Posts filed under ‘Strategic Management’
Postrel on Competitive Advantage
| Peter Klein |
Former guest blogger Steve Postrel gave an interesting presentation at last week’s AoM Professional Development Workshop on competitive advantage: “Competitive Advantage: Can’t Live With It, Can’t Live Without It.” Steve sent me the slides and was happy to share them here. Add your questions and comments below.
Steve provides a set of conditions that must be met for competitive advantage to be internally consistent and operationally meaningful, then presents his own (unique) definition, a simple and precise formulation in terms of gains from trade:
Seller 1 has competitive advantage over Seller 2 with respect to a specific transaction if and only if the economic surplus (gains from trade = V – C) from a transaction between 1 and the buyer is greater than the surplus from a transaction between 2 and the buyer. The difference in surplus is the CA.
A series of implications, qualifications, and applications follows. What do you think?
Will Mitchell’s Comments on Receiving the BPS Irwin Award
| Russ Coff |
A big congratulations to Will for winning this prestigious award. It is really something to hear a person’s students describe how their mentor has altered their lives. Many misty eyes in the room…
Embedded in Will’s comments after receiving the award was an observation that in many business settings, such as in developing countries, effective business decisions cannot be made using the risk-based tools (like NPV) that are so often taught in business schools. He argued that, in the face of Knightian uncertainty, these tools fail miserably.
So what would be a set of tools to address uncertainty? The closest that I teach would be scenario analysis and real options. Here, one still needs to estimate parameters like the volatility of the investment or probabilities of outcomes (for decision trees or binomial trees). Of course, the assumption that these parameters could be known still suggests reflect risk rather than uncertainty. However, I emphasize sensitivity analysis (such as simulations, etc.) on these parameters to address the fact that they cannot be known.
First, is this the best set of tools available for Knightian uncertainty?
Second, is Will right that these are left out of most strategy courses? Perhaps we need to re-think the curriculum a bit…
Short Piece on Probability Theory
| Peter Klein |
“Risk, Uncertainty, and Economic Organization” is my contribution to the Hoppe Festschrift. I got the topic idea from some blogger guy. My chapter focuses, as the title suggests, on Knightian uncertainty. Hoppe places Knight, along with Ludwig von Mises, squarely in the frequentist camp (typically associated with Ludwig’s brother Richard). I tend to agree with Hoppe although, as I discuss in the paper, there are many interpretations of Knight, and some commentators argue that subjective (Bayesian) probability theory renders untenable the Knightian distinction between insurable risk and true uncertainty (see, for example, Dick’s 1982 paper).
Ultimately, however, I don’t think the approach to the firm promoted on this blog depends on a particular interpretation of Knight. The central claim is that judgment represents a kind of decision-making that cannot be traded on the market, and that therefore requires the entrepreneur exercising such judgment to establish a firm (more specifically, to take ownership of capital resources). To put it differently, ownership of assets implies a kind of ultimate responsibility that the owner cannot delegate. I think one can be agnostic about exactly why judgment isn’t tradable — it could be a form of asymmetric information, rather than ontological differences between types of knowledge — and still buy the basic Knight-Mises-Foss-Klein approach to the firm.
Raising the Bar: The Strategy Research Initiative
| Nicolai Foss |
The Business Policy and Strategy Division is the largest and arguably dominant division of the Academy of Management. Strategy’s leading journal, the Strategic Management Journal, consistently ranks among the top-5 management journals. What is being done in strategy clearly matters to the rest of the Academy.
Strategy has a general reputation for being a relatively rigorous management field (whether this is well deserved or not is another matter), something that is often ascribed to the heavy influence of economics on the development of the field over the last three decades. And yet, strategy also exhibits a plethora of different approaches; there is still no agreement on the nature of the key dependent variables; and the field unabashedly employs key explanatory constructs (e.g., capabilities, dynamic capabilities, absorptive capacity, etc.), the nature, operationalization, and measurement of which are still unclear. It may also be noted that although strategy does rely quite a lot on economic reasoning in comparison to other management fields, the formal way of reasoning of modern economists seldom finds its way into the pages of the leading strategy journals.
