Lesson 01 the Economic Foundation of Business Strategy

8/12/2019 Lesson 01 the Economic Foundation of Business Strategy

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Lesson 01: The Economic Foundation of Business

Strategy (Printer Friendly Format)

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Introduction

The first lesson opens with an introduction of key economic concepts and an overview of thegeneral business environment. Also discussed in this lesson are economics of effectivemanagement and the economic way of thinking.

Before beginning this session, think about the following lesson objectives. After completing this

lesson, you should be able to:

1. escribe the basic economic concepts and the general business environment in whichfirms operate.

!. "nderstand the economic way of thinking.#. escribe the concept of thefive forcesframework, time value of money, and marginal

analysis.$. %&plain the economic foundation of business strategy.

Lesson 01 oad !a"

Note: The purpose of the Lesson Road Map is to give you an idea of what will be expected of you

for each lesson. You will be directed to specific tasks as you proceed through the lesson. achactivity in the To !o section will be identified as individual "#$% tea& "T$% graded "'$% or

ungraded "($.

To Read:

1. 'ead (lass )otes for *esson 1.!. 'eadcono&ics of )trategy+Besanko et al. te&t, -ntroduction +pp. 1/. The Besanko

te&tbook material should be read along with, or after reading the (lass )otes.#. 'eadcono&ics of )trategy+Besanko et al. te&t, (hapter 10 +pp. #1!#, including the

cases.

To Do:

1. 'eview each of 2orter3s five forces listed in Table 0.1and relevant economic conceptslearned in this lesson.
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!. (omplete Assignment 1.1 +T, ": 2repare a 2ower2oint 2resentation of the five forcemodel. 4ubmit this joint assignment to its drop bo& in the 5oint Term 2roject folder by#:00 a.m. %astern 4tandard Time +%4T on 6onday, 4eptember 1$, !00.

Economic #once"ts and Business Strategy

%conomics is typically divided into microeconomics and macroeconomics. 6icroeconomicsdeals with the theory of individual choices, while macroeconomics focuses on the overalleconomy and general economic e7uilibrium conditions. 6icroeconomic analysis studies decisionmaking undertaken by individuals and by firms. -n contrast, economic phenomena such aschanges in unemployment, inflation rate, and annual growth in the output of goods and servicesin the nation all fall into the realm of macroeconomic analysis. -n other words, macroeconomicsdeals with aggregates such as total output in an economy, which are the result of choices madeby individuals and firms.

Although managers of the business firm can do little to affect the aggregate economy, their

decisions should be consistent with the current economic outlook. By blending microeconomicsand macroeconomics in the study of markets, industries, and competitive forces, this courseenables students to understand how market determines prices, 7uantities, and activities in thebusiness firm and how business strategy should be formulated in light of both internal ande&ternal conditions to sustain competitive advantage.

4pecifically, in a competitive environment, managers must seek a pricing and output strategythat will ma&imi8e the present value of the future profit stream to the firm. The determination ofthe wealthma&imi8ing pricing strategy depends on the production capacity and technologyavailable to the firm in the short run, the potential for future changes in this production capacity,the cost of producing various levels of output, the nature of the demand for the firm3s products,

and the potential for immediate and longerterm competition. The theory of demand and thetheory of cost and production in the field of microeconomics are obviously useful in makingdecisions on such matters. The essence of business strategy can easily be gained from detailedapplication of such economic concepts and theories. 9nowledge of economics permits theformulation of more subtle and powerful hypotheses and the development of richer strategies.This knowledge provides significant insights into the major themes of strategy that we will studyin this course.

-n consideration of price and output determination, we will learn the concept of a relevant marketin *esson $.A relevant market refers to a group of economic agents +individuals andor firmsinteracting with each other in a buyerseller relationship. This interaction results in transactions

between the demand +buyer and the supply +seller side of the market.

6arkets are the focal point for economic activity and often have both spatial and productcharacteristics. 4ome markets are worldwide, drawing buyers and sellers from a broadgeographic region, while others are confined to a domestic and narrow geographic region.Because of the important role played by markets in pricing and allocating resources in acompetitive economy, managers must focus considerable attention on the market structures thathave developed for various goods or services. The distinct differences in market structures, and


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changes in market structures +e.g., the market concentration in the industry over time, haveimportant implications for the determination of price levels, price stability, resourceallocationefficiency, technological progress, and the likelihood of sustained profitability in these relevantmarkets.

2rofits signal to resource owners where resources are most highly valued and to potentialcompetitors where profits could be made. 6any interrelated forces and decisions influence thelevel, growth, and sustainability of profits. %ven if you can identify best strategies that yield awindfall to shareholders, there is no guarantee that these profits will be sustained in the long run.(rafting business strategy in a rapidly changing global environment to sustain profitability andstrategic competitiveness is no longer a task in which managers can get by with opinions, goodinstincts, and creative thinking. esigning viable strategies for a firm re7uires a thoroughunderstanding of the firm3s industry and competition, flowing directly from a cogent analysisofits e&ternal environment and internal conte&ts +e.g., its competitive capabilities, resources,internal strengths and weaknesses, and market position. And, there are four 7uestions that needto be answered:

;hat are the boundaries of the industry +e.g., problems with defining industry

boundaries, developing a realistic industry definition, etc.< ;hat is the structure of the industry +e.g., concentration, economies of scale, product

differentiation, barriers to entry, etc.< ;ho are the competitors of the firm +e.g., competitive analysis how to identify

competitors, common mistakes in identifying competitors< ;hat are the major determinants of competition +e.g., competitive analysisirms cannotdirectly control these elements. -nstead, the strategic challenge is to understand each segment

and its implications so appropriate strategies can be formulated and implemented.

