1/1
1.1 Introduction 1/2
1.2 Industries and the Life Cycle 1/3
1.3 The Five Forces Framework 1/16
1.4 Game Theory Perspectives 1/30
1.5 Conclusions 1/39
2/1
2.1 Introduction 2/2
2.2 Generic Strategies 2/2
2.3 The Value Chain 2/4
2.4 Cost Leadership 2/10
2.5 Differentiation 2/17
2.6 Focus 2/26
2.7 The Dangers of Hybrid Strategies 2/31
2.8 Conclusions 2/34
3/1
3.1 Introduction 3/2
3.2 The Innovative Process 3/3
3.3 The Characteristics of the Innovative Process 3/6
3.4 Why Innovation can be Squeezed off the Firm’s Agenda 3/10
3.5 Solutions 3/16
3.6 Conclusions 3/33
4/1
4.1 Introduction 4/2
4.2 Defining Vertical Relations 4/2
4.3 Trends in Vertical Relations 4/6
4.4 What Vertical Integration is Not 4/9
4.5 The Costs of Markets 4/10
4.6 The Costs of Vertical Integration 4/23
4.7 Choice of Strategy 4/29
4.8 The Varieties of Vertical Relations 4/31
4.9 Conclusions 4/32
5/1
5.1 Introduction 5/2
5.2 The Diversification Game 5/4
5.3 Why Diversify? 5/14
5.4 Forms of Diversification 5/30
5.5 Conclusions 5/40
6/1
6.1 The Diversification Game Goes International 6/3
6.2 The Question of International Competitiveness 6/6
6.3 Porter’s Diamond Framework 6/9
6.4 Using the Diamond Framework 6/19
6.5 Framing Company Strategy 6/25
6.6 Competing in International Markets 6/27
6.7 Competing Abroad: The Principles 6/33
6.8 Globalisation Versus Localisation 6/34
6.9 Conclusions 6/37
7/1
7.1 Example of a Combination 7/3
7.2 Evidence on the Performance of Combinations 7/6
7.3 Adding Value from Combination 7/8
7.4 Why Do Mergers and Acquisitions Perform So Badly? 7/13
7.5 Co-operative Activity 7/22
7.6 Conclusions 7/33
7.7 The Elective as a Whole: Conclusions 7/34
A1/1
A2/1

Learning objectives:
How industry life cycle can transform competitive environment
Implications of life cycle for competitive strategy
Implications of five forces on strategy
User five forces to analyse context
Contribution and limitation of game theory
How strategic moves help gain advantage
1.1 Introduction 1/1
Rulebook for competitive strategy is not clear nor commonly agreed
1.2 Industries and the Life Cycle 1/3
Seek some position that is difficult or impossible to imitate
Uniqueness poses problem for analysis
Lifecycle analogous to biological organism
But decline not inevitable or statistically predictable
Growth rate not passive, firm may influence:
Pricing strategies in the introductory phase (penetration, skimming)
Life cycle stretching and renewal (innovation and marketing improvements)
Some cycles more erratic than others
Professional wrestling, cinema have had multiple wax/wane phases
1.2.1 Critical turning Points
A – growth begins to slow o If unexpected then there will be overcapacity due to overproduction o => destructive competition o Even wise firms may still be under pressure

Rivals continue to invest

Difficult to identify timing

Intensified competition, price wars, market share o Start of shake-out phase
B – market growth ends o Could be zero growth or simply same growth as economy o Increased growth only by increasing market share

Decrease number or rivals or their share
C – market growth negative o Maintain current levels only by taking market share o Fierceness of struggle depends on how many firms exit
Turning points are almost impossible to predict
1.2.2 The Stages of the Life Cycle
Growth Stage
Relatively low price elasticity of demand for each brand o Limited substitutability; user unfamiliarity
Relatively high price o Problems: profit signal (to prospective entrants), slow growth, delay economies of scale, experience curve
High level of advertising to create demand o Informative then persuasive
Profits low initially then increasing o Ability of firm to sustain a loss is important
Variety of product designs
Radical product and process innovation
Major demands for new investment o Equipment; human (training)
Frequent bugs and defects
Capacity shortages o Buyers may vertically integrate backwards
Easy of market entry
Few firms
Patchy or limited distribution
Maturity Stage
Increasing price elasticity of demand o Informed consumers, increased competition, standardisation
Falling price

o Economies of scale, experience curve, process improvements, competitive pressures
Brand advertising important
Profitability begins to decline
Increased standardisation o Erosion of patent protection, better information on best design/practises, tightening competition
Incremental innovation, emphasis on process innovation
Replacement investment
Improved quality / reliability
Capacity matches demand
Entry more difficult / less attractive
Many firms
Well established distribution channels
Decline Stage
May be triggered by external event (e.g. technological substitution) or government regulation
High price elasticity of demand
Falling prices
Lack of differentiation and growth reduces need for advertising
Low profits
Further standardisation
Little innovation, investment
Overcapacity
Unattractive entry
Fewer firms
Distribution increasingly important
Porter: strategies in decline o Dominance and leadership

High market share may lead to cost advantage

Credible commitment (investment, aggressive pricing) o Niche exploitation o Harvest

Cut investment, maintenance, service o Exit

Best before decline sets in o Internalise threat

Need residual strengths and competences that contribute to competitive advantage in new regime
1.3 The Five Forces Framework 1/15
Prior to framework strategic management was based primarily on checklists and case studies
Considerations
Framework is not static but evolving
-
Doesn’t lead to clear and unambiguous conclusions, integrates major influences some quantitative, some qualitative
After identifying forces clearly, still variety of competitive strategies possible
1.3.1 Threat of Entry
Economies of scale o Minimum Efficiency Scale (MES) – point at which firm achieves lowest average cost (AC) o Cost gradient: steepness of slope of average cost (versus output) o High MES (high hurdle) and steep gradient (big advantage) => strong entry barrier

Natural monopoly (possible to separate ownership from operation, e.g. telco, rail)
Economies of scope o “Synergies” o Increased output can lead to fuller exploitation of indivisible resources (plant) o Opportunities for specialisation and direction of labour o Shift down long-run AC cost curve for each product (scale economy move along curve)
Experience curve o Unit cost falls in relation to accumulated output o E.g. complex technological products
Differentiation o Strongest barrier in areas of health, safety and welfare
Risky and costly capital requirements o Plant & Equipment, Intangibles (Research & Development)
Switching costs o Loyalty cards, air miles
Access to supplies and suppliers
Other cost advantages o Patented low cost process, ...
Government policy o Regulated industries, licensed operators
Exit barriers
Expected retaliation

