Strategy Class Notes PDF

20 September 2024 Strategy Class Notes Profitability How to calculate ○ Discount cash flows across the potential lifetime of the company ○ So if a company´s value is also dependent on how long it could be successful for About half of the companies that were pro...

20 September 2024 Strategy Class Notes Profitability How to calculate ○ Discount cash flows across the potential lifetime of the company ○ So if a company´s value is also dependent on how long it could be successful for About half of the companies that were profitable in 2006 are still profitable in 2019 Industry elements heavily impact profitability ○ Could still make money in a bad industry ○ Or not make much in a good industry Marginal Cost is the cost of producing one additional unit Pm is Price at monopoly, the price at which profit is maximized Ppc is Priced at the perfect competition Prices usually sit between Pm and Ppc 27 September 2024 Strategy Class Notes Session 2 Summary of Porter's Five Forces Porter's Five Forces of Competition framework is a widely used tool for analyzing competition within industries. The framework helps determine an industry's attractiveness by identifying five competitive forces that influence profitability. Porter's Five Forces Competition from Substitutes: ○ The availability of substitute products impacts the price customers are willing to pay.  ○ Close substitutes make customers more price-sensitive, while a lack of substitutes makes them less so. Ex. the availability of cheaper train travel as a substitute for air travel puts downward pressure on airfares. ○ More attractive to have low competition from substitutes Threat of Entry: ○ Industries with high returns on capital attract new firms, which can lower profitability. ○ Barriers to entry, such as high capital requirements or economies of scale, can deter new entrants and protect industry profitability. Ex. the high cost of developing large passenger jets serves as a barrier to entry for new airplane manufacturers, protecting the profitability of Boeing and Airbus. ○ If entry barriers are high then profits are high, if entry barriers are low, then profits are low Rivalry Between Established Competitors: ○ The intensity of competition between existing firms in an industry is a major determinant of profitability. ○ Factors influencing rivalry include the number of competitors, product differentiation, and industry growth rate. Ex, the airline industry, with its high fixed costs and low product differentiation, often experiences intense price competition, particularly during periods of excess capacity. Bargaining Power of Buyers: ○ Buyers can pressure industries to lower prices, which affects profitability. ○ Powerful buyers have leverage to negotiate lower prices, especially when they purchase large volumes or when switching suppliers is easy. ○ For example, large retailers like Walmart have significant bargaining power over their suppliers due to the volume of their purchases. ○ Buyer refers to the next link in the supply chain Ex: Supplier – Manufacturer — Distributor – Retailer – Consumer Bargaining Power of Suppliers: ○ Suppliers with bargaining power can demand higher prices for inputs, impacting industry profitability. ○ Factors increasing supplier power include the concentration of suppliers and the importance of their inputs to the industry. For example, the dominance of Microsoft in operating systems has given it considerable bargaining power over PC manufacturers, impacting their profitability.} Porter’s Five Forces in the Ready-to-Eat (RTE) Cereal Industry (1994) Competition from Substitutes: ○ Moderate ○ Who is Represented: Substitute Products: Bagels, yogurt, eggs, granola bars, and other quick breakfast alternatives. Private Label Brands: Store brands (e.g., Walmart’s Great Value, Costco’s Kirkland) offering cheaper, similar-quality cereals. Health-conscious Brands: Other breakfast alternatives that target specific health trends, like high-protein or low-sugar options. ○ Impact: These products offer alternatives to traditional RTE cereals, increasing consumer choice and applying downward pressure on cereal prices  Threat of Entry: ○ High ○ Who is Represented: Existing Dominant Players: Kellogg, General Mills, Philip Morris (Post). Potential Entrants: Smaller niche cereal producers, international brands, and private label brands looking to capture market share. Barriers: High advertising costs, brand loyalty, control of shelf space in grocery stores, and established production technology. ○ Impact: The “Big Three” maintain control over the market with significant advertising budgets, established distribution channels, and customer loyalty. Private-label brands challenge this by offering lower-cost alternatives. Rivalry Between Established Competitors: ○ Low (sort of, high for others, low between the big 3) ○ Who is Represented: Major Players: Kellogg, General Mills, and Philip Morris (Post). Private Label Competitors: Store brands from large retailers like Walmart, Kroger, and Costco. New Entrants: Niche brands offering specialized products, such as organic or gluten-free cereals. ○ Impact: Price competition escalates as General Mills slashes prices, forcing rivals to respond. Private label brands add to the rivalry by offering cheaper alternatives, putting pressure on the established brands’ market share and profitability. Bargaining Power of Buyers: ○ High ○ Who is Represented: Consumers: Individual customers who increasingly opt for cheaper private label brands due to price sensitivity. Retailers: Supermarkets (e.g., Walmart, Costco, Kroger), which have significant influence on what products get shelf space and how they are promoted. Mass Merchandisers: Large retail chains that can dictate terms to suppliers and offer consumers more product options at lower prices. ○ Impact: Consumers and retailers hold considerable power due to the availability of cheaper alternatives and the influence of large retailers on product placement and pricing strategies. Bargaining Power of Suppliers: ○ Low ○ Who is Represented: Raw Material Suppliers: Farms and suppliers of grains (wheat, corn, oats), sugar, flavoring agents, and packaging materials. Technology Providers: Manufacturers of cereal production equipment (e.g., flaking, puffing, extrusion technology). ○ Impact: Due to the availability of raw materials from multiple sources and established technology, suppliers have little power over large cereal companies, which benefit from economies of scale and can negotiate favorable terms. Summary: ○ Substitutes:  Represented by other breakfast options like bagels and yogurt, as well as private label cereals. ○ Threat of Entry: Dominated by Kellogg, General Mills, and Philip Morris, but private labels and niche brands present a growing challenge. ○ Rivalry: Fierce competition between the “Big Three” and private label brands, with price wars and promotional strategies intensifying rivalry. ○ Buyers: Consumers seeking lower prices and retailers (e.g., Walmart, Costco) that control shelf space and influence product success. ○ Suppliers: Farms and providers of grains, sugar, and cereal-making technology have limited power due to the commoditized nature of their inputs. Prisoner´s Dilemma Pricing Strategies Both parties benefit from both not confessing because it has the lower total number of years in jain ○ However, they can´t collude Big 3 Cereal companies wanted to maximize profits so they agreed to both keep prices high ○ It´s illegal to collude, and anti-trust agencies try to make sure companies don´t collude, but difficult to prove ○ They wouldn´t explicitly collude but they would answer to stakeholder/investors to let the other members of the big three to companies Barriers to Entry Professor convincing us that all of these are not barriers to entry for the cereal industry Economies of scale → Minimum efficient scale plant ○ Ex. Requires 100 Million investment ○ 75M needed in profit to stay afloat ○ 2.8 Billion in the market Only need 3% of market 33 efficient companies of the same side could fit ○ Would get: Revenue of 240 million, net income of 50M Would make back investment in 2 years  Distribution infrastructure ○ The companies trying to enter already have distribution infrastructure Preferential shelf space ○ Given based on historical sales ○ $1 million investment ○ So net income would be 49 million not 50 Marketing expenditures ○ Need to invest 20 Million in the first couple of years to have effective marketing strategy ○ So Invest 120million, Get 49M each year, break even 3 year Brand equity ○ General Mill´s doesnt have their name of the cereal on the box, so brand equity is not why there are barriers to entry R&D Investment ○ 5-10 million Brand Proliferation → Saturation of all possible niches ○ No available niches? There are options available ○ So not really ○ So only need 3% market sure, but how many products have a 3% market share To get a 3%, market share you need to introduce several brands So, an initial investment of 130million Ex. Kellogg´s was getting 4.7% of sales from new brands for 30 brands, so.16% of the market per brand So the new entrant would need 3%/.16% = 19 brands Would need to invest ○ Plant 100M ○ 19*(20+10M) = 399M ○ R&D 19*5M = 95M ○ TOTAL 594M Big 3 were intentionally proliferating, so that the barrier to entry was even more significant Private Labels began to enter; how were they successful? They had low prices They had low costs (lowered advertising costs, not investing in R&D) They were putting it in plastic bags (lower material costs) The ingredients