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The first lesson opens with an introduction of key economic concepts and an overview of the general business environment. Also discussed in this lesson are economics of effective management and the economic way of thinking. Before beginning this session, think about the following lesson objectives. After completing this lesson, you should be able to: 1. Describe the basic economic concepts and the general business environment in which firms operate. 2. Understand the economic way of thinking. 3. Describe the concept of the five forces framework, time value of money, and marginal analysis. 4. Explain the economic foundation of business strategy.
Lesson 01 Road Map
Note: The purpose of the Lesson Road Map is to give you an idea of what will be expected of you for each lesson. You will be directed to specific tasks as you proceed through the lesson. Each activity in the To Do section will be identified as individual (I), team (T), graded (G), or ungraded (U). To Read: 1. Read Class Notes for Lesson 1. 2. Read Economics of Strategy (Besanko et al.) text, Introduction (pp. 1-8). The Besanko textbook material should be read along with, or after reading the Class Notes. 3. Read Economics of Strategy (Besanko et al.) text, Chapter 10 (pp. 312-39), including the cases. To Do: 1. Review each of Porter's five forces listed in Table 0.1 and relevant economic concepts learned in this lesson.
2. Complete Assignment 1.1 (T, U): Prepare a PowerPoint Presentation of the five force model. Submit this joint assignment to its drop box in the Joint Term Project folder by 3:00 a.m. Eastern Standard Time (EST) on Monday, September 14, 2009.
Economic Concepts and Business Strategy
Economics is typically divided into microeconomics and macroeconomics. Microeconomics deals with the theory of individual choices, while macroeconomics focuses on the overall economy and general economic equilibrium conditions. Microeconomic analysis studies decision making undertaken by individuals and by firms. In contrast, economic phenomena such as changes in unemployment, inflation rate, and annual growth in the output of goods and services in the nation all fall into the realm of macroeconomic analysis. In other words, macroeconomics deals with aggregates such as total output in an economy, which are the result of choices made by individuals and firms. Although managers of the business firm can do little to affect the aggregate economy, their decisions should be consistent with the current economic outlook. By blending microeconomics and macroeconomics in the study of markets, industries, and competitive forces, this course enables students to understand how market determines prices, quantities, and activities in the business firm and how business strategy should be formulated in light of both internal and external conditions to sustain competitive advantage. Specifically, in a competitive environment, managers must seek a pricing and output strategy that will maximize the present value of the future profit stream to the firm. The determination of the wealth-maximizing pricing strategy depends on the production capacity and technology available to the firm in the short run, the potential for future changes in this production capacity, the cost of producing various levels of output, the nature of the demand for the firm's products, and the potential for immediate and longer-term competition. The theory of demand and the theory of cost and production in the field of microeconomics are obviously useful in making decisions on such matters. The essence of business strategy can easily be gained from detailed application of such economic concepts and theories. Knowledge of economics permits the formulation of more subtle and powerful hypotheses and the development of richer strategies. This knowledge provides significant insights into the major themes of strategy that we will study in this course. In consideration of price and output determination, we will learn the concept of a relevant market in Lesson 4. A relevant market refers to a group of economic agents (individuals and/or firms) interacting with each other in a buyer-seller relationship. This interaction results in transactions between the demand (buyer) and the supply (seller) side of the market. Markets are the focal point for economic activity and often have both spatial and product characteristics. Some markets are worldwide, drawing buyers and sellers from a broad geographic region, while others are confined to a domestic and narrow geographic region. Because of the important role played by markets in pricing and allocating resources in a competitive economy, managers must focus considerable attention on the market structures that have developed for various goods or services. The distinct differences in market structures, and
resource-allocation efficiency. technological progress. and. internal strengths and weaknesses. there is no guarantee that these profits will be sustained in the long run. ease of entry and exit. there are four questions that need to be answered: • • • • What are the boundaries of the industry (e..g. flowing directly from a cogent analysis of its external environment and internal contexts (e. Industry and General Business Conditions An industry is a group of firms producing products that are close substitutes. barriers to entry. problems with defining industry boundaries. the market concentration in the industry) over time. common mistakes in identifying competitors)? What are the major determinants of competition (e. A competitive analysis of the most common driving forces in today's economy and the implications for the industry is a prerequisite to sound strategy making and strategic positioning. resources. Industries differ significantly on such factors as market size and structure. economies of scale.)? What is the structure of the industry (e. industries include a rich mix of competitive strategies that firms use in pursuing strategic competitiveness. as competitive forces always are in motion that creates incentives or pressures for change. good instincts... and market position). competitive analysis . General Business Environment Perceptibly. etc. concentration. its competitive capabilities. Designing viable strategies for a firm requires a thorough understanding of the firm's industry and competition. growth. price stability. have important implications for the determination of price levels. the extent of scale economies and experience curve effects. In the course of competition.changes in market structures (e.g. Typically. Many interrelated forces and decisions influence the level.)? Who are the competitors of the firm (e. and the likelihood of sustained profitability in these relevant markets. markets shape the firm's external environments which are often challenging and complex. the scope of rivalry. Profits signal to resource owners where resources are most highly valued and to potential competitors where profits could be made. These economic characteristics. etc. pricing is used by firms as a competitive strategy. and the evolving business landscape.g.g. Even if you can identify best strategies that yield a windfall to shareholders.g. and sustainability of profits. product differentiation.g. and creative thinking.. The external environment of . developing a realistic industry definition.how to identify competitors. these firms influence each other in competing for the same buyer. the degree of product standardization or differentiation. Crafting business strategy in a rapidly changing global environment to sustain profitability and strategic competitiveness is no longer a task in which managers can get by with opinions. the number and relative sizes of buyers and sellers.. And. and overall profitability.. competitive analysis)? The answers to these questions provide a basis for thinking about the appropriate strategies available to the firm. are constantly changing.