1.3.2 Rivalry
Multiple dimensions
Objectives: profitability, market share, growth
Channels: price competition, advertising, innovation
Strength: weak/strong
Factors:
Relatively high fixed costs => marginal costs relatively low
Low growth => zero sum game
High exit barriers => no escape route
Weak differentiation and switching costs
Absence of dominant firm
1.3.3 Bargaining Power of Buyers
One or few major buyers
Buyers earn low profits o May be signalling low profits to sellers
Product is high proportion of buyers’ purchases o Increased price sensitivity
Standardised product, low switching costs
-
Buyers’ threat of backward integration
1.3.4 Bargaining Power of Suppliers
One or fewer suppliers
No close substitutes
-
Product is important input to buyers’ business
Buyer is not an important customer
Supplier products are differentiated
High switching costs
Supplier threat of forward integration
1.3.4 Pressure from substitutes
Similarity of function
Price/performance characteristics
1.4 Game Theory Perspectives 1/30
1.4.1 Prisoner’s dilemma
Associated with variety of strategic situations
Advertising
Pricing
Innovation
Investment
Theoretically sound but uncommon in reality
Preconditions:
Simultaneous decision-making
Accurate knowledge of pay-offs
No communication
No social ties and obligations
No history: no past or future (one-off decision)
Even when situation looks superficially like prisoner’s dilemma actual behaviour often different than predicted
Repetition, familiarity, negotiation, trust, loyalty, kinship, social pressure, personality
Caution against game theory models but valuable lessons from reasoning
1.4.2 Strategic Moves
Intended to alter beliefs and expectations of others in a favourable direction
Central issue in game theory: Credibility (e.g. empty threats and promises)
Means of achieving intangible asset of credibility:
Reputation – communicating a determination to protect reputation at all costs
Contracts – difficult to specify fully, room for misrepresentation
Specialisation – deliberately restricting options (burning your bridges)
Investment – form is important: sunk costs
Incrementalism – build up credibility/trust over time
Hostages – cooperative agreements, decrease opportunistic behaviour
Social context – range between diamond dealer and Hollywood producers...
1.5 Conclusions 1/39

2.1 Introduction 2/1
Scope for designing and developing competitive strategy in practice
2.2 Generic Strategies 2/2
Strategies have large variety of objectives and outcomes.
Some not directly related to profitability, but may help anticipate problems o Vertical integration (protect against being cut off from suppliers)
Three generic strategies (Porter)
Cost leadership
Differentiation
Focus (niche) o Cost focus / Differentiation focus
Problems in implementation:
Trade-off between cost and differentiation o Seek parity/proximity with competitors that are not sources of competitive advantage
Stuck in the middle o Confusing message to customer in case of multiple strategies
Single cost leader
Sustainability o Continual adaptation and innovation o
Entry barriers
2.3 The Value Chain 2/4
Breakdown of firm into component activities
Actual or potential sources of competitive advantage
Applied at SBU level
Physically and technologically separable activities
Identify activities with impact on cost or differentiation
Generic Value Chain:
R&D, Production, Marketing, Distribution
Look at linkages within chain to determine competitive advantage
Look at linkages between chains to see if shared activities can contribute value
Links to value chains of other firms: o Vertical: suppliers/buyers o Horizontal: collaborative arrangements with other firms
Clusters:
Vertical/horizontal interactions of geographically concentrated firms
Caution: mechanistic trawl may miss crucial activities
May look mundane individually, value is in interactions
Capabilities:
Sets of related activities where firm does relatively well
Analysis does not rely on bottom-up approach
Should be firm specific, difficult to imitate
Should not be application specific (reusable in other market contexts)
Problems with simplistic approach:
Competitive advantage may reside in entire value chain, not compoenents
Identified capabilities may be too general (e.g. Innovation)
Highly subjective
Competence can turn into liability (obsolescence)
Industry capabilities (e.g. oil firms successful but not unique)
Distinctive capabilities provide few direct lessons
Vertical links shift intermediate product
Horizontal links share resources
Value chains with many strong horizontal links between them may be treated as single chain
Divisional structure: appropriate when value chains are independent

Functional structure: may be more appropriate when there are significant linkages
Resources may have dual role
Within value chain (vertical links to other resources)
Connection with other value chains (horizontal)
Hybrid
Example three values selling to same market: divisional structure with combined Marketing
Problem in recognising profit
Matrix widely adopted by large diversified firms
2.4 Cost Leadership 2/10
Cost drivers:
Economies of scale
Learning and experience curve
Capacity utilisation o High degree of price discrimination (e.g. airlines)
Vertical links in value chain
Horizontal links with other value chains – economies of scope
Timing o First to market versus learning from others’ mistakes
Location o Land, labour, capital costs
Government regulation, taxes and subsidies
Discretionary policies o Direct sales, limiting product variety, standardisation
External economies o E.g. well-qualified labour pool in area
Cost leadership more sustainable when standardised product combines with economies of scale, and experience curve
High market share
Attract and retain buyers on basis of price. Most likely: o Early stages: first mover advantage o Later stages: high price-elasticity
Game theory:
Credible threat that leader will maintain strategy irrespective of competitor actions
Dominant strategy must be visible to competitor o Credible commitments (e.g. shut down R&D, reduce product variety, move production to low-cost location)
Porter steps to cost analysis:
1.
Identify value chain and elements
2.
Identify relevant cost drivers
3.
Identify competitor value chains, costs, advantages
4.
Develop strategy to reduce costs
5.
Guard against eroding differentiation
6.
Test for sustainability (competitor emulation)
2.5 Differentiation 2/17
2.3.1 Sources of Differentiation
Policy choices o E.g. Kelloggs doesn’t allow rebranding
Linkages o Just-in-time (Kanban)
Timing o Early entry: Hoover
Location o E.g. bureaux de change in airport terminals
Interrelationships with other value chains o Share cost elements, reputation
Learning o Quality, reliability, service
Vertical integration and control o Control over reliability and quality
Scale o E.g. Interflora
Reduced indirect costs for buyer:
Long-life bulbs, batteries (replacement)

