STR 421
Economics of
Competitive Strategy
Michael Raith
Spring 2007
3. The scope of the firm
 Horizontal scope: to what extent should a firm expand into new
products or businesses?
– CCS: diversify into plastics?
– Choice Hotels: pros and cons of covering full quality spectrum
 Vertical scope: To what extent should a firm be involved in activities
further upstream or downstream in the production chain?
– Coors: backward integration into everything
– Reynolds, beverage producers: integration into metal cans
– Dell vs. Compaq: resellers
 Closely related but not focus here: mergers within industry
Today’s class
3. The scope of the firm
3.1 Expanding scope: problems and
challenges
3.2 Expanding scope to realize synergies
3.3 Expanding scope to increase market power
Bad/questionable
reasons to diversify
 “We need to grow”
– Profitability often leads to growth, but growth for its own sake is
rarely profitable
– Agency problem: managers want growth because their
influence & compensation depends on it
– Managers often prefer to spend “free cash flow” on growth
strategies and pet projects than pay it out to shareholders
– Similar: diversification efforts in industries with declining
profitability
 Metal cans
More questionable reasons
 Diversify in production to reduce financial risk?
– Shareholders can instead diversify in financial markets
 Diversified firm as source of investment funds?
– Assumes financial market failure that can be overcome
internally
…and one more:
 Spread unique skills & capabilities into new industries?
– “Superior skills” exist but are hard to assess/verify
– Managers of successful firms often overestimate scope and
uniqueness of their capabilities
– Probably one of the major reasons why many acquisitions fail
 Many empirical studies document a “diversification
discount”, suggesting that firms often diversify for the
wrong reasons
Bad reasons to vertically integrate
 “Produce in-house to avoid paying a profit margin to
independent firms”
– If input market is competitive, “profit margin” is expected return
on invested capital = part of economic cost
– Examples: resellers in PC industry; car rental: fees for
reservation systems
 “Outsource to avoid certain costs of production”
– E.g. outsource transportation to avoid maintenance &
depreciation of trucks
 See BDSS for other make-or-buy fallacies
Organizational costs of integration/
expansion in scope
 Dilution of incentives of division managers
 Specialized resources spread too thin
 Management too complex, problems more difficult to
detect
 Many additional problems when two existing firms with
different organizations, cultures are merged
– CCS-Continental Can
Two main ways to expand scope
1. Internal development = Integration by developing own
capabilities in target industry/market
– This is like an entry decision
– What are the barriers to entry?
– Do we have a competitive advantage?
2. Acquisition of existing company
– Current owners must be compensated for profits they give up
– Acquisition must increase total value created between the two
companies!
 Compare Choice Hotels: new brand introductions vs.
acquisitions
What if several bidders compete
for acquisition target?
 Suppose firm A thinks of selling its unit X.
 A is worth $50M when it owns X; worth only $30M
without X.
 Two bidders:
– Firm B is worth $40M without X but $65M if acquires X
– Firm C is worth $70M without X but $100M if acquires X
 Who will buy X and at what price?
 Winning makes sense only if acquisition leads to larger
increase in total value than for any other bidder!
 “Winner’s curse” if value of target is overestimated
Today’s class
3. The scope of the firm
3.1 Expanding scope: problems and challenges
3.2 Expanding scope to realize synergies
3.3 Expanding scope to increase market power
3.2 Integration to realize synergies
 Parallel discussion of horizontal and vertical scope
because central questions are the same:
– What are the synergies/sources of economies of scope?
– Is integration better than contractual solutions?
 The main good reason to expand scope is to take
advantage of lower costs or a higher benefit.
Economies of Scope:
1. Efficient use of resources
 Production facilities and people
– Hollywood studios: movies and TV shows
– Pharmaceuticals: lab equipment
– Sales forces to sell different products
 Related: benefits of geographical proximity; e.g.
beverage bottling and can production
 Umbrella branding: Sony, Disney, Virgin, Choice Hotels
 Through transfer of organizational capabilities
– Philip Morris’ marketing skills applied to Miller Brewing Co.
– IBM’s Engineering and Technology Services division
2. Benefits from bundling
for buyers
 Convenience for buyers of buying multiple products
through same channels:
– Disney: movies, parks, toys, cruises etc.
– Masco Corp.: consumer brands for home
improvement/construction market
 Convenience of choice: Choice Hotels
 Lower costs of purchasing complementary goods:
Starbucks and Hear Music stores
3. Coordination and other
externalities in production
 Knowledge spillover:
– Pharmaceuticals: knowledge spillover
– Reynolds in aluminum cans
– Intel: microprocessors and ProShare videoconferencing?
 Product design and quality control
–
–
–
–
Hardware and software: Apple, Nintendo vs. Atari in 80s
PC Resellers: hardware and software support
Coors’ own trucking subsidiary to transport beer
Business school course packets
 Advances in IT (making coordination easier) are one
reason for general trend towards outsourcing
4. Externalities in pricing of
complementary products
 Recall oligopoly pricing: firms cutting price don’t take
negative effect on competitors into account
 Complementary products: firms don’t take positive
effect of cutting price on competitors into account
 Charge prices that are too high!
 Less business for both firms
 Integration may be only way to solve problem
 Careful, though: argument assumes some degree of
market power in both markets!
Examples
 Cars and financing: GMAC (est. 1919, divested 2006),
Ford Motor Credit (est. 1959), founded when credit
markets were less competitive/efficient
– Also possibly: transaction costs for buyers
 Michelin: tires and guidebooks?
