Advanced Management

• When entering a market, new products of well-known firms with high reputation have higher chances to succeed than new products of unknown firms

• “Umbrella branding”: advertisements for one product of a firm may encourage customers to consider other products made by the same firm

But: If products are too different, umbrella branding may cause ambiguities
• For example, Toyota decided to use a different brand for their luxury cars (Lexus)

• Economies of scale determine the boundaries of the firm

nearly no diseconomies of scale

• However, there are different institutional arrangements to obtain the minimum efficient scale (s*)
• Example: Firms A and B have each an output of s*/2:

Hierarchy solution:
• A and B can merge, A can acquire B, B can acquire A (horizontal boundaries of the firm change)

Market solution:
• A and B can outsource activities with economies of scale to a firm C (vertical boundaries of the firms change)
• A can outsource activities with economies of scale to B (vertical boundaries of firm A change)

Bottom line:
• If the transaction costs of using the market are low, a change in the horizontal boundaries of the firm is not required to obtain economies of scale and economies of scope

When do large firms dominate a market?
• There are large economies of scale and scope AND
• the transaction costs of using the market as institutional arrangement are very high

When do small firms dominate a market?
• There are no/small economies of scale and scope OR
• there are economies of scale and scope and the transaction costs of using the market as institutional arrangement are low

When are there both small and large firms in a market?
• There are large economies of scale and scope
• The large firms reach the minimum efficient scale internally
• The small firms reach the minimum efficient scale by outsourcing the activities with large economies of scale and scope (transaction costs of using the market as institutional arrangement are low)

• Diversification refers to the expansion in unrelated activities (conglomerates)

1. Common inputs
2. Internal capital markets
3. Internal labor markets

• Prahalad and Bettis (1986) define the dominant general management logic as “the way in which managers conceptualize the business and make critical resource allocations–be it in technologies, product development, distributions, advertising, or in human resource management.”

• The dominant general management logic applies when managers develop specific skills that can be applied to seemingly unrelated businesses

• But: Danger of congestion if the dominant general management logic
depends on tacit knowledge

• Firms may find it difficult to find external providers willing to fund new ventures due to asymmetric information
-  Firms know more about the prospect for success than potential bondand equity-holders outside the firm
-  Outsiders may suspect that firms disproportionately seek outside funding for questionable projects, saving their internal working capital for the most promising projects. This skepticism increases the cost of outside capital

• Diversification can help to generate a stable internal capital market
-  Profits from cash cows are used to fund increased production of early-stage question mark products and rising star products

• Firms have superior information about the abilities of their employees (lower information asymmetry within the firm than over the market)
-  Large diversified firms have access to a greater pool of talent
-  Large diversified firms have have greater opportunities to assign their best employees to the most appropriate and most challenging jobs

1. Risk reduction
2. Identifying undervalued firms

• Argument: A risk-averse shareholder might wish to invest in a single diversified firm

• But: Shareholders can diversify their own personal portfolios and do not need corporate managers to do so on their behalf

• If the market valuation of the target firm is incorrect and no other investors have yet identified this fact, it can be profitable to acquire this firm even when activities are unrelated

• But: Bidding wars reduce the profits an acquiring firm can hope to earn. Profits may even be negative due to the “winners curse”

Managers have incentives to diversify even when there is no value added for the firm:

• Firm growth enhances the social prominence, public prestige
• Diversifications reduces the volatility of profits and the risk of bankruptcy --> Executive managers benefit from such internal risk reduction due to their firm-specific knowledge
• As salaries and bonuses are often tied to the volume of business, managers have pecuniary incentives to growth

• Managers can pursue diversification even at the costs of shareholders, because (small) shareholders are systematically uninformed

1. Focus
2. Market Orientation
3. Scanning / Listening to Others
4. Networking
5. Strategic Orientation
6. Attitude toward Uncertainty
7. Willingness to challenge assumptions
8. Time horizon
9. Enabling exploration

picture

picture

• Managers are typically promoted to leadership positions based on their ability to deliver results --> operational excellence

• Few are prepared for broader challenges of being vigilant and fostering vigilance in the organizations

• Problem is especially challenging for COOs who are promoted to CEOs

• Welch set the standard for each business to become the #1 or #2 competitor in its industry – or to disengage

• If GE managers struggled to build #1 or #2 positions, businesses had to be fixed, sold or closed

• Between 1981 and 1990, GE freed up over $11 billion of capital by selling off more than 200 businesses, which had accounted for 25% of 1980 sales

• Welch developed his strategy based on work by Peter Drucker who asked: “If you weren´t in the business, would you enter it today? And if the answer is no, what are you going to do about it?”