Industry Environment

The industry environment, on the other hand, includes such factors as competitors, buyers andsuppliers that influence a firm and its competitive actions and responses. ;e will study thestructure of the markets and the economic implications of competitive forces. By marketstructure, we mean the behavior of the market participants +competitors and customers. Theknowledge of market structure and competitive forces is important for formulating the firm3sbusiness strategy. The study of market structures of the firm and the way businesses compete isoften referred to in the economics and strategic management literatures as industrial analysis,

which addresses the industry characteristics that define the distinctive strategic challenge facedby the firm. To apply the industry analysis framework, however, we must first define theindustry. To assess the threat of buyer or supplier power, we must know who the importantbuyers and suppliers are= to assess the state of competition, we must know who the competitorsare= to gauge entry barriers, we must know the boundaries of the industry. ?ence, coverage ofthis material will utili8e applied microeconomics we will learn in *essons 1$.

Macro-Environment

All firms operate in a &acro*environ&ent consisting broadly of economic, sociocultural,demographic, politicallegal, global, and technological factors, as well as the firm3s immediate

industry and competitive environment as depicted in >igure 1.1.


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Figure 1%1: !acro&en'ironment in hich firm o"erates

The macroenvironment includes all relevant factors outside a firm3s boundaries. These factorsare relevant in the sense that they are important enough to have effects on the decisions a firmultimately makes about its business model and strategy. Although many forces in the macroenvironment are beyond the sphere of influence of the firm, management is nonetheless obliged

to monitor them and adapt the firm3s strategy as may be needed. -ndeed, the forces in a firm3smacroenvironment which have the most impact on a firm3s strategy typically revolve around thefirm3s immediate industry and competitive environment. ?owever, without perceptiveunderstanding of the strategic aspects of a firm3s e&ternal and internal environments, managersare likely to conceive a strategic plan that is inconsistent with the competitive market situation,holding little prospect for attaining and sustaining competitive advantage.

Economics of Effecti'e !anagement

6anagerial decisions are on how to ma&imi8e the firm@s profits or, more generally, the value ofthe firm. To deal with the contending currents of the competitive forces, a firm must understandhow to work in its industry and how to affect the firm in its particular situation. (ompetition inan industry is rooted in its underlying economics.

There are a variety of important issues which managers must consider when operating in a globalcompetitive environment. They need to have a comprehensive set of economic concepts andtools to help them pull these issues together to make some decisions about a firm3s competitivestrategy. The application of economic principles will help ensure that resources are allocated


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efficiently within the firm and that the firm makes appropriate reactions to changes in theeconomic environment. This section provides an overview of the basic economic principles thatcomprise effective management, as well as the economic way of thinking in managerial decisionmaking. To enhanceyour understanding of sustainable competitiveness and profitability, it isconstructive to provide a conceptual framework for thinking about some of the factors that

impact industry profitability.Industry nalysis

The model of pure competition implies that riskadjusted rates of return should be constantacross firms and industries. ?owever, numerous economic studies have shown that differentindustries can sustain different levels of profitability and that part of this difference can bee&plained by industry structure.

-n his book, +o&petitive )trategy, 6ichael 2orter +1/0 presented such a conceptual frameworkfor identifying the sources of competitive advantage in a relevant market and e&ploring theeconomic factors that affect the profitability of a firm and its industry. ?e conceptuali8es these

economic factors into five major competitive forces. +>igure 1.! Among these competitiveforces, three are from hori8ontal competition: the threat of new entrants% the threat ofsubstitute products% andrivalry a&ong co&petitive fir&s, while the other two are from verticalcompetition:the bargaining power of buyersandthe bargaining power of suppliers. Thee&istence and the potency of these competitive forces determine the degree of competition,which in turn determines the opportunity to profit in an industry.

Figure 1%* The Fi'e Forces Frameor+

To contrast it with the more general term macro environment, 2orter referred to these forces asthe micro environment. -n a sense, the micro environment consists of those forces close to acompany that affect its ability to serve its customers and make a profit. A change in any of theseforces re7uires a company to reassess the marketplace. The overall industry attractiveness doesnot imply that every firm in the industry will return the same profitability. >irms that are able to


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apply their core competences, business model or network can achieve a profit above the industryaverage. A clear e&ample of this is the airline industry. As an industry, profitability is low= yet,individual companies, by applying uni7ue business models, have been able to make a return ine&cess of the industry average. To the e&tent that these five competitive forces influence anindustry, a business e&ecutive can use the model to better understand the industry conte&t in

which the firm operates and to determine how and where the firm should operate.

2orter@s model is based on the insight that a corporate strategy should be adaptable to theopportunities and threats in the firm@s e&ternal environment. %specially, competitive strategyshould base on an understanding of industry structures and the way they change. >ivecompetitive forces shape every industry and every market. These forces determine the intensityof competition and hence the profitability and attractiveness of an industry. The objective ofcorporate strategy should be to modify these competitive forces in a way that improves theposition of the firm. 2orter@s model supports analysis of the driving forces in an industry. Basedon the information derived from the five forces analysis, management can decide how toinfluence or to e&ploit particular characteristics of their industry.

-n essence, 2orter@s five forces model provides a framework for the industry analysis andbusiness strategy development. -t uses concepts developed in -ndustrial Crgani8ation economicsand hence attractiveness of a market. Attractiveness in this conte&t refers to the overall industryprofitability. An unattractive industry is one where the combination of forces acts to drivedown overall profitability. A very unattractive industry would be one approaching purecompetition. This model can be used to analy8e the attractiveness of an industry structure andto make decisions of entry or change within a market. -t should always be considered during thebusiness planning stage in a company life cycle.

