THE CONCEPT OF STRATEGY

Strategy: a unifying theme that gives coherence and direction to the actions and decisions of an
organization. Consists in the analysis of both the external and the internal environment of the firm.

For firms to play an influential role, their strategies have to be built on these 4 elements:
1. Goal focused.
2. Know their competitive environment.
3. Know their strengths and weaknesses.
4. Implement strategy with commitment consistency and determination.

Basic Framework of Strategy Analysis: strategy as a link between the firm and the industry
environment.
• Task of strategy is to determine how the firm will deploy its resources within its
environment to satisfy long-term goals.
• Strategic Fit: the consistency of a firm’s strategy in both the external and the internal
environment (aligned goals, values, resources, and capabilities).
• Internal Fit: when strategies and individual decisions are aligned with one another to create
a consistent strategic direction of development.
o Key is how internal activities fit together tom form a consistent, mutually reinforcing
system.

Strategy Today: as business environment has become more unstable and unpredictable, strategy
became less concerned with detailed plans and more about guidelines for success (shift from
strategy as a plan to strategy as a direction).
• Strategy as Decision Support: a pattern or theme that gives coherence to decisions.
• Strategy as Coordinating Device: a device to promote coordination in terms of the identity,
goals, and positioning of the company for all members.
• Strategy as a Target: the pursuit of long-term goals sets aspirations that can motivate and
inspire members.
o Strategic Intent: misfit between resources and ambitions, challenges the
organization to close the gap).
Corporate Strategy: the scope of the firm in terms of the industries and markets in which it
competes (diversification, integration, acquisitions, ventures, allocation of resources).
• Where to compete (choose to locate in industries where overall rates of return are attractive).
• Responsibility of top management.

Business Strategy: how the firm competes within a particular industry or market (competitive
advantage over rivals).
• How to compete (attain a position of advantage over competitors).
• Responsibility of the senior managers of divisions and subsidiaries.

The two are intertwined → the scope of a firm’s business has implications for the source of
competitive advantage, and the nature of a firm’s competitive advantage determines the industries
and markets it can be successful in.

The Strategy Process (Mintzberg):

• Intended Strategy: strategy as conceived by the top management (outcome of negotiation,
bargaining and compromise among the individuals and groups involved)
• Realized Strategy: the actual strategy implemented, only partly related to the intended one.
• Emergent Strategy: the decision that emerges from the complex process in which
individual managers interpret the intended strategy and adapt to changing circumstances.
o Should be emergent and permit adaptation and learning through continuous
interaction between strategy formulation and strategy implementation.
• Planned Emergence: combines design (organizational processes for deliberation,
discussion, and decision of strategy) and emergence (strategy enacted through decisions
made by organization members).
 INDUSTRY ANALYSIS – THE FUNDAMENTALS

Industry Analysis: identifying the sources of profit in the external environment.

• Corporate Strategy: relevant in deciding which industries the firm should be engaged in
and how it should allocate its resources among them.
• Business Strategy: relevant in establishing competitive advantage by analyzing competitors
and consumer needs and preferences (general sources of competitive advantage in an
industry).

Business Environment: all the external influences that impact its decision and its performance.
Industry Environment: the relationship with customers, competitors and suppliers.

Profits earned by the firms in an industry are determined by 3 factors:

1. The value of the product for customers.
2. The intensity of competition.
3. The bargaining power of industry members relatively to suppliers and buyers.

The level of industry profitability is neither random nor a result of entirely industry specific
influences: it is determined by the systematic influences of the industry structure.
• Wide variation in average profitability across different industries.
• Wide variation in firm profitability within the same industry.

Perfect Competition Oligopoly Duopoly Monopoly

Concentration /Rivalry Many firms Few firms Two firms One firm
Entry & Exit Barriers No barriers Significant barriers High barriers
Product differentiation Homogeneous products Potential differentiation
Information Perfect Imperfect

What Industry Analysis Tells Us:

• Assess the current status of the industry (Industry Structure): main players, power
distribution.
• Overall industry attractiveness: for incumbents (existing firms) or new entrants.
• How competitors might react
Porter’s Five Forces of Competition Framework: profitability of an industry (rate of return
relative to its cost of capital) determined by 5 sources of competitive pressure.
1. Competition from substitutes.
2. Competition from entrants.
3. Competition from established rivals.
4. Power of suppliers.
5. Power of buyers.
Industry Rivalry: refers to the number of firms competing. The intensity of the competition is the
result of interactions between six factors.

1. Seller concentration: the number and size distribution of firms competing within the
market.
a. Positive correlation between concentration and profits.

2. Diversity of competitors: ability to avoid price competition in favor of collusive pricing

depends on similarities in origin, objective, cost, strategy.

3. Product differentiation: differentiation reduces direct competition and increases switching

costs for buyers. The more differentiated products are, the more competition tends to focus
on quality, promotion, and customer service rather than price.
a. Low differentiation → high rivalry.

4. Excess capacity and exit barriers:

a. Unused capacity: demand for company’s goods and services is less than its
productive capacity (price cuts may become cyclical or part of a structural problem
of overinvestment or declining demand).
b. Barriers to exit: costs associated with leaving an industry.

5. Cost conditions: scale economies and ratio of fixed to variable costs.

a. Cost structures: determine how low prices can fall (high relative fixed costs mean
any business above variable cost is accepted)
b. Economies of scale: encourage competition on prices to gain cost benefits from
volume.

Measures of Competition:
• Concentration ratio: the combined market share of the leading producers.
• Herrfindhal Index (HHI): sum of squares of all market shares
o from 1/N to 1 → if above 0,25 the concentration is high
o Numbers equivalent → 1/HHI (no. of equal sized firms that would give
corresponding HHI)
o Gives more weight to larger firms.
 Threat of Entry: if an industry earns a return on capital in excess of its cost of capital, it will
attract entry from new firms and firms diversifying from other industries (profitability might fall to
competitive level). There are two Types of New Entrants:

New Entrant Innovativeness Assets and Resources Experience Probability of Survival

Large from other industry Low Plenty High High
Small, entrepreneurial High Scarce Low Low

Barriers to Entry: assets and capabilities firms must possess to enter a specific industry (any
disadvantage that new entrants face relative to established firms).
• Ex ante: what you need to do/have in order to enter.
o Exogenous (structural): governmental and legal restrictions, access to critical
resources and distribution channels, know how, raw materials, high capital
investment requirements.
o Endogenous (strategic): barriers created by incumbents such as high R&D,
economies of scale/learning, brand loyalty, absolute cost advantage, differentiation,
marketing…
• Ex post: incumbents’ behaviors in response to new entrants (retaliation, price war, capacity
increase…)

Competition from substitutes: products from a different industry that offers similar benefits. The
competitive pressure from substitute goods depends on:
1. Buyers’ propension to the substitute good.
Δ 𝐷𝑒𝑚𝑎𝑛𝑑 𝑜𝑓 𝑌
a. Y is a substitute of X if → >0
Δ 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑋

2. Price-performance characteristics of substitutes

Network effects drive up switching costs and reduce threat of substitutes:

• Customer loyalty: switching costs in cola industry with other beverages is low, but high
customer loyalty keeps the threat of substitution low.
• Industries with high switching costs: computers, video games, mobile phone contracts.
Bargaining Power of Buyers and Suppliers

Input market: purchase raw materials, components, services, labor.

