Managerial Economics Discussion Post

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Over the past five decades, Walmart Stores rose from “humble beginnings” as a small discount
retailer in Arkansas to become the world’s largest retailer with more than $476 billion in sales in
2014.1 Its discount-variety stores, Sam’s Clubs, supercenters (combined discount retail and bulk
grocery stores), and smaller “neighborhood” and express stores are located throughout the
United States, as well as in many other countries such as Mexico, Canada, Puerto Rico,
Germany, Brazil, Argentina, China, Korea, and Indonesia. In 2014, Walmart operated over 11,000
retail units under 71 banners in 27 countries with e-commerce websites in 10 countries. It
employed 2.2 million people around the world (1.3 million in the United States).
Since Sam Walton opened his first store in 1962, the overall financial performance of the
company has been nothing less than phenomenal. To illustrate, suppose you had purchased
$1,000 of the stock at the initial offering in 1970 and held it through 2008. This investment
would have been worth more than $5 million (i.e., a 20 percent compound annual growth rate);
in addition, you would have received cash dividends paid by the company over the period. This
performance made Walmart one of the hottest stocks in the market.
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While Walmart’s performance has been spectacular, it has not been flawless. Following a large
price drop in the second quarter of 1993 (over 20 percent during a period when the overall
market was essentially flat), Walmart’s stock price continued to decline modestly until 1997,
even though the overall stock market was rising. In addition, sales growth at Walmart, which for
a long period had outpaced the retail industry, fell to unremarkable levels.
In an attempt to increase performance during the 1990s, Walmart took a variety of actions; it
opened new stores internationally, opened new supercenters, and logged on to the world of
electronic commerce. In 1998, Walmart entered the traditional grocery store business in
Arkansas where it opened three “experimental” 40,000-square-foot grocery stores (about the
same size as traditional supermarkets). During the period from 1997 to 2005, Walmart stock
again performed well relative to the general stock market and retail industry. Between 2006 and
2014, Walmart continued to perform somewhat better than the general stock market but did
substantially worse than Costco Wholesale Corporation. It, however, performed much better
over this period than its rival, the Target Corporation. In July 2014, Walmart’s new CEO
announced a strategic shift from focusing on large supercenters to smaller stores and online
sales.
All managers would like to outperform the general market as well as their specific industry over
a sustained period. Examples like that of Walmart suggest that such performance is possible but
raise at least five important questions:2
What accounts for the success of these firms?
Should all properly managed firms expect sustained superior performance?
What actions can managers take to generate superior performance?
Can managers enhance financial returns through diversification (as Walmart was attempting to
do by opening grocery stores)?
Do all high-performing firms ultimately “fall back with the rest of the pack” as Walmart did in
the mid-1990s?
This chapter applies the basic economic concepts developed in this book to address these and
related questions.
Strategy
Strategy refers to the general policies that managers adopt to generate profits. For example, in
what industries does the firm operate? What products and services does it offer and to which
customers? In what basic ways does it compete or cooperate with other firms within its
business environment? Rather than focusing on operational detail, a firm’s strategy addresses
broad, long-term issues facing the firm.3 Typically, strategies do not remain constant but evolve
through time. For example, Walmart’s strategy in 2014 focuses on discount retailing and the
related grocery industry, as well as online sales. It owns and operates five basic types of stores
in the United States: discount-variety stores, Sam’s Clubs, supercenters, neighborhood markets,
and express stores. It offers a wide product assortment; “every-day low prices” (supported by a
low-cost structure); limited advertising; and friendly, well-informed “sales associates.” Originally,
its strategy focused on placing stores in the rural Southeast. Walmart now operates stores
throughout the world. Ultimately, along with the organizational architecture of the firm,
strategy is a key determinant of the success or failure of the enterprise.
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The ultimate objective of strategic decision making is to realize sustained profits.3 To achieve
this objective, managers must devise ways both to create and to capture value. Earlier chapters
focused on how value might be created and captured through input, output, and pricing
policies. Those chapters also analyzed how competition constrains the ability of managers to
capture value. But they (like most discussions in the traditional managerial economics literature)
focused on a single product, taking the industry and product characteristics as given.
This chapter takes a broader look at how managers create and capture value. The next section
presents an analysis of value creation within a given industry. Subsequent sections examine
capturing value and the choice of industries. The final section offers a general framework for
implementing the concepts in this chapter.
Firms often compete against a few identifiable rivals. For example, Boeing competes largely with
Airbus in the production of commercial jet airplanes. It is particularly important for managers in
such firms to consider likely responses of rivals when making strategic decisions about pricing,
new investment, advertising, and so on. For example, it would be foolish if Boeing failed to
consider likely responses by Airbus in setting the prices of its wide-body jets. In this chapter, we
concentrate on the broader issues of how firms create and capture value; thus we abstract from
how reactions by rivals might be incorporated explicitly in the analysis. In the next chapter we
use game theory to provide an explicit analysis of reactions by rivals in the strategic decisionmaking process.
Value Creation
Figure 8.1 displays supply and demand curves for an industry. It differs from our previous supply
and demand figures in one important respect: It explicitly displays both consumer-borne and
producer-borne transaction costs. Consumer transaction costs include such things as the costs
of searching for the product, learning product characteristics and quality, negotiating terms of
sale with a supplier, and enforcing agreements. If these costs were lower, demanders would be
willing to pay more for the product. For example, automatic teller machines increase the
demand for banking services by reducing the amount of time customers spend in line and by
providing basic banking services around the clock. The dotted demand curve indicates potential
demand—what demand would be if consumer-borne transaction costs could be eliminated. The
solid demand curve displays the effective demand given a per-unit consumer transaction cost of
a. Similarly, producers bear costs in transacting with consumers and suppliers (e.g., negotiating
terms with customers and paying attorneys to draft a supply agreement). The dotted supply
curve indicates potential supply—the willingness of producers to supply the product if producer
transaction costs were eliminated. The solid line shows the effective supply curve given a perunit transaction cost of b.4
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Figure 8.1 Ways to Create Value
This figure displays the supply and demand curves for an industry. It differs from previous
diagrams by including producer and consumer transaction costs. [Per-unit consumer-borne
(producer-borne) transaction cost is a(b).] Consumers would demand more and producers
would supply more if these costs were lower. Value consists of the sum of consumer and
producer surplus. Managers can increase value by reducing transaction or production costs or
by increasing the demand for the product—for example, by increasing the perceived quality of
the product.
The area under the dotted demand curve (demand before transaction costs) and above the
dotted supply curve (supply before transaction costs) up to Q* is divided into four areas. First,
there are the two parallelograms representing consumer and producer transaction costs. Next,
there are the two triangles representing consumer and producer surpluses. Total value created
by the industry is the sum of producer surplus and consumer surplus.
An important first step in making profits is discovering ways to create value. The second step,
discussed below, devises ways to capture this value. Figure 8.1 suggests at least four general
ways that managers within the industry might increase value.
They can take actions to lower production costs or producer transaction costs, thus shifting the
effective supply curve to the right.
Managers can implement policies to reduce consumer transaction costs, thus shifting the
effective demand curve to the right.
They can take actions other than reducing consumer transaction costs to increase demand,
shifting both the potential and effective demand curves to the right.
Managers can devise new products or services—in essence creating a new figure.
We discuss each of these strategies in turn.5
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Production and Producer Transaction Costs
Chapter 5 discussed how managers should choose inputs to minimize production costs. Over
time, managers can discover new technological opportunities to reduce these costs and
increase value. They also can devise ways to lower the costs of transacting with customers and
suppliers. For example, when personal computers first were developed, they were relatively
expensive to produce. Over time, companies learned to reduce these production costs. As a
result, the quantity of personal computers sold in the market has increased substantially—as
has the total value (consumer plus producer surplus) created within this industry. Computer
manufacturers also have devised ways to reduce their costs of transacting with suppliers and
customers. For instance, large computer manufacturers have developed electronic connections
with major software producers to lower the cost of ordering software programs. They also have
developed computer links that reduce their costs of transacting with customers.
Walmart has shifted its effective supply curve to the right by developing new low-cost methods
for producing and distributing retail services and products. For example, its extremely efficient
hub-and-spoke distribution system has lowered the costs of stocking its stores. Walmart has
reduced transaction costs through direct computer links with major suppliers, such as Procter &
Gamble. These links have cut the costs of restocking products and essentially have eliminated
writing paper checks to these vendors—they are paid through an electronic payment system.
MANAGERIAL APPLICATIONS
Small Banks Struggle to Provide Technology Demanded by Customers
Following the financial crisis of 2010–2012, big banks—seeking to improve their finances—
began closing or selling remote, unprofitable branch locations. They began focusing on the
largest U.S. cities, which are densely populated and more affluent. As the big banks pulled out
of smaller markets, some small community-based banks saw an opportunity and purchased
hundreds of former branches between 2012 and 2015. But a number of the community banks
trying to fill these gaps are struggling. Consumers used to relying on digital services, including
depositing checks and paying bills online, have lower demands for local branches. To attract the
tech-savvy customer, all banks, big and small, must invest in ever-increasing costly technology.
Small banks have more difficulty justifying the large fixed costs for online banking platforms, and
some have closed as depositors leave for big banks with mobile banking apps. The 4,600 small
community banks today hold 7 percent of all bank assets combined, down from 32 percent 30
years ago when there were greater legal restrictions on bank branching. This case illustrates the
strategic importance of creating customer value. Small community banks could not provide the
same customer value depositors came to expect from big banks and ended up paying a heavy
cost for this mistake.
Source: R. Ensign and C. Jones (2019), “Small-Town Banks Crippled by High-Tech Costs,” The
Wall Street Journal (March 2).