were cheaper Why did private companies enter now? ○ WTP = willingness to pay ○ The BIg 3 increased price and introduced coupons Lowered perception of the brand Made the brand seem lower quality Conflicting views for consumers now So their WTP decreases Are private labels a threat? The private labels are not making money They´re just surviving What could the big 3 do? Here are some options ○ Let´s buy the private labels and kill them It´s providing an incentive for other entrants ○ Let´s open up a new product line with the same model Causes cannibalism of your bigger brands ○ Kelloggs suggests seasonal - indirect messages of increases prices Reinforces source of the problem that is allowing private labels ○ So General Mills suggests an idea to lower the price and get rid of coupons Willingness to pay goes up Or at least brand erosion stops But how much would this cost General Mils Removing costs of printing coupons General Mills suggests to lower the price ○ Lower price leads to lower revenue  11% on larger brnadds (40% of sales) ○ Lower costs leads to higher revenue Reduced trade promotion (coupons) 175 M cost reduction ○ Balances out profit margins 8 billion (Market) *24.3% (GM Market Share) *{40%*(-11%)} = 86M Net profit margin: $175M -86M = 98M There is no cost, in fact an increase The assumption is that you maintain your market share The numbers makes sense only if the others do the exact same thing So what should the others do? Prisoner´s dilemma If the others do not follow, General Mills will lower it´s revenue, so they do this hoping they follow Kelloggs followed Other companies increased coupons ○ Maybe they´re just focused on short-term perspective So General Mills and Kelloggs reintroduced coupons Revenue dropped for the cereal market as a whole The lesson is not that this could happen ○ It´s that they avoided it for 50 years It showed that a small disruption on the other side of the market through private labels showed how it caused a major disruption to the equilibrium. 2 October 2024 Session 3 Wal-Mart vs Amazon Wal-Mart Global Revenue is and has been for the last 10 years higher than Amazon´s global revenue Wal-Mart´s industry is not attractive, so why is it successful Two things drive success for a company ○ Industry ○ Firm Competitive Advantage ○ For industry analysis you use five forces ○ For a firm´s competitive advantage analysis Ways to make more money ○ Cost competitive advantage Same price as competitors and lowering costs ○ Differentiation Increasing willingness to pay by customers What is Wal-Mart doing different from other customers? ○ Supplier → Distribution Center → Stores ○ Supplier Tough negotiation - aggressive Share real-time information with suppliers (tech) Place large orders to many Coordination like partnerships with suppliers (P&G) ○ Distribution Center Use them 80% vs 50% more than others Cross-docking Minimal storage time Move cargo from one truck to another 10% compared to other companies doing less Strategic location and grouping (having a DC close to several stores)  ○ Store Flexible pricing Prices were 5% lower than all No competitors nearby increase price by 6% (rural monopoly) Competitors 4-6 miles closer to consumer then -7-10% lower prices ○ A way to steal competitors Lots of stores ○ -1% lower prices Flexible portfolio Responsibility to store managers to incentivize them Private labels are lower price IT system, high coordination Don´t need to high inventory Once you know you are running low on inventory New store in rural areas All American Products and people Invest less in marketing ○ HQ - overall culture All-American Frugality Minimal design No investment in marketing HHRR - human resources practices were unique Wanted employees to have more responsibility Want to be happy Variable compensation CEO not renting luxury cars or spending a lot What about they do differently, does it reduce cost? Suppliers ○ Many suppliers - higher negotiation power lowers costs ○ Tough negotiators - lowers supplier costs ○ No intermediaries No need to pay intermediaries ○ Coordination (software) Lowers DC inventory cost Save on logistic costs (less trucks) ○ Overall Lowers purchasing costs DC inventory costs goes down Logistic costs goes down Distribution Centers (DC) ○ Cross docking (10%) Lowers DC inventory costs ○ Used more 80% vs 50% Greater DC costs Use more DC but use less inventory in stores Using all the space of the store for selling not to store Store is more expensive to store Lower store costs ○ 60% full back hauls  Trucks are more full compared to competitors So Less trucks Lower logistics costs Stores ○ Competitive pricing ○ Rural monopolies (6% price increase) ○ Tracking system ○ Coordination with DC ○ Overall Lowers marketing costs Flexibility of pricing - putting products that sell better Adapting supply to down Lowers inventory costs Lowers shrinkage (theft or loss) costs Using logistics more efficiently lowers logistics costs Rural monopolies leads to cheaper rent HQ ○ Frugal practices Lowers general costs Lower salaries costs How come the others aren´t doing the same? Suppliers Wal-mart has volume (not just sales but number of sales) ○ They are twice as large than next competitor (k-mart) ○ They have more leverage over suppliers Why would suppliers sign exclusive agreements with walmart? Because wal-mart has the power High costs for Technology Implementation ○ Wal-mart is a step ahead, more investment into technology DC Volume IT Infrastructure Density - Lots of stores close together ○ They were growing very little ○ Hub and spoke model Create a DC and then have several stores connected Stores IT Infrastructure volume HQ Strong culture coming from leader itself Analysis of Wal-Mart´s Relative Costs Investing about the same on information systems per 100/sales Cost per unit is lower but investing the same ○ Example of economies of scale ○ Spreading costs per unit ○ Once you´re larger, can spread fixed costs Economies of scale  ○ the larger firms have a larger advantage since they have lower per-unit costs, greater bargaining power with suppliers, and increased efficiency in production and distribution as they expand Wal-mart has lower price on average ○ In areas with a competitor with a k-mart 4-6miles apart with a 10% costs, Wal-mart makes almost no money Why do this? Supports lower cost model Pressures competition - kills competition VOLUME ○ Everything comes to volume ○ Become more efficient and it helps everywhere ○ Gold mine in rural areas ○ Larger volume spread costs across units Wal-Mart´s Competitive Advantage ○ Strategy Volume needs to be dense Strategy supported with strong culture Growth financed with rural monopolies ○ To what extent is this strategy sustainable? Can competitors replicate/imitate these resources/capabilities Competitors cannot replicate ○ To what extent is this strategy transferable to other industries/countries/Can Walmart leverage on the resources/capabilities in these other markets Potentially on a global scale ○ Is Walmart vulnerable at all Disruptive change that makes resources/capacities useless Ex. ecommerce Amazon is going from DC → Customer directly, without store Can wal-mart compete with ecommerce Spreading volume into two different directions, risking their advantage  Focus on from store delivery (pick-up, or employees to deliver on their way back home) Maintain advantage by leveraging model with store Amazon buys physical store Doing this to increase volume, but spreading out volume into two different directions ○ Their advantage is in DC → Customers, it´s cannibalizing their own advantage by opening stores Profit margins are reducing ○ Shutting down physical stores ○ They dont have the density yet 4 October 2024 Session 4 Pricing Dynamics Industry Analysis - Porter´s 5 Forces ○ Buyer Power ○ Supplier Power ○ Rivalry ○ Entry Barrier ○ Substitutes Firm Analysis - Competitive Advantage ○ Cost Competitive Advantage ○ Differentiation Competitive Advantage Soda Industry Initially just coke Pepsi entered, and it became a duopoly Concentrate Producers and Bottlers NOTE: IGNORING THE RELATIONSHIP BETWEEN PRODUCERS AND BOTTLERS Supplier Power ○ Bottler Not including relationship with bottlers and concentrate producers Attractive industry Including relationship with bottlers and concentrate producers Extremely unattractive industry ○ Concentrate Producers Raw materials Attractive industry Buyer Power ○ Bottler Not including relationship with bottlers and concentrate producers Attractive industry ○ Concentrate Producers Sell to restaurant chains - fountain channels McDonalds and Burger King have power and coke/pepsi also have power Medium/Attractive Threat of Substitutes ○ Bottler - Fountains  Not including relationship with bottlers and concentrate producers Attractive industry ○ Concentrate Producers Any other drink (tea, coffee) Trend of healthy drinking Unattractive (but for loyal customers not really an impact) Barriers to Entry - High so Attractive ○ Bottler Capital intensive $75 million, need to sell 40 million cases, in a $10 billion industry only need 0.4% of market share Current companies of exclusivity contract So technically fine, but legally difficult Not including relationship with bottlers and concentrate producers Attractive industry ○ Concentrate Producers Technically speaking, not a big deal Marketing is a fixed costs, with more volume means fixed costs are spread out across units - which drives economies of scale Medium/Attractive Rivalry - High so unattractive ○ Bottler Not high because of the exclusivity contracts Not including relationship with bottlers and