Economics of Strategy (7^th Ed.)

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Economics of Strategy, Binder Ready Version focuses on the key economic concepts students must master in order to develop a sound business strategy. Ideal for undergraduate managerial economics and business strategy courses, Economics of Strategy offers a careful yet accessible translation of advanced economic concepts to practical problems facing business managers. Armed with general principles, today's students--tomorrows future managers--will be prepared to adjust their firms business strategies to the demands of the ever-changing environment. 

Introduction: Strategy and Economics 1

Why Study Strategy? 1

Why Economics? 2

The Need for Principles 2

So What’s the Problem? 3

A Framework for Strategy 5

Boundaries of the Firm 6

Market and Competitive Analysis 6

Positioning and Dynamics 6

Internal Organization 6

The Book 7

Endnotes 7

Economics Primer: Basic Principles 8

Costs 9

Cost Functions 9

Total Cost Functions 9

Fixed and Variable Costs 11

Average and Marginal Cost Functions 11

The Importance of the Time Period: Long-Run versus Short-Run Cost Functions 14

Sunk versus Avoidable Costs 16

Economic Costs and Profitability 17

Economic versus Accounting Costs 17

Economic Profit versus Accounting Profit 18

Demand and Revenues 18

Demand Curve 18

The Price Elasticity of Demand 19

Brand-Level versus Industry-Level Elasticities 22

Total Revenue and Marginal Revenue Functions 22

Theory of the Firm: Pricing and Output Decisions 23

Perfect Competition 25

Game Theory 29

Games in Matrix Form and the Concept of Nash Equilibrium 30

Game Trees and Subgame Perfection 31

Chapter Summary 33

Questions 33

Endnotes 34

Part One Firm Boundaries 35

1 The Power of Principles: An Historical Perspective 37

Doing Business in 1840 37

Business Conditions in 1840: Life without a Modern Infrastructure 39

Transportation 39

Communications 40

Finance 41

Production Technology 42

Government 42

Doing Business in 1910 44

Business Conditions in 1910: A “Modern” Infrastructure 45

Production Technology 45

Transportation 45

Communications 46

Finance 46

Government 46

Doing Business Today 48

Modern Infrastructure 49

Transportation 49

Communications 49

Finance 50

Production Technology 50

Government 50

Infrastructure in Emerging Markets 51

Three Different Worlds: Consistent Principles, Changing Conditions, and Adaptive Strategies 52

