WEEK 1 // CHAPTER 1 – What is Strategy and the Strategic Management Process?

Strategy – to gain competitive advantages; generates advantages

Example: Pokemon Go >> product differentiation strategy
*The more accurate assumptions and hypotheses of a competition, the more competitive advantage
from implementing strategies
*Firm’s strategy = a theory; best bet

Strategic Management Process – a sequential set of analyses and choices that increases the
chances of a firm to choose a good strategy (which will generate a competitive advantage)

Mission > Objectives > External and Internal Analysis > Strategic Choice > Strategy Implementation
> Competitive Advantage

Mission – long-term purpose; what a firm aspires to be in the long run and what it wants to avoid;
written sa mission statements; can and can’t improve firm performance, can hurt firm performance
Mission statement – creates value for a firm, say something unique about a company, should
influence behaviour in the organization (example when a company is engaged in fraud, what should
be on the mission statement is about honesty and integrity); should not affect a firm’s performance
Objectives – specific measurable targets that a firm can use to evaluate the extent to which it is
realizing its mission
a. High-quality objectives – connected to elements of a firm’s mission and easily measured
b. Low-quality objectives – not quantitative and difficult to measure and track overtime; cannot
used by management to evaluate
External analysis – threats and opportunities; how competition in the environment evolves
Internal analysis – helps a firm identify its organizational strengths and weaknesses; helps firm
determine which resources and capabilities can be used for competitive advantages and which are
less likely; determine areas of organization that need improvement and change
Strategic choice – when a firm is ready to choose its theory of how to gain competitive advantage;
can be complex
a. Business-level strategies – actions firms take to gain competitive advantages in a single
market or industry
b. Corporate-level strategies – actions taken to gain competitive advantages by operating in
multiple markets or industries simultaneously

When choosing a strategic choice:

1. Supports the firm’s mission
2. Consistent with the organization’s objectives
3. Exploits opportunities in a firm’s environment with a firm’s strength
4. Neutralizes threats in a firm’s environment while avoiding a firm’s weaknesses

Strategy implementation – happens when a firm adopts organizational policies and practices that
are consistent with its strategy
Three specific organizational policies and practices are particularly important in implementing a
strategy:
1. Firm’s formal organizational structure
2. Formal and informal management control system
3. Employee compensation policies

Competitive Advantage – when it can create more economic value than rival firms
Economic value – the difference between what the customers are willing to pay for a firm’s product
or services and the total cost of producing these products and services
*Size of the competitive advantage of the form is based on the difference between the economic
value a firm can create, and the economic value of its rival can create

Types of Competitive Advantage

1. Competitive advantage – firm’s economic value > rival’s
a. Temporary competitive advantage – comp advantage that lasts for a very short time
b. Sustained competitive advantage – can last much longer
2. Competitive disadvantage – firm’s economic value < rival’s
a. Temporary competitive disadvantage – comp disadvantage that lasts for a very short
time
b. Sustained competitive advantage – can last much longer
3. Competitive Parity – firm’s economic value = rival’s economic value

Organizing Framework

Measuring Competitive Advantage (2 Approaches)

1. Examining accounting performance – calculated by using info from a firm’s published
profit and loss and BS statements (uses GAAP and standards); can be hard to measure
especially when firms are in different countries around the world; easy to compute
 Accounting ratios – numbers taken from a firm’s financial statements that are
manipulated in ways that describe various aspects of a firm’s performance
i. Profitability ratios
ii. Liquidity ratios – ability to meet short term obligations
iii. Leverage ratios – level of a firm’s financial flexibility (ability to obtain more
debt)
iv. Activity ratios – level of the activity in a firm’s business

Business Model – approach that identifies activities that affects the ability of a firm to create
economic value and then specifying exactly how a particular firm accomplishes these activities
Business model canvas – enable managers to see the entire landscape of their business in a
single page
 Value propositions – middle of the canvas; states how the firm will attempt to create value for
its customers; close to identifying strategy
 Key activities – firm needs to engage in
 Key resources – firm needs to control to engage in the activities ^^
 Key partners – firm needs to gain to access the resources ^^
 Customer relationships
 Channels – firm needs to use to reach critical customers
  Customer segments – a firm will address with its product or services
 Cost structure
 Revenue streams

Above-average accounting performance – performance > industry average

Average accounting performance – performance = industry average
Below-average accounting performance – performance < industry average; firms experience
competitive disadvantages

2. Economic measures of competitive advantage – compare a firm’s level of return to its

cost of capital instead of to the average level of return in the industry

Two categories of sources of capital:

1. Debt (capital from banks and bondholders)
2. Equity (capital from individuals and institutions that purchase a firm’s stock)

WACC - % of a firm’s total capital

*A firm that earns above its cost of capital is likely to be able to attract additional capital because
debt holders and equity holders will scramble to make additional funds available for this firm.

