Competitive Strategy Summary

The Elective as a Whole: Conclusions

This elective has been concerned with the really big questions in the firm. What
shape should the firm’s strategy have? Where should its boundaries end, and market
links with other firms begin? What directions should it pursue in the future? How
should it pursue these directions? There is usually no one answer to these questions;
more often strategic planners have a set of alternatives to choose from. These
alternatives are not always made explicit by the planners and often choices are made
from a limited menu. Formulation of strategy must be based on a proper evaluation
of the implications of a strategy, and also the alternatives to it.
We set out basic concepts in the first two modules. When we turned to particular
topics in the subsequent modules, we began to see how preconceived notions
concerning different types of strategies may be wrong and misleading. Innovation
(Module 3) is an area rich in fallacies; ‘what everyone knows’ is not always so. Past
enthusiasm for vertical integration (Module 4) has been replaced on many quarters
by arguments in favour of outsourcing and downsizing. Diversification (Module 5)
often fails to achieve its stated objectives and indeed these objectives may often be
more easily achievable through alternative means and more focused strategies.
Multinational enterprise (Module 6) can be expensive, underutilise the firm’s existing
capabilities, and lead the firm into areas where it has little or no expertise. Exporting
and various forms of co-operative solutions may be more efficient means for
achieving the same ends as going multinational in many cases. And mergers and
joint ventures (Module 7) have such a poor record in achieving their stated objectives
that a wealth warning to shareholders (‘warning: merger and joint venture may
be injurious to your wealth’) should probably be attached to any strategic plans or
prospectuses in which they figure.
Of course, each of these strategies has a major place in the strategist’s armoury.
The point about each of them is that it is often easier to see the advantages rather
than the disadvantages, and often alternatives are ignored or not fully taken into
account. The overall theme in this elective is that in formulating strategy it is
essential to identify and fully analyse all the alternative means for achieving a stated
objective. That does not guarantee the best strategy will be chosen in particular
cases, much of this will be down to the skill, experience, wisdom and luck of the
strategist. But it does increase the chances that the best strategy will be chosen, and
reduce the chances that an inappropriate one will be opted for. And that is what
formulating strategy to generate competitive advantage is all about.

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Module 1
Analysis of the Environment
 The module will help set the context for much of the analysis and discussion in later modules.
 It introduces the basic features of the strategic arena in which the firm operates.
 We shall first look at the relevance and significance of life cycle effects over time.
 Then we shall see how the Five Forces Framework can provide a basis for systematically analysing
the environment in which the firm operates at any given stage in the life cycle.
 We also look at how game theory can help provide useful insights to aid strategic thinking, while at
the same time warning against uncritical use of this technique in strategic planning.

The growth rate of an industry should not be thought of as necessarily a passive element that firms have to
adjust to. A firm may be in a position to influence the industry growth rates and the course of the life cycle.
Two main techniques for this are the following:
Pricing strategies in the introductory phase. An innovator may decide to go
for (low) penetration price and high initial growth, or for (high) skimming price
and slower initial growth. A penetration price is more likely if an innovator has a
deep pocket and is able to sustain initial losses, and if capturing a high market
share is seen as providing a major source of competitive advantage, for example
due to economies of scale. Amazon.com has pursued a penetration price strategy
in Internet book selling. A skimming price strategy is more likely if firms wish to
recoup expensive R&D expenditure and set up costs, and if it is expected that
competitors will soon enter this market anyway. Skimming prices are often observed
in consumer electronics markets.
Life cycle stretching and renewal. Firms individually or collectively may
extend the life of an industry through innovation and marketing improvements.
The invention of the bagless vacuum cleaner by Dyson revitalised a market
which had generally been regarded as rather settled and dull for many years.

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Critical Turning Points in the Life Cycle
In addition to broadly definable and self-explanatory stages, Figure 1.1 also identifies what may be critical
points in the evolution of the industry. They can be especially important where strategists base their plans on
recent and current trends and do not properly anticipate what is about to happen in this industry.

1. Critical point A. This point can represent a major turning point in the evolution
of the industry, precisely because it can signal subtle changes and appear very
innocuous at the time. After all, A is set about the middle of the growth phase so
what is so potentially significant about this point?

However, even wise firms may be put under pressure for a variety of reasons
They still invest because they worry about the implications of losing market share to rivals.
Critical point A may be uncertain and difficult to identify in advance (is the decline in growth this year a
temporary blip or the start of a new trend?).
The intensified competition represented by price wars and battles for market share may still hit them badly,
even if they have not overinvested.

At the same time some factors may counteract any tendency towards overinvestment and shake-out during
slowdown in the growth phase. These include the following:
Risk-aversion in the face of high uncertainty leading to cautious investment plans.
It can take time before investment plans are put in place (e.g. possibly years for new plant), so investment
may still be lagging behind demand growth by the time the turning point A is reached.

2. Critical point B. Point B represents a more obvious turning point in this

industry. The positive growth rates experienced by the industry so far have ended
and there is now zero growth (though ‘Maturity’ and the turning point may
not be represented by absolutely static sales, but may more generally be associated
with a state in which the market grows no faster than the economy overall).

3. Critical point C. Critical point C can mark the start of a dog-eat-dog phase. In

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Figure 1.1, if the firm wishes simply to maintain its current level of sales in the
decline phase, it can only do this by actually taking market share from other firms
in this industry. The same logic holds for its rivals in the industry. The fierceness
of the resulting struggle will depend on how easy it is for firms to exit the industry.
If there is little or nothing else it can do with the assets it has tied up in this sector
(i.e. there is little opportunity cost or sacrificed value from continuing the struggle
in this sector) then the battle may be long and bloody.

The Stages of the Life Cycle

Growth stage
Relatively low price elasticity of demand for each brand. If there is one or a few differentiated brands
then price elasticity of demand for each brand may be low because of:
(a) limited substitutability,
(b) user unfamiliarity with respect to what is the ‘right’ price and ignorance of alternatives, and/or
(c) early pioneering
Relatively high price. The problem with a high price in the early stages is that it may
(a) send a profit signal that makes the industry look attractive to other firms and encourages entry, and/or
(b) slow up growth, delay exploitation of economies of scale and experience curve advantages, and make it
easier for other firms to catch up.
High level of advertising to create demand for new product.
Profits low or negative to begin with, then increasing.
Variety of product designs.
Radical product and process innovation.
Major demands for new investment.
Product can be characterised by frequent bugs and defects.
Capacity shortages, at least in the early phase
Ease of entry into this market.
Few firms.
Patchy or limited distribution.

Maturity stage

Increasing price elasticity of demand.

Falling price.
Brand advertising important.
Profitability begins to decline.
Increased standardisation.
Mostly incremental innovations, emphasis on process innovation.
Replacement investment emphasised.
Improved quality and reliability of design.
Capacity may settle to match demand.
Entry becomes more difficult and less attractive.
Many firms.
Well established distribution channels.

Decline stage

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 High price elasticity of demand.
Price continues to fall.
Lack of both differentiation and growth creates little role or room for advertising.
Low or negative profits.
Further standardisation.
Little innovation.
Little investment.
Well established design, few bugs.
Overcapacity.
Entry unattractive.
Fewer firms.
Distribution and access to distribution increasingly important for firms.

Porter (1980. pp. 267–73) suggested that there may be a variety of strategies that
a firm in the decline stage can pursue.
(a) Dominance and leadership.
(b) Niche exploitation.
(c) Harvest.
(d) Exit.
(e) Internalise the threat.

The Five Forces Framework

The Five Forces Framework is more about possible constraints on strategy, less about the particular
directions that strategy can take.

The Five Forces:

1. Threat of new entrants
2. Intensity of rivalry among existing competitors
3. Bargaining power of buyers
4. Bargaining power of suppliers
5. Pressure from substitute products.

A firm’s industry would be an unattractive environment characterised by low or negative returns given the
following conditions.
New firms are about to enter the firms market.
There is intense competition from rivals in the same industry.
The firm faces a powerful set of buyers.
It also faces a powerful set of suppliers.
An external threat is about to send the industry into long-term decline.

In practice, few if any industries face such dire prospects. For one thing, the gloomy prospects signalled by
Forces 2–5 would probably be enough to dampen or eliminate the threat of entry (Force 1).
By contrast, an industry would be an attractive environment for a firm if the following conditions prevailed.
There is little danger of entry.
Competition from rivals is weak or non-existent.
The firm’s buyers are dispersed and weakly organised.
The firm’s suppliers are also dispersed and weakly organised.

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 There is no serious threat to the industry.

Force One: Threat of Entry

(1) Economies of scale
(2) Economies of scope
(3) The experience curve
(4) Differentiation
(5) Risky and costly capital requirement for entry
(6) Switching costs
(7) Access to supplies and outlets
(8) Other cost advantages
(9) Government policy
(10) Exit barriers
(11) Expected retaliation

Force Two: Rivalry

(1) Relatively high fixed costs
(2) Low growth
(3) High exit barriers
(4) Differentiation and switching costs weak
(5) Absence of a dominant firm

Force Three: Bargaining Power of Buyers

(1) One or a few major buyers
(2) The buyer earns low profits
(3) The product represents a large proportion of the buyer’s overall purchases
(4) Standardised, undifferentiated product with low switching costs for buyers
(5) Buyers can threaten backward integration

Force Four: Bargaining Power of Suppliers

(1) The supplying group has only one or a few firms
(2) There are no close substitutes for the supplier’s products
(3) The product is an important input into the buyer’s business
(4) The buyer industry is not an important customer
(5) The supplier’s products are differentiated or there are switching costs for buyers
(6) The supplier can threaten forward vertical integration

Force Five: Pressure from Substitute Products

Game Theory Perspectives

The Prisoners’ Dilemma

In the Prisoners’ Dilemma, the following specific conditions must be met.
Simultaneous decision-making by both players
Accurate knowledge of the pay-offs attached for each set of choices
No communication between the players
No social ties and obligations
No history to the game, no past until this situation, and no future beyond outcomes identified in the game.

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Strategic Moves
Even if it may be difficult to apply individual game theoretic models to competitive
situations, there are still important strategic principles which have been explored by
game theory. Indeed, many of these principles preceded the development of game
theory, which has merely formalised and demonstrated the applicability of these
principles in different contexts.
One important concept which game theory has developed is that of the strategic
move. A strategic move is something that is intended to alter the beliefs or expectations
of others in a direction favourable to you. Its fundamental characteristic is that
you deliberately limit your freedom to manoeuvre. Game theory models can be used
to demonstrate the logic and implications of different types of strategic moves in
principle.

A central issue that game theory has helped to illuminate is that of credibility.

