ECON 308 Week 9 Chapter 8 Economics of Strategy Creating and capturing value 1 Case Wal Mart Wall Mart Most profitable retailer in the world 5 170 stores 1 6 million emp 1962 First store opens rural Arkansas small towns 1993 q2 1997 stock value dropped Slow growth in value till 1997 2005 220 billion in sales 10 3 billion net income Responses to problems in mid 1990 s New international super centers E commerce sites Experimented with traditional sized grocery stores in Arkansas By 1998 the stock was performing well again 2 Superior Performance Beating the market over a long period What accounts for the success of these firms Should all properly managed firms expect superior performance What actions can managers take to generate superior performance Can managers enhance financial returns by diversification Do all firms eventually drop back to the pack 3 Strategy General policies intended to generate profits Choice of industry Combination of products and services Competitive and cooperative behaviors Strategies evolve as circumstances change Strategies must create and capture value 4 Economic Strategy Maximizing long run profitability Economic Profit Total Revenue Total Cost Increase Total Revenue Price x Quantity How to Increase Price Price is Demand determined Increase Value of the product to customer How to increase Quantity Decrease Total Economic Cost Efficiency in purchase Efficiency in production 5 Transaction costs Consumer transaction costs product search learning product characteristics and quality negotiating terms of sale enforcing agreements Producer transaction costs negotiating terms legal expenses 6 Creating Value Price Supply Consumer Surplus P Producer Producer Surplus Surplus Demand Q Quantity Time 7 Price Creating Value Reduce Transaction Costs Supply with Producer Transaction Costs Producer borne transaction costs Consumer Surplus P Producer Surplus Consumer borne transaction costs Demand with Consumer Transaction costs Q Quantity Time 8 Value creation Reduce production costs or producer transaction costs shift supply curve to the right Reduce consumer transaction costs shift demand curve to the right Shift demand to the right by other means Devise new products and services 9 Transaction Cost Creating Value Consumer Transaction Costs Costs of search Costs of learning about product quality Costs of Negotiation Producer Transaction Costs Costs of negotiation Attorney fees to draft sales agreements Examples Dell eliminates the middle man in direct web site PC sales and splits the gain between themselves and the buyer Early Wall Marts were in rural areas reducing transportation costs by opening stores closer to customers Kraft Lunchables Terrorist Attacks and the Airline Industry 10 Creating Value Advertising Major economic function Provide information about the product Lowers Search Cost Lowers Quality Identification Costs Second Function Create value in the minds of consumers Lowenbrau Perfumes 11 Creating Value Reducing Consumer Waiting Time Cable Installation 4 hour window Doctors Office Patients Waiting How to value your time Salary 50 000 Employee Cost to firm 50 000 100 000 2000 hours 50 per hour 12 Creating Value Alternative Product Pricing Pricing Complements Cut the price of the complement and increase the sales of both products Applications Printers and Personal Computers Razors Blades Pepsi Frito and Lays Potato Chips Pricing Substitutes Raise the price of a substitute Applications Don t allow people to bring food into a theater Airlines restrict the use of cell phones 13 Creating Value Product Quality Product Quality Profit is increased if MR MC Marginal Revenue depends on value created for Customer Product Quality Examples Titanium Golf Clubs Parabolic Skis 14 Technology and Value Rapidly falling cost of information processing Streamline Order processing shipments payables receivables Create custom products for smaller groups of customers Reduce transaction costs with suppliers and customers 15 Converting Organizational Knowledge into Value Hardware physical Assets Software Soft Assets formulas recipes for creating value can be replicated Wetware Employees brainpower biological computer Firm owns 1 2 but only rents Wetware Must convert 3 into 1 2 Macdonald s Fillet of Fish 16 Capturing value Long Run Profitability in Competitive Markets Economic Profit Accounting Profit Firms with Market power With barriers to entry Without barriers to entry 17 Market power comparison 18 Market power Porter s five forces that affect Market Power Potential rivals Existing rivalry Substitute products Buyer power Supplier power 19 Porter s Five Forces Affecting Market Power Upstream Sellers Value suppl y Chain Potential Rivals Current Rivals Substitute Products Downstream Buyers Competitiv e Environment 20 Capturing Value What Works Barriers to entry Degree of rivalry Number of competitors Relative size of competitors Threat of substitutes Example Email and fax pose serious threats to profits for Federal Express and UPS Buyer and Supplier Power Example Microsoft and Intel in Personal Computers 21 Superior factors of production People special talents or skills Physical assets prime real estate unique equipment But bidding for specialized assets may erode profits Some things are hard to copy Flexible Technology Team Production 22 Producer surplus captured by superior assets 23 Superior factors of production again Team production interdependencies among workers increase value beyond the sum of the parts luck or foresight may endow firms with unique team production capabilities Rivals may be unable to pinpoint source of advantage and unable to capture equivalent value 24 Sustainability Rank 1970 2004 1 IBM Wal Mart 2 AT T Exxon Mobil 3 General Motors General Motors 4 Standard Oil of NJ Ford Motor 5 Eastman Kodak General Electric 6 Sears Roebuck Chevron Texaco 7 Texaco Conoco Phillips 8 General Electric Citigroup 9 Xerox IBM 10 Gulf Oil American International Group 25 Increasing demand Increase expected product quality value added cost increase Reduce price of complements Raise price of substitutes limit entry of competitors 26 Diversification Benefits Economies of Scope Example When one input is used in several products you may get a better price when ordering it Promoting Complements Example Ford can advertise its auto financing when advertising its cars 27 Diversification Costs With larger firms it gets increasingly difficult to get lower level managers to act in the