Markets Organization and
Corporate Strategy
George Norman
Cummings Professor of
Entrepreneurship and Business
Economics
Some Introductory Comments
Textbook: The Economics of Strategy
Grading:
Two sets of essays: 20% and 25% respectively
Research paper: 30%
Industry analysis and presentation: 25%
Syllabus: not a legally binding description
Web-site
http://www.tufts.edu/~gnorman/cmba344.html
Objectives
 Focus on strategic decision-making
 Application of economic reasoning to develop
insights necessary for a firm to deal effectively
with its operating environment
 The central role of strategic decision-making in
determining a firm’s success
Strategy and Economics
The definition of strategy
no single definition
different from tactics - essentially short-term
Strategy Definition
The determination of the basic long-term
goals and objectives of an enterprise, and
the adoption of courses of action and the
allocation of resources necessary for
carrying out these goals. (Chandler, 1962)
Strategy Definition
The pattern of objectives, purposes or
goals, and the major policies and plans for
achieving these goals, stated in such a
way as to define what business the
company is in or should be in and the kind
of company it is or should be. (Andrews,
1971)
Strategy Definition
What determines the framework of a firm’s
business activities and provides guidelines
for coordinating activities so that the firm
can cope with and influence the changing
environment. Strategy articulates the
firm’s preferred environment and the type
of organization it is striving to become.
(Itami, 1987)
Why an Economic Perspective?
Other approaches are possible
game theory
psychology
how motivation and behavior of individuals shape
organizations
sociology
social structures, peer networks, routines and their
effects on organizational decisions and decisionmaking
Economics
 Requires that we be explicit about the elements
that generate strategies
decision-makers
goals
choice of strategic variables
relationships between choices and outcomes
 Provides a clear linkage between conclusions
and assumptions
 Cost: lose some detail
The Need for Principles
 What makes a profitable, successful business?
 Can general lessons be drawn from the behavior of
successful organizations?
 Reasons for success often unclear and complex
 No list of characteristics that guarantee success
 Partial data
 Success stories bias interpretation
 No automatic or general recipe for success
 Trek: outsourcing and brand-management (Raleigh)
 Usiminas: excellence in manufacturing (Bethlehem)
 Wal-Mart: initiative of local managers; inventory management
(Kmart)
Principles (cont.)
 Successful firms adopt strategies that exploit
potential profit opportunities.
 Adapt to changing environments
 Need to analyze decision making using
consistent principles of market economics and
strategic action
A Framework for Strategy
 The big issues:
boundaries of the firm
markets and competitive analysis
position and dynamics
internal organization
The boundaries of the firm
 These extend in three directions
 horizontal: how much of the product market the
firm serves
 vertical: the set of activities that the firm
performs itself and those it purchases from other
firms
 corporate: the set of distinct businesses in which
the firm operates
Markets and competitive analysis
Understand the markets in which the firm
operates
Industry-specific effects constrain
profitability and must be understood:
high-tech e.g. pharmaceuticals or low-tech e.g.
airline travel
determinants of entry
mistakes can be made e.g. major
pharmaceutical companies’ attempts to move
into production of generics
Position and dynamics
 How and on what a company competes
cost
advertising
product positioning
R&D
 Dynamics
how the firm accumulates resources
how the firm adjusts to changing circumstances
Internal organization
 How should a firm organize itself to give effect to
its strategies?
 Organizational structure determines information
flows and alignment of individuals with the
objectives of the firm
decentralized versus centralized
incentives versus culture
An Economics Primer
Some Introductory Ideas
 Objectives need well-defined strategies that are
under the control of the decision-maker
 Success is determined by the economic environment
within which the firm operates
 Strategies must be consistent with the environment
 law of demand
 size and profitability of price-matching
 is it reasonable to match a small competitor’s price cut?
 Price and cost: can additional volume be sold at a profit?
Costs
TC(Q)
Total Cost
 How do costs change
as output changes?
 This is the total cost
function - TC(Q)
 Describes the efficient
relationship between
output and total cost
 Total cost increases
with output
Output
Fixed and variable costs
 Variable costs increase with output
labor costs
materials costs
 Fixed costs are independent of output
general administration costs
property taxes
 The distinction is fuzzy
some costs have fixed and variable components
costs may be fixed over one range and vary over
another
Fixed and variable costs (cont.)
 Fixed costs are invariant with output but are
affected by other decisions
 Whether costs are fixed or variable depends
upon the time period
Average and marginal costs
 Average cost is
total cost divided by
output:
AC(Q)=TC(Q)/Q.
 Marginal cost is the
additional cost of
producing one
more unit of output:
MC(Q)=dTC(Q)/dQ.
