STR 421

STR 421STR 421

Economics of Economics of

Competitive StrategyCompetitive Strategy

Michael RaithMichael Raith

Spring 2007Spring 2007

3. The scope of the firm3. The scope of the firm

Horizontal scope: to what extent should a firm expand into new Horizontal scope: to what extent should a firm expand into new

products or businesses?products or businesses?– CCS: diversify into plastics?CCS: diversify into plastics?

– Choice Hotels: pros and cons of covering full quality spectrum Choice Hotels: pros and cons of covering full quality spectrum Vertical scope: To what extent should a firm be involved in Vertical scope: To what extent should a firm be involved in

activities further upstream or downstream in the production chain?activities further upstream or downstream in the production chain?– Coors: backward integration into everythingCoors: backward integration into everything

– Reynolds, beverage producers: integration into metal cansReynolds, beverage producers: integration into metal cans

– Dell vs. Compaq: resellersDell vs. Compaq: resellers Closely related but not focus here: mergers within industryClosely related but not focus here: mergers within industry

Today’s classToday’s class


3.1 Expanding scope: problems and 3.1 Expanding scope: problems and

challengeschallenges3.2 Expanding scope to realize synergies3.2 Expanding scope to realize synergies

3.3 Expanding scope to increase market power3.3 Expanding scope to increase market power

Bad/questionable Bad/questionable reasons to diversifyreasons to diversify

““We We needneed to grow” to grow”– Profitability often leads to growth, but growth for its own sake is Profitability often leads to growth, but growth for its own sake is

rarely profitablerarely profitable

– Agency problem: Agency problem: managersmanagers want growth because their want growth because their

influence & compensation depends on itinfluence & compensation depends on it

– Managers often prefer to spend “free cash flow” on growth Managers often prefer to spend “free cash flow” on growth

strategies and pet projects than pay it out to shareholdersstrategies and pet projects than pay it out to shareholders

– Similar: diversification efforts in industries with declining Similar: diversification efforts in industries with declining

profitabilityprofitability Metal cansMetal cans

More questionable reasonsMore questionable reasons

Diversify in production to reduce financial risk?Diversify in production to reduce financial risk?– Shareholders can instead diversify in financial marketsShareholders can instead diversify in financial markets

Diversified firm as source of investment funds?Diversified firm as source of investment funds?– Assumes financial market failure that can be overcome Assumes financial market failure that can be overcome

internallyinternally

……and one more:and one more:

Spread unique skills & capabilities into new industries?Spread unique skills & capabilities into new industries?– ““Superior skills” exist but are hard to assess/verifySuperior skills” exist but are hard to assess/verify

– Managers of successful firms often overestimate scope and Managers of successful firms often overestimate scope and

uniqueness of their capabilitiesuniqueness of their capabilities

– Probably one of the major reasons why many acquisitions failProbably one of the major reasons why many acquisitions fail

Many empirical studies document a “diversification Many empirical studies document a “diversification

discount”, suggesting that firms often diversify for the discount”, suggesting that firms often diversify for the

wrong reasonswrong reasons

Bad reasons to vertically integrateBad reasons to vertically integrate

““Produce in-house to avoid paying a profit margin to Produce in-house to avoid paying a profit margin to

independent firms”independent firms”– If input market is competitive, “profit margin” is expected return If input market is competitive, “profit margin” is expected return

on invested capital = part of economic coston invested capital = part of economic cost

– Examples: resellers in PC industry; car rental: fees for Examples: resellers in PC industry; car rental: fees for

reservation systemsreservation systems

““Outsource to avoid certain costs of production”Outsource to avoid certain costs of production”– E.g. outsource transportation to avoid maintenance & E.g. outsource transportation to avoid maintenance &

depreciation of trucksdepreciation of trucks

See BDSS for other make-or-buy fallaciesSee BDSS for other make-or-buy fallacies

Organizational costs of integration/ Organizational costs of integration/ expansion in scopeexpansion in scope

Dilution of incentives of division managersDilution of incentives of division managers Specialized resources spread too thinSpecialized resources spread too thin Management too complex, problems more difficult to Management too complex, problems more difficult to

detectdetect Many additional problems when two existing firms with Many additional problems when two existing firms with

different organizations, cultures are mergeddifferent organizations, cultures are merged– CCS-Continental CanCCS-Continental Can

Two main ways to expand scopeTwo main ways to expand scope

1.1. Internal development = Integration by developing own Internal development = Integration by developing own

capabilities in target industry/marketcapabilities in target industry/market– This is like an entry decisionThis is like an entry decision– What are the barriers to entry?What are the barriers to entry?– Do we have a competitive advantage?Do we have a competitive advantage?

