Sie sind auf Seite 1von 27

EBS MBA Competitive Strategy

Module 5 - Horizontal Links and Moves


5.2

The Diversification Game

The conglomerate corporate strategy is characterised by diversification into new and unrelated business.
Diversification is both a direction and a method. It is a direction because the firm expands along particular
horizontal lines and a method because the firm exploits these opportunities through internal organisation rather
than through agreements with other firms.

5.2.1

Horizontal Directions in the Diversification Game


Diversification game seen from firm 3s perspective:

Market

Helmets

Trousers

Jackets

Handbags

Umbrellas

10

Motor cycle Motor cycle Motor cycle Accessories Accessories

Technology Carbon-fire

Leather

Leather

Leather

Plastics/metals

The question is how Firm 3 should choose. Three rules which may help:
Rule 1: Competitive advantage: Each player must seek competitive advantage over the other. In our simple
game we assume particular moves may enhance competitive advantage in one of two ways; the move must help
shift at least one demand curve or one cost curve in a way that adds value to the firms activity. Diversified firms
do not compete; only their individual business units do. If diversification is to have benefits it must be in terms of a
positive impact of the ability of at least one of its businesses to compete in the market place.
Rule 2: Only one move at a time: It is expensive to diversify at all levels
Rule 3: Fair play: Here fair play is interpreted to mean that a particular move does not allow a firm to achieve a
dominant position that would allow them to exercise monopoly control over customer or suppliers.
Each move has different implication for competitive advantage.
Firm 3 merging or acquiring firm 8 the specialisation shown below

24-Nov-03

Page 1 of 27

EBS MBA Competitive Strategy


The value chain and gains from specialisation:

sales force
trucks

Distribution

marketing development
market research
advertisement

Marketing

plant
equipment
labour force

Production

research
development

R&D

Firm 3

R&D

mergers with...

Firm 8

Partial links between the value chains in the case of both helmet and handbag moves:

D
M

D
M

D
M

D
M

P
R&D

P
R&D

P
R&D

P
R&D

Firm 3 plus Firm 6


The MC market

Firm 3 plus Firm 9


Leather technology

= Marketing and distribution linkages


= Technological linkages

Good fits between both value chains in the case of jackets to trousers:

D
M

D
M

P
R&D

P
R&D

Firm 3 plus Firm 7


Leather MC garments
Leather technology
The MC market

24-Nov-03

Page 2 of 27

EBS MBA Competitive Strategy


Strong linkages throughout the value chain in the case of specialisation:

D
M

D
M

P
R&D

P
R&D

Firm 3 plus Firm 8


Leather MC jackets
Leather technology
The MC market
Jackets to umbrellas a conglomerate type move generate no real linkages:

D
M

D
M

P
R&D

P
R&D

Firm 3 plus Firm 10


Jackets and umbrellas
5.2.2

Preferred Moves in the Diversification Game

What to prefer? The firm should specialise as far as possible if it is seeking competitive advantage. There are four
main reasons for this:
1. Resource effects. Specialise if you can; if you have to diversify, stay as close to home as possible and
try to avoid unrelated diversification as long as related alternative exists.
2. Market power considerations. If the firm is seeking more control over its market, the specialisation
option is clearly the most direct and powerful route to achieve this.
3. Allergic reactions. Firms can display an adverse reaction to new activities that are unrelated or loosely
related to its existing competencies. Failure of synergy in corporate expansion, Michael Porter - it is often
what firm knows rather than what they do not know that can be the problem.
4. Rivals valuation. For example firm 4 value firm ten more than our firm 3.

5.2.3

Methods of Expansion in the Diversification Game

Why should the firm choose expansion by diversification as a method of expansion opportunities rather than
making some agreements with the firms to share resources?
Market power is one example. You may not trust your partner. Resource effects may be achieved by co-operation
as well as by diversification. The reason why firms diversify in some case is the transaction cost associated by cooperation. The opportunity cost is also a reason for going the conglomerate way.

5.3

Why Diversify?

5.3.1

Market Power

There are many ways that power could be exercised by diversification, but each tends to come down to the
increased share of the firm in particular markets.

24-Nov-03

Page 3 of 27

EBS MBA Competitive Strategy

How diversification can aid control of markets and technologies:

The MC market link


Helmets
D
M

Trousers
D
M

Jackets
D
M

Handbags
D
M

P
R&D

P
R&D

P
R&D

P
R&D

Leather technology link


5.3.2

Synergy

If resources can be shared across value chains for different businesses they may give rise to cost savings
described as synergy in strategic management and economics. If the businesses are effectively the same these
resource affects are described as economies of scale. There can be two sources of gains in such cases:

Indivisibilities Resources tend to come in lumps a factory, a truck, a machine, an economist, etc. If
you where to cut each of these resources in two physically, they would not be able to do their job any
more. The fuller the use that can be made of these indivisible lumps, the lower will the cost to the firm of
using these resources.

Specialisation Expansion of the firm may permit increased specialisation of resources which in turn
can lead to enhanced value for the combined firm.

Economics have traditionally focused at the level of individual products like a jacket or a helmet and looked at
cost and price considerations in the respective cases.
Strategic management focuses instead at the level of the individual firm and looks at the resource questions that
matter at this level. The bigger and the more diversified the firm, the less likely that economies from sharing
tangible resources such as plant and equipment are going to be important at the level of corporate strategy, and
the more likely that intangible resources such as managerial capabilities are going to be of relevance.

5.3.3

User Gains

Diversification can also help generate competitive advantage for the diversifier by providing benefits for the user.
These gains tend to be reflected in one of two main ways:
Cost advantage: e.g. one stop shopping with the convenience of one supplier of M/C goods to retailers
rather than three.

5.3.4

Differentiation: e.g. enhanced compatibility of products, with M/C jackets, trousers and helmets in
matching styles

Internal Markets

The diversified firm is in a position to create internal markets such as internal labour markets, internal markets for
R&D know-how or know-how in general, and so on. The form of transaction cost depends on the case in point,
but the advantages of internal markets over external markets are generally regarded as having tree major
sources:
Asymmetric information managers inside the firm will generally have access to more and better
information about the potential trade than outside individuals and organisations.

Control of opportunistic behaviour is easier from the inside

24-Nov-03

Page 4 of 27

EBS MBA Competitive Strategy

Divisionalisation gains - The growth of the diversified firm has been seen by some as creating possible
efficiency gains in terms of organisational structure. Instead of organising the firm around functions in
what has been termed a Unitary form or U-form structure, the firm could now be organised around
divisions in a Multi-divisional or M-form structure.
The major advantages that M-form structures have been identified as having over the U structures for the
large diversified firm include:
o The creation of profit centres to aid assessment and comparison of performance
o Putting together resources that have the most need to co-ordinate their activities into natural units
o The separation of strategy formulation management responsibilities at headquarters level in the
firm from the functional responsibilities at divisional level

The disadvantages in substituting external markets with internal markets, especially in terms of principal-agent
problems in which the shareholders are the principal and management are the agents:
Opaque performance A problem with creating an internal market is that it reduces the transparency of
performance since the performance of divisions may be concealed within consolidated accounts at he
level of the firm

Lock-in One of the great virtues of the market mechanism is its flexibility. Opportunity cost
considerations mean that assets have negative value in their present use, the market mechanism
provides very effective devices for reallocating assets to their best uses. Internal markets can be stickier.
For instance, one product can be dependent on the other, otherwise it wont be profitable.

Not invented here syndrome Divisions may place more value on ideas developed by themselves and
less on ideas developed elsewhere, even if these ideas have been developed by other divisions within
the same company.