Above-normal economic performance – firms with competitive advantages; firm that earns above its
cost of capital
Normal economic performance – firm that earns its cost of capital; normal because this is what
equity and debt holders expect; growth opportunities are limited; firms with competitive parity
Below-normal economic performance – firm that earns less than its cost of capital; process of
liquidating

Stakeholders – suppliers, customers, employees, community within which it does business

Residual claimants view – equity holders only receive payment on their investment in affirm after
all legitimate claims by a firm’s other stakeholders are satisfied

*firm’s equity holders, in this view, only receive payment on their investments after the firm’s
employees are compensated, its suppliers are paid, its customers are satisfied, and its obligations to
the communities within which it does business have been met.

Emergent vs. Intended Strategies

Emergent strategies – how to gain competitive advantage in an industry that emerge overtime or
have been reshaped once they are implemented

Three reasons why you need to know about strategy and the strategic management process:
1. Gives you tools to evaluate the strategies of firms that may employ you
2. Understanding the firm’s strategies and your role in implementing those strategies
3. As an employee, you can be involved in the strategic management process/ team

WEEK 2 // CHAPTER 2 – Evaluating a Firm’s External Environment

Understanding a Firm’s General Environment

1. Demographic trends – distribution of individuals in a society in terms of age, sex marital
status, income, ethnicity that can determine buying patterns (e.g. baby boomer – buy now
pay later)
 2. Cultural trends – values, beliefs, and norms that guide behaviour in a society >> define what
is “right and wrong”/ “acceptable and unacceptable”
3. Economic climate – overall health of economy systems where firms operate (recession – low
economic activities and depression – recession that lasts for several years)
4. Legal and political conditions – laws and legal system’s impact on business
5. Specific international events – events such as civil wars, political coups, terrorism, wars
between countries, famines, and country or regional economic recessions
6. Technological change – explore to create new products and services, and threats, as
technological change forces firms to rethink their technological strategies

Structure-Conduct-Performance Model of Firm Performance

S-C-P model
– suggests that industry structure can influence a firm’s competitive choices;
– objective of this is to describe conditions under which competition in an industry would not
develop;
– where social welfare is not maximized;
– assumes that any competitive advantages a firm has in an industry must hurt/ affect the
society
– S (structure) refers to industry structure: number of competitors in the industry,
heterogeneity of products in the industry, the cost of entry and exit
– C (conduct) refers to the strategies that the form implements to gain competitive advantages
– P (performance) has 2 meanings: 1) the performance of individual firms and 2) the
performance of the economy as a whole

*competitive are actually good for social welfare because firm addresses customer needs more
effectively than its competitors

*society is better off when industries are very competitive

Perfectly competitive – large numbers of firms are operating in an industry, low product
differentiation, not costly to enter or exit an industry

A Model of Environmental Threats

Environmental threat
– any individual, group, or organization outside a firm that seeks to reduce the level of that
firm’s performance
– increase costs, reduce revenue, or reduce the firm’s performance
– in S-C-P term, they are forces that tend to increase the competitiveness of an industry and
force firm performance to competitive parity level

*relationship between environmental threats and S-P-C model = the relationship of the threats and
the nature of competition in an industry

1. New competitors – motivated to enter an industry because of superior profits that some
firms are currently earning or can earn in the future

 if all 5 threats are high then there is perfect competition; if low, then industry
approaches monopoly
a) perfectly competitive – large numbers of competitive firms, products are the
same with respect to cost, and entry and exit costs are very low
b) monopolistically competitive – large numbers of firms, products are not the same,
entry and exit costs are low
 c) oligopolies – small number of competing firms, homogenous products, cost of
entry and exit is high
d) monopolistic industry – only one single firm, entry is costly

 4 important barriers to entry

a) economies of scale – firms’ cost fall as a function of its volume of production
b) product differentiation – incumbent firms possess brand identification and
customer loyalty that potential new competitors do not
c) cost advantages independent of scale -proprietary technology, managerial know-
how, favourable access to raw materials, and learning-curve cost advantages
d) government policy

2. Existing competitors – reduce the firm’s economic profits

 Attributes that increase direct competition

a) Large number of competing firms
b) Slow industry growth
c) Lack of product differentiation
d) Capacity added in large increments

3. Substitute products – meet approximately the same customer needs, but do so in different
ways

4. Supplier leverage – they make a wide of variety of raw materials, labor, and other assets
available to firms; can threaten a firm by increasing the price of their supplies or by reducing
the quality of those supplies

 Indicators of the threat of supplier leverage in an industry

a) Supplier’s industry is dominated by small number of firms
b) Suppliers sell unique or highly differentiated products
c) Suppliers are not threatened by substitutes
d) Suppliers threaten forward vertical integration (forward vertical integration –
suppliers cease to be suppliers only and become suppliers and direct
competitors)
e) Firms are not important customers for suppliers

5. Buyer’s influence – they act as to decrease a firm’s revenues

 Indicators of the threat of buyer’s influence in an industry

a) Number of buyers is small
b) Products sold to buyers are undifferentiated and standard
c) Products sold to buyers are significant percentage of a buyer’s final costs
d) Buyers are not earning significant economic profits
e) Buyers threaten backward vertical integration (buyers become both buyers and
direct competitors)

Industry Structure and Environmental Opportunities

 Network industries - exist when the value of a product or service that is being sold
depends, to a great extent, on the number of these products or services being sold