Chapter Summary 52

Questions 53

Endnotes 54

2 The Horizontal Boundaries of The Firm 55

Definitions 55

Definition of Economies of Scale 55

Definition of Economies of Scope 57

Scale Economies, Indivisibilities, and the Spreading of Fixed Costs 57

Economies of Scale Due to Spreading of Product-Specific Fixed Costs 58

Economies of Scale Due to Trade-offs among Alternative Technologies 58

Indivisibilities Are More Likely When Production is Capital Intensive 60

 “The Division of Labor is Limited by the Extent of the Market” 62

Special Sources of Economies of Scale and Scope 64

Density 64

Purchasing 65

Advertising 65

Costs of Sending Messages per Potential Consumer 65

Advertising Reach and Umbrella Branding 66

Research and Development 66

Physical Properties of Production 67

Inventories 67

Complementarities and Strategic Fit 68

Sources of Diseconomies of Scale 68

Labor Costs and Firm Size 69

Spreading Specialized Resources Too Thin 69

Bureaucracy 69

Economies of Scale: A Summary 70

The Learning Curve 70

The Concept of the Learning Curve 70

Expanding Output to Obtain a Cost Advantage 71

Learning and Organization 73

The Learning Curve versus Economies of Scale 74

Diversification 75

Why Do Firms Diversify? 76

Efficiency-Based Reasons for Diversification 76

Scope Economies 76

Internal Capital Markets 77

Problematic Justifications for Diversification 78

Diversifying Shareholders’ Portfolios 78

Identifying Undervalued Firms 78

Reasons Not to Diversify 79

Managerial Reasons for Diversification 79

Benefits to Managers from Acquisitions 79

Problems of Corporate Governance 80

The Market for Corporate Control and Recent Changes in Corporate Governance 81

Performance of Diversified Firms 83

Chapter Summary 85

Questions 86

Endnotes 88

3 The Vertical Boundaries of The Firm 90

Make versus Buy 90

Upstream, Downstream 92

Defining Boundaries 94

Some Make-or-Buy Fallacies 94

Avoiding Peak Prices 95

Tying Up Channels: Vertical Foreclosure 96

Reasons to “Buy” 98

Exploiting Scale and Learning Economies 98

Bureaucracy Effects: Avoiding Agency and Influence Costs 101

Agency Costs 101

Influence Costs 102

Organizational Design 104

Reasons to “Make” 104

The Economic Foundations of Contracts 104

Complete versus Incomplete Contracting 105

Bounded Rationality 105

Difficulties Specifying or Measuring Performance 106

Asymmetric Information 106

The Role of Contract Law 106

Coordination of Production Flows through the Vertical Chain 107

Leakage of Private Information 109

Transaction Costs 110

Relationship-Specific Assets 111

Forms of Asset Specificity 111

The Fundamental Transformation 112

Rents and Quasi-Rents 112

The Holdup Problem 113

Holdup and Ex Post Cooperation 115

The Holdup Problem and Transaction Costs 115

Contract Negotiation and Renegotiation 115

Investments to Improve Ex Post Bargaining Positions 116

Distrust 116

Reduced Investment 117

Recap: From Relationship-Specific Assets to Transaction Costs 117

Summarizing Make-or-Buy Decisions: The Make-or-Buy Decision Tree 118

Chapter Summary 119

Questions 119

Endnotes 122

4 Integration and Its Alternatives 124

What Does It Mean to Be “Integrated”? 124

The Property Rights Theory of the Firm 124

Alternative Forms of Organizing Transactions 125

Governance 127

Delegation 128

Recapping PRT 128

Path Dependence 129

Making the Integration Decision 129

Technical Efficiency versus Agency Efficiency 130

The Technical Efficiency/Agency Efficiency Trade-off 130

Real-World Evidence 134

Double Marginalization: A Final Integration Consideration 136

Alternatives to Vertical Integration 138

Tapered Integration: Make and Buy 138

Franchising 138

Strategic Alliances and Joint Ventures 140

Implicit Contracts and Long-Term Relationships 143

Business Groups 145

Keiretsu 145

Chaebol 147

Business Groups in Emerging Markets 148

Chapter Summary 149

Questions 150

Endnotes 151

Part Two Market and Competitive Analysis 153

5 Competitors and Competition 155

Competitor Identification and Market Definition 156

The Basics of Market Definition and Competitor Identification 156

Putting Competitor Identification into Practice 157

Empirical Approaches to Competitor Identification 158

Geographic Competitor Identification 160

Measuring Market Structure 162

Market Structure and Competition 163

Perfect Competition 163

Many Sellers 164

Homogeneous Products 164

Excess Capacity 165

Monopoly 166

Monopolistic Competition 168

Demand for Differentiated Goods 168

Entry into Monopolistically Competitive Markets 169

Oligopoly 170

Cournot Quantity Competition 171

The Revenue Destruction Effect 174

Cournot’s Model in Practice 175

Bertrand Price Competition 175

Why Are Cournot and Bertrand Different? 177

Bertrand Price Competition When Products Are Horizontally Differentiated 179

Evidence on Market Structure and Performance 181

Price and Concentration 181

Chapter Summary 182

Questions 182

Endnotes 184

6 Entry and Exit 186

Some Facts about Entry and Exit 187

Entry and Exit Decisions: Basic Concepts 188

Barriers to Entry 188

Bain’s Typology of Entry Conditions 189

Analyzing Entry Conditions: The Asymmetry Requirement 189

Structural Entry Barriers 191

Control of Essential Resources 191

Economies of Scale and Scope 192

Marketing Advantages of Incumbency 194

Barriers to Exit 195

Entry-Deterring Strategies 196

Limit Pricing 196

Is Strategic Limit Pricing Rational? 198

Predatory Pricing 200

The Chain-Store Paradox 200

Rescuing Limit Pricing and Predation: The Importance of Uncertainty and Reputation 202