-n many ways, this conceptual five forces framework enables practicing managers to assess each

force by referring to the economic principles that apply for each force. 'ather than concentratingonly on e&isting competitive firms, competition is viewed as a grouping of alternative ways forcustomers to obtain the value they desire. This is particularly important as industry boundarieshave become increasingly blurred in the new economy. >or e&ample, telecommunication firmsnow compete with broadcasters= software manufacturers provide personal financial services, andautomakers have e&panded their business into insurance and consumer financing.

;ith economic reasoning, an industry analysis such as 2orter3sfive forcesframework +>igure1.! helps develop useful insights for practicing managers to be more effective in dealing withthe e&ternal environment of the firm. -t facilitates the assessment of the industry and the firm@sperformance, the identification of factors affecting firm@s performance, and the determination ofhow changes in the business environment may affect performance.

?owever, according to 2orter, the five forces model should be used at the industry level= it is notdesigned to be used at the industry group or industry sector level. An industry is defined at alower, more basic level: a market in which similar or closely related products andor services aresold to buyers. >irms that compete in a single industry should develop, at a minimum, one fiveforces analysis for its industry. Thus, for diversified companies, the first fundamental issue incorporate strategy is the selection of industries +lines of business in which the company should


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compete= and, each line of business should develop its own, industryspecific, five forcesanalysis.

4pecifically, the fiveforce model can be used to analy8e the characteristics of an industry3senvironment and to e&amine competitive forces that influence the profitability potential in an

industry. %ach force can reduce the probability that a firm can earn profits while competing inan industry. >irms competing in an industry want to understand these forces so that they canposition themselves in the industry to ma&imi8e their ability to earn profits. >irms that arethinking of entering an industry want to understand these forces to decide whether the industryprofitability potential is sufficient to support a decision to enter that industry. 4uffice to way, thefive forces framework enables us to channel the many economic concepts we will study in thiscourse and shape them into a solid business strategy. +4ee Table 0.1

To be fair, however, we should recogni8e that 2orter3s five forces framework is just one of manyways of pulling together our later lessons to formulate strategy. -t is like a weaver3s loom thatbinds various materials into a strong, useful fabric. Also note that this conceptual framework has

been modified and strengthened over time by innovations such as the ,alue Netas described in(hapter 10 of the )trategyte&tbook. The ,alue Netprinciples introduced by Brandenberger and)alebuff provide a key insight on how a firm enhances its profits by assessing both threats andopportunities.

2lease read (hapter 10 in the )trategyte&tbook before proceeding to the ne&tsection.

2lease note that formulating a competitive strategy re7uires the following three tasks:

Assessing the industry in which the firm operates and the performance of other firms. etermining the factors that affect firms3 performance.

4eeing how any changes in the business environment might affect performance.

Cne assesses each of the five competitive forces by asking -s it sufficiently strong to reduce oreliminate industry profits


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industry. 2lease refer to *esson $ for a more detailed discussion of these measures. +(hapter Gof the Bensako et al., te&t

Industry Demand:-f the market is stagnant or declining, firms can generally increase

sales only by stealing share from other firms, and a firm3s strategy might focus on this.

!rices and Terms "re #nobservable $it%out Delay:4ellers in the market may be able

to negotiate terms and prices that are not immediately known to other sellers. This is trueof home improvement contractors, among others. The contractor3s negotiated price +e.g.,for a room addition with a home owner is determined privately. This makes it possiblefor a firm to gain substantial market share through pricecutting before rivals canretaliate. -n contrast, changes in the price of gasoline at service stations are immediatelyobservable= so, response by rivals to such price changes is apt to occur rapidly.

-n short, we can readily judge the nature of rivalry within a market by considering these factorsalong with:

The height of e&it barriers +cost of e&it

-nfre7uency of sales

%&istence of cooperative pricing or other industry practices

Threat of -e Entrants

2otential entrants are likely to be a threat to those firms already competing in an industry. Byentering that industry, new firms may take market share away from current competitors. And, bybringing additional production capacity, the entry of new firms may lead to overcapacity in theindustry. Cvercapacity reduces prices for consumers, but results in lower returns for industry

firms. Cn the positive side, new entrants may force incumbent firms to learn new ways tocompete. %ntry barriers make it difficult for new firms to enter an industry and often place themat a competitive disadvantage even when they are able to enter. Therefore, e&isting competitorstry to develop barriers that new firms must face when deciding whether to enter an industry.

-ncumbents favor conditions that make entry difficult, whilepotential competitors prefer ease ofentry. The ease of entry into a market helps determine its concentration, competitiveness, andstability. ;hen analy8ing entry conditions, we need to consider the following dimensions ofentry and their implications for the firm3s strategy:

%&istence of scale economies and minimum efficient si8e

Brand loyalty )ew entrants3 access to essential productive resources

The learning curve

)etwork e&ternalities

Hovernment regulations

%&pectations about postentry behavior

4witching costs


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>or e&ample, if there are significant economies of scale, it will be hard for a new firm to becomecompetitive in a market dominated by largescale sellers. And, entry of new sellers would beimpaired if current customers have strong loyalty to incumbent sellers andor newcomers havelimited access to supplies.