Winner take all strategies - a firm is an early mover in a network industry and builds large
market share quickly it may obtain an almost unassailable advantage
 Empty core industries – exist when 4 conditions are present: and there is no stable profit
making equilibrium.
1. Capacity in the industry is added in large increments
2. There are large unavoidable sunk costs associated with adding extra capacity
3. Demand fluctuates in difficult to predict ways
4. There is limited product differentiation

Cut throat competition – when the maximization of profit decisions of a firm generates
economic losses

 Opportunities in empty core industries

a) Can change technologies
b) Demand management – making demands more predictable (plane tickets)
c) Can find alternative bases of product differentiation which can enable them to
increase their prices
d) Can try to collude
e) Can seek government regulations
f) To keep prices above a cut throat level

 Fragmented industries - a large number of small- or medium-sized firms operate and no

small set of firms has dominant market share or creates dominant technologies

Consolidation strategy - strategy that reduces the number of firms in an industry by

exploiting economies of scale

 Emerging industries - newly created or newly re-created industries formed by technological

innovations, changes in demand, the emergence of new customer needs, and so forth

First-mover advantages – advantages that come to firms that make important strategic and
technological decisions early in the development of the industry
Can arise in 3 primary sources:
1. Technological leadership – firms may obtain a low-cost position based on their
greater cumulative volume of production with a particular technology and may
obtain patent protections that enhance their performance
2. Pre-emption of strategically primary valuable assets – resources required to
successfully compete in an industry
3. The creation of customer-switching costs – exist when customers make
investments in order to use a firm’s particular products or services

 Mature industries – includes:

1. Slowing growth in total industry demand
2. Development of experienced repeat customers
3. A slowdown in increases in production capacity
4. A slowdown in the introduction of new products or services
5. Increase in the amount of international competition
6. Overall reduction in the profitability of firms in the industry

Opportunities: Refining current products, emphasis on service, process innovation

 Declining industries - an industry that has experienced an absolute decline in unit sales
over a sustained period of time

Opportunities: Market leadership, market niche, harvest, divestment

WEEK 3 // CHAPTER 3 – Evaluating a Firm’s Internal Capabilities

The Resource-Based View of the Firm

Resources – defined as the tangible and intangible assets that a firm control so I can use to
conceive and implemented strategies

Capabilities - tangible and intangible assets that enable a firm to take full advantage of the other
resources it controls

Four categories of a firm’s resources and capabilities:

1. Financial resources – money; Retained earnings – profit the firm made earlier
2. Physical resources – physical technology
3. Human resources – training, experience, judgement, intelligence, relationships, and insights
4. Organizational resources – attribute of groups of individuals

Assumptions of the RBV

1. Resource heterogeneity - for a given business activity, some firms may be more skilled in
accomplishing this activity than other firms
2. Resource immobility

The VRIO Framework

VRIO framework -stands for four questions that must be asked about the resources and capabilities
to determine the firms’ competitive potential

1. The question of Value: “Do resources and capabilities enable a firm to exploit an external
opportunity or neutralize an external threat?”
Yes: resources and capabilities are strengths
No: resources and capabilities are weaknesses

Value chain - is the set of business activities in which it engages to develop, produce, and
market its products or services

A – suggests that the creation of value almost always includes 6 distinct activities:
 2. The Question of Rarity: “How many competing firms already possess particular valuable
resources and capabilities?”

3. The Question of Imitability: “Do firms without a resource or capability face a cost
disadvantage in obtaining or developing it compared to firms that already possess it?”

Forms of Imitation:
 Direct duplication
 Substitution

Sources of costly imitation:

 Unique historical conditions
 Casual ambiguity
 Social complexity
 Patents

4. The Question of Organization: “Is a firm organized to exploit the full competitive potential of
its resources and capabilities?”

- formal reporting structure (where does the organization report to?); management
control system (making sure managers are behaving along the business’ strategies);
formal management controls (budgeting and reporting activities to people higher in firm
being informed about what the lower people’s actions); informal management control
(employees monitoring each other’s behaviour); compensation policies (incentive to
employees base on their behaviour)

WEEK 4 // CHAPTER 4 – Cost leadership & CHAPTER 5 – Product Differentiation

Business-level strategies – often called “generic business strategies”

1. Cost leadership
2. Product differentiation
3. Flexibility
4. Collusion

Cost Leadership business strategy – reduce cost below competitors to gain advantage

Sources of Cost Advantages:

1. Size difference and economies of scale
– economies of scale exist when the increase in firm size (volume of production) is
associated with lower costs (cost per unit of production) (increase, decrease
respectively)
Higher production volume = lower costs?
1. Firms can use specialized machine
2. Firms can build larger plants – 2/3 rule
3. Firms can increase employee specialization
4. Firms can spread costs across more units produced

2. Size difference and diseconomies of scale

– If production volume rises beyond the optimal point >> increase in per-unit cost
 Sources of diseconomies of scale:
1. Physical limits to efficient size
2. Managerial diseconomies
3. Worker de-motivation – relationship between firm size, employee specialization, and
worker motivation
4. Distance to markets and suppliers can increase per-unit costs – transportation costs