Consumer Transaction Costs
Reducing consumer transaction costs also can increase value. For example, early Walmarts were
established in small rural towns. One way that these stores added value was through reducing
travel time for local residents, who previously had to drive to urban centers to do a larger part
of their shopping. Walmart also reduces consumer-borne transactions costs by the layout of
their stores. For example, Walmart captures “market-basket data” from customer receipts at all
its stores. By analyzing this data, Walmart can tell which products are likely to be purchased
together. Walmart uses this knowledge to reduce customers’ costs in navigating their stores by
placing commonly purchased bundles of products together. Examples of such pairings include
bananas with cereal, snack cakes with coffee, bug spray with hunting gear, tissues with cold
medicine, measuring spoons with baking supplies, and flashlights with Halloween costumes.6
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MANAGERIAL APPLICATIONS
The U.S. Government’s Global Entry Program Reduces Consumer Transaction Costs
Since the terrorist attack on the World Trade Center in 2001, international fliers have been
subjected to increased security checks when entering the United States. The associated increase
in waiting times imposes transaction costs on international fliers and potentially decreases the
demand for international travel.
The U.S. government’s Global Entry program is designed to reduce the time it takes for “lowrisk” fliers to enter the country. U.S. citizens (and certain others) can apply for a Global Entry
pass online. After receiving preliminary approval, the applicant must complete an in-person
interview with a U.S. customs agent at selected locations, during which the person is also
photographed and fingerprinted.
Pass holders entering the United States from international flights head directly to a passport
kiosk (at major airports) where they answer a few questions on a computer monitor. This
process avoids having to wait in line for standard passport control agents. There are also special
lines for pass holders to reduce the time they spend clearing customs.
A study released in July 2014 found that the use of Global Entry kiosks reduced average wait
times by 33 percent at New York’s JFK airport and more than 15 percent at New Jersey’s Newark
Liberty airport.
U.S. Customs and Border Protection spokeswoman Jennifer Evanitsky says the agency
recognizes the importance of international travel to the nation’s economy. The kiosks allow the
agency’s officers “to facilitate legitimate international travelers as quickly as possible while
maintaining the highest standards of security,” she says. This example, illustrates how
technology often reduces consumer transaction costs.
Source: G. Stoller (2014), “Passport Kiosks Reduce Fliers Customers Wait Time,” USA Today (July
16).
The entire industry that involves marketing over the Internet is another example of reducing
consumers’ transaction costs. For instance, when prospective customers use search engines to
explore the Internet, they often are presented with a list of related books, which can be ordered
electronically at a discount through companies such as Amazon.com. This service reduces
consumer transaction/search costs by identifying books of potential interest and making it
easier to place an order.
Other Ways to Increase Demand
The demand curve holds variables other than the price of the product constant. We already
have discussed how managers can increase demand by reducing consumer transaction costs.
They also can increase the effective demand for their products—and thus total value created
through transactions—by affecting variables such as expected product quality, prices of
complements, or prices of substitutes.
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HISTORICAL APPLICATIONS
Giving Away Razors to Increase Demand for Blades
King Gillette gave away free razors after he invented his famous double-edge disposable blade in
1885—United Cigar Store gave razors to customers who bought boxes of Cuban cigars—banks
bought razors for pennies and gave them away as part of shave-and-save campaigns. These
promotions were designed to get razors in the hands of consumers who would then buy a
stream of future blades for the razors. In 2005 Gillette was acquired by P&G for $57 billion.
Source: “No Charge,” Attaché (September 1999), 14–16; and A. Coolidge (2005), “Gillette: P&G
Not Our First Choice,” The Cincinnati Post (March 16).
Product Quality
Actions that enhance perceived quality increase demand; total value also is raised unless these
actions entail larger increases in production costs. For instance, the innovation of titanium golf
clubs increased the demand for golf equipment, while the invention of parabolic skis increased
the demand for skis and skiing. Another important dimension of product quality is delivery
time. Most consumers prefer to receive products sooner rather than later. Amazon, in particular,
recognizes this and strives to deliver its products to consumers faster than its competitors (even
exploring the use of drones). The resulting increases in demand have been greater than the
associated increases in production costs—thus, total value created within these industries has
increased.
Price of Complements
Managers sometimes can act to reduce the price of complements, thus increasing the demand
for their products. To illustrate, consider CompuInc, which produces personal computers, and
PrintCo, which produces a complementary printer.7 For simplicity, suppose that customers
purchase either both products or neither product (they are quite strong complements), the
price of CompuInc’s personal computers is Pc, the price of PrintCo’s printers is Pp, and the
demand for each product is
(8.1)
Q (measured in thousands) is the number of computer–printer combinations sold, and for
simplicity assume the marginal cost of producing both products is 0.
If the two companies do not cooperate in setting prices, each will seek to maximize its individual
profits, given its expectation of the other firm’s price. In this case, CompuInc will view its
demand curve as
(8.2)
while the PrintCo demand curve is
(8.3)
where and represent the expectations about the other firm’s price.8 Each firm’s profit is
maximized by setting MR = MC (0 in this example):
(8.4)
(8.5)
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Substituting for Q from Equation (8.1) and rearranging the terms yield the following two
reaction curves:
(8.6)
(8.7)
The equilibrium consists of prices P*p and P*c that simultaneously solve these two equations.9
Figure 8.2 displays the solution graphically. In equilibrium, both firms choose a price of $4; thus,
a total of 4,000 units of each product is sold. The profit for each firm is $16,000; combined
profits are $32,000.
Figure 8.2 Noncooperative Pricing for CompuInc and PrintCo
If the two companies price noncooperatively, each will try to maximize its individual profits
given its expectation of the other firm’s price. The equilibrium consists of prices P*p and P*c,
which simultaneously solves these maximization problems. This figure displays the solution
graphically. The figure displays the reaction curves for each firm. A given firm’s reaction curve
indicates its optimal price given the pricing decision of the other firm. In equilibrium (where the
reaction curves cross), both firms choose a price of $4. A total of 4,000 units of each product is
sold. The profits for each firm are $16,000. Combined profits are $32,000. (Note: If they
cooperate and set each price at $3, combined profits will be $36,000.)
Now consider what happens if the firms were to coordinate the prices, for example, through a
joint venture. To maximize the combined profits, the companies jointly set marginal revenue
equal to marginal cost10:
12 − 2Q = 0(8.8)
They sell 6,000 units at a combined price of $6 (e.g., Pc = $3). In this case, they make a
combined profit of $36,000. This combined profit by pricing the products jointly is higher than
the profit they would receive if they do not cooperate in setting prices. When the firms price
independently, they do not consider the negative effect that their higher prices have on the
other’s profit. Pricing cooperatively, they take this interaction into account. Note that in this
case, consumers also would be better off because the prices of both products are lower and, as
a result, more product is purchased.
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MANAGERIAL APPLICATIONS
Technology and Value
During the later part of the 20th century, there has been a massive change in information,
communication, and production technologies. This technological change has provided
important opportunities for increasing value. For example, the “business process reengineering”
movement in the 1990s used computer and information technology to lower costs (for instance,
by streamlining systems used to process orders, shipments, payables, and receivables). Flexible
production technologies have allowed firms to custom-design certain products to fit specific
customer demands better. Computer and information technologies have been used to reduce
the costs of transacting with suppliers, and 3D printing cuts manufacturing costs. Using
technology to increase value is likely to remain a significant focus well into the 21st century.
Prices of Substitutes
Low-priced substitutes reduce the demand for a product. Sometimes managers can affect the
price of substitutes. For example, movie theaters frequently prohibit patrons from bringing food
into the theater. These restrictions on lower-priced substitutes increase the demand for snacks
offered by the theater.
New Products and Services
To this point, our discussion has focused on creating value by increasing demand or reducing
the costs of producing existing products. Inventing new products and services also creates
value. For example, consider the consumer electronics industry. Many of today’s products that
create significant value are relatively new developments: for instance, MP3 technology, digital
cameras, and digital video displays (DVDs).11
Cooperating to Increase Value
Our example of computers and printers shows that firms sometimes can increase value through
cooperating with each other, rather than competing. In this case, the companies were producers
of complementary products. Opportunities to increase value through cooperation also can arise
with customers, suppliers, and even competitors. For instance, cooperating with suppliers and
customers in developing computer and information links can reduce supply costs and lead to
the production of more valuable products—ones more tailor-made for the customer (recall the
example of Dell Computers). One way competitors cooperate is in development projects to
reduce joint costs. For example, major automobile manufacturers have participated jointly in
the research and development of batteries for electric cars. Longer-lived batteries are essential
for these companies to market electric cars on a wide-scale basis. If each company acts
independently, development costs are expected to be higher. As another example, offshore
drilling is quite expensive. Prior to soliciting bids for offshore sites, the U.S. government allows
the oil firms to conduct a survey of the area jointly; they share the data and divide the costs.
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MANAGERIAL APPLICATIONS
Research and Development Joint Ventures
Firms can sometimes increase their values by cooperating with competing firms. One example is
research and development (R&D) joint ventures. R&D costs are particularly high in the
pharmaceutical industry. Pfizer CEO Ian Read predicted in 2013 that the number of joint
ventures among rivals formed for developing drugs and expanding into different geographical
markets would increase. Read believes the associated benefits from sharing costs, risks, and
commercial benefits are large. In 2013, Pfizer participated in a joint venture with Johnson &
Johnson to develop drugs for Alzheimer’s patients and was contemplating additional ventures.
Read cited vaccines, oncology, and neurodegenerative diseases as potential candidates for
future partnerships with competitors, given the growing pressures to cut costs in drug
development as healthcare systems demand increased savings.