So the intangible asset of credibility can be an important element in strategic

battles. If a firm can make its threats or promises credible, it may be more likely to
exercise control over a market and its rivals. How can credibility be won – and
maintained?
There are many ways that this may be achieved; the following are just some examples.

Reputation
This is perhaps the most obvious way that credibility can be built up for a firm.

Contracts
One obvious way that credibility can be created is by signing a contract committing a party to a certain
specified course of action.

Specialisation
Specialisation is one variant of a range of strategies which communicate a credible commitment to a specified
course of action by deliberately restricting the options open to the company (This strategy is similar to that of
burning your bridges in war).

Investment
Major investment by a firm in a particular business area can be a credible signal that a firm is committed to
that market.

Incrementalism
One way to build up credibility and trust is to build up a relationship over time.

Hostages
Clustering agreements with a preferred partner can provide the credible reassurance that partners are more
likely to adhere to the letter and the spirit of individual agreements if it knows the other has co-operative
agreements that can be used as ‘hostages’ in the event of any breach of faith.

Social context
Credibility (for example that a person’s statement can be treated as honest and reliable) may be influenced by
the social context in which actions take place.

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Module 2
Strategies for Competitive Advantage
 This module introduces the various options which the firm can choose from in formulating its
competitive strategy.
 The role of the value chain as a tool for strategic analysis is examined.
 Generic strategies of cost leadership, differentiation, focus are identified.
 We examine the circumstances in which it is appropriate to pursue a particular generic strategy.
 The need for clarity and consistency in strategy is established.
 The dangers of being ‘stuck in the middle’ through trying to pursue more than one generic strategy
simultaneously are discussed.

2.2 Generic Strategies

One of the first points that we must bear in mind is that strategies may have a large variety of objectives and
outcomes, some of which may have no observable impact on profitability. That does not mean that they are
necessarily inconsistent with the interests of shareholders, as we shall see in later modules.
 For example, vertical integration may be a defensive strategy designed to prevent the firm being cut
off from supplies or outlets (Module 4).
 Or diversification may be pursued to prevent the firm having all its eggs in one basket and finding its
survival threatened if its current market or technology is suddenly rendered obsolete (Module 5).
 Or a multinational may avoid seemingly lucrative licensing possibilities because it is worried about
losing control over its proprietary knowhow (Module 6).
None of these options may lead to direct improvements in the bottom line of companies’ balance sheets,
though they may help anticipate and deal with nasty problems that could appear on the corporate agenda at
some point in the future.

Competitive Strategies are generally expected to enhance profitability, and there are just two main ways a firm
can do this in any given product-market. It can shift the demand curve up, or the cost curve down.

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Competitive strategy can add to value by driving a wedge between demand and cost, so enhancing
profitability. Porter identified three generic approaches to competitive strategy analysed in such terms:
Cost leadership strategy, where the firm tries to become the low cost-producer in its
industry. If it is able to do so and still sell at comparable prices to its competitors,
then it will achieve above average performance.
Differentiation strategy, where a firm tries to become unique in its industry in some
characteristics that are valued by consumers. The firm that is able to do so may
be able to extract a premium price, and if it is also able to operate at costs that
are comparable to its competitors, it will enjoy above average performance.
Focus strategy, in which the firm targets a narrow segment or niche within an
industry and designs its strategy for this segment only. There are two variants
here, cost focus in which the firm tries to achieve a cost advantage over its competitors,
and differentiation focus in which the firm seeks a differentiation advantage in
this segment.

Problems: sources of competitive advantage may be easier to identify than achieve. In practice there may be
a number of difficulties facing the firm trying to pursue competitive advantage.
1. Trade-off between cost and differentiation.
2. Stuck in the middle
3. One cost leader.
4. Sustainability.

2.3 The Value Chain

The value chain is an essential element in searching for competitive advantage. It
breaks the firm down into component activities to identify actual and potential
sources of competitive advantage.

The value chain can be used to look at linkages within the chain itself to check
how the chain is configured and how it is (or is not) contributing to competitive
advantage. It can also be used to look at linkages between value chains to see whether
and where shared activities may contribute to added value (this latter area is something
we shall look at in some detail in Module 5). The firm’s value chain is unlikely
to exist in isolation, but will probably have links to the value chains of other firms.
These links may be vertical (to suppliers and buyers) or horizontal (collaborative
arrangements with other firms at the same stage). As we shall see in later modules,
these links with other firms may help to create or reinforce competitive advantage
for the firm. Perhaps the most striking example of this is contained in the notion of
clusters (Module 6) where competitive advantage may be stimulated by vertical and
horizontal interactions of geographically concentrated firms in the same or related
sectors.

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Warning flag: Some writers have interpreted the value chain rather mechanistically. Activities are
delivered by resources, and the resources

An approach that recognises this danger and tries to do something about it is a

version of the resource-based approach to the firm which tries to identify capabilities
as a potential source of competitive advantage to the firm. Capabilities are sets of
related activities which a firm does well compared to other firms. The advantage of
the capabilities approach is that it does not rely on a purely bottom-up analysis of
competitive advantage by trawling through all the activities in the value chain one by
one. Instead, it tries to identify the areas of activities that constitute the ‘distinctive
competences’ or ‘core competences’ of the firm and help provide it with enduring
and sustainable sources of competitive advantage.

2.4 Cost Leadership

The main cost drivers identified by Porter are as follows:
Economies of scale.
Learning and experience curve gains.
Capacity utilisation.
Vertical links within the value chain, and links with suppliers’ and buyers’ value chains.
Horizontal links with other value chains – economies of scope.
Timing.
Location
Institutional factors such as government regulation, taxation and subsidies.
Discretionary policies.
External economies.

Porter summarises the major steps to be taken in undertaking a strategic cost analysis of the value chain as
follows:
1. Identify the value chain, and separate out and assign costs and assets attributable to it.
2. Identify the relevant cost drivers and how they interact with each other.

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3. Identify competitor value chains, costs, and sources of cost advantage. (This should help test whether cost
leadership is a viable strategy, or at least whether there are further cost gains that the firm could seek out).
4. Develop a strategy to reduce costs through cost drivers or by reconfiguring value chain.
5. Guard against eroding differentiation.
6. Test for sustainability. (Can competitors replicate what you have done?)

2.5 Differentiation

1. The Sources of Differentiation

Policy choices.
Linkages.
Timing.
Location.
Interrelationships with other value chains.
Learning.
Vertical integration and control.
Scale.

2. Signalling Quality: The Market for Lemons

"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a 1970 paper by the
economist George Akerlof. It discusses information asymmetry, which occurs when the seller knows
more about a product than the buyer.

There are a number of devices that can be used to at least partially offset the lemons problem. The seller may
be able to draw on the following.
Reputation and word of mouth recommendations.
Warranties and guarantees.
Industrial and professional associations.
Brand name recognition.
Chains and franchising.
Consumer guides and reviews.
Intermediaries.

In addition, government or its agencies may also deal with some aspects of the lemons problem through
various devices including:
licensing;
regulation;
anti-trust policy.

3. Steps in Differentiation
Porter suggests that there are several steps that should be taken if a firm wishes to pursue a differentiation
strategy:
1. Identify the relevant buyer.
2. Identify the firm’s impact on the buyer’s value chain.
3. Identify the buyers’ criteria for purchasing.
4. Identify actual and potential sources of uniqueness.
5. Identify the cost of actual and potential sources of differentiation.
6. Assess benefit versus cost of differentiation alternatives.
7. Test for sustainability.

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 8. Reduce costs that do not affect differentiation.

2.6 Focus
- Focus strategies depend on differences between segments of the same market and can reflect search
for cost advantage in a particular segment or limited set of segments (cost focus) or search for
differentiation advantage gains in a segment or limited set of segments (differentiation focus).
- Unlike broad-based differentiation and cost leadership strategies on the part of the firm where we
start with the strategy then adapt it to the needs of particular segment, focus strategies start with the
needs of the segment and tailor the strategy accordingly.
- The logic is that there is a niche in the overall industry which the firm can tailor its value chain
towards uniquely satisfying, even if it does not have a competitive advantage in the industry overall.
The value chain is optimised for that particular segment or set of segments only.

The advantage of a firm-wide focused strategy

It allows the whole of the firm’s value chain to be dedicated to satisfying the purchase criteria for the buyers
in the selected market segment. In essence, it provides no more and no less than the straightforward gains
from specialisation, with the firm being able to identify and respond to the particular needs of its target
market.

The disadvantages of a firm-wide focused strategy

Limited opportunities for economies of scope.
Limited growth opportunities.
Vulnerability to external threats.

If the focused strategy results in no real linkages with value chains in the rest of the firm, then surely all this
means is that combining the focused segment with the rest of the firm has a neutral effect on value. So what
is the objection to having it inside the firm if it is doing no real harm?
This question goes to heart of the logic of corporate strategy, not only in the context of focus strategies but
for other strategies such as diversification (Module 5) and international strategies (Module 6).
The answer to it comes in two parts.
1. Fallacy of free focus.
2. Linkages cost.
Cost of co-ordination.
Cost of compromise.
Cost of inflexibility.

Consequently, the logic of focus strategies is based on a simple trade-off. From the point of view of adding
value at business unit level, the value chain for that unit should be customised and tailored as far as possible
to satisfy the purchase criteria for the buyers in that particular segment. From the point of view of adding
value based around interrelationships between business units, the firm should exploit as many linkages
between units as possible.

2.7 The Dangers of Hybrid Strategies

Being stuck in the middle is a consequence of a lack of clarity and consistency in
formulating and maintaining a competitive strategy designed to deliver competitive
advantage to the firm. It can be a particular temptation during the growth phase of
the product life cycle when the weakness of the strategy may be concealed by the
softer competitive conditions that may prevail during this period. Once the market
approaches saturation, firms that have failed to develop a clear strategy that can

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deliver competitive advantage may be particularly vulnerable in any shake-out phase.

At the same time Porter identifies possible cases when it may be possible for the
firm to pursue a ‘stuck in the middle’ strategy in which it pursues differentiation and
cost leadership strategy using the same business unit and based on the one value
chain. These cases include the following.
Competitors are also stuck in the middle.
Cost is strongly related to scale.
Being first to innovate.

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Module 3
The Evolution of Competitive Advantage
(Innovative)
- Innovation is an area which has several basic characteristics that strongly influence resource
allocation in this area, in turn leading to numerous hurdles to efficient management of this process,
and finally encouraging a variety of solutions to these hurdles.
- We show how the basic characteristics, the hurdles and the solutions relate to each other.
- One of the important issues discussed here is that there is no such thing as a free lunch in this
context; the various solutions to the problem of innovation may themselves be costly or generate
further problems in addition to those they are trying to solve.
- Innovation can be a complex, costly, time consuming, uncertain process with most of the benefits
accruing to others rather than those who are incurring the time, trouble and expense of pursuing it.

