Lecture Managerial economics - Chapter 6: Competition and strategy

Week 6
COMPETITION & STRATEGY

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INTRODUCTION
• How competition is rivalry to obtain a distinct advantage
• Categorizing and analyzing competitive strategies
• How mergers and lawful agreements among competitors can
sometimes increase economic value created in a market
• How restrictive vertical agreements between manufacturers and
dealers or parent companies and franchisees can increase
competition and benefit consumers
• Strategies for protecting profits
• costs and benefits of attempting to compete by influencing public
opinion or government policy
• How a business can identify tangible and intangible competitive
resources and formulate strategies that make the best use of them.
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Competition: Exceptional – Competitive Ideas
• Competition starts with ideas.
• Asked how he had produced so many good ideas over his
career, Nobel Prize–winning chemist LinusPauling responded
that “the best way to have a good idea is to have lots of ideas.”
Even the most original ideas build on a foundation of other
ideas.
• A competitive idea is not necessarily a scientific one
• It may be as simple as opening a business in an underserved

location, keeping it open all night, or outrightly imitating the
success of a competitor.

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Competition: The Paradox: Competing to Acquire
Market Power
• Businesses compete to distinguish themselves in the eyes of
customers, and by becoming distinctive they acquire some
market power.
• A business implements a risky competitive idea in order to reap
high returns.
• The possibility of high returns induces risk-taking.
• But entry will erode profits
• In actual markets, businesses often compete by discounting
prices rather than taking the equilibrium price as given and
unalterable.
• Business try to bind customers to themselves using techniques
like frequent-flier miles or other loyalty programs.
• In real markets advertising is valuable to offer information
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Competition: The Risks of Competition
• Competition is risky, particularly for small startups.
• Only about 40 percent of startups show accounting
profits over their lifetimes, which may not cover their
opportunity costs.
• Thirty percent break even and 30 percent are losers.

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Competition and Deception
• Competitive conditions constrain the freedom of all
producers, whether they face many competitors or
few.
• In this chapter we continue to assume that buyers and
sellers act rationally on information that is available
to them.
• In particular we rule out strategies that only succeed
if one side can deceive the other (the sale of lossleaders e.g).

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Selection Bias, Again
• People recall successes more easily than failures.
• They give more weight to more recent events.
• Our recall is biased and we often must use data that
are not random samples of an underlying population.
• Now to the success of Big-C
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What’s Big-C’s Secret?
• Here is a partial list of explanations that have been
offered for Big-C’s success:
• decentralized decision-making,

• centralized decision-making,
• decision-making between the center and the stores,
• regional relationships,
• relationships with employees
• using economics to determine strategy.

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Pitfalls in Studying Competition –Self-Serving
Recommendations
• The structure of corporate business further complicates the
analysis of strategy.
• A corporation’s executives and board of directors might make
choices that are in their personal interests rather than those of
their shareholders, who would prefer decisions that maximize
the values of their stock.
• As will be seen later, managers whose firms produce
substantial free cash flows may prefer to spend them on
questionable acquisitions that often fail to benefit
shareholders.
• This tactic increases the size of the firm which usually means
higher pay and prestige.
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Creating Economic Value
• Both seller and buyer benefit from a transaction if the seller
earns more than his opportunity cost and the buyer pays a
price below maximum willingness to pay.

• Economic value is the difference between cost and
valuation.

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Many Buyers and Many Sellers
1.

2.

3.

4.

Four points emerge from this model:
as the innovation spreads among producers the earlier
adopters will see longer-lived streams of profit before the
market reaches its new long-run equilibrium.
the number of firms that survive after the innovation depends
on the direction in which the innovation shifts the minimum
point of average costs.
as the percentage of sellers that use the innovation increases,
those who are slower to innovate will take losses if they
cannot shut down temporarily or leave the market quickly.
any newcomer to the market will only survive if it uses the
innovation.
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MERGERS & AGREEMENTS

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Horizontal Mergers and Agreements -Mergers
• Mergers and acquisitions can be important elements
of strategy.
• A horizontal merger puts the assets of two firms that
operate in the same market under the same
ownership.
• The consequences depend on market structure and on
how the merger affects costs.
• U.S. antitrust law says that a “naked” agreement
whose only goal is to fix prices is per se illegal—its
very existence is unlawful.
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Vertical Mergers and Agreements
• An industry’s output is often produced in stages.
• For example, oil is first extracted from the ground,
then refined, and finally the refined products are
retailed.
• A firm is vertically integrated if it subsumes multiple
stages.
• Integration can produce savings if it improves
coordination among the stages.
• But it also might raise costs if there are difficulties in
managing dissimilar activities.