concentrate producers Attractive industry ○ Concentrate Producers Intense duopoly - intense competition Unattractive Quantitative Analysis Bottlers are getting a 3% return on sales Concentrate Producers are getting a 23% return on sales Price-Cost Evaluation  BUT WAIT! They had a fixed-price contract The Concentrate Producers broke the contract and forced them to renegotiate With price flexibility (no contract), does it lead to higher or lower prices? Year Action Response Coke Pepsi 1974- Pepsi Challenge: Nothing (because of 34% Decrease 24% Increase 1978 Lower price where contract (execs freaking (industry converts Coke had a out because they to duopoly) fixed-price contract can´t do anything) 1978 Coke renegotiated contract 1978- Coke increased Pepsi increased price (if 35% Increase 24% Increase 1982 price (sends not, would have led to price messaging) war) 1982- Coke increased Pepsi increased advertising 40% Increase 30% Increase 1986 advertising from from $66M to $125M (made $74M to $181M ads with attacking each other - creates segmentation- you´re either coke or pepsi IT´S NOT A WAR THEY SPLIT THE MARKET They´re both winning They both have high, high (prisoner´s dilemma) If one lowered their price, they would not steal market share from the other ○ There is segmentation of the market ○ There is strong loyalty If it´s a war, then coke and pepsi are winning and then the others (dr. pepper) are losing Bottlers and Concentration Producers Concentration Producers are making more money and bottlers are getting thinner and margins Bottler: Why not switch to another CP? ○ To whom can you go? ○ No one has enough volume for you to be efficient ○ Maybe go to Pepsi from Coke, but they´re going to treat you the same  Bottler: Why not translate greater costs into higher prices ○ What is pressuring bottlers to not increase price Bottler´s biggest problem is that they need to be efficient If they dont sell 40 million cases they wont be making profit 10 Billion of industry 7.5B B cases being sold by bottlers 7.5B / 300 bottlers = $25 Million so they are below the margin ○ SO they need/want volume, and are willing to have lower prices So they can lower costs CP: Why not non-exclusive territories? ○ Why not increase competition to drive prices low? Bottlers will get more market share (one single bottler could start getting market share They would gain efficiency They get more power and be able to increase prices CP: Why not more bottlers in the same territory? ○ Becomes more inefficient ○ Volume has to spread into two bottlers and risks the bottlers closing their doors and shutting down ○ Coke and Pepsi have the bottlers where they want them Giving the bottlers enough to keep them industry but not too little that they shut down CP: SO Why vertically integrate into bottling? ○ What did the CP´s did after acquiring bottlers They invested in making them more efficient There would have been opportunities to make the bottlers more efficient But why didn´t they? ○ They improve cost structure so they´re price margins go up What will happen next day? ○ CP´s will immediately lower their margins Bottlers do not want to make investments ○ Investment gains immediately go to CP´s CP´s could tell the bottlers ¨let´s sign a contract, if you invest in improving efficiency, I won´t change my price¨ ○ Why would the bottlers trust them, if they already ripped contracts they´ve written in the past? ○ Lower power parties have no incentive to make investments in efficiency ○ CP´s buy botters, they make improvements to bottlers And then sells them 9 October 2024 Session 5 Class Notes on Game Theory Simultaneous Games: ○ Used to simplify complex environments by dividing cases into simultaneous games. ○ Example of application: Price Wars. Utilized game theory logic, particularly the Prisoner’s Dilemma, to understand pricing diagrams. Factors to consider: when to expect aggressive pricing vs. more collusive pricing behavior.  Actions to prevent aggressive price wars will also be discussed. Sequential Games: ○ New topic introduced for decision-making when one player makes a move, followed by another player’s response. ○ Application: New Market Entry. Decision-making based on the reaction of incumbents in the market. Player 1 decides: enter the market or not. Player 2 reacts: do nothing, try to kick them out, etc. ○ Key concept: sequentiality in decision-making. Combination of Game Types: ○ Some games combine aspects of both simultaneity and sequentiality. ○ Discussion will cover how these combined games work. Historical Context of Game Theory: ○ Mentioned a key military figure (no clear identification) associated with game theory applications during World War II. Germans used mathematical models to optimize submarine placements against US supply routes to the UK and France. Both sides had to predict each other’s movements, leading to recursive decision-making models. ○ Origins of Game Theory: Disputed origins: military applications in WWII vs. academic development. Notable academic figure: John Nash, a Princeton mathematician, known for the Nash Equilibrium in decision-making. Prisoner’s Dilemma Recap: ○ Revisited the Prisoner’s Dilemma as an example of a simultaneous game. ○ Emphasized that solving these games doesn’t mean finding a definitive solution but rather understanding the structure and possible outcomes. Game Theory in Various Fields: ○ Used not just in economics and markets but also in fields like evolutionary biology. ○ Central theme: decision-making involves anticipating others' choices and strategies. ○ Dilemma: Example of a simultaneous game where players face strategic decisions. ○ Solving Games: "Solving" doesn't mean finding a definitive solution but rather understanding the forces and likely outcomes. Focus on the forces pushing players toward specific strategies, helping predict behaviors. Dominant Strategy: ○ A dominant strategy is a player's best choice regardless of what the other player does. ○ Step 1: Identify if either player has a dominant strategy. Player A: Confessing is a dominant strategy since 0 years in jail is better than 2, and 5 years is better than 10. Player B: The situation is symmetric, so confessing is also the dominant strategy for Player B. Nash Equilibrium: ○ When both players have a dominant strategy, the game reaches a Nash Equilibrium. ○ Definition: A situation where no player can improve their position by changing strategies unilaterally. Example: In the prisoner’s dilemma, neither Player A nor Player B has an incentive to change their strategy alone (from confess to non-confess), as it would worsen their situation.  A key point is that the players need coordination to move away from this equilibrium. Nash Equilibrium Characteristics: ○ Hard to move away from the equilibrium without coordination and trust between players. ○ Both players must agree to change their strategies simultaneously for a different outcome to emerge. Example from a TV Show: ○ A TV show clip was used as an example to apply these concepts, demonstrating real-life applications of game theory in decision-making. Assumptions in Game Theory: Game theory typically assumes no communication between players. If there is communication, it depends on the type of communication (e.g., negotiations, strategic discussions). Without communication, it’s harder for players to align their strategies. Even with communication, players often struggle to convince one another of their intentions, particularly when there's fear of betrayal. Communication in Strategic Decision-Making: Communication often revolves around convincing the other party to collaborate rather than act selfishly (e.g., stealing in a game). Players may try to convince the other that they are trustworthy and will cooperate. The challenge lies in proving intentions, especially when both players fear that the other will act selfishly. Dominant Strategy & Its Limitations: Even though dominant strategies push players towards specific decisions (e.g., price wars), these strategies don’t always lead to the most rational outcomes. Examples show that not all situations result in price wars despite the existence of dominant strategies (e.g., Coca-Cola and Pepsi). Price Wars: Short-Term vs. Long-Term Thinking: Firms may sacrifice short-term gains for better long-term outcomes. Short-term strategies: Tempting to lower prices to capture immediate market share. Long-term strategies: Holding prices steady to avoid a destructive price war in the future. Simultaneous vs. Sequential Decision-Making: Coca-Cola and Pepsi’s pricing behavior is an example of simultaneous games where decisions are made daily, and both firms have the option to adjust prices at any time. Even though it appears sequential (one reacts to the other), decisions are made within similar timeframes. Factors Influencing Price Wars: Number of Firms: ○ Fewer firms = higher likelihood of collusion (firms work together on pricing). ○ More firms = more aggressive competition, as it's harder to collude with many players. Time Horizon: ○ Firms with a long-term perspective are more likely to avoid price wars and maintain higher prices for future stability. ○ Firms with short-term pressures (e.g., financial struggles, stock options) are more likely to lower prices aggressively. ○ Cereal Industry: Smaller firms were more aggressive with pricing due to short-term pressures, whereas larger firms like General Mills and Kellogg maintained a collusive pricing environment. Production Capacity:  ○ Firms that need to produce at full capacity due to high fixed costs are more likely to engage in price wars