ECONOMIC

FOUNDATIONS
OF STRATEGY
By Arvin Sahaym
with thanks to Charles Hill

Markets
A market is a collection of buyers and sellers that

interact, resulting in the possibility for exchange.

A market is not an industry!

An industry is a collection of rms that sell the

same, or closely related, products.

An Industry might serve several markets

An industry is the supply side of the market.

Markets are bounded by geography and by the

uses to which products are put.

Some Features of
The nature and intensity of competition varies
Markets
from market to market.

Perfectly competitive
Imperfectly competitive
Monopolistic

Nature of pricing varies from market to market

Perfectly competitive = single price
Imperfectly competitive = dierential pricing
Prices are determined by the interaction of

demand and supply

Demand and
Supply

The supply curve

slopes up from left
to right

Supply

Pe
The demand
curve slopes down
from left to right

Demand
Qe

Quantity

The Market Mechanism

Price

Surplus

P1
Assuming a
lack of friction

Pe
P2
Shortage

Q1

D
Quantity
5

The Market
Mechanism
The
Effect of Supply Restrictions
S
Pg

Pe and Qe are the equilibrium

price and quantity for cannabis
In a free market.

Aggressive law enforcement

Limits the supply to 0-Qg.

Pe

Black market price forced up

to Pg, increasing income to
successful criminals

D
0

Qg

Qe

Quantity
6

Shifting Demand Curves

The demand curve for autos
might shift from D1 to D2 as a
result of an increase in income (I),
an increase in the population (N),
a decrease in the price of
gasoline (Pr), an increase in
the price of public transportation
(Pr), expectations that prices
might be higher in the future (E),
or some combination thereof.

Price
P2
P1

D1
Q1 Q2

D2
Quantity
13

Shifting Supply Curves

S1
S2
The supply curve for
tablets/ micro-processors
might shift from

P1
P2

D1
Q1 Q2

S1 to S2 as a result of
a decrease in Pf, a
decrease in Pa, an
increase in Tp, and a
shift towards a more
competitive structure F

Quantity
8

Elasticity

Elasticity measures the responsiveness

of one variable to a change in another.

Price elasticity of demand (Ed)
measures the responsiveness of quantity
demand (Q) to changes in price (P).

Elastic -- small change in P, large change in Q.

Inelastic -- large change in P, small change in Q.

Ed = % in Q/% in P (point elasticity)

10% increase in P produces 20% fall in Q

Ed = --20%/10% = -2

Price Elasticity
P

Infinitely Elastic D Curve

Elastic D Curve; Ed < -1

D
D
Q

Q
P

D
Completely Inelastic D Curve

Inelastic D Curve;
E

d > -1

10

Elasticity and Total

TR = P.Q
Revenue
When Ed<-1 a cut in P will yield a greater
than proportional increase in Q and TR will rise.
When Ed>-1 a cut in P will yield a less
than proportional increase in Q and TR will fall.
When Ed= -1 TR is maximized.

11

Price Elasticity and

There is an important relationship
Revenues

between Ed, TR, and marginal revenue (MR).

MR - the addition to TR that comes from
selling one more unit of output.
MR is always < P since price must be
lowered to sell more units of output.
MR = TR/Q

12

Price Elasticity and

Revenues
P
Ed < -1
Ed= -1

If Ed < -1, TR increases as price is

reduced and MR > 0

Ed > -1
D

TR

MR

If Ed > -1, TR falls as price is reduced

and MR < 0
Therefore, if Ed = -1, TR is maximized,
and MR = 0.

Q
13

Income Elasticity
Estimates
Product

Elasticity

Airline travel

5.82

Electricity

1.94

Restaurant Meals

1.61

Cars

1.07

Alcoholic Drinks

0.62

Clothing

0.51

Telephone Service

0.32

Food

0.14

14

FIRM LEVEL: Economic

Rents

Positive accounting prot can arise if a rm has access to

rare and valuable factors of production.

Factors of Production (FoP)

Classic FoP: Labor, Capital, Land (including natural resources), Entrepreneurship.

Advanced FoP: Knowhow (technical and managerial), Organization Architecture.

Advanced FoP are human creations.

In competitive markets valuable and rare FoP lower the ATC of

the rm, allowing the rm to earn positive accounting prots.

Economic Rents
In sum:
In competitive markets positive accounting prots
(ROIC > cost of capital) can only arise from valuable and
rare factors of production that are owned by the rm and
protected by high barriers to imitation.

The durability of those prots depends upon

How high barriers to imitation are

Environmental change and obsolescence

For example....patent protected technical

knowledge may be

Owned by the rm.

Protected by high barriers to imitation (a strong intellectual

property right regime).

But made obsolete by the advances of others.

