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ECONOMICS OF STRATEGY

Cours 1
08-02-2022

To do before Class
Video: (John Van Reenen) how ‘’superstar firms’’ such as Google and Apple have changed the
global economy. The superstars, although big, employ relatively few workers and this has contributed
to depression of the overall aggregate share of labour in the economy. The risks arising the market
dominance of these firms also pose policy challenges

Why is it, over so many countries around the world, over the last 30/40y, the share of the economic pie
going to workers has shrunk so much?

In his work: their explanation=the rise of superstar firms (they are all around us) =>Facebook, Apple,
Netflix, Google (very large firms)
One of their characteristics=although they are big, they employ relatively few workers compared to
the mega-firms of the past. All these firms have got bigger, as concentration has increased in more
and more markets, the weight of the economy has shifted into these firms, and because these firms
have a low labour share, this has depressed the overall aggregate share of labour in the economy. The
story that we give in this paper is that really, what’s happened is that technology has changed. More &
more of these markets are kind of winner take all markets.

->One of the reasons for Google’s success is that it produces a better search engine, more people
search that search engine, so Google gets more and more data on them, so its search engine gets even
better. So the whole market, eventually, or a lot of the market, shifts towards G.
Another reason outside the digital markets is that many companies, to be successful, have to male
enormous investments in software. Those technological changes have also led to increased a
competition. And what competition does, is it makes it harder for the smaller firms to survive, the less
productive firms to survive. This also creates a “winner take all” type of effect. Although he don’t
think the rise of superstar firms is due to weak competition policy, he don’t think it poses a policy
challenge. Because even if these firms have managed to get to super stardom through their merits,
through competing on efficiency and innovation, now they are so powerful, there is a risk that they
may start abusing their market dominance. We have to focus on what future competition is like, rather
than just current competition. So that doesn’t mean a change in the way that anti-trust and competition
policy takes place.

podcast: The Great Reverseal


“In the last 20y the US has given up on free markets. As a result, (…) American families are each
$5000 a year poorer”

The trillion dollar hole in America's GDP from giving up on free markets ( = Le trou d'un billion de
dollars dans le PIB américain dû à l'abandon des marchés libres)

Where is the epicentre of capitalism, creative destruction an competition? We directly think at the
United states BUT Thomas Philip said that in the last 20 years the US has given up on free markets
and as a result its economy is a trillion dollars smaller and American families are each $5000 a year
poorer.

 What is the great reversal ? (thinking about cell phone plans in Internet access = forfait
internet)
I notice that many goods and services are cheaper in the US than in Europe. Also getting access to
Internet is cheaper in the US then in Europe and it was also cheaper 20 years ago. BUT today there is
the reverse (not a small reverse) => Today you get your broadband connexion in London for less than
half of what you pay in New York (for the same speed) => huge gap.

 these princes rise is because of markets are less free I, the US ? how do you measure free
market?
there is no perfect measure => look at all possible indicators to get a big picture.

We have 2 ways to think about free markets :


- a static way
- a dynamic way

The static way : The big firms look like they have a lot of power => we look at their market share of
the firm and if it controls a lot of the market => it has market power.
It is also called “concentration measures” : we look at the market share of the top (3-5) firms and if it
is a high number => then those are likely to be able to raise prices because there is nowhere else to go
(consumers cannot buy anywhere else, so those companies will higher their prices) => they are likely
to collude. Ex : telecommunication industry in France before regulation. The static view can be
misleading because market can become more concentrated (a firm that was good become better)

The dynamic view : focus on fluency. Is the market contestable? Can somebody else enter the
market? We look at the profit margin of the firm, the prices, the concentration of the market and some
measures of turnover.

 The massive influence of lobbying in the USA, how much bigger business is lobbying in
the US than it is in Europe?
‘Un lobby, ou groupe d'intérêt, groupe de pression, groupe d'influence, est un groupe de personnes
créé pour promouvoir et défendre des intérêts, privés, en exerçant des pressions ou une influence sur
des personnes ou des institutions publiques détentrices de pouvoir’.’ Faire du lobbying c'est
transmettre le bon message au bon moment et à la bonne personne. Mais le lobbying s'entend aussi et
surtout comme la planification et la réalisation d'actions qui cherchent à transformer les politiques,
les attitudes et les pratiques en faveur d'un groupe donné.’
The idea of lobbying is not very good.
US used to have really good measures of lobbying since the 1990s, with the law that requires all
business to report everything they spent on lobbying. BUT that law is weakly enforced SO today it's
hard to know exactly how much exactly they spend on lobbying. The influence is not directly
proportional to how much money you spend but the most important is where you spend it. A lot of the
money that spent is well hidden. Ex: many of the firms have non profit organisation that they use
strategically to influence policymakers.