Corner shop (location)
Car leasing (breakdowns)
Chopped wood (effort)
Interior design (reduced search costs)
Kinds of purchase criteria (Porter):
Use criteria: actual impact on buyer performance or cost o Can be intangible (style, prestige)
Signalling criteria: inferred quality o Advertising: Advertising spend is a crude indicator of quality (credible commitment)
Asymmetric information
Adverse selection: distorts trading in favour of sellers who misrepresent
Lemons: o If product of variable quality and o Buyers cannot distinguish quality, then o Market will be dominated by lemons

Market will underestimate real worth of superior products and sellers will remove from market o Complex, non-standardised product of variable quality o Trading relationship is occasional or one-off
Mechanisms to offset Lemons problem o Reputation and word-of-mount recommendations o Warranties and guarantees

Signal quality, but guarantee may also be lemon (restrictive clauses...) o Industrial and professional associations o Brand name recognition

Chains and franchising o Consumer guides and reviews

May be subjective o Intermediaries

Professional expertise – may also be lemon o Government

Licensing, regulation, anti-trust policy
2.5.3 Steps in differentiation
Identify relevant buyer
-
Identify firm’s impact on buyer’s value chain
Identify buyer’s purchase criteria
Identify actual and potential sources of uniqueness
Identify cost of actual and potential sources of differentiation
Assess benefit versus cost of differentiation alternatives
Test for sustainability
Reduce costs that do not affect differentiation
2.6 Focus 2/26
Strategy depends on differences between segments of same market
Start with needs of segment
Tailor strategy
Optimise value chain for segment
Strategy may refer to entire firm or part of firm o Advantages of firm-wide focus

Whole value chain can be dedicated o Disadvantages

Limited opportunities for economies of scope

Limited growth opportunity

Vulnerability to external threats o Usually just part of firm

Still links with other value chains
Focus should add value (linkage to other value chains) or else it may be destroying value
Fallacy of free focus o Opportunity cost of managerial and financial resources
Linkages cost o Cost of coordination o Cost of compromise (quality signals) o Cost of inflexibility

Difficult to divest of close down an unprofitable business
2.7 The Dangers of Hybrid Strategies 2/30
Not advisable to pursue both costs advantage and differentiation strategies in same segment (Porter)

Incompatible demands on firm
Worst outcome is to transfer inappropriate competencies into both sides of the market o False economies on quality-conscious end; unnecessary differentiation for cost-conscious segment o Mixed strategy must at least set up distinctive units o Some opportunities

Competitors are also stuck in the middle

Cost is strongly related to scale

First to innovate
2.8 Conclusions 2/33

3.1 Introduction 3/1
Fallacies:
Innovators must be first with new idea
Inferior products will lose in the market (survival of the fittest)
If you can convince public that product is good and affordable they will buy o E.g. network effects
3.2 The Innovative Process 3/3
Invention: act of devising/creating new idea
Innovation: commercialisation of the idea
Product innovation: new good or service
Process innovation: development of new production technique
Research and development
Articulable knowledge: can be sent down a telephone wire (e.g. specifications
Tacit knowledge: built up through experience, experimentation, learning (how to ride a bicycle
Basic research: no specific commercial objective
Applied research: directed commercial targets (products/processes)
Development: conversion of research findings into actual products/processes
Virtual / vicious circles protect successful design
and prevent better design from challenging leader
Economies of scale
Learning effects
Network effects
Network effects: raise question of bootstrap:
Expectations
Sold below cost initially
Small user groups with strong need for connection
3.3 The Characteristics of the Innovative Process 3/6
Specificity: range of eventual commercial outcomes (products/processes)
Low degree of specificity may provide high degree of synergies
Externalities: benefit/cost that impacts someone else (e.g. competitor)
Apprpriabjlity: ability for inventor to retain control
Uncertainty (whether project will solve problem, market will materialise, production will be cost-effective)
Reduced with fixed target, budget
Typically cumulative (reverse chronologically)

Timing
Delays cumulative
Cost of stage
Costs typically rise as development proceeds
Scale models, prototypes
Cumulative cost
Total (remaining) cost of a project being commercialised
3.4 Why Innovation can be Squeezed off the Firm’s Agenda 3/10
Hurdles (in M-Form, which is most common for large organisations)
1.
Appropriability problems: if benefits accrue to rival then may represent a net cost
2.
Neglect of potential internal spin-offs: rivalry between divisions, capital budgeting prioritisation
3.
Duplicated research efforts: M-form encourages compartmentalisation
4.
Uncertainty: risk avoidance means downside risk weighs more heavily than upside
Also median may be much lower than the mean, distorting the expected value
5.
Cost: capital budgeting restrictions
6.
Long time horizons: managers judged on short-term performance
7.
Asymmetric information: scientist know more than management
But gross underestimates, misaligned objectives
8.
Machiavelli’s problem : those who profit from old order will oppose the innovators, supporters tepid
9.
Compartmentalisation and need for integration
U-form even worse:
More specialised means spin-offs will benefit others
Smaller means less likely to afford up-front development costs
Must find balance between creativity and control
3.5 Solutions 3/16
Solutions in one dimension (e.g. reduce uncertainty through evaluation) may exacerbate others (delays)
Most obvious price to be paid is managerial time
1.
Conduct R&D In-house o Keep secret to avoid appropriability problems
2.
Internal funding of R&D o Avoid capital market (appropriability) o Improper external valuation: asymmetric information, uncertainty, long-time horizons
3.
Corporate level R&D o Enable spinoffs for other division, avoid duplicated research, absorb failures, long-time horizons o Problems: o Difficult to evaluate divisional performance o Distance from market means less sensitivity to opportunities o Divisional managers less aware of technological developments o Unfocused entity with disparate expertise
4.
Top-down budgeting o Fund allocation using rank ordering o Address unmeasurable uncertainty, long-time horizon, principal-agent problem
5.
Split the R&D function o Research: corporate; Development: divisional o Difficult to coordinate and integrate R&D activity
6.
Split budgets for operations and innovation o Solution to: spin-offs, uncertainty, high-cost, long-term, Machiavelli’s problem o Problem: divisional managers still inclined to spend more effort on short-term o Problem: muddles assessment criteria
7.
Targets for new product generation o Similar to 6 but focus on outputs rather than inputs
8.
Parallel R&D approaches o In some case additional effort may reduce time o Balance of cost versus long-time horizon
9.
Second-in strategies o Turn appropriability into an opportunity o Accelerated research programme to catch up to leader o Reduces uncertainty and high cost.
10.
Licensing and joint venture o Smaller firms can innovate more easily (Machiavelli’s problem) but larger firms have more resources for commercialization o Problem: managerial and transaction costs
11.
Research club o Deeper pocket o Administration costs, inconsistent objectives, anti-trust
12.
Corporate diversification

