuristics - Prospect theory - Loss aversion - Status quo bias Gambler's fallacy - Self-serving bias - money illusion
Framing - Cognitive framing - Mental accounting - Anchoring Anomalies (economic behavior) - Disposition effect - endowment
effect - inequity aversion - reciprocity - intertemporal consumption present-biased preferences - momentum investing - Greed and fear - Herd instinct
Anomalies (market prices and returns)- Equity premium puzzle Efficiency wage hypothesis - price stickiness - limits to arbitrage dividend puzzle - fat tails - calendar effect
4.2 Critical conclusions of behavioral economics
Critics of behavioral economics typically stress the rationality of economic agents (see Myagkov and Plott (1997) amongst others). They contend that experimentally observed behavior is inapplicable to market situations, as learning opportunities and competition will ensure at least a close approximation of rational behavior. Others note that cognitive theories, such as prospect theory, are models of decision making, not generalized economic behavior, and are only applicable to the sort of once-off decision problems presented to experiment participants or survey respondents. Traditional economists are also skeptical of the experimental and survey based techniques which are used extensively in behavioral economics. Economists typically stress revealed preferences, over stated preferences (from surveys) in the determination of economic value. Experiments and surveys must be designed carefully to avoid systemic biases, strategic behavior and lack of incentive compatibility, and many economists are distrustful of results obtained in this manner due to the difficulty of eliminating these problems. Rabin (1998) dismisses these criticisms, claiming that results are typically reproduced in various situations and countries and can lead to good
theoretical insight. Behavioral economists have also incorporated these criticisms by focusing on field studies rather than lab experiments. Some economists look at this split as a fundamental schism between experimental economics and behavioral economics, but prominent behavioral and experimental economists tend to overlap techniques and approaches in answering common questions. For example, many prominent behavioral economists are actively investigating neuroeconomics, which is entirely experimental and cannot be verified in the field. Other proponents of behavioral economics note that neoclassical models often fail to predict outcomes in real world contexts. Behavioral insights can be used to update neoclassical equations, and behavioral economists note that these revised models not only reach the same correct predictions as the traditional models, but also correctly predict some outcomes where the traditional models failed. Behavioral analyses are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases.
5. My Comments
Empirical studies of choice under uncertainty
For the last decades, researchers have worked hard on empirical studies of human choices in which uncertainty, risk, inconsistency, and incomplete information are present. On the basis of these studies, some of the general heuristics, or rules of thumb, that people use in making judgments have been compiled – heuristics that produce biases toward classifying situations according to their representativeness, or toward judging frequencies according to the availability of examples in memory, or toward interpretations biased by the way in which a problem has been framed. Cognitive bias is distortion in the way humans perceive reality. Some of these have been verified empirically in the field of psychology, others are considered general categories of bias. A bias is a prejudice in a general or specific sense, usually in the sense for having a preference to one particular point of view or ideological perspective. However, one is generally only said to be biased if one's powers of judgment are influenced by the biases one holds, to the extent that one's views could not be taken as being neutral or objective, but
instead as subjective. A bias could, for example, lead one to accept or deny the truth of a claim, not on the basis of the strength of the arguments in support of the claim themselves, but because of the extent of the claim's correspondence with one's own preconceived ideas. This is called confirmation bias. A systematic bias is a bias resulting from a flaw integral to the system within which the bias arises (for example, an incorrectly calibrated thermostat may consistently read — that is 'be biased' — several degrees hotter or colder than actual temperature). As a consequence, systematic bias commonly leads to systematic errors, as opposed to random errors, which tend to cancel one another out. In practice, accusations of bias often result from a perception of unacknowledged favoritism on the part of a critic or judge, or indeed any person in a position requiring the careful and disinterested exercise of arbitration or assessment. Any tendency to favor a certain set of values naturally leads to an uneven dispensation of judgment. It may also be noted that, if a person were to take their own preexisting view as a priori balanced without acknowledging their own personal inclinations, any person or organization that disagrees with their views is likely to be viewed as biased regardless of that person or organization's actual efforts at balance. It may be observed that bias is, in a sense, reflexive, unacknowledged or unrecognized bias potentially leading to its apprehension (with or without good reason) in others.