to increase volume. Price Elasticity: ○ High elasticity (small price changes lead to large volume changes) encourages aggressive price cuts to gain market share. ○ Low elasticity (price changes do not lead to significant volume changes) discourages price wars, as price cuts do not offer much competitive advantage. ○ Impact Industries with low elasticity (e.g., loyal customer bases) see fewer price wars, as price changes don’t significantly alter market share Coca-Cola vs. Pepsi: An example where aggressive price cuts aren't always the norm despite dominant strategy pressures. Price Flexibility and Collusion: Flexibility in pricing allows for constant adjustments and signaling between firms. ○ Fast flexibility: Firms can react quickly to competitors' pricing decisions, sending signals about future intentions (e.g., raising prices to encourage others to follow). ○ No flexibility: Firms set prices that cannot be changed for a long period (e.g., in catalog-based sales), limiting their ability to signal or respond to changes in the market. Impact of Flexibility on Pricing Behavior: No flexibility often leads to lower prices from the start. ○ Firms are more likely to set low prices since they cannot adjust later. They avoid getting stuck with high prices if competitors undercut them. ○ Inflexibility removes the opportunity to communicate through price changes or to punish competitors for lowering prices. High flexibility enables firms to: ○ Collude more easily: They can signal intentions through price changes and adjust prices in response to competitors’ actions. ○ Communicate: Pricing becomes a language, with firms using price movements to send signals, negotiate, and potentially maintain higher prices. Communication through Pricing: Prices are more than just technical decisions—they are a form of communication. When firms increase prices, they signal their intention for others to follow. The absence of flexibility means this form of communication is lost, leading to more competitive (lower) pricing. Example: Coke and Pepsi: When Coke and Pepsi gained more flexibility in pricing (breaking past contracts or constraints), they were able to communicate and coordinate prices more effectively, often leading to higher prices. Key Lesson: Prices as a language: Pricing is not just about optimizing profits; it’s a tool for communication between competitors. ○ When flexibility exists, prices can be used to signal cooperation or punishment. ○ In environments without flexibility, firms are more likely to start with lower prices to avoid getting stuck in disadvantageous positions. Evolutionary Biology and Game Theory: ○ Game theory has been applied to evolutionary biology to explain competition and cooperation among species. ○ Some species engage in symbiotic (cooperative) relationships, while others engage in competitive behavior. ○ Similar to firms, species must decide whether to compete or cooperate based on evolutionary advantages.  Tournaments and Tit-for-Tat Strategy: ○ Various academic departments competed in a game theory tournament using different strategies (e.g., high/low pricing) over 100 rounds against each other. ○ The tit-for-tat strategy consistently won in the first few years of the tournament. Tit-for-tat strategy: A simple strategy where a player mirrors the actions of their opponent from the previous round. If the opponent cooperates (chooses high), the player cooperates in the next round. If the opponent defects (chooses low), the player defects as well. Why Tit-for-Tat Works: ○ The strategy sends a clear message: "If you cooperate, I’ll cooperate; if you defect, I’ll defect." ○ The approach balances cooperation and punishment: Cooperation is rewarded by continuing to choose high, benefiting both parties. Punishment (choosing low) occurs when the opponent defects, but it’s not a permanent punishment. Once the opponent cooperates again, the player returns to cooperation. ○ This predictable behavior encourages long-term cooperation, as both players realize that defection only leads to temporary losses. Lessons from Tit-for-Tat: ○ Balance between being nice and punishing: Always being cooperative (e.g., always keeping prices high) leaves you vulnerable to being taken advantage of. On the other hand, being too aggressive results in missed opportunities for collaboration. ○ Predictability is key: The success of the tit-for-tat strategy lies in its predictability—opponents quickly understand the behavior and adapt to it, leading to more cooperative outcomes. Long-Term Cooperation: ○ Over time, players in the tournament learned that cooperating (choosing high) was mutually beneficial, as betraying (choosing low) led to short-term gains but long-term losses. ○ Predictability in strategy allows firms (or species) to avoid betrayal while building a constructive, collusive environment. ○ When opponents know they will be punished for defection but rewarded for cooperation, it becomes rational for both players to maintain cooperation. Takeaways: ○ Tit-for-tat is a simple yet effective strategy in repeated games where cooperation and defection are choices. ○ Punishment should be temporary, allowing players to return to cooperation once trust is rebuilt. ○ In the real world (whether among firms or species), predictability in behavior fosters trust and collaboration, reducing the likelihood of long-term conflicts or betrayals. Auction Example: German Mobile Phone Frequency Auction: Auction Setup: ○ The German regulator auctioned off blocks of radio frequency spectrum to mobile phone companies. ○ Companies had to bid for exclusive rights to specific frequency blocks. ○ Sequential Bidding: Each company made bids in successive rounds, and each subsequent bid had to increase by at least 10% over the previous bid. ○ The auction continued until no company was willing to raise their bid further, at which point the highest bidder won the block. Key Players:  Two major competitors: Mannesmann and T-Mobile. Mannesmann’s initial bid: 18.8 million for blocks 1-5 and 20 million for blocks 6-10. T-Mobile’s response: Increased each block by exactly 10%, bidding 20 million for blocks 1-5 and 22 million for blocks 6-10. Collusion Through Signaling: Message through bidding: T-Mobile’s bid sent a clear signal to Mannesmann that they could divide the market evenly. ○ T-Mobile bid exactly 10% higher, the minimum allowed, on each block, essentially offering a split of the market. ○ Mannesmann would get blocks 1-5 and T-Mobile blocks 6-10, each paying roughly the same amount for their blocks. Outcome: After this signaling, Mannesmann stopped bidding on blocks 6-10, and T-Mobile did not increase bids on blocks 1-5. The auction ended with both firms splitting the market at similar prices, without further competition. Takeaways: Auctions as a platform for tacit collusion: Firms used the auction process to communicate indirectly and agree on a fair division of the market without explicit coordination. Use of rules for communication: The only rule requiring a 10% bid increase served as a tool for the firms to convey their intentions and avoid overbidding each other. Collusion without direct communication: This example highlights how firms can use simple strategies within the rules to avoid aggressive competition and arrive at mutually beneficial outcomes. Auction Example: US Telecommunication Frequency Spectrum Auction Setup: ○ Companies bid for mobile phone licenses in 500 regions across the US. ○ Firms had to outbid each other for specific regions. ○ The auction focused on regions rather than blocks of spectrum. ○ Bids on regions had to be higher than the current highest bid. Key Players: ○ McLeod: Held highest bids in two Iowa regions. ○ US West: Held the highest bid for Rochester, New York. Bidding Escalation: ○ McLeod surpassed US West's bid for Rochester. ○ US West retaliated by outbidding McLeod in the two Iowa regions. ○ The retaliation was not just about winning regions but also sending a message to discourage McLeod from further bids in Rochester. Strategic Use of Numbers in Bidding: The Case of US West's Bid Signaling Through Numbers: ○ US West bid $313,378, a deliberate use of numbers to send a signal. ○ The ending 378 wasn’t random—it was a code to communicate with McLeod. ○ In auctions, where direct communication is restricted, firms use numbers as non-verbal cues. Retaliation and Deterrence: ○ US West's bid told McLeod: “We know you bid on Rochester, and we are targeting your Iowa regions in return.” ○ The bid was meant to deter McLeod from future aggression in Rochester. ○ US West signaled that continued escalation would lead to further retaliation, increasing costs for both firms. Outcome and Potential for Collusion  Outcome of the Signal: ○ The 378 bid indicated to McLeod that further bidding in Rochester would result in retaliatory bids in Iowa. ○ This non-verbal communication encouraged McLeod to back off, avoiding a costly bidding war. ○ The signal aimed to foster tacit collusion, where both companies could divide the market and avoid unnecessary expenses. Takeaways: ○ Bidding as a Communication Tool: Firms use bids strategically to communicate intent and retaliate. ○ Retaliatory Bidding: Bidding on each other’s territories serves as a deterrent to aggressive competition. ○ Potential for Tacit Collusion: The use of strategic bids, like US West’s 378, encourages firms to informally divide the market rather than escalate competition, saving costs for both parties. ○ This concise breakdown highlights how strategic bidding and the use of numbers can serve as a powerful tool for