Wars of Attrition 203

Predation and Capacity Expansion 204

Strategic Bundling 205

“Judo Economics” 206

Evidence on Entry-Deterring Behavior 207

Contestable Markets 208

An Entry Deterrence Checklist 208

Entering a New Market 208

Preemptive Entry and Rent-Seeking Behavior 210

Chapter Summary 211

Questions 212

Endnotes 213

7 Dynamics: Competing Across Time 214

Microdynamics 215

The Strategic Benefits of Commitment 215

Strategic Substitutes and Strategic Complements 216

The Strategic Effect of Commitments 217

Tough and Soft Commitments 219

A Taxonomy of Commitment Strategies 219

The Informational Benefits of Flexibility 220

Real Options 222

A Framework for Analyzing Commitments 223

Competitive Discipline 224

Dynamic Pricing Rivalry and Tit-for-Tat Pricing 225

Why is Tit-for-Tat So Compelling? 227

Coordinating on the Right Price 227

Impediments to Coordination 229

The Misread Problem 229

Lumpiness of Orders 230

Information about the Sales Transaction 231

Volatility of Demand Conditions 231

Asymmetries among Firms and the Sustainability of Cooperative Prices 232

Price Sensitivity of Buyers and the Sustainability of Cooperative Pricing 233

Market Structure and the Sustainability of Cooperative Pricing: Summary 233

Facilitating Practices 234

Price Leadership 234

Advance Announcement of Price Changes 234

Most Favored Customer Clauses 234

Uniform Delivered Prices 236

Where Does Market Structure Come From? 237

Sutton’s Endogenous Sunk Costs 238

Innovation and Market Evolution 240

Learning and Industry Dynamics 241

Chapter Summary 241

Questions 242

Endnotes 244

8 Industry Analysis 247

Performing a Five-Forces Analysis 248

Internal Rivalry 249

Entry 250

Substitutes and Complements 251

Supplier Power and Buyer Power 251

Strategies for Coping with the Five Forces 252

Coopetition and the Value Net 253

Applying the Five Forces: Some Industry Analyses 255

Chicago Hospital Markets Then and Now 255

Market Definition 255

Internal Rivalry 255

Entry 256

Substitutes and Complements 257

Supplier Power 257

Buyer Power 258

Commercial Airframe Manufacturing 259

Market Definition 259

Internal Rivalry 259

Barriers to Entry 260

Substitutes and Complements 261

Supplier Power 261

Buyer Power 262

Professional Sports 262

Market Definition 262

Internal Rivalry 262

Entry 264

Substitutes and Complements 266

Supplier Power 267

Buyer Power 267

Conclusion 267

Professional Search Firms 268

Market Definition 268

Internal Rivalry 268

Entry 269

Substitutes and Complements 269

Supplier Power 270

Buyer Power 270

Conclusion 270

Chapter Summary 271

Questions 271

Endnotes 275

Part Three Strategic Position and Dynamics 277

9 Strategic Positioning For Competitive Advantage 279

Competitive Advantage and Value Creation: Conceptual Foundations 280

Competitive Advantage Defined 280

Maximum Willingness-to-Pay and Consumer Surplus 281

From Maximum Willingness-to-Pay to Consumer Surplus 282

Value-Created 284

Value Creation and “Win–Win” Business Opportunities 287

Value Creation and Competitive Advantage 288

Analyzing Value Creation 288

Value Creation and the Value Chain 292

Value Creation, Resources, and Capabilities 292

Strategic Positioning: Cost Advantage and Benefit Advantage 296

Generic Strategies 296

The Strategic Logic of Cost Leadership 296

The Strategic Logic of Benefit Leadership 298

Extracting Profits from Cost and Benefit Advantage 301

Comparing Cost and Benefit Advantages 302

“Stuck in the Middle” 304

Diagnosing Cost and Benefit Drivers 306

Cost Drivers 306

Cost Drivers Related to Firm Size, Scope, and Cumulative Experience 307

Cost Drivers Independent of Firm Size, Scope, or Cumulative Experience 307

Cost Drivers Related to Organization of the Transactions 308

Benefit Drivers 308

Methods for Estimating and Characterizing Costs and Perceived Benefits 309

Estimating Costs 309

Estimating Benefits 310

Strategic Positioning: Broad Coverage versus Focus Strategies 310

Segmenting an Industry 310

Broad Coverage Strategies 311

Focus Strategies 312

Chapter Summary 314

Questions 315

Endnotes 318

10 Information and Value Creation 320

The “Shopping Problem” 321

Unraveling 322

Alternatives to Disclosure 323

Nonprofit Firms 327

Report Cards 327

Multitasking: Teaching to the Test 328

What to Measure 331

Risk Adjustment 335

Presenting Report Card Results 336

Gaming Report Cards 337

The Certifier Market 339

Certification Bias 340

Matchmaking 342

When Sellers Search for Buyers 343

Chapter Summary 345

Questions 346

Endnotes 347

11 Sustaining Competitive Advantage 349

Market Structure and Threats to Sustainability 349

Threats to Sustainability in Competitive and Monopolistically Competitive Markets 350