Antitrust laws in many countries restrict competitors from collaborating to set prices. However,
joint ventures to share development costs are frequently allowed under existing laws.
Source: A. Jack (2013), “Prizer Chief Looks to Joint Ventures to Bolster Drug Development,”
Financial Times (June 6).
American antitrust laws generally make it illegal for rival firms to cooperate for the purpose of
monopoly pricing. Nonetheless, many forms of cooperation are legal and increase the welfare
of both producers and consumers (again consider our PC-printer example).
Converting Organizational Knowledge into Value
To create value, employees must convert their existing knowledge about production processes,
transaction costs, customer demand, and so on, into ideas that can be implemented by the firm.
In Chapter 3, we discussed the knowledge conversion process. In this section, we consider the
strategic implications of this analysis. Recall that the resources within a firm can be divided into
three general categories. First are its tangible assets, which include property, plant, and
equipment. Second are its intangible assets, such as patents, trademarks, and brand-name
recognition. These assets typically are not shown on the firm’s balance sheet but can be
significant in creating and capturing value—the firm’s methods of doing business, its formulas
and recipes, are a particularly important type of intangible asset. Third and perhaps most
important are its human resources.
Firms in Silicon Valley frequently refer to these three types of resources as hardware, software,
and wetware. Hardware consists of physical assets. Software is broadly used to describe the
firm’s “soft” assets, such as its formulas and recipes for creating value. Wetware refers to
employee brainpower, that is, “wet computers.”
A firm owns and thus can capture value from its hardware and software, but it only “rents” its
wetware. Wetware is the private property of individual employees, who can take it with them to
another firm if they so choose. To create and capture value, managers must find ways to convert
the knowledge contained in employee wetware—even knowledge the employees may not
realize they have—into software.
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The evolution of the McDonald’s Corporation provides a good example of how this process
occurs. The first McDonald’s unit was established in 1956. The company’s hardware consisted of
property and equipment. However, its most important asset was its software. McDonald’s major
source of value was its new formula for selling hamburgers, fries, and drinks to customers. This
formula translated into a business approach that McDonald’s was able to replicate in locations
around the world. If McDonald’s had stopped innovating in 1956, new companies that copied
and improved on the original formula, such as Burger King, Wendy’s, and Kentucky Fried
Chicken, eventually would have forced McDonald’s out of business. But McDonald’s continually
improved its formula for creating and capturing value by converting wetware into new software.
Today McDonald’s has a much wider product offering, more effective store designs, and better
production processes than it had in 1956.
The development of the Filet-O-Fish Sandwich at McDonald’s illustrates the conversion from
wetware to software. Originally, the only food products McDonald’s sold were hamburgers and
fries. The product line intentionally was limited so that it could be produced efficiently and
quickly, according to McDonald’s formula for value creation. A franchisee in a Catholic
neighborhood, however, was unable to sell many hamburgers on Fridays because Catholics
were admonished from eating meat on Fridays. The franchisee worked hard to develop a tasty
fish sandwich. At first, McDonald’s objected to his selling the new sandwich because it was not
consistent with the image as a hamburger company. It also would lead to inconsistency across
units—something that a franchise company generally wants to avoid. Eventually, however,
McDonald’s saw the value that could be created and captured by offering a fish sandwich.
Specialists at the corporate level devised ways to improve the sandwich and to lower
production costs (e.g., by using a different type of fish that could be precut into a standard size).
Ultimately, the Filet-O-Fish sandwich was introduced across all McDonald’s units and has been a
menu staple ever since.
The idea of a fish sandwich initially was contained in the wetware of the franchisee, while the
ways to improve the product were in the wetware of specialists at the corporate level. At this
stage, the ideas and knowledge were not creating value. But the wetware was eventually
converted into software and is now part of the McDonald’s formula for creating and capturing
value. A similar story lies behind the “Big Mac,” which was the brainchild of a franchisee in
Pittsburgh who wanted a heftier sandwich to sell to steelworkers.
Software is different from hardware in that it is not a scarce resource. While a given machine
can be used only at one location, software can be replicated to create value at locations
throughout the world. For example, McDonald’s currently has over 10,000 units operating
under the same business format. (Of course, as we will discuss, software also can be copied by
competing firms, thus reducing its profit potential.)
Whether or not a firm is likely to be successful in converting wetware into software depends
critically on how decision rights are assigned within the firm and on how employees are
evaluated and rewarded (the firm’s organizational architecture). Chapters 11–17 provide a
systematic analysis of these considerations.
Opportunities to Create Value
The discovery of better ways to use existing resources drives much of the value that firms
create. Today’s personal computers are far more powerful than the 1980s mainframes, yet they
take significantly fewer resources to produce. The value created by improved computer
technology has not come from the discovery of new raw materials or resources, but by using
existing resources more efficiently. To quote growth theorist Paul Romer,12
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So it is not the raw materials or the mass of things on earth that really lies behind economic
success and high standard of living, it is the process of rearrangement. And what underlies this
process of rearrangement are instructions, formulas, recipes, and methods of doing things
[software].
MANAGERIAL APPLICATIONS
Sonic Drive-Ins Convert Wetware to Software
Sonic Corp. is one of the largest fast-food chains in America with more than 3,500 restaurants in
44 states in 2014. Former CEO, Pattye Moore, stated in 2002 that she spent half her time visiting
stores and eats at Sonic with her daughters three or four times a week. “We really get a lot of
ideas that way. . . . We just go out and ask them what they’re fixing for themselves. . . . We
encourage our employees to play with their food.”
Sonic employees at one store were bored with buns and started eating their burgers and
chicken on thick, grilled toast. Sonic introduced “toaster sandwiches” that became popular with
customers. One customer suggested sausage on a stick wrapped in a buttermilk pancake and
deep fried. It is now a breakfast staple. One store manager created the grilled chicken wrap. All
of these products were launched throughout the entire Sonic chain.
Notice how Sonic had encouraged people to experiment with new food dishes (enhancing their
wetware) and then converts this wetware into software. Corporate management then chooses
which of these ideas to pursue. The recipes are refined and codified. Sonic illustrates how one
company had used its organizational architecture to convert wetware at one drive-in into
literally new recipes (software) that are leveraged throughout the firm’s other locations.
Moreover, Sonic has a corporate culture that promotes experimentation, identifies potentially
valuable wetware, and converts that wetware into software, which are shared/exported
throughout the firm.
Source: http://corporate.sonic.drivenin.com (2014); and “Required Eating Makes This Job Fun,”
Democrat and Chronicle (June 3, 2002), 7D.
The possibilities for new value creation are immense. Consider Romer’s simple example of a
production process that involves just 20 steps. The order of the steps can be varied in an
extremely large number of ways (approximately 2.4 followed by 17 zeros) and thereby affect the
value created. In most production processes, of course, there is a natural ordering that
precludes certain combinations of steps—it doesn’t make sense to weld the body together after
the car is painted. But given all the ways to rearrange the many resources on the earth, the
possibilities for continued value creation are enormous. This discussion suggests that firms face
an essentially unlimited set of opportunities to create better “instructions, formulas, recipes,
and methods” for making improved products at lower cost. New opportunities are likely to
emerge as technology continues to evolve. For instance, the latter part of the 20th century saw
a massive change in information, communication, and production technologies. This
technological change has provided substantial opportunities for increasing value. The “business
process reengineering” movement in the 1990s used computer and information technology to
lower costs (for instance, by streamlining the systems used to process orders, shipments,
payables, and receivables). Flexible production technologies have allowed firms to tailor the
design of their products to fit specific customer demands. Computer and information
technologies reduce the costs of transacting with suppliers. Using technology to increase value
is likely to remain a significant focus well into the future.
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Capturing Value
Creating value is an essential first step in generating profits. But then it is necessary to capture
this value. It does the firm little good to reduce transaction/production costs or to increase
consumer demand (for instance, by creating new value-enhancing software) if rivals can copy
these changes quickly and enter the market—such competition will eliminate the profits. (But,
of course, failure to innovate and keep up with the competition can lead to ruin.)
Figure 8.3 compares a firm in a competitive market to a firm with market power. In competitive
markets, firms face horizontal demand curves and are price takers. With market power, firms
choose price–quantity combinations. Chapters 6 and 7 indicated that firms often can capture
value if they exploit their market power. Sometimes firms can capture value, even without
market power, if they employ superior factors of production that allow them to be more
productive than their rivals. In a competitive market, there typically are firms that would be
willing to continue to produce the product even if demand and the market price fell. This
production corresponds to the dashed section of the supply curve (below the market price P*)
in Figure 8.3. Also shown is the corresponding producer surplus. Sometimes (but not always) a
firm can capture a portion of this producer surplus as economic profit. Next, we discuss the
conditions under which market power and superior resources lead to economic profits.13
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Figure 8.3 Firm with Market Power versus a Firm in a Competitive Industry
The firm on the left has a downward-sloping demand curve and thus has market power. It can
choose price–quantity combinations. Firms with market power often can capture economic
profits. The other firm is in a competitive industry and thus faces a horizontal demand curve.
Earning economic profits in this market setting is difficult. Firms along the dotted section on the
supply curve (below the market clearing price of P*) still would produce the product if demand
and price fell. The shaded triangle represents producer surplus. This chapter discusses how a
firm sometimes (but not always) can capture a portion of this producer surplus as an economic
profit.
HISTORICAL APPLICATIONS
Creating but Not Capturing Value: Eli Whitney
A great problem in harvesting cotton during the 18th century was separating cotton from its
seed. This laborious task was done by hand. It was so difficult that it took a worker a whole day
to clean 1 pound of staple cotton. Eli Whitney, while visiting Georgia, was intrigued by this
problem. Within a few weeks, he produced a machine he called a “cotton gin” (a shortened
form of cotton engine). It greatly increased the amount of cotton that could be cleaned in a day
and soon led to cotton becoming the chief crop in the South. Clearly, the invention of the cotton
gin created significant value. Yet, before Whitney’s invention was completed and patented, his
first model had been widely copied. Virtually all his profits went into lawsuits to protect and
enforce his rights. He did, however, make profits in the financial markets speculating on the
price of cotton.