2.2. Acquisition of existing companyAcquisition of existing company– Current owners must be compensated for profits they give upCurrent owners must be compensated for profits they give up– Acquisition must Acquisition must increase total valueincrease total value created between the two created between the two

companies!companies! Compare Choice Hotels: new brand introductions vs. Compare Choice Hotels: new brand introductions vs.

acquisitionsacquisitions

What if several bidders compete What if several bidders compete for acquisition target?for acquisition target?

Suppose firm A thinks of selling its unit X.Suppose firm A thinks of selling its unit X. A is worth $50M when it owns X; worth only $30M A is worth $50M when it owns X; worth only $30M

without X.without X. Two bidders:Two bidders:

– Firm B is worth $40M without X but $65M if acquires XFirm B is worth $40M without X but $65M if acquires X

– Firm C is worth $70M without X but $100M if acquires XFirm C is worth $70M without X but $100M if acquires X

Who will buy X and at what price?Who will buy X and at what price? Winning makes sense only if acquisition leads to Winning makes sense only if acquisition leads to larger larger

increase in total valueincrease in total value than for any other bidder! than for any other bidder! ““Winner’s curse” if value of target is overestimatedWinner’s curse” if value of target is overestimated



3.1 Expanding scope: problems and challenges3.1 Expanding scope: problems and challenges

3.2 Expanding scope to realize synergies3.2 Expanding scope to realize synergies3.3 Expanding scope to increase market power3.3 Expanding scope to increase market power

3.2 Integration to realize synergies3.2 Integration to realize synergies

Parallel discussion of horizontal and vertical scope Parallel discussion of horizontal and vertical scope

because central questions are the same:because central questions are the same:– What are the synergies/sources of economies of scope?What are the synergies/sources of economies of scope?

– Is integration better than contractual solutions?Is integration better than contractual solutions?

The main good reason to expand scope is to take The main good reason to expand scope is to take

advantage of lower costs or a higher benefit.advantage of lower costs or a higher benefit.

Economies of Scope: Economies of Scope: 1. Efficient use of resources1. Efficient use of resources

Production facilities and peopleProduction facilities and people– Hollywood studios: movies and TV showsHollywood studios: movies and TV shows

– Pharmaceuticals: lab equipmentPharmaceuticals: lab equipment

– Sales forces to sell different productsSales forces to sell different products

Related: benefits of geographical proximity; e.g. Related: benefits of geographical proximity; e.g.

beverage bottling and can productionbeverage bottling and can production Umbrella branding: Sony, Disney, Virgin, Choice HotelsUmbrella branding: Sony, Disney, Virgin, Choice Hotels Through transfer of organizational capabilitiesThrough transfer of organizational capabilities

– Philip Morris’ marketing skills applied to Miller Brewing Co.Philip Morris’ marketing skills applied to Miller Brewing Co.

– IBM’s Engineering and Technology Services divisionIBM’s Engineering and Technology Services division

2. Benefits from bundling 2. Benefits from bundling for buyersfor buyers

Convenience for buyers of buying multiple products Convenience for buyers of buying multiple products

through same channels: through same channels: – Disney: movies, parks, toys, cruises etc.Disney: movies, parks, toys, cruises etc.– Masco Corp.: consumer brands for home Masco Corp.: consumer brands for home

improvement/construction marketimprovement/construction market

Convenience of choice: Choice HotelsConvenience of choice: Choice Hotels Lower costs of purchasing complementary goods: Lower costs of purchasing complementary goods:

Starbucks and Hear Music storesStarbucks and Hear Music stores

3. Coordination and other 3. Coordination and other externalities in productionexternalities in production

Knowledge spillover:Knowledge spillover:– Pharmaceuticals: knowledge spilloverPharmaceuticals: knowledge spillover– Reynolds in aluminum cansReynolds in aluminum cans– Intel: microprocessors and ProShare videoconferencing?Intel: microprocessors and ProShare videoconferencing?