One of the most widely considered markets in the context of the diversified firm has been the internal capital
market. By throwing corporate boundaries around the various businesses operated by the conglomerate, it was
argued that this would allow the firm to avoid the transaction costs associated with the blunter and less sensitive
instrument of the external capital market, these firms remained independent, smaller and more specialised.
Conglomerate could exploit advantages in terms of information, control and divisionalisation from treating the firm
as a mini-capital market.
If it works well for conglomerates it work even better for related diversification. The internal capital market
justification for the conglomerate is a justification of the conglomerate as a method. Essentially it says that in
certain circumstances internal markets are more efficient than external markets, so if you have to choose between
the conglomerate and a series of independent firms, you might be better of with a conglomerate.

24-Nov-03

Page 5 of 27

EBS MBA Competitive Strategy


Diversification and creation of internal markets:

Helmets
D
M
P
R&D

Jackets
D
M

Handbags
D
M

P
R&D

P
R&D

The related diversifier


can exploit a variety of
linkages in its internal
markets
The conglomerate
strategy exploits only
financial linkages in its
internal market

5.3.5

H.Q

DIV 1

DIV 2

DIV 3

Organisational structure
for the related diversifier
to help create internal
capital markets
Similar (divisionalised)
organisational structure
for the conglomerate

Umbrellas
D
M

Helmets
D
M

Fast food
D
M

P
R&D

P
R&D

P
R&D

H.Q

DIV 1

DIV 2

DIV 3

Growth

One frequently cited argument for diversification runs as follows: because of separation of ownership and control
asymmetric information, there is typically a principal-agent problem with manager having some discretion over
pursuing their objectives at the expense of owners objectives.
Owners would normally wish to maximise profits, but managers wish the firm to grow. Therefore, managers may
choose diversification for growth that may be why conglomerates grows.

5.3.6

Risk and uncertainty

Diversification can reduce risk in many contexts. If the management of a single-business firm is worried about its
dependence on the fortunes of one business it might consider diversifying into other business to spread risk.
There are two sets of problems as follows:
Opportunity cost of diversification Diversification moves the firm away from its core business and
competencies. It may turn out to be a mistake once opportunity cost considerations is taken into account.
There may be cheaper ways to dealing with risks.

Owners may spread their risks by diversifying their portfolios

The important issue in each case is to identify which, if any, problems are caused with volatile sales this may be
solution to reduce risk:
Liquid assets (assets that may be quickly realised by the firm) firm could set aside funds for dips

Short-term finance the firm may not even have to keep a fund in the form of liquid assets if presenting
the variation for a bank. They get short-term credit

Stockholding Keep the production on the same level

Insurance it may be possible to transfer the risk to insurance company

Long-term contracts is a way the firm could pass on the risk of variability,

24-Nov-03

Page 6 of 27

EBS MBA Competitive Strategy

Vertical integration can be a way to reduce risks and guarantee sales.

None of these solutions is free. Another risk is if a rival come up with improved technology and our sales goes
down. A strategic bomb is shown. When external threats hit a firm they may not focus just on individual
businesses, but on particular linkages. For example, if Firm 3 merged with Firm 8 above it will be able to extract
gains from marketing/distribution and technological linkages.
The linkages that can help generate enhanced value when the environment is relatively stable can also pose a
source of joint weakness when the environment begins to throw up nasty threats. For example, if the M/C
business begins to decline, then both jackets and trousers could be attacked along the M/C market linkage. If a
rival develops an improved synthetic substitute for leather, then both jackets and trousers can be attacked along
the shared technological linkage.
Corporate diversification can help provide a basis for defending the firm against unpleasant surprises such as
technological innovation by its competitors. However, there are further questions we can ask of this strategy; it is
not going to be let off so easily:

Why not specialise until you are forced to change to another business? Diversification usually
takes time and costs a lot, so when it has to it may be the worst timing

If some corporate diversification is designed to safeguard managerial jobs, can this also be in
interest of owners? It can be on very special occasion for instance where the alternative would be
bankruptcy or an alternative to loosing the best and necessary resources.

If risks such as technological innovation by competitors are often one off surprises, how can
management know in advance when they should diversify? This is impossible to answer- Good
strategic management may find indications or warnings

On the face of it, conglomerate diversification offers the most obvious way of anticipating threats to the viability of
individual businesses.

5.4

Forms of Diversification

Firms diversify for a number of reasons. These include market power, resource effect, user gains, creation of
internal markets, growth motives and dealing with the possibility of attacks on the viability of individual
businesses. Most motives suggest that the firm should stay as close to home as possible.
Related link strategy (Richard Rumelt Harvard Business School) is when firms simultaneously exploit the gains
from the linkages between businesses together with risk-spreading benefits of multiple markets and multiple
technologies that the conglomerate strategy offers.

24-Nov-03

Page 7 of 27

EBS MBA Competitive Strategy


New game:
Helmets

MC Audio
equipment
12

Jackets

Saddles

Handbags

Umbrellas

11

15

14

Fast food

13

10

16

Market

Motor cycle Motor cycle Motor cycle Horse riding Accessories Accessories Restaurant
Plastics/
Technology Carbon-fire Electronic
Leather
Leather
Leather
Retailing
metals

Some moves Firm 3 can make in game 2


MC jackets pursues market-based diversification, exploiting selling and distribution linkages:

Helmets
D
M
P
R&D

Jackets
D
M

Audio
D
M

P
R&D

P
R&D

Here MC jackets becomes a conglomerate, moving into new markets and technologies:

Umbrellas
D
M

Jackets
D
M

Fast food
D
M

P
R&D

P
R&D

P
R&D

Technology based diversification MC jackets exploits production and R&D competencies:

Handbags
D
M

Jackets
D
M

Saddles
D
M

P
R&D

P
R&D

P
R&D

The related-linked strategy; here MC jackets exploits different linkages in its moves:

Helmets
D
M
P
R&D
24-Nov-03

Jackets
D
M

Handbags
D
M

P
R&D

P
R&D
Page 8 of 27

EBS MBA Competitive Strategy


The most important attacks in real life corporate battles tend to be the following:
Innovation in from of new products or processes
Change in consumer tastes
Change in government restriction
Resource depletion, an industry can simple begin to run out of raw material. Resource depletion is likely
to be a slow ticking bomb at worst with firms usually having plenty of time to prepare for the worst.
How much damage can a simple bomb do? The answer depends on the pattern of linkage, not just the extent of
linkages.
Market bombs can be dangerous to firms that are diversified and market related. Technology bombs can be
dangerous for firms that are diversified and technological related. Technology and market threats do not affect
the firm as a whole if it is a conglomerate thats one favour for the conglomerate.

Growth using related-linked strategy:

Helmets
D
M
P
R&D

Jackets
D
M

Handbags
D
M

Umbrellas
D
M

P
R&D

P
R&D

P
R&D

Related-linked expansion; now no more than two of the


firm's businesses are vulnerable to any threat to specific
competencies
By the figure above, a single bomb could only impact on two of its four businesses even if it were aimed at a
competence and not a single business.
This is a degree of insulation from external threat, which is almost as good as the conglomerate, and indeed the
more that the related-linked firm expands using this strategy, the closer it approximates the degree of protection
offered by conglomerates.
But it is not a conglomerate since every business is linked to every other and there is a solid level of linkage
exploited as we move through the strategy, just as in the case of the market-based and technology-based
diversifiers. This is a strategy that seems to enable management to exploit the advantages of related
diversification without incurring the dangers of exposure to a single external threat.
The related-linked strategy is one of the unsung successes of corporate diversification. Rumelts study found that
it had been adopted by many of the most successful large firms in the US economy since the nineteen-sixties.
Conglomerates usually do not exist for synergy, deep pocket, market power reasons, or to absorb the risks to
individual businesses. Anything the conglomerate can do in these respects, related to diversification can match
and improve on. Answers to the riddle of the conglomerate must lie elsewhere and include the following:

The disguised related-link firm: many firms which appears to be conglomerates because of the diversity
of their businesses turn out on closer inspection to be related-linked firms rather than genuine
conglomerates.