-igh capital reuire&ents% extensive regulation% and cultureare major barriers to entry in manyindustries. ?igh capital re7uirements, for instance, may limit ebusiness potential because of thefinancial constraints in adopting new strategies. Cn the other hand, while it may be difficult toleverage ebusiness potential in a highly regulated industry, there may also be an opportunity ifebusiness improves regulatory responsiveness. ?igh cultural or regional specificity may lowerebusiness potential, as well. -ndeed, it is easier to enter the lawn service industry than thesemiconductor e7uipment industry. Cne re7uires some relatively ine&pensive e7uipment, whilethe other re7uires factories and much speciali8ed knowledge. 4witching costs protectcompanies, too. 2eople don@t switch email providers too often because having to alert manypeople of their new address is a hassle. Brands matter, too. 6any consumers would rather buy abrandname sneaker than an unknown brand.

4ee the brief discussions of these dimensions of entry on pp. !//G in the )trategyte&tbook.

Threat of Su.stitutes and #om"lements

4ubstitute products are the natural result of industry competition= but, theyhave the potential toinfluence an industry3s profitability potential or place a limit on profitability within the industry.)ubstitute productsare goods or services that perform similar functions to an e&isting product.There is a need to differentiate between substitutability within the industry +one brand of auto vs.

another brand of auto which is included in market structure or internal rivalry andsubstitutability within products outside the market or industry definition +auto vs. air travel vs.bus. The crossprice elasticitywith substitutes on fringe of market is e&pected to be lower thanthat of within market boundaries. +4ee *esson !

A substitute product involves the search for a product that can do the same function as theproduct the industry already produces. -n particular, substitute products take on addedimportance as their availability increases. The 7uestion is to determine how easy a product orservice can be substituted, especially made cheaper. As such, threats of substitutes depend on:

o Iuality. -s a substitute betterirms that are union shops agree to let the unionbe the sole provider of workers. 6ost car producers are heavily dependent on the "nitedAutoworkers "nion. Although the American 6edical Association is not a union in the strictestsense, for many years it has e&ercised strong control over the supply of physicians to hospitals.?ospitals, and communities needing medical practitioners, had little control over prices andsupplies of physician services. The recent trend toward employment of physicians trained

outside the "nited 4tates gave hospitals and communities more fle&ibility.

%&plicitly, suppliers3 actions can reduce a firm@s ability to earn profits while competing in anindustry. -f a supplier can either increase the price of its product or reduce the 7uality whileselling it at the same price, the effect on established firms3 profitability is negative. 4upplierstend to be powerful when:

There are a few large suppliers and the buying firms@ industry is not concentrated.
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4ubstitute products are not available to the buying firms.

The buying firms are not a significant customer for the suppliers.

The suppliers3 goods are essential to the buyers3 marketplace success.

The suppliers3 products have high switching costs for the buyers.

The suppliers pose a credible threat to integrate forward into the buyers3 industry.

-ndeed, suppliers have a great deal of influence over an industry because they affect priceincreases and product 7uality. These factors are generally out of the control of the industry orcompany= but, strategy can alter the power of suppliers. >or e&ample, there are only a fewairplane suppliers +think Boeing and Airbus. 4o, if you are running an airline, it is difficult toplay one against the other, trying to strike a bargain. -f there were many suppliers, they wouldlikely be competing more for your business, which might result in lower costs for you.

Bargaining Poer of Buyers

The buyer@s power is significant in that buyers can force prices down, demand higher 7uality

products or more services, and, in essence, play competitors off against one another, all resultingin potential loss of industry profits. ?ence, if we have a choice of suppliers or are amonopsonistic buyer, we have considerable leeway.1>irms that have many alternative suppliersmay be able to negotiate favorable prices or other conditions, such as delivery schedules. ;hilesellers are dependent on their customers, customers have little actual market power unless theyact collectively.

-n a competitive market, firms selling a product want to increase their profitability, while theircustomers +or buyers want to buy high7uality products at a low price. These goals mean thatbuyers try to reduce their costs by bargaining with selling firms for lower prices, higher 7uality,and greater levels of service. -n contrast, firms try to offer value to customers at prices that

clearly e&ceed the costs of providing that value. 4eemingly, powerful customers +or buyers havethe potential to reduce the profitability potential of an industry. Buyers or customers tend to bepowerful when:

They buy a large portion of the selling firm3s total output.

The selling firm depends on the buyers for a significant portion of its sales revenue.

They can switch to another seller3s product with few switching costs.

The selling industry3s products are undifferentiated or similar to a commodity.

They present a credible threat to integrate backward into the sellers3 industry.

The bargaining power of buyers changes with time and the competitive strategy of a firm +and its

industry. This is affected by brand power, switching costs, the relative volume of purchasesstandardi8ation of the product, and elasticity of demand +where demand increases as prices fall,and vice versa. ;hen buying electronics, for e&ample, we have many choices and somebargaining power. The important point here is that the firm should analy8e the market power ofits suppliers and its customers when designing competitive strategy.


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2lease read pages #!0##F in the )trategyte&tbook for e&amples of applications offive force analysis. Also, see the list of factors that affect the power of sellers and

buyers on pages ##/## of the )trategyte&tbook.

-n sum, the five forces model concentrates on five structural industry features that comprise the

competitive environment, and hence profitability, of an industry. Applying the model meansthat, to be profitable, the firm has to find and establish itself in an industry so that the companycan react to the forces of competition in a favorable manner. The model is a tool for managers toanaly8e competition in an industry in order to anticipate and prepare for changes in the industry,new competitors and market shifts, and to enhance their firm@s overall industry standing.?owever, it should be noted that the model does not cope with synergies and interdependencieswithin the portfolio of large corporations.