The general business environment of the firm and the industry is concerned with those elements in the broader society that affect industries and their firms. Hence. Macro-Environment All firms operate in a macro-environment consisting broadly of economic. however. By market structure. to gauge entry barriers. To assess the threat of buyer or supplier power. To apply the industry analysis framework. socio-cultural. we must know who the important buyers and suppliers are. economic. and global facets or aspects. political and legal. coverage of this material will utilize applied microeconomics we will learn in Lessons 1-4. regulatory. we must know who the competitors are. the strategic challenge is to understand each segment and its implications so appropriate strategies can be formulated and implemented. we must know the boundaries of the industry. we must first define the industry. on the other hand. demographic. . demographic. Firms cannot directly control these elements. Industry Environment The industry environment. which addresses the industry characteristics that define the distinctive strategic challenge faced by the firm.1. socio-cultural. includes such factors as competitors. to assess the state of competition. technological. The study of market structures of the firm and the way businesses compete is often referred to in the economics and strategic management literatures as industrial analysis. Instead. we mean the behavior of the market participants (competitors and customers). and technological factors. buyers and suppliers that influence a firm and its competitive actions and responses. as well as the firm's immediate industry and competitive environment as depicted in Figure 1.the firm includes both general business conditions and industry characteristics. global. We will study the structure of the markets and the economic implications of competitive forces. namely. The knowledge of market structure and competitive forces is important for formulating the firm's business strategy. political/legal.
There are a variety of important issues which managers must consider when operating in a global competitive environment. To deal with the contending currents of the competitive forces. The application of economic principles will help ensure that resources are allocated . Economics of Effective Management Managerial decisions are on how to maximize the firm’s profits or. management is nonetheless obliged to monitor them and adapt the firm's strategy as may be needed. the forces in a firm's macro-environment which have the most impact on a firm's strategy typically revolve around the firm's immediate industry and competitive environment. However. Indeed.Figure 1.1: Macro-environment in which firm operates The macro-environment includes all relevant factors outside a firm's boundaries. Although many forces in the macroenvironment are beyond the sphere of influence of the firm. managers are likely to conceive a strategic plan that is inconsistent with the competitive market situation. more generally. They need to have a comprehensive set of economic concepts and tools to help them pull these issues together to make some decisions about a firm's competitive strategy. the value of the firm. These factors are relevant in the sense that they are important enough to have effects on the decisions a firm ultimately makes about its business model and strategy. without perceptive understanding of the strategic aspects of a firm's external and internal environments. holding little prospect for attaining and sustaining competitive advantage. a firm must understand how to work in its industry and how to affect the firm in its particular situation. Competition in an industry is rooted in its underlying economics.
Competitive Strategy. which in turn determines the opportunity to profit in an industry. Firms that are able to . He conceptualizes these economic factors into five major competitive forces. Industry Analysis The model of pure competition implies that risk-adjusted rates of return should be constant across firms and industries. while the other two are from “vertical” competition: the bargaining power of buyers and the bargaining power of suppliers. (Figure 1. To enhance your understanding of sustainable competitiveness and profitability. the threat of substitute products. The overall industry attractiveness does not imply that every firm in the industry will return the same profitability.” In a sense. Threat of New Entrants Bargaining Power of Suppliers Rivalry Among Exiting Firms Bargaining Power of Buyers Threat of Substitute Goods or Services Figure 1. it is constructive to provide a conceptual framework for thinking about some of the factors that impact industry profitability. This section provides an overview of the basic economic principles that comprise effective management. numerous economic studies have shown that different industries can sustain different levels of profitability and that part of this difference can be explained by industry structure. In his book. the micro environment consists of those forces close to a company that affect its ability to serve its customers and make a profit. A change in any of these forces requires a company to re-assess the marketplace. The existence and the potency of these competitive forces determine the degree of competition.” Porter referred to these forces as the “micro environment.2) Among these competitive forces. as well as the economic way of thinking in managerial decision making. and rivalry among competitive firms.2 The Five Forces Framework To contrast it with the more general term “macro environment.efficiently within the firm and that the firm makes appropriate reactions to changes in the economic environment. three are from “horizontal” competition: the threat of new entrants. However. Michael Porter (1980) presented such a conceptual framework for identifying the sources of competitive advantage in a relevant market and exploring the economic factors that affect the profitability of a firm and its industry.
profitability is low. for diversified companies. In many ways. A very unattractive industry would be one approaching “pure competition.” This model can be used to analyze the attractiveness of an industry structure and to make decisions of entry or change within a market. at a minimum. an industry analysis such as Porter's five forces framework (Figure 1. Porter’s model supports analysis of the driving forces in an industry. software manufacturers provide personal financial services. the five forces model should be used at the industry level. competition is viewed as a grouping of alternative ways for customers to obtain the value they desire. In essence. telecommunication firms now compete with broadcasters. yet. Rather than concentrating only on existing competitive firms. With economic reasoning. This is particularly important as industry boundaries have become increasingly blurred in the new economy. Porter’s model is based on the insight that a corporate strategy should be adaptable to the opportunities and threats in the firm’s external environment. To the extent that these five competitive forces influence an industry. individual companies. As an industry. Firms that compete in a single industry should develop. management can decide how to influence or to exploit particular characteristics of their industry. it is not designed to be used at the industry group or industry sector level. by applying unique business models. Especially. An industry is defined at a lower. and automakers have expanded their business into insurance and consumer financing. competitive strategy should base on an understanding of industry structures and the way they change. Porter’s five forces model provides a framework for the industry analysis and business strategy development. It uses concepts developed in Industrial Organization economics and hence attractiveness of a market. An “unattractive” industry is one where the combination of forces acts to drive down overall profitability. The objective of corporate strategy should be to modify these competitive forces in a way that improves the position of the firm. It should always be considered during the business planning stage in a company life cycle. more basic level: a market in which similar or closely related products and/or services are sold to buyers. one five forces analysis for its industry. business model or network can achieve a profit above the industry average. Thus. It facilitates the assessment of the industry and the firm’s performance.2) helps develop useful insights for practicing managers to be more effective in dealing with the external environment of the firm. the first fundamental issue in corporate strategy is the selection of industries (lines of business) in which the company should . However. Five competitive forces shape every industry and every market. have been able to make a return in excess of the industry average. For example. according to Porter. and the determination of how changes in the business environment may affect performance. Attractiveness in this context refers to the overall industry profitability. the identification of factors affecting firm’s performance. a business executive can use the model to better understand the industry context in which the firm operates and to determine how and where the firm should operate. this conceptual five forces framework enables practicing managers to assess each force by referring to the economic principles that apply for each force.apply their core competences. These forces determine the intensity of competition and hence the profitability and attractiveness of an industry. Based on the information derived from the five forces analysis. A clear example of this is the airline industry.