The cost of running a successful political campaign has skyrocketed over the past 20y => So today, as
a politician, is hard to get anywhere without accepting donation from large firms because how much
you can spend in a political company is unlimited.

That’s the big difference with Europe where we have some form of limitation on the size of campaign
finance spending and that limit the power of lobbyists >< In the US you first finance the campaign,
and then if you have a chance that the candidate win, you have access to that candidate so you pay for
access by pay for the campaign.

 the money spent on lobbying by people who want to gain market power or restrict free
access that is money well spent ?
Answer : yes most of the time (pas trop compris son explication).
 ‘in the last 20 years the US has given up on free markets and as a result its economy is a
trillion dollars smaller and American families are each $5000 a year poorer.’ Did this
surprise you?

Prices in the US are about 7% to high (it is an average) (and twice to high in the
telecommunication).The households are overpaying by a half a trillion a year.

A more competitive economy has plenty of advantages : firms hire more, invest more, innovate more.

If you translate this 7% higher prices into a loss of private GDP of $1 trillion (=> private GDP is 5%
to low)

It’s more important for people who earns labor income.


With a competitive economy -> the profit margin of the firms decrease which means, payment to
capital owner in dividends decrease => less money going in the pocket of the shareholders. (and with
this money (money from capital payment) we will pay labour income).

The impact of higher competition would be mostly beneficial for the middle class => For these people,
most of their income is labor income. That means that if we have a policy that encourages labor
income, such as competition, the impact will be very big for them.
They didn’t have as much dividend, so they didn’t care where this goes. The most of their income
comes from labor income => that will be good just for the middle class.

(the very poor get subsidies from the government ; the very rich they might lose a little bit or not
because they get rid of capital)

 Free market VS single market


Rien compris wsh

 Health care (cost)

The third of the money spend is health care in the US is pure rent to monopolies.
Lobbies in health care in the US -> keep their prices high and keep margin.

There is no free market alternative in the health care!


All other countries in the world have such as a price control.
If we want to regulate health care, is imperative to have a price control => So the pure free market
doesn’t work. But limit on lobbing and limit influence of pharmaceutical firms and hospitals is very
similar in the health care.

Is the concentration a bad thing there?


There is different way to look at competition, we can look at the concentration (static way to look at it)
or we can look at dynamics (=> entry and turnover).
In the tech sector we can look at both.
There is a difference between how a firm get powerful and how they are comporting today.

 Old fashion model

Old fashion model = Doing a full analysis of the market and understand what’s going on => This
model doesn’t work well tech because on the time we have to make the decision, there is so much
uncertainty.

We should have old tools:


- We should revalue merger (=fusion) based on the value of the target not the income of the
target.
- More flexibility expose (being able to come back)
- Having precautional principal: …

 …

We have to do add some regulation.

 …

We can have some entry of this crisis (example of “Zoom”)

 Conclusion:

Biggest advantages of the US:


- Universities (-> innovation ecosystem of the US)
- Founding capacities (finance start-up)
- Uncorrupted system (thanks to a strong regulator and free market is a good deal for
consumers)

During the class


Introduction - Analyzing the firm’s environment

Make links with the strategy that occurs within the firm, between firms and within society.
Content of the class

• Static and dynamic views of competition


• The Structure – Conduct – Performance
(SCP) paradigm
• Porter’s five forces model
Static vision : neoclassical economics
Dynamic view to competition (Schumpeter)
SCP paradigm !

