Economics of Business Policy

Business Policy is concerned with specifying and achieving an organizations objectives. It therefore involves (a) setting out the long term goals for a firm in line with the expectations of its stakeholders, ith th t ti f it t k h ld (b) formulating an action plan for meeting these goals, (c) allocating resources for meeting the goals, (d) implementing the action plan by modifying/building an appropriate structure within the organization, and (e) evaluating the end-results through a review of results and future possibilities.

Economics of Business Policy

Goals Action Plan Allocation of resources Implementation Review

Action plan must be formulated in the light of systematic examination of the environment
External and Internal Analysis

Industrial Organization
We will be concerned with a field of Economics, which is called Industrial Organization in America and Industrial Economics in Europe. It studies how some organizing mechanism like the market or the firm brings the productive activities in an industry in harmony with the demand for its goods or services, - and how imperfections in these mechanisms affect the efficiency with which this demand is met.

Systematic Examination of the Environment Internal Analysis External Analysis human resources interest rates (knowledge) demographics manufacturing social trends abilities technology technology

Differences
Both Business Policy and Industrial Organization are concerned with the behavior of firms. But while Business Policy tries to spell out how firms should behave, Industrial behave Organization tries to find out how firms actually behave and why. Business Policy is process-oriented: it tells firms how they should go about doing what they do. Industrial Organization is logicoriented: it analyses why firms do what they do.

Differences
Business Policy is concerned with the private welfare of stakeholders, while Industrial Organization is concerned with social welfare. - Consequently, Business Policy addresses business managers, while Industrial Organization addresses policy makers.

Differences
Business Policy is multi-disciplinary and uses ideas from Economics, Political Science, Behavioral Sciences and other fields of management. Industrial Organization is firmly rooted in Economics. Economics - As a result, Business Policy tries to analyze behavior from a number of perspectives. Industrial Organization, on the other hand, assumes that firms maximize profits, subject to the availability of relevant information and the need to reconcile the aspirations of different stakeholders.

Differences
Business Policy derives its generalizations from in-depth studies of individual firms. Industrial Organization derives its generalizations from models developed to explain data collected from large samples of firms.

Why this course?

Notwithstanding these differences, there has in recent years been a fair amount of cross-fertilization of the concepts and analytical tools developed by the two disciplines. We try to examine how a firm can maximize short and long term gains to its stakeholders, especially shareholders. This will allow us to focus on trade-offs.

Why this course?

The aim of this course is to help students and practitioners of Business Policy think through the basic tradeoffs involved in some important decisions and how these tradeoffs may be optimized.

Value
The value created in the production process is distributed between the consumers and the firm The consumers get consumer surplus, surplus while the firm earns profit

Value Created
Value created = Consumer surplus + Producer surplus = (B - P) + (P - C) = B-C A positive (B - C) does not guarantee economic profit. Competition among producers can allow consumers to capture all of the value created.

Components of Consumer Surplus

Components of Consumer Surplus

A firm can increase consumer surplus by increasing the perceived benefit or by selling at a lower price The firm can also increase consumer surplus by reducing the cost of using the product and the transactions costs that the consumer incurs

Competition in Price-Quality Continuum

When products differ in quality, competing firms can be viewed as submitting consumer surplus bids with their qualityprice combinations When a firm fails to offer as much consumer surplus as its rivals, its sales will decline

Price-Quality Tradeoff

Price-Quality Tradeoff
The steepness of the indifference curve reflects the tradeoff between price and quality that the consumers are willing to make Consumers are willing to pay B more to obtain the incremental quality q Firms try to offer their products at the lowest feasible indifference curve P

The Value Map

Lower consumer
Product D surplus Product A

indifference curve

Product B

Product C

Higher consumer surplus

q, quality

Value Map: An Illustration

Products A and B exhibit consumer surplus parity Product C has a higher consumer surplus than A and B Product D has a lower consumer surplus

Value Map: An Illustration

Value Map: An Illustration

Mercedes slipped in sales when Japanese manufacturers started selling luxury cars of comparable quality at a lower price Over time, Mercedes lowered prices and time the Japanese luxury cars become more pricey and the consumer surplus parity was restored

Value Created and Competitive Advantage

To achieve competitive advantage, a firm must produce more value than its rivals Consumers will demand the same consumer surplus from the firm as from its rivals With superior value creation, the firm can offer as much consumer surplus as the rivals and still make an economic profit

Providing more value than competitors

Suppose there are two firms and one is creating more value than the other Consumer (B1 C1) > (B2 C2)

Providing more value than competitors

If firm 1 charges a price P1, the CS is B1 P1. CS is same from both firms for a price P1* such that B1 P1* = B2 C2, i.e. P1* = C2 + (B1 B2) CS from 1 is higher if P1 is slightly less than P1*, i.e. P1 < C2 + (B1 B2) At this price, firm 1s profit is slightly less than P1* - C1 = C2 + (B1 B2) - C1 = (B1 C1) - (B2 C2) > 0

If 2 sets P2 = C2, this ensures that consumer will get a CS of B2 C2 from firm 2. This is the most aggressive bid from firm 2

Value Creation and Value Redistribution

A firm can increase economic profits either through value creation or value redistribution Value redistribution can be accomplished through harsh bargaining with buyers and suppliers and by identifying and acquiring undervalued businesses

Value Creation and Value Redistribution

Firms rarely outperform their rivals solely through value redistribution With market competition, contest to acquire businesses quickly turn into an auction and all the surplus value gets competed away Competition to redistribute is fiercer than competition to create value

Did Tata Steel Overheat in Its Zeal to Win Corus?

