Managerial Economics and Organizational Architecture

Instructor’s Manual

CHAPTER 8

ECONOMICS OF STRATEGY: CREATING AND CAPTURING VALUE

This chapter is the first of two chapters on strategy. It concentrates on the basic
ways firms can create and capture value. Chapter 9 uses game theory to study strategic
interactions among a small number of identifiable rival firms. Chapter 8 presents a
framework for discussing how firms create value. It also discusses the conditions under
which a firm can capture value (either by having market power or, in certain cases,
having superior factors of production). The economics of diversification are examined,
and a framework for strategy formulation is presented. A mini-case (Wal-Mart.com)
highlights some of the issues in the chapter. Most managerial economics books focus on
a very limited set of decisions (for example, pricing, input selection and output), taking

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the market product, and its characteristics, as given; they also assume that a firm
produces only one product. This chapter uses basic economic principles to analyze a

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broader set of corporate policies.

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CHAPTER OUTLINE

STRATEGY
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VALUE CREATION
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Production and Producer Transaction Costs

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Consumer Transaction Costs

Other Ways to Increase Demand
New Products and Services
Cooperating to Increase Value
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Converting Organizational Knowledge into Value

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Opportunities to Create Value

CAPTURING VALUE
Market Power
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Superior Factors of Production

A Partial Explanation for Wal-Mart’s Success
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All Good Things Must End

ECONOMICS OF DIVERSIFICATION
Benefits of Diversification
Costs of Diversification
Management Implications

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STRATEGY FORMULATION
Understanding Resources and Capabilities
Understanding the Environment
Combining Environmental and Internal Analyses
Strategy and Organizational Architecture
Can All Firms Capture Value?
CASE STUDY: WAL-MART.COM
SUMMARY

TEACHING THE CHAPTER

We begin by defining strategy and discussing the objective of making profits by

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devising ways to create and capture value. We use Figure 8.1 to structure our discussion

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of value creation, and also discuss how value can sometimes be created through

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cooperation with other firms and customers.

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We discuss how creating value is not a sufficient condition for profits; the firm

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also has to capture value. In class we talk about PARC (Palo Alto Research Center of
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Xerox) and the many inventions they made (such as the computer mouse) but on which
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they failed to capitalize. The subsequent discussion is structured on capturing value by
organizing it around market power and superior factors of production. We begin with
Porter’s five forces and give examples of how firms have tried to capture value by
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increasing market power through taxes, import restrictions, etc. on competitors.

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Our discussion then turns to superior factors of production, indicating that this
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concept has been a primary focus in contemporary thought on strategy. Students

typically need help with the analytics showing how superior assets capture producer
surplus (Figure 8.4). We work through the Arco example in the chapter. Subsequently,
we talk about second-priced auctions and team capabilities. The students are asked
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whether (as some consultants suggest) all firms have special abilities that will allow them
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to make economic profits. We indicate that the answer is no. We end the discussion with
Figure 8.5, which presents a framework for strategic planning.
It is important to use a case to emphasize the concepts in this chapter. An
excellent case for discussing the implications of competition, short-run versus long-run
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competitive equilibrium is Growth and Profitability: A Tale of Two Competitive

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Industries by B. Peter Pashigian, available from CASENET. We also often use the mini-
case at the end of the chapter (Wal-Mart.com), or sometimes we use the HBS case on
Wal-Mart (Wal*Mart Stores, Inc., Harvard Business School Case #9-794-024). Many
other options are available. A good case discussing the economics of diversification is
Goodyear Restructuring (Harvard Business School Case #9-288-046). An instructor
wanting to spend more time on Porter’s “five forces” can supplement the material with
“Note on the Structural Analysis of Industries” by Michael E. Porter (Harvard Business
School Case #9-376-0543).
When this chapter is used in our organizations class, we emphasize the link
between organizational architecture and strategy highlighted in figure 11.1. (Typically,
in the organizations class this chapter is assigned during the second half of the course —

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after students read through chapter 17.) We stress how the architecture must fit the
strategy, how sometimes architecture can lead to a competitive advantage (it can be
difficult to copy another firm’s architecture), and how knowledge and incentive issues
arise in assigning decision rights on strategic planning within firms.