signaling, retaliation, and fostering collusion in competitive auctions. Sequential Games and Strategic Commitment Sequential Games: ○ One player makes a decision first, followed by the second player. ○ Example of historical relevance: Cortez burning the ships in 1520 during his invasion of the Aztec Empire. ○ Cortez’s decision to burn the ships removed the option of retreat, signaling a strong commitment to fight, forcing the second player (Aztecs) to react strategically. Cortez Example: ○ Decision Tree: Moctezuma (Aztec leader) had two choices: Wait and see how the Spaniards acted (risking them building alliances). Attack immediately, leveraging their strength. Outcomes for each choice were assigned utility values to predict behavior. ○ Backward Induction: Solving sequential games by looking at the second player’s optimal choice first. If Moctezuma waited, Cortez would have more time to prepare. If he attacked, Cortez would likely be defeated. Cortez burned the ships to remove his own option of fleeing, committing to the fight and sending a signal to the Aztecs. Strategic Value of Limiting Options: ○ Burning the ships is an irreversible action that removes the ability to retreat, signaling a strong commitment. ○ Limiting options can be beneficial by sending clear, credible signals to the opposing player. ○ For the strategy to work, the opposing player must see and understand the commitment (e.g., Cortez burning the ships must be visible to Moctezuma). Messaging and Credibility in Sequential Games Strategic Messaging: ○ Firms or players can use messages or threats to signal their next move, influencing the opponent’s actions. ○ Example: Players can send non-verbal signals or take visible actions (like burning bridges) to show commitment.  The Bomb Example: ○ Suppose one player claims they have a bomb and threatens to detonate it unless the other pays them. ○ The rational response, using backward induction, would be not to pay, as detonating the bomb is irrational and costly for both. ○ However, if the bomb holder convinces the other that they are irrational or desperate, the other player might believe the threat and pay. ○ Playing the irrational card can sometimes be the most rational strategy to elicit the desired response from an opponent. Chicken Game: A Sequential Example Chicken Game: ○ Two drivers head toward each other. Each has the choice to turn or keep straight. ○ If neither turns, they crash; if one turns and the other doesn’t, the one who keeps straight wins. ○ No dominant strategy: Decisions depend on the other player's choice, and reputation or threats can play a key role. ○ Commitment Escalation: One player can throw the steering wheel out of the car (like burning the ships), showing they cannot turn. This forces the other player to make the rational choice of turning to avoid a crash. ○ Escalation of Commitment: The risk is that both players continue making stronger commitments, which could lead to disastrous outcomes. Takeaways for Firms and Players Backward Induction: Used to solve sequential games by considering the second player’s optimal strategy first. Commitment: Limiting your own options (like burning ships or throwing the steering wheel away) can send a strong signal to the opponent. Messaging: In games, signaling intent through actions or irrationality can influence the opponent’s decision-making. Credibility: For a strategy based on commitment to work, the opposing player must know and believe the commitment is real. Escalation: The danger of escalation occurs when players continuously make stronger commitments, as seen in historical events like the Cuban Missile Crisis. 14 Oct 2024 Session 6 Class Notes Coors Case Coors Case Study - Class Notes Introduction: We’re using this case to understand the dynamics of the beer industry in the U.S. by exploring Coors’ situation in 1985. Key question: Should Coors build a new plant in the east? To answer, we need to understand why Coors was so successful up to 1985 and explore the industry's evolution. Industry Evolution & Demand 1. Early Expansion: ○ Post-Prohibition, U.S. beer consumption skyrocketed as the population grew. Initially, more companies entered the market to meet rising demand. ○ However, by the late 1970s, demand stabilized. The market hit its capacity as Americans reached peak beer consumption. 2. Consolidation: ○ While we might expect a stable market to welcome more brewers, the opposite happened: smaller brewers couldn’t keep up, leading to industry consolidation.  ○ Consolidation hints at economies of scale—large companies were doing better, benefiting from reduced per-unit costs due to high fixed costs spread over more units. Economies of Scale & Fixed Costs Economies of Scale: Larger players like Anheuser-Busch thrived because they could scale fixed costs, especially in production and marketing. Fixed Costs: Key fixed costs in this industry included equipment, production facilities, and marketing. To achieve economies of scale, brewers had to produce at a large enough volume to keep unit costs down. Coors’ Strategy: Understanding Their Competitive Advantage 1. One Plant Strategy: Coors operated only one plant in Colorado, giving them high capacity utilization and transportation cost savings in the West. 2. Vertical Integration: ○ Coors controlled many parts of its production process: it sourced its own water, made its own cans, and had its own trucks. This might have helped with quality control, but it also meant higher costs in some areas where third-party suppliers might have been cheaper. 3. Marketing Approach: ○ Coors didn’t invest heavily in advertising like competitors. Instead, its limited distribution created a sense of exclusivity, attracting consumers on the East Coast who would even drive to get it. Challenges in Coors’ Expansion 1. Increased Competition: ○ As Anheuser-Busch and Miller entered the western market, Coors’ transportation advantage faded. Coors had to expand east, but this meant higher distribution costs and more investment in advertising to compete. 2. Economies of Scale & Advertising: ○ Larger firms spread advertising costs across more units, but Coors didn’t have the same scale. As a result, Coors’ per-unit advertising costs were higher, making it difficult to keep up in a saturated market. 3. Profitability Decline: ○ By 1985, Coors’ profitability dropped significantly. Despite investing in advertising, they struggled to charge higher prices or match competitors’ reach. Coors’ Strategic Mistakes and Alternatives 1. Misalignment in Strategy: ○ Coors believed it had a quality differentiation advantage with its unique water source and no-additive formula. However, taste tests showed consumers didn’t necessarily prefer Coors, undermining their supposed differentiation. 2. Expansion Decision: ○ In 1975, consultants advised Coors to expand westward to California to strengthen their regional dominance. Instead, Coors expanded their Colorado plant, missing an opportunity to create a credible commitment to stay in the West, potentially discouraging competitors from entering the market. 3. Capacity vs. Demand: ○ Coors was producing at near full capacity in the West before competitors entered. When competitors built plants nearby, Coors had no choice but to expand eastward, losing its cost advantage and driving up costs without securing enough new market share. Should Coors Build a Plant in the East? 1. First Expansion Proposal: ○ Coors considered building a $45 million packaging plant in the east, which would save $2.5 per barrel in transport costs.  ○ Calculations showed the savings wouldn’t offset the investment cost, so a packaging plant alone wasn’t viable. 2. Full Plant Proposal: ○ A full production plant costing $300 million could produce 5 million barrels annually. However, this would drop capacity utilization from 92% to 75%, increasing per-unit costs and possibly leading to losses in the short term. 3. Risk of Over-Expansion: ○ The market in the east was already saturated, and recent expansions by Miller showed that additional capacity was leading to downsizing rather than growth. ○ Without guaranteed demand, the new plant might not achieve the high utilization needed for profitability. Alternative Strategies 1. Focus on the West: ○ Stay within the western U.S. market, where Coors had established dominance and avoided costly expansion east. 2. International Markets: ○ Explore international opportunities or consider untapped regional markets where demand might allow for smaller, more controlled growth. 3. Streamlined Production: ○ Coors could focus on streamlining processes, reducing vertical integration where it wasn’t cost-effective, and concentrating on quality without excessive costs. 4. Advertising Adjustment: ○ Instead of competing directly with the marketing budgets of larger competitors, Coors could adopt more niche marketing strategies to build loyalty without matching competitors’ advertising spend. Key Lessons 1. Understand Competitive Advantage: ○ If Coors had a true quality advantage, it should have fully aligned its strategy to reflect this, investing heavily in branding and marketing. 2. Consistent Strategy: ○ Companies must align their operations with their competitive advantage. Coors’ mix of cost-cutting and differentiation moves created inconsistencies, which weakened its position. 