3. Experience differences and learning-curve economies

– Learning curve: relationship between cumulative production volumes and per-unit
costs; similar to the concept of economies of scale
– First firm that successfully moves down the learning curve will obtain a cost advantage
over rivals

4. Differential low-cost access to productive inputs

– Productive inputs: labor (most important; race to the bottom), capital, land, raw
materials
5. Technological advantages independent of scale
– Firms with latest technology will typically enjoy cost advantages
– Not just physical tools but also the processes the firm used in this way (e.g.
technological software)
6. Policy choices

Value of Cost Leadership

*The ability of neutralizing external threats or exploiting external opportunities is a sign that a firm’s
resource or capability has a cost advantage

The Rarity of Sources of Cost Advantage

Likely-to-be-rare sources of cost advantage: (must be costly to imitate to be sustained)

1. Learning-curve economies of scale
2. Differential low-cost access to productive inputs
3. Technological software

Less-likely-to-be-rare sources of cost advantage:

1. Economies of scale
2. Diseconomies of scale
3. Technological hardware – if developed by suppliers and sold on the open market
4. Policy choices – if easy to observe and describe

Organizing to Implement Cost Leadership

 Organization Structure: functional structure with

1. Few layers in the reporting structure
2. Simple reporting relationships
3. Small corporate staff
4. Focus on narrow range of business functions

Functional structure – managed by functional manager; each functional manager reports to one
person, which could be president, CEO, chair, or founder
U-form structure – “U” for “unitary”
Responsibilities of CEO in a functional organization:
1. Formulate strategy of the firm (by applying the strategic management process)
2. Coordinate the activities of the functional specialists in the firm to facilitate the
implementation of this strategy

 Management control systems

1. Tight control systems
2. Quantitative cost goals
3. Close supervision of labor, raw material, inventory, and other costs
4. A cost leadership philosophy

 Compensation policies
1. Reward for cost reduction
2. Incentives for all employees to be involved in cost reduction

CHAPTER 5 – PRODUCT DIFFERENTIATION

Product differentiation – business strategy that attempts to gain competitive advantage by increasing
the perceived value of their products or services relative to the perceived value of other firms’
products or services

Bases of Product Differentiation

 Focus directly on the attributes of its products or services

1. Product features
2. Product complexity
3. Timing of product introduction
4. Location

Hedonic prices – part of a product or service that is attributable to a particular characteristic

of the product or sevice

 Relationship between the firm and its customers

1. Product customization
2. Consumer marketing
3. Product reputation

 Linkages within or between firms

1. Linkages among functions within a firm
2. Linkages with other firms
3. Product mix
4. Distribution channels
5. Service and support

The Value of Product Differentiation

*relationship between the 5 threats and product differentiation

Product Differentiation and Sustained Competitive Advantage

*Product differentiation strategies add value by enabling firms to charge prices for their products or
services that are greater than their average total cost
Organizing to Implement Product Differentiation Strategies

 Organizational Structure
1. Cross-divisional/ cross-functional product development teams
2. Complex matrix structures
3. Isolated pockets of intense creative efforts: skunk works (temporary teams whose
creative efforts are intensive and focused)

 Management control systems

1. Broad decision-making guidelines
2. Managerial freedom within guidelines
3. A policy of experimentation

 Compensation policies
1. Rewards for risk-taking, not punishment for failures
2. Rewards for creative flair
3. Multidimensional performance measurement

Guiding Innovative Principles at 3M

1. Vision – make innovation part of the company’s self-image

2. Foresight – find out where technologies and markets are going; identify needs of customers
3. Stretch goals – set goals that will achieve improvements
4. Empowerment – hire good people, delegate responsibilities
5. Communications – for sharing ideas and information
6. Rewards and recognition – individual recognition > monetary rewards through peer
recognition

WEEK 5 // CHAPTER 8 – Vertical Integration & CHAPTER 9 – Corporate Diversification

Vertical integration – the number of steps in the value chain that a firm accomplishes within its
boundaries

Backward vertical integration - when it incorporates more stages of the value chain within its
boundaries and those stages bring it closer to the beginning of the value chain, that is, closer to
gaining access to raw materials

Forward vertical integration - when it incorporates more stages of the value chain within its
boundaries and those stages bring it closer to the end of the value chain; that is, closer to interacting
directly with final customers

Value of Vertical Integration

1. Reducing threat of opportunism

Opportunism
– exists when a firm is unfairly exploited in an exchange
– is greatest when a party to an exchange has made transaction-specific-investment
(an exchange that has significantly more value in the current exchange than it does
in alternative exchanges
 2. Enabling a firm to exploit its valuable, rare, and costly-to-imitate resources and capabilities

– Walmart and its supplier example

3. Enabling a firm to retain its flexibility

Vertical Integration and Sustained Competitive Advantage

 The Rarity of Vertical Integration

– Firm’s vertical integration is rare when few competing firms can create value by
vertically integrating in the same way
– Also, when most of its competitors are not able to vertical integrate because of:

o a firm may have developed a new technology or a new approach to doing

business that requires its business partners to make substantial transaction-
specific investments.

o Rare capabilities

o a firm may be able to gain an advantage from vertically integrating when it

resolves some uncertainty it faces sooner than its competition

 The Imitability of Vertical Integration

– Direct duplication occurs when competitors develop or obtain the resources and
capabilities that enable another firm to implement a valuable and rare vertical
integration strategy
– Substitutes: major is strategic alliance

Organizing to Implement Vertical Integration

*Organizing to implement vertical integration involves the same organizing tools as implementing
any business or corporate strategy: organizational structure, management controls, and
compensation policies.