introducing new products. Chapter 10. however. In the following sections we review these principles along with each of the five competitive forces. and. Also note that this conceptual framework has been modified and strengthened over time by innovations such as the Value Net as described in Chapter 10 of the Strategy textbook. To Michael Porter. Firms competing in an industry want to understand these forces so that they can position themselves in the industry to maximize their ability to earn profits.1) To be fair.compete. Please also refer to Appendix 10. more attractive customer service and warranties. it is essential to refer to the economic principles that apply for each force. and price competition to enhance their standing and market share in a specific industry. Specifically. Firms that are thinking of entering an industry want to understand these forces to decide whether the industry profitability potential is sufficient to support a decision to enter that industry. industry-specific. the intensity of this rivalry is the result of factors like equally-balanced companies. Determining the factors that affect firms' performance.1. Each force can reduce the probability that a firm can earn profits while competing in an industry. the five forces framework enables us to channel the many economic concepts we will study in this course and shape them into a solid business strategy. It is like a weaver's loom that binds various materials into a strong. Suffice to way. Rivalries naturally develop between companies in the same market. useful fabric. slow . Seeing how any changes in the business environment might affect performance. One assesses each of the five competitive forces by asking “Is it sufficiently strong to reduce or eliminate industry profits?” To answer this question. Please read Chapter 10 in the Strategy textbook before proceeding to the next section. Competitors use such means as advertising. the five-force model can be used to analyze the characteristics of an industry's environment and to examine competitive forces that influence the profitability potential in an industry. (See Table 0. Rivalry among Existing Firms You may wish to preview the section on "Measuring Market Structure" in Lesson 4. Please note that formulating a competitive strategy requires the following three tasks: • • • Assessing the industry in which the firm operates and the performance of other firms. for a template for doing industry analysis for the joint term project. The Value Net principles introduced by Brandenberger and Nalebuff provide a key insight on how a firm enhances its profits by assessing both threats and opportunities. five forces analysis. each line of business should develop its own. we should recognize that Porter's five forces framework is just one of many ways of pulling together our later lessons to formulate strategy.
the intensity of the rivalry in an industry (or competitive intensity) depends. the first step in formulating a firm's strategic plan is to identify its rivals and to clearly define the market in which the firm is competing. over-capacity and price-cutting. we begin by assessing the nature of price competition. advertising. In a market with only a few sellers. A non-price strategy may be called for. switching costs. the more competitive an industry is. When one airline lowers its prices in a market. Here are a few factors to consider. competitive rivalry is likely to be based on such dimensions as price. It is important to keep in mind that firms compete in a number of dimensions. For example. Hence. diverse competitors. Thus. Other conditions that affect competitive rivalry in an industry include degree of product differentiation. thus. In other words. it is more reasonably to expect that the pricing and production strategies of any one firm will affect overall industry price and production levels. if the firm is a grocery store. (pp. A three-firm concentration ratio (CR). Competitive rivalry is the set of actions and reactions between firms competing for an advantageous market position.growth within an industry. high-stakes investments. One common measure is a concentration ratio. The firm's product pricing cannot vary much from the prices charged by these local rivals. the tactical action of one airline reducing its prices invites a competitive response by one or more of its competitors. number of competitors. For example. however. The reason for this is that the firm should identify the rivals that constrain its own actions. slow industry growth. its rivals are likely to be local firms within reasonable driving distance of its location. Depending on the nature of the industry. Knowing how your rivals compete is important. Price may be only one of them in this case. the firm has little pricing autonomy because there is likely to be at least one firm that tries to increase market share by pricecutting. discount coupons. high fixed costs. and so on. on industry concentration (the number and size distribution of sellers in the relevant market). high strategic stakes. 313-15) Some of these are discussed below. It would be useful for you to review these conditions and to clarify how they impact price competition. lack of product differentiation. An industry in which market share is "concentrated" in the hands of a few firms is likely to be less competitive than one in which market share is dispersed among many small firms. quality. competitive rivalry is highly visible and intense in the airline industry which is characterized by oligopolistic market structure. is the percentage of industry sales accounted for by the three largest firms in the industry. to a great extent. There are also numerous market entry barriers. which sums the squared market shares of each firm in the . for example. selection variety. its action is likely to affect a competitor's business in that market. Price is often the most important competitive instrument. high fixed costs or high storage costs. • Number of Sellers: When there are many sellers. and high exit barriers. Thus. and innovation. Another measure is the Hirshman-Herfindahl Index (HHI). the more likely price wars and reduced profitability will occur. and the high risk of industry exit. Others may be location. There are various ways to measure market concentration. The Strategy textbook lists several factors that intensify price competition.
. In contrast. Therefore. we need to consider the following dimensions of entry and their implications for the firm's strategy: • • • • • • • • Existence of scale economies and minimum efficient size Brand loyalty New entrants' access to essential productive resources The learning curve Network externalities Government regulations Expectations about post-entry behavior Switching costs . By entering that industry. This makes it possible for a firm to gain substantial market share through price-cutting before rivals can retaliate. On the positive side. firms can generally increase sales only by stealing share from other firms. response by rivals to such price changes is apt to occur rapidly. but results in lower returns for industry firms. Over-capacity reduces prices for consumers. for a room addition) with a home owner is determined privately. so. (Chapter 6 of the Bensako et al.g. The ease of entry into a market helps determine its concentration. text) • Industry Demand: If the market is stagnant or declining. and stability. new firms may take market share away from current competitors. And. The contractor's negotiated price (e. Prices and Terms Are Unobservable Without Delay: Sellers in the market may be able to negotiate terms and prices that are not immediately known to other sellers.industry. while potential competitors prefer ease of entry. new entrants may force incumbent firms to learn new ways to compete. existing competitors try to develop barriers that new firms must face when deciding whether to enter an industry. This is true of home improvement contractors. Entry barriers make it difficult for new firms to enter an industry and often place them at a competitive disadvantage even when they are able to enter. Please refer to Lesson 4 for a more detailed discussion of these measures. by bringing additional production capacity.. changes in the price of gasoline at service stations are immediately observable. When analyzing entry conditions. and a firm's strategy might focus on this. Incumbents favor conditions that make entry difficult. competitiveness. we can readily judge the nature of rivalry within a market by considering these factors along with: • • • The height of exit barriers (cost of exit) Infrequency of sales Existence of cooperative pricing or other industry practices Threat of New Entrants Potential entrants are likely to be a threat to those firms already competing in an industry. • In short. the entry of new firms may lead to over-capacity in the industry. among others.