Methods of empirical research
Finding the underlying bases of human choice behavior is difficult. People cannot always, or perhaps even usually, provide veridical accounts of how they make up their minds, especially when there is uncertainty. In many cases, they can predict how they will behave (pre-election polls of voting intentions have been reasonably accurate when carefully taken), but the reasons people give for their choices can often be shown to be rationalizations and not closely related to their real motives. Students of choice behavior have steadily improved their research methods. They question respondents about specific situations, rather than asking for generalizations. They are sensitive to the dependence of answers on the exact forms of the questions. They are aware that behavior in an experimental situation may be different from behavior in real life, and they attempt to provide experimental settings and motivations that are as
realistic as possible. Using thinking-aloud protocols and other approaches, they try to track the choice behavior step by step, instead of relying just on information about outcomes or querying respondents retrospectively about their choice processes. Perhaps the most common method of empirical research in this field is still to ask people to respond to a series of questions. But data obtained by this method are being supplemented by data obtained from carefully designed laboratory experiments and from observations of actual choice behavior (for example, the behavior of customers in supermarkets). In an experimental study of choice, subjects may trade in an actual market with real (if modest) monetary rewards and penalties. Research experience has also demonstrated the feasibility of making direct observations, over substantial periods of time, of the decision-making processes in business and governmental organizations--for example, observations of the procedures that corporations use in making new investments in plant and equipment. Confidence in the empirical findings that have been accumulating over the past several decades is enhanced by the general consistency that is observed among the data obtained from quite different settings using different research methods. There still remains the enormous and challenging task of putting together these findings into an empirically founded theory of decision making. With the growing availability of data, the theory-building enterprise is receiving much better guidance from the facts than it did in the past. As a result, we can expect it to become correspondingly more effective in arriving at realistic models of behavior.
Decision making over time (point for research….)
The time dimension is some how a difficult variable to deal with in decision making. Economics has always used the notion of time discounting and interest rates to compare present with future consequences of decisions, but as noted above, research on actual decision making shows that people frequently are inconsistent in their choices between present and future. Although time discounting is a powerful idea, it requires fixing appropriate discount rates for individual, and especially social, decisions. Additional problems arise because human tastes and priorities change over time. Classical SEU theory assumes a fixed, consistent utility function, which does not easily accommodate changes in taste.
Aggregation (point for research….) Overview
When applying our knowledge of decision making to society-wide, or even organization-wide (agency theory), the problem of aggregation must be solved; that is, ways must be found to extrapolate from theories of individual decision processes to the net effects on the whole economy, policy, and society. Because of the wide variety of ways in which any given decision task can be approached, it is unrealistic to postulate a "representative firm" or a "standard economic man," and to simply lump together the behaviors of large numbers of supposedly identical individuals. Solving the aggregation problem becomes more important as more of the empirical research effort is directed toward studying behavior at a detailed, microscopic level.
Organizations sometimes display sophisticated capabilities far beyond the understanding of single individuals. They sometimes make enormous blunders or find themselves incapable of acting. Organizational performance is highly sensitive to the quality of the routines or "performance programs" that govern behavior and to the adaptability of these routines in the face of a changing environment. In particular, the "peripheral vision" of a complex organization is limited, so that responses to novelty in the environment may be made in inappropriate and quasiautomatic ways that cause major failure. Theory development, formal modeling, laboratory experiments, and analysis of historical cases are all going forward in this important area of inquiry. Although the decision-making processes of organizations have been studied in the field on a limited scale, a great many more such intensive studies will be needed before the full range of techniques used by organizations to make their decisions is understood, and before the strengths and weaknesses of these techniques are grasped.
Learning (Market efficiency improves with time ? Internet influence? ……….) - (point for research….)
Until quite recently, most research in cognitive science and artificial intelligence had been aimed at understanding how intelligent systems perform their work. Only in the last decades has attention begun to turn to
the question of how systems become intelligent--how they learn. A number of promising hypotheses about learning mechanisms are currently being explored. One is the so-called connexionist hypothesis, which postulates networks that learn by changing the strengths of their interconnections in response to feedback. Another learning mechanism that is being investigated is the adaptive production system, a computer program that learns by generating new instructions that are simply annexed to the existing program. Some success has been achieved in constructing adaptive production systems that can learn to solve equations in algebra and to do other tasks at comparable levels of difficulty.
The Limits of Rationality (point for research….)