o Larger firms can absorb cost, delays and uncertainty more easily o Outcomes are often unpredictable => diversified firm can leverage more easily o Problem: loss of focus
13.
R&D diversification o Multiple simultaneous projects spreads uncertainty risk o Economies of scope o Problem: cost
14.
Matrix organisation - Divisional and Research reporting o Cross-divisional spin-offs while eliminating research duplication o Problem: confusion of lines of responsibility
15.
Organic structures o In contrast to rigid hierarchies, formalised M and U structures with demarcated tasks o Encourage flexible responses, lateral communication, minimal job differentiation, o Trade-off between imposing control and stimulating creativity
16.
Quasi-autonomy o Spin-off team with idea into separate company o Problem: reduced control of parent company
17.
Product champions o Counteract natural tendency toward organisational inertia, overcome departmentalisation o Difficult to institutionalise; can only create favourable environment
18.
Fixed-price versus cost-plus R&D contracting o Transfers uncertain between R&D and funding organisation o Often customer (e.g. government) can accommodate risk more easily
19.
Public funding of basic research o Appropriability, uncertainty, long-time horizons: strong disincentives for private firms o Still some incentives: scientist fulfilment, serendipity (unexpected commercial applicability) o Delays from basic to applied research are shortening
3.6 Conclusions 3/32

4.1 Introduction 4/1
Interest in vertical integration is only recent but one of the most dynamic topics in strategy.
4.2 Defining Vertical Relations 4/2
Shift or transfer of some intermediate product between states in the value chain
Vertical relations are compulsory, horizontal are optional
Can involve firms in activities that are very different from core business
There may be some discretion over supplier (cost versus quality) and customer (international or home market)
Range of relations:
Spot market
Long-term contract
Vertical integration
Franchising
Tapered integration – mixed market exchange and vertical integration
Vertical quasi-integration – long-term contract with dominant partner
Value-adding partnership – cooperation by independent companies
Two categories: market exchange, organisation within firm
Forms of relationship: Mixes of contracts and administrative devices
4.3 Trends in Vertical Relations 4/6
Lead US, early 20 th century, food and drink, forward integration (marketing and sales), and some backward integration
Expanded to: Oil, rubber, electrical machinery, primary metals, instruments
High volume, capital intensive, needed coordination and scheduling of input/output flows
Less integration in: furniture, paper, printing, leather, lumber, apparel, textiles
Labour intensive, product variety, shorter production runs
IBM: semiconductors to services
Complementary forces drive toward outsourcing:
If activities are standard then competition will eliminate excess profits
Firms need wide variety of inputs/services to operate. Focus managerial resources on core competencies
4.4 What Vertical Integration is Not 4/8
Not justified because potential acquisition is profitable
Profitability will be reflected in market valuation
Not obviously anti-competitive
As long as there is competition at each stage
Not justified solely on technological grounds
Technological interaction (stealmaking/reheating) does not preclude a business boundary
Transaction cost rather than technology is important
4.5 The Costs of Markets 4/10
Two forms of costs
Firms acting in own interest against contract partner
Reliance on market exchange
4.5.1 The Invisible Hand and Some Problems
Invisible hand of resource allocation (Adam Smith)
Problems:
Inelastic demand/supply curves (demand and supply vary little with price)
E.g. commodity market
Problem: instability: small change in demand/supply will lead to price volatility
Solution: Forward integration by sellers / Backward integration by buyers
Disadvantage: locks firm into internal arrangement when market exchange may be better (change in other direction)
Vertical integration replaced continuous market bargaining with planning and administrative process

4.5.2 Visible Relations and the Market
Suppliers of specialised components/products
Transaction costs:
Search for trading partner
Negotiate deal
Monitor/police agreement
Also potential loss of intellectual property
Transaction cost economics:
Bounded rationality – individuals have limited knowledge and cognitive abilities
Opportunism – individuals may cheat/misrepresent
Asset specificity – some assets have little use outside present application o Site specificity - physical assets cannot be redeployed o Physical assets specificity – e.g. moulds for statue o Human asset specificity – skills/knowledge not easily transferred o Dedicated assets – expanding plant for particular buyer
Hold-up problem
Once buyer and seller have built equipment (committed to transaction) may be vulnerable to hold up
Even contract may not be sufficient protection o Court settlements are costly and lengthy
Combination of factors is problem: o No Bounded rationality – would know whom to trust o No Opportunism – would be sensible resolution o No Assets specificity – would be able to withdraw and find alternative
Dangers greatest when only one party suffers from asset specificity o First glance: most favourable when firm not exposed to asset specificity but partners are

But: hard to find partner without robust contracts/guarantees
Fundamental transformation – the reduction from a large number of partners (e.g. suppliers before contract)
Hold-up strategy
Increases profits at expense of reputation
Good short-term tactic but possibly disastrous long-term implications
Attitudes toward opportunism may vary between sectors, regions
Not necessarily always extreme case of extortion o Potentially just different prioritisation of objectives
Solutions to hold-up
Repeated contracting: same preferred partner o Advantage: other party will be conscious of potential loss of future contracts o Disadvantage: reduces flexibility
Exhaustive contracting: tighten contract o Expensive, only partly effective, legalistic climate
Standardised assets o Advantage: readily available alternatives o Disadvantage: loss of distinctiveness
Hostages: o E.g. penalty clauses for late completion o Multiple transactions o Advantage: threat of retaliation o Disadvantage: lock-in, less choice
Multiple sourcing: o Advantage: Reduce asset specificity o Disadvantage: multiple contracts => increased costs
Vertical integration: internal expansion, merger, acquisition o Advantage: synchronised and aligned objectives
Tapered integration: partial integration (produce and purchase) o Advantage: limits threat of hold-up; increased competitive incentive for internal organisation o Disadvantage: sacrificed economy of scale; two separate organisation methods
4.6 The Costs of Vertical Integration 4/23
Most obvious alternative to market exchange
Administrative costs of bureaucracy:
Difference competences: sacrificing gains of specialisation
Dangers of specialisation: vulnerability increased through additional dependency
Lack of flexibility: in choice of sources and outlets o Insulated from competitive pressures but inefficient and anti-competitive o Industry wide vertical integration (silos) may impede entry of better performers o Not fit to deal with radical changes when they do occur
Sacrifice economies of scale (of target)
Dampened performance incentives o Guaranteed future irrespective of performance

o Principal-agent problem
Large size o Indivisibilities o Vertically integrated system may not be watertight
Vertical integration with rivals o Bounded rationality & opportunism