The cross-price elasticity with substitutes on fringe of market is expected to be lower than that of within market boundaries. High capital requirements. threats of substitutes depend on: o o o o Quality. extensive regulation. There is a need to differentiate between substitutability within the industry (one brand of auto vs. but. substitute products take on added importance as their availability increases. bus). In particular. there may also be an opportunity if e-business improves regulatory responsiveness. as well. (See Lesson 2) A substitute product involves the search for a product that can do the same function as the product the industry already produces.For example. they have the potential to influence an industry's profitability potential or place a limit on profitability within the industry. another brand of auto which is included in market structure or internal rivalry) and substitutability within products outside the market or industry definition (auto vs. for instance. Indeed. Brands matter. air travel vs. Substitute products are goods or services that perform similar functions to an existing product. The question is to determine how easy a product or service can be substituted. especially made cheaper. High capital requirements. and culture are major barriers to entry in many industries. it is easier to enter the lawn service industry than the semiconductor equipment industry. may limit e-business potential because of the financial constraints in adopting new strategies. On the other hand. how many people prepare meals at home. if there are significant economies of scale. Many consumers would rather buy a brand-name sneaker than an unknown brand. High cultural or regional specificity may lower e-business potential. Switching costs protect companies. 288-96 in the Strategy textbook. while it may be difficult to leverage e-business potential in a highly regulated industry. while the other requires factories and much specialized knowledge. it will be hard for a new firm to become competitive in a market dominated by large-scale sellers. entry of new sellers would be impaired if current customers have strong loyalty to incumbent sellers and/or newcomers have limited access to supplies. too. Is a substitute better? Buyers’ willingness to substitute The relative price and performance of substitutes The costs of switching to substitutes. and the availability of other alternatives. See the brief discussions of these dimensions of entry on pp. People don’t switch e-mail providers too often because having to alert many people of their new address is a hassle. One requires some relatively inexpensive equipment. Threat of Substitutes and Complements Substitute products are the natural result of industry competition. Is it easy to change to another product? If you’re in the restaurant industry. And. your business will be affected by how easily people can buy takeout meals at supermarkets. too. As such. .
As more manufacturers have introduced external memory devices that can be used in a variety of cameras. . dry cleaners will not have an opportunity to raise prices significantly for fear that customers will be driven to purchase washable and permanent-press clothing that does not require dry cleaning services. (See Lesson 2. (See Lesson 2. Suppliers tend to be powerful when: • There are a few large suppliers and the buying firms’ industry is not concentrated. suppliers' actions can reduce a firm’s ability to earn profits while competing in an industry. Labor unions are sometimes powerful suppliers who create constraints for employers.) Price-value characteristics of substitutes/complements. Some digitalcamera manufacturers have broadened their scope by selling these external devices which can be used in their cameras and in cameras sold by other manufacturers. Hospitals. for many years it has exercised strong control over the supply of physicians to hospitals. thereby. thus limiting the firm’s pricing flexibility. Although the American Medical Association is not a union in the strictest sense. If customers of dry-cleaning firms can readily purchase washable slacks and shirts at affordable prices. The availability of inexpensive external memory devices makes entry into the camera market more attractive and increases the demand for digital cameras. If a supplier can either increase the price of its product or reduce the quality while selling it at the same price. can squeeze profitability out of an industry unable to recover cost increases in its own prices. the effect on established firms' profitability is negative. Complementary goods or services are also important. for example. External storage components are complements to cameras. Most digital cameras have an internal memory that permits camera users to take and to store a small number of high-resolution pictures. The recent trend toward employment of physicians trained outside the United States gave hospitals and communities more flexibility. and communities needing medical practitioners. their availability to consumers has increased and their prices have declined. If customers can obtain close substitutes for the industry's output. (See Lesson 2. Suppose that our analysis concerns dry cleaning services. can exert bargaining power on participants in an industry by raising prices or reducing the quality of purchased goods and services. Firms that are union shops agree to let the union be the sole provider of workers. Most car producers are heavily dependent on the United Autoworkers Union. had little control over prices and supplies of physician services. Explicitly. Washable and permanent-press clothing can be cared for at home so that home cleaning is a substitute service for dry cleaning outside the home. this will exert considerable pressure on that industry. Powerful suppliers. Factors to consider when assessing substitutes and complements include: • • • Availability of close substitutes and/or complements. Many of these cameras permit users to insert external memory-storage devices and these devices may be provided by several manufacturers.Consider the external product markets that relate to a specific industry. Suppliers.) Bargaining Power of Suppliers The flexibility of a firm in designing competitive strategy is influenced by the relative power of its (upstream) suppliers and by its (downstream) customers (buyers).) Price elasticity of industry demand.