Product design and quality controlProduct design and quality control– Hardware and software: Apple, Nintendo vs. Atari in 80sHardware and software: Apple, Nintendo vs. Atari in 80s– PC Resellers: hardware and software supportPC Resellers: hardware and software support– Coors’ own trucking subsidiary to transport beerCoors’ own trucking subsidiary to transport beer– Business school course packetsBusiness school course packets

Advances in IT (making coordination easier) are one Advances in IT (making coordination easier) are one

reason for general trend towards outsourcingreason for general trend towards outsourcing

4. Externalities in pricing of 4. Externalities in pricing of

complementary productscomplementary products

Recall oligopoly pricing: firms cutting price don’t take Recall oligopoly pricing: firms cutting price don’t take

negative effect on competitors into accountnegative effect on competitors into account Complementary products: firms don’t take Complementary products: firms don’t take positivepositive

effect of cutting price on competitors into accounteffect of cutting price on competitors into account Charge prices that are too high!Charge prices that are too high! Less business for both firmsLess business for both firms

Integration may be only way to solve problemIntegration may be only way to solve problem Careful, though: argument assumes some degree of Careful, though: argument assumes some degree of

market power in both markets!market power in both markets!

ExamplesExamples

Cars and financing: GMAC (est. 1919, divested 2006), Cars and financing: GMAC (est. 1919, divested 2006),

Ford Motor Credit (est. 1959), founded when credit Ford Motor Credit (est. 1959), founded when credit

markets were less competitive/efficientmarkets were less competitive/efficient– Also possibly: transaction costs for buyersAlso possibly: transaction costs for buyers

Michelin: tires and guidebooks?Michelin: tires and guidebooks?– Also possibly: lower production costsAlso possibly: lower production costs

The vertical counterpart: The vertical counterpart: Double marginalizationDouble marginalization

Same in vertical production chains; e.g. manufacturer, retailer Same in vertical production chains; e.g. manufacturer, retailer – Both provide complementary goods/services!Both provide complementary goods/services!

– Retailer’s price > wholesale price; manufacturer’s price > MCRetailer’s price > wholesale price; manufacturer’s price > MC Problem: retail price higher, and Problem: retail price higher, and total profits lowertotal profits lower than if prices than if prices

were coordinated/ if upstream & downstream firm were integratedwere coordinated/ if upstream & downstream firm were integrated Example: Brewers and pubs in the U.K.Example: Brewers and pubs in the U.K.

– In late 1980’s, many pubs were owned and managed by brewersIn late 1980’s, many pubs were owned and managed by brewers

– Antitrust authority forces brewers to divest some of their pubsAntitrust authority forces brewers to divest some of their pubs

– Slade (1998) finds that beer prices in pubs subsequently increased Slade (1998) finds that beer prices in pubs subsequently increased

and industry profits decreasedand industry profits decreased Again, argument applies only if both upstream & downstream firm Again, argument applies only if both upstream & downstream firm

have market power!have market power!

But why integrate??But why integrate??

Many economies of scope can be realized through Many economies of scope can be realized through

contracts, without integrationcontracts, without integration When that is possible, it’s much easier than integrationWhen that is possible, it’s much easier than integration Integration best if contracts don’t work wellIntegration best if contracts don’t work well

– Why did Fedex buy Kinko’s in 2003? Why did Disney merge Why did Fedex buy Kinko’s in 2003? Why did Disney merge

with ABC? Both pairs had established relationships beforewith ABC? Both pairs had established relationships before

Think of “buy” instead of “make” as default, see if there Think of “buy” instead of “make” as default, see if there

are reasons to “make”. Independent suppliers…are reasons to “make”. Independent suppliers…– often benefit from scale & scope economies, experienceoften benefit from scale & scope economies, experience