Output market: firms sell their goods and services to customers (distributors, consumers,
manufacturers).

The ability of buyers to drive down prices they pay depends on:

• Price sensitivity: the extent to which buyers are sensitive to the prices charged by the firms
in an industry depends on different factors.
o Importance of an item as a proportion of total cost.
o The less differentiation of supplying industry products, the more willing to switch
based on price: more differentiation increases switching costs.
o The more intense the buyers’ competition, the more eager for price reduction from
sellers.
o The more critical an industry’s product to the quality of the buyer’s product or
service, the less sensitive are buyers to the prices they are charged.

• Bargaining power: rests on the refusal to deal with the other party, and the balance of
powers depends on the credibility and effectiveness of this threat. The real problem are the
relative costs incurred in the event of a hold-out by the counterparty.
o Size and concentration of buyers relatively to the suppliers.
o Volume of purchases.
o Buyers’ information.
o Ability of sellers to serve other industries.

Complements: a 6th Force

Companies or entities that sell goods or services that are compatible with, or complementary to, the
goods or services produced and sold by the incumbents.
• Complementary goods offer more value to the customer together than apar.
• Suppliers of complements create value for the industry and can exercise bargaining power.
Beyond the 5 Forces Framework: criticism has been moved against the 5 Forces Framework:
• Too simple: lack of theoretical rigor (only good starting point).
• Too static: doesn’t consider dynamics.
• Incomplete: no consideration of complementary products (we added it).
• Misplaced focus: overemphasis on importance of industry structure as determinant of profit
and underemphasis on significance of individual company differences (industry is too far
from actual dynamics of firm’s competitive interactions).
• Not representative for dynamic industries.

APPLYING INDUSTRY ANALYSIS TO FORECASTING INDUSTRY PROFITABILITY

Key elements of the industry’s structure: identifying the main players (producers, customers,
input suppliers, producers of substitute goods).

Assessing Industry Profitability: current profitability is a poor indicator of future profitability. If

we can anticipate changes in industry structure, we can predict changes in competition and
profitability.
• Industry profitability might be determined by the structure of the industry: observe structural
trends to forecast likely changes in competition and profitability (shifts in customer buying
behavior, technology, firm strategies).

Predicting future industry profitability:

1. Examine how the industry’s current and recent levels of competition and profitability are a
consequence of its present structure.
1. Identify the trends that are changing in the industry’s structure.
2. Identify how these structural changes will affect the five forces and resulting profitability.
 SEGMENTATION AND STRATEGIC GROUPS

Segmentation Analysis: characteristics of markets as the basis for disaggregating industries.

Strategic Group Analysis: segments an industry on the basis of the strategies of member firms.
The main usefulness of strategic group analysis is:
• Understanding strategic positioning.
• Recognizing patterns of competition.
• Identifying strategic niches.
It is less useful as a tool for analyzing interfirm profitability differences.

Strategic Group: the group of firms in an industry following the same or similar strategy along the
strategic dimension (niche). Examples are product range, geographical area, distribution channels,
degree of vertical integration, technology used…
• Identifies groups of companies that have adopted similar approaches in competing.
• Pros and cons of strategic groups:
o Upside:
▪ Identify most profitable niches to grow (Blue Ocean Strategy → unexplored
market areas).
▪ Easier to manage change.
▪ Less likely to invoke retaliation from rivals.
▪ Can benefit from a premium price,
o Downside:
▪ Not possible for all industries.
▪ Niches could vanish (can’t control what happens).

How to Identify Strategic Groups

• Are all firms within an industry comparable? Yes (commodity, no real benefit to niches)
• Are all segments within an industry growing at similar rates?
• Who are the firm’s main consumers?
• Do all consumers have similar WTP (willingness to pay)?
• Main suppliers? (Some heterogeneity, power, differences).
• Business model?
• Overall strategy: cost or differentiation based?
Strategic Group Map (Example: Retail Industry)
• Product Range: shows bags, clothes, belts.
• Input Costs: related to price.
• Companies likely not all competing directly: different business model and cost structure.
• Clusters show that they might be targeting similar consumers and competing more directly.
o High input costs but a more varied product range (Versace, Prada, Gucci), target
similar consumers and likely to compete directly.
o Not as pricey, various products, targeting the public (Zara, H&M, Mango, Bershka,
etc.): one cluster targeting similar consumers.
o Targeting very specific products and likely not competing with each other but a niche
in their own with low input costs (e.g. Levi’s’ Denim, Payless Shoes).
• Those with a more varied product range are more likely to be direct competitors, especially
those with a similar input cost and price range. If instead narrow product range will be more
niche-like and not have such direct competitors.
 COMPETITIVE ADVANTAGE

Competitive Advantage: when two or more firms compete within the same market, one firm
possesses a competitive advantage over its rivals when it earns (or has the potential to earn) a
persistently higher rate of profit.
• “when a firm is able to or has the potential to achieve above average profitability relative to
its industry in the medium to long term”
▪ May not be revealed in higher profitability (firm may forgo profit for
investments)
• Sustainability of competitive advantage is what really matters: it is likely that a company
will have high profits if it has been around for a long time, but it is still necessary to focus
on longevity.
• Creating competitive advantage is about making the gap between willingness to pay (WTP)
and cost bigger.
• Competitive advantage is always a relative statement (always compared to the average or a
particular competitor).

A firm can achieve a higher rate of profit in one of two ways:

• Cost advantage: supply an identical product or service (Goal to become cost leader in its
industry or industry segment by finding and exploiting all sources of cost advantage and
selling a standard, no frills product)
• Differentiation advantage: supply a product or service that is differentiated such that the
customer is willing to pay a price premium that exceeds the additional cost of differentiation
(achieved when it provides something unique that is valuable to buyers beyond a low price).

Value Creation: when a customer is willing to pay more for a product that its cost.
• Value Created = WTP – Cost

Value Capture: the share of the value created captured by the firm, which can be measured by a
profit margin.
• Value Captured = WTP – Price (for client)
• Value Captured = P – Cost (for business)
If we define Competitive Advantage as “the wider than average wedge between WTP and cost”, we
can identify different types of competitive advantage:
1. Differentiation Advantage: generate a higher-than-average WTP by incurring a higher-
than-average cost (wedge is greater than industry average)
2. Low-Cost Advantage: generate lower costs incurred but also lower WTP (wedge is greater
than industry average)
3. Dual Advantage: generate lower costs incurred and higher WTP (wedge is greater than
industry average)

Outside-in Value Creation: Competitive Advantage as a Fit.