Market Power
Entry Barriers
If there are no barriers to entry, competition from new firms tends to erode profits within the
industry.14 Entry barriers exist when it is difficult or uneconomic for a would-be entrant to
replicate the position of industry incumbents. These barriers include factors that make price
cuts likely if a new firm enters (such as economies of scale), incumbent advantages (such as
patents and brand names), and high costs of exit.
Numerous researchers have tested the theoretical link between entry barriers and profit
potential.15 Consistent with the theory, these studies generally confirm that price-cost margins
tend to be lower in competitive industries. Researchers also have found a positive correlation
between profit and specific entry barriers (such as economies of scale or advertising) as well as
a positive correlation between profit and concentration (combined market share of the top few
firms) across geographic markets within a given industry.16
While theory and evidence suggest that profit potential increases with entry barriers, the
existence of such barriers is no guarantee of economic profits. There are at least four additional
factors that are important. These include the degree of rivalry within the industry, threat of
substitutes, buyer power, and supplier power.17
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MANAGERIAL APPLICATIONS
Competition and the Number of Competitors
The degree of rivalry generally increases with the number of competitors. Depending on the
nature of the industry, however, competition can be quite fierce even with only a few
competitors. Coca-Cola had about 40 percent of global nonalcoholic beverage sales in 2018,
while Pepsi had a market share of about 20 percent. Yet the battle between Coke and Pepsi has
been intense for decades, with costly promotional contests and intense competition for
distribution. Similarly, competition has been strong in the U.S. tobacco industry, although the
two largest companies have had about 85 percent of the market. In detergents, two large
companies, Procter & Gamble and Unilever, have conducted a global “soap war.” To varying
degrees, each of these industries is characterized by excess capacity, high fixed costs, lack of
product differentiation, and slow growth—all factors that lead to greater rivalry.
Degree of Rivalry
When the degree of rivalry is high, profits will be low even if there are entry barriers. Two
factors that help determine the level of rivalry are the number and relative sizes of competitors.
The fewer the number of competitors (the more concentrated the industry), the more likely that
firms will recognize their mutual dependence and refrain from cutthroat competition. The
presence of a large, dominant firm (as opposed to a comparable number of similarly sized firms)
also can reduce rivalry because a dominant firm frequently takes the lead in setting prices and
takes actions to sanction others that do not follow its lead (within the limits of antitrust
constraints). The level of rivalry can change over time as basic conditions within the industry
change. For example, if existing firms within an industry have excess capacity, they often will
engage in price competition in an attempt to increase their individual outputs. In general, excess
capacity, high fixed costs, lack of product differentiation, and slow growth all increase the
degree of rivalry within the industry.
Threat of Substitutes
Even if entry is limited, firms within an industry are not immune to outside competition. There is
the threat of substitutes. For instance, the large scale of investment potentially limits entry into
the overnight delivery market (populated by firms such as FedEx and UPS). However, in recent
years effective substitutes, such as e-mail and fax machines, have reduced the demand for
delivery services (relative to what would have been without these technological developments).
Similarly, banks face competition from money market accounts that offer customers the ability
to write negotiable orders of withdrawal (usually restricted to amounts in excess of $100).
Buyer and Supplier Power
The final two factors that help determine a firm’s market power are buyer and supplier power. If
the industry has only a few large customers, profit is likely to be low since these customers will
use their buying power to extract lower prices. Similarly, if the key suppliers to an industry are
large, concentrated, or well organized (e.g., unionized), they will attempt to extract industry
profits through high input prices. During the 1990s Intel and Microsoft were essentially sole
suppliers of certain key inputs for the production of personal computers; hence, they have been
quite profitable.
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Market Power and Strategy
Firms sometimes can increase economic profit by taking actions that promote entry barriers,
reduce intra-industry rivalry, limit the availability of substitutes, or reduce buyer/supplier power.
Examples of each type of activity are easy to find. For instance, American manufacturers
frequently lobby for taxes or restrictions on imports to reduce entry by foreign firms. Firms in
certain industries form cartels or other collusive agreements to reduce competition.18 As we
have discussed, organizations like the AMA act to limit the availability of substitute products or
services (in their case new physicians, nurses, physician assistants, and midwives). Firms reduce
buyer power by opposing buyer-cooperatives. Finally, firms thwart supplier power by opposing
labor unions and expanding capacity in nonunionized locations—especially internationally.
Historically, many managers focused on capturing value through anticompetitive activities, such
as erecting entry barriers. They have found that often it is difficult to limit competition—
especially in a global marketplace. Also, as discussed in Chapter 21, regulators extract much of
the producer surplus created through limits on competition, for example, through campaign
contributions to encourage the adoption and enforcement of entry restrictions. Due to these
considerations, much of the contemporary focus in strategy is on superior resources—the
subject of the next section.19
ANALYZING MANAGERIAL DECISIONS: Investing in a New Restaurant Concept
For the last 10 years you have been working in the health food business. You have talked to
many customers who have suggested a new restaurant concept. The restaurant would feature a
variety of lowcalorie meals (under 500) made from healthy ingredients (e.g., organic fruits and
vegetables and steroid/hormone free meat). The restaurant would include a bar with an
extensive organic wine list and trendy decor. There would be an emphasis on high quality,
friendly service, and colorful meal presentation. Your customers suggest that they would be
willing to pay around $50 to eat a meal and have a glass of wine at this type of restaurant. They
lament the fact that their community has no upscale restaurants that offer this type of fare.
You have conducted a detailed financial analysis of this potential business opportunity. You
believe that you have good information on the costs of starting and operating the restaurant.
You project that with a $50 meal price and anticipated demand you would earn a high profit and
an excellent rate of return on your investment. You have the equity capital to start the business.
Several friends with MBAs argue that you would be crazy to start this business. They claim that
there are few entry barriers to the restaurant industry and that “every person with business
training knows that you can’t make profits in a competitive industry.” Should you drop the idea
of opening the new business based on this argument? Explain.
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Superior Factors of Production
Both human as well as physical assets vary in productivity. For example, Clayton Kershaw is a
great baseball player, Steve Jobs of the Apple Inc. was a superb CEO, land in California’s Imperial
Valley is incredibly fertile, land adjacent to an expressway interchange offers customers quite
convenient access, and so on. If an asset allows the firm to make a profit because of its superior
productivity, other firms will compete for this resource and bid up its price. Thus, with wellfunctioning markets, the gains from superior productivity accrue to the responsible asset.
Producer Surplus Captured by Superior Assets
Figure 8.1 divides value into consumer surplus and producer surplus. Consumers receive the
consumer surplus. Producer surplus goes to the owners of superior assets. As an example,
consider Pete Irving, general manager of Speedy Modems. Last year, Speedy was just breaking
even in producing modems at a price of $100. Demand for the particular type of modem
increased, and the price rose to $150; Speedy began making a profit (producer surplus) of $50
per unit. This profit motivated other firms to produce the same type of modems. They were less
productive than Speedy solely because they lacked a manager with Pete’s talents. The rival firms
began making job offers to Pete. To dissuade him from going to a rival firm, Speedy had to
increase Pete’s salary. Through this process, Pete’s salary increased to the point where Speedy
was making only a normal rate of profit—the same as the competing modem companies. The
gains from his special talents went to Pete, not to the firm. This same process works for physical
assets. For instance, if a firm rents a prime piece of land or a unique piece of equipment, rental
rates will be bid up to reflect the asset’s superior productivity. And if the firm owns the asset, its
value (and thus the opportunity costs for continuing to use it) will be bid up—in effect, the firm
pays the rent to itself for its continued use of the asset.
Figure 8.4 displays a graphical analysis of this general phenomenon. The illustration on the right
depicts supply and demand in the marketplace. The initial price is P0*. A typical firm in the
industry is depicted on the left and is making no economic profits—price equals long-run
average cost (LRAC0). The demand for the product increases and the market price goes up to
P1*. The firm appears to have the potential to make an economic profit, since the price is above
its initial long-run average cost. Competitors and new entrants, however, will bid for the special
resources (such as a talented manager or a productive piece of land) that would allow the firm
to produce the product at an average cost below price. In equilibrium, the firm’s costs would
increase to the point where its long-run average cost (LRAC1) again equals price.20 The
additional producer surplus created by the increase in price (shaded area) is reflected in the
price or opportunity cost of the scarce assets, which made lower-cost production possible at the
initial price and output level.
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Figure 8.4 Producer Surplus Is Captured by Superior Assets
The illustration below depicts supply and demand in the marketplace. The initial price is P0*.
The typical firm in the industry is depicted on the left and is making no economic profits—price
equals long-run average cost (LRAC0). The demand for the product increases and the market
price goes up to P1*. The firm appears to have the potential to make an economic profit, since
the price is above its initial long-run average cost. Competitors and new entrants, however, will
bid for the special resources (such as a talented manager or a piece of land) that would allow
the firm to produce the product at an average cost below price. In equilibrium, the firm’s cost
would have increased to the point where its long-run average cost (LRAC1) equals price. The
additional producer surplus created by the increase in price (shaded area) goes to the scarce
assets, which made lower-cost production possible at the initial price and output level.
MANAGERIAL APPLICATIONS
Sugar Prices
The average price of refined sugar in world markets over the past few decades years has been
around $0.15 per pound. In contrast, the U.S. average was close to $0.30 per pound. The
dramatic difference between the two prices is due largely to American tariffs on sugar imports.