 They are related as
follows:
MC(Q)
AC(Q)
Output
The importance of time
 In the short run
may have to live
with “wrong” plant
SACM(Q)
SACS(Q)
Average Cost
 Distinguish between
short-run and longrun costs
 In the long-run
choose plant size
that is adjusted to
anticipated output
The long-run cost curve
is the lower envelope of
the short-run cost curves
If expected output
is Q1 but actual
SACL(Q)
output is Q4 then
If expected output is Q3 install
costs
If expected
output
Ifshort-run
expected
is Q1plant
install
output is Q2 install
the large
scale
will
be
on
SAC
S(Q)
the small scaletheplant
medium
scale plant
Q1
Q4
Q2
Output
Q3
Sunk costs
 When assessing the costs of a decision consider
only those costs the decision affects
 Distinguish between sunk costs and avoidable
costs
inventory already existing is a sunk cost
additions to inventory are avoidable costs
 Sunk costs are not the same as fixed costs
some fixed inputs can be redeployed from their existing
use if conditions change
Sunk costs (cont.)
 Sunk costs affect strategy - particularly on entry
and exit
change of technology with existing production versus
adoption of new technology with greenfield site
existing firms generally more reluctant to adopt new
technologies
 The existence of sunk costs makes it difficult to
eliminate a competitor
 The existence of sunk costs is a barrier to entry
Demand and Revenues
 The demand function
describes the relationship
between quantity demanded
and variables that affect
demand
 income
 tastes
 advertising
 price
 The relationship between
quantity and price is generally
negative
At price P1 the
quantity demanded
is Q1
At price P2 the
quantity demanded
is Q2
P1
P2
Q1
Q2 Quantity
Demand and Revenues (cont.)
 There are exceptions to this “law of demand”
prestige goods: price confers prestige
goods where quality is not directly observable: price is
taken as a signal of quality
 Where this is true then a cut in price may
damage sales by damaging the good’s image
Price elasticity of demand
 An increase in price
generally reduces the quantity sold
has an ambiguous effect on sales revenue
 The relationship between a price change and
sales revenue is determined by the elasticity of
demand (or the sensitivity of demand to price)
 definition:
m = % change in quantity
% change in price
Price elasticity of demand (cont.)
 If price elasticity of demand is greater than unity
then an increase in price reduces sales revenue
 If price elasticity of demand is less than unity
then an increase in price increases sales
revenue
Increase in sales
revenue from increased
price
Reduction in sales
revenue from increased
price
Price
Price
Increase in sales
revenue from increased
price
Reduction in sales
revenue from increased
price
Quantity
Quantity
Elastic demand
Inelastic demand
Price elasticity of demand (cont.)
 Demand is elastic if:
close substitutes
buyers’ expenditures
are a large proportion
of total expenditure
product is an input to
another product with
elastic demand
 Demand is inelastic
if:
comparison is difficult
 complex product
 little experience
buyers’ pay only a
small proportion of
total cost
 insurance coverage
switching costs exist
complementary with
other products
Pricing Decisions
If firm aims to maximize profit then the
pricing and output rule is simple:
choose output such that marginal revenue
equals marginal cost
get price from the demand function: the price
that clears the market
Use the standard pricing formula:
P(1 - 1/m) = MC
Game Theory
 Firms not in competitive markets must make
strategic decisions
 When there are “few” firms these decisions are
interdependent
 game theory is a particularly useful tool for
analyzing such interdependence and strategic
choice
assumes rationality
Matrix form and Nash equilibrium
 Simple example of capacity choice by two firms
Dominant
strategy
for Beta
Beta
Dominant
strategy
for Alpha
Do Not Expand
Expand
Do Not Expand
$18, $18
$15, $20
Expand
$20, $15
$16, $16
Alpha
Nash
Equilibrium
Nash equilibrium
 Need not be attractive
generally does not maximize joint profits
Prisoners’ dilemma
 But it is compelling
neither firm would choose to change strategy if its rival
does not
 Timing is important:
simultaneous (or non-observable)
sequential (or observable)
Game trees and equilibrium
 Consider a modified and expanded example
Beta
Do Not Expand
Small
Large
$18, $18
$15, $20
$9, $18
Small
$20, $15
$16, $16
$8, $12
Large
$18, $9
$8, $12
$0, $0
Do Not Expand
Alpha
Sequential choice
 If choices are sequential the first mover can
anticipate rival’s choice
manipulate rival’s choice
 With sequential choice use game tree
A game tree
Beta
Do not Expand
Do not Expand
Small
Large
Beta
Alpha
Small
Do not Expand
Small
Large
Large
Large
Beta
Do not Expand
Small
Large
($18, $18)
($15, $20)
($9, $18)
($20, $15)
($16, $16)
($8, $12)
($18, $9)
($12, $8)
($0, $0)