• Sociological Perspective: competitive advantage is about a firm’s ability to fit with industry
conditions (adapting to protect and defend a CA).
o Firms gain competitive advantage by understanding and responding to
environmental pressures better than competitors.
• Changes in consumers’ preferences could drive changes in fit and differences in gain/loss of
competitive advantage: firms must adapt to keep with changing niche. In this context
Adaptation becomes crucial.
o Regenerate: investments in products (R&D, design, specifics) and consumer.
o Reconfigure: change the whole business model to match the market.

Inside-out Value Creation: Monopoly Protection.

• Economic Perspective: selling better products and/or a better price gives competitive
advantage.
o Innovation: firm’s ability to create better products.
o Goal: gain monopolistic power from improving efficiency.
• Defending by Protection: protect the firm from outside threats.
o Legal Protection: copyright, patents…
o Customer Loyalty: raise switching costs.
o Causal Ambiguity: hiding the source of advantage.
o Secrecy: trade secrets.
o Accounting skills: hiding financial sources of advantage.
 Implementing Strategies: a firm that is competing on low cost is distinguishable from a firm that
competes through differentiation in terms of market positioning, resources and capabilities, and
organizational characteristics.

Key Strategic Elements

Cost Leadership Differentiation Leadership
Scale efficient plants Branding
Maximizing Labor prodcutivity Advertising
Design for manufacture Design
Control of overheads Customer service
Process Innovation Quality
Outsourcing New product development
Avoid marginal customed accounts

Organizational requirements
Cost Leadership Differentiation Leadership
Access to capital Marketing abilities
Incentives linked to quantitative performance targets Product engineering skills
Product design coordinated with manufacture Cross-functional coordination
Tight cost controls Creativity
Process engineering skills Research capabilities
Benchmarking Incentives linked to qualitative performance targets
Measuring profit for customer
 COST ADVANTAGE

Cost Advantage: comes from finding and exploiting sources of cost reduction.
• Downside:
o Difficult to sustain if sources of advantage are visible and imitable by competitors.
o Risk of price war
• Upside:
o Low-cost focus on products, operations, employees…
o Keeping costs lower than competitors successfully captures a bigger market share.
o Low-cost model allows firms to provide the same service as competitors at lower
cost.
o Works well in a chronically unprofitable industry.

Lower prices allow the firm to capture a greater market share as a higher quantity of products is
sold with higher absolute profits (when target quantity is reached).

Price elasticity: measures how much the demand of a product changes when the price changes.
• High: price affects customers’ WTP. If p, D.
• Low: consumers are not sensitive to price change. If p, D is constant.

Price wars are a consequence of the industry competitiveness that brings firms to lower prices
more than competitors in order to defend the cost advantage (difficult to defend in the long term)

Sources of Cost Advantage:

1. Cost Drivers: principal determinants of a firm’s unit cost relative to competitors. They vary
across industries, within industries and across different firm activities.
2. Scale Economies: average cost per product decreases when quantity increases (quantity-
based advantage).
3. Scope economies: joint production of related goods may generate lower average costs
(variety-based advantage).
4. Learning Economies: over time, cost of production decreases (time-based advantage), go
down the learning curve.
5. Economies of Fixed Costs Absorption: the ability of a plant to use full capacity.
 6. Product Techniques/Organization: techniques that decrease cost of production.
7. Vertical Integration: reducing costs of coordinating between supplier, firm, and buyer.
8. Product Design: design of products that requires comparatively cheaper inputs or
manufacturing.
9. Input Costs: lower costs of inputs, including labor.
10. Capacity Utilization: short and medium terms plant capacity is relatively fixed and
variations in output cause capacity utilization to rise or fall.
a. Underutilization: raises unit costs as fixed cost are spread over fewer units of
production.
b. Output beyond normal: full capacity creates inefficiencies.

Economies of Scale: occur when proportionate increases in the number of inputs employed in a
production process results in lower units’ costs.
• Minimum Efficient Plant Size (MEPS): The point at which most scale economies are
exploited.
• Three main sources of Economies of Scale:
o Technical input-output relationship: output increases don’t require proportionate
increase in inputs.
o Indivisibility: many resources and activities are unavailable in smaller sizes
(“lumpy”) and offer economies of scale as firms spread costs of these items over
larger outputs.
o Specialization: increased scale allows greater specialization. Economies of
Specialization are especially important in knowledge intensive industries where large
firms are able to offer specialized expertise across a broad range of know-how.
• Key determinant of an industry’s level of concentration (proportion of industry output
accounted for by the largest firms).
Experience curve: formed by the sum of Economies of Scale and Economies of Learning, it is the
systematic reduction in the time taken to do something as your experience in doing it increases.

• Individual Level: through improvements in dexterity and problem solving.

• Group Level: through the development and refinement of organizational routines.

If a firm can expand its output faster than competitors, it can move down the experience curve more
rapidly and open up a widening cost differential.

• Describes the relationship between cost per unit and cumulative output.
• Weakness: fails to distinguish different sources of cost reduction (learning, scale, process
innovation) and assumes cost reduction from experience are automatic (have to be
managed).

Implications of the Experience curve on market share:

1. Works as an incentive to increase MS (the more output I can sell, the lower my costs, and by
holding price constant the higher my margins)
2. Pricing policy: from full-costing pricing to price by market-objective (price product in
terms of market- objective pricing e.g. with a certain amount of market penetration my
output will double, my costs will be 20% lower -> use price to increase quantity and reduce
costs)
3. Consistent relationship between market share and return on sales (ROS) = because holding
prices constant to increase market share (or even reducing them) will increase your margins.
a. Association doesn’t imply causation.
b. Pursuing market share can be useless if everyone else is doing that (achieve higher
market share by all results in overcapacity).
c. Pursuing market share can be dangerous if overcapacity makes the market dangerous
(results in competitive price cutting).
 DIFFERENTIATION ADVANTAGE

Differentiation: when a firm provides something unique that is valuable to buyers beyond simply
offering a lower price.

Differentiation Advantage: when a firm obtains from its differentiation a price premium that
exceeds the cost of providing that differentiation.
• Higher WTP (but also higher costs) than a reference offer.
• Uniqueness (real or perceived): appeals to a core group of consumers who most value the
product or service. Firms that successfully execute differentiation strategy:
o Understand core consumers.
o Know what these consumers value.
o Improve these core features of their product.
o Over time, add features to draw in more consumers/bigger core consumer groups
(increasing your product offering features and expanding the market you appeal to).
• Differentiation exists if a given offering faces higher costs to create a higher willingness to
pay.

Differentiation is not simply about offering different product features but about identifying and
understanding every possible interaction between the firm and its customers and asking how these
interactions can be enhanced or change to deliver additional value to the customer.
• Supply Side Analysis: identify the firm’s potential to create uniqueness (be aware of their
resources and capabilities through which it can create uniqueness).
• Demand Side Analysis: consider whether such differentiation creates value for customers
and whether it exceeds cost (key insight into customers and their needs and preferences).