Restructuring of related-linked firms: Related linked strategy can be fragile and it does not take much
to turn into a conglomerate, especially if the firm is under pressure to divest loss-making businesses.

24-Nov-03

Page 9 of 27

EBS MBA Competitive Strategy

If a related-linked firm decides to divest


loss-making businesses that act as
connectors to the rest of the firm
D
M

D
M

D
M

D
M

D
M

P
R&D

P
R&D

P
R&D

P
R&D

P
R&D

...then it may turn itself into


a conglomerate by default
D
M

D
M

D
M

P
R&D

P
R&D

P
R&D

D
M
P
R&D

No alternatives: There are some industries which have faced external threats in the past for which it has
been difficult to find closely related products. Tobacco and petroleum are two cases in point in which
attempts to expand and escape from a threatened industrial base led the firms into unrelated fields when
value-enhancing related opportunities proved difficult to find.

Rapid growth: Synergy takes time and patience to release. If the firm is seeking really fast growth rates
in the immediate time period and the capital market is willing to bankroll your plans, then synergy is less
important. Strategic planning can become dominated by availability of acquisitions rather than how they fit
existing businesses. This is how many acquisitive firms in the past turned into conglomerate.

Path dependency: Restructuring, the absence of alternative and rapid growth may explain why some
firms become conglomerates but they do not help explain why they remain such. One answer is the path
dependency. The managing skills in the firm may be built on managing unrelated businesses and shifting
strategy involve a major change among top management skills and substantial transaction costs in buying
and selling business until the new strategy is created.

Conglomerate focus: Management learn and adapt. They may not be able to change their spot easily
but they can do the next best thing they can shuffle them around.

24-Nov-03

Page 10 of 27

EBS MBA Competitive Strategy


Downsizing and conglomerate persistence:

This conglomerate has been hit by


threats to two of its businesses...

D
M

D
M

D
M

D
M

D
M

P
R&D

P
R&D

P
R&D

P
R&D

P
R&D

...so it has divested these loss makers


and instructed the three ramaining
groups to diversify into related fields
D
M
P
R&D
D
M
P
R&D

D
M
P
R&D

D
M
P
R&D
D
M
P
R&D

D
M
P
R&D

Vertical integration is unlikely to be a successful long-term solution for a firm in a declining industry.
Decline in unit cost with cumulative production is the definition of the learning curve

24-Nov-03

Page 11 of 27

EBS MBA Competitive Strategy

Module 6 - International Strategy


A company is international if it serves foreign markets. It is multinational if it also locates facilities abroad.
John Dunnings studies discovered that most of the worlds giant companies had the majority of their sales in their
home domestic market and located the most of their assets, including factories, in their home country. Since the
study (1993) the internationalisation and multinationalism is growing especially for giant companies.
It is not necessary to be highly multinational (or indeed even very international) to be an extremely successful
company. If this holds at the level of the world's largest companies, it holds even more strongly for small and
medium-sized companies where the tendency to stay close to home base is even more prevalent.

6.1

The Diversification Game Goes International

A major problem with diversification was that it could lead to the sacrifice of the rich resource linkages which may
be possible under specialisation. Though, it could have the possible advantage of saving the firm from
overdependence on a limited set of competences that may be vulnerable to obsolescence.
Resource implications of domestic versus multinational expansion:

sales force
trucks
Distribution

Distribution

Marketing

Marketing

Production

Production

R&D

R&D

Firm 17 ...multinational expansion... Firm 3

marketing dev.
market research
advertisement
plant
equipment
labour force
research
development

...and domestic expansion...

D
M
P
R&D

Firm 8

Multinational is quite simply a bad deal in terms of resource linkages, certainly compared to the domestic
specialisation option. If our manufacturer of motor cycle jackets were to export to this foreign market, then
exporting would allow the concentration of production in the home base and possible exploitation of economies of
scale in production.
Even if the firm can exploit few physical economies of scale from further expansion of production, there should
still be administrative economies compared to the alternative of having to administer separate production facilities
in different countries as in the multinational alternative.
Resource costs such as cheap labour in the production process could encourage the jacket firm to relocate its
production to an overseas location. Transport cost might seem to be an argument against exporting and in favour
of saving on transport costs and locating production near foreign markets through multinational expansion.
However, transport costs tend to be important in cases where a product takes up high volume or significant
weight in relation to value added. While transport costs undoubtedly exist they are not sufficient to explain why
some firms choose to fragment and disperse their production capabilities into a variety of different locations
scattered around the world.
It is not enough to establish international opportunities to justify international expansion. These opportunities will
only be worth pursuing if they beat alternative domestic investment opportunities, taking into account the ability of
the firm to compete against foreign firms on their home ground.

24-Nov-03

Page 12 of 27

EBS MBA Competitive Strategy


Resource implications of multinational versus exporting strategies:

Distribution

Distribution

Marketing

Marketing

Production

Production

R&D

R&D

Firm 17 ...multinational enterprise... Firm 3

6.2

D
M
plant
equipment
labour force
research
development

P
R&D

...and exporting

The Question of International Competitiveness

In his Competitive Advantage of Nations, Michael Porter (1990) makes some crucial points about the idea of
competitiveness of industry seen from a national perspective:
Is competitiveness of industry based on exchange rate?
Is competitiveness based on cheap labour?
Is competitiveness based on cheap natural resources?
The basic point that Porter is making is a sound one, that it may be simplistic and indeed misleading to identify a
cheap currency or cheap resources as necessary or sufficient for competitive advantage. If low cost is not
necessarily the only or even the best strategy for firms to achieve competitive advantage, we should not be
surprised to find that the same holds at the level of countries.
Porter makes the point that we have to be careful in using the notion of competitive advantage at the level of
countries at all. He argues that countries do not compete, firms do. Firms inside a country may often identify their
fiercest and most direct competition in that domestic market place.

For a given country, there are typically few industries or segments of industries, which perform,
strongly in an international context.
For a given industry, or especially segments of industry, there are typically few countries which
perform strongly in an international context

For example, there is a general belief that the Japanese are so efficient that they can beat firms from most other
countries at any activity they care to turn their hands to. In fact, their international success is quite concentrated
in a selective number of highly visible industries such as automotives and consumer electronics. There are other
areas where Japan has not been so internationally successful, such as the food and advertising industries.
There are only a few countries that are internationally successful in the automotive industry, and the numbers that
have a major international presence dwindle when we look at sectors within each industry. We may have to
question received wisdom about the sources of competitive success if we are to understand the sources of
international competitiveness.
Consider this dilemma, you are a maker of widgets choosing between producing and selling in Country
A or Country B, the countries differ in the characteristics indicated as far as your business is concerned. But are
similar in all other relevant characteristics such as size of domestic market and access to capital.

Where to compete: soft versus tough environments


Firms
Consumers
Government
Factors
24-Nov-03

Country A
You would be the only firm
Easy to please, undemanding
Lax regulations and controls
Abundant and cheap resources

Country B
Many fierce and capable rivals
Well informed and sophisticated
Tight regulations and controls
Scarce and expensive resources
Page 13 of 27

EBS MBA Competitive Strategy


Simple textbook economics suggests that it has to be Country A. However, when we look at firms that are
internationally successful in practice, they frequently come from countries with some or all of the characteristics of
Country B. In fact, Michael Porter goes further and claims that they may be more likely to come from countries
like B than countries like A.
It would be dangerous to believe that a single element is behind competitive success in these industries. Indeed
it will tend to be a combination of elements that contributes to international competitiveness or failure at industry
level. In fact, there are two issues at work here, and we can summarise them as space and time.
Standard economics tends to look at firms and sectors in isolation, but sometimes issues in other spaces or
territories can be very important. Major technological and organisational upheavals and transformations tend to
lie too far in the distance to be dealt with by standard economic tools.
The problem is that it is the longer time dimensions that can be associated with the forces which may create and
sustain competitive advantage and which we need to look at in this context. Today's comfortable monopolist may
be tomorrow's bankrupt firm.