It might be helpful to start out with some basic points and then build on them.
Point 1: to be a successful innovator it is best to be first with a good new idea.
Point 2: survival of the fittest means that if your product is inferior to competitors, it will lose out in the
market place.
Point 3: if you can convince the public

The Innovative Process

- Invention usually refers to the act of devising or creating some new idea.
- The term innovation is usually reserved for the commercialisation of that new idea by some
individual, firm or other organisation.
- The innovative process can refer to all the various stages and activities that combine to produce an
innovation.
- One obvious distinction in the context of innovation is between product and process innovation.
- Product innovation offers a new good or service, while process innovation is concerned with the
development of a new production technique.

- Research and development is the function or group in the firm responsible for searching for
technological innovations.
- The core of the R&D group is usually composed of QSEs (Qualified Scientists and Engineers),
though in smaller firms the R&D activity may be conducted on an occasional basis by professionals
mainly involved in other functions, such as production.
- The prime purpose of the R&D group is to generate and refine technical knowledge that can lead to
an innovation. However,
- Knowledge itself can be categorised into tacit and articulable categories
- Articulable knowledge is generally of the type that can be sent down a telephone line or faxed (e.g.
technical specifications or pictures of a bicycle),
- Tacit knowledge usually cannot be communicated by such means but may instead have to be built up
through experience, experimentation and individual learning (e.g. how to ride a bicycle).
- The process of innovation can involve both articulable and tacit knowledge on the part of the
organisation.

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 - The R&D process itself can also be divided into different stages.
- Basic research refers to research with no specific commercial objectives, though the field may be of
actual or potential interest to the R&D performer.
- Applied research refers to research directed to specific commercial targets in the form of possible
new products or processes.
- Development is concerned with the conversion of these research findings into actual products and
processes. This stage may include the creation of working models or prototypes.

- A further important influence on innovative activity in many sectors is the role of standard formats
or dominant designs.

The Characteristics of the Innovative Process

stages in the R&D process. Each of them can have implications for innovation strategy within the firm, and
we shall discuss each in turn.
1. Specificity refers to the possible range of eventual commercial outcomes (products or processes)
associated with a successful project at this stage. If the current R&D might lead to only one or two
commercial products or processes it has a high degree of specificity associated with it. A project that could
lead to numerous commercial applications has a low degree of specificity.
there are the related issues of externalities and appropriability that low degrees
of specificity may be associated with. An externality is a benefit or cost that
impacts on somebody other than the individual or organisation responsible for
the economic activity. In the case of innovation, externalities frequently take the form of benefits to other
firms;

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2. Uncertainty is also a typical feature of R&D projects. It may be unclear what the R&D project will
actually find, whether there will be a market for the output, and how much it will all cost to develop.

3. Time R&D can be time consuming and delay-ridden.

4. Cost of stage depends on the technology being developed, but in many technologies costs can be
considerable, and frequently rise towards the development end of the spectrum.

5. Cumulative cost of a project is a reminder that it can still cost a great deal to take a project to market,
even if the basic research end is relatively cheap. Cumulative cost refers to the total cost of getting a project
into commercial introduction

Why Innovation can be Squeezed off the Firm’s Agenda

We shall identify nine problems or hurdles for innovation in the firm. The first six of these follow from the
characteristics of the R&D spectrum already discussed, while three others can be said to be general problems
associated with the innovative process as a whole.

Summary of innovation hurdles:

1. Appropriability problems of leakage of competitive advantage to other rivals
2. Neglect of potential spin-offs to other divisions inside the firm
3. Duplicated research effort from each division concentrating on its own problems
4. Coping with uncertainty and the likelihood of failure
5. Potentially high cost of the full process of innovation
6. The long time horizons involved
7. Asymmetric information – those doing work for the project can know more about its true potential than
those funding it
8. Machiavelli’s problem – innovation attacks vested interests with those who might gain not being in place to
argue its case
9. Compartmentalisation of R&D and need to integrate complementary assets

Each of these hurdles contributes to what might be summarised as the innovation problem – the modern
corporation may fail to support adequately potentially value-enhancing innovative activity.

Some Solutions to the Innovation Problem

One of the problems in innovation is that any one of a

number of hurdles can be fatal as far as attempts to stimulate innovative effort in the
firm are concerned. There is no point on dealing with problems of appropriability,
cost and long time horizon if uncertainty still freezes innovative decision-making, and
there is no point in forming a dynamic, innovative organisation if most of the good
ideas finish up being grabbed by a competitor. Organisations have to take an overview
of how they deal with innovation considered as a systemic process. Also solutions that
deal with one problem may simply make another one worse.

Solutions rarely come free but usually involve some version of the
economic principle of TINSTAAFL (There Is No Such Thing As A Free Lunch).
The most obvious price that has to be paid in many cases is the increased expenditure

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of managerial time and resources to try to help overcome the hurdle or hurdles
that are proving particularly troublesome in the context under review.

The question ‘what does this solution do for

this hurdle?’ is one that has been applied right down the line in looking at the
potential contribution of each of the solutions below.

(1) Conduct R&D in-house Keeping the R&D in-house rather than contracting for it to an outside
agency makes it easier to keep the R&D secret until it is introduced into the market place, or at least near to
introduction.
(2) Internal funding of R&D Appropriability problems (Hurdle 1) again are at the heart of this issue. If
the firm were to discuss the R&D project with potentially interested parties in the capital market, there could
be a danger that the idea would leak out to potential competitors in the product market; firms which are rivals
or potential rivals might catch wind of this new idea and the firm could find its good idea being appropriated
by others.
(3) Corporate level R&D One solution that can be presented as dealing with a number of hurdles is to
amalgamate Engine Corp’s three R&D teams into one corporate R&D lab and make it report directly to
Headquarters
(4) Top-down budgeting the R&D Director or Manager is given an annual budget which may be
calculated on the basis of past experience and/or rules of thumb such as percentage of sales.
(5) Split the R&D function split R&D into ‘R’ and ‘D’ components with ‘R’ forming a corporate research
department and all the ‘D’s going to their natural divisional homes
(6) Split budgets for operations and innovation give divisional managers two separate budgets, one
for operational activities and one for innovative activities. This has the advantage of reducing the chances of
divisional managers treating the resources for R&D as trading off against resources for operational activities
(7) Targets for new product generation by giving each division a target for new product generation.
(8) Parallel R&D approaches and incur a possible time–cost trade-off will be influenced by the urgency
with which a rapid solution is sought
(9) Second-in strategies by following the leader and imitating the innovation in cases where it shows
strong commercial potential.
(10) Licensing and joint venture Co-operative strategies such as licensing and joint venture may help
firms put together the package of complementary assets needed for successful innovation
(11) Research clubs By clubbing together and forming a jointly owned R&D performing organisation
they can reduce the entry costs of participating in major research fields
(12) Corporate diversification Diversified firms are usually larger than their specialised counterparts and
so may be better able to cope with the cost and absorb the uncertainty associated with downstream R&D
stages. They may also be better placed to withstand the delays associated with major R&D activity.
(13) R&D diversification involves pursuing a number of different projects simultaneously and this
approach may also help spread the uncertainties of R&D output
(14) Matrix organization Matrix structures set up parallel lines of control that can help to deal with some
of the problems encountered in innovative activity.
(15) Organic structures Organic structures may be able to cope better with Hurdle 2 (cross-firm
linkages) Hurdle 4 (uncertainty) Hurdle 6 (long lead times that are difficult to fit into mechanistic
programmes), and they may be able to deal with Hurdle 9 (integration of necessary complementary assets) on
a case by case basis.
(16) Quasi-autonomy give an individual or team which comes up with a promising idea quasi-autonomy
by spinning it off into a separate unit or company.
(17) Product champions The product champion may also be able to devote the time to perform the
integrative function required to overcome the compartmentalization of specialised functions associated with
Hurdle 9.

17
(18) Fixed price versus cost plus R&D contracting The obvious alternative to fixed-price contracts
is cost-plus: the firm is guaranteed to be covered for its overall project costs, with an amount added for
profit.
(19) Public funding of basic research – usually, but not always

18
Module 4
Vertical Links and Moves
 In this module we explore strategic decisions relating to the vertical chain of production of which the
firm is a part.
 These relations may be handled in a number of ways that include full-scale single firm ownership
(vertical integration) and a variety of possible contractual and co-operative agreements with other
firms.
 We not only look at legitimate reasons for vertical integration, we also show why some common
justifications for the strategy can be seen to be spurious or false on closer examination.
 We see that alternative means for handing vertical relations can have different benefits and costs
attached to them, and that the appropriate choice of strategy may depend on the particular
circumstances in which the firm finds itself.

4.2 Defining Vertical Relations

 Vertical relations can be distinguished from horizontal relations.
 Relations between activities at the same stage of the production process are horizontal relations;
relations that involve moves between stages are vertical relations.
 Horizontal integration occurs when horizontal relations are co-ordinated within a firm, while vertical
integration is the corresponding case of vertical relations carried out within a firm.
 Horizontal relations tend to involve sharing some asset or resource (such as a factory or a sales
force) while vertical relations tend to involve the shift or transfer of some intermediate product
between stages in the value chain. Vertical integration involves combining separate stages within the
firm.
 Backward or upstream integration occurs when a firm moves to own earlier stages in the production
process, while forward or downstream integration involves moving into later stages in the production
process.

The range of Vertical Relations that may be open to the firm. Here are some of the most important types:
Spot contract: contractual agreement for the immediate supply of a good or service, usually for a specified
price and quantity.
Long-term contract: contractual agreement involving a long-term relationship between supplier and
customer involving agreed responsibilities and obligations on both sides.
Vertical integration: the administration of technologically separate stages within the firm.
Franchising: contractual arrangement in which the retailer operates using the franchiser’s brand name in
exchange for a fee.
Tapered integration: mixed market exchange and vertical integration. In the backward case, a firm may
buy and make some of the same inputs used by it. In the forward case, a firm may supply its own retail outlets
as well as separately-owned outlets.
Vertical quasi-integration: a form of long-term contract in which one partner dominates the other to
the extent it has a high degree of control over the decisions to be made by its partner.
Value-adding partnership: co-operation by independent companies to manage the flow along the
vertical chain.

