Tonight (9/12/23)

• Discuss Project 1
• Finish chapter 7 (slide #32)
• Ch. 8 – Creating and Capturing Value
• Ch. 9 – Game Theory
• Assign Homework Ch. 8-9

© McGraw-Hill 1
Economics of Strategy: Creating and Capturing
Value

Chapter 8

Because learning changes everything. ®

© 2021 McGraw-Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill.
 Learning Objectives
1. Explain the general ways by which managers within an
industry might increase value.
2. Discuss how competitive forces make it difficult for individual
firms to capture value over the long term.
3. Explain why producer surplus is often captured as “rents” by
superior assets.
4. List the conditions that must exist for a firm to make economic
profits over the long run.
5. Summarize the economic costs and benefits of diversification
(multiple businesses within the same firm).
6. Describe a general framework that can be used for strategic
planning.
7. Show why it is impossible for some firms to capture value and
why it is unlikely that any firm can capture value in perpetuity.

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 Strategy

General policies intended to generate profits

• Choice of industry
• Combination of products and services
• Competitive and cooperative behaviors
• See Amazon example next page

Strategies evolve as circumstances change

Strategies must create and capture value

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 Amazon Net Sales by Market Segment

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 Value Creation

Reduce production costs or producer transaction costs

• Shifts supply curve to the right

Reduce consumer transaction costs

• Shift demand curve to the right

Shift demand to the right by other means

Devise new products and services

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 Transaction Costs

Producer transaction costs

• Negotiating terms
• Legal expenses
Consumer transaction costs
• Product search
• Learning product characteristics and quality
• Negotiating terms of sale
• Enforcing agreements

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 Ways to Create Value Reduction
of Transaction Costs

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 Other Ways to Increase Demand

Improve product quality

Price complements so consumers will buy more

• Printer and ink cartridges, razors and razor blades

Change the price of substitutes

• Theaters prohibit outside food or drinks, no liquids
allowed past security gates at airports

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 Converting Organizational Knowledge into
Value
• Hardware – physical assets
• Software – formulas or recipes for creating
value
• Wetware – employee brainpower
• Implications – allow employees to experiment
and innovate

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 Capturing Value

Firms in competitive markets are price takers.

Firms with market power choose price-quantity

combinations
• They can capture value if they exploit their market
power

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 Firm with Market Power versus a Firm in a
Competitive Industry

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 Market Power

Entry barriers
• Economies of scale, patents, brand names, high costs of
exit
Degree of rivalry
• Number and size of competitors (cell phone providers,
streaming services)
Threat of substitutes
• Outside products (internet from cable, satellite, phone
carrier or fiber line)
Buyer and supplier power
• Number and size matters (Wal-Mart, Home Depot)

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 Other Value-Enhancing Strategies

• Introduce new products and services

‒ Gonzaga offering more online options, degrees and
certificate programs
‒ https://www.gonzaga.edu/center-for-lifelong-
learning/professional-development

• Cooperation with other firms

‒ UW-GU Health Partnership for medical school
‒ https://www.gonzaga.edu/academics/health-partnership

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 Superior Factors of Production

People:
• Special talents or skills
• Paying more for star athletes, leaders or other
specialists

Physical assets:
• Prime real estate – schools near medical or
research facilities
• Unique equipment

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 Superior Factors of Production

• Bidding for specialized assets may erode profits

• If a resource is adding value to a firm, other
firms will attempt to bid this resource away
• The price of this resource will rise, raising costs
• Initial profits will fall

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 Producer Surplus Is Captured by Superior
Assets

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 Superior Factors of Production

Team production
• Interdependencies among workers increase value
beyond the “sum of the parts”
• Luck or foresight may endow firms with unique team
production capabilities

Rivals may be unable to pinpoint source of advantage and

unable to capture equivalent value.
• Markets and competitors change, people may leave

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 Diversification

Benefits
• Economies of scope
• Promoting complements
Costs
• Bureaucracy: WWP and Sierra Pacific over
costs of energy sales, market vs. costs
• Incompatible cultures: 1998 merger of Daimler-
Benz and Chrysler. Paid $36 billion and sold
80% in a decade for $7 billion