– have better incentives to keep costs low and improve productshave better incentives to keep costs low and improve products

Examples of contracting solutionsExamples of contracting solutions

Use of resources: Use of resources: – Manufacturer’s representativesManufacturer’s representatives– Reservation systems for car rental, flightsReservation systems for car rental, flights

Coordination/qualityCoordination/quality– Nintendo and external game producersNintendo and external game producers– Supply chain management at DellSupply chain management at Dell

Complementary productsComplementary products– Partnerships to offer discounts: Choice HotelsPartnerships to offer discounts: Choice Hotels

Pricing in vertical chainsPricing in vertical chains– Non-linear pricing in franchisingNon-linear pricing in franchising– Gasoline: retail price maintenance as Gasoline: retail price maintenance as upper limitupper limit on price on price

Contracting problemsContracting problems

Costs of describing and measuring quality of Costs of describing and measuring quality of

performanceperformance Costs of describing the terms of a contractCosts of describing the terms of a contract

– E.g. B-school packets: costs of specifying penaltiesE.g. B-school packets: costs of specifying penalties

Costs of agreeing on prices for resources to share, or Costs of agreeing on prices for resources to share, or

on contributions to their costs on contributions to their costs – Underlying problem: parties have private information about Underlying problem: parties have private information about

what resource is worth to themwhat resource is worth to them

Unwanted leakage of proprietary knowledgeUnwanted leakage of proprietary knowledge Legal constraints: price fixing prohibitedLegal constraints: price fixing prohibited

The holdup problemThe holdup problem

1.1. Companies often make relationship-specific investments = useful Companies often make relationship-specific investments = useful

only when dealing with a particular business partneronly when dealing with a particular business partner– E.g. setting up a can factory near Coca-ColaE.g. setting up a can factory near Coca-Cola

2.2. Contracts are often incomplete for any of the above reasonsContracts are often incomplete for any of the above reasons– E.g. increase in cost of aluminum may require adjustment of can price E.g. increase in cost of aluminum may require adjustment of can price

The firm that made a specific investment may later be “held up” by The firm that made a specific investment may later be “held up” by

the otherthe other– E.g. Coca-Cola might say: your past investment in your plant is your E.g. Coca-Cola might say: your past investment in your plant is your

problem; let’s look forwardproblem; let’s look forward

– Consequence: firm making investment may not get its expected returnConsequence: firm making investment may not get its expected return The firm then has less incentive to invest in the first place => The firm then has less incentive to invest in the first place =>

inefficient outcome!inefficient outcome!

Integration as solution to the Integration as solution to the

holdup problemholdup problem

Possible solution: vertical integration (Coke produces its own Possible solution: vertical integration (Coke produces its own

cans), unless it’s possible to write long-term contractscans), unless it’s possible to write long-term contracts Examples:Examples:

– Automobiles Automobiles (Monteverde and Teece, 1982): Components requiring (Monteverde and Teece, 1982): Components requiring

high engineering effort (specific human capital) more likely to be high engineering effort (specific human capital) more likely to be

produced in-house.produced in-house.– Aerospace industry Aerospace industry (Masten, 1984)(Masten, 1984):: components with design specific components with design specific

to company more likely to be produced in-house.to company more likely to be produced in-house.– Electric utilities:Electric utilities: “Mine-mouth” electric utility plants more likely to be “Mine-mouth” electric utility plants more likely to be

vertically integrated with mines than others (Joskow 1985).vertically integrated with mines than others (Joskow 1985).– Electronic components Electronic components (Anderson and Schmittlein, 1984)(Anderson and Schmittlein, 1984):: components components

with greater human capital specificity ( = salespeople’s effort to learn with greater human capital specificity ( = salespeople’s effort to learn

about it) more likely to be sold through in-house sales force.about it) more likely to be sold through in-house sales force.