Tangible Differentiation: concerned with the observable characteristics of a product or service that
are relevant to customers’ preferences and choice processes.

Intangible Differentiation: the value that customers perceive in a product is rarely determined
solely by observable product features or objective performance criteria; social, emotional,
psychological, and aesthetic considerations are present in most customer choices.
• Differentiation choices involve the overall image of the firm and its offering (image
differentiation - brand).
While differentiation is concerned with how a firm competes (it is a strategic choice made by a
firm), segmentation is concerned with where the firm competes (customer groups, localities,
product types).

Sustainability of differentiation: differentiation represents a more secure basis for competitive

advantage, while cost advantage is more vulnerable (low-cost countries and innovation represent a
serious threat). We can say that a differentiation advantage is more sustainable.
• Large companies that consistently earn above-average ROC tend to be those that have
pursued differentiation through quality, branding, and innovation.

Demand side driver

• Role of Social and Psychological factors: a deep understanding of consumers’ relationship
with a product.

Supply side drivers

• Drivers of uniqueness:
o Product features and performance.
o Complementary services.
o Marketing
o Technology.
o Quality of purchasing inputs.
o Customer experience.
o Skill and experience of employees.
o Location.
o Degree of vertical integration (firm’s ability to control inputs and intermediate
processes).

• Product Integrity: consistency of a firm’s differentiation, the extent to which a product

achieves total balance of numerous product characteristics.
o Internal Integrity: consistency between the function and structure of the product.
o External Integrity: how well a product’s function, structure, and semantics fit the
customer’s needs.
 • Signaling and Reputation: The more difficult it is to ascertain performance prior to
purchase, the more important signaling is.
o Search Goods: qualities and characteristics can be ascertained by inspection.
o Experience Goods: qualities and characteristics are only recognized after
consumption.

• Brands: a brand provides a guarantee of the quality of a product simply by identifying the
producer of a product, thereby ensuring the producer is accountable for the product supplied.
o Credible signal of quality because of the disincentive of its owner to devalue it. It
acts as a guarantee and reduces uncertainty and search costs.
o Increasingly, consumer good companies are seeking new approaches to brand
development that focus less on product characteristics and more on “brand
experience, “shared value”, and “emotional dialogue”.

COST ADVANTAGE VS DIFFERENTIATION ADVANTAGE

Conditions for differentiation:

1. Costs don’t force the manufacturer to mark up prices excessively.
2. The “Value premium” is perceived as being greater than the “price premium” by a target
segment.
3. The target segment is large enough for sales to generate profits, but sufficiently narrow to
prevent, at least in the short/medium run, competitor’s entry.
In-the-Middle-Positioning: you can be in the middle if you have superior technology that provides
you with a better cost structure while delivering higher quality at the same time (e.g.
semiconductors) BUT very hard to find (often in technologically advanced industries, but if more
traditional industry with basic technology not advantageous).
• Can provide more protection as hard to imitate (sustainable based on efficiency and value).
What happens if competitors try to squeeze you from both ends?
• To protect yourself from those differentiating could be by being unique but difficult and
increases cost, with pressure also from those on the cost-leadership with large market power
your offering looks comparatively less appealing.
 INDUSTRY DYNAMICS

Industry Dynamics: refers to the factors that change the rules of competition in an industry.
• External changes: changes in demand.
• Internal changes: changes within the firm and in knowledge.

The Industry Lifecycle.

Introduction
• Innovation, experimentation, trial, and error.
• Generally small start-up with R&D as core competency.
• Little known products (new).
• Users are early adopters.
• Example: drones.

Growth
• Product industry is established, and demand rises (consumers understand the product).
• Lots of new entry and exit (more potential to make money but not everyone will succeed).
• Introduce technical improvements and increase efficiency: firms start to standardize.
• Example: solar technology, smart watches.

Maturity
• Competition shifts to cost (away from innovation and development).
• Stiff competition (often price based) with higher entry barriers.
• When more exit than entry → saturation of the market.
• Investment in process innovation: demand stabilizes.
• Example: smartphones (established commodity product, pricing competition).

Decline: often triggered because another product in the industry has become popular.
• Declining demand – may be due to new substitute (different skills, asset, business model).
• High exit – only big (consolidated) players remain, not a very profitable industry.
• Product and process innovation.
• Example: movie rental, iPod.
Reasons for which we see trends:

1. Changes in demand for the product: well-described by the S-curve model.

a. Introduction Stage: sales are small, rate of market penetration is low as the
industry’s products are little known and customers few (high costs and low quality
due to novelty of technology, small scale of production, and lack of experience).
b. Growth Stage: accelerating, technical improvements and efficiency open up the
mass market.
c. Maturity Stage: increasing market saturation, once saturation is reached, demand is
wholly for replacement, focus on cost competition.
d. Decline Stage: as the industry becomes challenged by new industries that produce
technologically superior substitute products.

2. Changes in firm knowledge.

a. Introduction Stage: product technology advances rapidly, no dominant product
technology and competition for attention, competition among alternative
technologies and design configurations.
b. Dominant Design and Technical Standards: competition results in a dominant
design, a product architecture that defines the look, functionality, and production
method for the product and becomes accepted by the industry.
i. Dominant Design: the overall configuration of a product or system.
ii. Technical Standard: a technology or specification that is important for
compatibility.
They both emerge where there are network effects: the need for users to connect
with one another (choose the same technology to avoid being stranded).
c. From Product to Process Innovation (Industry growth phase): once an industry
coalesces around a leading product design, there is a shift from radical to incremental
product innovation.
i. Greater standardization reduces risk to customers and encourages firms to
invest in production capacity → shift in emphasis from design to
manufacture which triggers process innovation (reduce costs and increase
product reliability through large-scale production methods).
 d. Knowledge diffusion = customers become increasingly informed and knowledgably
about performance attributes of rivals and better able to judge value for money (more
price sensitive).
e. As more concentration, leading firms focus on mass market and new firms create
niches.

Dynamics and Strategy: firms need to recognize these changes in demand and knowledge, identify
whether they are externally or internally driven and adapt accordingly.

Organizational Inertia

Different theories of organizational and industrial change emphasize different barriers to change.
• Organizational Routines: patterns of coordinated integration among organizational
members that develop through continual reputation. If well-established is very difficult to
establish new ones.
• Social and Political Structure:
o Social: develop patterns of interaction that make change stressful and disruptive.
o Political: change represent threats to those in positions of authority (stable
distribution of power).
• Conformity: propensity of firms to imitate each other to gain legitimacy.
• Limited Search: search as the “primer driver” of organizational change, and organizations
limit search to areas close to existing activities (prefer exploitation of existing knowledge to
exploration of new opportunities).

Organizational Inertia: the tendency of organizations to continue on their current trajectories, the
inability to change (its course) effectively.