Rival will expect to be at disadvantage o Vertical integration may spread once triggered
4.7 Choice of Strategy 4/28
4.7.1 Features Encouraging Market Alternatives
1. Stable and predictable demand and supply conditions
2. Standardised product
3. Many firms at each stage
4. Few other vertically integrated firms
5. Transaction-specific investments not required
6. Well established and widely distributed knowledge of technology
7. Slow-changing or static technology
8. Easy to monitor contractual obligations being fulfilled
9. Little chance of being cut off from supplies or inputs
10. Different scales of production necessary at each stage
11. Different competences required at each stage
12. Reputation important in this sector
13. High chance of repeated buyer–seller relationship
4.7.2 Features Encouraging Vertical Integration
Not sufficient for transaction costs to exist:
May be possible to patch up market alternative (e.g. with solutions to hold-up problem)
May still be cheaper than administrative costs of vertical integration
1. Unstable unpredictable demand and supply conditions
2. Differentiated product
3. Few firms, at least at one stage
4. Few firms not vertically integrated
5. Transaction-specific investment required
6. Technological knowhow concentrated in pockets in the sector
7. Rapidly changing technology
8. Difficult to check that contractual obligations are being fulfilled
9. Real fear of being cut off from supplies or inputs
10. Similar scale of production necessary at each stage
11. Similar competences required at each stage
12. Difficult to establish or maintain reputation and trust in this sector
13. Low possibility of repeated buyer–seller relationship
4.8 The Varieties of Vertical Relations 4/30
Often expressed as: Make or Buy
Production transactions
Higher degree of assets specificity => higher probability to make
R&D transactions
Control required to prevent leakage of non-specific items and
Control focus of tasks to specific requirements
Advertising transactions
Incentive to in-source: high specificity, hold-up problem
However: also specific competencies
4.9 Conclusions 4/32
Review Questions 4/32

5.1 Introduction 5/1
Limits to vertical integration
Central concepts to horizontal integration
Value, efficiency, opportunity cost
Principal-agent problems, transaction costs, value chains
Lifecycles apply to people and products, not necessarily to firms
Most large firms survive
Most are not conglomerates
If they are they tend to stay
5.2 The Diversification Game 5/3
Diversification is both a direction and a method
Direction: horizontal
Method: internal organisation rather than agreements
5.2.1 Horizontal Directions in the Diversification Game
Rule 1: Competitive advantage
Move mush shift at least one demand curve or one cost cruve to add value
Rule 2: Only one move at a time
Limited managerial resources
Rule 3: Fair play
No dominant position (monopoly control)
More gains through rich linkages at multiple points in value chain
Distribution, marketing, production, R&D
E.g. Duopoly => monopoly: higher price using less resources
Specialisation – linkage of all elements in value chain
5.2.2 Preferred Moves in the Diversification Game
Resource Effects
Specialisation best
Avoid unrelated diversification (opportunity cost)
Market Power
Specialisation best
Market linkage: Influence over retailers
Allergic reactions
Resources come in bundles (strategic planning team, marketing team plant facility) o Difficult to separate elements to share
BIC diversification into perfumes; gourmet/fast-food => improve cost, damage image
Porter: Failure of synergy in corporate expansion
Rivals’ valuation
Rivals may value business more highly => excessive acquisition cost
5.2.3 Methods of Expansion in the Diversification Game
Same benefits through cooperation:
Market power: cooperative agreement
Anti-competitive regulation
Partner trust
Diluted control
Transaction costs
Expansion of single link (e.g. advertising):
Limits transaction costs to that link
Reduced risk of allergic reaction
Diversification
Allergic reaction costs increase the less related the firms
Co-operation
Transaction costs increase the more related the firms
5.3 Why Diversify? 5/13

5.3.1 Market Power
Dominance versus suppliers/buyers clear a benefit
Depends also on other circumstances:
Attitudes of firm
Other players
Potential entrants
Government regulations/intervention
5.3.2 Synergy
Cost savings through resource sharing
Economies of scope
If businesses are similar there may be economies of scale
Indivisibilities o Increased resource utilisation (machines, workers) o Specialisation

Individuals can specialise in area of expertise
 Reduced transition costs from switching

Improved learning
Spreading competencies/capabilities across more activities
Larger firms: o Resource sharing or tangible products (plant and equipment) less important o Intangible resources (managerial capabilities) more important
5.3.3 User Gains
Cost advantage
E.g. one-stop shopping
Differentiation
E.g. product compatibility
User gains lead to differentiation advantage that allow it do sell at premium
5.3.4 Internal Markets
Internal markets for Labour, R&D...
Advantages over external markets:
Asymmetric information
Control of opportunistic behaviour
Divisionalisation gains
Conversion from Unitary Form to Multi-divisional structure o Creation of profit centres o Collecting resources with coordination needs into units o Separation of strategy formulation (HQ) and functional responsibilities (SBU) o Disadvantages: principal-agent problems

Opaque performance: concealed in consolidated accounts

Lock-in: impedes reallocation of assets; artificial support of obsolete businesses

Not-invented-here syndrome: less value placed on ideas from other businesses
Internal capital market o HQ has advantages over external market in: information, control, dvidisionalisation
5.3.5 Growth
Principal-agent problem
Shareholders want to maximise profits
Managers want to maximise growth
5.3.6 Risk and Uncertainty
Diversification clearly reduces risk
But:
Opportunity costs (versus related diversification)
Owners may spread business risks by diversifying portfolios o If managers pursue risk spread => principal agent problem
Simpler solutions to volatile sales:
Liquid assets: smooth out sources of funds
Short-term finance
Stockholding: absorb surplus production during slack periods
Insurance: not sales directly but events causing fluctuations
Long-term contracts: with buyer/retailer
Vertical integration: forward
Solutions are not free but allow firm to concentrate on core competencies

Risk of disruptive surprise (e.g. new substitute)
Linkages generate enhance value in stable environment but can be source of joint weakness in crisis
Diversification reduces risk o Why not specialise until forced to change?