Economic Profit and Economic Value Added

ROIC
Economic profit = [ROIC Invested Capital] - [WACC Invested Capital]

Economic profit = [ROIC - WACC] Invested Capital

Economic Profit= NOPAT - [WACC Invested Capital]
EVA= NOPAT - (Invested Capital X WACC)
EVA = Net Operating Profit After Tax - (Invested Capital x WACC)
These go beyond calculating net income.
Economic value added asserts that businesses should create returns at a rate
above their cost of capital
117

Economic Value Added

Assume that Company XYZ has the following components to use
in the EVA formula:
NOPAT = $3,380,000
Capital Investment = $1,300,000
WACC = .056 or 5.60%

EVA = $3,380,000 - ($1,300,000 x .056) = $3,307,200

The positive number tells us that the firm more than covered its
cost of capital.
A negative number indicates that the project did not make
enough profit to cover the cost of doing business.

118

BACKGROUND NOTE 1
Introduction
and
Overview
of Strategy
Prepared by
Arvin Sahaym, Ph.D.

What is Strategyand Does it matter

1. What is Strategy?
2. Does strategy matter?
3. Define strategy, strategic competitiveness,
competitive advantage, above-average returns, and
the strategic management process.
4. Explain the strategic management process.

120

What is Strategy?
Michael Porters view
Richard Rumelts view
Our view

121

Michael Porters view: Positioning +

Alignment
Strategy is the creation of a unique and valuable position,
involving a different set of activities.
Strategy is creating fit among a companys activitiesdoing
many things well and integrating among them.
Competitive strategy is about being dierent
Choosing a different set of activities to deliver a unique mix of
value and choosing what not to do.
Building defenses against the competitive forces or finding a position in
the industry where the forces are weakest.

Strategy is different from Operational Effectiveness

122

Five Forces Model

What is the potential of this business?
Five forces are about the industry environment
Provide a baseline for sizing up a companys S&W.
Where does the company stand versus buyers, suppliers,
entrants, rivals, and substitutes?

Industry analysis is about learning the

underpinnings of competition and the root causes
of profitability.

123

What do the best strategies do?

Firms should exploit more than one of these possibilities
based on Five Forces Analysis
1) Positioning the company for a win over competitive forces;
2) Anticipating and exploiting shifts in the forces; and
3) Shaping the balance of forces to create a new industry
structure that is more favorable to the company.

http://blip.tv/hbr-video-ideacast/the-five-competitiveforces-that-shape-strategy-1868180
http://hbr.org/2008/01/the-five-competitive-forces-thatshape-strategy/ar/1
124

Rumelts View on bad and good

strategies
Bad Strategy
1.
2.
3.
4.

Failure to face the problem

Mistaking goals for strategy
Bad strategic objectives
Fluff

Kernel of Good Strategy

1. A diagnosis: Nature of the challenge?
2. A guiding policy: an overall approach to overcome the
obstacles identified in the diagnosis.
3. Coherent actions: coordinated steps to support the
accomplishment of the guiding policy
4. Accomplishments via resources and capabilities for
Performance
125

Rumelts Views
Why so much bad strategy?
The inability to choose:
Often, it is not feasible to do two separate, deep
transformations of a companys core at once.
Template-style planning

Strategy is coherent action backed by (an argument)

Arvins musings: (research-based logic) for superior performance.

The core of the strategists work: Identify the crucial

factors/ critical issues in a situation and design a way to
coordinate and focus actions to deal with them.
126

The etymology of strategy

Origins in military history
strategus a military commander in ancient Athens and a member of
the Council of War
stratos () army
agein () to lead

Strategy
the intelligent use of individual battles for the design of a sustainable
campaign
Business Strategythe intelligent use of (ResourcesProducts???)
during quarters for the design of long-term success for years???
tactics involve the use of armed forces in the engagement, strategy
[is] the use of engagements for the object of war
Carl von Clausewitz, On War 1832
127

Important Denitions
Strategy: An integrated and coordinated
set of commitments and actions designed
to exploit core competencies and gain a
competitive advantage.
Strategic Competitiveness
When a firm successfully formulates and implements a
value-creating strategy.

Competitive Advantage
When a firm implements a strategy that its competitors are
unable to duplicate or find too costly to try to imitate.
128

Important Denitions (contd)

Above-average Returns
Returns in excess of what an investor expects to earn from
other investments with a similar amount of risk.
Excess of opportunity costs of capital (risk adjusted)

Market Value
Determined by what investors believe a firm is worth
Number of shares outstanding X Current market price of a
firm's shares.