1. Myopic Inertia: firms do not anticipate change; it is difficult for firms to look into the
future (unexpected crisis or innovation by competitor).
a. Consequence: inability to see the future (e.g. Blackberry couldn’t see that phones
would be personal devices, not security objects used for jobs, saw the change too
late).
 2. Procedural Inertia: even if firms can anticipate change, they cannot easily implement
change (changing routines is hard) – change routine, create consensus, acquire new
competences.
a. Consequence: even if the firm can tell it should do something, it is tough to change
(e.g. Kodak missed digital, they knew they needed to change but could put it in
action; Nokia couldn’t change the business model to build the ecosystem).

3. Size and Growth: the bigger the firm, the greater the inertia.
a. Harder to change because of coordination and communication challenges.

GROWTH STRATEGIES

Reasons for a firm to grow:

• Easier to survive unexpected environmental challenges.
• Invest access capital gained (funds to develop and sell the product, needs to raise funds).
• Behavioral motivations of managers.
• Public firms must ensure that shareholders are incentivized to invest in the firm, expect
positive return → need to demonstrate a positive future output (it does, can, or will grow).
• Firm growth may be correlated with more money, growing firms could possibly survive
longer (resources needed to deal with environmental dynamism), and in general firms who
last longer tend to be bigger.

Three Dimensions of Growth: they create a space for managers to position the company for
competitive advantage and developing and leveraging the need and determinants of their strategy
(economies of scale, scope, cost of transacting economic exchanges).
1. Vertical Expansion (stages of industry value chain).
2. Geographic Scope (Regional, national, global markets).
3. Horizontal Expansion (Products and services).
Buy, Ally, Make Strategies:
• Buy on the market at competitive prices.
• Ally with another firm
• Make yourself by building the business or buying an existing business (making it yourself).
Neither option is inherently superior, they emphasize different activities and trade off different
factors, the key engine of the two approaches (make or buy) is the administrative vs. market
mechanism.

Administrative or Market Mechanism

Market Mechanism: where individuals and firms, guided by market prices, make independent
decisions to buy and sell goods and services.

Administrative Mechanism: of firms, where decisions concerning production and resource

allocation are made by managers and carried out through hierarchies.

What determines which activities are undertaken within a firm and through market contracts?
• Transaction Costs: the cost of organizing across markets (e.g. search, negotiation,
contracting, monitoring and enforcing contracts, etc.).
• Administrative Costs: incurred if activity is internalized within a firm.

Make: An Administrative Mechanism.

Must build its own administrative mechanism, requires the firm to plan and organize economic
exchanges.
• Hire workers.
• Buy machinery.
• Manage design and production process.

Buy: A Market Mechanism.

Efficient market hypothesis: competition and opportunistic behavior will settle prices optimally
by wringing out knowledge asymmetries between buyers and sellers (market is self-organizing,
doesn’t require any planning).
 • Purchase inputs form supplier.
• Negotiate price.
• Coordinate design.
BUT markets are not always efficient -> trade-off ownership, control, dependence, flexibility, etc.

Reasons for Acquisitions:

• Increased Market Power: intended to change the competitive balance in the industry.
• Overcome Barriers to Entry: especially if a hindrance (e.g. Hyatt’s acquisition of 24 hotels
in 9 new markets).
• Lower Cost of Product Development: buying established businesses reduces risk of start-
up ventures.
• Quick Access to New Products: faster market entry.
• Diversification: quickly move into businesses where firm lacks industry experience (e.g.
Google’s acquisition of Motorola Mobility).
• Reshaping Competitive Scope: restrict dependence on few products or markets (e.g.
Facebook’s acquisition of Instagram).
• Learning New Capabilities: learning new technologies and gaining knowledge base.

Problems with Acquisition (at least 60% fail to generate value):

• Integration Difficulties: differing financial and control systems.
• Inadequate Evaluation of Target: “Winner’s Curse” leads to overpay.
• Large or Extraordinary Debt: costly debt creates burden on cash outflows.
• Inability to Achieve Synergy: usually if unrelated but even if similar businesses.
• Too Much Diversification: acquirer doesn’t have expertise required to manage unrelated
businesses.
• Managers Overly Focused on Acquisition: “managerial hubris”.
• Too Large: reduces innovation and flexibility.
Perspectives for Acquisition
• Shareholders of acquired firms often earn above-average returns from acquisition (30%
increase in stock prices) due to premium received on its market value (25% on average).
• Shareholders of acquiring firms are less likely to do so → in 2/3 of acquisitions, the
acquisition firm’s market value diminishes immediately after the acquisition announcement.

Key to Success: Effective Due Diligence → A way of preventing harm to either party involved in a
transaction.
• Buyer’s offer to purchase an asset is usually dependent on the results of due diligence
analysis:
o Reviewing all financial records.
o Reviewing anything else deemed important to the sale (e.g. technology).
• Seller could perform analysis on the buyer to evaluate the buyer’s ability to purchase, as
well as other items that would affect the purchased entity or the seller.
• Effective due diligence helps the firm understand how difficult it will be to integrate
operations and how much the target tis worth to you and not pay an excessive premium.

When to Ally and When to Acquire

Acquisitions: competitive, based on market prices, risky -> generally to increase scale or cut cost.
Alliances: cooperative, negotiated, not so risky -> generally to enter new markets, customer
segments, and regions.

Most acquisitions and alliances fail:

• Acquisitions: on average either destroy or don’t add shareholder value.
• Alliances: create very little wealth for shareholders.

Executives must analyze three sets of factors before deciding on a collaboration option:
1. The resources and synergies they desire.
2. The marketplace they compete in.
3. Their competencies at collaborating.

Firms (especially managers) should develop ability to execute both but knowing when to use which
strategy may be a greater source of competitive advantage than knowing how to execute.
Resources and Synergies

• Modular Synergies: manage resources independently and pool only the results for greater
profits (modularly interdependent resources generate them).
o Nonequity alliances are usually best suited (no new entity is created).

• Sequential Synergies: when one company completes its task and passes on the results to a
partner to do its bit (sequentially interdependent resources).
o Must customize resources to some extent, which will likely happen only if partners
sign rigid contracts that they monitor carefully or enter into equity-based alliances
(new entity).

• Reciprocal Synergies: by working closely together and executing tasks through an iterative
knowledge-sharing process, combining and customizing resources (reciprocally
interdependent).
o Acquisitions are better than alliances.

• Nature of Resources: hard resources are better combined through acquisitions (easy to
value, generate synergies quickly), soft resources are better combined through equity
alliances (people tend to leave during acquisitions, collaborations during alliances).

• Extent of Redundant Resources: can be used to generate economies of scale or cut costs
by eliminating them, if there are many they should opt for acquisitions or mergers (complete
control)

Market Factors
• Degrees of Uncertainty: risks exist when companies can assess the probability distribution
of future payoffs, uncertainty exists when it is not possible to assess future payoffs.
• Forces of Competition: should check if they have rivals for potential partners before
pursuing a deal, and if there are several suitors should buy a firm to pre-empt the
competition BUT should avoid taking over firms when uncertainty is high, and instead
negotiate and alliance allowing them majority stake at a future date.
Collaboration Capabilities: some companies have developed abilities to manage acquisitions or
alliances over the years and regard them as core competencies.
• It is tempting to use the strategy they are good at (improves chances of working), but
specialization poses a problem because the firm will stick to the same strategies even if not
appropriate and will end up making poor choices.