The important point here is that the firm should analyze the market power of its suppliers and its customers when designing competitive strategy. if you are running an airline. higher quality. we have many choices and some bargaining power. which might result in lower costs for you. The suppliers' products have high switching costs for the buyers. Buyers or customers tend to be powerful when: • • • • • They buy a large portion of the selling firm's total output. all resulting in potential loss of industry profits. These goals mean that buyers try to reduce their costs by bargaining with selling firms for lower prices. such as delivery schedules. there are only a few airplane suppliers (think Boeing and Airbus). trying to strike a bargain. for example. These factors are generally out of the control of the industry or company. When buying electronics. The selling industry's products are undifferentiated or similar to a commodity. the relative volume of purchases standardization of the product. and vice versa). Seemingly. and greater levels of service. but. This is affected by brand power. Indeed. it is difficult to play one against the other. customers have little actual market power unless they act collectively. play competitors off against one another. strategy can alter the power of suppliers. So. For example. we have considerable leeway. The buying firms are not a significant customer for the suppliers. firms try to offer value to customers at prices that clearly exceed the costs of providing that value. Bargaining Power of Buyers The buyer’s power is significant in that buyers can force prices down. powerful customers (or buyers) have the potential to reduce the profitability potential of an industry. The bargaining power of buyers changes with time and the competitive strategy of a firm (and its industry). The selling firm depends on the buyers for a significant portion of its sales revenue. suppliers have a great deal of influence over an industry because they affect price increases and product quality. while their customers (or buyers) want to buy high-quality products at a low price. In contrast. Hence. They can switch to another seller's product with few switching costs. if we have a choice of suppliers or are a monopsonistic buyer. and. in essence. The suppliers' goods are essential to the buyers' marketplace success. While sellers are dependent on their customers. If there were many suppliers.1 Firms that have many alternative suppliers may be able to negotiate favorable prices or other conditions.• • • • • Substitute products are not available to the buying firms. they would likely be competing more for your business. switching costs. firms selling a product want to increase their profitability. and elasticity of demand (where demand increases as prices fall. The suppliers pose a credible threat to integrate forward into the buyers' industry. . They present a credible threat to integrate backward into the sellers' industry. demand higher quality products or more services. In a competitive market.
necessary investment for competitiveness. a monopoly (see Lesson 4) is a condition where there is only one seller. Also. but. The firm can use it as a virtual checklist of factors that it must take into account in strategy design. competitive firms in many markets act cooperatively in their mutual self-interest. The region had many small dairy farms and Hershey quickly became a dominant customer of these farms. Here are some examples: . which Porter defines as “the underlying economic and technical characteristics of an industry. "Coopetition" The five forces framework is widely used and is very helpful. Applying the model means that. and hence profitability. Consider factors such as these and you might learn that an industry is or isn’t as attractive as you thought. The strength of each force is a separate function of the industry structure. Porter’s model depends on the concept of power within the relationships of the five forces. Milk is an important ingredient in chocolate and it is costly to ship over long distances. The discussion of these strategies will be presented in Lessons 8 and 9. new competitors and market shifts. analyze. However. market share. and thus the key to the model. In practice. The strategies are cost leadership. 1 Monopsony is a market condition in which firms have one dominant buyer. the firm has to find and establish itself in an industry so that the company can react to the forces of competition in a favorable manner. especially when it had contracts with them. potential profits. The Hershey Company established its original plant in south central Pennsylvania because large supplies of fresh milk were available there. Further.five- Please read pages 320-335 in the Strategy textbook for examples of applications of force analysis. differentiation. In contrast. business unit. of an industry. The best decision will position the firm to leverage strengths and defend against adverse effects of the five forces.” Collectively. the five forces model concentrates on five structural industry features that comprise the competitive environment. The model is a tool for managers to analyze competition in an industry in order to anticipate and prepare for changes in the industry. is analyzing the changing dynamics and continuous flux between and within the five forces. to be profitable. profit margins. and to enhance their firm’s overall industry standing. Monopsony receives less attention from economists than monopoly. Hershey soon became a near monopsony and exerted considerable market power over its many suppliers. Though the five forces model in regards to decision making is to collect. In sum. and industry volume. However. Strategies can be formed on there levels – corporate. some later students of strategy noted that Michael Porter seems to have regarded firms as primarily acting independently. it should be noted that the model does not cope with synergies and interdependencies within the portfolio of large corporations. The key to the success of an industry. when considered together. and functional or department level. the five forces affect prices. but it can be important. and competitive advantage. Porter identifies three generic strategies to address industry rivalry. and present data for the decision makers. these competitive forces determine long-term profitability within the specific industrial sector. the strength of each competitive force can vary from industry to industry. see the list of factors that affect the power of sellers and buyers on pages 338-339 of the Strategy textbook.
• • • • Assignment (Team) 1.• Cooperative price (see Lesson 5). or most.) to post your ideas. and high). Blu Ray) agreed on a technology for producing these products and producers of players subscribe to a complementary method for displaying content. Question 2 . Trade associations to which firms may contribute to promote government regulations. or legislation that favors all. Objective: This preliminary presentation is to help you develop an understanding of an industry structure and competitive forces with the focus on economic issues (threats and opportunities) operating in all of the firms within this industry. Note that this is a team assignment. VHS.. Choose one team member to finalize your team answers and submit them to the Lesson 01: Assignment (Team) 1. using Michael Porter’s five forces framework. In this initial presentation. which are cooperative arrangements among buyers and sellers. you should attempt to assess the most important features of the Home Furnishings & Housewares Retail (sub) industry. medium. as well as other innovations in supplychain management. Assignment (Team) 1. or another means of communication (conference call. HD DVD vs.1 drop box. low. The popularity of "just-in-time" product delivery. This is an example of cooperative behavior in which competitors worked in concert to enlarge their collective market rather than to enlarge individual shares of a stagnant market. of the association's membership. Check the due date for this assignment by viewing the Course Schedule. in preparation of Joint Project Task #1 in Lesson 05. group e-mails. and indicate the degree of effect of each competitive force (e. such as when producers of recorded programs (DVD vs. You and your team members should use your team's discussion forum.g. such as when meat packagers work with growers to develop better methods of production and handling. Submission: Your team leader will lead a discussion that will result in specific decisions. whereby firms tacitly settle on a uniform price to avoid price competition.1 The assignment is to learn how to prepare a PowerPoint Presentation of the five forces model. Cooperation by buyers and sellers to improve product quality. but will not be graded. etc. Set technology standards.2 Answer the following questions in your Economics of Strategy textbook: • Chapter 10.