6.3

Porter's Diamond Framework

Michael Porter argues that competitive strategy for a firm should be framed in the context of the attributes of its
national environment that may help generate or inhibit competitive advantage. These attributes fall into four main
categories, which together go to make up Porters Diamond Framework:
1. Factor conditions
2. Demand conditions
3. Linked and related industries
4. Firm strategy, structure and rivalry
The important driving forces of the Diamond can be analysed in terms of:
Space considerations. The space covered by the relevant Diamond is essentially contained within the
home base (usually the nation) to which the firm belongs. An important unit of analysis here is the cluster
(a group of firms in linked or related industries that trade or compete with each other). A cluster typically
occupies an even more localised space than the nation state, and in practice may be found within
regions, cities, districts or even single streets.

Time considerations. Time or dynamic considerations reflect the fact that the normal logic of
competitiveness may be turned on its head once we look at the time long enough to allow for major
innovative and organisational changes.

(A) Factor conditions


These can have a critical influence on competitive advantage. Porter distinguishes between factors in term of:
Degree of sophistication. At one end of the spectrum we have basic factors which tend to be inherited
(natural resources) or easily created (unskilled labour) and at the other we have advanced factors
(research scientist) which are more sophisticated.

Degree of specialisation. At one end of the spectrum we have generalised factors which can be turned
to many different kinds of tasks (village hall). While at the other end we have highly specialised factors
whose value lies in a limited set of tasks or one specific task (brain surgeon).

One of the most important issues that Porter introduces in this context is the notion of selective factor
disadvantage. It occurs when scarcity or other problems of a certain factor stimulate technological or
organisational innovation to deal with the problematic factor, and this innovation turns out to help generate
subsequent competitive advantage in an international context.

Japanese language
Distances in US
24-Nov-03

Examples of Selective factor disadvantages:

Fax technology

Communications and transport innovations


Page 14 of 27

EBS MBA Competitive Strategy


Short Swedish building season

Prefabricated technology

In each of these cases there was a factor disadvantage which created immediate costs or barriers to industrial
activity and triggered a search for innovative solutions. These solutions not only alleviated or neutralised the
original source of disadvantage, but turned out to be a source of international competitive advantage. The
opposite is also possible in some cases.
Factor disadvantages, including scarcity, can turn out to stimulate eventual competitive advantage while factor
advantages, including abundance, can eventually lead to declining competitive advantage. The problem is that
not all sources of factor disadvantage turn out to have this eventual benign effect, any more than factor
abundance need turn out to be an eventual source of declining advantage.

(B) Demand conditions


The home market may dominate in terms of the quantity of information feeding back into the framing of
competitive strategy. But it may also be important in terms of the quality of the information that feeds back into
the planning process. If those involved in the formulation of strategy are based in the same country as the firm's
headquarters and home market, they are likely to be heavily influenced by the characteristics of that domestic
market.
Porter argues that there are three main features of demand conditions that can be important in a dynamic context
in terms of helping develop and reinforce competitive advantage:
1. Composition of home demand. The composition of home demand can provide pressures and
opportunities since the signals coming from home demand can be clearer than weaker signals coming
from foreign markets. The main issues here include:
i.
ii.

Segment structure of demand: the distribution and variety of patterns of demand within a sector.
The existence of sophisticated and demanding buyers: sharpening up and honing the competitive
skills of firms that could prove useful in competing with firms that have had an easier life.
iii. Anticipatory buyer needs: providing an early warning system and experience of trends that may
emerge in the future in foreign markets
2. Demand size and pattern of growth: there are a number of features here that can reinforce the effects
of home demand composition on competitive advantage:
i. Size of home market can help generate economies of scale and learning curve effects.
ii. Number of independent buyers, including at wholesale or retail levels can generate variety of
information and market feedback, and reduce the chance of inertia for firms that attend to this source
of information.
iii. Rate of growth of market demand: advantages of a growing market include possible entry room for
innovative new firms - otherwise incumbents may have an inbuilt advantage if the customer base
does not change and expand.
iv. Domestic market saturates early: this may stimulate fierce rivalry amongst domestic firms that can
enhance cost competitiveness and innovativeness and in turn enhance their fitness to compete on a
world stage.
3. Internationalisation of home demand. These aspects can help pull a nation's products abroad.
i.

Mobile or multinational buyers may seek to buy or be receptive to buying the products that they
consumed at home
ii. Influence on foreign needs: historical or cultural factors may influence.

(C) Linked and relative industries


Internationally competitive industries and sectors tend not to emerge in isolation but instead are associated with
other internationally competitive industries within their nation or region. These industries or sectors may be linked
vertically or horizontally to each other.
Linked and related industries can exert a strong influence on the competitive advantage of a sector through
proximity of innovative and enterprising companies in neighbouring sectors. Competitiveness and high
24-Nov-03

Page 15 of 27

EBS MBA Competitive Strategy


performance in one sector can have spill-over benefits into linked and related sectors in the domestic market
through a variety of means:
User sector firms imposing high specifications on supplier sector
Reputational spill-overs
User sector firms demanding cost competitiveness from supplier sector
Supplier sector protecting their brands by raising user sector performance
Technology spill-overs between related sectors
Related sectors sharing marketing and distribution channels
Spill-over of highly trained and well-qualified labour pool between sectors
Best practice diffusion by example and observation
Proximity reduces transaction costs between sectors
The fundamental point is that sectors may benefit in a variety of ways that enhance performance or reduce costs
from having an internationally competitive sector nearby.

(D) Firm strategy, structure and rivalry


Important themes in this context include the following.
1. Strategy and structure of domestic firms. As an example of this, Porter argues that the value placed on
technical skills in Germany has helped create and support its competitive advantage in optics and some
chemical and machinery sectors.
2. Goals and objectives. These can be important at the level of the individual, the company or the nation, and
can be heavily influenced by the cultural context. For example, Porter notes that Germany has a tradition of
long-term holding of shares by institutions and a more cautious approach to risk taking. The US has a culture
that tends to encourage the taking of risks and therefore place a strong emphasis on start-ups, such as
biotechnology.
3. Domestic rivalry. This is one of the most important aspects in the Diamond Framework. When the industrial
structures of internationally competitive industries are dissected, it often turns out to be based on strong
domestic rivalry between firms. (Example, Volvo/Scania)

(E) The jokers in the pack: chance and government


Porter adds that both chance (e.g. wars and inventions) and government can play roles in the relationships,
which evolve in the Diamond in the context of creating an international competitive advantage.

6.4

Using the Diamond Framework

6.4.1

Identifying and Using a Diamond

Some of the issues and difficulties that are raised in using a Diamond approach:
6.4.1.1 Interdependence of the Four Main Elements. An essential feature of the Diamond is that no one
element can be isolated as 'the' element that has (or will) create competitive advantage for a sector in a
particular country. In practice, a number of elements will contribute and interact with each other.
6.4.1.2 Essential Contribution of All Four Main Elements. Porter argues that each of the four main categories
in the Diamond should usually actively contribute to competitive advantage if it is to be generated and
maintained. Though, just as it may be possible to have a three-legged chair in certain cases, so the
absence of a strong fourth leg can sometimes be compensated for. But, just a two-legged chair is
impossible.
6.4.1.3 Continuous upgrading and improvement. The Diamond uses just snapshot and are static, in real
world it does not work so.
6.4.1.4 Subjectivity and Multiplicity. The Diamond reflects an art rather than a science, different people may
construct the Diamond differently.

