MGTECON 580: Firms, Markets, and Policy Strategies in Europe

MGTECON 580:Firms, Markets, and Policy Strategies in Europe Karl Aiginger

Autumn 02/03 M/TH 8:00 – 9:45First class: Sept. 26Last class: Oct. 24 Professor Karl Aiginger Office: Encina Hall E 105 Tel: 650.723.0249 aiginger@stanford.edu Assistant: Jenny Smith Office: Littlefield 216 Tel: 650.736.1634 smith_jenny@gsb.stanford.edu

The content of the course • Objective • diversity of business environment in Europe • the interrelation of firm strategies, market characteristics and business environment • to analyze firm strategies in the framework of theoretical concepts • Non-goals • Another strategy or econ course • Everything about Europe • “the market solves all” • “one model fits all” • To be achieved: • Knowledge: Diversity of European business • Ability: Strategy evaluation guided by theory based framework • Confidence: Diversity can be turned into an advantage for persons, firms, countries

The three core elements • The analytical framework: • Industrial Organisation • Strategy & Management • Location, FDI, & Trade Theory • Growth theory • The relevant market: • Industry growth • Regional dynamics • Technology & input structure Strategies of European Firms Industry structure and market dynamics Policy Strategies and Business Environment • Differences Across EU members: • Innovation, industrial, regional policy • Competition policy, Industrial Relations • Welfare, taxes, openness • Low cost, high-tech strategy The ultimate reason:Matching firm strategies with business environment and economic policy increases firm performance

The analytical framework Industrial Organization Performance of markets and strategies of firms to escape profit squeeze Management and Strategy How to gain and sustain a competitive advantage Location, International Production (FDI), and Trade Where to locate and what to trade Growth theory, macroeconomic, structural policy What drives growth, limits, what policy can do The rationale:Theory should provide the framework for the analysis. There are four strands of theories relevant as background for firm strategies, market dynamics, and policy strategies.

Industrial organisation: The “profit dissipation hypothesis” • The perennial threat for business is that prices eventually decline to average costs, or even worse, to marginal costs • If not, firms develop specifically successful strategies • Footnote 1: • Market perfection criteria in Welfare Theory: • if markets work well, prices equal marginal costs • this is good for consumers, good for society (short run), however, bad for firms • Footnote 2: • tension is less in the long run (see innovation theory)

Profit dissipation in detail • For the competition model • p = MC: in the short run • p = AC: in the long run • For Bertrand competition, if there are two firms • p = MC • p= AC; PCM = 0 • For Cournot competition, if n increases • PCM = 1 / (n*e) • And if entry p = AC; PCM = 0 • For monopolistic competition • entry leads to zero profits; • and fragmented structures Remark: This is the “old” Industrial Organization SCP Paradigm (S determines C, C determines P) Critique 1: causalities can be reversed Critique 2: firms are actors, strategic units (game theory)

Strategies to escape profit dissipation The tenfold path to entrepreneurial happiness 1. Monopoly 2. Collusion 3. Entry blockades 4. Shifting demand curve 5. Product differentiation 6. Costs advantage 7. Productivity lead 8. Quality upgrade 9. Size 10. Diversification Conclusion: Modern Industrial Organization indicates 10 active firm strategies to escape profit squeezeHowever: In contrast to Nirvana and eternal happiness profit dissipation will come back again

Path to profitability 1 and 2 #1 Monopoly: allows p > MC (more exactly (p-MC)/P = 1/ e; e = elasticity of demand) But: How to get a monopoly ? Competition policy exists to prevent it International competition Threat of potential competitor sufficient #2 Collusion: boosts profits But: Usually forbidden Hard to sustain (cheating can be profitable) Sometimes only marginally helpful (large n) Eroded by international competition Uncertainties and cost asymmetries makes it hard Easy if government helps If entry is blockaded Interactions are repeated Profits from colluding and punishment for defecting are large

Path to profitability 3 #3 Entry blockades: prevents dissipation In competition, in oligopoly in monopolistic competition Entry/ non-entry is important for firms Legal blockades: Patents Early mover advantages Size Large upfront costs Research, advertising, goodwill Illegal: Threats Predation Foreclosure Refusal to supply Refusal to connect Strategic moves: Early commitments Reputation, skills Economic policy (Competition policy) tries to prevent, eliminate entry barriers

Path to profitability 4 - 7 #4 Shifting demand curve advertising: higher demand for given price research: new products increase industry demand #5 Product differentiation -even if horizontal- softens competition Profit margin up to “distance costs” Some sort of economies of scale or entry barriers must help If profits are large, entry is attractive Size and scope advantages can be combined #6 Cost advantage Profit margin up to cost differential But: how to get it How to defend it Persistent advantages imply persistent improvements Overtaking phenomena: stuck in, inertia #7 Productivity lead Higher productivity Increasing output for given resources Similar in result to #6 Different in perspective and means