Computational complexity is not the only factor that limits the literal application of EU theory. The theory also makes enormous demands on information. For the utility function, the range of available alternatives and the consequences following from each alternative must all be known. Increasingly, research is being directed at decision making that takes realistic account of the compromises and approximations that must be made in order to fit real-world problems to the informational and computational limits of people and computers, as well as to the inconsistencies in their values and perceptions. The study of actual decision processes (for example, the strategies used by corporations to make their investments) reveals massive and unavoidable departures from the framework of SEU theory. The sections that follow describe some of the things that have been learned about choice under various conditions of incomplete information, limited computing power, inconsistency, and institutional constraints on alternatives. Game theory, agency theory, choice under uncertainty, and the theory of markets are a few of the directions of this research, with the aims both of constructing prescriptive theories of broader application and of providing more realistic descriptions and explanations of actual decision making within U.S. economic and political institutions.
Limited Rationality in Economic theory
Although the limits of human rationality were stressed by some researchers in the 1950s, only recently has there been extensive activity in the field of economics aimed at developing theories that assume less than fully rational choice on the part of business firm managers and other economic agents. The newer theoretical research undertakes to answer such questions as the following:
• Are market equilibria altered by the departures of actual choice behavior from the behavior of fully rational agents predicted by Expected Utility Theory? • Under what circumstances do the processes of competition "police" markets in such a way as to cancel out the effects of the departures from full rationality? • In what ways are the choices made by bounded rational agents different from those made by fully rational agents? Theories of the firm that assume managers are aiming at "satisfactory" profits or that their concern is to maintain the firm's share of market in the industry make quite different predictions about economic equilibrium than those derived from the assumption of profit maximization. Moreover, the classical theory of the firm cannot explain why economic activity is sometimes organized around large business firms and sometimes around contractual networks of individuals or smaller organizations. New theories that take account of differential access of economic agents to information, combined with differences in self-interest, are able to account for these important phenomena, as well as provide explanations for the many forms of contracts that are used in business. Incompleteness and asymmetry of information have been shown to be essential for explaining how individuals and business firms decide when to face uncertainty by insuring, when by hedging, and when by assuming the risk. Most current work in this domain still assumes that economic agents seek to maximize utility, but within limits posed by the incompleteness and uncertainty of the information available to them. An important potential area of research is to discover how choices will be changed if there are other departures from the axioms of rational choice--for example, substituting goals of reaching specified aspiration levels (satisficing) for goals of maximizing. Applying the new assumptions about choice to economics leads to new empirically supported theories about decision making over time. The classical theory of perfect rationality leaves no room for regrets, second thoughts, or “weakness of will Some researchers state that there are no evidences confirming that markets like the New York Stock Exchange work efficiently--that prices reflect all available information at any given moment in time, so that stock
price movements resemble a random walk and contain no systematic information that could be exploited for profit. Recently, however, substantial departures from the behavior predicted by the efficientmarket hypothesis have been detected. All of these results are consistent with the empirical finding that decision makers often overreact to new information. In the same way, it has been found that stock prices are excessively volatile--that they fluctuate up and down more rapidly and violently than they would if the market were efficient.
Camerer, C. F.; Loewenstein, G. & Rabin, R. (eds.) (2003) Advances in Behavioral Economics Barberis, N.; A. Shleifer; R. Vishny (1998) ``A Model of Investor Sentiment Journal of Financial Economics 49, 307-343. Daniel, K.; D. Hirshleifer; A. Subrahmanyam, (1998) ``Investor Psychology and Security Market Over- and Underreactions Journal of Finance 53, 1839-1885. Lawrence A. Cunningham, Behavioral Finance and Investor Governance, 59 Washington & Lee Law Review (2002) Kahneman, D. & Tversky, A. 'Prospect Theory: An Analysis of Decision under Risk,' Econometrica, XVLII (1979), 263–291 Matthew Rabin 'Psychology and Economics,' Journal of Economic Literature, American Economic Association, vol. 36(1), pages 11-46, March 1998. Shefrin, Hersh (2002) Beyond Greed and Fear: Understanding behavioral finance and the psychology of investing. Oxford Universtity Press Shleifer, Andrei (1999) Inefficient Markets: An Introduction to Behavioral Finance, Oxford University Press Shlomo Benartzi; Richard H. Thaler 'Myopic Loss Aversion and the Equity Premium Puzzle' (1995) The Quarterly Journal of Economics, Vol. 110, No. 1.
