Correction first session exam

GEST-S406 – Strategy
ULB - SBSEM
Teachers: François Faelli and Giorgio Zanarone
Academic year 2021-2022
First session exam – 2/06/2022

Question 1 – multiple choice questions

1. When the production technology exhibits diseconomies of scale:

a) Firms’ marginal costs are constant in output and equal to average costs.
b) Average costs are minimized by merging small firms.
c) Firms’ average costs decrease in the output produced.
d) Average costs are minimized by splitting large firms.
e) None of the above.

Correct answer: d)

Under diseconomies of scale, the average costs of a firm increase in production volume → the
average cost of producing a given output is smaller when such output is split among two firms,
each producing a small amount, than when all output is produced by one large firm. Thus, d) is
correct while a), b), c) are incorrect.

2. Which of the following characteristics of a firm are not potential sources of economies of scope?

a) A popular and established brand.

b) A strong R&D department.
c) Operating in a market characterized by limited competition.
d) A technology based on the use of modular, interchangeable components.
e) None of the above.

Correct answer: c)

Limited competition (a feature of market structure) has nothing to do with economies of scope (a
feature of technology), so c) cannot be a source of economies of scope. In contrast, a), b), d) are
all sources of economies of scope as discussed in the textbook and slides.

3. Managerial empire building is

a) A potential benefit of diversification.

b) A manager’s tendency to be authoritarian towards workers
c) A cost of diversification that can be governed by linking managerial pay to the firm’s growth.
d) A cost of diversification that can be governed by paying the manager a high fixed salary.
e) None of the above.

Correct answer: e)
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a) is incorrect because empire building is a cost, not a benefit of diversification. c) is incorrect

because by linking the manager’s pay to firm growth, the manager’s incentive to engage in
empire building is magnified, not reduced. d) is incorrect because paying a fixed salary does not
remove the manager’s incentive to engage in empire building, which typically comes from
prestige concerns. b) is clearly unrelated to empire building as defined in the textbook and slides.

4. Outsourcing is a potentially risky strategy because

a) An outsourced supplier may locate its facilities too close to the client.
b) An outsourced supplier may locate its facilities too far from the client, and compete with the
client in the end-product market.
c) An outsourced supplier may supply excessively high quality at an excessively low price.
d) An outsourced supplier typically benefits from lower economies of scale compared to a
vertically integrated component production unit.
e) None of the above.

Correct answer: b)

b) is correct because failure to make relationship-specific investments (such as locating close to

the buyer) and appropriation of knowledge (via competition in the end market) are both
drawbacks of outsourcing as discussed in the textbook and slides. For the very same reason, a) is
incorrect. c) is incorrect because a supplier’s incentive is precisely the opposite – sell low quality
(which costs less to provide) at high price. d) is incorrect because an outsourced supplier benefits
from economies of scale as she can serve multiple buyers who need the same kind of component
(in contrast, a vertically integrated unit typically only supplies is parent firm).

5. In incentive systems based on subjective performance evaluation…

a) Compensation of employees is rigid and formulaic, and as a result, employees tend to be

narrow and unimaginative.
b) It is especially easy for managers to redefine employees’ tasks and targets as the market
context evolves.
c) Employees may not be motivated to work hard if supervisors rotate frequently.
d) Employees may “game” the system, that is, they may focus on unproductive tasks that
increases their chances to get the end-of-year bonus.
e) None of the above.

Correct answer: c)

c) is correct because SPE is only credible in the presence of a long-term, trust-based employment
relationship, and frequent rotation prevents the formation/continuation of such relationship. a)
is the opposite of SPE, which is all about avoiding rigid formulas and measuring employees’ real
contribution to the firm. b) is incorrect because under SPE it is difficult to modify performance
evaluation criteria as the environment changes as those criteria are not formally spelled out (we
called this the “clarity problem”). d) is incorrect because gaming is a feature of objective
performance evaluation systems in which employees find clever but unproductive ways to
achieve a target and hence get a bonus or promotion.
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6. Suppose two firms are considering whether to enter a market. Which of the following statements
is correct?

a) Each firm would like to choose after observing the other firm’s move as that will allow it to
achieve higher profits.
b) Each firm can benefit from making an irreversible investment, such as building a large
production facility, which commits it to enter the market.
c) If the two firms make their entry decisions simultaneously and without communication, they
will certain end up in a Prisoner’s Dilemma situation in which profits are minimized.
d) It is optimal for each firm to enter, regardless what the other firm does.
e) None of the above.

