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Integrated Strategy

Felix Oberholzer-Gee and Dennis Yao1 February 2008 DRAFT

A. Introduction The key challenge for strategists is to identify and implement a course of action that leads to sustained profitability. Opportunities for supra-normal profits typically arise in markets that are less-than-perfectly competitive. Management scholars have developed many frameworks that help strategists identify such instances of weakened competition. In developing their theories, however, researchers have largely focused on market factors that lessen competition, differences in economies of scale and barriers to entry being two prominent examples. By concentrating on the characteristics of markets, scholars have typically neglected how political and social forces can influence the intensity of competition and create opportunities for sustained profitability. In this paper, we propose a framework that integrates market and non-market strategy, offering a more complete view of the sources of competitive advantage. There is no conceptual reason for separating market and non-market analysis and certainly none for leaving political and social forces out of strategic management. While many executives recognize the importance of political and social considerations for the financial performance of their companies, to date we lack an integrated framework that links market and non-market considerations.2 As a result, strategic planning is separated from legal and public affairs, both intellectually and as an organizational matter in many companies. In practice, questions of non-market strategy are typically relegated to the general counsels office, government relations or other positions that are removed from strategic decision-making. In providing a unified framework for market and non-market strategy, our hope is to link classic strategic management with political and legal analysis both intellectually and in organizations. Our framework is based on the notion of market failure, a set of conditions that interfere with effective competition. As we will explain in greater detail below, firms that earn supra-normal profits exploit one of four types of market failure. As with many other conventional strategy frameworks, the proposed market-failure lens serves analytical and filtering functions.

Harvard Business School, Boston, MA 02163; foberholzer@hbs.edu and dyao@hbs.edu. Baron (2006) provides an outstanding general discussion of non-market strategies and the business environment.
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Analytics Because there are only a few types of market failure, it is fairly straightforward to identify business situations that offer the potential for supra-normal profits. As both market forces (e.g., economies of scale) and non-market factors (e.g., rent-seeking regulatory interventions) can lead markets to fail, there is a natural integration of these considerations in our framework. What matters is whether companies face instances of market failure that result in weakened competition, not whether these instances are due to political, social, technological or market forces. There is a second, perhaps even more important link between market and non-market forces in our framework. Strategists are not alone in their interest in poorly functioning markets. Correcting market failures is also one of the main tasks of government. As a result, it is insufficient for managers to spot and pursue business opportunities created by market failures. They also need to anticipate how government will respond. Such anticipation is valuable because it allows managers to distinguish opportunities to create long-term value from situations in which government quickly steps in to restore competition. The market-failure framework not only helps identify opportunities for supra-normal profits, it also sheds light on the sustainability of the resulting strategies. Filter The sense that political and social forces influence the profitability of companies is of course widespread and not a new insight. However, for any given firm there is a wide range of environmental forces that may impact its profitability. A manager contemplating the sea of possible factors to consider is likely to feel adrift. As a filtering tool, the market-failure framework pares down the set of environmental factors that a strategist needs to be intimately concerned with. We consider a political or social factor to be strategy-essential if the factor directly affects the market failure that supports the companys strategy. All other environmental forces are strategy inessential, and they can be separated from the strategy-making process and delegated to specialized units within the organization. In the next section we provide an example that illustrates the value of an integrated strategy. We then proceed to a discussion of the centrality of market failures for market strategy. Next we discuss our vision of integrated strategy. We end with discussions about stakeholders outside the traditional value chain, management issues associated with implementing an integrated strategy and limitations of our market-failures perspective.