>urther, the strength of each competitive force can vary from industry to industry= but, whenconsidered together, these competitive forces determine longterm profitability within thespecific industrial sector. The strength of each force is a separate function of the industry

structure, which 2orter defines as the underlying economic and technical characteristics of anindustry. (ollectively, the five forces affect prices, necessary investment for competitiveness,market share, potential profits, profit margins, and industry volume. The key to the success of anindustry, and thus the key to the model, is analy8ing the changing dynamics and continuous flu&between and within the five forces. 2orter@s model depends on the concept of power within therelationships of the five forces. (onsider factors such as these and you might learn that anindustry is or isn@t as attractive as you thought.

Though the five forces model in regards to decision making is to collect, analy8e, and presentdata for the decision makers, 2orter identifies three generic strategies to address industry rivalry.4trategies can be formed on there levels J corporate, business unit, and functional or department

level. The strategies are cost leadership, differentiation, and competitive advantage. The bestdecision will position the firm to leverage strengths and defend against adverse effects of the fiveforces. The discussion of these strategies will be presented in *essons / and .

16onopsony is a market condition in which firms have one dominant buyer. -n contrast, a monopoly +see *esson $is a condition where there is only one seller. 6onopsony receives less attention from economists than monopoly,but it can be important. The ?ershey (ompany established its original plant in south central 2ennsylvania becauselarge supplies of fresh milk were available there. 6ilk is an important ingredient in chocolate and it is costly to shipover long distances. The region had many small dairy farms and ?ershey 7uickly became a dominant customer ofthese farms. ?ershey soon became a near monopsony and e&erted considerable market power over its manysuppliers, especially when it had contracts with them.

/#oo"etition/The five forces framework is widely used and is very helpful. The firm can use it as a virtualchecklist of factors that it must take into account in strategy design. ?owever, some laterstudents of strategy noted that 6ichael 2orter seems to have regarded firms as primarily actingindependently. -n practice, competitive firms in many markets act cooperatively in their mutualselfinterest. ?ere are some e&amples:


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(ooperative price +see*esson F, whereby firms tacitly settle on a uniform price to avoid

price competition.

4et technology standards, such as when producers of recorded programs +K vs. K?4,

? K vs. Blu 'ay agreed on a technology for producing these products and

producers of players subscribe to a complementary method for displaying content. This isan e&ample of cooperative behavior in which competitors worked in concert to enlargetheir collective market rather than to enlarge individual shares of a stagnant market.

Trade associations to which firms may contribute to promote government regulations, or

legislation that favors all, or most, of the association3s membership.

(ooperation by buyers and sellers to improve product 7uality, such as when meat

packagers work with growers to develop better methods of production and handling.

The popularity of EjustintimeE product delivery, as well as other innovations in supply

chain management, which are cooperative arrangements among buyers and sellers.

ssignment (Team) 1%1

The assignment is to learn how to prepare a 2ower2oint 2resentation of the five forces model. -nthis initial presentation, you should attempt to assess the most important features of the ?ome>urnishings L ?ousewares 'etail +sub industry, using 6ichael 2orter@s five forces framework,and indicate the degree of effect of each competitive force +e.g., low, medium, and high.

&b'ective:This preliminary presentation is to help you develop an understanding of an industrystructure and competitive forces with the focus on economic issues +threats and opportunities

operating in all of the firms within this industry, in preparation of 5oint 2roject Task M1 in *esson0F. )ote that this is a team assignment, but will not be graded. Dou and your team membersshould use your team3s discussion forum, or another means of communication +conference call,group emails, etc. to post your ideas.

ubmission:Dour team leader will lead a discussion that will result in specificdecisions. (hoose one team member to finali8e your team answers and submit them to the(esson )*: "ssignment +Team, ** drop bo&. (heck the due date for this assignment byviewing the (ourse 4chedule.

ssignment (Team) 1%*

Answer the following 7uestions in yourcono&ics of )trategyte&tbook:

(hapter 10, Iuestion !
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&b'ective:This is a team assignment. Dou and your team members should use your team3sdiscussion forum, or another means of communication +conference call, group emails, etc. topost your ideas. Dour team must make decisions for the firm under a variety of alternativescenarios. Dour answer will be judged on the basis of your reasoning.

ubmission:Dour team leader will lead a discussion that will result in specificdecisions. Cne team member is to be chosen to finali8e your team answers and submit them tothe (esson )*: "ssignment +Team, *.drop bo&. (heck the due date for this assignment byviewing the (ourse 4chedule.

el"ful Ta,onomy

Dou might wrap up your study of the five forces model by going over the template in

Appendi& 10.1, (hapter 10+pp. ##N# of the )trategyte&tbook. This template providesspecific 7uestions for each of the five forces.

The Time alue of !oney

6any business decisions involve benefits and costs that are e&pected to occur at different futurepoints in time. >or e&ample, the construction of a new production plant re7uires an immediateoutlay of cash and results in a stream of e&pected cash inflows +benefits over many future years.-n this instance, it is important to recogni8e that O1 today is worth more than O1 received in thefuture. The reason is simple: The opportunity cost of receiving the O1 in the future is the forgoneinterest that could be earned were O1 received today. This opportunity cost reflects the ti&e

value of &oney. Thus, to determine if the e&pected future cash inflows are sufficient to justify theinitial outlay, we must have a way to compare cash flows occurring at different points in time.To properly account for the timing of receipts and e&penditures, managers must understandpresent value analysis.

o to 2se Economic #osts in 3ecision&!a+ing: Presentalue [NOTE: Changing to a smaller font size as a subsection];hy do banks charge interest for loans< ;hy do banks pay depositors an interest rate forinvestments in certificates of deposit< To approach this issue, think about what you give up whenyou put your money into a bank ( for one year. Dou give up the opportunity of spending this

money, which is an opportunity cost. The bank pays you interest as an incentive for you to giveup your ability to spend your money for one year. -n other words, the bank covers youropportunity cost.