Ratios?
ROA, ROEweaknesses?
Economic Profit or EVA or ROIC
129

Economic Profit and Economic Value Added

ROIC
Economic profit = [ROIC Invested Capital] - [WACC Invested Capital]

Economic profit = [ROIC - WACC] Invested Capital

Economic Profit= NOPAT - [WACC Invested Capital]
EVA= NOPAT - (Invested Capital X WACC)
EVA = Net Operating Profit After Tax - (Invested Capital x WACC)
These go beyond calculating net income.
Economic value added asserts that businesses should create returns at a rate
above their cost of capital
130

Economic Value Added

Assume that Company XYZ has the following components to use
in the EVA formula:
NOPAT = $3,380,000
Capital Investment = $1,300,000
WACC = .056 or 5.60%

EVA = $3,380,000 - ($1,300,000 x .056) = $3,307,200

The positive number tells us that the firm more than covered its
cost of capital.
A negative number indicates that the project did not make
enough profit to cover the cost of doing business.

131

Stock Price Performance

132

Compared to the Industry

AMZN Compared to Indexes: S&P 500, NASDAQ and DOW

OPERATIONS: Economic Performance

BBY Compared to Indexes: S&P 500, NASDAQ and

DOW

136

Fundamental Questions of Strategy

1. Why are some firms more successful than others?
2. What Determines Sustainable Profitability?
Macroeconomic factors
Global/National markets

Industry factors
Industry growth
Competitive rivalry
Entry barriers\New entrants
Technological innovation
Customer tastes

Firm-specific Factors
Overall competitive capability
(strategy implementation)
Productivity through efficient
and effective resource
allocation
Adaptability to changing
market conditions

Two fundamentally different views of

strategy

These different models or views that shed light

on achieving above-average returns are:
Industrial organization model
Resource based model

138

Thank you!

139

Context of Globalization for Global Managers

How many hours it takes to earn enough for a Big Mac around the world:

Does Strategy Matter?

S&P 500 Review
Of the original Fortune 500 companies (1957), only 74
remained on the list 1997. The number was 86 in 2007.
The remaining 414 companies were either taken over, went
bankrupt, or were otherwise removed from the index
Only 12 outperformed the market up to 1997
Forbes 100
Of the original 100 companies (1917), 61 failed by 1987
Of the remaining 39, only 18 were still on the list
Only 16 of 100 largest US firms in 1900 remained competitive by
1990s
Of the 501 firms listed on the NYSE in 1925, only 65 (13%) existed
in their independent corporate form in 2004
141

Do Strategies Work? Yes, they

do15,000 to 20,000 businesses fail every year in
About
the US but some attain huge success...
So, who succeeded and who failed in getting the top slot?

1.Crush Adidas (1960s)

2.Become the company most known for changing the
worldwide poor quality image of Japanese products
(1950s)
3.Become the Harvard of the West (1940s)
4.Become a $125 billion company by the year 2000
(1990)(Hint: Retailer)

142

Industrial Organization model

Above-average returns are determined primarily
by the factors EXTERNAL to the firm.
What matters in the I/O model:
Industry structure
Attractiveness of the external environment

The industry in which a firm competes has a

stronger influence on the firms performance
than do the choices managers make inside
their organizations.
143

AVERGE ROE (US), 1991-1996.is it almost the same over decades

Construction

Electric
Utilities
Metals

Retailing
Food
Distributors

Financial
Services
Entertainment
& Information

SOURCE: Forbes, Annual Report on American Industry, January, 1996

Food, Drink
& Tobacco

Computers &
Communications

Health

Resource-based model
Above-average returns are determined
primarily by factors INTERNAL to the firm.
What matters in the resource-based model
developing/obtaining valuable resources
resources should also be hard to imitate
barriers to resource/capabilities acquisition

145

Summary of Two Models

Industrial Organization
(I/O) Model
Focuses on the
environment outside the
firm.

Resource-Based
Model
Focuses on the inside
of the firm

Successful strategy formulation and implementation

actions result only when the firm properly uses both
models.

146

Food for Thought:

Do Leaders and their Strategies matter?

Any Examples? Turnarounds

1.Could strategy be about where to be and how
to compete, i.e. positioning by the
managers?
2.Could it be about an integrative pattern of
decisions and actions engaging all the levels
of the firm?
3.Could it be about how resources should be
acquired and combined in order to achieve

147

Nortel bankruptcy! January 14, 2009

48

Save Netflix, Mr. Reed Hastings!

149

Hindsight is 20/20Did Strategy MatterDid Mr. Hastings Save Netflixhow?

150

BBY Compared to Indexes: S&P 500, NASDAQ and

DOW

151

Thank you!

152

153

Important Denitions (contd)

Strategic Management Process
Strategic Inputs, Actions and Outputs for AboveAverage Returns
The full set of commitments, decisions, and actions
required for a firm to achieve strategic
competitiveness and earn above-average returns.

154

Strategic Management Process

Study external and internal environments.
Identify marketplace opportunities and threats.
Determine how to use core competencies.
Use strategic intent to leverage resources,
capabilities and core competencies and win
competitive battles.
Integrate formulation and implementation of
strategies.
Seek feedback to improve strategies.
155

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