B. Example of the Value of an Integrated Strategy Perspective Consider the U.S. homebuilding industry as an example for the interplay between market and non-market factors that determine the strategic success of companies. Prior to the most recent turmoil in credit markets, large homebuilders like Toll Brothers, Inc. experienced a long period of record earnings. While growing incomes and low interest rates helped fuel the demand for new housing, rising home prices mostly reflected a sharp drop in the growth rate of the housing stock in the United States, from 40% in the 1950s to only 14% in the 1990s. This decline is largely due to more restrictive zoning. Zoning laws are meant to limit the negative externalities that new development imposes on

Oberholzer and Yao Integrated Strategy

existing residences. Externalities are a classic type of market failure. As a result of stricter zoning, the number of new permits declined by 37% since the 1960s. The restricted supply was a boon for developers who secured land and building permits in the communities most likely to adopt restrictive zoning. While the physical cost of building a home made up 90% of its price in the 1970s, this figure dropped to 60% by 2000. The homebuilding industry is a good example for the ways in which the response to a market failure, the rising demand for more restrictive zoning, can influence the profitability of companies. Homebuilders were able to achieve supra-normal profits if they understood how zoning trends would affect the price of housing and if they secured land prior to the tightening of the supply. To be successful, homebuilders needed to predict where supply shortages would be most severe. For instance, more affluent and better-educated communities are much more likely to adopt restrictive zoning than poorer places. Hence, a focus on early land purchases in well-off areas and the construction of housing for more affluent families represented attractive strategies. The homebuilding example also illustrates the multi-faceted relation between government intervention and strategic decision-making. At times, government regulation renders markets more competitive, making it difficult to achieve strategic success. In many other instances, however, government intervention improves the functioning of some markets only to create other distortions that open up strategic opportunities. Zoning advances the efficiency of housing markets because the restrictions force developers to take into account how new projects affect current residents. By tightening the land supply, however, zoning also creates strategic openings. As the analysis of the homebuilding industry suggests, integrated strategy affords market factors (rising incomes, low interest rates, a cost advantage in construction) the same status as non-market influences (restrictive zoning, building codes, the regulation of the mortgage market). In each instance, executives would ask if these forces weaken competition, and if so, whether their company was in a unique position to take advantage of the reduced competitive pressures. C. Market Failures and Market Strategy We begin with a discussion of the market failures perspective on strategy, then discuss how the perspective fits to the other perspectives on market strategy. The intellectual basis for our approach is the theory of market failures which categorizes all failures as transactions costs, information imperfections, market power, or externalities. Gerard Debreu (1959) and Kenneth Arrow and Frank Hahn (1971) showed that fully competitive markets would not allow companies to earn returns in excess of their cost of capital. Economists refer to this famous result as the First Welfare

Oberholzer and Yao Integrated Strategy

Theorem.3 From this glass mostly empty economists logic we learn that some market failure is necessary, though not sufficient, to sustain sustainable above-normal profits.4 Each source of market failure indicates a specific reason why a companys profit is not eroded in competition. The value of the categorization is that it groups a large number of profit opportunities into four distinct categories that represent different mechanisms through which companies can obtain supra-normal profits. Transactions cost are the cost of identifying, preparing and executing a commercial transaction. Where customers transactions cost are high, it may not pay to search for a better deal, reducing competition between companies. Similar to transactions cost, information imperfections can protect companies from full-fledged competition. For example, in recent research we found that a company with a superior product had difficulty breaking into existing buyersupplier networks because buyers did not trust the new entrant. As a result, current suppliers were able to charge higher prices. Companies with market power offer products and services for which there is no close substitute, allowing them to charge a premium. Markets are also less-than-perfectly competitive when companies cause externalities by influencing their rivals cost or the value of rivals products. For example, frequent-flyer programs reduce the value of flying with a new carrier, allowing incumbents to increase prices