Table des matières


To do before Class.......................................................................................................................1
During the class...........................................................................................................................4
Static and dynamic views of competition...................................................................................5
THE STRUCTURE-CONDUCT-PERFORMANCE (SCP) PARADIGM (OPEN
QUESTION AT THE EXAMEN)....................................................................................7
THE STRUCTURE............................................................................................................8
PERFORMANCE...............................................................................................................9
GOVERNMENT POLICY.................................................................................................9
THE PORTER’S FIVE FORCES MODEL..................................................................10

Static and dynamic views of competition


The neoclassical theory of the firm considers four main theoretical market structures
(Market structure = a way to characterize a market):

• Perfect competition
• Monopolistic competition
• Oligopoly
• Monopoly

Characteristics of perfect competition


• There are large numbers of buyers and sellers (atomicity => everybody is an atom in
the market => no influence on the others => they are price takers ) ;
• Producers and consumers have perfect knowledge;
• The products sold by firms are identical (=homogeneity : if I am a consumer and I
don’t want to go to firm A, I can go to firm B and get the same product);
• Firms act independently of each other and aim to maximize profits;
• Firms are free to enter or exit (no barrier to enter and no barrier to exit);
• Firms can sell as much output as they wish at the current market price.

If these conditions are satisfied  competitive equilibrium : all firms earn a normal profit.
If I am a firm in a really competitive environment, I don’t have a margin to increase my
prices, because I know that if I increase my prices, all my consumers will go to my
competitors.
Because the others sell the same product as me, also because they (= consumers) have perfect
knowledge so consumers know that my competitor sells the same product with a lower price.
And I am acting independently of the others so I can not make a agreement with the others
to increase the prices. And finally, I have the threat that others will enter the market and I will
lose my share market.
 Companies can not make more than a 0 economic profit. 0 economic profit is the
difference between total revenue and total cost (cost is equal to revenue) and we
put in the cost all the remuneration of any production factor (not only the price of
raw materials, the wages,.. BUT also the amount you pay your capital investors
(remuneration of the capital to its opportunity cost => your remunerate the capital to
what the capital investor could have received if they decided to invest in another firm
that our).

If we make Abnormal profit => it will direct become a normal profit because new firms
will enter the market => supply increase => the price decrease => profit decrease.
As long as they enter the market they make the profitability (rentabilité) decrease => in at
certain point of time => no one will enter the market and we will have an equilibrium => and
the profit of all companies will be 0.
 It is a static vision because we always return to the same equilibrium.

• Perfect competition imposes discipline: all surviving firms are forced to produce as
efficiently as the current state of technology will allow. (it is a theoretical model)
• In reality, Competition doesn’t lead to many firms being competing against each
other BUT it leads  market or industry structure comprising a relatively small
number of large firms. (example “The Rise of Superstar firms”)
• Each firm has sufficient market power to determine its own price, and some or all
firms are able to earn an abnormal profit in the long run. (abnormal profit is all the
profit generate beyond the 0 economic profit).

There is a small numbers of firm and they are quite large so they determine its own price.

Why does competition leads to a decrease in the number of firms in the long run?
• As firms grow, they realize economies of scale and average costs of production tend
to fall. Economic of scales = when you double or triple the scale of your production.
(it is less costly for us on average)
• In the case of natural monopoly, a single firm can produce at a lower average cost
than any number of competing firms. (example : train rails, it cannot be done with
many firms)

o (example : train rails, it cannot be done with many firms, we need a company that manages
everything)

What about the welfare effects of a small number of firms?


o Economies of scale might be a beneficial aspect of monopoly, if the cost savings are
passed on to consumers in the form of lower prices.
o However, if a monopolist restricts output and raises price, then monopoly may have
damaging implications for consumer welfare.

Theory of imperfect competition includes monopolistic competition and oligopoly :


o Theory of monopolistic competition: large number of firms but non-price as well as
price forms of competition are emphasized. They don’t compete only on price
BUT they compete also on other aspects than only the prices (example : shampoo
firms => shampoo for black, blond,… hair, women shampoo, men shampoo,…) => it
gives a market power to some companies (they produce something that the
competitors don’t have). Many firms but de degree of competition is decreased by
the fact that the product isn’t homogeneous/ not identical.

o Theory of oligopoly: small number of firms (but mor than 1 firm) and these firms are
in a strategy of interdependence.
o Essentially, the neoclassical theory of the firm is based on a static conception of
competition. (it is made with concepts that always say that at the end of the day the
market will return to an equilibrium)
o The main focus is on long-run equilibrium.