3. Timing is Critical: ○ Market entry decisions are time-sensitive. Coors missed the chance to secure the western U.S. by not expanding to California, allowing competitors to erode their position. Summary Coors’ initial success in the West stemmed largely from geographic advantages. These advantages did not provide a sustainable competitive edge as the market consolidated. Coors struggled to adapt its strategy amidst industry consolidation, leading to: ○ Missed key expansion opportunities. ○ Investments in areas that did not support their core strengths. To regain competitiveness, Coors should: ○ Streamline operations. ○ Reconsider the extent of their vertical integration. ○ Adopt a more realistic view of their position within the market. Going forward, Coors should: ○ Clearly align their strategy around either cost leadership or differentiation. ○ Avoid trying to achieve both, as it creates strategic inconsistencies. 18 Oct 2024 Session 7 Class Notes Class Notes: Strategy Session on Ryanair Case and Entry Strategy Overview of Entry Decision & Market Dynamics Context: Ryanair is considering entering the London-Dublin route in the mid-1980s, a route already served by established carriers British Airways and Aer Lingus. Key Decision: Should Ryanair enter the market with a low-cost strategy? Market Analysis Current Market: ○ British Airways and Aer Lingus offer fares of £208, with reduced advance-purchase fares at £99. ○ Average revenue per passenger on this route is approximately £166.5. ○ About 500,000 passengers currently use this route, with a capacity utilization of 60%. Ryanair's Proposed Entry Strategy: ○ Ryanair plans to offer a single low fare of £98, aiming to attract budget-conscious travelers and stimulate additional demand. Discussion on Potential Demand and Pricing Price Sensitivity: ○ A portion of travelers may be price-sensitive, choosing longer travel times on ferries and trains for cheaper fares (~£55). ○ The assumption is that a lower price (compared to the £208 standard fare) could attract these budget travelers. Market Segmentation: ○ Potential exists for a low-cost alternative for price-sensitive travelers unwilling to pay the higher airfares. Cost Analysis for Ryanair Revenue and Cost Projections: ○ Ryanair’s proposed price is £98, compared to the competitors' average revenue per passenger of £166.5. ○ Ryanair's strategy relies on cost efficiencies through: Higher staff productivity: 33% less staff per passenger. Maximized capacity utilization (flying at full capacity). Cost Breakdown: ○ Ryanair's costs could be reduced to approximately £94.4 per passenger, making a small margin at the £98 fare. Competitive Response: Potential for a Price War Incumbent Response Options: ○ Do Nothing (Accommodate): Maintain current prices and allow Ryanair to capture market share. ○ Aggressive Price War: Match or undercut Ryanair's fare to retain market dominance. Price War Scenarios: ○ If Aer Lingus and British Airways engage in a price war: They could match Ryanair’s £98 fare, forcing Ryanair to absorb losses due to lower economies of scale. Incumbents have larger capacity and deeper pockets, potentially allowing them to sustain low fares longer than Ryanair. Game Theory Analysis Backward Induction: ○ Ryanair must anticipate Aer Lingus and British Airways' responses. ○ If incumbents accommodate, Ryanair profits; if incumbents engage in a price war, Ryanair could incur significant losses.  Cost of Aggression: ○ For incumbents, engaging in a price war is costly but could effectively deter Ryanair and other potential low-cost entrants. Outcome and Historical Context Historical Outcome: ○ British Airways and Aer Lingus did respond aggressively, reducing prices significantly, leading Ryanair to incur heavy losses. ○ Ryanair eventually declared bankruptcy but later restructured to adopt an even lower-cost model with further efficiencies. Strategic Implications and Lessons Judo Strategy: ○ Ryanair could have entered with a smaller initial market share, signaling to incumbents that they were not a direct threat. ○ This strategy may have reduced the likelihood of an aggressive price war by positioning Ryanair as a complementary rather than competing service. Cost Leadership: ○ Ryanair's future success relied on dramatically lowering costs across all areas, including operations, staffing, and utilizing secondary airports to further reduce fees. Long-Term Positioning: ○ Ryanair learned to position itself as a true low-cost carrier, reducing its service offerings and amenities to minimize costs and cater exclusively to price-sensitive customers. Key Terms and Definitions Entry Decision: The choice of whether to enter a new market, based on potential profitability and competitive response. Capacity Utilization: The extent to which a company or route uses its maximum operational capacity. Price War: A competitive strategy where companies aggressively lower prices to drive out competitors. Cost Efficiency: Reducing costs to improve profit margins, especially critical in low-cost business models. Judo Strategy: A market entry tactic where a new entrant positions itself as a small player to avoid provoking a competitive response. 18 Oct 2024 Session 8 Class Notes Group Project: Overview and Expectations Focus: The upcoming group project will be a simulation in class, not an exam. Materials: I’ll provide a one-page PDF with instructions and a basic Excel simulation file. The Excel format is simple, so feel free to explore it and get comfortable with it. Structure: You’ll be divided into groups and compete against each other in the simulation. ○ Preparation: Try to meet for 30 minutes in advance to discuss strategy before playing the simulation. After Simulation: Each group will submit a brief report explaining: ○ What you liked about the simulation. ○ Mistakes you made. ○ Application of the logic we’ve covered in class. Key Tip: Coordination is key here. Ensure your group is on the same page for the best results. Transition to Innovation and Technology Module Context: We’re moving into a new block on innovation and technology. ○ We’ve discussed sequential games and new market entry in the last sessions. ○ Today’s Apple case will be the starting point for this module.  Next Cases: We'll cover: ○ Video Game Industry (evolution with Nintendo). ○ Online Innovation and Digital Industries (platform models and digital transformation). Big Question: What kind of strategies allow a company to profit from innovation? ○ Reality Check: Innovation alone does not guarantee profitability. ○ We’ll use case studies to explore why some innovative companies succeed and others don’t, looking specifically at how companies use strategy to profit. Framework for Profiting from Innovation 1. Three Battles for Innovation Success: ○ Battle 1: Value Creation – Is there a market? Does demand exist for your innovation? Timing matters here; sometimes, companies come too early or too late. ○ Battle 2: Winning the Standard War – Even if there’s demand, competing technologies might be vying to become the “standard.” Only the winner captures the most value. ○ Battle 3: Value Appropriation – Assuming you’re successful in the first two battles, how do you ensure that competitors or powerful suppliers/customers don’t absorb all your profits? 2. Decisions for Strategic Success: ○ System Choice: Open vs. closed. For example, Apple’s closed system offers control over quality, while Microsoft’s open model attracted broader software compatibility. ○ Outsourcing vs. Insourcing: Should you manufacture in-house or let others build for you? ○ Pricing Strategy: Key, especially in tech products with network effects. Consider pricing fixed (console) and variable (games) products for optimal impact. ○ Complementary Goods: Do you encourage more software developers or game creators to build for your platform? Case Study: Apple in the Computer Industry 1. Apple’s Niche Strategy: ○ High Price, High Quality: Apple positioned itself as a premium, high-loyalty brand with complete control over hardware and software integration. ○ Contrast with Industry: While most computer companies pursued mass market through low-cost strategies, Apple maintained a niche strategy, attracting a loyal customer base. ○ Challenges of Being Niche in a Network-Driven Industry: Computers are network goods. Customers care about compatibility with others for file sharing, software use, etc. Unlike luxury cars (e.g., BMW), network goods like computers require compatibility with a standard to maximize value. 2. Network Effects in the Computer Industry: ○ Network Effects: The value of a product (like a computer) increases as more people use it, as it allows for easier sharing and compatibility. Direct Network Effects: As more people adopt a system, new users are more likely to join it. Indirect Network Effects: The more complementary goods (software, applications), the more attractive the system becomes. ○ Apple’s Dilemma: Apple’s niche strategy limited its install base, making it difficult to compete with the standard (Windows). In a winner-takes-all market, this small market share is a huge disadvantage. 3. Competitive Advantage of the PC Model (Microsoft and Intel): ○ High Fixed Costs, Low Variable Costs: Developing an OS has a high initial cost but near-zero marginal cost for each additional copy sold. With a large install base, Microsoft profited heavily from each additional sale.  ○ Low-Quality Tolerance: Since Microsoft was the standard, it could afford to maintain lower quality without losing market share – people kept buying it because of compatibility, not because it was the best. Steve Jobs’ Return and Apple’s Strategic Shift 1. Steve Jobs’ Changes: ○ Vertical Integration and Ecosystem: Jobs doubled down on Apple’s ecosystem, integrating hardware and software tightly to enhance quality and user experience. ○ Focus on Fewer, Higher Quality Products: Apple focused on creating iconic products (e.g., iMac, iPhone) instead of expanding its product line. ○ Microsoft Partnership: Microsoft invested in Apple, guaranteeing ongoing support for Microsoft Office on Mac. This reduced compatibility concerns and made Apple computers more attractive. 