VERTICAL INTEGRATION

Value chain Analysis

• Primary Activities: add value directly in transforming inputs into outputs (physical creation
of the product, sales, distribution, logistics, inventory management, warehousing).
• Secondary Activities: are necessary for the primary activities to take place.
Along this chain of activities creation of more and more value, there is the assumption that the
finished product is worth significantly more than the sum of the components.

Vertical Integration: a firm’s ownership and control of multiple vertical stages in the supply chain
of a product.
• Backwards: into its suppliers’ activities (also upstream).
• Forwards: into its customers’ activities (also downstream).
The extent of a firm’s vertical integration is indicated by the number of stages of the industry’s vale
chain that it spans and can be measured by the ratio a stages value added to sales revenue.

Benefits of Vertical Integration

• Superior coordination.
• Greater control of process and quality inputs.
• Cost reductions
o Transaction and communication costs.
o Scale and scope economies.
o Technical economies.
• Potential to raise entry barriers (block competitors’ access to market resources).
• Deal with market uncertainty.
• Get strategic independence.
• Transaction specific investments: producer needs to invest in equipment or technologies
specific to the needs of the other parties.
Challenges of Vertical Integration: while vertical integration avoids the transaction costs of using
the market, it imposes an administrative cost, and the extent of these costs depends on several
factors.
• Difficult to develop and integrate different capabilities for many activities.
• Resource intensive, need significant investment, especially initially.
• Differences in optimal scale at different stages of production may mean that the number of
products you would need to produce wouldn’t justify vertical integration excess capacity.
• Risks of managing different businesses with different goals.
• Flexibility may be reduced as processes become interlocked.
• Vertical integration represents a compounding risk (risk associated with dependence
between businesses).
• Might require you invest in unattractive industries.
• Risk of becoming rival to your partners (especially if only partial vertical integration) and
damaging its competitive position in its core business.

Criteria to Integrate Vertically: vertical integration all depends upon the specific context; the value
of our analysis is that we can identify the factors that determine the relative advantages of the
market transaction vs. internalization:
• Firms in the vertically adjacent activity: greater number of firms means Vertical
Integration is less advantageous.
• Transaction-specific investments: the greater the need, the greater the Vertical Integration
advantage.
• Information distribution: the greater the information asymmetries, the more likely is
opportunistic behavior, and the greater the advantages of Vertical Integration.
• Uncertainty of the relationship: the greater the uncertainty, the more incomplete is the
contract and the greater the advantages of Vertical Integration.
• Scale of operation and strategy: the greater the similarity, the more advantageous is
Vertical Integration.
• Capability development: the greater the need to continually upgrade capabilities in the
adjacent activity, the greater the disadvantage of Vertical Integration.
• Incentives: the greater the need, the lower the advantage of Vertical Integration.
• Market demand: the more unpredictable is demand, the less advantageous is Vertical
Integration.
• Risk: the greater are risk at each stage, the more Vertical Integration compounds risk.
Types of Vertical Relationships

• Long-Term Contracts: a series of transactions over a period of time that specify the terms
of sales and the responsibilities of each party. Can help avoid opportunism and provide
security to make necessary investments BUT problem of anticipating circumstances
(restrictive, disputes).

• Spot Contracts: work well under competitive conditions when there is no need for
transaction-specific investment.

• Vertical Partnership: vertical relationships based on trust and mutual understanding that
provide security to support transaction-specific investments, flexibility to meet changing
circumstances, and incentives to avoid opportunism. May rely on relational contracts with
no written contract.

• Franchising: a contractual agreement between the owner of a business and trademark that
permits the franchisee to produce and market the franchiser’s product or service in a
specified area. It combines the advantages of vertical integration in terms of coordination
and investment in transaction-specific assets with advantages of market contracts in terms of
high-powered incentives, flexibility, and separate ownership of strategically dissimilar
businesses.

Industry Life Cycle Perspective of Vertical Integration:

• Industry affects the development of external markets; if they don’t exist, firms have to
internalize.
• In early (fluid) phases of an industry’s life cycle, early entrants may not be able to find
upstream suppliers and downstream buyers and must fully integrate to serve the markets.
• As the industry evolves and transition into a more stable industry, dominant designs are
accepted and standards are established, which allow for specialists to emerge who can
develop scale and/or scope economies to serve a particular value chain.
• Over time, firms tend to vertically disintegrate and rely on the market to obtain factors of
production.
Transaction Cost Economics (TCE) Perspective

Total Cost = transaction costs + production cost.

• Transaction Costs: the costs of making an economic exchange.

o Search costs (supplier, partner, customers).
o Bargaining costs (of establishing a supposedly temper proof contract).
o Monitoring cost (monitoring and implementation of contract).
o Incomplete contracts (difficulty writing contracts and enforcing them, higher
associated costs if incomplete and take more time).

Key Question: what form of governance minimizes transaction costs (costs of making it in house
lower than transactions costs incurred when leveraging market mechanism)?
• A Priori Assumption: market governance is more efficient than vertical integration given
the benefits of competition.

Core Determinants of Transactions Leading to Market Failure

Making vertical integration more efficient than market governance.

Asset Specificity: specialized assets cannot be put to alternative uses, tailored to a particular
transaction, cannot be redeployed easily outside a specific relationship.
• Gives rise to bilateral dependence.
• Idiosyncratic nature makes protection of interest difficult because market competition
cannot restrain opportunistic exploitation.
• Vertical integration (authority and control) makes it easier to govern the transaction.

Uncertainty: the more unknowns about the requirements, the stronger the contractual safeguards
Arise when the relevant conditions surrounding an exchange are too unpredictable to be specified in
a contract ex ante or performance cannot be easily verified ex post.
• Primary consequence is difficulties with adjusting agreements (raise transaction cost), could
be addressed through vertical integration even at the cost of flexibility.
 • Volume uncertainty: inability to accurately forecast the volume requirements in a
relationship, when volume uncertainty is high you have unexpected production costs or
excess capacity.
o Buyer could resolve the problem by backwards integrating - manufacturing
components.

Transaction Frequency: The extent to which transactions reoccur -> reoccurring transactions can
be optimized. It provides an incentive for firms to vertically integrate as the cost can be spread over
recurring transactions.
• Costly renegotiation requirements.

Example: TCE Determinants of Organizations as a Function of Asset Specificity

• Market is more efficient if asset specificity is low.