Worst time to switch when forced o Can corporate diversification also be in interest of owners (as well as managers)?

Transaction costs of bankruptcy o How can management know when to diversify?

Difficult to anticipate future threats but possible to recognise environment where likely

But not always
5.4 Forms of Diversification 5/30
Most evidence suggestion expansion into closely related business most effective
Related-linked: (Richard Rumelt)
Combine linkage gains with risk-spreading of multiple markets/technologies
Forms of disruption:
Innovation: new products/processes
Change in consumer tastes: fashions, sports fads, health scares o Often triggered by technological innovation
Changes in government restrictions: safety, deregulation, privatisation
Resource deletion
Innovation most important source
Attack on business (i.e. product) less severe than attack on competence
Linkages create shared vulnerabilities
Conglomerate most resistant to disruption
Related link: advantages of related diversification wiout dangers of exposure to single external threat
The more links the less exposed
Conglomerates usually exist for:
Synergy, deep-pocket, market power, or to absorb individual business risk
Related diversification (especially related-linked) can usually match/outdo
Reasons for conglomerates:
Disguised related-linked
Restructuring of related-linked (e.g. initially related-linked but linkages very fragile, divesture of central element)
No alternatives: some industries such as tobacco and petroleum
Rapid growth objective
Path dependency: once conglomerate it may be expensive (transaction cost) to shift
Conglomerate focus: Adapted strategy after partial failures o Divest unprofitable businesses o Pursue related diversification of remaining businesses o There may be some disconnections: e..g independent groups of related businesses
5.5 Conclusions 5/39
Review Questions 5/39

International: serves foreign markets
Multinational: locates operating facilities abroad
Dunning: with exception of oil companies, most giants:
Located most assets in home country
Most sales in home country
Not necessary to be multinational to be extremely successful
6.1 The Diversification Game Goes International 6/3
Expected links from internationalisation:
Few: no shared production. separate distribution channels, separate markets
Potential with R&D
Poor comparison with domestic specialisation
Export:
Economies of scale from further expansion
Administrative economies compared to multinationalism
Resource costs: cheap labour
Transport costs: significant volume or weight
Market saturation
But why not related diversification
6.2 The Question of International Competitiveness 6/6
Factors, but neither necessary nor sufficient conditions:
Exchange rate (counterexample Germany)
Cheap labour (counterexample Sweden)
Cheap natural resources (counterexample Japan)
Countries do not compete, firms do (Porter)
For a given country, few industries perform well internationally
For a given industry, few countries perform strongly
Successful companies often come from countries with tough competitive environment
Dilemma for standard economics:
Space: territories are not isolated
Time: Standard economics long-run doesn’t consider technological upheavals
6.3 Porter’s Diamond Framework
6/9
Diamond: Factor conditions, Demand Conditions, Linked and related industries, Firm Strategy
Analysis in space and time:
Space: Home base exerts influence over each category; Cluster: typically smaller than nation, e.g. region, city, even street
Time: Long time frame; innovation and organisational changes may be very disruptive
Factor Conditions
Degree of sophistications o Basic factors: Natural resources, unskilled labour o Advanced factors: research scientist
Degree of specialism o Generalised factors: village hall o Specialised factors: brain surgeon
Selective factor disadvantage stimulates innovation to deal with problematic factor o E.g. Japan: ideographic language => fax o E.g. Sweden: short building season =?prefabricated buildings o E.g. US: great inter-city distances => telephone, railway, aircraft, car o Converse: US: Low fuel price => fuel-inefficient cars o
No guarantee, not all factor disadvantages are converted into competitive advantage

Difficult to forecast
Demand conditions
Paramount role of home market o Strategic planners are based in home market o Home market dominates quantitatively and qualitatively
Main features (Porter) o Composition of home demand: pressures and opportunities


Segment structure of demand: distribution and variety of patterns of demand
 Existence of sophisticated buyers

Anticipatory buyer needs: early warning system, experience, trends o Demand size and pattern of growth

Size of home market: economy of scale, learning curve

Number of independent buyers: variety of information and market feedback

Rate of growth: possible entry of innovative firms

Domestic market saturates early: fierce rivalry o Internationalisation of home demand

Mobile, international buyers

Influence on foreign needs
Linked and related industries
Internationally competitive industries/sectors don’t emerge in isolation o Associated with other industries/sectors that are vertically or horizontally related
Spill-over benefits o User sector firms imposing high specifications on supplier sector o Reputational spill-overs o User sector firms demanding cost competitiveness from supplier sector o Supplier sector protecting their brands by raising user sector performance. o Technology spill-overs between related sectors o Related sectors sharing marketing and distributional channels o Spill-over of highly trained and well qualified labour pool between sectors o Best practice diffusion by example and observation o Proximity reduces transaction costs between sectors.
Firm strategy, structure and rivalry
Fukuyama: Trust can be important influence on economic activity o Japan: Trust well distributed => diminishes principal-agent problem => larger firmst o China: Family/kin => favours family-owned businesses
Strategy and structure of domestic firms o Germany: technical skills => optics, chemical, machinery o Italy: family/kin emphasis => fragmented sectors, e.g. furniture, footwear, woollen fabrics
Goals and objectives o Level of individual, company, nation o Germany: risk averse => emphasis on mature industries o US: risk-friendly => start-ups, sectors with start-ups (e.g. biotechnology)
Domestic rivalry o Competitive pressure o Visible examples of best practices o Silicon Valley, Hollywood, Swiss pharmaceuticals, Scania/Volvo
Implications for public policy o Creation of national champions may be mistaken o Cautious of advantages of domestic mergers (reduce rivalry)
Jokers in the pack
Chance: wars and invention
Government: effect may be benign but excessive intervention may be problematic
6.4 Using the Diamond Framework 6/19
Implications for governments as well as firms
Domestic clusters: any means to encourage their formations, maintain robustness
6.4.1 Identifying and Using a Diamond
Issues with approach:
Interdependence of Four Main Elements: difficult to isolate critical element
Essential Contribution of all Four Elements o All four best, three can occasionally compensate weak 4 th , two almost impossible
Continuous Upgrading and Improving o Diamond representation static; reality dynamic
Subjectivity and Multiplicity o Some factors subjective (cultural influence) o Some elements based on combination of elements (nature and degree of inter-firm rivalry) o Weighting not obvious o Different individuals might construct different Diamonds for same industry/country
6.4.2 Diamond in Action: US Competitive Advantage in Economics Textbooks
Factor Conditions:
Leading authors