– Also possibly: lower production costs
The vertical counterpart:
Double marginalization
 Same in vertical production chains; e.g. manufacturer, retailer
– Both provide complementary goods/services!
– Retailer’s price > wholesale price; manufacturer’s price > MC
 Problem: retail price higher, and total profits lower than if prices
were coordinated/ if upstream & downstream firm were integrated
 Example: Brewers and pubs in the U.K.
– In late 1980’s, many pubs were owned and managed by brewers
– Antitrust authority forces brewers to divest some of their pubs
– Slade (1998) finds that beer prices in pubs subsequently increased
and industry profits decreased
 Again, argument applies only if both upstream & downstream firm
have market power!
But why integrate??
 Many economies of scope can be realized through
contracts, without integration
 When that is possible, it’s much easier than integration
 Integration best if contracts don’t work well
– Why did Fedex buy Kinko’s in 2003? Why did Disney merge
with ABC? Both pairs had established relationships before
 Think of “buy” instead of “make” as default, see if there
are reasons to “make”. Independent suppliers…
– often benefit from scale & scope economies, experience
– have better incentives to keep costs low and improve products
Examples of contracting solutions
 Use of resources:
– Manufacturer’s representatives
– Reservation systems for car rental, flights
 Coordination/quality
– Nintendo and external game producers
– Supply chain management at Dell
 Complementary products
– Partnerships to offer discounts: Choice Hotels
 Pricing in vertical chains
– Non-linear pricing in franchising
– Gasoline: retail price maintenance as upper limit on price
Contracting problems
 Costs of describing and measuring quality of
performance
 Costs of describing the terms of a contract
– E.g. B-school packets: costs of specifying penalties
 Costs of agreeing on prices for resources to share, or
on contributions to their costs
– Underlying problem: parties have private information about
what resource is worth to them
 Unwanted leakage of proprietary knowledge
 Legal constraints: price fixing prohibited
The holdup problem
1. Companies often make relationship-specific investments = useful
only when dealing with a particular business partner
– E.g. setting up a can factory near Coca-Cola
2. Contracts are often incomplete for any of the above reasons
– E.g. increase in cost of aluminum may require adjustment of can price
 The firm that made a specific investment may later be “held up” by
the other
– E.g. Coca-Cola might say: your past investment in your plant is your
problem; let’s look forward
– Consequence: firm making investment may not get its expected return
 The firm then has less incentive to invest in the first place =>
inefficient outcome!
Integration as solution to the
holdup problem
 Possible solution: vertical integration (Coke produces its own
cans), unless it’s possible to write long-term contracts
 Examples:
– Automobiles (Monteverde and Teece, 1982): Components requiring
high engineering effort (specific human capital) more likely to be
produced in-house.
– Aerospace industry (Masten, 1984): components with design specific
to company more likely to be produced in-house.
– Electric utilities: “Mine-mouth” electric utility plants more likely to be
vertically integrated with mines than others (Joskow 1985).
– Electronic components (Anderson and Schmittlein, 1984): components
with greater human capital specificity ( = salespeople’s effort to learn
about it) more likely to be sold through in-house sales force.
Scale economies and
firm/market size
 “The division of labor is limited by the extent of the market”
1. Make if no one else has use for the same input, or because input
is unique
– Independent suppliers would not want risk of holdup
– Integrated cell phone makers: Nokia, Ericsson, Motorola
2. Buy if independent supplier can sell to others as well
– Solves two problems: reduces holdup risk, helps realize EOS
– Small cell phone makers that purchase standard components
– Small companies selling through manufacturer’s representatives
3. Possibly make if the quantity you need is large enough to realize
all scale economies
– Big companies often prefer to have an in-house sales force
– GM more integrated than Ford
Today’s class
3. The scope of the firm
3.1 Expanding scope: problems and challenges
3.2 Expanding scope to realize synergies
3.3 Expanding scope to increase market
power
Integration and market power
 So far, considered reasons to integrate that are purely
between two firms (and their buyers)
 Other possible reasons are to increase market power
over other firms
 Often stated as reasons for M&A in practice
 But whether they are good reasons is much less clear
Horizontal scope and bargaining
power
 Diversify to increase bargaining power vis-à-vis buyers
or suppliers?
– Important reason for horizontal mergers, e.g. hospitals
 Choice Hotels and suppliers
– Rarely main reason for diversification
 But e.g. Pepsi-Quaker Oats: influence in distribution
channels
Foreclosure
 Integrate into another stage of vertical chain to make
competitors’ access to suppliers or customers difficult
or impossible => raise rivals’ costs
 Examples:
– U.S. Steel’s acquisition of iron ore mining rights in early 20th
century
– Murdoch’s acquisition of DirecTV in 2003: greater control over
distribution of programming may place other producers (e.g.
Time-Warner [CNN], Disney [ESPN)] at disadvantage
Foreclosure (cont’d)
 Potential problems with this strategy:
1. need barriers to entry in target industry
2. threat of antitrust intervention
3. winners might be owners of the scarce input
 Not much evidence that this strategy is effective
 BDSS consider this argument a make-or-buy fallacy
(#5)!
“Leveraging” market power
 Can a firm “leverage” its market power into another
market through integration and tying?
 Can NewsCorp, with market power in programming
(Fox), increase its power over cable companies
(=downstream firms) by buying DirecTV?
 Popular argument, but hard to get to fly: works only if it
prevents entry / induces exit in target market