• As asset specificity increase to k1 it might be better to switch to some form of alliance
(hybrid governance form) to the blue line Example: establish a short-term contract rather
than leverage the market).
• As asset specificity continues to increase to k2 the firm may increasingly prefer an equity-
based alliance or joint venture to reduce uncertainty.
o As the partner invested money, they are less likely to break the contract.
• Beyond k2 the company may consider acquiring the target and internalizing the activity by
vertically integrating (green line).
 DIVERSIFICATION

Why Care About Diversification?

• Growth is often a goal of companies.
• Survival and growth are correlated (growth associated with survival).
• Diversification is one very common mode of growth.
• Related to the horizontal expansion of the firm.

Diversification: entry into different industries that are not linked by any vertical (buyer/supplier)
relationship, into other lines of business.

Motives for Diversification

1. Growth: the desire to escape stagnant or declining industries are powerful motives for
diversification (e.g. tobacco, oil, newspapers).
a. In the absence of diversification, firms are prisoners of their industry. Generally
successful in generating revenue growth (especially through acquisition) BUT efforts
become a cash drain in companies for declining industries, then it may hasten rather
than stave off bankruptcy.
b. Growth satisfies managers, but not shareholders, in that achieving growth (especially
via acquisition) tends to destroy shareholder value.
i. Not a good reason.

2. Risk Reduction: diversification reduces the variance of profit flows, If the cash flow of two
different businesses are imperfectly correlated, then bringing them together under common
ownership certainly reduces the variance of the combined cash flow.
a. Doesn’t necessarily create shareholder value as shareholders can hold diversified
portfolios of securities and diversify their own risk, what is the advantage for them?
b. Firms can diversify at a lower cost than individual investors BUT not true as
transaction costs for shareholders is far less than diversifying through acquisition.
i. Not a good reason.
 3. Value Creation: for diversification to create shareholder value, bringing different
businesses under common ownership must increase their total profitability.
a. Diversification makes sense when it will show shareholder value.
b. When a corporation or group enhances the competitive advantage of its component
businesses.
c. Increasing WTP and decreasing costs through Economies of scope.
i. A good reason (value creation + growth).

Value Creation: Porter’s “Essential Tests”

Sources of superior profitability: industry attractiveness and/or competitive advantage.

In establishing the conditions for profitable diversification, Porter refines there are “three essential
tests” that determine whether diversification will create shareholder value:

1. Attractiveness Test: industries chosen for diversification are structurally attractive or

capable of being made attractive (potential to become attractive).

Example: Microsoft into videogames (Xbox), have high potential, high growth margins, and those
how are successful make significant amounts of money (passes the attractiveness test).

2. Cost-of-Entry Tests: the cost of entry must not capitalise all the future profits (may
counteract industry attractiveness).

Example: pharmaceuticals, corporate legal services, and defence contracting offer above-average
profitability precisely because they are protected from barriers to entry.
• Should acquire an established player (acquisition cost is likely to fully capitalise profit
prospects, or even an acquisition premium), or establish a corporate venture (the
diversifying firm must directly confront barriers to entry).

3. Better-off-Test: if two businesses are brought together under common ownership, they
should become more profitable, either the new unit must gain competitive advantage form
its link with the corporation or vice versa (some sort of synergy or profitable link must be
present) → Economies of scope.
Economies of Scope: when using a resource across multiple activities uses less of that resource
than when the activities are carried out independently.
• From increasing the output of multiple products (not one product as economies of scale).
Value creation by exploiting linkages between different businesses.

Cost Side: relative total cost of producing a variety of goods and services together in one firm vs.
separately in two or more firms.

Demand Side: increases either WTP, demand, or both (generally from customers buying multiple
products such as in one-stop shops).

Economies of scope come from resources and capabilities that can be shared or transferred
across different units (synergy creation):
• Tangible Resources: by eliminating duplication (sharing among several businesses) such as
through distribution channels, R&D (e.g. Disney).
• Intangible resources: ability to extend them to additional businesses at low marginal costs,
such as brand extension, patents (e.g. Armani).
• Capabilities in a Specific Function: can be transferred within a diversified company, such
as innovation, marketing, product development (e.g. LVMH distinctive capability in the
management of luxury brand).
• Capabilities of General Management: leadership, coordination, organization (e.g. GE).
Nature of economies of scope varies among different types of resources and capabilities.

Empirical Research Finding: How do diversified firms perform relative to specialized firms?

• No consistent relationship.
• Some evidence of a curvilinear relationship: enhances profitability up to a point, but beyond
after which it reduces it profitability (increasing cost of complexity?).
• McKinsey & Co. identify benefits from moderate diversification.
• Problem of distinguishing between association and causation: does diversification drive
profitability, or vice versa?
Negative Effects of Diversification

• Loss of focus – dispersed managerial attention.

• Complexity and/or coordination problems (associated with more complex companies and a
higher number of functions and divisions) -> could results in higher costs to manage them.
• Diversification can be done for the wrong reasons.
o Managerial ego.
o Manager’s compensation tied to size and scope.
o Imitation of successful, diversified competitors.

Relatedness in Diversification

Relatedness: the potential for sharing and transferring resources and capabilities between
businesses.
• Distinction between “related” and “unrelated” is far from clear (may depend on strategy or
firm characteristics).

Economies of scope in diversification derive from two types of relatedness:

1. Operational Relatedness: synergies from sharing tangible and intangible resources across
businesses (common distribution facilities, brands, joint R&D, manufacturing, marketing).

2. Strategic Relatedness/Parenting Advantage: synergies at the corporate level deriving from

the ability to apply common corporate-level management capabilities to different
businesses.

Risks of Unrelated diversification:

• Potential shortfall in managerial attention.

• Larger commitment in terms of resources needed.
• Integration issues.
• More dilution of control.
What Type of Diversification is Most Profitable?

• Importance of economies of scope and shared resources would point to related

diversification as more profitable, and initially empirical research predicted this.
• Most studies (but not all) show related diversification outperforms unrelated diversification.
• Related diversification offers greater synergies BUT imposes higher management costs.
• Once risk and industry influences are considered, superiority is less apparent.

Measuring Diversification

Specialization Ratio (SR): fraction of revenue that comes from the single largest business.
• Single Businesses: SR > 0.95.
• Dominant Businesses: 0.7 < SR < 0.95.
• Diversified Businesses (related or unrelated): SR < 0.7

Relatedness Ratio (RR): fraction of revenue that comes from businesses that draw form a common
core skill, resource, strength.
• Related Businesses: RR > 0.5.
• Unrelated Businesses: RR < 0.5.

Economies from Internalizing Transactions

Economies of scope provide cost savings from sharing and transferring resources and capabilities
among different businesses BUT a company doesn’t necessarily have to diversify to exploit
economies of scope.
• Can be achieved by selling or licensing the use of the resource or capability to another
company.
• Marketing relationship and licensing allow for economies of scope to exist outside of
diversification (capabilities to another company).
Example: airport lease space to specialist retailers and restaurants, Kraft distributed Starbucks’
packaged coffee, EasyGroup.
Licensing vs Diversification

Are economies of scope bettered applied internally within the firm through diversification or
externally through market contracts with independent contracts?
• Depends on the nature of these resources and capabilities that generate the benefits.