2 drop box. Sheila wants to buy a pair of skis this October so that she can go skiing in Colorado in December. Your team must make decisions for the firm under a variety of alternative scenarios. The skis cost $500 (she is a serious skier). One team member is to be chosen to finalize your team answers and submit them to the Lesson 01: Assignment (Team) 1. to determine if the expected future cash inflows are sufficient to justify the initial outlay. To properly account for the timing of receipts and expenditures. Chapter 10 (pp. The reason is simple: The opportunity cost of receiving the $1 in the future is the forgone interest that could be earned were $1 received today. which is an opportunity cost. her friend Elliot asks her to lend him $500 so he can fix the furnace in his house before the cold winter weather. we must have a way to compare cash flows occurring at different points in time. group e-mails. etc. In other words.1. it is important to recognize that $1 today is worth more than $1 received in the future. The Time Value of Money Many business decisions involve benefits and costs that are expected to occur at different future points in time. however. managers must understand present value analysis. . The bank pays you interest as an incentive for you to give up your ability to spend your money for one year. This template provides specific questions for each of the five forces.) to post your ideas. 337-39) of the Strategy textbook. This opportunity cost reflects the time value of money. Thus. or another means of communication (conference call. How to Use Economic Costs in Decision-Making: Present Value [NOTE: Changing to a smaller font size as a subsection] Why do banks charge interest for loans? Why do banks pay depositors an interest rate for investments in certificates of deposit? To approach this issue. Before she makes her purchase.Objective: This is a team assignment. the bank covers your opportunity cost. In this instance. Your answer will be judged on the basis of your reasoning. For example. Check the due date for this assignment by viewing the Course Schedule. A Helpful Taxonomy You might wrap up your study of the five forces model by going over the template in Appendix 10. You and your team members should use your team's discussion forum. Submission: Your team leader will lead a discussion that will result in specific decisions. You give up the opportunity of spending this money. think about what you give up when you put your money into a bank CD for one year. the construction of a new production plant requires an immediate outlay of cash and results in a stream of expected cash inflows (benefits) over many future years.
the basic evaluation framework for the present value (PV) is PV = ∑ n πt t t = (1 + r ) 1 where r is the interest rate. How do you make rational calculations of opportunity costs when time is involved and we should. Given the stream of future profits. A slightly better grade of skis is priced today at $520.14 =) $570. Once the electronics firm commits its resources to the production of HD DVDs. revenues. She should get some compensation for waiting. Most business decisions relate to costs and revenues over time. your Adjusting Business Decisions for Risk: Net Present Value [NOTE: Changing to a smaller font size as a subsection] . Therefore. In the ski example. One way of rewarding her for waiting is to let her buy better skis next year. interest is paid to Sheila to compensate her for having to postpone her purchase. Elliot would have to pay Sheila an interest rate of at least 10% to compensate her for the expected inflation in the price of the skis. that 10% interest rate would give her the $550 she would need next year to buy the skis that cost $500 this year. we can say that to use a popular expression "time is money" in the investment and lending business. let us be fair to Sheila. it locks itself into a sequence of expenses. So.The sports-equipment dealer informs Sheila that these skis are going to cost $550 next year. and profits that may stretch out over years. πt. This would give her 10% to cover expected inflation and 4% for "waiting. the loan of $500 would be repaid next year by ($500 x 1." Interest is paid to investors to compensate them for the opportunity cost of their funds. see the equation and example of present value on page 21-23 of Strategy textbook. which is 4% higher than the $500 price for the original skis she wanted to buy. therefore. Before reading on. That means that Elliot would have to pay her back $550 in October of next year so that she can purchase the same pair of skis at that time. She would have to give up the satisfaction of having her skis for one year if she lends her money to Elliot. But. Elliot offers to pay Sheila an interest rate of 14%. The present value (PV) of an amount received in the future is the amount that would have to be invested today at the prevailing interest rate to generate the given future value. include the interest rate? The answer is a convenient concept called the present value (PV) of a sequence of money income over time.
NPV is a neat way to compare projects with different cash flows over time. Most investors are willing to accept greater risk only if there is the promise of greater returns when compared to an investment with less risk. there was only one relevant outcome of this decision. That is. the basic evaluation framework PV = ∑ n πt t t = (1 + r ) 1 is modified by using an appropriate risk-adjusted interest or discount rate for r. net cash flows for a high-risk investment would be discounted using a higher discount rate than would be used for a low-risk alternative. and. The discount rate is a convenient way of capturing this risk: the discount rate is proportional to the degree of riskiness. πt.e. For example. the interest rate is used to calculate PV or NPV and it is called the discount rate. That is because every project or resource commitment has its own unique likelihood of success and its own risks of failure. but it is doubtful that much confidence can be placed in such efforts. For example. Clearly. There may be no way to provide anything but some rough guesses about demand.. we label this sum the net present value (NPV). Specifically. If the sums represent revenues minus costs (i. the present value of a stream of dollars over time (costs or revenues) is the sum of money you need today that. Matching the risk of a business investment project to a specific financial asset is almost as hard as matching pairs of . there is more. However. There are degrees of success. such as a bond or stock or mutual fund that has equivalent riskiness. The result was a unique solution that maximized the firm’s profit. perhaps many. amounts of profit or loss.e. suppose that the typical return on an insured bank certificate of deposit is 10 percent per year. profits). there is no way to estimate the potential demand for it. The marketing department may undertake various market surveys in an attempt to estimate how many people might buy the product. They use the annual rate of return of that asset as their discount rate.. Alternatively. no rational investor will invest in very risky ventures higher than 10 percent per year. Given the stream of future profits. In decision making under uncertainty. the most common method is to use a risk-adjusted discount rate in determining the present value of the future profits associated with an investment. But. Because consumers have had no experience with the product. all relevant dimensions of the decision are known. decision making may be under risk. the outcome of a decision is not a dichotomy. The analysis of risk under this situation is based largely on the concepts of probability and probability distributions. outcomes of a decision. And. In evaluating various investments. Although there are several ways to incorporate risk into the decision process. NPV is based on both cash flows and on an interest rate. That is.Managerial decisions are made in different risk environments. i. the differential discount rates would be used to evaluate the present value of future profits. there are several. In the case of decision making under certainty. Financial analysts try to find a financial asset. The same discount rate is not appropriate for every project. if placed in an interest-earning bank account that pays an interest rate. All the relevant information was assumed to be known with certainty. but the probability of each of those outcomes occurring is unknown. a firm may be considering the production of a completely new product. would generate this same stream of funds. the selection of an appropriate discount rate is a complex business.