In the 20th century, researchers rejected this static view of competition, and developed a
more dynamic approach.
For both Joseph Schumpeter and the Austrian school, abnormal profit does not constitute
evidence of market power abuse.
For the neoclassical (static view), as long as you get far away from the perfect competition,
you are considered as having too much market power and being too far away from the perfect
market structure which is the competitive market.
Competitive market structure is the most efficient for production et beneficial for consumers.
When you get away from the competition, you are having market power and this market
power abuse give you an abnormal profit.
BUT Schumpeter says that abnormal profit isn’t a failure of the market. It is an engine
for competition.

o Instead, monopoly profits play an important role in the process of competition :


guiding entrepreneurs towards an improved allocation of scarce resources in the long
run.
o For Schumpeter, competition is driven by innovation.
Innovation destroys old products and production processes, and replaces them with new
and better ones à "Creative destruction".
o Monopoly status and profits = reward for the successful innovator...
... but only for a time.
o An innovator may even come along with a better product
o à previous innovation = obsolete.

free market = perfect competitive market


if you are a successful innovator you will generate abnormal profit BUT only for a time
because you will have imitators. In a dynamic view, the monopoly status is only temporary.
Even if we have abnormal profit in the beginning but our innovation will be obsolete
because our competitors will do the same thing as us, or they will create a better
innovation.

THE STRUCTURE-CONDUCT-PERFORMANCE (SCP) PARADIGM (OPEN


QUESTION AT THE EXAMEN)
o The static and dynamic theories presented above have found an empirical counterpart
in the field of industrial organization (IO).
o Industrial Organization analyses empirical data and, by induction, develops theories
to explain the behavior and performance of firms and the industries to which they
belong.
o Early work in this area is based predominantly on the Structure– Conduct–
Performance (SCP) paradigm.

o Mason (1939, 1949) and Bain (1951, 1956, 1959) developed of the SCP paradigm.
o According to SCP, the structure of a market influences the conduct of the firms
operating in the market, which in turn influences the performance of those firms.
structure of a market = oligopoly, monopoly, perfect competition

Industrial Organization is concerned with :


o the size structure of firms (= do we have a small amount of large firms or a big
amount of small firms)
o the causes of this size structure (above all the economies of scale),
o the effects of concentration on competition, and people welfare. (link with superstar
firms, how they grow fast,…)
o the effects of competition on prices, investment, innovation, and so on... (Stigler,
1968, p. 1).

The conduct is influenced by the structure of the market and the conduct will have an impact
on the performance of the firm.
The structure of the market depend on the supply conditions and demand conditions
Market are always in the society (they don’t exist alone, they exist in the society) and have to
respond to some rules and regulation => take into account the impact of government policy.

THE STRUCTURE
Structural characteristics can often be regarded as fixed in the short run. (characteristic of a
market structure
o The number and size distribution of buyers and sellers (are they a few of them, a lot
of them and how big are they).
o Entry and exit conditions : if entry is difficult, then incumbents are sheltered from
outside competition. (= are they barrier, enter is easy => they will be a threat for the
other companies because they will come in and compete with other companies).
o Product differentiation : any change in the characteristics of the product may affect
the shares of the total market demand that each firm is able to command.
Diversification ( I am only selling closing or I am selling closes and parfum)
o Vertical integration : the extent to which a firm is involved in different stages of the
same production process;
 Best known examples of Vertical Integration : the oil industry : in the 70, many
firms were engaged in exploration of petroleum and they decided to do also
distribution. so they had power on every step from extracting oil and bringing
it to a vehicle.

Inditex : zara has the whole control from production to the distribution (=vertical integration)
=> the aim is to gain control on all the production line

PERFORMANCE
o Performance is measured by the Profitability (rentabilité) of a firm : Neoclassical vs.
Schumpeterian
 To the extent that profitability influences firms’ decisions to continue or exit
from a market, this performance indicator has direct implications for future
structure. In neoclassical view, if there is a profit in a point or another, it will
disappear, because we will come back to the equilibrium.
o Performance is also Growth (through diversification) : more relevant for a firm that
pursues other objectives than profit maximization; (growth is the first objective and
not profit)
o performance is also Quality of products and services
o Acting for a sustainable society (socially and environmentally)

o Performance is also Technological progress : consequence of the level of investment


in R&D; (example : vaccines during the covid crisis)
o Performance is also Productive efficiency :
 Technical efficiency : the extent to which a firm achieves the maximum
technologically feasible output from a given combination of inputs,
 Economic efficiency (X-efficiency) : and whether it (=the firm) chooses the
most cost- effective combination of inputs to produce a given level of output.