Prompted, apparently, by similar observations and frustrations, a group of Young(er) Turks (“mid-career scholars,” to use their own words) has gathered under the banner of the Strategy Research Initiative. (more…)
Organizations, Markets, and Health Care Reform
| Russ Coff |
Amidst the fierce debate about the U.S. health care system is a raving lack of clarity. At the core, is whether organizations and markets fail to produce an optimal solution. Even the most neoclassical of economists these days acknowledge that market externalities exist and that these should be the focus of government intervention. Unfortunately, I don’t feel that the debate has been rigorous or well-informed in defining the market failure or why a government run system would be superior.
Liberal Economist Paul Krugman explains why markets fail summarizing Kenneth Arrow’s arguments (here). Basically, the third-party payee system and the information asymmetries render comparison shopping ineffective (and hence competition fails to yield an optimal solution).
Indeed, there is a good bit of inefficiency in the current U.S. system. A recent NY Times article notes that health care costs the average U.S. household $6,500 more each year than other comparable wealthy nations. Unfortunately, looking at many of the important outcomes, it appears that consumers are not getting much for their money on many dimensions (e.g., chronic disease outcomes). So it should be possible to lower costs and improve outcomes. Of course, this ignores the question of whether costs are higher to subsidize R&D that ultimately spills over into other countries.
Unfortunately, the article continues to point out how the reform efforts seem to ignore this low-hanging fruit. (more…)
Alliances and Internal Capital Markets
| Peter Klein |
An interesting contribution to the literature on internal capital markets from David Robinson, “Strategic Alliances and the Boundaries of the Firm,” appeared recently in the Review of Financial Studies (now the third-ranked journal in finance behind the JF and JFE):
Strategic alliances are long-term contracts between legally distinct organizations that provide for sharing the costs and benefits of a mutually beneficial activity. In this paper, I develop and test a model that helps explain why firms sometimes prefer alliances over internally organized projects. I introduce managerial effort into a model of internal capital markets and show how strategic alliances help overcome incentive problems that arise when headquarters cannot pre-commit to particular capital allocations. The model generates a number of implications, which I test using a large sample of alliance transactions in conjunction with Compustat data.
The model builds on Williamson’s concept of forbearance, the idea that courts will enforce contracts between distinct legal entities but will not intervene in intra-firm disputes. The idea is that moving project with particular characteristics — Robinson calls them “longshots” — from a subunit of a diversified firm to an alliance partner allows the firm’s management to make a credible commitment not to expropriate value from the project manager ex post. Empirical evidence shows that projects with longshot characteristics, measured in various ways using Compustat segment data, are indeed more likely to undertaken by alliance partners. A nice paper with a good mix of theory and evidence.
The Organization of Firms Across Countries
| Peter Klein |
Interesting new NBER paper by Nicholas Bloom, Raffaella Sadun, and John Van Reenen, “The Organization of Firms Across Countries” (ungated version here, may be older):
We argue that social capital as proxied by regional trust and the Rule of Law can improve aggregate productivity through facilitating greater firm decentralization. We collect original data on the decentralization of investment, hiring, production and sales decisions from Corporate Head Quarters to local plant managers in almost 4,000 firms in the US, Europe and Asia. We find Anglo-Saxon and Northern European firms are much more decentralized than those from Southern Europe and Asia. Trust and the Rule of Law appear to facilitate delegation by improving co-operation, even when we examine “bilateral trust” between the country of origin and location for affiliates of multinational firms. We show that areas with higher trust and stronger rule of law specialize in industries that rely on decentralization and allow more efficient firms to grow in scale. Furthermore, even for firms of a given size and industry, trust and rule of law are associated with more decentralization which fosters higher returns from information technology (we find IT is complementary with decentralization). Finally, we find that non-hierarchical religions and product market competition are also associated with more decentralization. Together these cultural, legal and economic factors account for four fifths of the cross-country variation in the decentralization of power within firms.
The emphasis on institutional determinants of organizational form makes this a welcome addition to the (slim) set of papers relating institutional arrangements to the institutional environment. (more…)
Austrian Theory of the Firm Bleg
| Peter Klein |
This post is for devotees and fellow-travelers of the Austrian school. As some of you know I maintain an online bibliography of articles and books dealing with applications of Austrian economics to the theory of the firm (and strategic management more generally). Happily, this literature has grown dramatically in the last few years. Sadly, I have not had time to update the bibliography on a consistent basis. So, please send me your suggested additions and corrections (ideally with URLs). Self-nominations are welcome!