RESEARCH PART I.3: Strategic Management
Strategic management is the art and science of formulating, implementing and evaluating cross-functional decisions that will enable an organization to achieve its objectives. It is the process of specifying the organization's objectives, developing policies and plans to achieve these objectives, and allocating resources to implement the policies and plans to achieve the organization's objectives. Strategic management, therefore, combines the activities of the various functional areas of a business to achieve organizational objectives. Strategic management provides overall direction to the enterprise and is closely related to the field of Organization Studies. “Strategic management is an ongoing process that assesses the business and the industries in which the company is involved; assesses its competitors and sets goals and strategies to meet all existing and potential competitors; and then reassesses each strategy annually or quarterly (i.e. regularly) to determine how it has been implemented and whether it has succeeded or needs replacement by a new strategy to meet changed circumstances, new technology, new competitors, a new economic environment., or a new social, financial, or political environment.” (Lamb, 1984:ix) Contents 1 Processes 1.1 Strategy formulation 1.2 Strategy implementation 1.3 Strategy evaluation 2 General approaches 3 The strategy hierarchy 4 Reasons why strategic plans fail 5 Criticisms of strategic management
6 My Comments
Strategic management is a combination of three main processes which are as following:
1.1 Strategy formulation
Performing a situation analysis, self-evaluation and competitor analysis: both internal and external; both micro-environmental and macroenvironmental. Concurrent with this assessment, objectives are set. This involves crafting vision statements (long term view of a possible future), mission statements (the role that the organization gives itself in society), overall corporate objectives (both financial and strategic), strategic business unit objectives (both financial and strategic), and tactical objectives. These objectives should, in the light of the situation analysis, suggest a strategic plan. The plan provides the details of how to achieve these objectives. This three-step strategy formulation process is sometimes referred to as determining where you are now, determining where you want to go, and then determining how to get there.
1.2 Strategy implementation
Allocation of sufficient resources (financial, personnel, time, technology support) Establishing a chain of command or some alternative structure (such as cross functional teams) Assigning responsibility of specific tasks or processes to specific individuals or groups
It also involves managing the process. This includes monitoring results, comparing to benchmarks and best practices, evaluating the efficacy and efficiency of the process, controlling for variances, and making adjustments to the process as necessary. When implementing specific programs, this involves acquiring the requisite resources, developing the process, training, process testing, documentation, and integration with legacy processes.
1.3 Strategy evaluation
The effectiveness of the organizational strategy must be measured. A good system/philosophy to support is the Balanced Scorecard (BSC)
2. General approaches
In general terms, there are two main approaches, which are opposite but complement each other in some ways, to strategic management: The Industrial Organization Approach: based on economic theory — deals with issues like competitive rivalry, resource allocation, economies of scale assumptions — rationality, self discipline behavior, profit maximization. (Research I.1) The Behavioral/Sociological Approach: deals primarily with human interactions assumptions — bounded rationality, cognitive biases, satisfying behavior, profit sub-optimality. (Research I.2)
Strategic management techniques can be viewed as bottom-up, top-down, or collaborative processes. In the bottom-up approach, employees submit proposals to their managers who, in turn, funnel the best ideas further up the organization. This is often accomplished by a capital budgeting process. Proposals are assessed using financial criteria such as return on investment or cost-benefit analysis. The proposals that are approved form the substance of a new strategy, all of which is done without a grand strategic design or a strategic architect. The top-down approach is the most common by far. In it, the CEO possibly with the assistance of a strategic planning team, decides on the overall direction the company should take. Some organizations are starting to experiment with collaborative strategic
planning techniques that recognize the emergent nature of strategic decisions.
