STR 421

1. STR 421 Economics of Competitive Strategy Michael Raith Spring 2007

2. 3. The scope of the firm • Horizontal scope: to what extent should a firm expand into new products or businesses? • CCS: diversify into plastics? • Choice Hotels: pros and cons of covering full quality spectrum • Vertical scope: To what extent should a firm be involved in activities further upstream or downstream in the production chain? • Coors: backward integration into everything • Reynolds, beverage producers: integration into metal cans • Dell vs. Compaq: resellers • Closely related but not focus here: mergers within industry

3. Today’s class 3. The scope of the firm 3.1 Expanding scope: problems and challenges 3.2 Expanding scope to realize synergies 3.3 Expanding scope to increase market power

4. Bad/questionable reasons to diversify • “We need to grow” • Profitability often leads to growth, but growth for its own sake is rarely profitable • Agency problem: managers want growth because their influence & compensation depends on it • Managers often prefer to spend “free cash flow” on growth strategies and pet projects than pay it out to shareholders • Similar: diversification efforts in industries with declining profitability • Metal cans

5. More questionable reasons • Diversify in production to reduce financial risk? • Shareholders can instead diversify in financial markets • Diversified firm as source of investment funds? • Assumes financial market failure that can be overcome internally

6. …and one more: • Spread unique skills & capabilities into new industries? • “Superior skills” exist but are hard to assess/verify • Managers of successful firms often overestimate scope and uniqueness of their capabilities • Probably one of the major reasons why many acquisitions fail • Many empirical studies document a “diversification discount”, suggesting that firms often diversify for the wrong reasons

7. Bad reasons to vertically integrate • “Produce in-house to avoid paying a profit margin to independent firms” • If input market is competitive, “profit margin” is expected return on invested capital = part of economic cost • Examples: resellers in PC industry; car rental: fees for reservation systems • “Outsource to avoid certain costs of production” • E.g. outsource transportation to avoid maintenance & depreciation of trucks • See BDSS for other make-or-buy fallacies

8. Organizational costs of integration/ expansion in scope • Dilution of incentives of division managers • Specialized resources spread too thin • Management too complex, problems more difficult to detect • Many additional problems when two existing firms with different organizations, cultures are merged • CCS-Continental Can

9. Two main ways to expand scope • Internal development = Integration by developing own capabilities in target industry/market • This is like an entry decision • What are the barriers to entry? • Do we have a competitive advantage? • Acquisition of existing company • Current owners must be compensated for profits they give up • Acquisition must increase total value created between the two companies! • Compare Choice Hotels: new brand introductions vs. acquisitions

10. What if several bidders compete for acquisition target? • Suppose firm A thinks of selling its unit X. • A is worth $50M when it owns X; worth only $30M without X. • Two bidders: • Firm B is worth $40M without X but $65M if acquires X • Firm C is worth $70M without X but $100M if acquires X • Who will buy X and at what price? • Winning makes sense only if acquisition leads to larger increase in total value than for any other bidder! • “Winner’s curse” if value of target is overestimated

11. Today’s class 3. The scope of the firm 3.1 Expanding scope: problems and challenges 3.2 Expanding scope to realize synergies 3.3 Expanding scope to increase market power

12. 3.2 Integration to realize synergies • Parallel discussion of horizontal and vertical scope because central questions are the same: • What are the synergies/sources of economies of scope? • Is integration better than contractual solutions? • The main good reason to expand scope is to take advantage of lower costs or a higher benefit.

13. Economies of Scope: 1. Efficient use of resources • Production facilities and people • Hollywood studios: movies and TV shows • Pharmaceuticals: lab equipment • Sales forces to sell different products • Related: benefits of geographical proximity; e.g. beverage bottling and can production • Umbrella branding: Sony, Disney, Virgin, Choice Hotels • Through transfer of organizational capabilities • Philip Morris’ marketing skills applied to Miller Brewing Co. • IBM’s Engineering and Technology Services division

14. 2. Benefits from bundling for buyers • Convenience for buyers of buying multiple products through same channels: • Disney: movies, parks, toys, cruises etc. • Masco Corp.: consumer brands for home improvement/construction market • Convenience of choice: Choice Hotels • Lower costs of purchasing complementary goods: Starbucks and Hear Music stores

15. 3. Coordination and other externalities in production • Knowledge spillover: • Pharmaceuticals: knowledge spillover • Reynolds in aluminum cans • Intel: microprocessors and ProShare videoconferencing? • Product design and quality control • Hardware and software: Apple, Nintendo vs. Atari in 80s • PC Resellers: hardware and software support • Coors’ own trucking subsidiary to transport beer • Business school course packets • Advances in IT (making coordination easier) are one reason for general trend towards outsourcing

16. 4. Externalities in pricing of complementary products • Recall oligopoly pricing: firms cutting price don’t take negative effect on competitors into account • Complementary products: firms don’t take positive effect of cutting price on competitors into account • Charge prices that are too high! • Less business for both firms • Integration may be only way to solve problem • Careful, though: argument assumes some degree of market power in both markets!