Foreign producers would be willing to sell to Americans at lower prices. Yet, they are not
permitted to do so. This restriction benefits domestic sugar producers, who are able to sell their
sugar at the higher price. Without entry restrictions, the U.S. price would be driven down to the
world price. Such a domestic price decline would benefit American consumers but hurt
American sugar producers.
If the firm owns the scarce asset (e.g., a piece of land), the wealth of the firm’s owners increases
as the price of the asset is bid up. It is important, however, to realize that a firm does not have
to use a superior asset to realize this value. In fact, the firm might be better off selling the assets
to another firm. Managers sometimes overlook this alternative.
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As an example, it has been argued that British Petroleum (BP) has a competitive advantage in
producing retail gasoline because it owns productive oil fields in Alaska that it bought long ago
at low prices.21 Potential competitors are disadvantaged, it is argued, because they have to buy
oil on the open market at a higher price than BP’s current cost of extracting its oil. This
argument is flawed because it fails to apply the concept of opportunity costs appropriately. If BP
can sell its oil on the open market, the cost of using it internally is the revenue forgone from not
selling it—and that is the current spot market price of oil, not just BP’s extraction cost. If other
companies were more efficient in refining crude oil and producing gasoline for retail customers,
BP would be more profitable if it sold the oil on the open market and did not compete in the
production of gasoline. The wealth of BP shareholders is certainly greater because the company
owns valuable oil rights in Alaska. But the critical question is how managers best exploit this
valuable asset. It might be best either to sell the land to another company, sell the oil from the
land to another company, or refine the oil internally to produce and sell retail gasoline (or some
other petroleum product). Its best course of action depends on the relative efficiency of BP
versus its competitors in the extraction and distribution of oil or the production and distribution
of gasoline. BP should not extract oil or produce retail gasoline simply because it owns its oil
reserves.
Table 8.1 illustrates the difference between accounting and economic profits for BP’s selling
gasoline through its own retail gasoline stations. The following assumptions are used: (1) BP’s
cost of extracting enough oil and refining it into a gallon of gasoline is $0.40; (2) this gasoline
can be sold on the wholesale market for $2.00; (3) station operating costs (e.g., wages for
station attendants) are $2,000,000; (4) BP produces 1 million gallons of gasoline a month; and
(5) there are no other relevant costs or revenues, except for $2 million of other retail gasoline
operating costs. The top panel shows BP’s income statement using standard accounting
techniques assuming retail gasoline prices of either $4.00 or $3.60. Here the cost for gasoline is
BP’s extraction and refining cost of $0.40 per gallon. BP reports positive profits at both prices—
$1,600,000 and $1,200,000, respectively. Based on these accounting profits, it might appear
that it is profitable for BP to operate its own retail stations. The bottom panel reproduces the
income statements using the opportunity cost of the gasoline sold at the stations its market
price. Using opportunity costs, BP breaks even when the price of gasoline is $4 but loses money
when the price is $3.60. In the latter case, it is more profitable for BP to get out of the retail
business and to sell gasoline in the wholesale market (or possibly the land or the mineral
rights—this choice depends on BP’s efficiency in extracting and refining the oil). BP makes
$400,000 more in profits by selling the gasoline wholesale. BP is indifferent between selling
gasoline wholesale or retail when the price is $4.00; either way, BP makes $1,600,000 over its
production costs. This example illustrates a basic point: Managers should make business
decisions using opportunity costs—not accounting costs.22
Table 8.1 BP Retail Gasoline Stations: Accounting versus Economic Profits
In this hypothetical example, BP’s cost of extracting enough oil and refining it into a gallon of
gasoline is $0.40. This gasoline can be sold on the wholesale market for $2.00. It costs $2 million
to operate the retail stations (e.g., wages for station attendants). BP produces 1 million gallons
of gasoline a month. There are no other relevant costs or revenues, except for the $2 million of
other costs to operate the retail gasoline stations. The top panel shows BP’s income statement
using standard accounting techniques assuming gasoline prices of either $4.00 or $3.60 per
gallon. Here the cost of gasoline is BP’s cost of $0.40 per gallon for extracting oil and refining it
into gasoline. BP reports positive profits at prices, $1,600,000 and $1,200,000, respectively. The
bottom panel reproduces the income statements using the opportunity cost of the gasoline sold
at the stations (its current spot market price). In the latter case, it is better for BP to get out of
the retail market and to sell its gasoline (or possibly its land or gasoline) on the wholesale
market. It nets $1,600,000 by selling the gasoline in the wholesale market compared to
$1,200,000 by selling it through its own stations. BP is indifferent between the two alternatives
when the price is $4.00 (in either case, BP nets $1,600,000). This example emphasizes the basic
point made in Chapter 5: Managers should make business decisions using opportunity costs, not
accounting costs.
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Second-Price Auctions
Competition tends to take a differentiated asset to its highest valued use, but at a price that
reflects its second-highest valued use. In a competitive auction, no one has an incentive to bid
more than the value they place on the asset. For example, if Lena Otis is the second-highest
valued user of a piece of land, she will bid only up to her value, while José Ricardo, the highest
valued user, can obtain the asset by bidding just slightly more. This principle implies that the
producer surplus captured by the winning bidder is limited to the difference between the
asset’s first and second-highest valued uses; the rest of the value will be reflected in the price of
the superior asset.
Team Production
Firms consist of collections of assets and explicit or implicit contracts with employees and other
parties. For example, at Microsoft, their collection consists of CEO Satya Nadella, all his senior
managers and employees, the company’s physical assets, brand name, and other intangible
assets. Because of the interdependencies among workers and assets, the value of the inputs as
a “team”23 sometimes can be greater than the simple sum of the values if each worker and
asset were employed at its next best use across other firms. Thus, it is possible that the overall
firm will be more valuable than the sum of its parts. We characterize such a firm as having team
production capabilities. A firm can capture value by maintaining team production advantages
only if competing firms cannot assemble comparably productive teams. If rivals can, then in a
competitive marketplace, the price of the product will be driven down so that the firm makes
only a normal profit.
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How do firms create team production capabilities that are difficult to duplicate? Part of the
answer is a natural consequence of differences in the past histories of firms and the now-sunk
choices by managers about goods produced, markets entered, individuals hired, and capital
acquired. Due to these differences, firms acquire unique combinations of assets, organizational
processes, communication channels, collective learning, and so on. As environments evolve,
some firms find themselves—either through luck or foresight—to be in the enviable position of
having developed team capabilities that are especially productive in these new circumstances,
whereas others do not. For example, Walmart developed an efficient hub-and-spoke
distribution network to serve its chain of successful rural stores. This system, along with its
brand name and procurement advantages, also helped it compete successfully in larger urban
areas.
MANAGERIAL APPLICATIONS
Team Capabilities at Sharp Corporation
During the 1970s, Sharp began marketing electronic calculators with liquid crystal displays. As
the company developed expertise with LCD technology, Sharp began to apply it to other
products, such as television sets. Through these actions, Sharp developed a set of resources and
capabilities that other companies did not have. With the large growth in consumer electronics
and computers during the 1980s and 1990s, potential applications for LCDs expanded rapidly.
Sharp profited from this growth. Other companies could not immediately overcome Sharp’s
competitive advantage because of time constraints and their lack of Sharp’s accumulated assets
and experience. Companies such as Matsushita, NEC, and Canon entered the industry. Yet,
Sharp was able to maintain its dominant position because of its special team capabilities. It
continues as a leader in LCD technology; in 2007, Sharp negotiated a major deal with Toshiba to
exchange its LCD sets for Toshiba TV chips. This advantage was not completely captured by its
individual assets in their market values; individual assets would not have allowed other firms to
copy Sharp’s advantage. Thus part of this advantage went to Sharp’s shareholders and was
reflected in its stock price. No competitive advantage, however, lasts forever; in recent years
Sharp has been outperformed by some of its competitors. In 2018 Samsung Electronics
captured about 20 percent of the global TV market, followed by LG with 12 percent, and Sony
with 7 percent. Sharp was not among the top eight TV producers.
Source: D. Collis and C. Montgomery (1997), Corporate Strategy (Irwin: Chicago); and K. Hall
(2007), “Sharp and Toshiba: Big TV Tieup,” BusinessWeek.com (December 21).
Other firms can observe the team production capabilities of successful firms. Yet, duplicating
these capabilities can be difficult because, from the outside, it is frequently difficult to pinpoint
the exact source of synergies within the team: Many assets are combined in the typical firm. It
also can be expensive to acquire the necessary assets (contracting/transaction costs), provide
training to workers, and so on. In addition, implementing significant changes within an existing
organization presents daunting challenges. That team capabilities often are expensive to
duplicate is consistent with the observation that many firms enter a new business by buying an
existing firm in the industry, rather than by developing the new business within the firm.
Team Capabilities and Organizational Architecture
A firm’s architecture consists of its assignment of decision rights and its systems for evaluating
and rewarding performance. Organizational architecture is important in contributing to team
capabilities. For example, a decentralized firm can respond more quickly and effectively to a
new opportunity that requires rapid “front-line” decision making (for instance, in competitive
pricing to customers) than can a firm with a more centralized decision-making structure.
Alternatively, other new opportunities that require detailed coordination of activities across
several business units might favor the firm with the more centralized structure. As we shall
discuss, it often is hard to copy another firm’s architecture because multiple systems have to be
changed in a coordinated manner. Implementing this type of major change within an
organization can be surprisingly difficult.