Events @CBS
| Peter Klein |
I’ve just arrived in Copenhagen, where I’m spending a month as a visiting professor at the SMG. Copenhagen Business School has become one of the most intellectually exciting places in Europe. This week alone the school is hosting the DRUID summer conference which features people like Anita McGahan, Sid Winter, Will Mitchell, Russ Coff, Mike Ryall, and many others, along with a workshop on corporate governance with keynotes by Mark Roe, Randall Morck, Annette Poulsen, and Florencio Lopez-de-Silanes Molina. Of course these are only appetizers for the next week’s main course, the PhD seminar on The Theory of the Firm and Its Applications in Management Research conducted by Professors F. and K. Truly an embarrassment of riches!
Campello and Fluck
| Lasse Lien |
Here is a paper from 2006 by Maurillo Campello and Zsuzsanna Fluck that is even more interesting now than it was in 2006. If you are interested in the micro-implications of the current crisis, you’ll surely like this one.
Abstract: We model the interaction of product market competition and firms’ financing decision when firms face capital market imperfections and consumers face switching costs. In our model, consumers anticipate that capital market frictions may drive their supplier out of business and account for welfare losses that firm bankruptcy imposes upon them. Likewise, managers, when investing in long-term market share building, take into account the possibility of business failure and the residual value they may capture from the firm’s liquidation process. Our theory yields four central implications. In response to a negative shock to demand: (1) more leveraged firms will experience significant market share losses; (2) the market share losses of more leveraged firms will be more pronounced in industries where low debt usage is the norm; (3) the market share losses of more leveraged firms will be more pronounced in industries where consumers face higher switching costs; and (4) the market share losses of more leveraged firms will be magnified in industries where asset liquidation is less efficient. Using detailed firm- and industry-level data from U.S. manufacturers over the 1990-91 recession, we present empirical evidence supporting our model’s predictions. We later expand our empirical analysis, studying a large panel of firms over the various phases of the full business cycles contained in the 1976-96 period. Results from these broader tests provide additional evidence in support of our theory.
Is the Future in Contract Manufacturing?
| Benito Arruñada |
The purchase of Opel by Magna shows the strength of contract manufacturers and their strategies, which I discussed with Xosé H. Vázquez in our 2006 article in the Harvard Business Review. Once thought of as a lifebelt for the decreasing margins of large-brand owners, contract manufacturing has now become a major source of competition. Shanghai Automotive Industry Corporation (SAIC), which learned the business by producing initially for Volkswagen and GM, has actually started to sell its own cars in Europe and North America. It has even bought R&D knowledge, acquiring from bankrupt MG Rover the drawings needed to build the Rover 25, Rover 45, and Rover 75.
The economic crisis is accelerating this process. The need to liberate assets to increase ROI has been facilitated by technological and organizational change. This is stimulating business practices at the corporate level that are pushing outsourcing practices to dangerous limits. The wrong management of contract manufacturing will thus increasingly provoke knowledge leaks to direct competitors and the loss of internal manufacturing knowledge; more importantly, it will continue to eliminate barriers to entry, allowing large distributors and contract manufacturers themselves to market their own brands much more easily.
De Figueiredo on Political Strategy
| Peter Klein |
We’ve previously mentioned the chapters by Nicolai and Nils Stieglitz and by Lasse and me in the forthcoming Advances in Strategic Management volume titled Economic Institutions of Strategy. John de Figueiredo’s chapter, “Integrated Political Strategy,” is now available as an NBER Working Paper. John is a leader of this emerging field, which studies how firms attempt to influence the legal and political environment to achieve competitive advantage. As he points out:
Legal and acceptable competitive behavior is determined endogenously by legislators, regulators and judges who are influenced, positively and negatively, by the very same firms the regulations are designed to control. By understanding the theories of how firms affect politics, one can better determine how to gain competitive advantage through political institutions. This is a natural extension of the traditional tools of strategic management. Moreover, for young scholars, this is an area in which the lines of investigation are clear and the openings for serious research opportunities available. In this sense, it is robust area for future research and major contributions to understanding firm performance.
Entrepreneurship Exemplars Conference
| Dick Langlois |
The Center for Entrepreneurship and Innovation at the UConn business school is sponsoring an “exemplars” conference in conjunction with the Entrepreneurship Division of the Academy of Management. The idea of the conference is to help young scholars by providing “exemplars” of good scholarship. Editors from the top management and entrepreneurship journals are here (including frequent O&M participant Joe Mahoney) to comment on these exemplar papers and provide advice.