24-Nov-03

Page 16 of 27

EBS MBA Competitive Strategy


6.4.2

Diamond in Action: US Competitive Advantage in Economics Textbooks


(A) Factor
conditions
Leading authors
English language
Major university

(B) Demand
Conditions
Large domestic
market
Anticipates wider
trends
Sophisticated
distribution channels

(C) Linked and related


industries
Advertising and software
industries

(D) Firms strategy,


structure and rivalry
Advertising-oriented
Glamorous industry
Risky venture
Numerous rivals

6.5

Framing Competitive Strategy

Porters Diamond has a number of implications for company strategy.


1. Possibility of competitive advantage depends on home Diamond
2. Choice of strategy influenced by home Diamond
3. Continuous innovation. The diamond needs continuous upgrading and improvement to maintain
competitive advantage. To survive and maintain competitive advantage from innovation pressure Porter
suggests:
Seeking sophisticated buyers
Seeking buyers with most demanding needs
Overshooting most stringent regulations or standards
Sourcing from leading home based suppliers
Seeing leading rivals as benchmarking
Such solutions do not guarantee competitiveness
4. Perceiving and anticipating industry change The diamond can help a firm position its strategy with future
opportunities and threat in mind. Porter suggests a variety of ways in which this may be pursued:
Seeking buyers with anticipatory needs
Exploring emerging buyer groups
Seeking locations with early regulations
Identifying trends in factor costs
Linking with research centres
Studying new competitors
Having outsiders in the management team
But an uncritical emphasis on emerging signals and apparent trends can be dangerous (Ex. Dot.com)
5. Difficulties of replicating a Diamond advantages Porters analysis helps to illustrate how difficult it may
be to replicate the advantages that a foreign Diamond may give its local firms
6. Awareness of foreign Diamonds The bottom line is that firms should be aware of their merits and
deficiencies of their Diamond and those of their competitors when framing their competitive strategy.

6.6

Competing in International Markets

What does it take to compete effectively in international markets? We can approach this problem by using what
Dunning (1993) has called the Eclectic Paradigm. This suggests that multinational enterprise is a consequence
of ownership advantage, internalisation advantage and location advantage.

If foreign firms had no ownership advantage, they would find it difficult to play away from home against
local firms and their home advantage. However, there are other kinds of ownership advantage that may
be drawn on to help support competition in an international environment, these include:
o marketing know-how and resources
o organisational advantages
o access to finance
o purchasing know-how

24-Nov-03

Page 17 of 27

EBS MBA Competitive Strategy


o
o

favoured access of resources (e.g. ownership of oil reserves)


brand recognition (e.g. McDonalds)

If there were no location advantages, firms would find it attractive to service global markets from one
centralised base. There are a variety of possible influences that may encourage a firm to locate some of
its activities overseas, including:
o access to cheap or high quality resources
o transport costs
o need to service local market quickly
o to learn from the local Diamond or increase sensitivity to local market requirements
o government impediments to imports (e.g. tariffs, quotas, non-tariff barriers).

If there were no internalisation advantages, licensing local firms could appear as an obvious alternative
to multinationalism. Such advantages include:
o search costs for a suitable partner to co-operate with
o negotiation costs
o policing costs
o lack of able and suitable local partners
o residual problems of opportunistic behaviour
o reducing vulnerability to fluctuations and uncertainty of external variables
o control over secrecy of ownership know-how advantages (intellectual property)
o control over brand image
o problems of controlling delivery, quality of inputs
o reducing chances of losing access to inputs or outlets
o being able to indulge in monopoly practices such as a predatory pricing using transfer pricing and
cross subsidisation

Ownership, location and internalisation advantages are all necessary for multinational enterprise to exist in
particular cases. Take away one element and another strategy becomes more effective. Indeed, the fact that we
do observe some domestic firms competing successfully in their home markets suggests that foreign firms may
not have an ownership advantage in some cases.
The fact that international co-operative ventures exist between firms suggests that the associated transaction
costs of these ventures are not sufficient to give an internalisation advantage from the multinational alternative in
such cases.
International expansion will tend to become a major option after the firm has exhausted specialisation and
diversification opportunities in its home base to the point that the weaker resource linkages, associated with
overseas expansion begin to look relatively attractive. Firms first preferences are to stay at home from very
rational and sensible resource-based reasons.

6.7

Competing Abroad: The Principles

Porter (1990) suggests a number of principles that are important for firms to bear in mind if they are to compete
successfully abroad.
Seek sophisticated overseas buyers. This is simple extension of the logic of Porters analysis of the
benefits of sophisticated home demand in a Diamond framework. If the firm also seeks sophisticated
customers overseas it can strengthen its ability to compete at the highest level in an international context.

Source basic factors globally. If an input is a basic standardised commodity it is easy to write a contract
for its delivery and such factors on their own are unlikely to generate sources of competitive advantage
for the firm. So there is every opportunity to outsource such factors, usually few dangers with that.

Keep strategic assets close to home. Diamond considerations and the advantage of domestic
clustering for strategic resources encourage many multinationals to emphasis home locations for strategic
assets such as R&D laboratories.

Selective tapping of foreign technology. While transaction cost problems of potential leakiness of
technological know-how can also discourage them from co-operating with foreign firms. These same
properties mean that the firms may be able to pick valuable scraps of technical information through cooperating with or simply observing foreign firms.

24-Nov-03

Page 18 of 27

EBS MBA Competitive Strategy

Attack rivals directly to learn from them and neutralise them. It may be tempting to avoid direct
competition with strong competitors in home and overseas markets, but Porters Diamond analysis
suggests that this may be a mistaken strategy in the long run. Head to head competition can be a
valuable learning opportunity to observe what generates competitive advantage for its, best rivals, and
may help inhibit these rivals from growing even stronger.

Locate Regional HQs at best Diamond. In deciding where to locate a regional HQ overseas within a
nation or trading bloc, an international firm should be sensitive to the possibilities afforded by local
Diamond and cluster opportunities.

International acquisitions and alliances for access and learning. In spite of the downside, merger
and co-operative strategies can be useful ways of gaining access to foreign markets when all else fails or
proves too expensive.

Globalisation versus localisation. The world is not a homogenous entity but comprises many different
cultures, societies, legal and political systems.

6.8

Globalisation Versus Localisation

The issue of globalisation versus localisation can be best set out in resource-based terms using a value chain
analysis. The best solution for the firm in resource-based terms is what is called 'sticking to the knitting', by
keeping as close to home as possible, by staying in the same product line and the same home market.
Resource-based logic suggests that the firm should organise and manage itself the same way, try to make the
same type of product using the same technology and sell that product the same way in different world-markets.
Market-oriented logic may suggest that what works in one country may not work in another. This may have
implications for the way the firm manages and organises itself, the technology it uses, the type of product it sells,
and how it sells these products.
Can the tension between resource-based and market oriented logic be resolved? There are at least three issues
that may still encourage the evolution of international firms, even in markets traditionally dominated by local tastes
and brands:
Surface differentiation
It is important to dig deeper into cases where brand names differ across countries. In some cases this
may represent a product with quite different specifications from that which exists elsewhere, while in
others the brand name may be all that distinguishes the national product from that produced and sold in
other countries. In the latter case, the international firm may still be able to draw heavily on its
established base of technical and marketing know-how in different national contexts.

Access to factors of production


Firms may go international, not just to get access to foreign markets but to get access to cheap or better
factors of production.