Correct answer: b)

If firm A can be sure that firm B enters, and hence the market will be competitive, it has a lower
incentive to enter. Thus, commitment is useful to firm A as it allows it to maintain a monopoly
position after entering. Answer a) is incorrect because in this kind of entry game, there is a first
mover advantage – it is not good for firm B to choose after firm A has made a move as that
enables firm A to commit deter entry, as discussed above. Answer c) is incorrect because if the
two firms don’t communicate and enter simultaneously, neither firm has a dominant strategy
(i.e., a move it wants to make regardless what the other firm does). Instead, there are two
equilibria, one in which firm A enters and firm B stays out, and one in which B enters and A stays
out. Or the same reason, answer d) is also incorrect.

7. Considering contact lenses and saline solution, choose all propositions that apply (there can be
one or more correct answers):
a) They are two separate markets
b) They are one market with potential for substitution
c) They are two separate markets with potential for bundling
d) They have relatively high customer sharing but low cost sharing
e) They have high customer sharing and high cost sharing

Correct answer: c) and d)

Based on the business definition framework (cf. slide below), we can say that contact lenses and
saline solution are 2 separate markets with potential for bundling, as they have a relatively high
customer sharing (those 2 products are usually used together) but low cost sharing (different raw
materials and manufacturing process).
Correction first session exam

8. How does digital impact an industry's 5 forces? Choose all propositions that apply (there can be
one or more correct answers):
a) It increases industry attractiveness by lowering barriers to entry and giving higher bargaining
power to customers
b) It decreases industry attractiveness by lowering barriers to entry and giving higher
bargaining power to customers
c) It decreases industry attractiveness by creating substitutes
d) It increases industry attractiveness by increasing barriers to entry as more capital is usually
required

Correct answer: b) and c)

As discussed in class, digital lowers barrier to entry for an industry (e.g., you can create an app,
an ecommerce website, … without a large initial investment), gives higher power to customers
(while customer base used to be fragmented/ scattered, digital now gives them more power
through e.g., social media) and creates substitutes (e.g., online banking services, Uber, …).

9. Based on the concept of competitive advantage, choose all propositions that apply (there can be
one or more correct answers):
a) Competitive advantage is what explains why a company over time wins over competitors
b) Company performance is mostly driven by the strength of the industry they play in
c) In all industries, scale is the first source of competitive advantage
d) Leveraging one core proprietary asset (their brand), Disney was able to expand into
unrelated business

Correct answer: a) and d)

A): definition of competitive advantage

D): cf. case discussed in class; Disney has multiple businesses (streaming platform, film/ studio,
amusement parks, stores …) that are almost unrelated (no cost sharing, limited consumer
sharing, different competitors in each business); however they are still one business as they
leverage their brand/ their magic in all of those businesses. If they didn’t have that, they would
become a conglomerate and likely suffer from a penalty.
Correction first session exam

10. In the context of ESG, choose all propositions that apply (there can be one or more correct
answers):
a) Circular Economy aims at slowing down economic growth to save on material resource
consumption as both are following the same trajectory
b) In the case discussed in class, Unilever's CEO faced a trade-off between short term financial
profit and long term ESG goals
c) ESG elements are only applicable to certain industries that have a direct impact on the
environment and natural resources
d) ESG elements can be a source of competitive advantage

Correct answer: b) and d)

B) cf. case discussed in class

D) ESG benefits of a brand/ company can be put forward to create a competitive advantage and
differentiate themselves/ win over competitors
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Question 2 – Alcoa

In 1945, Alcoa was controlling 90% of capacity in the US aluminum market. Alcoa’s capacity was
above demand, and building up capacity is expensive. What was Alcoa doing? Why did they
accumulate so much production capacity? In developing your answer, think of an enriched version of
the extensive form “entry game” in which:

1) Alcoa decides whether to invest in high capacity or not, then

2) A potential competitor decides whether to enter the aluminum market or not, and finally, if
the competitor enters,
3) Alcoa decides whether to price aggressively (fight) or not (accommodate).

Think about how the decision to invest in high capacity at stage 1) of the game may affect Alcoa’s
decision at stage 3). Please respond in no more than half a page.