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 Diversification and Management

Diversification for earnings volatility

• May not increase value
• Investors can diversify on their own
Related diversification
• Can increase value
• Positive – Itron and Ecova
• Negative – Communications and Labs
Capturing the gains
• Target firms often obtain largest gains in takeover

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 Strategy Formulation

Understanding internal resources and capabilities

• Physical, human, and organizational capital

Understanding the environment

• Markets, technology, and government regulation

Combining environmental and internal analyses

Strategy and organizational architecture

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 Framework for Strategic Planning

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 Capturing Value

• Can a firm capture value on a sustained basis?

• Market will bid prices of required services up
• Environments change
• Normal rates of return will be earned in the long run

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Economics of Strategy: Game Theory

Chapter 9

Because learning changes everything. ®

© 2021 McGraw-Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill.
 Learning Objectives

1. Define game theory.

2. Understand simple diagrams that depict
games in strategic (normal) form.
3. Define dominant strategy.
4. Explain the economics of a prisoner’s dilemma
and provide examples of how these dilemmas
can arise within firms.
5. Determine (pure strategy) Nash equilibria in
simple two-person games.

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 Learning Objectives

6. Define mixed strategy and describe why

managers might sometimes choose to use
one.
7. Understand simple diagrams that depict
sequential games in extensive form.
8. Apply backward induction to find the
equilibrium in two-person sequential games.
9. Define first-mover advantage.
10.Describe the key managerial insights obtained
from game theory.

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 Game Theory

Managers must put themselves in their rival’s

shoes

Determine how they will respond to your actions

Assume:
• All decision agents are rational
• Each attempts to anticipate actions of rivals

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 Simultaneous-Move,
Nonrepeated Interaction
Simultaneous
• Rivals must make decisions without knowledge of
decisions made by their competitors

Nonrepeated
• The interaction is presumed to occur only once

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 Example

• Boeing and Airbus individually choose and

simultaneously submit a bid price (high or low) for 10
planes.
• Each cell entry presents the payoffs in millions.
• A dominant strategy is one the firm chooses no
matter what its rival does.

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 Strategic Form

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 Nash Equilibrium Revisited

• In the absence of a dominant strategy, Nash

equilibrium may predict outcome.
• Nash equilibrium is set of strategies where firm
does its best given rival’s actions
• Use the circle technique to identify Nash
equilibrium

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 Nash Equilibrium

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 Nash Equilibrium

• This is a stable outcome.

• No firm has an incentive to make another choice
• When dominant strategies exist, firms have strong
incentives to choose them
• More likely to occur when rivals have good
information about potential payoffs

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 Competition Versus Coordination

Boeing and Airbus make simultaneous choices of new

communications systems for their planes.
• Two technologies: Alpha and Beta
• Both firms benefit with the same choice

Results in two Nash equilibria

• Alpha/Alpha and Beta/Beta
• Benefits from precommitment communication

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 Coordination Game

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 Coordination/Competition Game

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 Mixed Strategies

Mixed strategy offers an element of surprise.

Boeing and Airbus must simultaneously commit to an

advertising campaign.
• Boeing benefits most from same strategy.
• Airbus benefits most from differentiation.

Randomization with p=0.5 is Nash equilibrium for both.

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 Mixed Strategy

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 Managerial Implications

• Estimate payoffs given the potential actions of your firm

and your competitors.
• If a firm has a dominant strategy, follow it.
• Make best estimate of what competitor will do and
identify best action.
• How do you obtain this type of market data?
‒ Publicly available – regulatory filings, news reports,
company announcements, etc.
‒ Industry/association knowledge
‒ Ethics of getting or sharing this data

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 Sequential Interactions

Boeing and Airbus communications technology choice.

• Boeing chooses first.

Analyze with backward induction.

• Boeing must take Airbus’s best response into account in
making its choice.
• Boeing has a first-mover advantage.