Cultural globalisation
Tastes and preferences are not static but change and in some cases there may be some convergence.
French commentators may complain about the lowering of food standards represented by the spread of
fast food chains. But internationalisation of brands can work both ways and may also reflect a taste for
increasing sophistication and variety of choice on the part of consumers.

The tension between globalisation (of brands) and localisation (of tastes and preferences) does represent a
challenge for firms that wish to transfer their national sources of competitive advantages into foreign fields. If
national conditions are very different from each other, then it may be difficult to compete abroad on existing
sources of competitive advantage.
At the same time, local differences may only be skin deep and a determined firm may be able to use a great deal
of common technical skills and competence in marketing to compete in different national context. It is important to
bear in mind that international firms may not just respond to a given set of tastes and preferences they may be
able to change these national tastes and characteristics as well.
24-Nov-03

Page 19 of 27

EBS MBA Competitive Strategy

Module 7 - Making the Moves


There may be gains to be had by combining different bundles of resources and co-ordinating their activities.
Strategies should only be seriously considered if it looks likely that they will deliver net gains, even after taking
opportunity costs into account.

7.2

Evidence on the Performance of Combinations

One of the most surprising things about merger, acquisition and joint ventures is how badly they tend to perform
in practice, and yet how popular they remain with strategic planners. Surveys of merger and acquisition activity
have tended to conclude that, on average, there is no strong evidence that they lead to increases in profitability
and efficiency, and indeed the evidence tends to point in the opposite direction, with merger on average reducing
efficiency.
However there are some pitfalls in terms of judging whether or not a particular combination has or has not added
value.

Measurement difficulties. How do you know if a merger, acquisition or joint venture has been a success?
One would look at its effect on performance. Here the test should be on whether this combination added
value compared to what would have been the case if it had not take place.
However, the immediate effects are usually easier to observe and this can make it difficult to separate out and
measure the benefits from combination if they do not fully emerge until some years down the line, especially if
these effects are lost in the wash of other merger and joint venture activity by the firm during that period.

Other motives. The intention may not be to increase profitability; management may pursue merger because
they desire the status and reward that go along with a larger firm and be less sensitive to the possible effects
on performance. For example, if management acquire a supplier to prevent a rival cutting them off from
essential supplies, this may not directly increase profits but could instead reduce the chances of a future
reduction.

Wrong criteria. Even if a combination actually adds value it may be a failure according to some criteria.
Many joint ventures are deemed to be failures because they do not fully achieve their stated objective and
allotted life span. However, it may be that the gains to either or both partners are not fully reflected in the
performance of the joint venture.
For example, if a co-operative agreement between an innovative firm and a firm that is strong in marketing
and distribution breaks up well before its planned end date. The innovator may still have acquired valuable
know-how about selling techniques, while its partner may also have learnt something about why its former
partner is such a good R&D performer. Both may be able to apply the know-how gained to their advantage in
other activities.

Opportunities cost. It is usually only possible to make limited judgements on whether or not a particular
combination has added value. The true measure of the value of a particular combination in strategic terms
should allow for the opportunity cost of alternatives forgone.
It is difficult to measure these opportunity costs in practice, but what this does mean is that where viable
alternatives to merger, acquisition and joint venture have not been taken up, the true cost and real failure rate
of the chosen options may be even higher than is observed and reported.

There are two important messages we should take from the empirical evidence on combination activity as
follows:
a) They frequently tend to disappoint in terms of adding value, especially from the point of view of making an
acquisition and most especially from the point of view of joint venturing;
b) The strategic motives and implications of combination may be more complex than just short-term profit
maximising motives, and this may be reflected in the apparently poor performance of combinations when they
are judged in those terms.

24-Nov-03

Page 20 of 27

EBS MBA Competitive Strategy

7.3

Adding Value from Combination

Many textbooks on strategic management contain checklists on the gains that may be made from various
methods of trying to pursue competitive advantage such as merger, joint ventures and alliances. One checklist
may tell that merger may be useful to help obtain R&D economies, share distribution channels, transfer
technology, combine production facilities, etc, while another checklist may inform us that joint venture is useful for
exactly the same things.
Competitive advantage is achieved by reducing costs or increasing market power. The first thing we need
to do in looking at the potential gains from combining resources of different business units is to produce the
corporate version. What is that combination intended to achieve? Only after that should we go on to consider the
merits or demerits of alternative methods for pursuing these potential gains.
It should also be remembered that resource-based gains from combination are obtained at the level of individual
resources. If we want to consider the potential impact of combination on competitive advantage then we have to
look at the level of the individual resources and activities that make up the respective value chains.
The potential gains from combination then depend on the resources at the corresponding stage on the respective
value chains having some similarity in terms of their contribution to activities in the chain. At this level the
resources may be 'allergic' to each other (display negative synergy), just as they may generate synergy.
Synergies and allergies from combination:
Similarities and differences between
the sales forces to be combined may
lead to gains or losses

Distribution

Marketing

Production
R&D

Firm 3

sales force
trucks
marketing development
market research
advertisement
plant
equipment
labour force
research
development

mergers with...

P
R&D

Firm 8

Resource gains in this case should be reflected in cost saving/productivity gains for the combination, Whether or
not those occur will depend on the current disposition and characteristics of respective sales forces and how
actual changes are managed.
In particular it depends on the nature of the similarities and the differences between the two parts of the
combination, their resources and their product lines. How may these gains be achieved? There are a number of
ways and they may include some or all of the characteristics below.
1. Similar outlets: eliminating duplication. If the two sales forces duplicate each other's products, territories
and outlets, then there may be substantial gains possible from eliminating that duplication through combining
sales forces and now having only one sales representative visiting an individual retail outlet.

24-Nov-03

Page 21 of 27

EBS MBA Competitive Strategy


2. Similar products: eliminating competition. This means that our new combined sales force may be able to
push up margins on the products delivered to retailers, and worry less about price and other forms of
competition from a rival.
3. Similar activities: increasing sales. Suppose the two helmets are differentiated from each other and have
quite different brand images. The sales representatives in the combination can now represent two sets of
helmets during each visit to a retailer, potentially increasing their sales productivity in the process. This
represents both increased sales revenues for the firm in the aggregate and reduced marketing costs per unit
of helmets.
4. Similar activities: improving capabilities. Suppose (before combination) one firm has superior selling
capabilities such as superior selling practices and training methods compared to its rival. Combining sales
forces may allow these capabilities to be accessed and diffused to help the rest of the combined sales force
catch up with these superior practices, improving the quality or reducing the cost of selling. The result should
be reflected in increased aggregate sales revenue and/or reduced marketing costs per unit of sales.
Combining the two sets of activity and resources represented by two sets of sales force could result in a number
of potential benefits in this one category of potential resource linkage. These include:
(1) elimination of duplicated activity,
(2) increased control over buyers,
(3) increased productivity, and
(4) diffusion of superior or best practice capabilities throughout the combination.
The gains may be thought of in terms of supply-side gains (sharing resources and reducing costs) or demandside gains (shifting demand curve and/or increased market power). The particular form the gains take will depend
on the actual linkage in question. For example, increased market power here is reflected in increased bargaining
power with respect to buyers, while market power effects from combining purchasing departments could be
reflected in increased bargaining strength with respect to suppliers.
The most obvious way to achieve gains through resource sharing or enhanced market power is through merger of
two firms, or acquisition of one firm by the other. There are two comments worth making at this juncture.
1. The whole chain matters. The point is that where the economies may be obtained through combination
depends very much on the case in hand, for example, production or sales force.
2. Alternative methods of combining activities. Mergers and acquisition are not the only way such enhanced
value may be pursued. An obvious alternative is internal expansion. Where the benefits are built on
increased scale of output, organic growth may allow the firm to achieve the necessary size eventually without
the problems of integrating different systems that may be incompatible.
Where the benefits reflect reduced duplication of activity, the firm may be able to achieve the same ends by
concentrating on competing against its rival and encouraging or forcing its withdrawal from this market. In
principle, the intended outcomes of merger and acquisition may also be achievable through internal growth or
co-operative arrangements.