• Work-outs were intended to take unnecessary work out of the system

• Groups of 40 to 100 employees were invited to share their views and opinions about their business and how it might be improved

• Procedure:
-  2-3 days
-  Team´s manager starts the session with a presentation and afterwards leave the facility
-  Employees list problems and develop solutions with the help of a neutral facilitator
-  Manager returns, listens to the employees´ presentations for change
-  Managers make an immediate yes-or-no-decision on 80% of the ideas presented

“A strategy is an integrated and coordinated set of commitments and actions designed to develop and exploit core competencies and gain a competitive advantage” (Volberta)

• Understanding how to exploit a competitive advantage is important for firms seeking to earn above-average returns
• Above-average returns are returns in excess of what an investor expects to earn from other investments with a similar amount of risk

A business-level strategy is an integrated and coordinated set of commitments and actions the firm uses to gain a competitive advantage by selecting specific product markets and positioning within this market.

A corporate-level strategy specifies actions a firm takes to gain a competitive advantage by making optimal make or buy decisions.

Price determination:
• Price is lower than the maximal willingness to pay,  which equals the (perceived) benefit
P ≤ B
• The firm will not supply the product or service unless it receives a price that at least covers the costs
P ≥ C
• Thus, the price lies between the (perceived) benefit and the costs
B ≥ P ≥ C

The value added is split between the firm and the consumers
• The consumers receive the consumer surplus, defined as:
(B - P)
• The firm receives the producer surplus, defined as:
(P - C)

An industry is a group of firms producing products and/or services that are close substitutes
• Firms should select an industry with low competition
• Porter‘s (1980) five-forces framework helps to analyze industry competition

1. Internal rivalry
2. Threat of new entrants
3. Threat of substitute products
4. Bargaining power of suppliers
5. Bargaining power of buyers

1st step --> defining the market and by that competitors are identified

SSNIP criterion: competitors are identified, if a merger among them would lead to a small but significant nontransitory increase in price

Subsitutes: same or similar product performance characteristics, same or similar occasion for use, same geographic market

+ cross-price-elasticity of demand: Goods X and Y are substitutes if consumers increase their purchases of good Y as the price of good X increases [dx_i/x_i / dp_j/p_j]

--> price competition is more harmful than non-price competition (internal rivalry)

1. There are many sellers in the market
2. The industry is stagnant or declining
3. Excess capacity
4. Products are undifferentiated/Buyers have low switching costs
5. There are strong exit barriers

• Oligopoly theory predicts that prices are lower when there are many sellers
• The more sellers, the less likely is cooperative pricing

• Firms cannot expand their own output without stealing from competitors

• Firms with excess capacity are willing to sell their products below full costs as long as the price exceeds marginal costs
• Firms with excess capacity can rapidly expand output to steal business from rivals

• When products are undifferentiated and switching costs are low, price elasticity of demand is high
• Only price differences remain as a source of competitive advantage

• Industry-specific investments cause substantial exit barriers, because these investments are lost when the firm exits
• Firms with exit barriers often prefer continuing price wars than exiting the industry

generally:
The higher the threat of new entrants, the less attractive is the industry
• New entrants „steal“ market share, if overall market demand remains the same. Market share generally decreases with the number of firms within an industry
• New entrants reduce the market concentration, which intensifies price competition

The likelihood that firms will enter an industry is a function of two factors:
• Entry barriers
• Expected retaliation

1. Production entails significant economies of scale
2. Consumers highly value reputation/consumers are brand loyal
3. Restricted access to key inputs and resources:
4. Experience curve
5. Network externalities

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6. Expectations about retaliation and post-entry competition (not directly an entry barrier but affects the entry in the industry)

• The entrant must achieve a substantial market share to reach minimum efficient scale, and if it does not, it may be at a significant cost disadvantage

• Brand-loyal consumers are unlikely to switch to competitors

• Reputation and brand-loyalty is especially important for experience goods, whose quality cannot be determined ex ante
-  Firms with high quality products establish a good reputation
-  Entrants must invest heavily to establish a strong reputation and brand awareness

• If access to key inputs and resources (e.g., patents, unique locations, technologies), entry barriers are high