3 The strategy hierarchy
In most (large) corporations there are several levels of strategy. Strategic management is the highest in the sense that it is the broadest, applying to all parts of the firm. It gives direction to corporate values, corporate culture, corporate goals, and corporate missions. Under this broad corporate strategy there are often functional or business unit strategies. Functional strategies include marketing strategies, new product development strategies, human resource strategies, financial strategies, legal strategies, supply-chain strategies, and information technology management strategies. The emphasis is on short and medium term plans and is limited to the domain of each department’s functional responsibility. Each functional department attempts to do its part in meeting overall corporate objectives, and hence to some extent their strategies are derived from broader corporate strategies. Many companies feel that a functional organizational structure is not an efficient way to organize activities so they have reengineered according to processes or strategic business units (called SBUs). A strategic business unit is a semi-autonomous unit within an organization. It is usually responsible for its own budgeting, new product decisions, hiring decisions, and price setting. An SBU is treated as an internal profit centre by corporate headquarters. Each SBU is responsible for developing its business strategies, strategies that must be in tune with broader corporate strategies. The “lowest” level of strategy is operational strategy. It is very narrow in focus and deals with day-to-day operational activities such as scheduling criteria. It must operate within a budget but is not at liberty to adjust or create that budget. Operational level strategy was encouraged by Peter Drucker in his theory of management by objectives (MBO). Operational level strategies are informed by business level strategies which, in turn, are informed by corporate level strategies. Business strategy, which refers to the aggregated operational strategies of single business firm or that of an SBU. in a diversified corporation, refers to the way in which a firm competes in its chosen arenas.
Corporate strategy, then, refers to the overarching strategy of the diversified firm. Such corporate strategy answers the questions of "in which businesses should we compete?" and "how does being in one business add to the competitive advantage of another portfolio firm, as well as the competitive advantage of the corporation as a whole?"
4. Reasons why strategic plans fail
There are many reasons why strategic plans fail, especially: - Failure to understand the customer - Why do they buy - Is there a real need for the product inadequate or incorrect marketing research - Inability to predict environmental reaction - What will competitors do - Fighting brands - Price wars - Will government intervene - Over-estimation of resource competence - Can the staff, equipment, and processes handle the new strategy - Failure to develop new employee and management skills - Failure to coordinate - Reporting and control relationships not adequate - Organizational structure not flexible enough - Failure to obtain senior management commitment - Failure to get management involved right from the start - Failure to obtain sufficient company resources to accomplish task
- Failure to obtain employee commitment - New strategy not well explained to employees - No incentives given to workers to embrace the new strategy - Under-estimation of time requirements - No critical path analysis done - Failure to follow the plan - No follow through after initial planning - No tracking of progress against plan - No consequences for above - Failure to manage change - Inadequate understanding of the internal resistance to change - Lack of vision on the relationships between processes, technology and organization - Poor communications - Insufficient information sharing among stakeholders - Exclusion of stakeholders and delegates
5. Criticisms of strategic management
Although a sense of direction is important, it can also stifle creativity, especially if it is rigidly enforced. In an uncertain and ambiguous world, fluidity can be more important than a finely tuned strategic compass. When a strategy becomes internalized into a corporate culture, it can lead to group think. It can also cause an organization to define itself too narrowly. An example of this is marketing myopia. Many theories of strategic management tend to undergo only brief periods of popularity. A summary of these theories thus inevitably exhibits survivorship bias (itself an area of research in strategic management). Many theories tend either to be too narrow in focus to build a complete
corporate strategy on, or too general and abstract to be applicable to specific situations. Populism or faddishness can have an impact on a particular theory's life cycle and may see application in inappropriate circumstances. See business philosophies and popular management theories for a more critical view of management theories. In 2000, Gary Hamel coined the term strategic convergence to explain the limited scope of the strategies being used by rivals in greatly differing circumstances. He lamented that strategies converge more than they should, because the more successful ones get imitated by firms that do not understand that the strategic process involves designing a custom strategy for the specifics of each situation. Ram Charan, aligning with a popular marketing tagline, believes that strategic planning must not dominate action. "Just do it!", while not quite what he meant, is a phrase that nevertheless comes to mind when combating analysis paralysis.
6. My Comments
Strategic Dynamics research is the next step of my research. Researchers have confirmed with deep studies that corporate strategy, which is of my interest, is very dynamic. Globalization brings worldwide effects inside the company, i.e., actions/events in Asia will affect the operations in North America, if for example, production cost is lower in Asia. Customers may ask to ship parts from low cost countries. How to react fast on such issue? So, one may say that flexibility is strategic right for multinational companies. For customers react fast is a must, and how to make such decisions and implement it, is a key point to be investigated, so corporate can achieve success in this dynamic business world.
