STR 421
Economics of
Competitive Strategy
Michael Raith
Spring 2007
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Today’s class
0. Introduction
0.1 Course overview
0.2 Organizational information
1. Competition and markets
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Strategy
 We will be concerned with major, often irreversible
decisions such as
– entry in a market and product positioning
– acquisitions and make-or-buy decisions
– strategies to deter competitors, strategies to enter a market
– technological competition
 Objective: to achieve and maintain above-normal returns
3
Competitive strategy
 All of these decisions take place in a competitive
environment
 Understanding of short- and long-run competition
among firms is essential
 Strategic interaction: one company’s moves lead to
responses by others
 need to understand and anticipate these
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Economics of Competitive Strategy
 See “Why economics has been fruitful…“ article
 Economic perspective introduced by Michael Porter in 1980
– Can learn a lot about what firms should do by observing what firms
are doing
 But real progress in “economics of strategy” after 1980: application
of Game Theory to the field of Industrial Organization.
 Better understanding of
1. Competitive advantage
2. Strategic interaction
 One main takeaway from course: Business environments change,
but the principles underlying good strategic decisions don’t.
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What to expect
 Course is heavily case-based: case discussions take up
2/3 of class time
 You will spend most of your time outside class on
analyzing cases (reading, discussions in teams, case
writeups)
 In class, your active participation is expected
 Focus on “big picture”, not on details of implementation
 Cases almost never have “right answers”
 Be sure to attend next Tues to see what course is like!
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Part I: Obtaining and Sustaining a
Competitive Advantage
1. Markets and competition, industry analysis
–
–
Coors: Intro to major themes of the course, Market dynamics
Crown, Cork & Seal: Industry analysis (5 forces)
2. Value creation and competitive advantage
–
–
Dell: Quantification of cost advantage
Enterprise: Competitive advantage and organizational
structure, sustainability
3. The scope of the firm
–
–
Choice Hotels: Horizontal scope
Birds Eye in the U.K.: Vertical integration
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Part II: Strategic Interaction
4. Dynamics of price competition:
–
American Airlines: How can firms avoid price wars?
5. Strategic commitments, entry & exit:
–
–
–
Dupont: Strategic commitments, entry deterrence
Cereal industry: Dealing with new market entrants
ValuJet Airlines: How to succeed as an entrant
6. Technological competition:
–
–
EMI: Managing innovation
Instant messaging: Standards
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Today’s class
0. Introduction
0.1 Course overview
0.2 Organizational info
1. Competition and markets
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Read the information on the web/
in the handout!
 Organizational info: details on almost everything
 Schedule: info on assigned readings, cases to be
discussed, assignments due
 Case questions
 I must be able to reach you by email
 Please fill out questionnaire on course web page!
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Course materials
1. Textbook: Besanko, Dranove, Shanley, Schaefer:
Economics of Strategy, Wiley, 4th Edition (2007).
2. Course packet with cases
3. Additional readings and lecture notes that I will hand
out in class and/or post on the web
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Grading
Class participation:
20%
5 Case write-ups:
20%
3 Assignments:
15%
Final exam:
45%
(No midterm)
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Case discussions - preparation
 Use only the information provided in the case
 Do not discuss cases with students who have taken this
course, or conduct web or library research on cases
 You should know the facts of the case and have thought
through the assigned case questions
 See organizational info for details
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Case discussions – in class
 Please bring name card;
card up = prepared, card down = unprepared
 I’ll open by calling on someone to give brief overview of
case
 You carry the discussions! I’ll mainly ask questions.
– I cold-call occasionally
 Pay attention to flow of discussion, build on previous
contributions
 Take notes!
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Case write-ups




5 in total, best 4 will count towards grade
Choose from bold-faced case questions
Up to 2 pages + additional calculations
You may form teams of up to 4 students
 Submit electronically by 6pm on day before class,
to: STR421@simon.rochester.edu
 See write-up guidelines for details
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Problem sets and final
 Problem sets
– 3 in total, see schedule
– Individually, or in your team
– Mix of quantitative theoretical, essay-style, true-false,
quantitative case-related
 Final exam
– One half based on HBS case (available a week before exam)
– Other half: same style of questions as on problem sets
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Finally, please treat classes like
business meetings:




Attend each class.
Be on time.
Keep electronic devices off.
Raise your hand and wait for me to call on you.
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Today’s class
0. Introduction
1. Competition and markets
1.1 Starting point
1.2 Basics of game theory
Next week:
1.3 Oligopoly
1.4 Industry analysis
1.5 Market dynamics
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Efficient markets
 Where there is an opportunity to make a profit, it will be
seized by someone, diminishing or eliminating the
opportunity.
 On average and in the long run, all investment
opportunities have the same (risk-adjusted) return
 In principle, it’s same in industries as in financial
markets!
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The zero-profit equilibrium
P
MC
AC
S
D
q
q*
Profits attract entry, entry reduces profits
 In the long run, all firms in all industries make zero profit!