Examples of the Application of the Market-Failures Perspective to the Analysis of Market Strategy Example 1 (financing constraints): Building on Porters seminal work on industry structure, managers are encouraged to think about barriers to entry in their industry as one indication of an attractive business environment. A common example for a barrier to entry is financing constraints, suggesting that capital intensive industries are attractive. However, capital intensity is a poor guide to determining industry attractiveness. In fact, capital markets sometimes have no difficulty financing huge deals (e.g., the $45 billion bid for TXU Corp. by two private equity firms). On the other hand, tens of thousands of business proposals, many of them of moderate size, cannot be funded. So when is it the case that capital requirements constitute a barrier to entry? Our approach encourages strategists to analyze the conditions under which capital markets fail. One common reason for market failure is the presence of information imperfections in the form of asymmetric information: if potential lenders have difficulty determining the quality of the proposed undertaking, they are unlikely to invest. Instead of charging astronomical fees
Debreu (1959) and Arrow and Hahn (1971) Market failures are linked to various elements needed for an efficient market, i.e., market power to price taking, transactions costs and externalities to complete markets, and information imperfections to complete information. 4 Yao (1988) argues that a market failures perspective provides a useful focus for identifying profitable strategies, but his analysis does not extend to the nonmarket environment.
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and interest rates that reflect the poor information conditions, capital markets generally dont provide funds when uncertainty exceeds a critical level. As the example shows, the market-failures approach is more successful than conventional advice in identifying barriers to entry. Capital market constraints can improve profitability not when the stakes are huge, but when information conditions are poor. Example 2 (building brands): Developing a valuable brand is often seen as a way to sustained superior performance. As with capital constraints, this has worked for some firms but not for others. Cokes brand, valued at $67 billion, has greatly contributed to the financial performance of the company. In contrast, Ford Motor Companys brand does not appear to result in sound financial performance. The reason is not that Ford lacks marketing skills. Valued at $11 billion in 2006, Fords brand is ranked 30th worldwide, an impressive accomplishment. So why is Cokes brand strategically valuable while Fords is not? Cokes (and Pepsis) marketing expenditures increase industry fixed cost to a level that makes entry into the Cola market unattractive, keeping this market less than perfectly competitive and protecting the high prices for sugar water. In contrast, the automobile industry has been far less successful at deterring entry with the help of increases in fixed cost, Hyundais performance in the United States being a recent example. Relative to the size of the automobile market, marketing expenditures for cars are not high enough to shut out potential competitors. One of the rationales for building a brand, deterring entry, applies to the Cola industry but not to automobiles. Marketing expenditures lead to market failure in the former market but not in the latter. Asking when building a brand leads markets to fail helps identifying instances in which brand-building contributes to superior performance.5 Positioning Perspective on Market Strategy Strategy is frequently viewed as a choice of position and an alignment of production activities consistent with that position (e.g., Porter 1979, 1980, 1985). The positioning approach has its roots in industrial organization economics and identifies a set of market factors that make an industry more amenable for supra-normal profits. In this industrylevel perspective an attractive position is one where competition is less fierce, say because of high barriers to entry, significant economies of scale, and competitive upstream and downstream markets. Analysis is not typically focused on the factors that lead to market failures see Yao (1988) for an exceptionbut market failures thinking is clearly implicit in such an approach. An advantage of a market failures analysis over the more aggregated industry factor-based analysis, is that the analysis of market failures provides insight into the underlying mechanism that drives the opportunity for competitive advantage.

Deterring entry is not the only way in which marketing expenditures can lead markets to fail. Making goods and services less comparable is another avenue. In this respect, Fords trouble is that many of its competitors also have brands (Toyota $28 billion, Mercedes $22 billion, BMW $20 billion, Honda $17 billion), leading the companies to compete on price and quality.