Example: If the resource can be traded out for anything close to its real value, then it is not
necessary to enter a new business through diversification.
• Transaction cost of licensing (drafting, negotiating, monitoring, and enforcing contracts),
clearly defined property rights make licensing highly effective but for more general
organizational capabilities it might be problematic.
• Firms may lack the other resources and capabilities required for successful diversification
(e.g. Dolce and Gabbana doesn’t have resources and capabilities for fragrances).
 INTERNATIONALIZATION

Internationalization: firms’ expansion into different international markets or production sites.

• When a firm enters new markets with new products (diversification) if they also move into a
new geographical sector, it is a step towards internationalization.

Value Chain: the production of most goods and services comprises a vertical chain of activities
where input requirements of each stage vary considerably.
• International Fragmentation: firms seek to locate countries whose resource availability
and cost best match each stage of the value chain. Benefits must be traded off against the
added costs of coordinating dispersed activities.
• Global Value Chain (GVC): activities and people involved in the production, supply,
distribution, and post-sale activities (the supply chain) are coordinated across geographies.

Patterns of Internationalization: internationalization occurs through trade (supplying goods and

services from one country to another) and direct investment (building and acquiring productive
assets in another country).

• Sheltered Industries: shielded from imports and inward direct investment by regulation,
trade barriers, or due to the localized nature of the products (only by indigenous firms), not
able to or unwilling to expand internationally, but also not threatened by international
competition.

• Trading Industries (Trade Firms): where internationalization occurs primarily through

imports and exports, such as if goods are transportable, not nationally differentiated, and
subject to scale economies.

• Multidomestic Industries: internationalize through direct investment, either because trade

is not feasible (e.g. service industries such as banking, consulting, hotels) or the products are
nationally differentiated.

• Global Industries: feature high levels of both trade and direct investment - include most
major manufacturing and extractive industries, populated by multinationals, usually with a
global value chain and different adaptation.
Implications for Competition: internationalization means more competition and lower industry
profitability. We can use porter’s five forces of competition framework to analyze the impact of
internationalization on competition and industry profitability.

• Competition from Potential Entrants: internationalization as a cause and consequence of

falling barriers to entry (tariff reductions, declining real cost of transportation, foreign-
exchange convertibility, internationalization of standards, converging preferences).

• Rivalry among Existing Firms: internationalization increases rivalry as it increases the

number of firms competing within national markets.
o Internationalization stimulates competition by increasing investments in capacity and
increasing the diversity of competitors.

• Increasing the Bargaining Power of Buyers: sourcing from overseas enhances power of
industrial buyers and allows distributors to engage in international arbitrage.

Competitive and Comparative Advantage.

• Competitive advantage: achieved when a firm matches its internal strengths and resources
and capabilities to the key success factors within its industry.
o When competing firms are based in different countries, competitive advantage
depends also on the availability of resources within those countries.

• Comparative Advantage: a country has a comparative advantage in those products which

make intensive use of those resources available in abundance within that country.
o Relative efficiencies of producing different products.
Porter’s National Diamond: the key role of the national environment upon a firm’s potential for
international competitive advantage is its impact upon the dynamics through which resources and
capabilities are developed. Four key factors determine whether firms from a particular country can
establish competitive advantage within their industry sector.

1. Factor Conditions: role of highly specialized resources, “home grown” rather than
“endowed” (e.g. US movie production due to concentration in LA of highly skilled labor and
supporting institutions), more important than natural endowments.
a. Combination of specialized skills and resources that explain the comparative
advantage.

2. Related and Supporting Industries: national competitive strengths tend to be associated

with “clusters” of industries, as closely related industries are sources of critical resources
and capabilities.

3. Demand Conditions: domestic customers are the primary drivers of innovation and quality
improvement in the domestic market.
a. Customer preferences in countries leading to a comparative advantage for certain
firms.

4. Strategy, Structure, and Rivalry: international competitive advantage depends upon how
firms within a particular sector interact within their domestic market, intense domestic
competition drives innovation, quality, efficiency, and upgrading.
a. Firms outperforming others in their domestic competitive marketplace have a better
ability to take on the global competition.

Entering a Foreign Market: choice between high control and low investment (and risk).

• Greenfield: set up your own company (full control and ownership).

• Merger & Acquisition: full or partial stake in existing company (if the integration process
works you have a readily available fully running company).
 • Joint Venture: two companies invest funds in creating a third, jointly owned, company
(depending on terms agreed could share control and ownership).

• Alliance & Licensing: contracting and forming a partnership with an existing company (to
operate a certain line of business from a larger firm who wants to sell it, could get a licence
from that firm to operate).

• Exports: entering a market without making an FDI, directly through exports.

Reasons for Internationalization:

1. Comparative advantage in production:

a. Cheaper or specialized labor supply (national resources).
b. Cheaper or specialized raw materials (natural resource endowments).
c. Capital stock.
d. Local expertise (learning benefits), supply chain, industrial districts, clusters, etc.

2. Firms want to expand into new markets:

a. Exploit economies of scale.
b. Access new customers.
c. Face internationalization of demand.
d. Compete strategically – cross-subsidization (diverting profits from other areas of
business).

Challenges for Internationalization:

1. Liability of newness:
a. Challenge: buying, producing, or selling a new culture, market, environment.
b. New ways of doing business – regulation, customer (preferences, modes of contact,
channels), supplier perception.
c. Home bias effect – tendency for investors to invest majority of their portfolio in
domestic equities.
2. Complexity of MNEs:
a. Difficult coordination across countries (values, culture, goals, strategies).
b. HQ-subsidiary relationships are key (may suffer depending on level of commitment
to new investment, some subsidiaries may have to compete for limited resources e.g.
attention).
c. Tension between the need for integration (between HQ and subsidiaries) and the
need for local responsiveness.

3. Distance (CAGE): Four key components of distance between countries.

a. Cultural distance: about adaptation costs that new businesses face in a foreign
market.
b. Administrative distance: about transaction costs, contract negotiations, and
enforceability of contracts (e.g. laws and regulations, bureaucracy).
c. Geographic distances: costs of transportation and control for physically distant
operations, management strain (BUT if established business model no need for
frequent interaction).
d. Economic distance: about the cost of inputs and operations in the foreign country
and the specific set of preferences of customers in the new geography, demand, and
WTP.
Internationalization strategy choices have been viewed as a trade-off between the benefits of global
integration and those of national adaptation.

• Industries where scale economies are huge and customer preferences homogenous call for a
global strategy.
• Industries where national preferences are pronounced and meeting them doesn’t impose
prohibitive costs favor multidomestic strategies.

Some industries may be low on both dimensions or offer benefits from operating on a global scale,
but national preferences and standards may also necessitate adaptation.

Global localization: standardizing product features and company activities where scale economies
are substantial and differentiating where national preferences are strongest.