Managerial Economics:Economics of Strategy

Economics of Strategy Patrick McNutt www.patrickmcnutt.com Abridged

Workshop Lesson plan.

Plan is to follow Besankos Economics of Strategy 5th Edition Day 1 : Revision of Chapters 3 and 5 (Agency and Co-ordination) and Introduce Chapter 2 (Economies of Scale and Scope) Day 1 Workshop Study Groups & Case Analysis Break-out Sessions at 330-530pm Day 1 and Day 2 with group Presentation Day 3 at 2pm start Day 2 & 3: Focus on Chapters 8,9,10 and 11 and link into Units 3 and 4 Day 1: Introduction and setting the scene using McNutts Game Embedded Strategy Chapters 1 and 2

Workshop Focus
Management type and relevance of TCE..Unit 1. Besanko Ch 3 and 5, McNutt Ch 1 Cost leadership and economics of capacity..Unit 2. Besanko Ch 2 and McNutt Ch 5 Market-as-a-gamemarket structure, oligopoly, and dynamic gamesUnits 3 and 4. Besanko Ch 8,9,10 and 11 and McNutt Ch 6,7,8 and 9 Real Time case Analysisgo to Page 45 of colourcoded Storybook

Why the focus?At the frontier of economic analysis..

Understand management as they are not as theory hitherto assumed them to be Management can be ranked (by type) and are faced with trade-offs => something must come top of the menu Firms are conduits of information flows (vertical chain) Supply chain capacity constraints and technology-lag Reducing price does not necessarily lead to an increase in revenues (elasticity) Prices are primarily signals (observed behavior) Companies understand the competitive threat as (recognised) interdependence (zero-sum and entropy)

The competitive threat!

Traditional Analysis is biased towards answering this question for Company X: what market are we in and how can we do better? Economics of strategy (GEMS) asks: what market should we be in?

Coase asked in The Nature of Firms in 1937:

Why are not all economic transactions coordinated by markets?

Co-ordination
When transaction costs are too high, exchange to be coordinated by organisations

Transaction costs: costs of negotiating, monitoring and enforcing contracts. Behavioural assumptions: bounded rationality & opportunism. The relative cost of organising transaction through different forms of governance determined by: Extent to which complete contracts are possible. Where contract refers to agreement between two parties which could be explicit or not. Extent to which there is a threat of opportunism by parties in the transaction. Degree of asset specificity in the transaction. Frequency with which the transaction is repeated.

Storybook p.12

Organisation vs. Market

division of labour
Adam Smith

Specialisation

Co-ordination
market

Transaction cost economics

Hybrid

organuisation

Companies as Players in a Market-as-a-game?

Principal-agent relationship Shareholders as principals and management as agents Who are decision makers? Management firms companies = PLAYERS (key decision makers)

Costs of not being a Player

Agency costs can accrue..across the shareholders (esp institutional)..changing CEOs Bounded rationality and opportunity costs with trade-offs Make or Buy dilemma First Mover Advantage (FMA) v Second Mover Advantage (SMA) Play to win v Play not to loose! Follower status behind the curve Technology lag and failure to differentiate fast enough to sustain a competitive advantage

Bridging Unit 1 and Unit 3: Game analysis

Binary reaction; Will Player B react? Yes or No? If YES, decision may be parked If NO, decision proceeds on error Surprise Non-binary reaction: Player B will react. Probability = x% Decision taking on conjecture of likely reaction No Surprise

Lets begin! Unit 1: Why the emphasis on behaviour (of players)?

The Firm as a nexus of contracts Vertical chains and agency costs Shareholders and management-as-agent GHM Theory (Besanko pp158-161) and incomplete contracting Type of management and Bounded rationality

Management Models
Understand Penrose effect Understand Bounded Rationality Go to Table 1.2 pp14 McNutt Game

Embedded Strategy Compare with Next Slide where you add in Williamson/TCE

Behavioural

Baumol

Marris

Williamson

Objective Approach

Multiple goals Satisficing subject to Profit Constraint Yes Varies Yes Yes

TR:Sales Maximisation subject to Profit Constraint Yes Short and also dynamic Partial Management and zero-sum

Growth:gd Maximisation - subject to Security Constraint Yes Long Partial Relevance of shareholders

Managerial Utility or Value Maximisation - subject to Profit Constraint

Principal Agent Issue Short v Long Term Reaction & Interaction Decision Making Coalitions

Yes Short Partial Yes,..TCE

Baumol strategy or Maximising Market Share: MMS

Recognise zero sum constaint and entropy (redistribution within market shares) Market Shares (before): 40+30+20+10 Zero-sum (after): 30+40+20+10 Entropy (after): 30+35+25+10 Iff {qi/Q} > 0 market exhibits nonprice competition: Check {qNOKIA/QSmartphones} < 0