Oberholzer and Yao Integrated Strategy

Uniqueness and the Resource-Based View of the Firm Of course, existence of a market failure is not a sufficient condition for above-normal profits because of competition to exploit such failures (See, e.g., Rumelt 1979 and Barney 1986.) Competitively-valuable uniqueness is also a critical element in the quest for sustainable competitive advantage and forms the basis for the influential resource
basedview(RBV)ofstrategy.6

While the market failures view is easily seen to underlie the positioning view of strategy and also operates at the same industry level of analysis, we also see market failures as largely consistent with RBV. Much of the discussion in the RBV literature is concerned with resources that are not tradable and which therefore are the source of rents that can stay with the firm.7 We see market failures as underlying the RBV analysis in two ways. First, resources are valuable because they allow a firm to take advantage of a market failure. So, for example, a firms brand would be a resource that has value because of an information market failure.8 Second, market failures in factor markets may ensure that the resource remains unique or that its value is not captured by others. D. Market Failures and the Nonmarket Environment In this section we examine the value a market failures perspective has for providing insight about government and NGO interventions into the market. Government interventions are arguably more easily classified than NGO interventions and we begin with them. Public interventions affecting specific markets are typically sought to improve social welfare by increasing the efficiency of the market or through redistribution, or to increase private benefits (rent-seeking). The Social Quest for Economic Efficiency Before addressing the question of when and how governments intervene in markets, it is useful to briefly consider the bigger question of social organization: which functions are delegated to the market and which to government? The market is seen by most commentators as offering the greatest efficiency in terms of resource use and allocation, but it also preserves the status quo in terms of distribution and has the potential for interfering with rights (see, for example, Arthur Okuns (1975) trenchant discussion of the domain of dollars versus the domain of rights.)9 Thus, at least in capitalist societies, markets are given primary domain when efficiency is the key objective and rights are little affected. Redistribution is typically, but not exclusively, delivered outside of the market via income tax and welfare systems. Once the decision is made to allocate decisions to a market, many capitalist societies such as the United States are quite reluctant to intervene in said markets for (outwardly)
See Peteraf (1993) for a synthesis of this perspective on strategy. See, e.g., Dierickx and Kool (1989). 8 A resource may also be the source of lower costs in which case a market failures analysis is mostly helpful in understanding why that position can be maintained. 9 Okun (1975).
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redistributive reasons. This reluctance reflects, in part, legitimate concerns regarding an inappropriate use of government power and widely-held views that private property ownership should be thought of as rights.10 However, government intervention to improve the efficiency of the market has been generally accepted and is arguably the principal justification for intervention.11 Inefficiency is traceable to market failures and, hence, both the reason for intervention and the proposed remedies center around reducing market failures.12 When governments and NGOs intervene in markets, they typically improve the functioning of some markets only to distort the economy in some other way, which then creates new strategic opportunities for profit. Consider, for example, the protection of intellectual property. Markets for innovation are prone to fail because new information, once created, can be shared at almost no cost. Governments correct this market failure by granting temporary monopoly positions in the form of patents and copyrights to innovators. Intellectual property serves the public by stimulating innovation, and it is an important source of supra-normal profits. Thus, the key to finding strategic opportunity in these complex settings can be thought of as the identification of the market failure as mediated now by non-market actors. Non-Governmental Organizations Government interventions in the market emerge from political or bureaucratic processes. Political processes can be thought of as requiring majority assent, so that interventions must satisfy, for example, the median legislator. Bureaucratic processes are one step isolated from the direct democratic machinery, yet bureaucrats are directly constrained by their enabling statutes and indirectly constrained by elected officials. In contrast, NGO activity outside of the formal political processwhat Baron (2003) calls private politicsdoes not need to satisfy a median voter.13 Private politics can be an effective channel of action when, for example, a group has strongly-held preferences that are not held by the majority.14 In such a case conventional politics would not likely lead to the desired outcome. As a preference for efficiency would seem to appeal to the majority, NGOs employing private politics will frequently be driven by other preferences driven by redistribution, values (e.g. environmental rights), or fairness concerns. We discuss these issues later in the paper. NGOs are not, of course, immune from more general social concerns. In fact, such organizations depend on private donors (and sometimes even the government) for financial support. While it is no longer necessary to appeal to the equivalent of the median voter for donations, positions taken by NGOs will affect their funding. Thus,
See, e.g. Dahl (1985) for a discussion of economic rights and democracy. Correcting market failures is an important task of government (Musgrave and Musgrave 1980). 12 Breyer (1982, p. 15) notes that the justification for intervention can be traced to an alleged inability of the marketplace to deal with particular structural problems. 13 Baron (2003). 14 Hansmann (1996) argues that activities are organized under NGOs rather than under governments when a group of individuals has largely homogenous interests that are not shared by a majority of citizens.
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NGO positions can sometimes be made stronger when they have stronger efficiencybased justifications. Admittedly, our focus on market failures is relatively less valuable to deal with NGO activism than government intervention because NGO activism will frequently be driven by nonefficiency concerns, yet a market failures perspective still helps a firm evaluate the competitive effects of actions (or nonaction) taken in response to NGO pressures. This set of actions includes both the focal firms actions and actions taken by other firms that may exploit activist activity to increase their competitive advantage (e.g. DeBeers use of the conflict diamonds). In addition, if a public debate over activist demands seems warranted, appeals to market failure-efficiency logic may help a firm sway public opinion in its favor.15 E. Integrated Strategy The preceding discussion argued that the existence of market failures not only shapes firms strategies, it affects the public interest and guides the public intervention. A market failure is a private opportunity to generate profits and a public opportunity to increase welfare. We see market failures as a lynchpin to both private and public action. Analytics An integrated strategy that focuses on market failures provides a tool for analyzing strategy. Market failures are the mechanism through which supranormal profits are generated as well as a significant driver of nonmarket action. Understanding this mechanism for profit generation gives the strategist insight into both what market strategies are attractive and how changes in the market rules would improve the value of a given strategy. Understanding this mechanism also highlights areas where public intervention may occur and provides a guide to possible interventions and the effects of such interventions. The sustainability of a high profit stream depends on the responses of market participants and, increasingly, on nonmarket participants. High profit induces imitation and substitution in the marketplace. High profits also attracts attention of nonmarket players, especially in the presence of viable solutions such as mitigating an underlying market failure. Filter A focus on integrated strategy also suggests which environmental factors need to be considered by strategists and which factors may be delegated to various functions. A difficulty with current strategic models is that they do not do a good job helping managers identify which nonmarket factors are important. For example, sometimes,
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Baron (2003) notes that some NGOs provide information to the public regarding various product/service attributes that consumers cannot observe and which would otherwise matter to some consumer purchase decisions (e.g. worker conditions in plants that produce textiles). One can see this as an NGO mitigation of an informational market failure.