17. Examples • Cars and financing: GMAC (est. 1919, divested 2006), Ford Motor Credit (est. 1959), founded when credit markets were less competitive/efficient • Also possibly: transaction costs for buyers • Michelin: tires and guidebooks? • Also possibly: lower production costs

18. The vertical counterpart: Double marginalization • Same in vertical production chains; e.g. manufacturer, retailer • Both provide complementary goods/services! • Retailer’s price > wholesale price; manufacturer’s price > MC • Problem: retail price higher, and total profits lower than if prices were coordinated/ if upstream & downstream firm were integrated • Example: Brewers and pubs in the U.K. • In late 1980’s, many pubs were owned and managed by brewers • Antitrust authority forces brewers to divest some of their pubs • Slade (1998) finds that beer prices in pubs subsequently increased and industry profits decreased • Again, argument applies only if both upstream & downstream firm have market power!

19. But why integrate?? • Many economies of scope can be realized through contracts, without integration • When that is possible, it’s much easier than integration • Integration best if contracts don’t work well • Why did Fedex buy Kinko’s in 2003? Why did Disney merge with ABC? Both pairs had established relationships before • Think of “buy” instead of “make” as default, see if there are reasons to “make”. Independent suppliers… • often benefit from scale & scope economies, experience • have better incentives to keep costs low and improve products

20. Examples of contracting solutions • Use of resources: • Manufacturer’s representatives • Reservation systems for car rental, flights • Coordination/quality • Nintendo and external game producers • Supply chain management at Dell • Complementary products • Partnerships to offer discounts: Choice Hotels • Pricing in vertical chains • Non-linear pricing in franchising • Gasoline: retail price maintenance as upper limit on price

21. Contracting problems • Costs of describing and measuring quality of performance • Costs of describing the terms of a contract • E.g. B-school packets: costs of specifying penalties • Costs of agreeing on prices for resources to share, or on contributions to their costs • Underlying problem: parties have private information about what resource is worth to them • Unwanted leakage of proprietary knowledge • Legal constraints: price fixing prohibited

22. The holdup problem • Companies often make relationship-specific investments = useful only when dealing with a particular business partner • E.g. setting up a can factory near Coca-Cola • Contracts are often incomplete for any of the above reasons • 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 other • E.g. Coca-Cola might say: your past investment in your plant is your problem; let’s look forward • Consequence: firm making investment may not get its expected return • The firm then has less incentive to invest in the first place => inefficient outcome!

23. Integration as solution to the holdup problem • Possible solution: vertical integration (Coke produces its own cans), unless it’s possible to write long-term contracts • Examples: • Automobiles (Monteverde and Teece, 1982): Components requiring high engineering effort (specific human capital) more likely to be produced in-house. • Aerospace industry (Masten, 1984): components with design specific to company more likely to be produced in-house. • Electric utilities: “Mine-mouth” electric utility plants more likely to be vertically integrated with mines than others (Joskow 1985). • Electronic components (Anderson and Schmittlein, 1984): components with greater human capital specificity ( = salespeople’s effort to learn about it) more likely to be sold through in-house sales force.

24. Scale economies and firm/market size • “The division of labor is limited by the extent of the market” • Make if no one else has use for the same input, or because input is unique • Independent suppliers would not want risk of holdup • Integrated cell phone makers: Nokia, Ericsson, Motorola • Buy if independent supplier can sell to others as well • Solves two problems: reduces holdup risk, helps realize EOS • Small cell phone makers that purchase standard components • Small companies selling through manufacturer’s representatives • Possibly make if the quantity you need is large enough to realize all scale economies • Big companies often prefer to have an in-house sales force • GM more integrated than Ford

25. Today’s class 3. The scope of the firm 3.1 Expanding scope: problems and challenges 3.2 Expanding scope to realize synergies 3.3 Expanding scope to increase market power

26. Integration and market power • So far, considered reasons to integrate that are purely between two firms (and their buyers) • Other possible reasons are to increase market power over other firms • Often stated as reasons for M&A in practice • But whether they are good reasons is much less clear

27. Horizontal scope and bargaining power • Diversify to increase bargaining power vis-à-vis buyers or suppliers? • Important reason for horizontal mergers, e.g. hospitals • Choice Hotels and suppliers • Rarely main reason for diversification • But e.g. Pepsi-Quaker Oats: influence in distribution channels

28. Foreclosure • Integrate into another stage of vertical chain to make competitors’ access to suppliers or customers difficult or impossible => raise rivals’ costs • Examples: • U.S. Steel’s acquisition of iron ore mining rights in early 20th century • Murdoch’s acquisition of DirecTV in 2003: greater control over distribution of programming may place other producers (e.g. Time-Warner [CNN], Disney [ESPN)] at disadvantage

29. Foreclosure (cont’d) • Potential problems with this strategy: • need barriers to entry in target industry • threat of antitrust intervention • winners might be owners of the scarce input • Not much evidence that this strategy is effective • BDSS consider this argument a make-or-buy fallacy (#5)!

30. “Leveraging” market power • Can a firm “leverage” its market power into another market through integration and tying? • Can NewsCorp, with market power in programming (Fox), increase its power over cable companies (=downstream firms) by buying DirecTV? • Popular argument, but hard to get to fly: works only if it prevents entry / induces exit in target market