Proposed solution: see attached slides

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Question 3 – Lincoln Electric

Lincoln Electric, a U.S. company, is a leading producer of arc welding machines. The company has
been long famous for its aggressive incentive system, in which 60% to 100% of workers’ pay consists
of a bonus tied to the supervisors’ subjective performance evaluation. Other notable features of
such system were the practice to employ workers for life, and the non-hierarchical, close, and
familiar relationship between workers and managers. In the 1980s and 1990s, Lincoln Electric
opened subsidiaries in several foreign countries. While in past offshore expansions Lincoln relocated
its own managers abroad, its strategy in this new expansion wave was to recruit local managers,
who received a short training course on the Lincoln managerial culture. In some of these countries,
such as Italy, Spain, and the UK, Lincoln did not succeed at transplanting its celebrated incentive
system. Among the problems encountered by Lincoln were (a) unionized workforces, and (b) legal
rules that considered any compensation consistently paid for two consecutive years as an
entitlement.

After briefly summarizing the pros and cons of incentive systems based on subjective performance
evaluation (SPE), please discuss how the specific features of the countries where Lincoln expanded
made SPE difficult to implement. Also, please discuss whether the choice to rely on local
management was a good or poor fit to a SPE incentive system. Please respond in no more than half a
page.

In a SPE system, performance can be measured more precisely than in a “piece rate” system where
incentives are linked to an objective metric. By linking rewards to a close supervisor’s assessment,
performance evaluation can better reflect the employee’s actual contribution, and the employee will
have limited incentives to “game” the system, that is, to do useless or even harmful things so long as
they allow her/him to “get the bonus”. On the negative side, SPE suffers from a credibility and clarity
problem. Credibility, because rewards are non-contractual, hence an opportunistic supervisor may
claim the employee has not performed satisfactorily just to save on the bonus/reward. Thus, there
has to be sufficient trust between employer and employee for SPE to be credible and motivating.
Clarity, because what constitutes “good performance” is not codified once and for all, and it is
sometimes tricky to redefine it when the environment changes. In particular, employees may
interpret an attempt to change performance targets and definition as breach of the “relational
contract” underlying SPE. A case in point is how Netflix articulated its “leading by context” principle
through a process of trial and error.

Regarding LE, the fact that workers were strongly unionized and had a culture of confrontation with
management undermined one of the pillars of SPE, namely, a trust-based and informal employment
relationship. Legal rules that turned discretionary rewards into entitlement also undermined the SPE
system: if employees know they will get the bonus anyway, they won’t consider it an incentive, and
thus the bonus will not motivate them to increase their initiative and effort.

Reliance on local management with little training in the LE system was probably a bad idea,
particularly from the perspective of the clarity problem. Managers at LE would know how to carefully
redefine performance targets without appearing to violate their “relational contract” with employees
concerning performance evaluation. An “alien” managers might get that wrong, causing loss of
morale and potential defections.
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Question 4 – Mars Petcare

During the last session, Poul Weihrauch, the CEO of Mars Petcare, shared the transformation story
of the company. In particular, he explained:
• The evolution of Mars Petcare from a food company to a food and care company
• The strong role of purpose in their development

Based on his presentation and concepts seen in class, please answer the following questions:

1. What are the opportunities and risks to expanding business definition from food to food and
care? Please don’t hesitate to give other examples (discussed in class or not).

• Mars Petcare: went from pet food to pet care & health with vet clinics, diagnostics,
connected devices, … creating an ecosystem
• Opportunities:
o Economies of scope (branding, …)
o Economies of learning (can apply knowledge of the category across business units)
o High customer sharing, potential cross-selling
o Vertical integration (clinics selling pet food)
o Data/ insights leveraged across business units
• Risks:
o Adjacencies failure if too far from core business
o Conglomerate penalty
o If business units are too unrelated: economies of scope/ learning disappear (different
skills required, different competitors, limited cost & customer sharing, …)
o Increased organizational complexity

2. How can purpose become a competitive advantage? Do you agree that for Mars Petcare, their
purpose is a competitive advantage?

• Competitive advantage = what differentiate them from competitors

• Purpose: mission & vision of the company. Mars Petcare purpose: “a better world for pets” +
Five Principles (Quality, Responsibility, Mutuality, Efficiency, Freedom)
• Helps them attracting partners, suppliers, talents, customers → yes it is a competitive
advantage (e.g., attracting talents, securing supply during COVID shortages, …)