Business Journal 1

Spring 2018

Lecture 1

ECO 526: Business Strategy

Plan

 Class Introduction

 Syllabus and course roadmap

 Review of basic economics framework for business strategy

 The Profit Function

 Costs

 Demand

Roadmap

 Part 1: Nuts and Bolts

 Basic Economics

 Value creation and capture

 Industry analysis: Porter’s Industry Forces

 Competitive advantage

Roadmap…

 Part 2: Power tools

 Game Theory and Coopetition

 Differentiation and strategic positioning

 Growth, dynamics and sustainability

 Organization and boundaries of the firm

Some Insights of the Strategy Framework

 Focus on “big” strategic questions, e.g.,  Does the firm create value for customers? If so, does it capture

such value? How so?  Does the firm have unique advantages (e.g., resources, positioning)

over the competition?  Does the industry/market environment allow turning these

advantages into profits?  If the industry environment is adverse, what can the firm do to deal

with this adversity?  If strategies result in profitability, how can the firm sustain it in the

long-run?  What can the firm do to reinforce its advantages in the long run?

 Foundations: Microeconomics and Game Theory  Implications, allocentrism, uncertainty, and biases  Other disciplines

Allocentrism

Insights...

 Some specific examples

 Entering a market, big versus small

 Diversify? Or focus on niches?

 Retain valuable resources?

 Become cost or quality leader/follower

 Deter/accommodate entry

 Adopt “socially responsible” strategies

 Provide complements/Create ‘eco-systems’

 Expand/restrict firm boundaries

A Closer Look at Profits

 The Profit Function   = TR – TC

 TR = P Q

 AC = TC/Q

 Thus, 

A Closer Look….

 Increasing Profits: Strategies must be tied to

 Evaluation of strategies must recognize interactions, e.g.,…

Costs

 Economic Costs = Accounting Costs + Opportunity Costs

 Opportunity Costs: Value of forgone alternatives (explicit or hidden)

 Why consider opportunity costs?

 Examples

Opportunity Costs and Profits

 Profits = Total Revenues – Total Costs

 Economic Profits = Total Revenues –

(Accounting Costs + Opportunity Costs), or

(Total Revenues – Accounting Costs) – Opportunity Costs

 Terminology

 Positive Economic Profits = Profits in Excess of Opportunity Costs

 Zero Economic Profits = Opportunity Costs

 Competition pushes profits toward…

Opportunity Costs and EVA

 Empirical Study: “EVA. An Analysis of Market Reaction,” by Deyá Tortella and Brusco (2003)

 Sample of 65 firms from various sectors that introduced the EVA technique

 No significant short term abnormal returns

 Significant performance improvement in the long run

 Adoption provides incentives for increased and more selective investment activity

 Adoption has positive effect on cash flow measures

 Methodology…

Deyá Tortella and Brusco Sample

Costs in the Short and Long Run

 Short run

 Long run

Average and Marginal Costs

 Average Cost: Cost per unit

AC = TC/Q

 Marginal Cost: Cost of an additional unit

MC = TC/Q

 Marginal pulls average in the same direction

 Focus on marginals

Typical Short Run AC and MC Curves

Why the Shapes?



Typical Long Run AC and MC Curves

Why the Shapes?



Empirical Long Run AC Curves

Estimated LRAC

Q

$

More Cost Terminology 

 Avoidable Costs: May be at least partially recovered once they are incurred

 Unavoidable (Sunk) Costs: Gone forever once incurred

 Do sunk costs matter?

 Strategic implications of manipulating sunk and avoidable costs  Commitments

Avoidable vs. Unavoidable Costs

 Some fixed costs may be avoidable

 Resale

 Alternative use

 Rental

 Salvage

 Some variable costs may be unavoidable

 Severance pay/job security

 Delivery/consulting contracts

Demand

 Demand is a function

Q = f(P)

 Quantity demanded is a value of the function

 Inverse demand and interpretation

P = g(Q)

Demand Function

D

Price

Quantity

P1

P2

Q1 Q2

A

B

Shifts and Movements within and along Demand Functions

 A to B?

 A to C?

D1

D2

Price

Quantity

P1

P2

Q1 Q2 Q2’

A

B

C

Demand Elasticity

 Measures how sensitive quantity demanded is to changes in price

ɛ = % Quantity/% Price  Elastic vs. Inelastic

 Determinants

 Substitutability  Item “size”  Necessity or “luxury”  Time length of demand definition

Example: The (original) Amazon Tax

 Enacted in 2011 in Illinois: Forced out of state online retailers to pay IL taxes if they worked with affiliates with a physical presence in the state

 Working with any IL-based warehousing or marketing affiliates -even blogs/forums who link to your product- was enough to trigger an IL tax bill

 Some notable actors: Amazon, Overstock, Fatwallet, CouponCabin, Retailmenot, etc.

 Expected annual revenue was $150 mill.

 But…

Elasticity and Total Expenditure

 P and Q are negatively related on a demand function

 Effect of changes of P over TR=(P Q) is

ambiguous

 But ɛ = % Quantity/% Price

 Magnitude of ɛ says something about dominant %

Inelastic Demand and Total Revenue

Quantity

P ri

c e

D

Elastic Demand and Total Revenue

Quantity

D

Market Structure and Profitability

 Degree of Monopoly Power: Extent to which the firm has the power to profitably set prices (or quantities) in its industry

 Proxy is ability to mark-up:

(P - MC)/P = 1/ɛ

 AKA “Lerner Index”

 Intuition

Market Structure and Profitability…

 Use mark-up pricing to think about industry competition:

(P - MC)/P = 1/ɛ

 Perfectly Competitive Firms: Firms have no market power (ability to mark-up)

 Sources of profitability?

 Monopolistic firms: Varying degrees of market (price-setting) power

 Sources of profitability?

Next Session

 Economics of Strategy framework wrap

 Demand and Surpluses

 Value creation and capture

 Strategy preliminaries

 Check syllabus/D2L for readings