2. Network Effect Decisions for the iPod and iTunes: ○ First Decision: Initially, Apple made iTunes exclusive to iPod users to drive iPod sales. ○ Second Decision: Eventually, Apple opened iTunes to other platforms to become a leader in multimedia content distribution, capitalizing on the network effects of having a wider user base. Reflection on Market Share and Standards Standard Power: Microsoft had a near-monopoly, with about 98% of the market share. Apple’s limited share (around 3%) restricted its ability to recover R&D investments in the same way. ○ Difficult Reality: Apple could make the highest-quality computers, but without a large install base, it couldn’t attract enough developers to create complementary software. Lessons in Standards and Profitability: ○ High Market Share Enables Lower Quality Standards: Microsoft could maintain its standard despite lower quality, simply due to its install base. ○ Complex Decisions in Compatibility: Apple had to make calculated decisions on compatibility based on which “war” (e.g., standard dominance, product sales) it wanted to win. Key Takeaways on Strategy and Innovation In Network-Driven Industries, Standards Trump Quality: Profiting from innovation requires a large install base and complementary goods, not just high quality. Strategic Trade-Offs: Companies must decide which wars they want to win and align compatibility, exclusivity, and pricing accordingly. Flexibility in Strategy: The decision to make iTunes compatible with other devices reflected Apple’s shift toward multimedia content leadership, showing that long-term success often requires adapting to changing network effects. Summary: This class explored the strategic complexity of innovation and standards, using Apple’s experience as a lens to understand network effects, compatibility, and the decisions that shape profitability in network-driven markets. 6 Nov 2024 Session 9 Class Notes Class Notes: Strategies for Profiting from Innovation and Case Studies Introduction to Profiting from Innovation Main Idea: There’s a big difference between innovating and making money from that innovation. Lots of firms innovate, but they don’t necessarily profit from it. ○ Previous Class Recap: We looked at the computer industry, where IBM created the PC model and Apple launched the Mac. Both were incredible innovations, yet Microsoft was the one that made massive profits.  ○ Key Question: Innovation is great, but how do you actually profit from it? Three Essential Battles to Profit from Innovation 1. Value Creation: There must be a market that wants and values the product. ○ Example: Some brilliant products end up having no market or appeal; they’re innovative but unwanted. 2. Winning the Standard War: You have to become the standard in industries with network effects. ○ In networked industries, whoever becomes the standard dominates and profits. We saw this with PCs; the PC model became the standard instead of Apple’s closed Mac model. 3. Value Appropriation: Capture the profits generated from innovation—don’t let others (like suppliers, customers, or retailers) take that value. Network Effects and the Standard War Network Effects: To profit from network effects, becoming the standard is crucial. ○ Direct Network Effects: The more people use your product, the more valuable it becomes, reinforcing future growth. ○ Indirect Network Effects: The more complementary goods (like software) that are available, the more people want your product. ○ Example: In video games, people often buy consoles based on what games are available or what their friends own, which reinforces these effects. Case Study 1: Atari’s Downfall 1. Atari’s Rise: In the late ’70s and early ’80s, Atari was leading the video game industry, with huge demand for its games and consoles. 2. Failure to Sustain Profit: Despite early success, Atari didn’t profit sustainably, and the industry crashed. ○ Standard War: Atari initially led, but it failed to secure its position as the standard due to compatibility issues. Other companies developed adapters to play Atari games on their own systems, weakening Atari’s control. 3. Value Appropriation Issue: Game developers, not Atari, started capturing more value, leading to a market flooded with low-quality games that reduced consumer trust. 4. End Result: In three years, the video game industry dropped by 97%, a nearly complete collapse caused by over-saturation and lack of quality control. Understanding the "Market for Lemons" Akerlof’s Theory of Market Failure: This explains how information asymmetry can cause markets to fail. ○ Example: If you can’t tell the quality of a used car, you’ll only pay an average price, assuming it’s a bad deal. Sellers with high-quality cars won’t sell at that price, so only poor-quality cars (lemons) end up in the market. ○ Connection to Atari: Since consumers couldn’t judge game quality before buying, game developers had little incentive to invest in high-quality games, which ultimately led to the market’s collapse. Case Study 2: Nintendo’s Strategy and Success 1. Rebuilding Trust in the Market ○ Nintendo restored trust by ensuring high-quality games reached consumers. ○ In-store Demos: Nintendo allowed consumers to try games before buying them—tackling information asymmetry head-on. ○ Strict Quality Control: Low-quality games weren’t allowed on the platform, protecting Nintendo’s reputation and consumer trust. 2. Winning the Standard War (by Default) ○ Exclusive High-Quality Games: Nintendo created a library of exclusive, high-quality games, which attracted players and reinforced network effects.  ○ Security Chip: By using a security chip, Nintendo ensured its games were compatible only with Nintendo’s console, preventing competitors from playing Nintendo games. 3. Effective Value Appropriation ○ Razor-and-Blade Pricing Strategy: Nintendo sold consoles at or below cost, profiting instead from game sales. ○ Exclusivity Contracts: Game developers were only allowed to produce games for Nintendo, giving Nintendo full control over the ecosystem and game quality. ○ Retailer Relationships: Nintendo required retailers to sell its products at a minimum price to avoid price wars that could empower large retailers. 4. Setting Strong Standards: By controlling game quality, ensuring exclusivity, and maintaining compatibility only with its console, Nintendo won the standard war by becoming the default choice as the industry revived. Conclusion Nintendo showed how carefully managing value creation, standard-setting, and value capture allowed them to rebuild an industry. Even though their success partly relied on being the only major player after the market crash, Nintendo’s strategy emphasized the importance of high standards, strong control over quality, and thoughtful pricing. Nintendo’s actions shaped a profitable and resilient market position and created a sustainable model for profiting from innovation. 8 Nov 2024 Session 10 Class Notes Exploring Platform Markets and Network Effects Introduction to Platform Markets Definition of Platform Markets: Unlike traditional business models, platform markets create a virtual or physical space where different types of agents can interact. ○ Characteristics: Platforms don’t provide standalone value; they facilitate interactions between groups that want to connect. Examples include: Airports: Connect travelers with airlines. Newspapers: Connect readers, journalists, and advertisers. Digital Platforms: Examples are Google (connecting searchers with websites), Airbnb (connecting renters with property owners), and Facebook (a social network for users to interact with each other). Platform Success: Success in platform markets often hinges on network effects, which drive value as the number of participants increases. Types of Network Effects in Platform Markets 1. Indirect Network Effects: Platforms become more valuable as they offer more connections on the opposite side. ○ Example: Airbnb is attractive to renters if many properties are available and vice versa for property owners. 2. Single-Sided Platforms: Platforms like Facebook, where one type of user interacts with each other without needing a distinct opposite side. 3. Multi-Sided Platforms: Platforms that cater to multiple types of agents, such as Uber (drivers, riders, and restaurants) or newspapers (readers, advertisers, and journalists). The Complexity of Network Effects Positive Network Effects: More users typically make the platform more valuable, such as in a marketplace where more sellers attract more buyers. Negative Network Effects: Sometimes, an increase in users can reduce platform value, such as a dating site attracting non-serious users, which lowers its appeal for users seeking long-term relationships.  Balancing User Quality and Quantity: Platforms need strategies to maintain quality interactions without compromising the benefits of a large user base. Dating Platforms: A Case Study in Network Effects and Platform Strategy 1. Offline Dating and Social Locations: Traditionally, people meet partners in social settings like schools, workplaces, and bars, each offering different balances of compatibility and interest signals. ○ Social Settings: High in compatibility due to shared interests but low in explicit interest for relationships. ○ Bars and Events: Better at signaling interest in a relationship but offer limited compatibility information. 