CASE STUDY
WAL-MART.COM1

Conventional wisdom holds that to succeed in electronic commerce, you have to

get in early. But in late 1999, Wal-Mart decided to challenge that most sacred of web
rules. After several years of tinkering with its web site, watching while others broke new
Internet ground, the retailing giant was ready to flex some cyber muscle. Up to that
point, Wal-Mart.com had realized modest success online, ranking forty-third among

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Internet shopping sites according to Media Metrix. It trailed web pioneers like eBay and

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Buy.com. For example, in May 1999 Amazon.com greeted almost 10 million online

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visitors; Wal-Mart.com saw only 801,000. For 1999, analysts expected Wal-Mart’s e-

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commerce activities to produce sales of less than $50 million out of the company’s total
sales of $157 billion.

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The company announced plans to expand its online store offerings before the end
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of 1999 to match more closely the breadth of its traditional outlets. To facilitate this
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expansion, Wal-Mart had penned deals with Fingerhut Business Services and Books-a-
Million. Both had expertise in distributing individual orders directly to customers’
homes—quite a different set of skills from bulk shipments, which had been Wal-Mart’s
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Wal-Mart has done this before. When preparing to enter the grocery business
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with its initial super-centers, it scouted the competition and than signed deals with
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wholesalers to do much of the support work. As it worked through the details of its
operating plan, Wal-Mart brought this work in-house and became a formidable
competitor. It planned to implement the same approach online. “This process is not new
for us as we begin new businesses,” said Senior Vice-President Glen L. Hobern, the
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leader of Wal-Mart’s e-commerce efforts.

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Wal-Mart is facing direct competition from Amazon.com; in July 1999, Amazon

announced its expansion from books, music, and videos into toys and consumer
electronics. Wal-Mart already has become a powerhouse in these product categories
through its traditional stores. It announced that it is planning to offer products from all
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25 categories that are carried in a typical Wal-Mart discount store. Moreover, it expected
to offer a broader array of higher-priced items than its traditional stores—for instance,
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DVD players and digital cameras. Moreover, customers would be able to return products
ordered online to any of Wal-Mart’s 2451 U.S. discount stores. Like Amazon, it planned
to provide tailored online specials to match the shopping habits of its repeat customers.
Demographic shifts that have been occurring in cyberspace offer the potential to
help Wal-Mart. According to research from Jupiter Communication, e-commerce is
expected to continue to grow from approximately $12 billion in 1999 to an estimated $41
billion in 2002. Much of this expansion would be concentrated in Wal-Mart’s existing
lower- and middle-class customer base. Jupiter analyst Kenneth R. Gasser noted,
“Internet users are increasingly coming to resemble the population at large.”

1
Source: W. Zellner (1999), “When Wal-Mart Flexes Its Cybermuscles,” Business Week (July 26), 82.

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Discussion Questions:

Placing yourself back in 1999, answer the following questions in a well-

developed discussion:

1. What is the impact of Wal-Mart.com on customer-borne transaction costs?

Introducing Wal-Mart.com should lower customer-borne transaction costs

by giving them an additional channel to purchase products — via the web.
For those customers using this channel, their search and information costs
about products are lower. They also save time and expense of driving to a
store to buy the products. And, these search costs are directly related to
income. High-income individuals have a higher opportunity cost of their time
and thus tend to have higher search and information costs.

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2. Do you think that Wal-Mart.com is likely to create additional value?

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Wal-Mart.com creates value by reducing customers’ costs of a physical
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shopping experience and the information and search costs incurred when
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deciding which products to buy. Wal-Mart.com also creates value by
capturing economies of scope by more intensively using its existing
distribution channel. For example, existing regional warehouses can carry
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items that individual stores find it unprofitable to stock. Providing on-line

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terminals in the stores would allow customers to purchase these items and
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have them shipped directly to their homes. Alternatively, these items can be
accessed directly from the Internet.
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3. Is it likely that Wal-Mart will capture any value created by Wal-Mart.com?