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ACADEMIC APPLICATIONS
Flexible Manufacturing and Team Capabilities
Economists argue that often it is appropriate to view managerial policies as a system of
complements—each policy is more valuable when it is adopted along with other
complementary policies. For example, a fall in the costs of flexible manufacturing equipment
can favor the following simultaneous changes in a firm’s strategy and organizational
architecture: investment in more flexible manufacturing equipment, increased output, more
frequent product innovations, more continuous product improvements, higher levels of
training, additional investment in more efficient production design procedures (computer-aided
design), greater autonomy of workers and hence better use of local information, more crosstraining, greater use of teams, additional screening to identify prospective employees with
greater potential, and increased horizontal communication.
Changing only a subset of these policies might be less productive than changing them all at
once because of the complementarities: More value is created when there are reinforcing
changes across this collection of policies. For example, employee training is likely to add less
value if employees are not given increased autonomy to employ their new skills. Yet, making
rapid changes in many elements of a firm’s strategy and organizational architecture is expensive.
Firms in which more of these policies are already in place are more likely to take advantage of a
reduction in the cost of flexible manufacturing than firms without these policies in place.
Because of their team capabilities, these firms are likely to generate economic profits that will
not be competed away in the near term.
In this example, the unexpected change in the environment is a fall in the cost of flexible
manufacturing technology. This change benefits some firms but not others. If a different
environmental change occurred, a different group of firms might benefit.
Source: J. Roberts (2007), The Modern Firm: Organization Design for Performance and Growth
(Oxford Press: Oxford, UK).
A Partial Explanation for Walmart’s Success
Sam Walton’s initial strategy in the early 1960s was to establish stores in small towns
(populations under 25,000) in rural Arkansas, Missouri, and Oklahoma. His intent was to place
“good-sized stores in little one-horse towns, which everybody else was ignoring.” As he
increased the number of stores, he designed an extremely efficient distribution system—a huband-spoke system with regional distribution centers. He also cultivated key vendor relationships,
a distinctive human resource management system, and a nonunionized workforce. As his
network of stores increased, he opened additional stores in nearby states, eventually expanding
throughout the country and internationally.
As Walmart continued to expand, its success became evident. Would-be competitors envied this
success; yet, they did not have the capability to mimic Walmart’s strategy. First, it did not make
economic sense for companies to construct competing stores in the small rural communities
where Walmart already operated. Surely, the resulting competition with Walmart would drive
prices down in these “one-horse” towns. Walmart’s first-mover advantage created an entry
barrier and market power. Without a sufficient number of existing stores, it also did not make
economic sense to copy Walmart’s distribution system in the rural Southeast. As Walmart
gained experience, it developed organizational processes and resources (team capabilities) that
provided potential advantages over would-be competitors as it expanded into new geographic
areas, such as the Pacific Northwest.
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Walmart could have sold some of its resources, such as individual stores, yet potential buyers
would have limited incentives to bid up the price of these assets unless they could have
purchased them all together. For example, the value of an individual store is lower when it is not
coupled with Walmart’s distribution system.24 Thus, although Walmart faced an opportunity
cost from not selling its individual assets piecemeal to other firms, the value of keeping these
assets together within the same firm was likely to be far higher than this opportunity cost. If
Walmart were to construct an income statement based on its opportunity costs (as we did for
BP in the bottom panel of Table 8.1), it would show a positive economic profit.25
ANALYZING MANAGERIAL DECISIONS: Leaving New York City for the Farmlands of Illinois
You have worked as an investment banker in New York and Hong Kong for the last five years.
You are tired of living in populated cities and yearn for a more peaceful environment.
The Wall Street Journal contained a story about the federal government’s actions to increase
corn-based ethanol as a substitute for gasoline in the United States. According to reports, new
laws and regulations will result in the construction of hundreds of new ethanol factories over
the next decade. Demand for corn to fuel the plants is expected to soar.
Based on a Web search, you found 80 acres of prime farmland for sale in Illinois at a price of
$10,000 per acre. You have saved enough from your past bonuses to purchase the land. You are
tempted to quit your job and purchase the land to farm corn.
Several colleagues have told you that it sounds like a good idea. They say that not only would it
allow you to move to a less populated area, but it is a great business opportunity with little risk.
Surely the price of farmland will increase dramatically over the next few years as the ethanol
plants begin operation and the demand for corn skyrockets. Good farmland is limited, and you
might reasonably expect its price to double or even triple over the next few years. You are smart
and should be able to learn the farm business very quickly. In addition, you will have a cost
advantage over farmers who wait to buy land at much higher prices. If you decide that you do
not want to be a farmer, you can always sell the land at a “huge profit.” Do you think your
colleagues are giving you good advice? Explain.
Even though Walmart has had a competitive advantage in rural America, its advantage has been
smaller in urban centers. Urban areas can support more than one discount store—thus
promoting entry by Target, Kmart, and others. There also is more competition from nondiscount
stores. Competing firms have copied many of Walmart’s innovations in distribution, vendor
relationships, and so on. Thus, in urban areas Walmart has had both less market power and a
smaller productivity advantage. Walmart also has had problems at some of its international
locations, such as Brazil. Internationally, Walmart’s advantages from superior distribution and
vendor relations are arguably smaller; also its brand name is less well-known than in the United
States.
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MANAGERIAL APPLICATIONS
Economic Profits without Market Power—A Summary of the Key Concepts
Chapter 6 characterized competitive output markets in terms of four basic conditions: (1) many
buyers and sellers, (2) product homogeneity, (3) rapid dissemination of accurate information at
low cost, and (4) free entry into and exit from the product market. In this setting, firms have no
market power and essentially are price takers in the output market: Firm demand curves are
horizontal at the market price. The marginal firm sells the product at average cost and makes no
abnormal profit.
In this chapter, we discuss how it is possible for some firms in highly competitive markets to
make economic profits (produce at an average cost below the market price). Economists refer to
these firms as being “inframarginal.” Sustaining a position as an inframarginal firm requires two
conditions to be met:
Rivals cannot imitate the inframarginal firm and assemble teams of assets that produce the
product at the same low cost—at least in the near term. If competitors can erode cost
advantages through imitation, competition will drive the price down and eliminate abovenormal profits (rents).
The full value of the firm’s superior productivity cannot be captured by selling its assets to other
firms—unless they are sold together. Otherwise the opportunity cost of production will be the
same as for their rivals (even if they can’t assemble equally productive teams).
Firms might also earn economic profits by differentiating their products from the competition.
Successful differentiators have a larger gap between their prices and costs than the typical firm
in the industry. As discussed in Chapter 6, sustaining economic profits in monopolistically
competitive industries over the long run is difficult due to entry and imitation by competing
firms. The ability to sustain long-run economic profits again depends on whether there are
barriers to imitation.
The fact that firms have different histories and paths can help explain the existence of team
capabilities and inframarginal firms. Nonetheless, sustaining economic profits is not easy.
Potential competitors have strong incentives to discover ways to imitate successful firms or
otherwise counteract their advantages. Also, to the extent that an advantage is based on an
identifiable asset, such as a talented manager or a prime location, the opportunity cost of the
resource is likely to rise from competitive pressures in factor markets. Thus, competitive
pressures in both the product and factor markets make sustaining economic profits difficult.
All Good Things Must End
The business environment is constantly evolving with new technological innovations, changes in
consumer tastes, new business concepts, new firms, and other developments. Given these
changes, it is unlikely that any competitive advantage will last forever, unless the firm can find a
succession of new value-increasing strategies. Just as the elements erode a mountain, persistent
competition erodes firm profits over time. While entry may be limited, outside firms have
strong incentives to devise methods of capturing profits from successful firms. Ultimately, one
of these methods is likely to work. If one compares today’s top firms with those of, say, 50 years
ago, the lists are quite different. For example, today’s top firms like Google, Microsoft, Walmart,
and Apple did not exist 50 years ago, whereas many of the top firms from yesteryear have
become less successful or gone out of existence.
Consistent with this view, Walmart’s growth slowed significantly during the first part of the
1990s. Although its performance improved during the late 1990s, economic theory and
experience suggested that continued superior performance should not be expected over the
long run.
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MANAGERIAL APPLICATIONS
Nomura Securities Company: It Is Not Easy to Remake a Business
Japan’s Nomura Securities Company—whose roots go back to the 19th century rice exchanges
of Osaka—was one of the world’s most profitable securities firms in the 1980s. In 1997
following a serious scandal involving payoffs to racketeers, the company almost collapsed. The
company also was hurt because it strongly recommended a set of stocks to customers that then
fell significantly in value. The new president, Junichi Ujiie, vowed to remake the company. He
wanted to deemphasize the selling of individual stocks to customers and focus more on asset
gathering and portfolio advice. His objective was to become more like Merrill Lynch or Morgan
Stanley. By late 1999, Ujiie had failed to turn the company around. Indeed Nomura continued to
lose out to smaller competitors in obtaining new business. Between 2000 and 2014, Nomura
continued to struggle relative to competitors, such as Goldman Sachs. Its stock fell significantly
during the 2007–2009 financial crisis, and it largely failed to recover over the subsequent fiveyear period. Like many large companies, Nomura had trouble remaking itself to regain lost
success and profitability.
Source: Yahoo Finance (2014), “Nomura Holdings,” finance.yahoo.com; and B. Spindle (1999),
“Nomura Restructuring Falters; Can Mr. Ujiie Still Remake the Firm?” The Wall Street Journal
(September 3), A1.
Changing Fortunes
The fortunes of firms change over time. Due to competitive pressures, the top firms in one
period are often not the top firms in subsequent periods. Below is a listing of the top 10 firms in
terms of market value in 1970 and 2019. The lists are different, only General Electric is on both
lists. (Standard Oil of NJ changed its name to Exxon in 1972 and merged with Mobil in 1999.)