English language
Major university
Demand Conditions
Large domestic market
Anticipates wider trends
Sophisticated distributions channels
Linked and related industries:
Advertising and software industries
Firms’ strategy, structure and rivalry
Advertising-oriented
Glamorous industry
Risky venture (new textbook)
Numerous rivals; clusters (New York)
6.5 Framing Company Strategy 6/24
Possibility of competitive advantage depends on home Diamond
E.g. US publisher has supportive cultural and social environment, extensive resources
Non-US publisher would need to find niche market
Choice of strategy influenced by home Diamond
May facilitate certain strategies and discourage others
Continuous Innovation
Seek sophisticated buyers
Seek demanding buyers
Overshoot stringent regulations
Source from leading home-based suppliers
Seek rivals as benchmarks
Anticipate industry change
Seek buyers with anticipatory needs
Explore emerging buyer groups
Seek locations with early regulations
Identify trends in factor cots
Link with research centres
Study new competitors
Include outsiders in management team
Caution: uncritical emphasis on emerging signals can also be dangerous
Difficulty replicating Diamond’s advantages
Creation of healthy clusters can take decades to achieve and reflect numerous interdependencies
Awareness of foreign Diamonds
Merits and deficiencies compared to home Diamond
6.6 Competing in International Markets 6/26
Dunning: Eclectic Paradigm (OLI Model)
Ownership advantages:
Technical know-how – most easily transferred and shared
Marketing. Purchasing knowhow
Access to finance
Access to resources (e.g. ownership of oil reserves)
Brand recognition
Location advantages:
Access to cheap/high quality resources
Transport costs
Government impediments to imports (e.g. tariffs, quotas)
Internalisation advantages: (versus cooperative agreement with local firms)
Transaction costs of cooperative alternatives o Search, negotiation, policing, lack of suitable local partners, o Residual problems of opportunism o Control of ownership (IP), brand o Reduced chance of losing access to inputs/outlets
Enable monopoly practices such as predatory pricing using cross-subsidisation
Without ownership advantage => no international firms
Without location advantage => international trade but no foreign direct investment
Without internalisation advantage => co-operative ventures but no multinationals
Eclectic Paradigm assumes most attractive investments found overseas
However, this is only the case after exhausting all specialisation and diversifications in home base until resources linkages unattractive
6.7 Competing Abroad: The Principles 6/32

Seek sophisticated overseas buyers
Strengthen ability to compete
Source basic factors globally
Commodities not source of competitive advantage => best/cheapest suppliers
Keep strategic assets close to home
Benefit from local interactions, easier to manage, guard against unplanned leakage
Selective tapping of foreign technology
Potential leaks of technical knowhow also opportunity to harvest from foreign cooperation
Attack rivals directly to learn from them and neutralise them
Head-to-head competition valuable learning lesson; prevent rivals from further growth
Locate Regional HQs at best Diamond
Provide valuable information on what makes the local system work
International acquisitions and alliances for access and learning
Means of learning new skills
Globalisation versus localisation
World not homogenous: different cultures, societies, legal, political systems => products with regional technical/market characteristics
6.8 Globalisation Versus Localisation 6/33
Resource-based versus market-based approach
Resource-based:
Same product line, same home market
If diversification is necessary (e.g. market saturation) => leverage maximum of existing resources
If international expansion => leverage common information
E.g. PC, Food & Drinks (Coca Cola)
Market-based
Different requirements in different countries
Customisation required even if it implies sacrifice of scale
Local market conditions dominate => incumbents can fight off challenges
E.g. educational materials, confectionary
Hotels, clothing are combination (Hilton, Nike... many national brands)
Characteristics which encourage international firms in markets dominated by local tastes/brands:
Surface differentiation: common brand but different specifications for local product
Access to factors of production: lower labour costs
Cultural globalisation: Convergence in tastes through international communication and contact
6.9 Conclusions 6/36
Review Questions 6/36

Combination options:
Vertical integration, diversification, multinational expansion
Internal growth, merger/acquisition, licensing, franchising, joint venture
Must be compared to opportunity costs
7.1 Example of a Combination 7/3
Synergy benefits:
Resource side:
Economies of scope in marketing, distribution
Lower the Average Cost
Market-side
Shifting of demand curve to right and reducing demand elasticity
7.2 Evidence on the Performance of Combinations 7/5
Perform badly, yet popular with strategic planners
Acquisitions reduce efficiency
70% of joint ventures fall short of expectations
Challenges in judging:
Measurement difficulties – difficult to separate out and measure benefits
Other motives – management status, rewards, prevent rival action with supplier (no increase but prevent future decrease)
Wrong criteria – stated objectives of allotted life span don’t reflect performance (e.g. knowhow benefits other activities)
Opportunity costs – true cost of failure may be higher than observed
Conclusions:
Frequently disappoint
Motives and implications may be more complex than short-term profit
7.3 Adding Value from Combination 7/8
Combining a sales force example:
Similar outlets, avoid duplication in products territories and outlets – only one salesperson per outlet
Similar product, eliminate competition – push up price and margins
Similar activities, increase sales – each sales person promotes both products in assigned territory
Similar activities, improve capabilities – leverage best selling practices and training methods
Considerations of merger/acquisition
The whole value chain matters: sales, production, etc
Alternative methods of combining activities o Internal expansion: Merger is faster o Cooperative agreements achieve some gains without the need for combination o Even intangible elements (brand image) can be transferred o Competition authorities will closely monitor for anti-competitive operations
7.4 Why Do Mergers and Acquisitions Perform So Badly? 7/13
Two parts:
Why the gains are often so poor
Why does one party do badly compared to counterparts
7.4.1 Why the Gains from Merger or Acquisition May Be So Disappointing
Compatibility Problems
Different skills and competencies
Tangible differences can be assessed but intangible (identity, character) more difficult
Standards, jargon, operating procedure; social and knowledge-based characteristics
Consequences: o Limited coordination o Attempts to harmonise may prove costly
Optimistic bias
Easier to identify opportunities to enhance value than the pitfalls and problems