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Wal-Mart captures the value created by Wal-Mart.com if other firms cannot

emulate the Wal-Mart strategy. If existing .com retailers, such as
Amazon.com, can do it cheaper than Wal-Mart, Wal-Mart will capture little,
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if any, of the value. One potential problem faced by traditional bricks-and-

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mortar retailers such as Wal-Mart and Sears involves local sales taxes. Some
states are claiming that on-line sales in that state must be charged sales tax if
the on-line company has a retail store in the state (especially if the consumer
has the right to return merchandise to the retail store). If these states are
successful at collecting sales taxes from Wal-Mart.com customers, Wal-Mart
will find it more difficult to capture value from Wal-Mart.com because
Amazon.com customers are not subject to these sales taxes (assuming the tax
laws facing Amazon.com are not changed as well).

4. Should Wal-Mart have pursued e-commerce more aggressively sooner?

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It is not obvious that Wal-Mart should have pursued e-commerce vigorously

prior to 1999. Few consumers were on-line prior to 1999, and those that were
on-line tended to be more affluent (not the typical Wal-Mart customer). Note
that a potential disconnect exists between Wal-Mart’s traditional customer
base (mid to lower income families) and the higher income consumer who
can afford the hardware, software, and connectivity services required to be
on-line. Until the cost of getting connected falls to the point that traditional
Wal-Mart shoppers are on-line, or public access to the internet through
institutions like local libraries becomes broader, investing a lot to create Wal-
Mart.com may not be warranted even now.

5. What do you think the potential impact of Wal-Mart.com will be on the

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company’s efforts to expand internationally?

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On-line, e-commerce businesses jump international borders very quickly. An

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e-commerce strategy might give Wal-Mart the ability to enter international

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markets more quickly and less costly than a bricks-and-mortar store that
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generates conflicts involving domestic, Byzantine bureaucratic regulations
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which protect local retailers. Local domestic retailers can erect more barriers
to entry for bricks-and-mortar competitors than for e-commerce
competitors.
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REVIEW QUESTIONS

8–1. Choose a company that markets computer products over the Internet (for example,
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through a web search). In what ways does the company create value? Is it likely
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to capture much of this value? Explain.

The answer to this question depends on the example developed by the

student. Internet companies often create value by reducing transaction costs.
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In discussing the potential to capture value, the student should focus on the
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effects of competition and whether this is likely to reduce the ability of the
firm to capture profits.

8–2. Airbus and Boeing are two major producers of jumbo jets. Are these firms
guaranteed to make high profits since there are only two large firms in the
industry? Explain.

No. Even if there are only two firms in the industry, they may compete
vigorously to reduce prices and profits. This issue is discussed in more detail
in chapter 6, and in particular in chapter 9 (on game theory).

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8-3. The Watts Brewing Company owns valuable water rights that allow it to produce
better beer than competitors. The company sells its beer at a premium and reports
a large profit each year. Is this firm necessarily making economic profits?
Explain.

No. Its advantage is that it owns a valuable but marketable asset. The firm
may be only making normal profits given the opportunity cost of keeping the
water rights itself rather than selling them to others in the marketplace. The
company is more valuable because it owns the water rights. However, selling
the rights to others might be the best way to capture this value.

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8–4. What are team capabilities? Give examples of firms that appear to have them.

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Because of the interdependencies among workers and assets, the value of the

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inputs as a “team” can sometimes be greater than the simple sum of the

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values if each worker and asset were employed at its next best use across
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other firms. Thus, it is possible that the overall firm will be more valuable
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than the sum of its parts. We characterize such a firm as having team
production capabilities. Sharp is an example from the book. Many other
examples exist.
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8–5. Sun Resorts has a hotel on a Caribbean Island. It recently spent money to lobby
the government to build a better airport and expand air service. Why did they do
this? Do you think that Sun Resorts cares about how many airlines will serve the
island? Explain.
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Airline service is a complement for Sun Resorts. Cheaper air service to the
island increases the demand for Sun Resorts. Thus, Sun Resorts wants better
airport service and lower airfares. Lower fares are more likely to result if
there are several airlines that compete in serving the island. These concerns
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are clearly important to Sun Resorts.