4heila wants to buy a pair of skis this Cctober so that she can go skiing in(olorado in ecember. The skis cost OF00 +she is a serious skier. Beforeshe makes her purchase, however, her friend %lliot asks her to lend himOF00 so he can fi& the furnace in his house before the cold winter weather.
https://cms.psu.edu/section/content/default.asp?WCI=Goto&WCU=CRSCNT&MATCH=Team+Assignment+1.2https://cms.psu.edu/section/content/default.asp?WCI=Goto&WCU=CRSCNT&MATCH=Team+Assignment+1.2https://courses.worldcampus.psu.edu/imba501fa08/common/syllabus.html#lesson1https://courses.worldcampus.psu.edu/imba501fa08/common/syllabus.html#lesson1https://cms.psu.edu/section/content/default.asp?WCI=Goto&WCU=CRSCNT&MATCH=Team+Assignment+1.2https://courses.worldcampus.psu.edu/imba501fa08/common/syllabus.html#lesson1


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The sportse7uipment dealer informs 4heila that these skis are going to costOFF0 ne&t year. That means that %lliot would have to pay her back OFF0 inCctober of ne&t year so that she can purchase the same pair of skis at thattime. %lliot would have to pay 4heila an interest rate of at least 10P tocompensate her for the e&pected inflation in the price of the skis= that 10P

interest rate would give her the OFF0 she would need ne&t year to buy theskis that cost OF00 this year.

But, let us be fair to 4heila. 4he would have to give up the satisfaction ofhaving her skis for one year if she lends her money to %lliot. 4he should getsome compensation for waiting. Cne way of rewarding her for waiting is tolet her buy better skis ne&t year. A slightly better grade of skis is pricedtoday at OF!0, which is $P higher than the OF00 price for the original skisshe wanted to buy. 4o, %lliot offers to pay 4heila an interest rate of 1$P=the loan of OF00 would be repaid ne&t year by +OF00 & 1.1$ Q OFN0. Thiswould give her 10P to cover e&pected inflation and $P for Ewaiting.E

-nterest is paid to investors to compensate them for the opportunity cost of their funds. -n the skie&ample, interest is paid to 4heila to compensate her for having to postpone her purchase.Therefore, we can say that to use a popular e&pression Etime is moneyE in the investment andlending business.

6ost business decisions relate to costs and revenues over time. Cnce the electronics firmcommits its resources to the production of ? Ks, it locks itself into a se7uence of e&penses,revenues, and profits that may stretch out over years. ?ow do you make rational calculations ofopportunity costs when time is involved and we should, therefore, include the interest rate< The

answer is a convenient concept called thepresent value+PV,of a se7uence of money incomeover time. Thepresent value+/, of an amount received in the future is the amount that wouldhave to be invested today at the prevailing interest rate to generate the given future value. Hiventhe stream of future profits, Rt, the basic evaluation framework for the present value +/, is

+

==

n

t t

t

r/,

1 ,1+

where r is the interest rate.

Before reading on, see the e7uation and e&ample of present value on page !1!# of

your )trategyte&tbook.

d4usting Business 3ecisions for is+: -et Present alue[NOTE: Changing to a smaller font size as a subsection]


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6anagerial decisions are made in different risk environments. -n the case of decision makingunder certainty, all relevant dimensions of the decision are known. All the relevant informationwas assumed to be known with certainty. The result was a uni7ue solution that ma&imi8ed thefirm@s profit. That is, there was only one relevant outcome of this decision. -n decision makingunder uncertainty, there are several, perhaps many, outcomes of a decision, but the probability of

each of those outcomes occurring is unknown. >or e&ample, a firm may be considering theproduction of a completely new product. Because consumers have had no e&perience with theproduct, there is no way to estimate the potential demand for it. The marketing department mayundertake various market surveys in an attempt to estimate how many people might buy theproduct, but it is doubtful that much confidence can be placed in such efforts. There may be noway to provide anything but some rough guesses about demand.

Alternatively, decision making may be under risk. The analysis of risk under this situation isbased largely on the concepts of probability and probability distributions. Although there areseveral ways to incorporate risk into the decision process, the most common method is to use ariskadjusted discount rate in determining the present value of the future profits associated with

an investment. Hiven the stream of future profits, Rt, the basic evaluation framework

+

==

n

t t

t

r/,

1 ,1+

is modified by using an appropriate riskadjusted interest or discount rate for r. 6ost investorsare willing to accept greater risk only if there is the promise of greater returns when compared toan investment with less risk. >or e&ample, suppose that the typical return on an insured bankcertificate of deposit is 10 percent per year. (learly, no rational investor will invest in very riskyventures higher than 10 percent per year. -n evaluating various investments, the differentialdiscount rates would be used to evaluate the present value of future profits. That is, net cash

flows for a highrisk investment would be discounted using a higher discount rate than would beused for a lowrisk alternative.

4pecifically, the present value of a stream of dollars over time +costs or revenues is the sum ofmoney you need today that, if placed in an interestearning bank account that pays an interestrate, would generate this same stream of funds. -f the sums represent revenues minus costs +i.e.,profits, we label this sum the net present value+NPV,.N/,is a neat way to compare projectswith different cash flows over time. But, there is more.N/,is based on both cash flows and onan interest rate= and, the interest rate is used to calculate/,orN/,and it is called the discountrate. The same discount rate is not appropriate for every project. That is because every project orresource commitment has its own uni7ue likelihood of success and its own risks of failure. And,

the outcome of a decision is not a dichotomy. There are degrees of success, i.e., amounts ofprofit or loss. The discount rate is a convenient way of capturing this risk: the discount rate isproportional to the degree of riskiness.