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Vertical Mergers and Agreements (cont.)
• The degree of integration matters because costs and
revenues can vary with the number of stages in which
a firm operates.
• Costs may increase if there are problems managing
dissimilar operations.
• Vertical mergers are hardly ever strongly scrutinized
by anti-trust regulators.
• A firm will merge vertically to improve its
competitiveness.

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Vertical Mergers and Agreements _ Restrictive
Agreements
• Many vertical agreements greatly restrict the future
choices of both parties.
• A franchise contract between a carmaker and a dealer
often prohibits the manufacturer from opening
another outlet close by, that is, it specifies an
exclusive territory.
• Fast-food franchises often require the owner of an
outlet to buy all its food through the parent
organization, and the parent organization promises to
always have food on hand to fulfill its side of the
requirements contract

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Vertical Mergers and Agreements _ Restrictive
Agreements (cont.)
• Manufacturers and retailers may have exclusive
dealing contracts.
• All these contracts contain vertical restrictions that
limit the parties choices.
• Often a parent will franchise outlets and hire
employees to run others.
• McDonald’s only owns 15% of its stores.
• Starbucks Coffee has no individual franchises.

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Sustaining & Extending Competitive
Advantage

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Barriers to Entry-Size and Commitment
• Building barriers to entry that protect profits against
existing and future competitors can be an important
element of strategy.
• Size and specificity may serve as barriers to entry.
• A firm may need to be sufficiently large to achieve
available economies of scale.

• Firms may also need to invest in specific assets that
are not easily redeployed to other uses and locations.
A power plant for instance.

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Intangible Assets: Trademarks & Advertising

• A seller wants to inform customers about more
than price—consistent quality, for instance,
may engender customer loyalty.
• A producer can use a brand name or trademark
to assure buyers it will produce the quality
they expect.
• Signalling

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Influencing the Public and Government –Public
Relations
• Public recognition and approval of a firm’s practices can also
be a competitive tool.
• Government can also help a business to advantage itself or
disadvantage competitors.
• Among possible strategies, a firm might seek legislation that
makes competition illegal, as cable TV operators have done in
many cities. Cable, however, has failed to suppress satellite
TV, which is beyond local control.

• Government can also make competition costly for foreigners
by imposing quotas or tariffs in return for support from the
domestic industry.

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Choosing a competitive strategy
• How do businesses choose a competitive
strategy?
• Strategy is resource-based and market-based.
• Firms in the same market will have different
resources leading to different choices.
• Strategy is about more than price.
• It can range from product design, to mergers, to
political activity.

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Resources and Strategies
–Innovation Pro and Con
• Strategy need not entail innovation or entry into new
markets—some firms have resources better suited to
perfecting an established product.
• Properly carried out, imitation can be as profitable as
innovation and sometimes less risky.
• Ampex invented the VCR and Xerox invented the
first office computer, but neither firm found
commercial success in those areas.

• Success is surprisingly short-lived.

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Competence and Sustainability - Identification of
Resources and Feasible Strategies
• A firm’s strategy choice starts by identifying its
resources and the resources of its competitors, paying
attention to those resources competitors have that it
does not itself, and vice versa.
• Discussions of strategy must go beyond simple
models that treat constraints as unalterable by the
decision makers.
• The best choice depends on our resources and those
of our competitors.
• We will often wish to use or acquire resources that
make our strategy more resistant to their attacks.
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Competence and Sustainability -The Search for
Strategies
• The idea remains that no strategy that competitors can
easily duplicate will produce long-term profit.
• The search for strategy must be a continuing one.
• Having a grand strategy may not be the road to success.
• Tactical moves are responses to idiosyncratic, short-lived
developments.
• If your competitors are flexible and unpredictable you

might do better by deemphasizing global strategy and
seeking to seize more immediate opportunities.
• Emphasize tactics rather than a strategic mission.
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