The conference started last night with a keynote by Venkat Venkataraman and continues through Saturday. You can actually participate in the conference online: register here. I am about to wander over (physically, not electronically) to hear Jay Barney’s keynote at 10:50 EDT.
ACAC Schedule
| Peter Klein |
The Atlanta Competitive Advantage Conference begins tomorrow. The updated schedule, along with other logistical information, is here. You can also download many of the papers. Emory, Georgia Tech, and Georgia State Universities have co-hosted this event the past five years and it’s become one of the main events for research in strategy, organizational economics, entrepreneurship, and related fields.
Debt, Relationship-Specific Investments, and Boundaries
| Lasse Lien |
Here is a link to a nice paper by Jayant R. Kalea and Husayn Shahrurb from JFE back in 2007. The key finding in the paper is that low leverage is used as a commitment device to induce customers and suppliers to make relationship-specific investments (RSI). In short; the higher the need for RSI, the lower the choice of leverage. This raises some intriguing questions about the financial crisis. On the one hand the crisis should generally reduce the willingness to make RSI, as leverage and bankruptcy risks are driven upwards. Presumably then, firms will want to take compensating measures, but what can those measures be? The classical Williamsonian response would be vertical integration. For a given sensitivity to RSI, the inventive to integrate vertically should be strongest for highly leveraged firms. But who would want to integrate with a highly leveraged firm in these times? Or vertically integrate with any firm for that matter? And if the crisis is a temporary phenomenon, vertical integration seems pretty drastic. Another obvious counter measure would be to reduce leverage. That is of course easier said than done during the crisis. A third alternative is increased use of hybrids and alliances of various kinds, but it is difficult to see how this can alleviate the fundamental problem of liquidation risk. So is bruxism the only option?
Lund Routines and Capabilities Workshop
| Nicolai Foss |
Niklas Hallberg, a post-doc researcher at the Lund University School of Economics and Management, and currently a visiting scholar at the Center for Strategic Management and Globalization at the Copenhagen Business School, has put together a nice afternoon workshop on the subject of “Routines and Capabilities — Useful Constructs for Management?”. It takes place on Thursday, June 25, so if you are in the vicinity of Lund University you may pop in and listen to various luminaries as well as yours truly. The program and other details are below. (more…)
Killing the Fax
| Lasse Lien |
I’m in Spain, and I just got a fax. It’s been quite a while since I got one of those (faxes). The experience got me thinking about why the fax network still exists. The technology is clearly inferior to other technologies for any use I can think of, and has been so for quite a while now. Still you will be hard-pressed to find a business address that does not include a fax number. We seem to be in a prisoner’s dilemma situation now. The aggregate benefits are probably smaller than the aggregate costs, but nobody wants to exit first.
In general there seems to be a bias in the literature on network technologies, where a lot of attention has been devoted to bandwagon effects on the adoption side, but little has been said about the exit phase (based on a 5-minute poolside literature review). This could be because the two phases are completely symmetric, with the disincentive to exit early mirroring the disincentive to enter early. If the two phases are not fully symmetric, however, it would be nice to know more about the exit side. Since new network technologies are invading our lives at an accelerating pace (MsN, Facebook, Twitter, etc.), the problem of exit is IMHO as acute as the problem of adoption.
HT: Peter Klein (who adopts them all).
Economic Institutions of Strategy
| Peter Klein |
That’s the title of a forthcoming volume of Advances in Strategic Management edited by Jackson Nickerson and Brian Silverman. You’ll recognize the allusion to a certain classic book. Like that book, this volume maps out an ambitious agenda for new scholarship on institutions and organizations, particularly within the field of strategic management. The chapters provide critical reviews and syntheses of various strands of the strategy literature, intended to support and to challenge new and established scholars starting work in these areas. (They should make excellent readings, for example, for doctoral courses in strategy and the economics of organization.)