Rank 1970 2019
1
IBM
Walmart
2
AT&T ExxonMobil
3
General Motors
Apple
4
Standard Oil of NJ
Berkshire Hathaway
5
Eastman Kodak
Amazon.com
6
Sears Roebuck United Health Group
7
Texaco McKisson
8
General Electric
9
Xerox AT&T
10
Gulf Oil
CVS Health
Amerisource Bergen
Polaroid’s Success and Ultimate Failure to Capture Value
From 1948, when Polaroid introduced its first instant camera, until 1972, when it unveiled its SX70, the company continually improved its almost magical product. The first Polaroid camera
produced sepia-toned prints, but over the years the company developed the ability to produce
color photos that materialized right before one’s eyes. In 1972, Polaroid’s stock price was 90
times earnings, propelling the company into the Nifty Fifty (the top 50 companies in the Fortune
500). But the SX-70 was followed by a series of flops, including Polavision, a moving version of
instant photography that was inferior to video. Moreover, the development of digital imaging
provided an alternative method of viewing pictures immediately and precipitated Polaroid’s
Chapter 11 bankruptcy filing in October 2001. It stopped making instant cameras in 2007. The
history of Polaroid illustrates two important points. First, successful firms develop new wetware
that leads to innovative products, which satisfy customers’ demands. Second, competition—
often arising from new technologies—erodes the profitability of companies that, on a
continuing basis, fail to innovate successfully.
Source: D. Whitford (2001), “Polaroid, R.I.P.,” Fortune (November 12), 44;
and http://en.wikipedia.org/wiki/Polaroid_Corporation.
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Economics of Diversification
Although the New York Times Company concentrates on a single major business, most large
firms engage in numerous businesses: They are diversified. This raises the question: Is corporate
diversification a productive strategy to create and capture value? Economies of scope are the
primary reason that diversification might enhance value. In addition, combining businesses
within the same firm can promote complementary products. But diversification also entails
costs. Value maximization requires that firms consider both the benefits and the costs of
diversification. In this section, we discuss these costs and benefits and analyze the
circumstances under which diversification is most likely to create value. We also examine who is
most likely to capture this value.
Benefits of Diversification
Economies of Scope
As discussed in Chapter 6, economies of scope exist when one firm could produce multiple
products at lower cost than separate firms could produce the products. Economies of scope
might occur anywhere along the vertical chain of production.26 Consider the following
examples: A diversified firm buys inputs at a discount reflecting its higher volume from using the
same inputs in producing different products, a firm economizes on transportation costs because
it delivers different products to the same customer, a firm uses salespeople more efficiently
because they are able to offer customers an array of products, and a firm economizes on
flotation costs because it raises capital to fund several businesses at once. Sometimes,
producing one product unavoidably also produces others because of a jointness in the
production process. For instance, if a firm produces beef by slaughtering cows, it also frequently
makes economic sense to produce other products with the bones and hides.
Combining activities inside the same firm is not the only way to achieve these types of
economies. There are alternative ways to organize that also accomplish this objective. For
example, an independent wholesaler might offer retailers an array of products produced by
separate manufacturers, centralize the billing of retailers, and provide a more efficient inventory
and distribution system. Which method of organization is best depends on contracting costs. For
example, negotiating and enforcing contracts among independent firms can be expensive, as
can organizing activities within the same firm (see below). Sometimes integrating activities
within the same firm is less expensive than contracting among firms. In this case, diversification
creates value. We discuss the trade-offs in choosing among organizational forms in greater
detail in Chapters 11–17 of this book.
Promoting Complements
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Another potential reason for diversification is to promote the supply of complementary
products. For example, Ford and General Motors entered the consumer credit business in 1919
and 1959, respectively.27 One potential benefit of auto manufacturers’ entering the financing
business would be to increase the demand for automobiles by offering low-interest-rate loans
to customers (recall Figure 8.1).28 Contracting/transaction costs also were reduced because the
consumer could fill out the loan application while purchasing the automobile. Today,
communication systems, computers, and sophisticated credit-scoring systems make it easy to
apply for a car loan from a lender over the phone or the Internet. This was true in neither 1919
nor 1959. Again there may have been other ways of organizing to achieve these economies
(e.g., the automobile companies could have contracted to process loan applications for a bank).
However, the costs of these organizational alternatives evidently were higher than combining
the businesses within one company.
MANAGERIAL APPLICATIONS
Diversification Has Both Costs and Benefits
Kellogg sold its Keebler, Famous Amos, and fruit snacks businesses to Ferrero Group for $1.3
billion. Kellogg retains its “power brands”: Pop-Tarts, Cheez-Its, Club Crackers, Rice Krispies
Treats, and Pringles brands. Selling the cookie and fruit snacks businesses allows Kellogg to
focus on its core brands. Ferrero acquires a portfolio of well-established brands with very strong
market positions, which allows it to significantly diversify its portfolio and capitalize on new
growth opportunities in the world’s largest cookies market. Recently, Ferrero purchased Ferrara
Candy for $1 billion and Nestlé’s U.S. candy business for $2.8 billion. Product diversification is
most likely to be profitable when the added product has a substantial overlap in its inputs, its
production technology, and its distribution methods. Although both Ferrero and Kellogg have
overlaps in each of these aspects, with their recent product expansion, Ferrero now has a
comparative advantage in owning, manufacturing, and distributing these products over Kellogg.
Source: “Kellogg to Sell Keebler and Other Brands to Ferrero for $1.3 Billion,”
www.cfo.com/ma/2019/04/kellogg-to-sell-keebler-and-other-brands-to-ferrero-for-1-3-billion/.
As another illustration, recall our example of PCs and printers. The companies benefited by
coordinating the pricing of their products; another way of achieving this cooperation would be
to merge the two firms.
Costs of Diversification
Although diversification has potential benefits, it also has potential costs. As firms grow, they
often become bureaucratic and more expensive to manage. As we shall discuss in more detail in
later chapters, it is difficult to devise compensation plans that motivate managers in large
companies to behave like owners of smaller companies. Owners have a natural incentive to
work hard and increase the value of their firms because they keep the profits of the firm,
whereas salaried managers do not. If diversification occurs through the merger of two firms (as
is often the case), it also can be quite expensive to develop common personnel, communication,
information, and operating systems.
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Management Implications
A Faulty Reason to Diversify
Some managers diversify to reduce earnings volatility. For example, the former CEO of
Goodyear Tire justified diversification into the oil business because it was countercyclical to the
tire industry. He reasoned that when gas prices were low, the company would do well in tires
since people would be driving more. When gas prices were high, the company might do poorly
in tires but would do well in the oil business. Overall, earnings would be less volatile.
It is true that diversification can reduce earnings volatility. The problem with using this as a
justification for diversification is that this reduction in volatility need not increase a firm’s value.
Shareholders (the owners of public companies) can diversify within their own investment
portfolios at low cost. For example, it is easy for investors to purchase shares of both a tire
company and an oil company. Through this diversification investors reduce return volatility on
their overall portfolios. There is no reason for investors to pay a premium for a company simply
to reduce return volatility, since they can achieve this same objective by purchasing stock in the
two separate companies.29 At the same time the costs of integrating diverse businesses within
the same firm can be significant.
When Does Diversification Create Value?
Related diversification occurs when the businesses serve common markets or use related
technologies. For example, Disney Corporation operates theme parks, hotels, retail shops, and
television stations. In each of these industries, Disney concentrates on employing its strong
brand name to market family-oriented products. Their brand name reduces transaction costs to
consumers in their search for quality products appropriate for children.
Net benefits are likely to be greater in related rather than unrelated diversification. If there is
little interaction on either the production or demand side of the businesses, it is hard to
envision where economies of scope might arise and by definition the two businesses would not
produce complementary products.30 An example of unrelated diversification is the decision by
KinderCare Learning Centers, a day-care management firm, to enter the savings and loan
business; it subsequently entered bankruptcy.
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Value is increased only when the benefits of diversification are larger than the costs. There is a
significant body of research on the value consequences of diversification.31 For the most part,
diversified firms have not performed well. Indeed, many of the large conglomerates during the
1980s, such as ITT and Tenneco, increased their values by divesting units (through sales and
spinoffs) and refocusing on a more narrow line of businesses. Research documents that 55.7
percent of exchange-listed firms had a single business segment in 1988, compared to 38.1
percent in 1979. More importantly, the research shows that this increase in focus was
associated with higher stock returns.32 Diversification has been most effective in the case of
related diversification where there are potential economies of scope and opportunities to
promote complements.
MANAGERIAL APPLICATIONS
Diversification Problems at Xerox
During the 1980s Xerox diversified into financial services. The company had gained experience
in finance through the leasing of its copy machines, and management believed that by acquiring
firms in the financial sector, it could leverage this experience. In late 1982, Xerox purchased a
property/casualty insurance company for $1.6 billion. This acquisition was followed by other
acquisitions in life insurance, real estate, and investment banking.
With minor exceptions, this diversification turned out to be a financial drain on Xerox. The
economies of scope were not as great as had been hoped and problems in the financial
businesses distracted top management from Xerox’s main business—copiers. In the 1990s Xerox
repositioned itself as the “document company” and sold its financial businesses to other
companies. As of 2014, Xerox remained focused on providing business process and document
solutions. In 2016, Xerox spun off its information technology services arm and refocused its
efforts on areas in print where demand was projected to grow, not fall.
Source: N. Heath (2017) “Xerox CEO: Our Journey from Paper Docs to Printed Electronics,”
Techrepublic.com (April 18).
Who Captures the Gains from Diversification?