4.3 Trends in Vertical Relations The history of VR

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4.4 What Vertical Integration is Not
1. Vertical integration is not justified simply because a potential acquisition is highly profitable.
existing profitability is not enough; vertical integration must be able to add further value if it is to be
worthwhile considering.
2. Vertical integration is not obviously anti-competitive. However, while vertical integration certainly
creates a bigger firm, the important point here is that this does not automatically imply concomitant
monopoly power in practice.
3. Vertical integration is not justified solely on technological grounds.

4.5 The Costs of Markets

The costs of markets come in two main forms;
1. from firms acting in their own interests and actively against the interests of the firm with which they
have a contract,
2. and a further layer of problems which firms may encounter as a general consequence of problems of
reliance on market exchange. This second layer of problems arises from the arms-length and
anonymous relations that the market creates.

4.5.1 The Invisible Hand and Some Problems

What could the producers do about this? It is too late once the new supplies have
come on to the market. One answer is to be a forward-thinking producer, forward not
just in terms of anticipating or defending against such problems before they happen,
but forward in terms of direction of integration. If a producer of ingots were to buy
up a producer at the next stage downstream before the disruption in the market
caused by the new producer, it could give them a guaranteed market for ingots
shielded from the ensuing chaos. Forward integration here could be a form of
insurance policy, in a situation in which no insurance company would write an
insurance policy.

A solution for forward-thinking buyers of ingots in this market may be to think

backward – backward in the sense of backward integration. If there is a real possibility
that supplies can be disrupted in this market by whatever means, then one way to
guard against the problems of price escalation or difficulties of getting supplies may
be to own your own supplies. Backward integration could provide a stable hedge
against the vagaries of the market that the future may hold.

Vertical integration can provide further advantages even if the market is not
subject to such wild swings as in our examples. It may be important to maintain a
continuous and balanced throughput in the production process to make sure that
the plant and machinery is used to full capacity, or as near it as possible. It may be
desirable to maintain control over the quality, grades and delivery of the raw
material (see Exhibit 4.2 for examples of this). Vertical integration may help in this
context by replacing continuous market bargaining with planning and administrative
processes.

4.5.2 Visible Relations and the Market

Oliver Williamson (1985) set out the basic framework which allows us to investigate the reasons why firms
may choose to vertically integrate in such cases. This approach is called transaction cost economics.

20
A transaction is an exchange of goods and services and Transaction Costs are costs incurred in such an
exchange.

Transaction Costs: Real expenditures of time and money in: 1- searching for a trading partner, (b) negotiating
the deal, and (c) monitoring and policing the agreement.

Transaction cost economics builds on three important concepts.

First, the concept of bounded rationality, which simply means individuals may not have sufficient knowledge
or information processing power to optimise in a given situation.
Second, the concept of opportunism, which means that individuals are prepared to cheat, lie and generally
misrepresent the situation in the pursuit of their own interests.
Third, we have the notion of asset specificity, or assets specialised by use or user. If an asset has a high
degree of asset specificity it means that it is of little use or value outside its present application, or to someone
else.

Asset specificity can take many forms. Here are some of the most important categories identified by
Williamson.
1. Site specificity, where physical assets cannot be easily redeployed once they
have been built and put into position. Our steel example illustrates the problems
of site specificity.
2. Physical asset specificity, where specialised equipment is needed for production
to take place. An example of this would be the particular moulds developed
to produce a specially designed statue.
3. Human asset specificity, where the skills and knowledge acquired by an
individual cannot be easily transferred to another use or user. An example of this
would be much of the training given to a shuttle astronaut.
4. Dedicated assets, which involve expanding an existing plant on behalf on a
particular buyer. An example of this would a footwear manufacturer who expands
facilities to supply Nike.

It is when bounded rationality and opportunism join with asset specificity that real problems begin to appear
in economic activity.

Both the buyer and seller of the molten steel may also face problems of bounded
rationality, even though they may both receive assurances concerning the terms of
trade from their respective trading partners. The seller may affirm that it will supply
a given quantity of steel on demand at a specified price, while the buyer may testify
that they will pay for an appropriate amount of steel at a particular price. The
problem is that both are dependent on the other keeping to its part of the bargain
and bounded rationality means that there may be no way of guaranteeing that they
mean what they say. Add in the possibility that either partner may behave opportunistically
and breach the agreement if it suits him, and now you have a recipe for a
highly problematic transaction. The hold up problem is the most obvious source of
transaction costs in such a situation. Let us see how this can arise.

4.5.2.1 The Hold Up Problem

the transaction cost dangers may be most severe where only one
party to the transaction suffers from asset specificity.

it would seem to be most advantageous for a firm to be in a

position where it does not suffer severe problems of asset specificity but its potential
partners do. That would give it the chance to extract maximum benefit using the

21
threat of hold up.

It is important to recognise how asset specificity can change the relationship between
buyer and seller once the respective parties have committed themselves to the
relationship.

The situation in which one of the parties is able to choose from a large
number of bidders before the contract is settled, but only one (or a few) after the
contract is settled, is called the fundamental transformation in transaction cost economics.

4.5.2.2 Is the Hold Up Problem a Serious Issue?

The hold up problem is not a serious issue or, if it is, pursuing hold up is a bad managerial strategy.
Exercising the opportunity for hold up may be a good short-term tactic but can be a disastrous long-term
one. A great deal will depend on the culture and attitudes of the other firms that the hold up merchant is
likely to deal with.

Perhaps the most useful way to see the hold up problem is in terms of not necessarily
representing something as crude and direct as a threat to terminate the
relationship unless the other firm pays up. Instead, the major problem in market
exchange relations characterised by asset specificity lies in the fact that the parties to
the transaction are likely to have different objectives and strategies.

4.5.2.3 Solutions to the Hold Up Problem

There are a number of solutions to the hold up problem; each has its advantages and disadvantages:

Repeated contracting stick to
the same preferred partner every
time the possibility of a new
contract
Exhaustive contracting tighten
up the contract so much
that it reduces the possibility and
opportunity for hold up
Standardised assets. design the
system so that off-the-shelf
standard components or materials
can be used, instead of one that
advantages disadvantages
hold up should be less likely it may lock the firm into this
because the other firm is more supplier and reduce the flexibility
likely to be conscious of the of choosing from a wider pool of
possibility of losing future potential suppliers at the new
contracts unless it performs contract stage, and with it the
well and responsibly in the present chances of obtaining a potentially
situation better or cheaper supplier in the
process.
It may give the firm a higher it is likely to be expensive and only
degree of security than would have partly effective; bounded
been the case in a loosely drawn rationality means it may be
contract. difficult or impossible to
anticipate all eventualities and to
be sure of the truth behind the
other firm’s actions and
statements.
if the transaction is dominated by
a legalistic approach, it may
impede the give-and-go take that
may be essential for flexible
responses to evolving situations.
readily available alternatives Lose at least some of the
to the present supplier in the event distinctiveness in design or
of a hold up problem. performance that would provide a
source of competitive advantage.

22
may involve the creation of
specialised equipment.
Hostages a common form of
hostage comes from
involvement in multiple
transactions with the same firm,
say the same producer
supplying more than one
component to the car firm.
Multiple sourcing means that
more than one supplier is chosen
for a component or material.
Vertical integration it may be
possible to eliminate the problems
of market exchange and its
associated transaction costs by
full-scale combination of
the two stages of production in
one firm
Tapered integration it involves
partial integration backwards or
forwards. The firm sells
the same product to its own in-
house units and to external
purchasers, or it produces
some of its own components and
purchases some of these same
components
from outside suppliers.
both firms know that they have
more riding on their joint
relationship than a single
transaction, and they may avoid
hold up opportunities if they think
it could lead to retaliation against
them in the other transactions
they hold jointly with the firm.
asset specificity and vulnerability
to hold up can be reduced or
eliminated, if it means that there is
an alternative
source of supply that can be
turned to if one supplier tries to
hold up the firm
it may help
to synchronise and align the
objectives and actions of those
involved in both sides
of the transaction so that they are
not acting against each others’
interests
limiting the opportunity for
external firms to exert hold up
threats. The firm may now have
the in-house capability to
compensate for hold up with
stepped up production of its
version of the components or, in
the case of forward links it may be
able to divert downstream supplies
in-house.
the firm may
become locked in and face a more
limited choice over who to deal
with than might
otherwise be the case.
multiple suppliers mean multiple
contracts and associated costs
of setting up and dealing with
these contracts. It may also mean
higher cost of supplies if the scale
of output of individual suppliers is
now insufficient to reap
economies of scale fully.
the possible sacrifice of economies
of scale by having at least
two separate sources of supply or
methods of distribution for an
activity,
the firm has to deal with two very
different methods
of organising the vertical chain
when there is a tapered solution

It will also be able to get a more

intimate working knowledge of
the stages it has bought directly
into, and this familiarity and
experience should also help to
limit the ability of external firms to
misrepresent the true situation to
them.

On the internal side, the

knowledge that there is an external
alternative should have a beneficial
effect on incentives and help keep
the firm’s own in-house units on
their toes

23
4.6 The Costs of Vertical Integration
Vertical integration is the most radical solution to the problems of market exchange
because it involves not simply compensating for or preventing some of the costs of
market exchange as a method of organising transactions; it involves changing the
method of organising transactions entirely.

The costs and disadvantages of vertical integration are not necessarily any more straightforward
than the complications of market exchange even though it avoids the complications
and games that may be played out when there are different parties with different
objectives and interests.

Essentially the costs are the administrative costs of bureaucracy whose main features are the following:
Different competences
Dangers of specialization
Lack of flexibility
Sacrifice of economies of scale
Dampened performance incentives
Large size (problem of indivisibilities)
Vertical relations with rivals

The market alternative may not discriminate between bad luck and incompetence
in punishing poor performance, but at least a competitive system provides a
continuing stimulus to perform well which may be dampened within a large
vertically integrated bureaucracy.

4.7 Choice of Strategy

So far we have concentrated on the problems of various alternatives for organising
the vertical chain of goods and services, and now we should be in a position to draw
together the threads to explore the question of the strategy to choose in particular
circumstances.
To some extent this question is the obverse of the previous discussion;
if market exchange finds difficulties in dealing with certain kinds of
transactions, then vertical integration may become a relatively more attractive
solution, and vice versa. However, certain circumstances are more likely to throw up
certain kinds of problems than others, so it will be useful to go through some of the
major influences here.