Lasse and I contributed a chapter, “Diversification, Industry Structure, and Firm Strategy: An Organizational Economics Perspective,” that you can download on SSRN. Here’s the abstract:
We review theory and evidence on corporate diversification, industry structure, and firm strategy from an organizational economics perspective. First, we examine the implications of transaction cost economics (TCE) for diversification decisions. TCE is essentially a theory about the costs of contracting, and TCE sheds light on the firm’s choice to diversify into a new industry rather than contract out any assets that are valuable in that industry. While TCE does not predict much about the specific industries into which a firm will diversify, it can be combined with other approaches, such as the resource-based and capabilities views, that describe which assets are useful where. We also discuss the transaction-cost rationale for unrelated diversification, which focuses on the potential efficiencies from exploiting internal capital markets. We review this argument as it emerged in the transaction cost literature in the 1970s and 1980s and, more recently, theoretical and empirical literature in industrial organization and corporate finance. We then discuss how diversification decisions, both related and unrelated, affect industry structure and industry evolution. Here, the stylized facts suggest that diversifying firms have a crucial impact on industry evolution because they are larger than average at entry, grow faster than average, and exit less often than the average firm. We conclude with thoughts on unresolved theoretical, methodological, and empirical issues and problems and provide suggestions for future research.
Antitrust and the Theory of the Firm
| Peter Klein |
Josh has a nice post at Truth on the Market on the place of antitrust research and practice within the legal academy. “[C]ontrary to the conventional wisdom I hear from the legal academy, it is an incredibly exciting time to practice, think about, and write about antitrust issues. . . . I suspect that right now is one of the most intellectually active antitrust eras in history.” Josh proposes several hypotheses on the increasingly popularity of antitrust analysis in law schools and within the law-and-economics movement.
Josh’s post got me thinking about the economic theory of the firm. The pioneers in this field — Coase, Williamson, Klein, Alchian, Demsetz, Teece, Masten — were actively interest in antitrust issues. The subtitle of Williamson’s Markets and Hierarchies (1975), after all, is “Analysis and Antitrust Implications.” In the more recent literature, however, antitrust doesn’t make much of an appearance. None of the leading scholars, such as Oliver Hart, Bengt Holmström, Jean Tirole, John Moore, Bob Gibbons, George Baker, Kevin Murphy, Tom Hubbard, or Steve Tadelis works juch on antitrust (please correct me if I’m wrong). Even giants like Foss, Klein, Langlois, and Lien are not active in this area.
One might respond that antitrust is an economic policy issue, not a firm-strategy issue, and note that transaction cost economics (TCE) has migrated from economics departments to business schools, where it joins the resource-based view (RBV) as a leading theoretical perspective on the the firm. Indeed, while the people mentioned above are economists, mostly teaching in economics departments, Williamsonian TCE has largely been supplanted by the Grossman-Hart-Moore model among mainstream economists, while it remains highly influential within the fields of strategic management, organization theory, and marketing.
This leaves us with two questions: (1) Why isn’t the property-rights or Grossman-Hart-Moore approach to the firm more influential in antitrust economics? (2) Why isn’t antitrust a bigger topic within strategic management (e.g., as part of a firm’s legal and political strategy)?
Value Creation in Middle-Market Buyouts
| Peter Klein |
Here’s a paper by John Chapman and me, “Value Creation in Middle-Market Buyouts: A Transaction-Level Analysis,” forthcoming in Douglas J. Cumming, ed., Companion to Private Equity (New York: Wiley, 2009). Get your copy today, while they’re hot. Abstract:
Is private equity an effective governance structure, or simply a means of transferring wealth from “Main Street” to “Wall Street”? How do buyouts affect target-company organization and strategy? How do deal characteristics such as size, industry, transaction complexity, buyer characteristics, holding period, and the like affect the performance of private-equity transactions? Are revenue improvements driven primarily by changes in employment and capital expenditures, or by changes in organization and strategy? Despite a healthy literature on buyouts, little is known about the details of private equity transactions, as most studies rely on publicly available data or confidential data from a single buyout firm. This paper uses a unique sample of 288 exited transactions over a 20-year period across 19 industries from 13 buyout firm firms, based on confidential data from detailed interviews with the general partners of several leading private-equity partnerships. While prior studies have focused on whole-company, going-private buyouts, our sample includes transactions with minority stakes, syndicate deals, and consolidating roll-up or add-on strategies, and we have detailed information on internal rates of return, leverage, equity stakes, and other deal characteristics. We find that the pursuit of ancillary consolidating acquisitions is the biggest driver of post-buyout revenue and profit growth, that solo deals and deals with controlling stakes outperform syndicated or “club” deals, that rates of return have declined over time as buyout markets have become more competitive, that mitigation of agency costs is critical for deal success, and more generally, that private equity can improve the performance even of sound businesses by providing access to resources, industry-specific expertise, capital for recombining assets (most often, consolidation in a fragmented industry), or recapitalization and ownership transition. Finally, our findings suggest the potential for further research of private equity at the transaction level.
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