*Cost leadership and product differentiation is also used to implement vertical integration strategy;
this the functional or U-form structure

The Management Committee Oversight Process

1. Executive committee
– CEO and two or three functional senior managers
– Track the short-term performance of the firm, to note and correct any budget
variances for functional managers
– Can help avoid many functional conflicts in a vertically integrated firm before they
arise
– Weekly and reviews performance in a short-term basis
– Subset of operations committee

2. Operations committee
– Monthly
– Consists of the CEO and each head of the functional areas in the firm
 – Track firm’s performance overtime intervals slightly longer and monitor longer-term
strategic investments and activities

CHAPTER 9 – Corporate Diversification

Corporate diversification strategy – when a firm operates in multiple industries or markets

simultaneously

Types of Corporate Diversification

1. Limited corporation diversification

– When all or most of its business activities fall within a single industry and geographic
market
– Single-business firms
o firms with > 95% of their total sales in a single product market
o engages only in one business
– Dominant-business firms
o firms with between 70 and 95 % of their total sales in a single-product
market
o pursues two businesses
o example Donato’s pizza

2. Related corporate diversification

– When less than 70% of a firm’s revenue comes from a single-product market and
they share important economies of scope
– An economy of scope exists when the value created by several businesses operated
together is greater than the value of these businesses operated separately
– Related-constrained – if all the business in which a firm operates share the
same economies of scope
 Related because the economies of scope exist among a firm’s
business
 Constrained because all of the businesses in a firm’s portfolio share
the same economies of scope
– Related-linked corporate diversification - If the different businesses that a
single firm pursues realize different types of economies of scope

3. Unrelated corporate diversification

 When less than 70% of firm’s revenue is generated in a single-product market and
when the businesses in firm’s portfolio share few economies of scope

The Value of Corporate Diversification

For corporate diversification to be economically valuable:

1. There must be some valuable economy of scope among the multiple business
2. It must be less costly for managers in a firm to realize these economies of scope than for
outside equity holders on their own

Economies of scope - exist when the value created by operating several businesses simultaneously
is greater than the value of operating these businesses separately
Different types of economies of scope:
1. Shared activities as an economy of scope

Value Chain Activities (pg. 859)

 Input activities
 Production activities
 Warehousing and distribution
 Sales and marketing
 Dealer support and service

Limits of Activity Sharing

1. Substantial organizational issues are often associated with a diversified firm’s learning
how to manage cross-business relationships. Managing these relationships effectively
can be very difficult, and failure can lead to excess bureaucracy, inefficiency, and
organizational gridlock
2. Sharing activities may limit the ability of a business to meet its specific customers’
needs
3. If one business in a diversified firm has a poor reputation, sharing activities with that
business can reduce the quality of the reputation of other businesses in the firm.

2. Core competencies as an economy of scope

 Shared business level competencies
– May or may not be accompanied by shared activities
– Transnational strategy: When the business within a diversified firm that
develops and then shares this core competence with other businesses in the
firm in a non-domestic market
 Corporate competencies
– Exists when firm develops managerial skills, technical know-how, experience,
and wisdom in managing diversified corporation

Core competence
– the collective learning in the organization, especially how to coordinate diverse
production skills and integrate multiple streams of technologies
– complex sets of resources and capabilities that link different businesses in a
diversified firm through managerial and technical know-how, experience, and
wisdom

Limits of Core Competencies

1. the way that a firm is organized can either facilitated exploitation of core
competencies or prevent this exploitation from occurring
2. A result of the intangible nature of these economies of scope

3. Financial economies of scope

 Internal capital allocation
 Risk reduction
 Tax advantages

4. Anti-competitive economies of scope

 Multipoint competition
 – Exists when two or more diversified firms simultaneously compete in multiple
markets
 Exploiting market power
– Predatory pricing: setting prices so that they are less than the subsidized
business’ costs >> may drive competitors out of the subsidized business and
then obtain monopoly profits in that subsidized business

5. Maximizing management compensation

WEEK 6 // CHAPTER 7 – Collusion & CHAPTER 10 – Organizing Diversification

Collusion – firms in an industry or market cooperate to reduce competition

Explicit collusion – firms in industry directly negotiate agreements about how to reduce competition;
illegal

Tacit collusion – when firms cooperate reducing competition but engage and no face-to-face
negotiations to do so

Dead weight loss - reduction in social welfare

The Value of Collusion

1. Colluding to reduce the threat of new competitors
2. Colluding to reduce the threat of competitors

Collusion and Sustained Competitive Advantage

1. Cooperation
2. Price Taking
3. Bertrand cheating
– Assumption that each time cheating firms adjust their prices, they assume that other
firms will continue operating
– No economic profit
4. Cournot cheating
– Colluding firms cheat by adjusting the quantity of their output and let market forces
determine prices