?owever, the selection of an appropriate discount rate is a comple& business. >inancial analyststry to find a financial asset, such as a bond or stock or mutual fund that has e7uivalent riskiness.They use the annual rate of return of that asset as their discount rate. 6atching the risk of abusiness investment project to a specific financial asset is almost as hard as matching pairs of


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people by a dating serviceS *ike matchmaking, selecting a discount rate is more of an art thanscience, even though analysts may use sophisticated statistical methods to help them to do thejob. But we can confidently say this: if 2roject A has more risk than 2roject B, the former shouldhave a higher discount rate. -t should be emphasi8ed that there is no e7uation or table that relatesrisk and the discount rate. (learly, there is a positive relationship between these two factors, but

the relationship between them is strictly judgmental and must be made by individual decisionmakers.

?ence, when making longterm capital budgeting +investment decisions, the riskadjusteddiscount rate approach should be used in dealing with the risk associated with future cashflowestimates. -n the basic net present value decisionmaking model, net present value +N/, isdefined as

01 )1(

Cr

NPVn

t t

t

+=

=

where Rtis the net cash flow in period t+for each of nperiods. +ois the net investment= and, risthe firm@s cost of capital.An investment project is accepted if itsN/,is greater than or e7ual to8ero. -n the riskadjusted discount rate approach, the net cash flows for each project arediscounted at a risk-adjusted rate, r, rather than the firm@s cost of capital +r. The magnitude ofr0depends on the risk of the project: the higher the risk, the higher the riskadjusted discountrate. And the risk premiums +r0 r applied to individual projects are commonly establishedsub1ectively.

-n short, a decision maker faces risk when there are several outcomes associated with a decisionand the probabilities of those outcomes are known. The greater the variation in those outcomes,the greater the risk is likely to incur. -f the probabilities of the outcomes are not known, the

decision maker faces uncertainty. The most common method for compensating for risk whenmaking decisions is to add a risk premium to the rate used to discount future profits. The riskpremium increases as the risk associated with the decision increases. An alternative method foradjusting for risk is to evaluate the certainty e7uivalent of a risky decision. ?ere in this course,we simply provide you with the basic concept of the net present value without actuallydetermining the )2K 7uantitatively. -n i6BA F0!, you will learn how to use this formula tofind )2K and its applications.

!arginal nalysis

To make optimal decisions about various business activities, managers are re7uired to analy8ebenefits and costs to make the best possible decision that leads to the best outcome. 6anagersneed to choose the level of activity to obtain the ma&imum possible net benefit from the activity.This is an essential skill re7uired of all managers in business.

The net benefit+N2 associated with a specific amount of economic activity +3 is the differencebetween total benefit +T2 and total cost +T+ for the activity:


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N2 4 T2 * T+

-t serves as the objection function to be ma&imi8ed= and, the amount of activity,3, represents thechoice variable. -n this section, we will learn how to use a very simple, yet powerful, method forfinding the optimal levels of business activities. This analytical techni7ue, referred to as

Emarginal analysisE by economists, forms the basic foundation of the profitma&imi8ation theory,production, input choice, and even consumer behavior.

The #once"t of !arginal nalysis [NOTE: Changing to a smallerfont size as a subsection]

6arginal analysis focuses on changesin economic variables and the results that occur directlyfrom these changes. -t involves applying the fundamental principles of optimi8ation theory indecision making, including some commonsense ideas and concepts that you already know andhave applied, probably without knowing it, in your everyday decisions.

>or instance, in order to adjust a specific business activity +e.g., the number of workers to hire,the amount of output to produce, the amount to spend on advertising, etc., either up or down, toattain the best value for your firm, you would estimate how the change will affect both thebenefits your firm will receive and the costs your firm will incur from engaging in this activity. -fthe change will cause benefits to rise more than costs, or, alternatively, costs to fall by more thanbenefits, then the net benefit your firm receives from the activity will rise. "nder thesecircumstances, you will continue adjusting the activity level until no further net gain is possible,which means the activity has reached its optimal value or level. This is the essence of marginalanalysis.

There are two key elements of this methodology: marginal benefit and marginal cost.Marginal

benefitis defined as the change in total benefit caused by an incremental change in the level ofan economic activity= and, &arginal costis defined as the change in total cost arising from anincremental change in the level of an economic activity +e.g., the production of an additional unitof output. -n these definitions, you can think of incremental changes in activity to be any changethat is small relativeto the total level of activity. -n most applications, it is convenient toconsider an incremental change as a oneunit change= in some decisions, it may be impractical tomake changes as small as oneunit. But, this should cause no problem for applying marginalanalysis, as long as the activity can be adjusted in relatively small increments changed.

6arginal benefit and marginal cost can be e&pressed mathematically as

3T2

3ctivityin+hange2enefitTotalin+hangeM2

==

and

3

T+

3ctivityin+hange

+ostTotalin+hangeM+

==


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where the symbol EUE means Ethe change inE and3denotes the level of an activity.

'ecall from your high school math classes or a precalculus course in college that EmarginalEvariables measure rates of change in corresponding EtotalE variables. The slope of a curve at anyparticular point can be measured by first constructing a line tangent to the curve at the point of

measure and then computing the slope of this tangent line by dividing the EriseE by the ErunE ofthe tangent line. ;hen a line is tangent to a curve, it touches the curve at only one point. >orsmooth, continuous curves, only one line can be drawn tangent to the curve at a single point.(onse7uently, the slope of a curve at a point is uni7ue and e7ual to the slope of the tangent lineat that point. ?ence, marginal benefit and marginal cost are also slopes of total benefit and totalcost curves, respectively, as illustrated in >igure 1.#.