4.7.1 Features Encouraging Market Alternatives

The above discussion suggests that certain features would tend to encourage a
market solution to vertical relations, with contracts being set and agreed between
buyers and sellers at the stages to which they apply. These include the following
situations:
1. Stable and predictable demand and supply conditions
2. Standardised product
3. Many firms at each stage
4. Few other vertically integrated firms
5. Transaction-specific investments not required
6. Well established and widely distributed knowledge of technology
7. Slow-changing or static technology

24
8. Easy to monitor contractual obligations being fulfilled
9. Little chance of being cut off from supplies or inputs
10. Different scales of production necessary at each stage
11. Different competences required at each stage
12. Reputation important in this sector
13. High chance of repeated buyer–seller relationship

4.7.2 Features Encouraging Vertical Integration

The point to bear in mind is that vertical relations should not be the first port of call
for firms when they are looking for an effective way to organise the vertical chain of
production. But if the market alternative begins to be associated with transaction
costs, then it may be time to start looking for alternatives.

It should be noted that it is not sufficient for transaction costs to exist for vertical integration to be adopted.
First, it may be possible to patch up the market alternative, for example by drawing
on one or more of the solutions to the hold up problem discussed
Second, even if the transaction remains bedevilled by transaction costs, this
may still be a cheaper or better solution than resorting to vertical integration.

Vertical integration is still a solution which will involve administrative costs. The
question is, will these costs be less than the transaction costs of market exchange
solutions, including market solutions where the firm has taken steps to try to guard
against or reduce transaction costs?

With these points in mind, the features encouraging vertical integration tend to be the other side of the coin
from those encouraging the market alternative and will include some at least of the following:
1. Unstable unpredictable demand and supply conditions
2. Differentiated product
3. Few firms, at least at one stage
4. Few firms not vertically integrated
5. Transaction-specific investment required
6. Technological knowhow concentrated in pockets in the sector
7. Rapidly changing technology
8. Difficult to check that contractual obligations are being fulfilled
9. Real fear of being cut off from supplies or inputs
10. Similar scale of production necessary at each stage
11. Similar competences required at each stage
12. Difficult to establish or maintain reputation and trust in this sector
13. Low possibility of repeated buyer–seller relationship

These features will tend to push vertical integration higher up the firm’s strategic
agenda. However, it is also important to note that vertical relations can take many
forms and involve many different types of activity. We deal with some of these
issues in the next section.

4.8 The Varieties of Vertical Relations

Production transactions
R&D transactions
Advertising transactions

25
Module 5
Horizontal Links and Moves
 In this module we look at diversification and its place in strategy formulation.
 We look at why firms might want to diversify and show that many of the supposed advantages of
diversification may often be achieved more easily or cheaply though alternative means.
 We look at what diversification can actually deliver for the firms, as well as reasons why it frequently
fails to produce the expected gains.
 We also see that the pattern of diversification (e.g. related, conglomerate) can be as important as the
direction and degree of diversification.

 In this module we shall look at corporate diversification. If there is one topic which is associated with
variety as to where corporate boundaries are set, it is diversification.

 Firms can only vertically integrate so far, and as we shall see in Module 7, expanding firms’
boundaries into joint ventures often tends to be regarded as an option of last resort.
 Even multinational expansion is something which tends to rank low in firms’ preferences. As we
shall see in Module 6, firms typically prefer to concentrate their assets at home rather than disperse
them globally in the form of overseas subsidiaries.
 However, diversification is less subject to such constraints and limitations, and this has led to a
profusion of directions and patterns of competitive

5.2 The Diversification Game

The first thing to realise about diversification is that like vertical integration (Module 4) it is both a direction
and a method.
It is a direction because the firm expands along particular horizontal lines; whether the direction involves
exploiting market and/or technological similarities to its existing business
It is a method because the firm exploits these opportunities through internal organization rather than through
agreements with other firms such as licensing, joint venture or strategic alliances.

Any analysis of an individual firm’s diversification must help explain two things:
why has the firm chosen this direction and why has it chosen this method to pursue this direction?
The notion of opportunity cost will be extremely helpful here because it serves to remind us that strategy is
about choice and alternatives.

5.2.1 Horizontal Directions in the Diversification Game

5.2.2 Preferred Moves in the Diversification Game

The firm should specialise as far as possible if it is seeking competitive advantage.
There are four main reasons for this:
(1) Resource effects If a firm seeks competitive advantage by exploiting linkages across value chains,
then the firm should stick as close to home as far as possible. Specialise if you can; if you have to diversify,
stay as close to home as possible, and try to avoid unrelated diversification as long as related alternatives exist.

26
(2) Market power If the firm is seeking more control over its market, the specialisation option is clearly the
most direct and powerful route to achieving this. However, while the related diversification moves may not
offer such complete control, they may still offer some chances to enhance market power in some areas
(3) Allergic reactions firm may display an adverse reaction to new activities that are unrelated or loosely
related to its existing competencies
(4) Rivals’ valuations

5.2.3 Methods of Expansion in the Diversification Game

Remember expansion by diversification or specialisation involves a method as well as a direction.
We have begun to look at directions, but why should the firm choose this method of organising expansion
opportunities rather than making some agreements with other firms to share resources?
Just as in the case of vertical integration, there is nothing that the firm could organise within its own
boundaries in the way of market power or resource effects that could not in principle also be achieved by
cooperating with other firms.

Market power is the most obvious example; you may not have to merge with another firm to achieve the
benefits of market dominance if a nice cosy agreement with the other firm could be made instead
-- you may not be able to trust your partner. As long as they are separate rivals, they may breach any collusive
agreement if they see it is in their interests to do so

Resource effects may also be achieved by co-operating with other firms without the need to expand
boundaries by diversifying

5.3 Why Diversify?

Why choose to diversify in the first place? So far we have identified some reasons such as resource effects
and market power that may help to generate or reinforce competitive advantage.

Why choose a particular form of diversification such as related or unrelated diversification? It is not enough
to show that a particular move can generate gains from resource effects and market power. The move must
also take into account the opportunity cost of alternative moves, especially those that would allow the firm to
exploit deeper linkages.

Why diversify rather than co-operate? Co-operation with another firm is generally available as an alternative
means of exploiting linkages across businesses. There may be circumstances where it may be more efficient to
cooperate than to diversify.

With these points in mind, we shall look at a number of candidate explanations for diversification,
starting with market power.

5.3.1 Market Power

Diversification can enhance the diversifier’s market power,
In practice there are many ways that power could be exercised by diversification, but each tends to come
down to the increased share of the firm in particular markets.

5.3.2 Synergy
If resources can be shared across value chains for different businesses they may give rise to cost savings
described as synergy in strategic management and economies of scope in economics.

27
If the businesses are effectively the same, then these resource effects are described as economies of scale.
There can be two main sources of gains in such cases.
Indivisibilities Resources tend to come in lumps – a factory, a truck, a machine,
an economist etc. If you were to cut each of these resources in two physically, they
would not be able to do their job any more. The fuller the use that can be made of
these indivisible lumps, the lower will be the cost to the firm of using these resources.
These gains may be achieved by increasing utilisation of an existing resource;
Specialisation. Expansion of the firm may permit increased specialisation of
resources which in turn can lead to enhanced value for the combined firm.

5.3.3 User Gains

The most obvious gains from diversifying are directly to the diversifier itself in the
form of resource effects or enhanced market power. However, diversification can
also help generate competitive advantage for the diversifier by providing benefits for
the user. From the perspective of the user these gains tend to be reflected in one of
two main ways:
cost advantage: e.g. one stop shopping with the convenience of one supplier of
goods to retailers rather than three.
differentiation: e.g. enhanced compatibility of products, with M/C jackets,
trousers and helmets in matching styles.

From the perspective of the diversifying firm these user gains should allow it to achieve
differentiation advantage and sell its products at a premium above those of its competitors.

5.3.4 Internal Markets

The diversified firm is in a position to create internal marketssuch as internal labour markets, internal
markets for R&D knowhow or knowhow in general, and so on.

The advantages of internal markets over external markets are generally regarded as having three major
sources.
Asymmetric information.
Control of opportunistic behaviour.
Divisionalisation gains. The growth of the diversified firm has been seen by some as creating possible
efficiency gains in terms of organisational structure.
Instead of organising the firm around functions (such as marketing, R&D and
production) in what has been termed a Unitary form or U-form structure, the
firm could now be organised around divisions (created around products, processes
or territory) in a Multi-divisional or M-form structure.

The disadvantages in substituting external markets with internal markets, especially in terms of principal–
agent problems in which the shareholders are the principals and management are the agents. The most
important include the following:
Opaque performance.
Lock-in.
‘Not invented here’ syndrome.

5.3.5 Growth
Owners would normally wish the firm to maximize profits, but managers may wish the firm to maximise
growth – growth brings with it certain managerial rewards.

28
This possible conflict of objective suggests that managers might pursue diversification for growth rather than
profitability reasons

5.3.6 Risk and Uncertainty

Diversification can clearly reduce risk in many contexts.

If the management of a single-business firm is worried about its dependence on the

fortunes of one business, it might consider diversifying into other businesses to
spread risks.

These arguments might be seen as reasonable but there two sets of problems with them:
Opportunity costs of diversification. Diversification moves the firm away from
its core business and competencies. Even if a diversification move appears profitable, it may turn out to
be a mistake once opportunity cost considerations are taken into account.
Owners may spread business risks by diversifying their portfolios. While managers might be
uncomfortable at remaining so exposed to the fortunes of particular markets or technologies, owners should
be able to sleep at night knowing they have effectively insulated themselves from
such risks by diversifying their portfolios. If managers do persist in pursuing
diversification to spread risks, then it would suggest that there is a principal–
agent problem here, with managers not necessarily acting in the best interests of
the owners of the firm.

There could be a number of simpler and cheaper solutions to the problems that caused by volatile sales.
Liquid assets.
Short-term finance.
Stockholding.
Insurance.
Long-term contracts.
Vertical integration.
While vertical integration carries its own risks and problems, in some cases it
may allow the firm to stay closer to its core skills than does diversification.

None of these solutions is free. Liquid assets have an opportunity cost in that they
might be used for more profitable investment opportunities. There will be a price to
pay for short-term finance, insurance and long-term contracts that may be reflected in
interest charges, insurance premiums, and price discounts respectively. There will be
warehousing and maintenance costs incurred from storing stocks. And vertical
integration may bring with it its own special sets of problems.

However, each of these solutions has one fundamental advantage over corporate
diversification; it allows the firm to concentrate on its core competencies and avoid
the opportunity costs associated with diversifying away from these core competencies
simply to reduce risk.

29
corporate diversification can help provide a basis for defending the firm
against unpleasant surprises such as technological innovation by its competitors.
However, there are further questions we can ask of this strategy
Why not specialise until you are forced to change to another business?
The problem is that the worst time
to try to make such a switch is when you are forced into it. Diversification can
take time and considerable managerial and financial resources to achieve, and
even then success for individual diversification may be uncertain. The firm in the
decline stage of Figure 5.8 will find its internal resources dwindling as the business
fades, while outside financial institutions are likely to have second thoughts
about providing financial props to allow the firm to bridge between the old and
new activities.