GOVERNMENT POLICY
Can operate on structure, conduct and performance variables to :
o promote competition
o prevent abuses of market power
o regulate the externalities generated by the firms’ activity.
o Structure : in the structure, the government policy may act for Preventing a
horizontal merger or requiring the break-up of a large incumbent producer into
smaller firms.

o Conduct : Imposing price controls, preventing a firm from setting a profit-


maximizing monopoly price.

o Performance : the government may have an impact through Fiscal policy,


employment policy, environmental policy,... may have implications for firms’
performance (profitability, growth, productive or allocative efficiency...).

Why is the SCP paradigm so widely used to study the conduct and performance of firms and
industries?
o The SCP paradigm allows the breakdown of complex industry-level data into
meaningful categories. (in the examen, an exercise about the GAFAM)
o It is grounded within the neoclassical theory of the firm, which assumes direct links
between market structure, firm conduct and performance.
o By defining a workable or acceptable standard of performance, it is useful for policy
analysis.

THE PORTER’S FIVE FORCES MODEL

o Extent and intensity of competition : depends on the number and size distribution of
the industry’s incumbent firms;
o Threat of entrants
 The perceived threat of entry is likely to be higher in industries where
incumbents are highly profitable ; (if firms see that there is a lot of profit in
this market, the threat of entrants will be higher, because many firms want to
go in this market to make profit)
 Government regulation also plays a part in determining the ease of entry;
(the government increase or decrease the barriers to entry (most of the time
government decrease it)
 The size of the entry threat depends on economies of scale, product
differentiation and brand loyalty, the level and specificity of capital
investments, and the availability of access to distribution outlets.

o Threat of substitute products and services


 The availability of substitute products and services increases :
 the intensity of competition. (example of WhatsApp, in the past we
used messages and now WhatsApp => it is another system, another
product but it responds to the same need)
 the price elasticity of demand for existing products,
 à reducing the market power of incumbent firms.
 Incumbents may respond by seeking to differentiate their products (branding or
advertising, f.ex.).
o Power of buyers
 Depends on their number and size distribution, and their level of
dependence on the firm’s output. If you have only 1 or 2 buyers, their power
will be higher than yours. Also if you produce something that a lot from
produce than the buyers will have a high power)
 In order to secure their own supplies, large buyers may seek to integrate
backwards (by taking over an input supplier), reducing their reliance on
external suppliers. (the example of Ikea with the wood buyers)

o Power of suppliers
 If suppliers of important inputs into a firm’s production process are large in
size and small in number (they have a large power) => these suppliers can
exercise market power by raising price, reducing quality, or even threatening to
withhold supplies.

o Management strategists tend to emphasize the distinctive internal characteristics of


firms, in order to explain how a competitive advantage can be acquired and
sustained.
o Competitive advantage is measured by the value a firm is able to create in excess of
its costs.
o Porter (1980) introduces the concept of the value chain, which disaggregates the firm
into its strategically relevant activities.

o Primary activities are those associated with the physical creation of the product or
service.
o Support activities are those that support primary activities and each other (activities
associated with the purchase of inputs, management of human resources, R&D).
Firm select and follow a generic strategy in order to add value and gain a competitive
advantage over rivals.
Generic strategies include :
o Cost leadership: the firm attempts to keep its costs lower than those of competitors.
o Differentiation : the firm’s product has some unique characteristic which appeals to
its customers, leading to higher margins and profits. (apple>< Microsoft)
o Focus : on a particular market segment (e.g. identifying a particular group of
customers and gearing the firm’s product towards their tastes or needs)

Video : https://www.youtube.com/watch?v=33XmkfbzwO8
Exercise :
• You will pick up the elements of the theories we’ll see together in order to elaborate a complete
analysis of the competitive environment of one of the GAFAM, both for :
• The SCP Paradigm
• M. Porter’s Five Forces Model

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