Total Cost

Total Revenue

Min Profit Constraint Output Sales driven beyond the point of max profit but within the minimum profit constraint Profit/Loss

MMS-strategy
Entropy when the industry elasticity is less than the firm-specific elasticity: p < p

MSa = [p + .MSb]/p
Market Penetration: p < .MSb and Market poaching < 1

Precis on a Marris model

McNutt Ch 4: Understand balanced equation gc = gd to identify parameters of profitability Supply of capital: debt v equity Demand for capital: R&D exp v dividends Instrumental variables influencing growth visit Diageo case in Kaelo v2.0 KFIs: profits/output and output/capital Tobins q and Marris v ratio

U1 Valuation ratio V1 V2

U2 x

U3

U4 Shareholders perference Best to management y Valuation curve

V(min) 0 G1 G2 Growth rate

Marris equations/dividends paradox

Calculating share price by DCF formula P = eps/r : Static firm no growth opportunities P = eps/r + PV(GO): Dynamic firm with growth opportunitiesthis is a Marris firm

Common denominator is the plough-back ratio (PBR) = 1 divs/epsThis is a Marris equation More dividends can signal an absence of R&D growth But more R&D from G1 to G2 can accrue an agency cost as Bayesian shareholders SELL as value falls V1 to V2.

Unit 2: Cost leadership as a type (of player)

Profitabiltiy v scale and (size and scope) Production as a Cost-volume constraint Understanding the economcis of productivity as exemplar for incentives Normalisation equation Sources of Cost Efficiency [next slide] Cost leadership checklist..McNutt p61

Sources of cost efficiency

Measure of the level of resources needed to create given level of value
Capacity utilisation
How much to produce given capital size?

Other
X-inefficiencies, location, timing, external environment, organisation discretionary policies Production-cost relationship

Economies of scale
How big should the scale of the operation be?

Transaction costs
Which are the vertical boundaries of the firm?

Economies of scope
What product varieties to produce?

Learning and experience factors

How long to produce for?

MES Point: Production - demand - production to attain cost leadership

Lower per unit cost for more units sold

SAC1 SAC
2

SAC
3

LAC
Av.Cost = marginal cost

0,0

q1

qt

q
2

Current plan of plant closures to lower cost base not completed

Capacity Constraints: Why ?

Case A: Unexhausted economies of scale due to prodcut differentiation Case B: Firm-as-a-player does not produce large enough output to reach MES Case C: Firm-as-a-player restraints production (deliberate intent)..McNutts dilemma as production drives demand(Veblen monopoly type) Convergence of technology increases the firmspecific risk of Case C..avoid Case C or not?

Bridge Unit 1 and Unit 2

Shareholder as principals expect max value Management to minimise the agency costs Positive Learning Transfer, PLT Nomenclature on type: Baumol type (signal = price), Marris type (signal = dividends). Cost leadership type (link into Besanko Ch 13 on stategic cost advantage)

Unit 3: Game type and signalling

Decisions are interpreted as signals Observed patterns and Critical Time Line.see Nissan example pp20 in McNutt Recognition of market interdependence (zero-sum) Price as a signal v Baumol model of TR max Scale and size: cost leadership Dividends as signals v Marris model

Oligopoly and Game Theory T3 + GEMS

Study of strategic interactions: how firms adopt alternative strategies by taking into account rival behaviour Structured and logical method of considering strategic situations. It makes possible breaking down a competitive situation into its key elements and analysing the dynamics between the players. Key elements: Players. Company or manager. Strategies. Payoffs Equilibrium. Every player plays her best strategy given the strategies of the other players. Objective. To explore oligopolistic industries from a game embedded strategy (GEMS) perspective. The use of T3 framework, which considers 3 key dimensions (Type, Technology & Time), will allow oligopolists to better predict the likely strategic response of competitors when analysing competition from game embedded strategy perspective.

Describe (prices as signals) game dimension

Players and type of players Prices interpreted as signals Understand (price) elasticty of demand and crossprice elasticity Patterns of observed behaviour Leader-follower as knowledge Accomodation v entry deterrence Reaction, signalling and best you can do, given reaction of competitor

Link Units 3 and 4: Game Dimension

What is a game loss of independence? Nash premise: Action, Reaction and Reply Non-cooperative sequential (dynamic) games Introduce oligopoly and players (companies) n < 5 TR Test and Elasticity McNutt pp36 Single shot price reduction: (i) fail TR test and revenues fall; (ii) near rival misreads the price as a signal

Type of Players
Incumbent type v entrant type Dominant type v monopoly incumbent De novo entrant type and geography of the market Potential entrant type and the threat of entry Newborn players and extant (incumbent) type