Path to profitability 8 - 10 #8 Quality upgrade (quality/cost relation) Characteristics valued by consumer Similar in result to #5 and #6 and #7 Different in perspective and means #9 Size If there are economies of scale Cost advantage from size But also higher risk of uncertainty Market power (big three strategy) But: If crisis come threat of P = MC Many firms try this strategy No worth if n = 2 and market large & competitive #10 Diversification – Global player Production of different products Presence on different local markets If there are economies of scope Diversifiable risks Common headquarter, research resources But: Costs of diversification (loss of focus) Adversity of financial markets to conglomerates

Empirical facts Industries do matter Industries with high R&D grow faster Industries with high R&D more productive Country strategy matters Countries with high R&D grow faster

Management Science Five “key forces determine industry performance” Michael Porter: Competitive Strategy 1980 • Entry • Flat costs • No patents • No regulation • Internal Rivalry • Number of firms • Excess capacities • Exit barriers • Price competition • Supplier power • Large and few suppliers • Relation specific investment • Threat of forward integration • Buyers power • Large and few buyers • Relation specific investment • Threat of backward integration • Substitutes and compliments • Close substitutes • No compliments • Price elastic

Porter’s five forces in the perspective of 30 years • These are threats to superior performance • They are industry specific, not firm specific • Behind these forces there are formal IO models • What is missing: • Industry demand (low growth) • Government (regulation) • Recall active strategies shaping the market, • synergies between firms (Brandenberry, Nalebuff) Conclusion: These forces are the “strategy analog” to profit dissipation They define the speed at which profit dissipation occurs And they indicate limits to escape strategies

To escape the bad forces: Getting a competitive advantage What is a competitive advantage: An advantage relative to other firms in the same industry Two types of competitive advantage: Cost advantage Benefit advantage How to create a competitive advantage: Development of resources or capabilities

Which resources and capabilities Resources: firm specific assets Patents Trademarks Brand name Reputation Organization Specific natural resource Coca Cola, Barbie, Toyota Capabilities: activities in which firms excel Marketing skills Research skill/acquiring knowledge Organizational routines Skills multiple useable Difficult to reduce to algorithm and guides Resources:What a firm has – “nouns” Capabilities:Activities in which a firm excels – “verbs”

Factors explaining profitability: Conclusion:Competitive advantage is larger than industry effect Source: Porter McGahan, in Strategic Management Journal 1997 pp 15–30. BDS p 390

Sustaining competitive advantage The threat: - all markets (with entry, without collusion) tend to zero profits - competitive advantages can be copied The strategy: 1. Develop resources and capabilities that are a) Specific Patents, brand names, human assets b) Scarce Non-reproducible c) Immobile Not tradable on well-functional markets 2. Develop isolating mechanism with a) Early mover advantage Learning Network economies Reputation Buyer switching costs b) Impediments to imitation Legal Superior access to inputs Scale economies in market of limited size Intangible barriers 3. The instrument needed: Innovation 4. Look for a great help: the best business environment (cluster)

The best business environment: Porter’s diamond Attributes of the local environment create/sustain Competitive Advantage worldwide • Factor conditions • Specialized inputs • Human Resources • Physical infrastructure • Administrative, scientific infrastructure • Demand conditions • Size of sophistication of local demand • Customer needs anticipate those elsewhere • Character (specific demand J for small, quiet, energy efficient air conditioners) • Related and supporting industries • Skillful suppliers • Clusters of industries • Competitive rivalry • Management practice • Governance • Efficiency encouraging environment • Local capital markets Source: Porter Source: Porter McGahan, Competitive Advantage of Nations, 1990, p.72

The Holy Trinity of Regional Optimization • Economic geography • where to locate business • specific core or periphery • Theory of Foreign Direct Investment • the decision to become an MNE • why to produce abroad • Trade Theory • who sells/buys what?

Economic geography: where to locate business • The dichotomy of core and periphery • there is a constant battle between centrifugal and centripetal forces • firms are optimizing production costs and transport costs • The attractiveness of the core • big market (center of demand) • specialized inputs: • - trainees of many professions • - capital goods or capital good production on order • backward linkages • forward linkages • skills spillovers (from universities and other firms) • accelerating force: economies of scale • The remote chances of the periphery • low wages • absence of congestion costs • all non-mobile factors cheaper • The policy issue • The common belief (threat) that integration favors the core • Model: lowering “transport costs” i.w.s. • Outcome: inverted U • Decreasing t boost size and spillover effect • If t becomes very small cost difference effect becomes dominant