Signals are needed in tacit collusion:

a. Tough signals
– signal that they will aggressively respond to cheating
– the firm sending the signal will decrease prices more or increase output more
than would have otherwise
b. Soft signals
– signal that they will not aggressively respond to cheating
– the firm sending the signal will decrease its price less or increase its output
less

 Puppy-dog ploy – maintaining a non-aggressive stance leads other to be non-

aggressive
 Fat-cat effect – actively investing in ways that others will not find threatening leads
others to be non-aggressive
  Top-dog strategy – aggressive strategic investments threaten massive retaliation if
another firm engages in aggressive behaviour
 Lean-and-hungry look – retaining the ability to make aggressive strategic
investments has the effect of reducing the incentives of others to make these
aggressive investments

Conscious parallelism – firms that consciously make price and output decisions in order to reduce
competition

Maintenance of Tacit Collusion

 Small number of firms
 Product homogeneity
 Cost homogeneity
 Price leaders
 Industry social structure
 High order frequency and small order size
 Large inventories and order backlogs
 Entry barriers

Organizing to Implement Tacit Collusion

1. Organizational efficiency
2. Organizational self-discipline

CHAPTER 10 – Organizing Diversification

M-form or multidivisional structure

– Each business that the firm engages in is managed through a division
– Profit and losses can be calculated at the level of the division in these firms
– Designed to create checks and balances for managers that increase the probability that a
diversified firm will be managed

Roles and Responsibilities of Major Components of the M-Form Structure

 Board of directors
– Monitor decision making to ensure it is consistent with the interests of outside equity
holders
– 10 to 15 individuals

Agency relationship – when one party in an exchange delegates decision-making authority

to a second party
Principal – the party delegating
Agent – the party whom this authority is delegated

2 common agency problems:

1. Managerial perquisites – do not add economic value to firm but do directly benefit
those managers
2. Managerial risk aversion –

3 issues/ Effectiveness of Boards of Directors

 1. Roles of insiders and outsiders on the board
2. Whether the board chair and the senior executive should be the same or different
people
3. Whether the board should be active or passive

Board of directors are organized into subcommittees:

c. Audit committee – responsible for ensuring the accuracy of accounting and financial
statements
d. Finance committee – maintains the relationship between the firm and external capital
markets
e. Nominating committee – nominates new board members
f. Personnel and compensation committee – evaluates and compensates the
performance of a firm’s senior executive and other senior managers

 Institutional investors
– Monitor decision making to ensure it is consistent with the interests of major institutional
equity investors
– Pension funds, mutual funds, insurance companies, or other groups of individual
investors that have joined together to manage their investment

 Senior executives
– Formulate corporate strategies consistent with equity holders’ interest and assure
strategy implementation
– CEO, CFO, the chairman of the board
o Strategy formulation
 Decide the business in which the firm will operate
 Decide how the firm should compete in those businesses
 Specify the economies of scope around which the diversified firm will
operate
o Strategy implementation
 Encourage cooperation across divisions to exploit economies of scope
 Evaluate performance of divisions
 Allocate capital across divisions
 Resolve conflicts within and between each of the major managerial
components of the M-form structure: corporate staff, division general
managers, and shared activity managers

Division of Senior Executive: roles are called: Office of the President

1. Board chair – supervision of the board of directors in its monitoring role
2. Chief executive officer (CEO) – strategy formulation
3. Chief operating officer (COO) – strategy implementation

 Corporate staff
– Provide info to the senior executive about internal and external environments for strategy
formulation and implementation
– Functions that provide external info are: finance, investor relations, legal affairs,
regulatory affairs, and corporate advertising
– Functions that provide internal info are: accounting and corporate human resources

 Division general managers

– Formulate divisional strategies consistent with corporate strategies and assure strategy
implementation
 – Divisional staff managers >> solid line reporting relationship with corporate staff
functional managers and >> dotted line reporting relationship to their divisional general
manager
– Managing the firm’s businesses from day-to-day
o Strategy formulation
 Decide how the division will compete in its business, given the corporate
strategy
o Strategy implementation
 Coordinate the decisions and actions of functional managers reporting to
the division general manager to implement divisional strategy
 Compete for corporate capital allocation
 Cooperate with other divisions to exploit corporate economies of scope

 Shared activity managers

– Support the operations of multiple divisions
– As cost centers, are assigned a budget and manage their operations to that budget
– As profit centers, managers are then required to compete for their internal customers
based on the price and quality of the services they provide

Management controls and implementing corporate diversification

1. Measuring Divisional Performance

 Accounting performance
 Economic performance

2. Allocating Corporate Capital

 Zero-based budgeting – corporate executives create a list of all capital allocation
requests from divisions in a firm, rank them from most to least important

3. Transferring intermediate product

– Managed through a transfer-pricing system >> one division sells its product or
service to a second division for a transfer price

Compensation Policies and Implementing Corporate Diversification

WEEK 8 // CHAPTER 11 – Strategic Alliance & CHAPTER 12 – Mergers and Acquisitions

Strategic alliance – when 2 or more independent company cooperate in the development,

manufacture, or sale of products and services

Types of Strategic Alliances

1. Nonequity alliance – cooperative relations are managed using different kinds of contracts
a. Licensing agreements – allows other organization to its brand name to sell products
b. Supply agreements – one firm agrees to supply others
c. Distribution agreements – one firm agrees to distribute the products of others
2. Equity alliance – incorporated firms use contracts with equity holding in alliance partners
(e.g., buying stocks of other company; also common in biotechnology industry >>
pharmaceutical firms)
3. Joint venture – cooperating firms create a legally independent firm in which they invest and
from which they share any profits generated

Strategic Alliances creating value?