2. Early Online Dating Platforms: First online dating sites appeared to bridge gaps in interest and compatibility. They were convenient, cheaper, and allowed access to a larger pool of potential partners. 3. eHarmony’s Unique Model: Entering later, eHarmony aimed at a niche market focused on long-term relationships. ○ Matchmaking Process: Intensive initial questionnaire (2 hours) to assess compatibility, followed by a scientific matching algorithm. ○ High Barriers: By being exclusive and costly, eHarmony filtered out users less interested in serious relationships, catering to a highly specific audience. Analyzing eHarmony’s Niche Strategy Pros: eHarmony provides strong compatibility information, attracting users serious about long-term relationships and creating high-quality matches. Cons: eHarmony’s strategy limits its network size, which may weaken network effects over time, especially if competing platforms can offer more connections. Balance of Network Effects: Although network effects are essential in dating, eHarmony’s model shows that niche strategies can still thrive by filtering for “positive” network effects (serious users). Competitive Dynamics and Threats 1. Match.com and Chemistry: Match.com, with a broader approach, launched Chemistry, a platform somewhat similar to eHarmony but less exclusive. ○ Positioning of Chemistry: Chemistry targets users looking for meaningful connections but without eHarmony’s intense filtering, potentially drawing users looking for a middle ground. ○ eHarmony’s Defensive Position: If Chemistry grows in network size, it may challenge eHarmony by appealing to users who want quality matches without eHarmony’s high commitment threshold. 2. eHarmony’s Response Options: ○ Staying True to Niche: eHarmony could focus on its unique value by further refining compatibility. ○ Expanding User Base: Small adjustments, like reducing the questionnaire, could attract more users without sacrificing its core values. 3. Trade-Offs: Moving towards a more open model risks diluting eHarmony’s niche appeal, while becoming too exclusive could limit growth and network effects, especially in smaller markets. Conclusion: Strategic Choices in Platform Markets Generalist vs. Niche: Platforms can thrive with either a generalist approach (large user base, broader network effects) or a niche strategy (high-quality interactions). Applications Beyond Dating: This model applies to various industries: ○ Payments: PayPal’s open model versus credit card companies’ stricter approval processes. ○ Social Media: Platforms like Facebook vs. niche social networks tailored to specific communities. Key Takeaway: Success in platform markets depends on understanding and balancing network effects with the platform’s unique value proposition. Platforms can operate effectively with distinct strategies by focusing on either broad user access or filtering for high-quality interactions PepsiCo Case and Strategic Corporate DiversificationCourse Structure Overview Remaining Schedule: ○ Today: PepsiCo Case ○ Monday: Disney Case ○ Tuesday: Group Simulation 12-3 PM, groups of 8. Deliverable: A two-page report analyzing your best and worst decisions during the simulation. Due one week after the exam. ○ Thursday: Exam Example exam and instructions for the simulation will be uploaded tomorrow. Course Objectives Recap 1. Understand the Sources of Profit: ○ Industry characteristics: Porter’s Five Forces Example: Beer Case – Coors analyzed industry profitability based on supplier power, buyer power, substitutes, and rivalry. ○ Firm characteristics: Competitive Advantage Example: Coors Case – Competitive advantage tied to taste and brand rather than cost, highlighting differentiation strategy. 2. Enable Firms to Capture Profit: ○ Strategic positioning based on competitive advantage. Example: Beer Case (Coors) – Strategic decisions regarding expansion based on brand-driven differentiation. ○ Competitive dynamics: Sequential logic for market entry. Examples: Haus Beckert Case – Sequential game logic for West Coast expansion analyzed competitive reactions. Corn Products International Case – Decisions to enter new markets based on potential reactions by incumbents. ○ Innovation and platform-based markets: Understanding network effects and standard wars. Examples: Nintendo Case – Success tied to market creation, standardization, and innovation control. Sony/Philips CD Standard Case – Illustrated how network effects influence standardization. 3. Expand Strategy to Corporations: ○ Move from business-level to corporate-level strategy. ○ Analyze diversification and vertical integration: Horizontal: Expanding into unrelated industries. Vertical: Forward/backward integration within the same industry. PepsiCo Case: Diversification Strategy Analysis Central Question: Should PepsiCo keep its three divisions (drinks, snacks, restaurants) together, or would they generate more value as separate entities? Corporate Strategy Framework (Collis & Montgomery’s Triangle) 1. Business Units: What industries/divisions are active? ○ PepsiCo: Drinks, Snacks, and Restaurants. 2. Resources: What synergies can be shared across divisions? ○ Tangible: Distribution channels, production facilities. ○ Intangible: Brand reputation, marketing expertise. 3. Structure: How is the corporation organized to exploit synergies? ○ Decentralized: Divisions operate independently with minimal headquarters control. ○ Challenges: Lack of coordination mechanisms limits potential synergies. Key Test: Does A + B together create more value than A and B apart? Value = Benefits of synergies − Costs of added structure. Case Examples for the Framework 1. Business Units: ○ PepsiCo’s industries: Drinks, Snacks, and Restaurants. ○ Analogous Example: Disney with its content creation (movies, TV) and distribution (theme parks, streaming). 2. Resources: ○ Shared synergies: PepsiCo: Distribution channels between drinks and snacks. Nintendo Case: Leveraging complementary products to create a network effect in gaming. ○ Questions of limited synergies: PepsiCo: Doubts about synergies between restaurants and other divisions. Sony vs. VHS Case: Failures to generate sufficient network effects despite technology superiority. 3. Structure: ○ PepsiCo’s decentralized structure minimized headquarters' role: Thin structure (700 employees at HQ) but lacked coordination mechanisms. ○ Contrasts: Nintendo: Strong centralization for product control and standardization. Yum! Brands (Pepsi Divestiture): Post-divestiture improved structure allowed focus on restaurants. PepsiCo’s Case Findings Structure: ○ Extremely thin headquarters (700 employees). ○ Divisions operate independently with minimal coordination. ○ Lack of a centralized mechanism to enforce or enable synergies. Resources & Synergies: ○ Drinks and snacks: Shared distribution channels. Shared marketing campaigns. ○ Restaurants and the rest: Questionable synergy. Vertical integration into restaurants primarily justified by: Guaranteed access for Pepsi products. Blocking competitor entry.  Control over customer experience. Issues: No mandatory policies (e.g., restaurants not forced to sell Pepsi exclusively). Why limit to restaurants and not other channels like vending machines or retailers? Quantitative Analysis: ○ Hypothetical benchmarks (1993 data): Compared PepsiCo's market valuation to standalone companies in drinks, snacks, and restaurants. Result: PepsiCo’s value was 9.4% lower as a combined entity versus separated divisions. Alternate methodology (market-to-sales): 24% lower value when integrated. Suggests potential destruction of shareholder value. Critical Insights 1. Coordination Issues: ○ Without adequate structure to enforce synergies, even potential benefits cannot be realized. ○ Example: Divisions failed to agree on simple cost-saving measures like a unified toilet paper supplier. 2. Questionable Synergies: ○ Cash Flow: Not a unique synergy; accessible through external markets if efficient. ○ Shared Functions (e.g., legal, HR): Generic resources do not justify diversification. ○ Human Resources: Expertise can often be hired externally without diversification. 3. Skepticism Towards Vertical Integration: ○ Why only restaurants? If vertical integration is beneficial, why not other channels like universities or retailers? ○ Coca-Cola, the industry leader, does not integrate into restaurants—why? 4. Market Reaction: ○ After divesting its restaurant division in 1987 (Yum! Brands), PepsiCo’s valuation improved, suggesting that separating restaurants added shareholder value. Takeaways for Diversification and Vertical Integration Key Questions: ○ Are the synergies real and significant? ○ Is the structure sufficient to capture those synergies? ○ Do the benefits outweigh the costs? Lessons: ○ Superficial synergies (e.g., shared resources) often fail under scrutiny. ○ Strong market evidence shows divestitures often improve valuation. ○ Coordination is critical—thin structures save costs but may fail to exploit synergies. Next Steps: ○ Monday: Apply similar analysis to Disney’s diversification strategy. Reflection for PepsiCo Drinks and snacks seem to have clear synergies. Restaurants raise doubts due to weak evidence of synergies and poor structural coordination.  By 1997, post-divestiture, PepsiCo’s improved valuation supports the hypothesis that keeping restaurants was not value-accretive. Key Thought: Always challenge synergies and ensure structure matches strategy.