If some corporate diversification is designed to safeguard managerial

jobs, can this also be in the interest of owners?
If diversification has an opportunity cost
in diverting resources from more specialised attention to core competencies,
then it clearly may conflict with the interest of owners. Where such diversification
may also be in the interests of owners is where there are transaction costs
associated with bankruptcy. In particular, the demise of the specialised firm as in
Figure 5.8 may lead to the break up of the management team. Corporate diversification
may increase the chances of preserving this team, which may be counted
as a valuable – indeed critical – asset in its own right.

If risks such as technological innovation by competitors are often one-off

surprises, how can management know in advance when they should diversify?
In the context of corporate diversification,
it may be difficult for management to anticipate the timing and form of future

30
threats to individual businesses, but it may be possible to identify business environments
that are more likely to throw them up.

A chief executive once described his strategic management problem as coping with surprises.

On the face of it, conglomerate diversification offers the most obvious way of
anticipating threats to the viability of individual businesses. After all, having as many
unrelated markets and technologies as possible would seem the most direct way of
avoiding dependence on a limited set of competencies. However, in the next section
we shall see that this is not necessarily the case. In the late twentieth century,
corporations have developed new tricks that allow them to match the ability of
conglomerates to absorb outside threats without incurring the severe opportunity
costs associated with such extreme diversification.

5.4 Forms of Diversification

We can summarise what we have learnt so far as follows:
 Firms may diversify for a number of reasons. These include market power, resource effects, user
gains, creation of internal markets, growth motives and dealing with the possibility of attacks on the
viability of individual businesses.
 Diversification may help the firm deal with these problems in ways that are more effective or cheaper
than alternative solutions (such as co-operating with other firms). However, most of these motives
for diversification still suggest that the firm should stay as close to home as possible even when it
diversifies into other businesses.
 It is only when the risk of threats to the viability of linkages are brought into the reckoning that
linkages may be seen to have price tags attached to them that could suggest they should be avoided
or restricted in some circumstances.

Does this give us a justification for the conglomerate?

No. In recent years firms have discovered strategies that have allowed them to
extract many of the benefits of simultaneously exploiting the gains from linkages
between businesses together with the risk-spreading benefits of multiple markets and
multiple technologies that the conglomerate strategy offers.
The name of this strategy is Related–Linked

The non-conglomerate strategies all pursue related diversification based on a single market or technological
link between businesses.

We shall let our firms be subjected to attack from the outside. Worse, from the point of view of our firms,
the form of attack will often be kept a surprise until the last minute. This follows from sound strategic
principles. From the point of view of the attacker, the element of surprise can be an essential weapon.

What form is such an attack likely to take, or to put it in military terms what kinds of ‘bombs’ can be dropped
on the firm’s activities? In practice they can take many forms, but the most important in real life corporate
battles tend to be the following:
Innovation in the form of new products or processes.
Change in consumer tastes,
Changes in government restrictions,
Resource depletion,

31
Suppose we were to lob a
bomb in the form of, say, technological innovation in the direction of our diversifiers
in Figure 5.9? How much damage could a single bomb do? Interestingly, the
answer depends on the pattern of linkages, not just the extent of linkages.

The only strategy that appears insulated from such threats is the conglomerate.
Individual businesses may be attacked, but there are no marketing/distribution or
technological competencies running across its businesses that may expose the firm
to a single bomb threat. Clearly this is one advantage the conglomerate has over the
market- and technology-related diversifiers.

Related–Linked Strategy. It is called this because the various businesses are linked together but not
necessarily directly as in the cases of the other two related diversifiers

This is a degree of insulation from external threat which is almost as good as the

32
conglomerate, and indeed the more that the related–linked firm expands using this
strategy, the closer it approximates the degree of protection offered by conglomerateness.
Yet this is clearly not a conglomerate strategy since every business is
(indirectly at least) linked to every other and, as we can see, there is a solid level of
linkage exploited as we move though the strategy, just as in the case of the marketbased
and technology-based diversifiers. This is a strategy which seems to enable
management to exploit the advantages of related diversification without incurring
the dangers of exposure to a single external threat.

So why do conglomerates exist when they appear to have no justification in economic or strategic terms?
The disguised related–linked firm. We already have one answer to the puzzle
of the conglomerate. Many firms which appear to be conglomerates because of
the diversity of their businesses turn out on closer inspection to be related–
linked firms rather than genuine conglomerates.
Restructuring of related–linked firms. Although it has an attractive logic to it,
the related–linked strategy can be very fragile and it does not take much to turn
it into a conglomerate, especially if the firm is under pressure to divest lossmaking businesses.
No alternatives. There are some industries which have faced external threats in
the past for which it has been difficult to find closely related products.
Rapid growth. If you are seeking really fast growth rates in the
immediate time period and the capital market (shareholders, banks) is willing to
bankroll your plans, then synergy becomes much less important in the overall
scheme of things. Strategic planning can become dominated by availability of
acquisitions rather than with how they fit your existing business or businesses;
this is how many acquisitive firms in the past turned into conglomerates. They
concentrated on what was available rather than on what would be a good fit for
their existing businesses.
Path dependency. Restructuring, the absence of alternatives and rapid growth
may explain why some firms become conglomerates but they do not help explain
why they remain as such. One answer is path dependency.
Such teams build up skills in managing unrelated
businesses and shifting the strategy to one which emphasises linkages across
divisions as in the related–linked case would involve a major change in top management
skills and substantial transaction costs in buying and selling businesses
until the new strategy is created.
Conglomerate focus. The final reason for the continued survival of the
conglomerate strategy is that management learn and adapt. They may not be able
to change their spots easily, but they can do the next best thing – they can shuffle
them around.

33
Module 6
International Strategy
 In this module we look at the implications of internationalising the firm’s activities.
 One of the fundamental issues is that multinational expansion may make far less use of the firm’s
existing resource base than alternative methods of expanding, both domestically and internationally.
 As with the previous modules, we see the importance of properly assessing the advantages and
disadvantages of specific strategies (such as multinationalism) against all other alternatives.
 We discuss the Diamond Framework, which provides a systematic basis for evaluating strategic
alternatives for firms facing international competition, whether it is venturing abroad itself, or facing
threats from foreign firms in its home territory.

We have to distinguish between international firms and firms that are multinational.
A company is international if it serves foreign markets.
It is multinational if it also locates operating facilities abroad.

Stay-at-home character

We need to explore the circumstances that will help to create multinational enterprise.

6.1 The Diversification Game Goes International

A major problem with diversification was that it
could lead to the sacrifice of the rich resource linkages which may be possible under
specialisation, though it could have the possible advantage of saving the firm from
overdependence on a limited set of competences that may be vulnerable to obsolescence.

It is not enough to establish international opportunities to justify international

expansion. These opportunities will only be worth pursuing if they beat alternative
domestic investment opportunities, taking into account the ability of the firm to
compete against foreign firms on their home ground.

6.2 The Question of International Competitiveness

Michael Porter (1990) makes some crucial points about the idea of ‘competitiveness’ of industry seen from a
national perspective.
Is competitiveness of industry based on exchange rate? But over sustained periods Germany
combined economic growth with an appreciating exchange rate.
Is competitiveness based on cheap labour? But Sweden sustained long periods of economic growth on
the back of relatively expensive labour.
Is competitiveness based on cheap natural resources? But Japan achieved rapid economic growth in
the post war period with very little in the way of indigenous natural resources.

It may be simplistic and indeed misleading to identify a cheap currency or cheap resources as
necessary or sufficient for competitive advantage. If low
cost is not necessarily the only or even the best strategy for firms to achieve

34
competitive advantage, we should not be surprised to find that the same holds at the
level of countries.

There are two other important observations that Porter makes before we begin to look at the link which
provides the basis for international competitive success.
For a given country, there are typically few industries or segments of industries
which perform strongly in an international context.
For a given industry, or especially segments of industry, there are typically few
countries which perform strongly in an international context.

6.3 Porter’s Diamond Framework

Michael Porter argues that competitive strategy for a firm should be framed in the context of the attributes of
its national environment that may help generate or inhibit competitive advantage.

The diamond framework is widely used by corporate strategists and public policy makers to explore the
circumstances which can help stimulate and maintain international competitiveness.

These attributes fall into four main categories, which together go to make up Porter’s Diamond Framework:
(A) factor conditions;
(B) demand conditions;
(C) linked and related industries;
(D) firm strategy, structure and rivalry.

Consistent with the discussion of the previous section the important driving forces of the Diamond can be
analysed in terms of space and time.
Space considerations. The space covered by the Diamond is essentially contained within the home base
(usually the nation) to which the firm belongs. An important unit of analysis here is the cluster (a group of
firms in linked or related industries that trade or compete with each other). A cluster typically occupies an
even more localised space than the nation state,
Time considerations. Time or dynamic considerations reflect the fact that the normal logic of
competitiveness may be turned on its head once we look at the time periods long enough to allow for major
innovative and organizational changes.

Porter’s Diamond Framework provides an interesting and persuasive account of the influences at work in the
development of national advantage.

We shall look at each of the four attributes in turn in terms of how space and time considerations may
influence international competitiveness.

(A) Factor conditions

Porter distinguishes between factors in terms of:
1. Degree of sophistication. At one end of the spectrum of degree of sophistication
we have basic factors which tend to be inherited (such as natural resources) or
easily created (such as unskilled labour) and at the other we have advanced factors
(such as a research scientist) which are more sophisticated.
2. Degree of specialisation. At one end of this spectrum we have generalised
factors which can be turned to many different kinds of tasks (such as a village
hall) while at the other end we have highly specialised factors whose value lies in
a limited set of tasks or one specific task (such as a brain surgeon).

35
While degree of specialisation may be linked to the notion of asset specificity, specialisation does not
guarantee specificity

Selective factor disadvantage occurs when relative scarcity or other problems of a certain factor stimulate
technological or organizational innovation to deal with the problematic factor, and this innovation turns out
to help generate subsequent competitive advantage in an international context.

So factor disadvantages, including scarcity, can turn out to stimulate eventual competitive advantage while
factor advantages, including abundance, can eventually lead to declining competitive advantage.

(B) Demand conditions

Demand conditions play an integral part in Porter’s Diamond in determining
whether or not a country has achieved or can achieve a competitive advantage in a
particular area.