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RESEARCH PART II: Strategy Dynamics (PhD at ………, 2009 - 2012)
The dynamic model of strategy is a way of understanding how strategic actions occur. It recognizes that strategic planning is dynamic, that is, strategy involves a complex pattern of actions and reactions. It is partially planned and partially unplanned. Contents 1 The Dynamic Model of Strategy 2 Criticisms of Dynamic Strategy Models 3 References
1. The Dynamic Model of Strategy
Several theorists have recognized a problem with this static model: it is not how it is done in real life. Strategy is actually a dynamic and interactive process. Some of the earliest challenges to the planned strategy approach came from Linblom in the 1960s and Quinn in the 1980s. Charles Lindblom (1959) claimed that strategy is a fragmented process of serial and incremental decisions. He viewed strategy as an informal process of mutual adjustment with little apparent coordination. James Brian Quinn (1980) developed an approach that he called "logical incrementalism". He claimed that strategic management involves guiding actions and events towards a conscious strategy in a step-by-step process. Managers nurture and promote strategies that are themselves changing. In regard to the nature of strategic management he says: "Constantly integrating the simultaneous incremental process of strategy formulation and implementation is the central art of effective strategic management." (?page 145). Whereas Lindblom saw strategy as a disjointed process
without conscious direction, Quinn saw the process as fluid but controllable. Joseph Bower (1970) and Robert Burgelman (1980) took this one step further. Not only are strategic decisions made incrementally rather than as part of a grand unified vision, but according to them, this multitude of small decisions are made by numerous people in all sections and levels of the organization. Henry Mintzberg (1978) made a distinction between deliberate strategy and emergent strategy. Emergent strategy originates not in the mind of the strategist, but in the interaction of the organization with its environment. He claims that emergent strategies tend to exhibit a type of convergence in which ideas and actions from multiple sources integrate into a pattern. This is a form of organizational learning, in fact, on this view, organizational learning is one of the core functions of any business enterprise (See Peter Senge's The Fifth Discipline (1990).) Constantinos Markides (1999) describes strategy formation and implementation as an on-going, never-ending, integrated process requiring continuous reassessment and reformation. A particularly insightful model of strategy dynamics comes from J. Moncrieff (1999). He recognized that strategy is partially deliberate and partially unplanned. The unplanned element comes from two sources : “emergent strategies” result from the emergence of opportunities and threats in the environment and “Strategies in action” are ad hoc actions by many people from all parts of the organization. These multitudes of small actions are typically not intentional, not teleological, not formal, and not even recognized as strategic. They are emergent from within the organization, in much the same way as “emergent strategies” are emergent from the environment. In this model, strategy is both planned and emergent, dynamic, and interactive. Five general processes interact. They are strategic intention, the organization's response to emergent environmental issues, the dynamics of the actions of individuals within the organization, the alignment of action with strategic intent, and strategic learning.
2. Criticisms of Dynamic Strategy Models
Some detractors claim that these models are too complex to teach. No one will understand the model until they see it in action. Accordingly, the two part linear categorization scheme is probably more valuable in textbooks and lectures. Also, there are some implementation decisions that do not fit a dynamic model. They include specific project implementations. In these cases implementation is exclusively tactical and often routinized. Strategic intent and dynamic interactions influence the decision only indirectly. This is edited part :)
Bower, J. (1970). Managing the resource allocation process : A study of planning and investment, Graduate school of business (papers), Harvard University, Boston, 1970. Burgelman, R. (1980). Managing Innovating systems: A study in the process of internal corporate venturing, Graduate school of business (PhD dissertation), Columbia University, 1980. Lindblom, C. (1959). The science of muddling through, Public Administration Review, Vol. 19, No. 2, 1959, pp 79-81. Markides, C. (1999). A dynamic view of strategy. Sloan Management Review, vol 40, spring 1999, pp 55-63. Markides, C. (1997). Strategic innovation. Sloan Management Review, vol 38, spring 1997, pp 31-42. Moncrieff, J. (1999). Is strategy making a difference? Long Range Planning Review, vol 32, no 2, pp 273-276. Mintzberg, H. (1978). Patterns in Strategy Formation, Management Science, Vol 24, No 9, 1978, pp 934-948. Quinn, B. (1980). Strategies for Change: Logical Incrementalism, Irwin, Homewood Ill, 1980.
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