Even if diversification creates value, the owners of the diversified firm do not always capture
this value. Again, it depends on whether the firm brings some special resource or team
capability to the transaction. If it does not, the value is likely to be captured by another party
due to competition. Consider the potential benefits of merging a television cable company with
a long-distance telephone company. Suppose that there is one cable company with the rights to
operate in a specific area, whereas there are several long-distance telephone companies.
Competitive bidding among the telephone companies would imply that the phone company
that valued it the most would get the cable company at a price equal to its value to the secondplace phone company. This process would give most of the value gains to the owners of the
cable company: They own the unique resource. Consistent with this example, substantial
research documents many cases where target firms obtain most of the gains in corporate
takeovers.33
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Strategy Formulation
Developing and implementing strategies that increase a firm’s value require an understanding of
both the internal resources and capabilities of the firm and its external business
environment.34 Figure 8.5 displays these two factors.
Figure 8.5 Framework for Strategic Planning
Members of the management team should have a good understanding of their firm’s internal
resources and capabilities before they modify their strategies. They also should understand
their external business environment. The objective is to use this knowledge to discover ways of
creating and capturing value.
Understanding Resources and Capabilities
An important first step in strategy development is understanding the firm’s resources and
capabilities. By resources and capabilities, we mean the firm’s physical, human, and
organizational capital. This includes the firm’s hardware, software, and wetware; specifically,
those activities which the firm can do better than other firms—its team production capabilities.
It also is important to understand the opportunity costs of using these assets within the firm.
For example, how much would they be worth if they were sold to other firms?
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Understanding the Environment
As depicted in Figure 8.5, important factors in the business environment include the firm’s
markets (both input and output), technology (production, information, and communications),
and government regulation. Effective managers monitor the business environment to keep
abreast of new developments in each of these areas.
Referring to Figure 8.1, managers must understand the business environment to identify
opportunities for value creation. For example, what technological opportunities exist to reduce
costs? It would be a poor decision to invest in an expensive technology to lower costs, if
forecasted technological innovations are expected to make the investment obsolete soon. What
opportunities exist to reduce consumer or producer transaction costs? Managers must have a
detailed understanding of how transactions take place in the marketplace to discover ways of
reducing transaction costs. What opportunities exist for improving consumer products? Are
there ways of promoting complementary products? Are there potential industries in which the
firm could leverage its resources and capabilities? Are there opportunities to create value
through cooperating with other firms?
An understanding of the firm’s environment also is important for identifying opportunities for,
as well as threats to, capturing value. For example, what opportunities are there to block entry
or the development of substitutes? What threats loom from potential substitutes, buyer power,
supplier power, and industry rivalry?
Combining Environmental and Internal Analyses
Most resources and capabilities are finite—choices must be made. For example, firms have
limited production capacity and human resources. Thus, they face trade-offs in deciding how to
use these resources and in deciding whether it is worth the investment to supplement them.
Also managers must decide whether it is best to use their marketable assets within the firm or
whether to sell them to other firms. These strategic choices require managers to combine
environmental and internal analyses: They must understand both their internal strengths and
weaknesses, as well as the threats from and opportunities within their business environment.
Typically, strategies do not remain constant, but evolve through time. It usually is important for
managers to consider how other economic agents in the business environment will react to
their strategic decisions (e.g., rival firms, suppliers, and buyers). In Chapter 9 we examine this
issue in detail.
MANAGERIAL APPLICATIONS
A Retail Success Story and Luck
IKEA, one of few retailers that has flourished on foreign soil, had over 400 stores in 38 countries
selling $42 billion a year worth of furniture in 2018. Its strategy is that well-designed furniture
can be inexpensive without being ugly. IKEA entered international commerce by chance. Started
in Sweden in the 1960s, local Swedish retailers pressured Swedish manufacturers to cut off
supplies to the upstart IKEA. In response, IKEA turned to Poland for supplies and was surprised
to find that it could buy well-crafted furniture more cheaply. This transformed IKEA into thinking
about foreign suppliers and retail markets. The firm now has spread to Asia and North America.
IKEA is a very patient firm. While trying to figure out how to please U.S. shoppers, IKEA
absorbed losses for years. They “had to learn that Americans expected jumbo beds and didn’t
think in centimeters.”
Source: IKEA.com.
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In deciding how best to use special resources and capabilities, it is important to be forwardlooking. Sometimes it is more profitable to invest in complementary resources and capabilities
that allow the firm to exploit its unique position better in the future. For example, it might have
been profitable for Sharp to invest in acquiring complementary knowledge about computers
and other technologies to supplement the firm’s skills in LCDs.
Strategy and Organizational Architecture
To be successful, a company must have not only a good strategy, but also an appropriate
architecture. Ultimately, both strategy and organizational architecture are key determinants of
value. Chapters 11–17 of the book presume that the strategy of a firm has been determined and
present a detailed analysis of how a firm’s environment and strategy influence its organizational
architecture. This approach is reasonable because the organizational design often is based on
what the firm wants to do strategically. For example, if a firm adopts a strategy to react quickly
to customer demands, it will probably have to design a decentralized decision system with
accompanying performance evaluation and reward systems to motivate productive decisions.
Figure 8.5, however, emphasizes that the effects are not all in one direction. A firm’s
architecture also can influence its strategy—it is an important part of the firm’s internal
resources. For example, if the firm has a well-functioning, decentralized decision-making
system, it is more likely to enter markets for which this type of organizational design is well
suited.
ANALYZING MANAGERIAL DECISIONS: Walmart.com
Conventional wisdom holds that to succeed in electronic commerce, you have to get in early.
But in late 1999, Walmart decided to challenge that most sacred of web rules. After several
years of tinkering with its website, watching while others broke new Internet ground, the
retailing giant was ready to flex some cyber muscle. Up to that point, Walmart.com had realized
modest success online, ranking 43rd among Internet shopping sites. It trailed web pioneers like
eBay and Buy.com. In May 1999, Amazon.com greeted almost 10 million online visitors;
Walmart.com saw only 801,000. For 1999, analysts expected Walmart’s e-commerce activities
to produce sales of less than $50 million out of the company’s total sales of $157 billion.
Walmart faced increasing direct competition from Amazon.com. In July 1999, Amazon
announced its expansion from books, music, and videos into toys and consumer electronics.
Walmart already was a powerhouse in these product categories through its traditional stores. It
announced that it would offer products from all 25 categories carried in a typical Walmart
discount store. Moreover, it expected to offer a broader array of higher-priced items than its
traditional stores—for instance, DVD players and digital cameras. It also enabled customers to
return products ordered online to any of Walmart’s 2,451 U.S. discount stores. Like Amazon, it
planned to provide tailored online specials to match the shopping habits of its repeat
customers.
The company announced plans to expand its online store offerings before the end of 1999 to
match more closely the breadth of its traditional outlets. To facilitate this expansion, Walmart
penned deals with Fingerhut Business Services and Books-a-Million. Both had expertise in
distributing individual orders directly to customers’ homes—quite a different set of skills from
bulk shipments, which had been Walmart’s forte.
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Demographic shifts occurring in cyberspace offered the potential to help Walmart. Back in 1999
Jupiter Communication projected e-retailing to grow from approximately $12 billion in 1999 to
an estimated $41 billion in 2002. Much of this expansion would be concentrated in Walmart’s
existing lower- and middle-class customer base. Jupiter analyst Kenneth R. Gasser noted,
“Internet users are increasingly coming to resemble the population at large.”
By 2005, Walmart.com had logged $1 billion of Internet sales. However, the world’s largest
retailer only ranked about 13th in Internet sales while Amazon.com had sales of over $10
billion. About 500 million total visitors clicked on Walmart.com in 2005, and the company
predicted this to increase to 700 million in 2006. But, its online sales still only accounted for
about 1 percent of Walmart’s annual sales.
In January 2007, Walmart.com launched Soundcheck, an original series of musical
performances that feature punk pop and rock bands to increase its digital music offerings. In
March 2007, Walmart.com announced “Site to Store” where Walmart.com shoppers can
purchase online and have orders delivered to their local store for free. By July, Site to Store sales
more than doubled since its March rollout, and about 90 percent of participating stores had at
least one Site to Store order within the first 48 hours of service activation. In January 2008, only
11 months after initiating its movie download service, Walmart.com quietly dropped this
service because Hewlett-Packard Co. stopped providing the application that allowed shoppers to
purchase and download videos such as movies and TV shows.
Placing yourself back in 1999, answer the following questions in a well-developed discussion:
What is the impact of Walmart.com on customer-borne transaction costs?
Do you think that Walmart.com is likely to create additional value?
Is it likely that Walmart will capture any value created by Walmart.com?
Should Walmart have pursued e-commerce more aggressively sooner?
What do you think the potential impact of Walmart.com will be on the company’s efforts to
expand internationally?
In November 2007, Walmart.com announced that it wants to be “the most visited, most valued
online retail site.” Suppose you were hired by an outside consulting firm to evaluate
Walmart.com’s potential to achieve this goal. Write a short report listing those factors that will
enhance and those factors that will impede Walmart.com’s ability to achieve the goal of “the
most visited, most valued online retail site.”
Source: W. Zellner (1999), “When Wal-Mart Flexes Its Cybermuscles,” BusinessWeek (July 26),
82; S. Murphy (2007), “The Walmart.com Way,” Chain Store Age (July), 80;
www.internetretailer.com; and www.today.msnbc.msn.com/id/21940867.
Can All Firms Capture Value?
Consultants often suggest that any firm can develop a strategy that produces economic profits,
even if it does not begin with unique resources or team capabilities. What is necessary is that
the manager be a “visionary” and make sound investments in developing the skills and
capabilities to compete successfully in the future. (Of course, for a fee these gurus would be
happy to help the manager accomplish this objective.)
Basic economics suggests that these consultants are wrong. Even if a manager is exceptional at
pre…