Porter argues that there are three main features of demand conditions that can be
important in a dynamic context in terms of helping develop and reinforce competitive
advantage.
1. Composition of home demand.
Porter notes that the main issues here include:
(a) Segment structure of demand: the distribution and variety of patterns of demand within a sector.
(b) The existence of sophisticated and demanding buyers: sharpening up and honing the competitive skills
of firms that could prove useful in competing against firms that have had an easier life.
(c) Anticipatory buyer needs: providing an early warning system and experience of trends that may emerge in
the future in foreign markets.

2. Demand size and pattern of growth

There are a number of features here that can reinforce the effects of home demand composition on
competitive advantage.
(a) Size of home market can help generate economies of scale and learning curve effects.
(b) Number of independent buyers, including at wholesale or retail levels can generate variety of
information and market feedback
(c) Rate of growth of market demand: advantages of a growing market include possible entry room for
innovative new firms
(d) Domestic market saturates early: this may stimulate fierce rivalry amongst domestic firms that can
enhance cost competitiveness and innovativeness and in turn enhance their fitness to compete on a world
stage.

3. Internationalisation of home demand.

These aspects can help pull a nation’s products abroad.
(a) Mobile or multinational buyers: the internationally mobile customer may seek to buy or be receptive to
buying the products that they consumed at home.
(b) Influences on foreign needs: historical or cultural factors may influence the pattern of demand in foreign
markets.

(C) Linked and related industries

Internationally competitive industries and sectors tend not to emerge in isolation but instead are associated
with other internationally competitive industries within their nation or region.

36
Competitiveness and high performance in one sector can have spillover benefits into linked and related
sectors in the domestic market through a variety of means:
User sector firms imposing high specifications on supplier sector
Reputational spill-overs
User sector firms demanding cost competitiveness from supplier sector
Supplier sector protecting their brands by raising user sector performance.
Technology spill-overs between related sectors
Related sectors sharing marketing and distributional channels
Spill-over of highly trained and well qualified labour pool between sectors
Best practice diffusion by example and observation
Proximity reduces transaction costs between sectors.

The fundamental point is that sectors may benefit in a variety of ways that enhance
performance or reduce costs from having an internationally competitive
sector nearby. These may include forcing a related or linked sector to raise its
standards by direct pressure or example, indirect benefits in the form of externalities
or spill-overs, or simply the ability for high performing sectors to reinforce each
other’s performance because proximity reduces communication problems and
transaction costs.

(D) Firm strategy, structure and rivalry

These can include a wide variety of social and cultural aspects

A simple cultural difference can have a profound effect on the organisation and competitiveness of sectors
and firms. And as we shall see, they can also influence the kind of sectors in which a country is more likely to
develop a competitive advantage. Important themes in this context include the following.
1. Strategy and structure of domestic firms.
2. Goals and objectives.
3. Domestic rivalry.

(E) The jokers in the pack: chance and government

Porter adds that both chance (e.g. wars and inventions) and government can play
roles in the relationships which evolve in the Diamond in the context of creating an
international competitive advantage. The effects may be partial and not sufficient to
create and sustain a competitive advantage in practice.

6.4 Using the Diamond Framework

The Diamond is a tool which draws on many issues and can have a number of
abstract elements such as culture, legal context and corporate objectives. However
the operation of the Diamond can result in highly visible real-world clusters of firms
in particular regions of the world. The task is to construct and use the Diamond
framework in ways that will help to illuminate and inform strategy and policy.

6.4.1 Identifying and Using a Diamond

The Diamond is similar to Porter’s Five Forces Framework in that it combines the
rigour of economic analysis with the comprehensiveness of the checklist approach
common in areas such as strategic management.

37
The scope of individual Diamonds can be exhaustive and far reaching and this
can create problems as well as opportunities for such analysis.

Here are some of the issues (and difficulties) that are raised in using a Diamond approach.

6.4.1.1 Interdependence of the Four Main Elements no one element can be isolated as ‘the’ element
that has (or will) create competitive advantage for a sector in a particular country. In practice, a number of
elements will contribute and interact with each other.

6.4.1.2 Essential Contribution of All Four Main Elements each of the four main categories in the
Diamond should usually actively contribute to competitive advantage if it is to be generated and maintained,
though just as it may be possible to have a three-legged chair in certain cases, so the absence of a strong
fourth element in the Diamond can sometimes be compensated for.

6.4.1.3 Continuous Upgrading and Improvement essential feature of the Diamond is its emphasis on
dynamic aspects, in particular the processes that take place over time and influence the evolution of particular
sectors and firms. A further implication is that firms and sectors may need to upgrade their skills,
competences and technologies continuously if they are to maintain their competitive advantage. This is
particularly important in the context of the Diamond since we rely on ‘snapshots’ of sectors and countries to
make sense of the structures and processes that are important at any point in time

6.4.1.4 Subjectivity and Multiplicity It means that constructing and interpreting a Diamond may be a
matter of art as much as science.

6.4.2 Diamond in Action: US Competitive Advantage in Economics

Textbooks

6.5 Framing Company Strategy

Porter’s Diamond has a number of implications for company strategy.
1. Possibility of competitive advantage depends on home Diamond.
2. Choice of strategy influenced by home Diamond.
3. Continuous innovation. Porter suggests that firms seeking to maintain their competitive advantage
should maintain the pressure for innovation in ways which include the following:
Seeking sophisticated buyers
Seeking buyers with most demanding needs
Overshooting most stringent regulations or standards
Sourcing from leading home based suppliers
Seeing leading rivals as benchmarks.

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 4. Perceiving and anticipating industry change. The Diamond can help a firm position its strategy
with future opportunities and threats in mind. Porter suggests a variety of ways in which this may be
pursued:
Seeking buyers with anticipatory needs
Exploring emerging buyer groups
Seeking locations with early regulations
Identifying trends in factor costs
Linking with research centres
Studying new competitors
Having outsiders in the management team.
5. Difficulties of replicating a Diamond’s advantages.
6. Awareness of foreign Diamonds.

6.6 Competing in International Markets

What does it take to compete effectively in international markets? We can approach this problem by using
what Dunning (1993) has called the Eclectic Paradigm.
In the Eclectic Paradigm the issues can be examined by reference to three main questions. We shall look at
these questions using the example of US multinational expansion into Europe.

Question 1
Why were US firms able to compete successfully in European markets?
Answer: The US firms had ownership advantages

Ownership advantages
The kind of ownership advantage that a firm may possess in an international
context is most clearly technical knowhow since that may be the asset most
easily transferred and shared between international locations. This helps
explain why many multinationals come from high technology sectors and are
themselves R&D-intensive; high levels of R&D economies may help to
compensate for the costs and problems of going international.
However, there are other kinds of ownership advantage that may be drawn
on to help support competition in an international environment. These
include:
marketing knowhow and resources
organisational advantages
access to finance
purchasing knowhow
favoured access to resources (e.g. ownership of oil reserves)
brand recognition (e.g. McDonalds)

Question 2
Why did US firms produce in Europe rather than the US?
Answer: There was some location advantage that European production gave
over keeping all production at home.

Location advantage
There are a variety of possible influences that may encourage a firm to locate
some of its activities overseas, including:
access to cheap or high quality resources
transport costs

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 need to service local market quickly

Question 3
Why did US firms not exploit their ownership advantage through co-operative
agreements with European firms?
Answer: Because there was an internalisation advantage in US firms going it
alone.

Internalisation advantages
Such advantages include:
search costs for a suitable partner to co-operate with
negotiating costs
policing costs
lack of able and suitable local partners
residual problems of opportunistic behaviour
reducing vulnerability to fluctuations and uncertainty of external variables
control and secrecy of ownership knowhow advantages (intellectual property).
control over brand image
problems of controlling delivery, quality of inputs
reducing chances of losing access to inputs or outlets
being able to indulge in monopoly practices such as predatory pricing using transfer pricing
and cross subsidisation

So the Eclectic Paradigm is useful in combination with our earlier analysis. It may
help sort out the issues that may give international firms a competitive advantage
over domestic firms. It may help suggest why firms may make direct investment in
foreign locations rather than export. It may help explain why this foreign direct
investment may take the form of multinational expansion rather than co-operative
ventures with local firms.

However, it should still be noted that the Eclectic Paradigm is not the whole story,
since it assumes that firms’ most attractive investment opportunities may be found in
overseas markets. As we noted above, international expansion will tend to become a
major option only after the firm has exhausted specialisation and diversification
opportunities in its home base to the point that the weaker resource linkages, associated
with overseas expansion begin to look relatively attractive. Firms’ first preferences are to
stay at home for very rational and sensible resource-based reasons.

6.7 Competing Abroad: The Principles

Porter suggests a number of principles that are important for firms to bear in mind if they are to compete
successfully abroad.
We shall consider how they make sense, not only in terms of Porter’s own Diamond and value chain analyses,
but in resource-based and transaction cost terms as well.
They are not hard and fast rules and exceptions can always be found, but they stem from looking at Porter’s
Diamond Framework with the help of the resource-based and transaction cost perspectives.
Seek sophisticated overseas buyers.
Source basic factors globally.
Keep strategic assets close to home.
Selective tapping of foreign technology.
Attack rivals directly to learn from them and neutralise them.

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 Locate Regional HQs at best Diamond.
International acquisitions and alliances for access and learning.
Globalisation versus localisation.

6.8 Globalisation Versus Localisation

The issue of globalisation versus localisation can be best set out in resource-based terms and using a value
chain analysis.

Even once the firm has fully exploited economies of scale though specialisation, continuing to specialize can
help the firm to avoid diseconomies if it were to wander into areas which required resources and
competencies which it did not possess.

As we have noted, the best solution for the firm in resource-based terms is what is called ‘sticking to the
knitting’, by keeping as close to home as possible, by staying in the same product line and the same home
market. If it has to diversify, resource-based considerations suggest that it should try to use as much of its
existing resources (including core competencies) as possible.

What is sensible in resourcebased

terms may not be ideal in market terms. Resource-based logic suggests that
the firm should organise and manage itself the same way, try to make the same type
of product using the same technology and sell that product the same way in
different world markets. But market-oriented logic may suggest that what works in
one country may not work in another. This may have implications for the way the
firm manages and organises itself, the technology it uses, the type of product it sells,
and how it sells these products. The ideal solution from the point of view of
market-oriented logic may be to customise all or some of these issues and be
sensitive to the conditions and needs of the different global markets that the firm is
servicing. But, of course, the more the firm differentiates its activities to reflect local
market conditions, the more it runs the risk of sacrificing economies from shared
resources and competencies across different world markets, and the more it may
risk leaving at home the competencies and sources of ownership advantage that
encouraged it to consider going multinational in the first place.

There are at least three issues which may still encourage the evolution of international firms even in markets
traditionally dominated by local tastes and brands:
Surface differentiation.
Access to factors of production.
Cultural globalisation.