Strategy matching, interdependent strategies
Wave-feature of mergers/acquisitions: fear of being cut off triggers desire for vertical integration
Conservatism: match rival strategy of acquisition to reduce relative risk
Insulation from environmental surprises
Avoid dependency on single market or technology with related-constrained/related-linked
Objective to reduce risk not to enhance profitability
Agency problems – managerial motives for merger
The Prisoner’s Dilemma
-
Downstream move provides competitor base to foreclose on firm’s market
Only protection is same downstream move
7.4.2. Why Do Acquirers Do Even Worse than Those Bing Acquired
The Grossman-Hart Problem
Dispersed share ownership means increased price for acquisition
Price must increase until last critical shareholder sells; others will hold for free-ride
Winners Curse
High degree of uncertainty regarding present value of firm
Potential bidders make errors: some overly optimistic, some overly pessimistic
Winning bid likely to be based on overestimation
Best defence is natural caution and risk aversion in face of uncertainty o Bidders value in risk premiums
Hubris (or excessive self-confidence)
Management caught up in excitement => lack of balanced judgement
Reasons for M/A over internal growth
Growth objectives of management
Speed is important, e.g. pre-empt competitive response
Gain competencies and resources
No room for entry (supplier or customers locked up)
Eliminate a competitor
Merger may be quick fixed but questionable if sustainable
Reduction of rivalry may also lead to loss of sharpness
7.5 Co-operative Activity 7/22
Forms of cooperation
Licensing
Franchising
Informal cooperation
Sub-contracting
Alliances
Network participation
Joint venture
Licence: permission for any firm to indulge in activity otherwise prohibited
Intellectual property rights, patents, designs, trademarks
Usually part of business/technology
Franchise: transfer of intellectual property rights for specified periods and territories
Knowhow ranging over entire business (purchasing, productions, presentation, selling)
Information Cooperation
Example: one engineer may ask another from rival for advice expectation of reciprocity
Senior management may or may not approve
Sub-contracting
Separating part of business as contract for separate firm
Trend more responsibility, e.g. R&D and Design
May evolve into long-term cooperation
Joint Venture
Two or more parent firms agree to cooperate
New entity created for specified task and duration
Own decision-making capability

Co-owned by parents
Provision for continuing parental supervision and control
Issues: o Contractual: managerial and legal resources of create, police and monitor o Complex hierarchy: conflict and confusion regarding objectives, priorities, perceptions, procedures, cultures o Appropriability problems: intellectual property leakage
 Parent’s reluctance to reveal/commit sensitive resources
Why a joint venture
International expansion: may be required to enter national markets
Why a joint venture and not other forms of cooperation (licensing, franchising)?
Other forms more appropriate where market and technical characteristics are known
Where there is uncertainty: give child decision-making capabilities
Why joint venture and not merger/acquisition?
In can be design to cover only selected range of activity
Joint venture of selected resources:
Selected pieces of value chain (e..g sales only)
Selected business of firm o E.g. two related-linked parents:

One firm offers technical expertise,

The other marketing skills
Joint venture more expensive that merger over the range of activity
But avoids additional problems of merging entire system
Value not in was it does to but what it does not do
Joint venture not only alternative to corporate diversification: also a consequence of it
Not likely to be preferred route to growth of small specialised firms
Alliance: formal/informal agreement to cooperate on a variety of matters
Resource-based logic: o Both sets of management teams build up familiarity with other firm
 I.e. would be major effort if firm selects a new partner for each agreement
Transaction-cost logic: o Inhibits opportunism: jointly held hostages
Cost of alliance o Partner may not be ideal choice for each constituent agreement

Dull competitive edge, limits competition
Networks: three or more firms directly/indirectly linked by series of cooperative agreements
Access and transaction cost benefits above the 1:1 agreements
Vary in scope: o Mailing list

Major cooperative agreements with collective retaliation threat
Encourage open information flows and reduce transaction costs
Need not involve deliberate joining decision (blurred membership)
May soften competitiveness o Immediate disadvantage of those excluded o Eventual disadvantage of network members
7.6 Conclusions 7/32
7.7 The Elective as a Whole: Conclusions 7/33
Review Questions 7/33

+ Brand advertising
+ Standardisation
- Price elasticity
- Margins
+ Excess capacity
- Entry incentive, # firms
- Bugs
- Innovation
- scale/experience/utilisation
- vertical/horizontal links in value chain
- timing, location, government
- Appropriability
- Long-time horizon
- Budget
+ In-house
- Uncertainty
- Neglect of spin-offs
- Duplicate research
+ Split budgets
- Asymmetric information
- Machiavelli
- Compartmentalisation
+ Matrix org
+ Internal funding
+ Corporate R&D
+ Split R&D
+ Top-down budget
+ New product targets
+ Parallel
+ R&D diversification
+ Second-in
+ Licensing, JV
+ Organic structure
bounded rationality, opportunism, specificity (site, physical, human, dedicated)
Production, R&D, Advertising
+ Contracts: repeat; exhaustive
+ Integration: vertical, tapered
+ Hostages
+ Standardisation
+ Quasi-autonomy
+ Champions
+ Research club
+ Public funding, Fixed price versus cost-plus
+ Multi-source
+ Unpredictable supply/demand
+ Differentiated product
+ Few firms not integrated
- different competencies
- specialisation differences
- inflexibility
- economy of scale (target)
+ contracts difficult to verify
+ similar scale/competence
+ transaction-specific investments
- performance incentives
- vertical relations with rivals
- Large size (mgmt)
- prisoner's dilemma

+ Market power
+ Economy scope/scale/experience
+ User gains
+ Internal market
+ Risk
- Rival valuation
- Rival reaction
- Costly
- Opaque performance
- Allergic reactions
+ Growth
- agency, optimistism
- Late recognition
Grossman Hart, Winner's curse, Hubris
Export
JV, Alliance
Direct investment
Acquisition
+ promotes innovation, efficiency; information access
License
Franchise
- May lose competitive advantage, root success factor, may not survive
+ potential to combine complimentary strengths
- major costs and problems
Horizontal: R&D; Vertical: resource, transport costs => production
seek sophisticated buyers
source factors globally
strategic assets close to home
selective foreign technolgy
frontal attack of rivals
regional HQ at best diamond
acquisitions/alliances: learning & access
globalisation / localisation
JV probl: Contractual resources, complex hierarchy, appropriability

JV problems