and. managers are required to analyze benefits and costs to make the best possible decision that leads to the best outcome. the decision maker faces uncertainty. net present value (NPV) is defined as NPV = ∑ n πt t t =1 (1 + r ) − C0 where πt is the net cash flow in period t (for each of n periods). The risk premium increases as the risk associated with the decision increases. selecting a discount rate is more of an art than science. This is an essential skill required of all managers in business. And the risk premiums (r* . In the basic net present value decision-making model. there is a positive relationship between these two factors. Marginal Analysis To make optimal decisions about various business activities. the risk-adjusted discount rate approach should be used in dealing with the risk associated with future cash-flow estimates. The greater the variation in those outcomes. the net cash flows for each project are discounted at a risk-adjusted rate. In iMBA 502. the former should have a higher discount rate. r*. when making long-term capital budgeting (investment) decisions. If the probabilities of the outcomes are not known. Clearly. Here in this course. But we can confidently say this: if Project A has more risk than Project B. rather than the firm’s cost of capital (r).r) applied to individual projects are commonly established subjectively. In short. An alternative method for adjusting for risk is to evaluate the certainty equivalent of a risky decision. r is the firm’s cost of capital. even though analysts may use sophisticated statistical methods to help them to do the job.people by a dating service! Like matchmaking. you will learn how to use this formula to find NPV and its applications. a decision maker faces risk when there are several outcomes associated with a decision and the probabilities of those outcomes are known. In the risk-adjusted discount rate approach. The net benefit (NB) associated with a specific amount of economic activity (A) is the difference between total benefit (TB) and total cost (TC) for the activity: NB = TB . The magnitude of r* depends on the risk of the project: the higher the risk. Co is the net investment. the higher the risk-adjusted discount rate. Hence. we simply provide you with the basic concept of the net present value without actually determining the NPV quantitatively. Managers need to choose the level of activity to obtain the maximum possible net benefit from the activity. An investment project is accepted if its NPV is greater than or equal to zero.TC . the greater the risk is likely to incur. but the relationship between them is strictly judgmental and must be made by individual decision makers. The most common method for compensating for risk when making decisions is to add a risk premium to the rate used to discount future profits. It should be emphasized that there is no equation or table that relates risk and the discount rate.
then the net benefit your firm receives from the activity will rise. the amount to spend on advertising. costs to fall by more than benefits. the number of workers to hire. in your everyday decisions. input choice. In these definitions. forms the basic foundation of the profit-maximization theory. There are two key elements of this methodology: marginal benefit and marginal cost. represents the choice variable. the production of an additional unit of output). A.It serves as the objection function to be maximized. and even consumer behavior. In most applications. alternatively. or. we will learn how to use a very simple. in some decisions. marginal cost is defined as the change in total cost arising from an incremental change in the level of an economic activity (e. this should cause no problem for applying marginal analysis.). It involves applying the fundamental principles of optimization theory in decision making. Marginal benefit is defined as the change in total benefit caused by an incremental change in the level of an economic activity. either up or down. probably without knowing it. as long as the activity can be adjusted in relatively small increments changed. In this section. to attain the best value for your firm. The Concept of Marginal Analysis [NOTE: Changing to a smaller font size as a subsection] Marginal analysis focuses on changes in economic variables and the results that occur directly from these changes. Marginal benefit and marginal cost can be expressed mathematically as M = B Change in Total Benefit Change in Activity = ∆ TB ∆ A and M = C C hange in Total C ost ∆ TC = Change in Activity ∆ A where the symbol "Δ" means "the change in" and A denotes the level of an activity. Under these circumstances. For instance. etc.g. you will continue adjusting the activity level until no further net gain is possible. But. This is the essence of marginal analysis. and. you would estimate how the change will affect both the benefits your firm will receive and the costs your firm will incur from engaging in this activity. the amount of activity. the amount of output to produce. If the change will cause benefits to rise more than costs. This analytical technique. you can think of incremental changes in activity to be any change that is small relative to the total level of activity. and.. yet powerful. it may be impractical to make changes as small as one-unit. . which means the activity has reached its optimal value or level. including some commonsense ideas and concepts that you already know and have applied. method for finding the optimal levels of business activities. referred to as "marginal analysis" by economists. in order to adjust a specific business activity (e.g.. it is convenient to consider an incremental change as a one-unit change. production.
. When a line is tangent to a curve. the slope of a curve at a point is unique and equal to the slope of the tangent line at that point. it touches the curve at only one point. only one line can be drawn tangent to the curve at a single point. as illustrated in Figure 1. Consequently. Hence. marginal benefit and marginal cost are also slopes of total benefit and total cost curves. The slope of a curve at any particular point can be measured by first constructing a line tangent to the curve at the point of measure and then computing the slope of this tangent line by dividing the "rise" by the "run" of the tangent line.3.Recall from your high school math classes or a pre-calculus course in college that "marginal" variables measure rates of change in corresponding "total" variables. respectively. For smooth. continuous curves.