7.4

Why Do Mergers and Acquisitions Perform So Badly?

If we want to explore this question from the point of view of competitive strategy, it really breaks down into two
parts.
1. Why do mergers and acquisition so often fail to realise the added value that had been promised from the
combination?
2. Why does one party to the transaction (the shareholders of acquiring firms) often seem to do badly
compared to their counterparts on the other side of the transaction?
The answers will tell us a lot about the nature of this method of pursuing competitive strategy.
7.4.1

Why the Gains from Merger or Acquisition May Be So Disappointing


There are a number of possible reasons for the frequent disappointments in terms of adding value.

Compatibility problems
This is something that may be fairly obvious problem in the case of conglomerate acquisitions where the skills
built up in running one part of the business are not readily transferable to other parts.
24-Nov-03

Page 22 of 27

EBS MBA Competitive Strategy


It may also be observed in some vertical mergers where different stages may involve different skills and
competences. These issues can also result in principal-agent problems in which the divisional managers may be
able to conceal the true reasons for poor performance from corporate level management
Even firms that offer similar or identical products have their own unique identity and character, whether they are
fast food chains or oil companies. This holds for human capital as well as physical capital, and for procedures
and practices as well as technical manuals.
Some of these differences may be explicit, such as specifications of equipment and materials; other aspects may
be intangible and reflect custom and practice, the way things are done. The trouble is that these latter sets of
characteristics may be less visible than physical characteristics, and managers may find difficulty in changing
them, even in cases where they are aware of the differences in the first place.
This has potentially at least two adverse consequences:
1. The component parts may continue to go their own way and do things the way they did before the
merger. This would limit co-ordination of resources across the combined firm and mean that the new firm
could fail to achieve its perceived potential in terms of adding value by harmonising and standardising
activities across the firm.
2. Attempts to co-ordinate and harmonise activities across the board may be costly, especially if the skills
and competence's to be transferred are not appropriate to the other parts of the firm.

Optimistic bias
It is often easy to identify where meshing of market and resources from combination could lead to enhanced value
if all goes smoothly. The pitfalls and problems that lie in wait on the way to extracting that value are often less
easy to identify in advance.

Strategy matching, interdependent strategies


One feature of mergers and acquisitions is that they often appear in waves not only in the economy, but
sometimes in a particular sector even when there is not much activity of this nature in the rest of the economy. A
firm may observe its close rival pursuing a particular strategy (Strategy X) through merger or acquisition.
Our firm may be uncertain as to whether its rival's strategy is wise (adds value) or foolish (does not add value).
But, it knows that it can match its rival by doing a similar merger or acquisition move, and so maintain its
competitive position relative to its rival. The implications for our firm can be seen in the following table.

OUR FIRM
Does not match
rival
Matches rival

Whether or not to play follow the leader


RIVAL FIRM
Strategy X turns out to be foolish
Strategy X turns out to be wise
Our firm gains competitive edge over Our firm loses competitive edge
rival
over rival
Our firm maintains its competitive
Our firm maintains its
position relative to its rival
competitive position relative to its
rival

If it is a risk avoider, it will choose the option with the least worst possible outcome, which would be to match its
rival's strategy, otherwise know as the maximin solution. It is important to note that strategy matching may be
seen as providing our firm with potential benefits which are not necessarily reflected in added value from
combination.

Insulation from environmental surprises


The reason for the acquisition or merger may be that it is a way of diversifying into other markets and
technologies and generating a related-constrained or even a related-linked strategy. With strategy matching, the
benefit of such insulation may not necessarily be reflected in enhanced profitability since that is not the purpose of
the exercise.

Agency problems managerial motives for the merger


If managerial remuneration and rewards are more closely tied in to the size of the firm rather than its
performance, then it would be quite rational for management to push for increased growth and size, even if
combinations to achieve this may dissipate rather than enhance value.
24-Nov-03

Page 23 of 27

EBS MBA Competitive Strategy

The Prisoners Dilemma


We saw above that strategy matching may be sensible to prevent foreclosure. However, there may be cases
where the firms finish up choosing the same value-destroying merger and acquisition strategy even when it is
clear to both firms that they would be better off if they could agree not to pursue such strategies.
The real benefit that either firm could extract from making a downstream move is that it gives it a base on which it
could build to foreclose the other firm's market. The downstream stage involves very different skills and
competencies for the two upstream firms and neither firm has the suitable expertise to manage this stage; indeed
they would destroy rather than add value at this stage. 'OUR FIRM' is the first entry in each box.

OUR FIRM

The Prisoners dilemma and possible effects of mergers & acquisition


RIVAL FIRM
Acquires downstream
Does not acquire downstream

Acquires
downstream

-10 / -10

25 / -15

Does not acquire


downstream

-15 / 25

20 / 20

The fact that the combined profits of the pair have fallen from $40m ($20m + $20m) to $10m ($25m - $15m)
reflects the poor fit of the upstream and downstream stages and the fact that overall efficiency has been reduced
by this move.
However, if both firms decide to move downstream, their moves cancel each other out in competitive terms and
they are left with poorly fitting activities in which there is little carryover in competencies from one stage to
another. Efficiency on the part of both firms is impaired by the moves and they now make losses of $10m each.
Clearly, they would have been better off individually and collectively (profits of $20m each) if they had agreed to
stick to the stage that their competencies were based in rather than move downstream (losses of $10m each). If
our firm's rival moves downstream, then it would be rational for our firm to follow and make a loss of only $10m
compared to $15m loss it would make if it stayed put.
If the rival decides not to move downstream, our firm can make a profit of only $20m by doing the same, but could
beat that with a profit of $25m by integrating and building a base downstream that may help to cut its rival out of
some of that market.
Whatever its rival does, our firms most profitable strategy is to move downstream. Exactly the same logic holds
for the rival firm, with the result that both firms move downstream and start to make losses in a sector where they
had previously been making profits.
A Prisoners' Dilemma structure to a situation can result in merger and acquisition destroying value, even in cases
where the management are aware of these dangers in advance.

7.4.2

Why Do Acquirers Do Even Worse than Those Being Acquired?

The Grossman-Hart
Grossman and Hart (1980) showed that dispersion of ownership of the firm amongst a number of shareholders
could create difficulties for take-over bids. If there are a number of dispersed shareholdings in the firm, then each
shareholder may reason that anything any individual does will not affect the chances of the bid going through or
failing.
Each may reason that, rather than sell out, it may be better to hang on and free ride on a full share of the
increased value of the asset once the bid goes through. But if each shareholder reasons the same way, then the
bid will fail at least until the price gets to the point where sufficient shareholders reason it will be better to sell than
to hold on. And of course this may be at the price that redistributes all the gains from merger from the acquirer to
the shareholders of the target firm.

The 'Winner's Curse'


Suppose that a firm is in play and that a number of potential bidders are interested in acquiring it. The potential
bidders value what they think this firm is worth and its future prospect. Inevitably the potential bidders make
24-Nov-03

Page 24 of 27

EBS MBA Competitive Strategy


errors, some of an overly-optimistic nature and others of an overly-pessimistic nature, thus biasing their estimates
of the present value of this asset.
If the realistic present value of the firm lies below one or more of those based on overly-optimistic assumptions,
the winning bid is likely to be based on an overestimation of how much its new acquisition is really worth. The
result could be eventual disappointment for the 'winning' firm when it discovers that it had an inflated estimate of
the true worth of its prize in the first place.
The Winner's Curse can distribute gains from acquisition from the owners of the acquiring firm who 'win' the bid to
the owners of the acquisition who find they have been paid more than their asset is realistically worth. This can
hold whether or not the combined firm is worth more than the sum of the value of the two separate parts preacquisition.
Probably the best defence against the Winner's Curse is natural caution and risk aversion in the face of
uncertainty.