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8–6. Evaluate the following statement: “Business is war. Never consort with the
enemy.”

Cooperating with competitors can sometimes create value. An example is

Kodak and Fuji cooperating to adopt a common standard for the Advanced
Photo System. Managers should consider possible cooperation with
suppliers, customers, regulators, competitors, etc. in thinking about ways to
create value. Also, while certain practices are illegal in certain countries,

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firms can sometimes capture value by cooperating to increase monopoly

power (e.g., forming a cartel).

8–7. The Long-Drive Golf Company manufactures a new line of golf clubs. The
Cushion Bag Company makes a special golf bag that protects the delicate shifts
on these clubs. The respective prices are Pc and Pb for the clubs and bags. The
marginal cost for producing either product is 100. Demand for each product is

Q = 1000 – (Pc + Pb) when Pc + Pb is 1,000 or less, 0, otherwise

How will the two companies price the products if they do not cooperate? What
are the resulting quantities and profits? What are the prices, quantities, and
profits if the two companies price cooperatively? Explain why there is a

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difference.

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In the noncooperative situation, each firm will take the other firm’s price as

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given. Demand for each firm is given by Pj = (1000 – Pi*) – Q, where Pi* is

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the expectation of the other firm’s price. Setting marginal revenue equal to
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marginal cost of 100 yields an optimal quantity for each firm of Q = 450 - .5
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Pi*. Substituting the overall demand curve (Q = 1000 – (Pj + Pi)) yields the
following reaction curve for each firm: Pj = 550 – 0.5Pi. In equilibrium, both
firms set the same price (since the problem is the same for both firms). The
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resulting prices are $367 each for the clubs and the bags. The firms sell 267
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bags and 267 sets of clubs. Profits are $71,201 for each firm. Note that the
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answers might vary slightly due to rounding. If the firms price collectively,
they will use the combined demand curve PT = 1000 – Q, where PT is the
combined prices of the two products. The marginal cost of producing the
combination is 200. Setting marginal cost equal to marginal revenue yields a
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combined price of $600 (e.g., $300 for the bags and clubs, respectively). A
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total of 400 sets of clubs and bags are sold. The combined profits are
$160,000, which is greater than the combined profits under independent
pricing of $142,402. In the noncooperative situation each firm fails to
consider the negative effect that raising its own price has on the other firm’s
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demand and profits. In cooperative pricing these cross effects are taken into
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account. This accounts for the difference in the outcome.

8–8. One CEO justified the merger of his soft-drink company with a machine tool
company in the following manner: “This is a great merger. First the products are
unrelated. Thus our company’s earnings volatility is likely to decrease. Second,
our management team has proved that we are better managers than the former
management team of the tool company, and thus we are likely to discover new
ways to create and capture value within the tool company.” Evaluate this
rationale.

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It is true that the merger might reduce earnings volatility. However,

shareholders can diversify on their own by buying shares in the two
companies. Thus, it is not obvious that the merger of the two companies
creates value (which is likely to involve higher transaction costs than simply
having investors buy the shares on their own). While the company’s
management team may be good in their industry, it is not obvious that they
will have an advantage in competing in an unrelated industry. They are more
likely to be able to exploit any special talents they have in a related business.

8–9. Pepsi produces Fritos and Lays potato chips in addition to its basic soft-drink
products. Discuss potential ways that this business combination might increase
value.

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There may be economies of scope, such as in jointly marketing the products

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through Pepsi’s marketing channels (they are related products and sold to

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many of the same customers). Also, the products are complements and Pepsi

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can take this into account in their pricing.

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8–10. The Strippling Drug Company has just obtained an important patent for a new
drug that increases male virtility and cures male pattern baldness at the same time.
Does this imply that Strippling has a competitive advantage in producing the
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drug? Explain.
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No. It might be better off for the company to sell the patent to another
company that has more experience and scale for producing the new drug.
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