Tata Steel's $12.1 billion Corus deal offers the promise of access to high-end European markets combined with lowcost Indian manufacturing. Potential B C high if outlook for steel industry continues to be bright Tata Steel claims a production cost of about $150 a ton, while the industry average is about $330. When Tata Steel wore out rival bidder CSN of Brazil with its final offer of 608 pence a share, it was nearly 34% higher than its original October 2006 bid. How close was P to B?

Tata-Corus
Wharton management professor Paul Tiffany reads Tata's statement differently. "When Tata said he would have even paid more, I wonder about that," he says. "Was that simply a statement [made] in the joy of winning or was it indicative of too much emotion triumphing over reason?" Tiffany says he finds the price and the rationale for the Corus acquisition to be "a little dubious.... It's a very cyclical industry and prices today will not be the price of tomorrow if history is any guide. We are near the peak of the cycle. So, clearly, the price that Tata is paying [for Corus] is a lot more than anyone thought."

Competitive Advantage
The Ability to Create More Economic Value Than Competitors

Competitive Advantage
Two Types of Difference

there must be something different about a firms offering vis vis competitors offerings vis--vis competitors if all firms strategies were the same, no firm would have a competitive advantage competitive advantage is the result of doing something different and/or better than competitors

1) Preference for the firms output people choose the firms output over others people are willing to pay a premium

Example: Nordstrom
2) Cost advantage vis--vis competitors lower costs of production/distribution

Example: Wal-Mart

Strategic Positioning
Thus there are two broad approaches to strategic positioning in order to achieve competitive advantage
Attain a lower cost while matching the benefit provided by the competitor (cost advantage) Offer a higher benefit while keeping the cost the same the competitors (benefit advantage)

The Strategic Logic of Cost Leadership

A cost leader can create more value than its competitors by
offering the same benefits as the competitors do (benefit parity) offering a slightly lower benefit (benefit proximity) offering a qualitatively different product

The Strategic Logic of Cost Leadership Benefit parity

Price, unit cost P, C, PF PE CF C CE qF q qE q, quality E F indifference curve

The Strategic Logic of Cost Leadership

Firm E offers lower quality than the rest of the industry (F) and has much lower costs than the rest of the industry If the cost leader attains consumer surplus p parity with the rest of the firms in the industry it earns a higher profit margin CF CE > PF PE PE CE > PF CF

The Economic Logic of Cost Advantage Benefit Proximity

The Economic Logic of Benefit Advantage

A firm with a benefit advantage can offer higher consumer surplus than the rivals and earn higher profits than the rivals Successful benefit leaders go for cost proximity and offer significantly larger benefits

The Strategic Logic of Benefit Leadership

Price, unit cost P, C, PF PE CF C CE E F indifference curve

The Strategic Logic of Benefit Leadership

Firm F offers higher benefit than the rest of the industry (E) at a slightly higher cost If the benefit leader attains consumer surplus parity with the rest of the firms in the industry it earns a higher profit margin PF PE > CF CE PF CF > PE CE

q qE qF q, quality

Extracting Profits From Cost and Benefit Advantage

When the products are not differentiated, the firm that has a cost (or benefit) advantage over others can capture the entire market With product differentiation, this extreme result does not hold since firms face downward sloping demand curves With differentiated products, customers do not switch easily

Exploiting a Competitive Advantage Through Pricing

When the product differentiation is weak the firm should follow a market share strategy With a cost advantage, the firm should advantage underprice its rivals and build share With a benefit advantage, the firm should maintain price parity and let the benefit build the share

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Exploiting a Competitive Advantage Through Pricing

When the product differentiation is strong the firm should follow a profit margin strategy With a cost advantage, the firm should advantage maintain price parity with its rivals With a benefit advantage, the firm should charge a price premium over the competitors

Conditions Suitable for Seeking a Cost Advantage

Cost advantage should be sought
when the nature of the product does not allow benefit enhancement when consumers are relatively price sensitive and when the product is a search good rather than an experience good

Conditions Suitable for Seeking a Benefit Advantage

Benefit advantage should be sought
when consumers are willing to pay a premium for benefit enhancements when economies of scale and learning have been already exploited and differentiation is the best route to value creation and when the product is an experience good

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