Threats to Sustainability under All Market Structures 351

Evidence: The Persistence of Profitability 351

The Resource-Based Theory of the Firm 353

Imperfect Mobility and Cospecialization 353

Isolating Mechanisms 355

Impediments to Imitation 358

Legal Restrictions 358

Superior Access to Inputs or Customers 359

The Winner’s Curse 361

Market Size and Scale Economies 361

Intangible Barriers to Imitation 362

Causal Ambiguity 363

Dependence on Historical Circumstances 363

Social Complexity 363

Early-Mover Advantages 364

Learning Curve 364

Reputation and Buyer Uncertainty 364

Buyer Switching Costs 364

Network Effects 365

Networks and Standards 365

Competing “For the Market” versus “In the Market” 366

Knocking Off a Dominant Standard 367

Early-Mover Disadvantages 367

Imperfect Imitability and Industry Equilibrium 368

Creating Advantage and Creative Destruction 370

Disruptive Technologies 370

The Productivity Effect 371

The Sunk Cost Effect 371

The Replacement Effect 372

The Efficiency Effect 372

Disruption versus the Resource-Based Theory of the Firm 373

Innovation and the Market for Ideas 373

Evolutionary Economics and Dynamic Capabilities 375

The Environment 376

Factor Conditions 376

Demand Conditions 376

Related Supplier or Support Industries 376

Strategy, Structure, and Rivalry 378

Chapter Summary 378

Questions 379

Endnotes 381

Part Four Internal Organization 383

12 Performance Measurement and Incentives 385

The Principal–Agent Relationship 386

Combating Agency Problems 386

Performance-Based Incentives 388

Problems with Performance-Based Incentives 393

Preferences over Risky Outcomes 393

Risk Sharing 394

Risk and Incentives 396

Performance Measures That Fail to Reflect All Desired Actions 399

Selecting Performance Measures: Managing Trade-offs between Costs 401

Do Pay-for-Performance Incentives Work? 404

Implicit Incentive Contracts 405

Subjective Performance Evaluation 405

Promotion Tournaments 406

Efficiency Wages and the Threat of Termination 409

Incentives in Teams 410

Chapter Summary 413

Questions 414

Endnotes 416

13 Strategy and Structure 419

An Introduction to Structure 421

Individuals, Teams, and Hierarchies 421

Complex Hierarchy 424

Departmentalization 424

Coordination and Control 426

Approaches to Coordination 428

Types of Organizational Structures 431

Functional Structure (U-form) 431

Multidivisional Structure (M-form) 433

Matrix Structure 434

Matrix or Division? A Model of Optimal Structure 435

Network Structure 436

Why Are There So Few Structural Types? 438

Strategy-Environment Coherence 439

Technology and Task Interdependence 440

Information Processing 442

Structure Follows Strategy 443

Strategy, Structure, and the Multinational Firm 445

Hybrid Organizations 449

Chapter Summary 451

Questions 452

Endnotes 453

14 Environment, Power, and Culture 456

The Social Context of Firm Behavior 456

Internal Context 458

Power 459

The Sources of Power 460

Structural Views of Power 463

Do Successful Organizations Need Powerful Managers? 464

The Decision to Allocate Formal Power to Individuals 466

Culture 468

Culture Complements Formal Controls 470

Culture Facilitates Cooperation and Reduces Bargaining Costs 471

Culture, Inertia, and Performance 472

A Word of Caution about Culture 473

External Context, Institutions, and Strategies 474

Institutions and Regulation 477

Interfirm Resource Dependence Relationships 478

Industry Logics: Beliefs, Values, and Behavioral Norms 481

Chapter Summary 483

Questions 484

Endnotes 485

Glossary 488

Name Index •••

Subject Index •••

David Dranove is the Walter McNerney Distinguished Professor of Health Industry Management at Northwestern University's Kellogg School of Management, where he is also Professor of Strategy. He was previously Director of the Health Enterprise Management program. He has a PhD in Economics from Stanford University.
Professor Dranove's research focuses on problems in industrial organization and business strategy with an emphasis on the health care industry. He has published nearly 100 research articles and book chapters and written five books, including The Economic Evolution of American Healthcare and Code Red. His textbook, The Economics of Strategy, is used by leading business schools around the world. Professor Dranove regularly consults with leading healthcare organizations in the public and private sector and has served on the Executive Committee and Board of Directors of the Health Care Cost Institute. He has also served as an economics expert in several high profile healthcare antitrust cases.