The Theory of Direct Investment: at home or abroad • How can foreign firms be successful? • Domestic firms have “natural” advantages • Firms specific assets compensate them • Knowledge, patent, organizing principle, goodwill • Size effects in research, marketing, finance may add, but not plant size economies • Trade barriers (tariff jumping) ironically attract investments • Why do firms go multinational? • Market extension • Cost reduction • Uncertainty reduction • Asset utilization • The problem with the theory is that there are usually alternatives such as patenting, licensing, and long-term contracts. • Modern version: vertical split of production chain • The make or buy decision. • All come back to the hidden treasure: • There is something, the firm has, it is privately owned, and better used. • If it stays within the boundary of the firm (widely used, closely hidden) • Some predictions: • Cheap countries are good locations for mature, competitive industries AND for labor intensive industries • Core/rich locations offer research input as well as research spillovers • And have an advantage of test markets (early relative large demand for sophisticated products) • Headquarter in sophisticated location allows optimal recruiting and saves in door education

Trade theory: from resources to chance • Who (which country) sells (buy) what? • The specialization pattern • Production takes place • Where the most important input is cheapest • Where productivity is highest • Specifically partial productivity of important factor • Rich countries engage in exchange of similar products • First mover advantages • Economies of scale • Commitments, oligopolistic structures • Specialization by chance

Taking together: Location/FDI/Trade • Starting from hard facts • Natural resources • Manmade resources • Size, low cost of labor, and physical capital • Dematerialization of the determinants • Getting hold of linkages and spillovers • Utilizing firm specific effects: FDI • Making use of quality, product differentiation • First mover advantages and commitments • Towards specifically rewarding activities • In parallel to active strategies • And activities defining competitive advantages

Growth Theory: determinants of the growth of an economy Research(to produce technical progress) Human capital(to innovate and use technologies) Technical progress(falling down like manna from heaven) Physical investment (share of output used for investment) Population growth (including migration) Natural resources • Remark: The missing factors • Cost of inputs • Business environment: red tape, flexibility • Tension between Competitiveness Studies and Growth Analysis

Macroeconomic environment: A Macro-Web • Growth factors • (Physical) infrastructure • R&D • Education • ICT - technology • Competition indicators (competitiveness) • Openness/Market access • Toughness of competition • System costs (taxes, bureaucracy, governance, law, incentives) • Factor cost advantages (wages, other inputs, finance) • Forward orientation • Sophisticated industries • High level income, dynamic countries • High quality segments • Environmental content • Innovativeness • Risk capital • Diffusion speed • Implementation, absorption speed • Stability • Maximal use of resources • Lack of imbalances (trade, finance, goals/achievements • Cyclical amplitude • Income inequality, poverty • Energy resources

The framework in a nutshell • Industrial Organization • Describe structure, conduct, performance • Discuss profit dissipation • Ten escape strategies for firms • Management and Strategy • Industry specific limits to profitability (5+) • Strategies to gain a competitive advantage • How to sustain a competitive advantage • Location, FDI, Trade • Where to locate, whether to go international • What to trade, to produce, to buy • Growth Theory, Policy • What drives and limits country growth • Link between country growth and market dynamics Conclusion:Using this framework for firm strategy analysis makes this analysis theory-based, less arbitrary; open to stimulating, scientific discussion

The comparison with Industrial Organization (A1) Threats are the same as in profitability dissipation hypothesis • Difference IO vs. Strategy • IO-Models are more specific • Specify conditions and quantitative predictions • Entry, competitive mode • The formal model in IO • Who are the players • What are the goals • What are the choices • Relationship between choices and outcome • Game theory (non-cooperative class) • The perspective of Welfare Theory • All these threats are welfare maximizing (total surplus) • More 1-3 leads MC pricing, lower PS higher TS • 4 and 5 if they are; this is “countervailing” market power • Preventing these threats does not increase GNP or generate labor • This is the old focus: threats • Go to active strategies: • Shaping the market (via sunk costs, quality upgrade, innovation) • Changing the position in markets • R&D, advertising product differentiation • The last two are also surplus increasing Conclusion:Both IO and strategy first define the threats then the opportunities

Core decisions about best route to Competitive Advantage (A2) • Decision 1: Cost advantage or Benefit advantage • Porter’s warning: If you try both, you may get “stuck in the middle” • Decision 2: Share or margin strategy • Decision 3: Targeting (focus) or full line • Decision 4: Make or buy Conclusion:Each course, book suggest important decisions. The most important thing is to develop a competitive advantage.