Q
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Industry and firm profitability differences
High performers
Industry
Computer hardware
Computer software
Steel
Building supplies
Mass merchandising
Personal Care
Appliances
Cellular/wireless
Satellite radio
Firm
Dell
Microsoft
Nucor
Home Depot
Wal-Mart
Estee-Lauder
Whirlpool
Borders Group
XM
Return on invested
capital minus cost of
capital (%), 2000-2004
21.57
20.25
7.75
6.9
5.02
2.53
1.22
-1.94
-26.54
Low performers
Firm
Apple Computer
Siebel Systems
U.S. Steel
Lowe's
Target
Revlon
Maytag
Amazon.com
Sirius
Return on invested
capital minus cost of
capital (%), 2000-2004
-14.41
-22.78
-1.58
3.78
1.54
-6.27
0.93
-14.26
-28.88
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Month
7/3/2006
1/3/2006
7/3/2005
1/3/2005
7/3/2004
1/3/2004
7/3/2003
1/3/2003
7/3/2002
1/3/2002
7/3/2001
1/3/2001
7/3/2000
1/3/2000
7/3/1999
1/3/1999
7/3/1998
1/3/1998
7/3/1997
1/3/1997
7/3/1996
1/3/1996
7/3/1995
1/3/1995
Closing price adjusted for dividends and splits (Jan. 1996 = 100)
Differences in performance over
time: Dell vs. Gateway
Relative share price performance of Dell, Gateway and the S&P 500 (Jan. 1995 - Dec. 2006)
10000
1000
100
GTW
Dell
SP500
10
1
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Persistent above-normal returns?
 Some companies seem to be consistently more
profitable than others
 Central question of this course: Why do some
companies succeed in making profits in the long run,
while others fail?
 Two main sources of above-normal returns:
1. Returns from unique resources and capabilities that are
difficult to imitate
2. Market power due to a position in the market that others
cannot profitably get into (aka first-mover advantages).
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We need tools that go beyond
STR 401
 STR 401: understand perfect competition and
monopoly
 In most markets, we have neither: markets that are
dominated by a small number of firms = “oligopoly”
 Roadmap for this week and next:
– Need a bit of game theory to understand interaction of firms in
oligopoly
– Link oligopoly theory to traditional industry analysis
– Finally, look at market dynamics: what determines market
structure in the long run?
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Today’s class
1. Competition and markets
1.1 Starting point
1.2 Basics of game theory
Next week:
1.3 Oligopoly
1.4 Industry analysis
1.5 Market dynamics
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Game theory
 Set of tools to analyze situations of strategic
interdependence, i.e. where A’s best decision depends
on what B does
 A game consists of:
1. Players: Which decision makers are involved
2. Strategies: What are the options available to each?
3. Outcomes: What is the outcome for each player, depending on
which strategies are chosen?
 What will happen if each player pursues his own
interests?
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Example: Time and Newsweek
choose a cover story
 Two options:
A: Discovery of a new cure for AIDS
B: A battle between House and Senate over the budget
 Suppose:
– 30% of readers buy only if budget story on cover.
– 70% of readers buy only if AIDS story on cover.
– If magazines run same story, then 60% buy Time, 40% buy
Newsweek.
 Suppose both magazines decide independently.
What will happen?
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Payoff matrix
Newsweek
AIDS
Time
Budget
AIDS
,
70, 30
Budget
,
,
 Players: Time, Newsweek
 Strategies: each chooses between A or B
 Outcomes: the shares of potential readers for each
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Best responses
 One player’s best response = best strategy, given the
strategy(ies) chosen by the other player(s)
 Time’s best response…
…if Newsweek chooses A:
…if Newsweek chooses B:
 Newsweek’s best response…
…if Time chooses A:
…if Time chooses B:
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Equilibrium
Three equivalent definitions of a (Nash) equilibrium:
An equilibrium is a combination of strategies such that
 each player’s strategy is a best response to the
strategies of the other players
 each player maximizes his payoff, taking as given the
others’ strategies
 given the strategies of the others, no player has an
incentive to deviate
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The equilibrium in our example:
 What’s the equilibrium? Here, it’s fairly easy:
– Time has a dominant strategy
– Newsweek does not have a dominant strategy, but
can anticipate Time’s choice and choose its best
response.
– Each player’s strategy is best response to the
other’s. Only one such combination.
 Newsweek must put itself in Time’s shoes!
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Example 2:
 Disney and Dreamworks release new animated movies
 Choice for each: Thanksgiving or Christmas
 Christmas is larger market, but both want to avoid
head-to-head competition
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Payoff matrix might look like this:
Dreamworks
Thanksg.
Xmas
Thanksg.
40, 40
70, 90
Xmas
90, 70
50, 50
Disney
Equilibria?
Problem: coordination may be difficult!
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Games with sequential moves
 In many situations, one player moves before the other.
 Example:
– Firm 1 is a monopolist, making a profit of 10
– Firm 2 can enter market at a cost of 1, or stay out
– If firm 2 enters, firm 1 can either
 accommodate entry: both firms get 4 (not including 2’s cost
of entry)
 fight: firm 1 gets 2, firm 2 gets 0 (not including 2’s cost of
entry)
 Here, firm 2 moves before firm 1. What will happen?
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Game tree
(10, 0)
Don’t
enter
Firm 2
(2, -1)
Fight
Enter
Firm 1
Accommodate
(4, 3)
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Look ahead and reason back
Firm 2’s best strategy depends on what 1 does.
 Look at 1’s decision: If 2 enters, …
 2’s simplified tree:
(10, 0)
Don’t
enter
Firm 2
Enter
(4, 3)
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Game theory in practice
 Formal games capture essentials of strategic interaction
 In practice,
– not set up model and solve;
– rather, gain insight into the strategic interaction
– What kind of game best describes the situation?
 Put yourself in the shoes of others you interact with! If
they don’t do what you expect them to,
– don’t assume they’re irrational, instead
– try to understand how they perceive the game
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