Credible commitment by second mover can alter first

mover choice.

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 Extensive Form

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 Repeated Strategic Interaction

Strategic choices can come to incorporate more than

short-term payoffs.
The cooperative outcome is more likely if
• Long-run gains from cooperating are larger relative to
short-run gains from not cooperating.
• It is easier for firms to recognize whether or not
cooperation has occurred.
• The expected length of the repeated relationship is
longer.

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 Strategic Interaction and Organizational
Architecture
• Kiana manages Lenin.
• Len must choose between working and shirking
• Kiana must choose whether to incur monitoring costs
• No pure-strategy equilibrium exists.
• A labor contract paying a share of output may solve this
problem.

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 Incentive Game

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 Chapter 7 Homework Due 9/19/23
Review questions 7-1 through 7-3, 7-7 and 7-13 (pages 252-253)
7-1:Macrosoft is a new producer of word processing software. Recently it announced it is
giving away its product to the first 100,000 customers. Using the concepts from this chapter,
explain why this might be an optimal policy.

7-2: The local space museum has hired you to assist them in setting admission prices. The
museum’s managers recognize that there are two distinct demand curves for admission. One
demand curve applies to people ages 12 to 64, whereas the other is for children and senior
citizens. The two demand curves are: PA = 9.6 – 0.08QA and PCS = 4 – 0.05QCS, where PA
is the adult price, PCS is the child/senior citizen price, QA is the adult quantity, and QCS is
the child/senior citizen quantity. Crowding is not a problem at the museum, so managers
consider marginal cost to be zero.
a. What price should they charge to each group to maximize profits?
b. How many adults will visit the museum? How many children and senior citizens?
c. What are the museum’s profits?
Remember to set MR = MC and the MR curve is twice as steep as the D curve, so
MR = 9.6 – 0.16QA for adults and MR = 4 – 0.1QCS for children

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 Chapter 7 Homework Due 9/19/23

7-3: Textbook publishers have traditionally produced both US and international editions
of most leading textbooks. The US version typically sells at a higher price than the
international edition.
(a) Discuss why publishers use this pricing plan.
(b) Discuss how the internet might affect the ability of companies to implement this
type of policy.

7-7: Why do companies grant discounts to senior citizens and students?

7-13: Consider three firms: a shoe store at the mall, an automobile dealership, a house
painting firm.
(a) Which firm would you expect to engage in the most price discrimination? Why?
(b) How has the internet changed the pricing policies of these businesses?

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 Chapter 8 Homework Due 9/19/23

Review Questions 8-2, 8-3, 8-5, 8-8 and 8-9 (pages 291-292)
8–2: Airbus and Boeing are two major producers of jumbo jets. Are these
firms guaranteed to make high profits since there are only two large firms in
the industry? Explain.

8-3: The Watts Brewing Company owns valuable water rights that allow it to
produce better beer than competitors. The company sells its beer at a
premium and reports a large profit each year. Is this firm necessarily making
economic profits? Explain.

8-5: Sun Resorts has a hotel on a Caribbean Island. It recently spent money
to lobby the government to build a better airport and expand air service. Why
did they do this? Do you think that Sun Resorts cares about how many
airlines serve the island? Explain.

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 Chapter 8 Homework Due 9/19/23

8-8: One CEO justified the merger of his soft-drink company with a
machine tool company in the following manner: “This is a great
merger. First the products are unrelated. Thus our company’s
earnings volatility is likely to decrease. Second, our management
team has proved that we are better managers than the former
management team of the tool company, and thus we are likely to
discover new ways to create and capture value within the tool
company.” Evaluate this rationale.

8-9: Pepsi produces Fritos and Lays potato chips in addition to its
basic soft-drink products. Discuss potential ways that this business
combination might increase value.

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 Next Class (9/19/23)

Sep 19 Ch. 10 – Incentive Conflicts & Contracts

Ch. 8 and 9 homework due

Sep 26 Project 1 due (100 points)

11 – Organizational Architecture

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