Business Journal 1

Spring 2018

Lecture 2

ECO 526: Business Strategy

Plan

 Review of basic economics framework for business strategy

 Costs

 Demand

 Surpluses

 Value creation and capture

 Strategy preliminaries

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

Typical Long Run AC and MC Curves

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

 Fixed and variable vs. avoidable and sunk  Fixed  Sunk?  Avoidable  Variable?

 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?

Putting it all together: Creating and Capturing Value

 Total Market Surplus (Value Created): Excess of consumer willingness to pay over production cost  Economic “cake”

 Market price splits surplus between producers and consumers

 Consumer Surplus: Excess of willingness to pay over market price

 Producer Surplus (Value captured): Excess of market price over production cost

Creating and Capturing Value: Consumer and Producer Surplus

V

P

C

(V - P) = Consumer Surplus

(P - C) = Producer Surplus or Value Captured

(V -

C )

= V

a lu

e C

re a te

d

Maximum Consumer is Willing to Pay

Price the Consumer Actually Pays

Production Cost

Q Number of Consumers who Purchase the Firm’s Product

Creating and capturing….

Creating and capturing…

 Creating and capturing generally, but not necessarily, go together

 Creating but not capturing  Adverse industry structure

 Faulty strategy

 Capturing but not creating, e.g., collusion/price fixing  CS decreases  PS increases at the expense of CS  Deemed anticompetitive; prosecutable through Antitrust laws

 Blurring the lines  Monopolization  Competitive vs. anticompetitive

 Capitalist system is biased toward activities that create value, but not necessarily against those that capture value, if done in a competitive way

Creating and capturing…

 Typically, more intense competition and greater innovation leads to more value creation  Only way to increase profits

 Trying to capture more value without creating more drives customers away; possibly toward competitors

 Thus, competition forces a closer link between creating and capturing value  Mechanisms

 Institutions

Creating and capturing…

 Some observations  Consumer WTP is crucial

 Increases the size of the cake (value created)  Strategies aimed at shifting demand out

 Innovation and efficiency do not necessarily create or capture value  Understand market and position your product correctly  Short vs. long run  Competitive process

 Value creation and capture go through

 Market structure: Part of size and distribution of cake is predetermined

 Strategy: Convert part of cake into economic profits

Creating and capturing…

 Market structure creates different strategic foci

 Competitive or highly contested markets  Higher WTP (e.g., increase value to consumers)

 Lower C (e.g., simplify, leverage competitive advantages)

 Try to differentiate

 Form partnerships

 Monopolistic or less contested markets: Above plus…  Pricing strategy

 Demand management

 Other…

Creating and capturing…

 What goes into WTP?  Monetary value of expected utility  Appeal and brand value  Objective vs. subjective  Market type

 Can be shaped by firm strategy (demand shifters)  Differentiation

 Features  Persuasion

 Certainty  Reputation

 Demand Inelasticity/Inertia  Other…

Creating and capturing…

 Some examples of potential “win-win” strategies for value capturing  (Low cost) differentiation

 Efficient innovations that lead to persistent cost advantages

 Premium pricing  Pay attention to elasticity

 Eye on sustainability: Increase cake in way that is hard to replicate or imitate

Creating and capturing…

 Success breeds envy: Key is to maintain (and possibly increase) WTP while making imitation/entry difficult…

 Some examples  Enhance fundamental product characteristics

 Add complements

 Lower user costs

 Improve reputation

Creating and capturing…

 … Or lower costs in a sustainable way

 Some examples

 Improve input yields through innovations or learning/knowledge

 Reduce operational complexities/redundancies

 Use information advantages  Importance of data

 Enhance worker productivity and motivation through organizational change (not just incentives…)

There is more to Strategy than Being Efficient

1. Efficiency is only the starting point

V Delivered to Consumers

Firm’s Production Cost C

HIGH LOW

HIGH

LOW

Efficiency

• Delivering a given V at as Low a C as possible or • Delivering as high a V as possible for a given C

Inside Productivity Frontier Possible to Improve Efficiency by Adopting Better Practices

But, … strategic competitors tend to rapidly learn about efficient practices

2. Seek uniqueness – avoid crowded sections of the frontier

V D

e li v e re

d t

o C

o n s u m

e rs

Firm’s Production Cost C

HIGH LOW

HIGH

LOW

Product Positioning Stay away from crowded

areas and look for

unserved or

underserved areas

There is more…

3. A Unique Value Creation Proposition is Crucial to Profitability

Different Set of Activities Performed

Whole Foods sells “the finest natural and organic foods available, maintains the strictest quality standards in the industry, and has an unshakeable commitment to sustainability”

Different Way of Performing Activities

Southwest Airlines Entered by Flying Aircraft on “Point-to-Point” Routes. Legacy Airlines Used a “Hub-and-Spoke” System.

There is more…

4. Sustainability: Protect Against the Imitators that Successful Value Creation Propositions Will Inevitably Attract

Tradeoffs

You Can’t Do It All! Incompatibilities Make it Hard for Firms to Imitate Strategies that Are Successful Elsewhere

Fit/Activity Systems

Competitive Advantages Built Through a Collection of Policies Are More Self-Reinforcing and Difficult to Imitate

There is more…

Example: SWA

Positioning and Sustainability: Examples

 Lowering Transaction Costs as a value-creating disruption engine

 2016-17 CNBC Disruptor 50

E.g., Airbnb, Lyft, WeWork, Grab, Ezetap, Klarna, Slack, Houzz, Palantir, Coursera, Udacity, Cloudera, InsideSales, Oscar, SoFi, Synack, Teespring, 23and Me, Cylance, Instacart, Blippar, DAQRI, Uber

Next…

 Performance Indicator case questions and strategy journal 1 due next week

 Industry Analysis

 Crown case due in two weeks

 Check Syllabus/D2L for Readings