In short, the tension between globalisation (of brands) and localisation (of tastes
and preferences) does represent a challenge for firms that wish to transfer their
national sources of competitive advantage into foreign fields. If national conditions
and circumstances are very different from each other, then it may be difficult to
compete abroad on existing sources of competitive advantage built up in a domestic
context. At the same time, local differences may be only skin (or brand) deep and a
determined firm may be able to use a great deal of common technical skills and
competences in marketing to compete in different national contexts. Finally, it is
important to bear in mind that international firms may not just respond to a given
set of tastes and preferences, they may be able to change these national tastes and
characteristics as well.

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Module 7
Making the Moves
 We look at alternative methods for pursuing the various strategies analysed in previous modules,
such as merger, acquisition, and various forms of co-operation.
 We show how the various sources of added value and competitive advantage in such cases can be
reduced to two main categories; demand-side effects from enhanced market power and supply-side
effects in the form of economies of scale and scope from shared resources.
 We examine why the claimed benefits from merger, acquisition and co-operation frequently fail to
materialise. We also look at the logic underlying the phenomenal development of alliances and
networks in many high technology sectors.

The various issues that we looked at in Module 4 (vertical moves), Module 5 (horizontal moves) and Module
6 (international moves) can all be summarised under one umbrella issue – there may be gains to be had by
combining different bundles of resources and co-ordinating their activities.

If the act of combination is done internally within the firm, it can result in vertical integration (Module 4),
diversification (Module 5) or the multinational enterprise (Module 6).

However, there are various ways that these strategies can be achieved (such as internal growth, merger and
takeover) and there may also be alternative means (such as licensing, franchising and joint venture) of
pursuing the gains from combining and co-ordinating resources that do not require the resources to be
internalised within a single firm.

This module is concerned with these alternative means of pursuing the gains from combination.

One of the fundamental themes in this elective has been that you must always bear the alternatives in mind in
selecting a course of action.

The notion at the heart of all these modules has been that of opportunity cost – the cost of the net gains
sacrificed from the best alternative foregone by undertaking this action.
Strategies should only be seriously considered if it looks likely that they will deliver net gains, even after taking
opportunity costs into account.

7.1 Example of a Combination

Gains from merger here fall into two categories, those that lead to sharing of resources and a fall in costs and
those that may increase the market power of the firm, which here means shifting the demand curve(s) to the
right and possibly reducing demand elasticity.

Merger is not the only way that the firms could achieve the gains from combination. For example, they could
agree to pool resources and selling efforts in a co-operative venture. They could agree to have their sales
forces sell each other’s products, press for retailers to stock the other firm’s products as well, and so on. One
common way for these gains to be pursued is in a joint venture where two or more firms co-manage a jointly
owned combination of resource

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7.2 Evidence on the Performance of Combinations
Perhaps one of the most surprising things about merger, acquisition and joint
venture is how badly they tend to perform in practice, and yet how popular they
remain with strategic planners.

There are some pitfalls on the way in terms of judging whether or not a
particular combination has or has not added value.
Measurement difficulties.
Other motives.
Wrong criteria.
Opportunity costs.

There are two important messages we should take from the empirical evidence on combination activity.
First, they frequently tend to disappoint in terms of adding value, especially from the point of view of making
an acquisition and most especially from the point of view of joint venturing.
Second, the strategic motives and implications of combination may be more complex than simple short-term
profit maximising motives, and this may be reflected in the apparently poor performance of combinations
when they are judged in those terms.

But before we get to these issues, we need to explore the basics of how combination could actually add value
in the first place.

7.3 Adding Value from Combination

The first thing we need to do in looking at the potential gains from combining resources of different business
units (whether through internal expansion, merger, acquisition, joint venture, or other means) is to produce
the corporate version of the laundry list. What is that combination intended to achieve? Only after that
should we go on to consider the merits or demerits of alternative methods for pursuing these potential gains.

Resource gains in this case should be reflected in cost savings/productivity gains for the combination.
Whether or not those occur will depend on the current disposition and characteristics of the respective sales

43
forces and how actual changes are managed. In particular it depends on the nature of the similarities and the
differences between the two parts of the combination, their resources and their product lines

How may these gains be achieved? There are a number of ways and they may include some or all of the
characteristics below.
1. Similar outlets: eliminating duplication.
2. Similar products: eliminating competition.
3. Similar activities: increasing sales.
4. Similar activities: improving capabilities.

Combining the two separate sets of activities and resources represented by the two sets of sales forces could
result in a number of potential benefits in this one category of potential resource linkage. These include
(1) elimination of duplicated activity,
(2) increased control over buyers,
(3) increased productivity and range of output of resources, and
(4) diffusion of superior or best practice capabilities throughout the combination.

The gains may be thought of in terms of supply-side gains (sharing resources and reducing costs) or demand-
side gains (shifting demand curve and/or increased market power). The particular form the gains take will
depend on the actual linkage in question, for example increased market power here is reflected in increased
bargaining power with respect to buyers, while market power effects from combining purchasing
departments could be reflected in increased bargaining strength with respect to suppliers.

The most obvious way to achieve gains through resource sharing or enhanced market power is through
merger of the two firms, or acquisition of one firm by the other.
There are two comments worth making at this juncture.
1. The whole value chain matters.
2. Alternative methods of combining activities.

7.4 Why Do Mergers and Acquisitions Perform So Badly?

If we want to explore this question from the point of view of competitive strategy, it really breaks down into
two parts.

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First, why the gains are often so poor – why do mergers and acquisitions so often fail to realise the added
value that had been promised from the combination?
Second, why does one party to the transaction (the shareholders of acquiring firms) often seem to do badly
compared to their counterparts on the other side of the transaction?

The answers will tell us a lot about the nature of this method of pursuing competitive strategy.

7.4.1 Why the Gains from Merger or Acquisition May Be So

 Disappointing
 Compatibility problems
 Optimistic bias
 Strategy matching, interdependent strategies
 Insulation from environmental surprises
 Agency problems – managerial motives for merger
 The Prisoners’ Dilemma

To summarise, there are enough reasons for merger and acquisition to fail to add
value in practice for us not be surprised when such an outcome occurs. Indeed,
perhaps it could be expressed the other way that there may be grounds for surprise
and delight when a merger or acquisition beats the odds and actually turns out to
have led to enhanced value!

7.4.2 Why Do Acquirers Do Even Worse than Those Being Acquired?

The Grossman–Hart Problem
The ‘Winner’s Curse’
Hubris (or excessive self-confidence)

In practice, merger or acquisition may be chosen over internal growth for a variety of reasons as in the
following cases:
 Growth objectives of management
 Where speed is important, for example to pre-empt competitive response of rivals
 To gain competences and resources that could not be easily developed internally
 In the absence of room for entry through internal growth (e.g. the existing firms may have the
supplier and customer bases locked up)
 In order to eliminate a competitor.

7.5 Co-operative Activity

There are a number of ways that firms can co-operate in practice.
Licensing
Franchising
Informal co-operation
Sub-contracting
Alliances
Network participation
Joint venture

A licence is effectively permission for another firm to indulge in an activity that would otherwise be
forbidden by law.

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A franchise also involves the transfer of intellectual property from one party to another for specified periods
and territories, usually based around the rights to use the franchisor’s name and trademarks,

The main difference between licensing and franchising is that licences usually relate to part of a business (the
technology for a specified product or products), while franchising tends to involve the transfer of knowhow
ranging over the entire business, from purchasing through production to presentation and selling.

Informal co-operation is difficult to pin down and define in formal terms; it really depends on the context in
which it takes place. But the logic of it is clear enough and can be summarised as; ‘you scratch my back and I
may scratch yours’.

Sub-contracting involves separating out part of a production process to be dealt with under contract by a
separate firm.

Joint venture is a form of co-operative activity that has increased rapidly in numbers in recent years.
Definitions vary, but generally speaking a joint venture tends to have five main characteristics.
Two or more ‘parent’ firms agree to co-operate;
The new entity (the ‘child’) is created for a specified task and possibly duration;
The child has its own decision-making capability;
The child is co-owned by the parents;
There is provision for continuing parental supervision and control over the venture.

Three particular considerations when joint venture is compared to the merger option:
1. Contractual issues.
2. Complex hierarchy.
3. Appropriability problems.

So joint venture has at least three sets of disadvantages compared to merger or acquisition – two sets of
transaction costs (arising from the joint venture contract and the residual problems of appropriability
problems that contract cannot eliminate), and the administrative costs arising from the dual control system of
joint management.

However, in recent years we can seen an escalation in joint venture activity. So what can explain these kinds
of joint ventures?

1. Why joint venture and not other forms of co-operation?

These other forms of co-operation are more appropriate
for cases where the fundamental market and technical characteristics that will
help generate competitive advantage are fully known in advance and can effectively
be specified in a contract.6 Joint venture is frequently adopted in areas
where there is still major uncertainty concerning market and/or technical possibilities,
such as technological innovation, new market entry and searching for
natural resources. That is why the child is given a decision-making capacity to
deal with future issues as market and technical information unfolds in the course
of developing the venture.

2. Why joint venture and not merger and acquisition? Joint venture does
essentially the same thing that merger and acquisition does; that is, it provides a
hierarchical structure and decision-making apparatus that allows the business to

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respond creatively and exercise influence over future events. As we have seen,
joint venture has a long list of disadvantages relative to merger and acquisition,
but it has one critical advantage. It can be designed to cover only the selected
range of the resources that are of relevance to this venture opportunity, and
these in turn may relate to only a small part of the relevant partner’s activities.

There are two basic ways that joint venture can perform it.
(a) Selected pieces of the value chain:
(b) Selected businesses of the firm:

Joint venture is almost certainly more costly than merger or acquisition over the range of the activity to
which it is applied.

Joint venture is not just an alternative to corporate diversification

through merger and acquisition, it is also a consequence of it. As long as firms are small
and specialised, exploitation of new opportunities through merger and acquisition is
likely to be the preferred route to growth, especially if internal expansion opportunities
are limited. However, the evolution of the large diversified corporations in the
Sixties created the conditions under which joint ventures were seen as increasingly
attractive options compared to merger and acquisition alternatives.

An alliance between two firms involves a formal or informal agreement to co-operate

on a variety of matters. Some alliances involve swapping equity to help cement the alliance and increase the
involvement and commitment of both parties to their joint success. They are
analogous to the twinning or partnership agreements that are formed between cities
and institutions such as universities.
Alliances can have both a resource-based and transaction-cost logic. The advantage
of alliances from a resource-based perspective is that both sets of
managerial teams can build up familiarity and understanding in terms of how the
other firm works.

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