Hubris (or excessive self-confidence)


Management involved in a takeover may become so caught up in the thrill of the chase and the excitement of deal
making that they allow their bids to become unrealistically inflated. Lack of balanced judgement may result in bid
prices being pushed up beyond what should be regarded as reasonable.
As far as direction is concerned, stick as close to home as possible if you want to add value, and choose internal
growth over merger and acquisition (if you have the time and opportunity). The further away from your existing
competencies that a move takes you, the greater the chances that the move will destroy rather than add value.
In practice, merger or acquisition may be chosen over internal growth for a variety of reasons as follows:
Growth objectives of management
Where speed is important, for example to pre-empt competitive response of rivals
To gain competencies and resources that could not be easily developed internally
In the absence of room for entry through internal growth (e.g. the existing firms may have the supplier and
customer bases locked up)
In order to eliminate a competitor.
Merger or acquisition may be seen as a quick fix to problems that internal growth may find more difficulties in
dealing with, at least within the time scale envisaged by the management. Even if the merger deliver immediate
pay-offs this still leaves the issue whether such a strategy is suited to deliver sustained competitive advantage
over the longer time horizons.

7.5

Co-operative activity

There are a number of ways that firms can co-operate in practice as follows:
Licensing
Franchising
Informal co-operation
Sub-contracting
Alliances
Network participation
Joint venture
A license is effectively permission for another firm to indulge in an activity that would otherwise be forbidden by
law. It usually involves the transfer of intellectual property rights in technology for specified periods and territories,
in the form of patents, designs, trademarks, etc.
A Franchise involves the transfer of intellectual property from one party to another for specified periods and
territories, usually based around the rights to use the franchisor's name and trademarks, as in the case of
McDonalds and KFC.
The main difference between licensing and franchising is that licences usually relate to part of a business (the
technology for a specified product or products). While franchising tends to involve the transfer of know-how
ranging over the entire business, from purchasing through production to presentation and selling.
24-Nov-03

Page 25 of 27

EBS MBA Competitive Strategy


By its nature, informal co-operation is difficult to pin down and define in formal terms; it really depends on the
context in which it takes place. But the logic of it is clear enough and can be summarised as: 'you scratch my
back and I may scratch yours'.
Sub-contracting involves separating out part of a production process to be dealt with under contract by a
separate firm. They are increasingly assuming more responsibility for R&D and design activities, with the relation
between buyer and supplier now frequently evolving into long-term co-operation.
Joint venture is a form of co-operative activity that has increased rapidly in numbers in recent years. Definitions
vary, but generally tend to have these five characteristics:
1. Two or more parent firms agree to co-operate
2. The new entity (the 'child') is created for a specified task and possibly duration
3. The child has its own decision-making capability
4. The child is co-owned by the parents
5. There is provision for continuing parental supervision and control over the venture
Merger versus joint ventures:

D
M

D
M

D
M

D
M

D
M

D
M

P
R&D

P
R&D

P
R&D

P
R&D

P
R&D

P
R&D

Merger

Joint Venture

A joint venture involves three particular considerations when this alternative is compared to the merger option:
1. Contractual issues. The joint venture contract between the parties may absorb considerable amounts of
managerial and legal resources just to set up. The rights, responsibilities and obligations of the parties will
have to be discussed and agreed. Each party will normally need to police and monitor each other's
performance and actions. The possibility of opportunistic behaviour may be seen as greater in joint venture
compared to mergers because firms other than your own are involved, adding to the cost of monitoring.
2. Complex hierarchy. Joint ventures can lead to conflict and confusion since there is no reason that the
objectives, priorities and perceptions of the partners as to the outcomes of the joint venture should be the
same. They may also face the incompatibility problem in that procedures and cultures may be very different
in the two parents, leading to further co-ordination problems, miscommunication and misunderstanding.
3. Appropriability problems. The fear of losing competitive advantage because it leads to intellectual property
leaking out is a real one for joint ventures. A great advantage of mergers is that it is more able to keep
important secrets and technique private by internalising all critical assets. The joint venture may provide direct
or indirect access to the partners techniques and processes. Either firm may permanently acquire
competencies that it lacked or was weak in.
Firms may naturally fear revealing the basic competencies that drive their competitive advantage, especially if
there is a danger that their present partner could become a future rival in these areas.
1. Why joint venture and not other forms of co-operation?
The reason that joint venture may be preferred to other forms of co-operation, such as licensing and
franchising, is that there are often still major strategic decisions to be made involving the venture. These
24-Nov-03

Page 26 of 27

EBS MBA Competitive Strategy


other forms of co-operation are more appropriate for cases where the fundamental market and technical
characteristics that will help generate competitive advantage are fully known in advance and can effectively
be specified in a contract. Joint venture is frequently adopted in areas where there is still major uncertainty
concerning market and/or technical possibilities, such as technological innovation, new market entry and
searching for natural resources.
2. Why joint venture and not merger and acquisition?
Joint venture can be designed to cover only the selected range of the resources that are of relevance to this
venture opportunity, and these in turn may relate to only a small part of the relevant partners activities.
There are two basic ways that joint venture can perform:
a) Selected pieces of the value chain. Suppose a group of firms were to form a joint venture in sales
only, and keep the rest of their activities separate? This would allow them to set up a decision-making
facility to co-ordinate potential gains from sharing sales forces, while localising most of the costs of coordination to that region of the firm.
In principle, there is no reason why other regions of the value chain could not be picked off and joint
ventures set up by the two firms in, say, distribution, production, purchasing or R&D.
b) Selected businesses of the firm. Suppose a group of firms form a joint venture in the new business,
keeping the rest of the firms separate. This would help them set up a decision-making facility to coordinate resource sharing over the relevant region of the firm, again localising most of the costs of coordination to that region of the firm.
Joint venture is almost certainly more costly than merger or acquisition over the range of the activity to which it
is applied. It is not just an alternative to corporate diversification through merger and acquisition, it is also a
consequence of it. As long as firms are small and specialised, exploitation of new opportunities through merger
and acquisition is likely to be the preferred route to growth, especially if internal expansion opportunities are
limited.
An alliance between two firms involves a formal or informal agreement to co-operate on a variety of matters.
Alliances can have both resource-based and transaction-cost logic.
The advantage of alliances from a resource-based perspective is that both sets of managerial teams can build up
familiarity and understanding in terms of how the other firm works.
The transaction-cost logic for alliances is that they should inhibit opportunism. It may be easier to behave
opportunistically for one-off acts of co-operation where the partners do not have any other co-operative
agreements with each other.
Network participation can display some of the features and attractions of joining a club. Networks may exist
where three or more firms are directly or indirectly linked by a series of co-operative agreements. It may be set
up by formal agreement, or it may simply evolve without any central set of objectives, direction or planning. The
essential quality of a network is that there are access and transaction cost benefits from joining, over and above
the benefits which one-on-one co-operative agreements or alliances can provide.

Acquisition may be the best method in securing access to supplies or transferring technological ideas and so
adding value. However, profitability is not in itself an acceptable reason for acquiring another firm. High
profitability would normally be reflected in the present value of the acquisition and the resulting price that has to
be paid for an acquisition, effectively removing the profit incentive for merger.

24-Nov-03

Page 27 of 27