We also note the following: Loss . and net benefit scaled in dollars on the vertical axis.quantity produced and sold) scaled on the horizontal axis. and the number of the management control variable (e. cost.g. with benefit. marginal cost (MC). cost. is graphed as the slope of the total cost (TC). and net benefit curves of microeconomic theory. and. is graphed as the slope of the total benefit (TB) curve. output . is graphed as the slope of the total benefit (TB) curve.Total B Benefits and Costs TB The figure shows typical benefit. Marginal benefit (MB). the change in total cost per unit change in the level of activity.. the change in total benefit per unit change in the level of activity.
then the values for A and B must satisfy two conditions at once: MBA = MCA and MBB = MCB. the slope of the total benefit function. The activity must then be increased (if MB > MC) or decreased (if MB < MC) to reach the highest net benefit. constructing tangent lines and measuring slopes of the tangent lines presents a rather tedious and imprecise method of finding marginal benefit and marginal cost curves. at a given level of activity. • This marginal analysis shows that if. when decision makers wish to maximize the net benefit from several activities. a small increase or decrease in activity causes net benefit to increase.3. The problem is somewhat more complicated mathematically because the manager will have to equate marginal benefits and marginal costs for all of the activities simultaneously. The optimal level of the activity (the level that maximizes net benefit) is attained when no further increases in net benefit are possible for any changes in the activity. if we draw a line tangent to the TB curve and another line tangent to the TC curve. then this level of the activity is not optimal. When the level of activity is greater than Q1 and less than Q2. Indeed. At this level of activity. For example. marginal cost. that is to say. the marginal benefit and marginal cost curves can be obtained without drawing tangent lines as follows: MB = d (TR ) d ( PQ D ) = dQ D dQ D . However. MB = MC. Outputs below Q1 or above Q2 result in a negative net benefit.1 by presenting the relation between marginal benefit. or marginal benefit (MB). Using the marginal benefit and marginal cost curves in Figure 1. At this level of activity. positive net benefits result. is zero. if the decision maker chooses the levels of two activities A and B to maximize net benefit. we can summarize the logic of marginal analysis in Table 1. This means that at a Qm level of activity.• At activity levels Q1 and Q2.1 Marginal Analysis Decision Rules MB > MC Increase Activity Decrease Activity NB rises NB falls MB < MC NB falls NB rises The preceding discussion of unconstrained optimization has allowed only one activity or choice variable to influence net benefit. the slopes of the two curves are equal. Table 1. precisely the same principle applies. so net benefit is zero. and net benefit set forth in the above discussion. TB is just equal TC. The firm maximizes net benefit when the marginal benefit from each activity equals the marginal cost of that activity. by applying the technique of differential calculus (if you still remember it). However. which occurs at the activity level for which MB = MC at Qm. it can be seen that these lines are parallel.
MC = d (TC ) d (TVC + TFC ) = dQ D dQ D Note that the calculus used in this course requires no more than the ability to take a first derivative or partial derivative of a function. Long-term investment decisions also are made using marginal analysis decision rules. is a family-operated enterprise that sells its products in a purely competitive market in which the market sets the price. The market price is $20 per decanter. but it is not required of this knowledge in this course. If the expected return from an investment project exceeds the marginal cost of capital that must be acquired to finance the project. you should have little difficulty with the theories that are developed later in the course. Questions: a. Illustrative Problem Hershey Crystal Products.000 .5Q + 0. What is Hershey Crystal's maximum profit per week? Solutions: . in the marginal analysis framework. The crystal wine decanter Hershey Crystal produces has enjoyed its popularity for many years in the United States. Inc. Now. The formulas for these operations can be found in Appendix A. What is Hershey Crystal's profit-maximizing output per week? b. If you thoroughly understand these important marginal decision rules and concepts. Managers must determine the additional costs and additional benefits associated with a proposed action. resource-allocation decisions are typically made by comparing the incremental (marginal) benefits of a change in the level of an activity with the incremental (marginal) costs of the change.05Q2 where Q denotes the number of crystal wine decanters produced per week. Understanding this logic enables managers to make better decisions while avoiding some common types of business decision errors. Only if the marginal benefits exceed the marginal costs should the action be taken. A change in the level of an economic activity is desirable if the incremental benefits exceed the incremental costs. let us learn more about the marginal analysis technique using the following example. The vice president of marketing at Hershey Crystal has estimated that the cost function for its crystal wine decanter is TC = 1. and the level of the economic activity should be increased to the point where the difference between marginal benefits and marginal costs is zero. The profit-maximization rule for the firm of setting output at the point where "marginal cost equals marginal revenue" is one such example. In sum. and TC denotes the total cost of production per week. then the project should be undertaken. This reasoning forms the fundamental logic for optimal decision making in business.
Hopefully.10Q Q* = 250 decanters per week Note: The asterisk indicates that this particular value of Q is optimal. As we learn in this lesson.10 Q = 0 dQ Solve for Q* = 250. you are beginning to feel comfortable thinking like an economist.a. arranged by product market. b. a good starting point might be the following web site: http://www. That is.000 . Based on our discussion above.000 .5(250) + 0.05Q2 At optimum.5Q + 0. Lesson 01 Bookmarks An important prerequisite for the five force analysis is identification of the firms that constitute the market the firm is in.05(250)2] = $2. TR = PQ = 20Q TC = 1.TC.000 . Hence.[1.10Q MR = MC 20 = -5 + 0.TC = PQ .05Q2 dπ = 25 − 0.5Q + 0.gomez.0. MC is the first derivative of the TC function. MR is the first derivative of the TR function. The next step is to identify the elements of differentiation and the sources of firms' market power. When accessing this site you are given a choice of product groups. setting it equal to zero. you can move onto Lesson 2. That's it for Lesson 1! Now you have learned the economic way of thinking and the business environment in which the firm operates. what do customers look for when comparing sellers and how do the firms compare with one another? With respect to e-commerce. i.000 + 25Q . the specific competitors that occupy the market.5Q + 0. The same result can be obtained by taking the derivative of the profit function. profit is maximized when MR = MC. as above. for major firms that sell goods or services online.com/ This site provides consumer guides..TC = PQ .[1.. π = 20Q .e.125 per week.05Q2] = -1. profit (π) = TR . each of . i.[1. and and MR = 20 MC = -5 + 0.05Q2] = 20(250) .000 . Profit (π) = TR . When you are ready. and solving for Q*.e.TC = 20Q . Q* is the optimal output that maximizes the profit.
Click on a specific firm's name and look at an analysis of that firm. .which has a link. This analysis provides useful information on how these firms compete. including strengths and weaknesses. Each firm has a link to an in-depth analysis.
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