Which route to take: CA or BA (A3) • When to go for a cost advantage • Scale economics and high growth • Commodities • Price elastic industries • Search goods (quality is observable) • When to go for a benefit advantage • People value quality (steep indifference curve price-quality) • Scale economies exist but are exploited • Experience goods • Porter: • Firms should try either of these, but not both. • Could be stuck in the middle (Competitive Strategy, ch2, 1980) • Empirically often both • Price (cost) quality frontier p. 426

Cost and Benefit Drivers in detail (A4) • Cost drivers (determinants) • Size scope, utilization • Experience • Input prices, density, location, efficiency, focus/complexity, policies • Organizational, agency efficiency • Benefit drivers • Product performance, quality, aesthetics, durability, easy installment, operation • Services and complementary products, repair • Delivery characteristics • Consumer perceptions, anticipations, fears • Image, advertising, packages, labeling • More details in BDS p. 420 (table 12.4 or appendix p. 432 ff) • PHD idea: regressing empirically revealed price and quality intensive industries on these indicators for CA vs. BA

An important second decision: Share or margin strategy (A5) • If you get a CA or a BA it depends how large demand elasticity • And/or how divergent preferences are • In extreme, it is possible to get the whole market by either technique • If horizontally differentiated and low price elasticity: margin strategy (enjoy p>c) • If price elasticity is high: gain market shares (share strategy) • For both CA and BA • An important third decision: Targeting or full line • Choosing the market (within industry) • Broad coverage strategies vs. focus strategies • Serve all segment, full line • Gilette: cartridges and disposable, men, woman, complementary products • Focus strategies • Only one product and/or only one market • Cray Research only supercomputers, but universities and business

A successful strategy consists of four classes of issues (BDS pp. 6-8) ( A6) • Boundaries of firm: What should a firm do, how large • Horizontal how big: share of markets • Vertical: Integration, make or buy • Corporate portfolio of businesses • Market and competitive analyses: Nature of market and interactions • Which type of market • Dynamics • Competitive rivalry • Position and dynamics • How to position firm in the market • Defining competitive advantage • Developing capabilities and resources • Internal organization

Cost advantage vs. benefit advantage on national level (A8) • Cost advantage • Keeping costs (input prices) low • Wages, working time, capital prices, interest rates, import prices, system costs • Pushing productivity up: lower unit costs • Benefit advantage • Quality • Prices • Service • Cost strategy • Leads to lower wage and lower GDP (1st order) • If not positive, competition effect (2nd order) • Share strategy successful if price elasticity is high • If growth, wages will grow again • - competitive advantage not sustainable • Productivity strategy • Leads to unemployment (1st order) • If not positive competition effect (2nd order) • Margin strategy acceptable, since rents for innovation • If growth, self-enforcing strategy • - spillovers, experience curve • High cost country going for cost advantage fights an uphill battle

Porter today on his homepage (A7) • Industry Structure and Structural Change • A company’s profitability depends in part on the structure of the industry in which it competes • Industry structure resides in five basic forces of competing: • Intensity of rivalry among existing competitors • Threat of new entrants • Threat of substitute products or services • Bargaining power of suppliers • Bargaining power of buyers • Industry structure is relatively stable, but industries are sometimes transformed by changes in buyer needs, regulation, or technology. • Companies can shape industry structure rather than passively react to it.

Distribution of tasks • Framework: me, help appreciated • Country profiles: me, list of open questions • Policy issues: jointly • Firm strategies: you Homework • Issue paper: overview on issue defining business environment • Firm strategy paper: interpretation of firm strategies using framework • Evaluation paper: short summary about country for CEO • Upcoming problem overview may substitute 3 or • Rescue option for absentees, improvement requests

Homework: content, length, timing Homework 1: The strategy of large European firms Objective: To analyze the strategy of a firm against the background of the framework Not: short run, stock market (crash) related Not: when did the firm what Not: history of management or founders But: relative to framework (profit dissipation, competitive strength, etc.) But: relative to other companies in the industry But: encouraged by the business environment/policy in country of origin • 1-3 firms in groups of 1-3 students • 5-10 pages per firm • References required; must be public and accessible. • - If not original, clearly indicate. • Be prepared to present and defend it in class and to put it on internet • - Must be sent 3 days in advance to me and assistant, Jenny

Homework 2: Report on a policy issue important for business environment Objective: To analyze an issue, cross European differences and difference to US and Japan List of issues to be discussed (starting literature refers to authors in reference list): Competition policy Corporatism FDI (Foreign Direct Investment) Regional policy, Clusters Integration, Specialization Welfare & Labor Reforms Innovation, telecommunication policy • The task is to present a short paper (one issue per person) • To define the question in a tractable and sensible way • To find literature (beyond indicated here) • To relate the topic to the country of the session • To condense the information to a 15 page paper / 15 minute presentation

Homework 3: A three-page evaluation report Business opportunities evaluation Page 1: A short briefing on a specific EU country Page 2: A recommendation: I would invest in this country, if .. (type of investment, caveats) Page 3: What can be learned from this country for my firm, for my government The evaluation report can be substituted only IF an interesting question comes up during the course IF there are specific interests well-fitting to the course objective

MGTECON 580: Firms, Markets, and Policy Strategies in Europe