Scale economies and Scale economies and firm/market size firm/market size

““The division of labor is limited by the extent of the market”The division of labor is limited by the extent of the market”

1.1. MakeMake if no one else has use for the same input, or because input if no one else has use for the same input, or because input

is uniqueis unique– Independent suppliers would not want risk of holdupIndependent suppliers would not want risk of holdup– Integrated cell phone makers: Nokia, Ericsson, MotorolaIntegrated cell phone makers: Nokia, Ericsson, Motorola

2.2. BuyBuy if independent supplier can sell to others as well if independent supplier can sell to others as well– Solves two problems: reduces holdup risk, helps realize EOSSolves two problems: reduces holdup risk, helps realize EOS– Small cell phone makers that purchase standard componentsSmall cell phone makers that purchase standard components– Small companies selling through manufacturer’s representativesSmall companies selling through manufacturer’s representatives

3.3. Possibly makePossibly make if the quantity you need is large enough to realize if the quantity you need is large enough to realize

all scale economiesall scale economies– Big companies often prefer to have an in-house sales forceBig companies often prefer to have an in-house sales force– GM more integrated than FordGM more integrated than Ford



3.1 Expanding scope: problems and challenges3.1 Expanding scope: problems and challenges

3.2 Expanding scope to realize synergies3.2 Expanding scope to realize synergies

3.3 Expanding scope to increase market 3.3 Expanding scope to increase market

powerpower

Integration and market powerIntegration and market power

So far, considered reasons to integrate that are purely So far, considered reasons to integrate that are purely

between two firms (and their buyers)between two firms (and their buyers) Other possible reasons are to increase market power Other possible reasons are to increase market power

over other firmsover other firms Often stated as reasons for M&A in practiceOften stated as reasons for M&A in practice But whether they are good reasons is much less clearBut whether they are good reasons is much less clear

Horizontal scope and bargaining Horizontal scope and bargaining powerpower

Diversify to increase bargaining power vis-à-vis buyers Diversify to increase bargaining power vis-à-vis buyers

or suppliers? or suppliers? – Important reason for horizontal mergers, e.g. hospitalsImportant reason for horizontal mergers, e.g. hospitals

Choice Hotels and suppliersChoice Hotels and suppliers

– Rarely main reason for Rarely main reason for diversificationdiversification But e.g. Pepsi-Quaker Oats: influence in distribution But e.g. Pepsi-Quaker Oats: influence in distribution

channelschannels

ForeclosureForeclosure

Integrate into another stage of vertical chain to make Integrate into another stage of vertical chain to make

competitors’ access to suppliers or customers difficult competitors’ access to suppliers or customers difficult

or impossible => raise rivals’ costsor impossible => raise rivals’ costs Examples:Examples:

– U.S. Steel’s acquisition of iron ore mining rights in early 20th U.S. Steel’s acquisition of iron ore mining rights in early 20th

centurycentury

– Murdoch’s acquisition of DirecTV in 2003: greater control over Murdoch’s acquisition of DirecTV in 2003: greater control over

distribution of programming may place other distribution of programming may place other producersproducers (e.g. (e.g.

Time-Warner [CNN], Disney [ESPN)] at disadvantageTime-Warner [CNN], Disney [ESPN)] at disadvantage

Foreclosure (cont’d)Foreclosure (cont’d)

Potential problems with this strategy:Potential problems with this strategy:1.1. need barriers to entry in target industryneed barriers to entry in target industry

2.2. threat of antitrust interventionthreat of antitrust intervention

3.3. winners might be owners of the scarce inputwinners might be owners of the scarce input

Not much evidence that this strategy is effectiveNot much evidence that this strategy is effective BDSS consider this argument a make-or-buy fallacy BDSS consider this argument a make-or-buy fallacy

(#5)!(#5)!

““Leveraging” market powerLeveraging” market power

Can a firm “leverage” its market power into another Can a firm “leverage” its market power into another

market through integration and tying? market through integration and tying? Can NewsCorp, with market power in programming Can NewsCorp, with market power in programming

(Fox), increase its power over (Fox), increase its power over cable companiescable companies

(=downstream firms) by buying DirecTV?(=downstream firms) by buying DirecTV? Popular argument, but hard to get to fly: works only if it Popular argument, but hard to get to fly: works only if it

prevents entry / induces exit in target marketprevents entry / induces exit in target market

STR 421

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