  Operation performance improvement
o Exploiting economies of scale
 Economies of scale exist when the per-unit cost of production falls as
the volume of production increases
 To realize economies of scale: must have large volume of production
o Learning the competitors
 Firms can improve their own operations by learning from other firms that
can result to competitive advantage over others
 Learning race – when both parties to that alliance seek to learn from
each other (learning rate varies); first firm to learn can begin to
underinvest in or withdraw from the alliance; can create a sustained
competitive advantage for the fast-learning firm
 Absorptive capacity – firms’ ability to learn; higher capacity means
firm is fast learner; an important organizational capability
o Managing risk and sharing costs
 Creating competitive environment
o Helping with the development of technology standards
 Returns to scale – value or returns on each product increases as the
number of these products increases
o Tacit collusion
 Not directly communicating but exchanging signals with other firms
about their intent to cooperate (e.g. of signals: public announcement of
price increase, public announcement of reductions in a firm’s productive
output, or announcement about decisions not to pursue new
technologies
 Facilitating low-cost entry into and exit from industries
o Low-cost exit from industries and industry segments
o Managing uncertainty
 Joint venture is an option that a firm buy
o Low-cost entry into new markets

Alliance Threats: Incentives to Cheat on Strategic Alliances

How cheating? Firms in alliance do not cooperate in a way that maximize the value of the alliance

Ways to cheat in Strategic Alliance:

1. Adverse selection – potential partners misrepresent the value of the skills and abilities they
bring to the alliance
 Exists when alliance partner promises to bring to an alliance a certain resources that
either does not control or cannot acquire
2. Moral hazard – partners provide to the alliance skills and abilities of lower quality than
promised
 The engineer example
3. Holdup – partners exploit the transaction-specific investments made by others in alliance
 Transaction specific investment – when an investment value in its first-best use
(within the alliance) is greater than its value in its second-best use (outside the
alliance)

Strategic Alliance and Sustained Competitive Advantage >> Analyzed using VRIO Framework

 Rarity of strategic alliance

 o Do the benefits obtain from their alliance common across firms competing in
an industry? >>> Conclusion: not rare and not a source of competitive
advantage
 Imitability of strategic alliance (based on resources and capabilities)
o Direct duplication?
 Based on social complex relations among partners (page 1001)
o Substitutes
 Alliance will not have a sustained competitive advantage if low-cost
substitutes are available
 Substitutes for strategic alliance
- “Going it alone” – when a firm attempt to develop all the
resources and capabilities they need to exploit market
opportunities and neutralize market threats
o Alliances > “Going it alone” when:
1. The level of transaction-specific investment is
moderate when completing an exchange
2. Exchange partner has valuable, rare, and costly-
to-imitate resources and capabilities
3. There is a great uncertainty about the future value
of an exchange
- and acquisitions
o Alliances > Acquisitions when:
1. There are legal constraints on acquisition
2. When acquisitions limit a firm’s flexibility because
of uncertainty
3. Acquired firm has an unwanted substantial
organizational baggage
4. Value of firm’s resources and capabilities
depends on its independence

Organizing to Implement Strategic Alliances

** primary purpose of organizing a strategic alliance is to enable partners in the alliance to gain all
the benefits associated with cooperation while minimizing the probability that cooperating firms will
cheat on their cooperative agreements

Tools that constraints incentive to cheat:

 Explicit Contracts and Legal Sanctions
– Define legal liability if cheating does occur
– Common clauses in contracts used to govern strategic alliances (page 1009)
o Establishment issues
o Operating issues
o Termination issues
 Equity Investments
 Firm reputations
 Joint ventures
o Creation of separate legal entity
o Returns on joint ventures depend on the economic success of the joint venture
 Trust

CHAPTER 12 – Mergers and Acquisitions

Acquisition – when a firm purchases a second firm (cash to purchase, debt to purchase, use own
equity to purchase, or can use mix of these)
 Friendly acquisition – when the target firm wants to be acquired
 Unfriendly acquisition – when the target firm does not want to be acquired
o Hostile takeovers – a type of unfriendly acquisition

Acquisition premium – difference between the current market price of a target firm’s shares and
the price a potential acquirer offers to pay for those shares
Tender offer – approach to purchasing a firm; can be made with or without the support of the target
firm’s management

Merger – the transaction when the assets of two similar-sized firms are combined

**In a merger, one firm purchases some percentage of a second firm’s assets while the second firm
simultaneously purchases some percentage of the first firm’s assets.