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Figure 1.3

Total Benefit, Total Cost, and Net Benefit Functions

Benefits

and

Costs

Net

Benefits

0

Q1 Qm Q2

Q1

Q2

Q

Q

Loss Loss

Units of the Management Control Variable (eg! "#t$#t)

C

%B

Loss

Positi&e Benefits

'

%C

%C

Net Benefits

Q1 Lo*er brea+e&en o#t$#t

Qm Ma,im#m benefit o#t$#t

Q- U$$er brea+e&en o#t$#t

.lo$e MB at Qm

.lo$e MC at Qm

Qm

TB = TC

TB = TC

MB = MC

Maximum Net Benefits

(.lo$e of net benefit f#n/tion 0)

Net Benefits

Loss

Units of the Management Control Variable

The figure shows typical benefit, cost, and net benefit curves of microeconomic theory, withbenefit, cost, and net benefit scaled in dollars on the vertical a&is, and the number of themanagement control variable +e.g., output 7uantity produced and sold scaled on the hori8ontala&is.Marginal benefit+M2, the change in total benefit per unit change in the level of activity, isgraphed as the slope of the total benefit +T2 curve= and, &arginal cost+M+, the change in totalcost per unit change in the level of activity, is graphed as the slope of the total benefit +T2curve, is graphed as the slope of the total cost +T+. ;e also note the following:


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At activity levels 51 and 5!, T2is just e7ual T+, so net benefit is 8ero. Cutputs below 51

or above 5!result in a negative net benefit.

;hen the level of activity is greater than 51and less than 5!, positive net benefits result.

This marginal analysis shows that if, at a given level of activity, a small increase or decrease inactivity causes net benefit to increase, then this level of the activity is not optimal. The activitymust then be increased +ifM2 6 M+ or decreased +ifM2 7 M+ to reach the highest netbenefit. The optimal level of the activity +the level that ma&imi8es net benefit is attained whenno further increases in net benefit are possible for any changes in the activity, which occurs at theactivity level for whichM2 4 M+at 5m. At this level of activity, if we draw a line tangent to theT2 curve and another line tangent to the T+curve, it can be seen that these lines are parallel= thatis to say, the slopes of the two curves are e7ual. This means that at a 5mlevel of activity,M2 4M+. At this level of activity, the slope of the total benefit function, or marginal benefit +6B, is8ero.

"sing the marginal benefit and marginal cost curves in >igure 1.#, we can summari8e the logicof marginal analysis in Table 1.1 by presenting the relation between marginal benefit, marginalcost, and net benefit set forth in the above discussion.

Table 1.1Marginal Analysis ecision !ules

MB > MC MB < MC

Increase "ctivity N2rises N2falls

Decrease "ctivity N2falls N2rises

The preceding discussion of unconstrained optimi8ation has allowed only one activity or choicevariable to influence net benefit. ?owever, when decision makers wish to ma&imi8e the netbenefit from several activities, precisely the same principle applies. The firm ma&imi8es netbenefit when the marginal benefit from each activity e7uals the marginal cost of that activity.The problem is somewhat more complicated mathematically because the manager will have toe7uate marginal benefits and marginal costs for all of the activitiessi&ultaneously. >or e&ample,if the decision maker chooses the levels of two activities3and2to ma&imi8e net benefit, thenthe values for3and2must satisfy two conditions at once:M23QM+3andM22QM+2.

-ndeed, constructing tangent lines and measuring slopes of the tangent lines presents a rathertedious and imprecise method of finding marginal benefit and marginal cost curves. ?owever,by applying the techni7ue of differential calculus +if you still remember it, the marginal benefitand marginal cost curves can be obtained without drawing tangent lines as follows:

!

!

! d5

/5d

d5

TRdM2

,+,+==


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a. Based on our discussion above, profit is ma&imi8ed whenMR 4 M+,MRis the first derivativeof the TRfunction.M+is the first derivative of the T+function.

TR 4 /5 4 !05 and MR 4 !0T+ 4 1,000 F5V 0.0F5! and M+ 4F V 0.105

At optimum, MR 4 M+ !0 4 F V 0.105 50 4 !F0 decanters per week

)ote: The asterisk indicates that this particular value of 5is optimal. That is, 5 is the optimaloutput that ma&imi8es the profit.

The same result can be obtained by taking the derivative of the profit function, setting it e7ual to8ero, and solving for 5.

2rofit +R 4 TR * T+ 4 /5 * T+4 !05 W1,000 F5V 0.0F5!X4 1,000 V !F5 0.0F5!

010.0!F == 5d5

d

4olve for 5 Q !F0, as above.

b. As we learn in this lesson, profit +R 4 TR * T+ 4 /5 * T+. ?ence,

R 4 !05 W1,000 F5V 0.0F5!X4!0+!F0 W1,000 F+!F0 V 0.0F+!F0!X

4O!,1!F per week.

That3s it for *esson 1S )ow you have learned the economic way of thinking and the businessenvironment in which the firm operates. ?opefully, you are beginning to feel comfortablethinking like an economist. ;hen you are ready, you can move onto *esson !.

Lesson 01 Boo+mar+s

An important prere7uisite for the five force analysis is identification of the firms that constitutethe market the firm is in, i.e., the specific competitors that occupy the market. The ne&t step is toidentify the elements of differentiation and the sources of firms3 market power, i.e., what do

customers look for when comparing sellers and how do the firms compare with one another

Lesson 01 the Economic Foundation of Business Strategy

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Transcript of Lesson 01 the Economic Foundation of Business Strategy