Limit Pricing Model in Besanko pp310-318 and McNutt pp71-76 Outline the game dimension: dominant incumbents v camuflaged entrant type Define strategy set for incumbents Allow entry and define the equilbrium Preference - entry deterrent strategy v accomodation [next slide]

0,10
Do Not Enter

1
Agressive Enter

-7,2

2 5,8

Accommodating

Entry Deterrent Strategy

Reputation of the incumbents Entry function of the entrant De novo and entry at time period t Potential entrant and forces reaction at time period t from incumbent Coogans bluff strategy (classic poker strategy)

Continuing with Unit 4: Define a price war

Determine the Bertrand reaction function Signalling Compute a Critical Time Line (CTL)from observed signals..Examples of CTL in McNutt pp 20 Figure 2.1 and pp94 Fig 7.4 Find a price point of intersection Case Analysis of Sony v Microsoft at McNutt pp 114-116 and also in Kaelo v2.0

Visit Kaelo v2.0 and Games/Signalling

Example: Critical Time Line in Sony v Microsoft in Kaelo v2.0, Apple v Nokia game dimension McNutt pp92 Play a PD game and investment game in Kaelo v2.0 Altruism, fairness, selfish gene, dominant strategy Understand the husband and wife payoff matrices [next slide]

The husband and wife payoffs

Simultaneous game between husband & wife who must decide on how to spend the evening wife in in husband out 10,5 0,1 out 2,4 4,8

Problem of coordination where players have different preferences but common interest in coordinating strategies. One key application includes the battles for standards: VHS by JVC vs Betamax by Sony in the 1980s BlueRay DVD by Sony vs HD DVD by Toshiba in 2008 Effect of sequentialisation? Solution. Commitment? Signalling?

Nash Equilibria
Define the Nash equilibria [next slide] Analyse the Payoff matrix (B,Y) > (A, X) Commitment and chat Punishment strategy Strategic ToolBox in terms of credible mechanisms

Player 2
Strategy X Strategy Y

Strategy A

0,0

8,-5

Player 1

Strategy B

-5,8

10,10

Prisoners Dilemma
Player 2 Confess Player 1 Confess Dont confess 8 20 8 0 Dont Confess 0 3 20 3

Would outcome change if the game is repeated? The Folk Theorem Apply Prisoners Dilemma to Pricing Policy
Firm 2 High Price Firm 1 High Price Low Price 8 20 8 0 Low Price 0 3 20 3

Application of husband and wife game

Two pharmaceutical companies must simultaneously decide which products to research.
A O A O -2,-2 10,20 20,10 -1,-1

This example does illustrate the concept of first mover advantage. How could companies sequentialise? Signing contracts with leading universities, hiring expert.

Games as Strategy: Strategic ToolBox

Segmentation strategy to obtain FMA Relevance of chain-store paradox Dark Strategy and 3 Mistakes in McNutt pp95-97 Second Mover Advantage Strategic ToolBox in terms of identfying the competitive threat v cartel coordination on (High. High)..Cheating

Player 2
Low Prices High Prices

Low Prices

2,2

13,0

Player 1

High Prices

0,13

10,10

Absence of price wars? Link into the HBR articles

Hypothesis: Price Wars occur due to a mis-match in price signals. Mismatch can occur due to (i) declining volumes qi/Q < 0; (ii) uncompetitive cost structure; (iii) decreasing productivity; (iv) mangement type (predator)

GEMS and Strategic Analysis

Knowledge of the identity of near rival:

Actionyou -> Reactionrival

-> NashReplyyou

Locate Your Company in the Next Slide Scenario A? Scenario B? Scenario C?

GEMS and Tn=3 Framework [next slide] pp 130-132 in McNutt

Organizational Goals

Porters 5 Forces BCG Value Net

Industry Analysis

S.W.O.T. P.A.R.T.S. McKinsey

Strategic Options (Identify the Games)

Game theory Insights Game theory

Play-out Game Scenario A

e.g. market entrycompetitors reactions

Play-out Game Scenario B

e.g. change the gamenew product development

Play-out Game Scenario C

e.g. change the game Consolidation

Strategic Decisions

GEMS and Strategic Analysis

Knowledge of likely reaction of near rival Binary reaction; Will Player B react? Yes or No? Non-binary reaction: Player B will react. Probability = x%

Game Embedded Strategy: GEMS: Complete the Diagram

What Market should Your Company be in?
Games & Feedback

Final Scenarios for YOUR Company

The Rationale The Strategy Markets evolve Non-binary The Rationale The Strategy Type, Technology and Game metrics and Time analytics The Rationale The Strategy Know your market GEMS

Thank you for participating

Sapere aude That which one can know, one should dare to know