Value of Mergers and Acquisitions

No economies of scope = no economic profits for both bidding and target firms

Types of Economies of Scope in Acquisitions

 Vertical merger - A firm acquires former suppliers or customers
o Backward vertical integration – firm purchasing suppliers of raw materials
o Forward vertical integration – firm acquiring customers and distribution networks
 Horizontal merger - A firm acquires a former competitor
 Product extension merger - A firm gains access to complementary products through an
acquisition
 Market extension merger - A firm gains access to complementary markets through an
acquisition
 Conglomerate merger - There is no strategic relatedness between a bidding and a target firm

Lubatkin’s List of Potential Sources of Economies of Scope Between Bidding and Target
Firms
1. Technical economies
– Physical processes inside a firm are altered so that the same amounts of input
produce a higher quantity of outputs
– Marketing, production, experience, scheduling, banking, compensation
2. Pecuniary economies
– Achieved by the ability of firms to dictate prices by exerting market power
3. Diversification economies
– Achieved by improving a firm’s performance relative to its risk attributes or lowering
its risk attributes relative to its performance
– Portfolio management and risk reduction

Jensen and Ruback’s List of Reasons Why Bidding Firms Might Want to Engage in Merger
and Acquisition Strategies
1. To reduce production or distribution costs
 Through economies of scale
 Through vertical integration
 Through the adoption of more efficient production or organizational technology
 Through the increased utilization of the bidder’s management team
  Through a reduction of agency costs by bringing organization-specific assets under
common ownership
2. Financial motivations
 To gain access to underutilized tax shields
 To avoid bankruptcy costs
 To increase leverage opportunities
 To gain other tax advantages
 To gain market power in product markets
 To eliminate inefficient target management

Event Study Analysis

– popular way to evaluate the performance effects of acquisitions for bidding firms
– compares actual performance of a stock after an acquisition has been announced with the
expected performance of the stock if there is no acquisition had been announced
– based on the capital asset pricing model (downside), which is not a good predictor of a
firm’s expected stock price
– assumes that a firm’s equity holders can anticipate all the benefits associated with making
an acquisition at the time acquisition is made (downside)

Possible Motivations to Engage in Mergers and Acquisitions Even Though They Usually Do
Not Generate Profits for Bidding Firms
1. To ensure survival
2. Free cash flow
3. Agency problems
4. Managerial hubris
5. The potential for above-normal profits

Mergers and Acquisitions and Sustained Competitive Advantage

Market for corporate control – market created when multiple firms actively seek to acquire one or
several firms

**If one bidding firms offers higher price or any extra benefit to the target firm then there is an
imperfect competitive market for corporate control

Rules for Bidding Firm Managers

1. Search for valuable and rare economies of scope
2. Keep information away from other bidders
3. Keep information away from targets
4. Avoid winning bidding wars
5. Cloe the deal quickly
6. Operate in thinly traded acquisition markets

Implications for Target Firm Managers

1. Seek information from bidders
2. Invite other bidders to join the bidding competition
3. Delay, but do not stop, the acquisition

Wealth Effects of Target Firm Management Responses to Acquisition

1. Responses that reduce the wealth of target firm equity holders
 Greenmail
 oManeuver in which a target firm’s management purchases any target firm’s
stock owned by a bidder and does so for a price that is greater than the
current market value of that stock
 Standstill agreements
o Often negotiated in conjunction with greenmail
o Contract where the bidding firm agrees not to attempt to take over the target
for some period of time
 Poison pills
o Variety of actions that target firm managers can take to make the acquisition
expensive
o Not very effective
2. Responses that do not affect the wealth of target firm equity holders
 Shark repellents
o Minor corporate governance changes that are supposed to make it
somewhat difficult to acquire the target firm
o Examples are supermajority voting rules (where more than 50% of the target
firm’s board of directors must approve a takeover) and state incorporation
laws
o Will not slow down an acquisition attempt nor prevent it
 Pac Man defense
o Fends off an acquisition by taking over the firm or firms bidding for them
 Crown jewel sale
o When a bidding firm is only interested in just a few of the business currently
being operated by the target firm
 Lawsuits
o Automatic as soon as an acquisition effort is announced
3. Responses that increase the wealth of target firm equity holders
 Search for white knights
o Looking for another bidding firm that agrees to acquire a particular target in
the place of the original bidding firm
 Creation of bidding auctions
o Can increase the equity holders’ wealth by 20%
 Golden parachutes
o A compensation agreement between a firm and its senior management team
that promises these individuals a substantial cash payment if their firm is
acquired and they lose their jobs in the process

WEEK 9 // CHAPTER 6 – FLEXIBILITY

**A firm has strategic flexibility when it can choose different strategic options

Strategic options - exist when firms have the ability, but not the obligation, to invest in a particular
strategy
Real option – exists when a firm has the ability, but not the obligation, to invest in real assets of
some type

Types of Flexibility
1. Option to defer – purchasing land for oil companies
2. Option to grow – building a plant that has the capacity that can increase
3. Option to contract - employees
4. Option to shut down and restart
5. Option to abandon
6. Option to expand - R&D