Oberholzer and Yao Integrated Strategy

government is treated as an additional force. In other approaches, government influences the various market forces and, through these forces, ultimately the attractiveness of an industry itself. Obviously there are many other factors that impact the five forces: new technology, evolving consumer tastes, market fragmentation, switching costs, overcapacity and so on. Because there are so many factors, managers are forced to work with long and unwieldy lists of possible influences on profitability, without clear guidance as to when they need to pay attention to non-market forces. In addition, because government is seen as something else to worry about, non-market strategy is organizationally separated from strategic planning in many businesses. Most often, the something else is the responsibility of the legal department or a special governmentrelations group. Our approach offers a first step toward integrating market and nonmarket forces. Residual Market Failures The key to finding strategic opportunity in these complex settings remains the identification of the market failure as mediated now by non-market actors. While such interventions typically improve the functioning of some markets, they also frequently distort the market in some other way, which then creates new strategic opportunities for profit. This residual market failure represents a supranormal profit opportunity and should be the focus of firm strategy. In Table 1 we provide some examples that illustrate residual strategic opportunities that result from government or social group action intended to mitigate various types of market failures.

Table 1: Examples of Market Failures and Strategic Opportunities


Type of Market Failure Market Power Direct Strategic Opportunity for Firm Lack of close substitutes allows firms to raise prices. Imitation reduces costs of complements, thereby raising value of focal product Co-location with others increases knowledge diffusion Adverse selection and moral hazard increase value of understanding risk in insurance markets. Response of Governments and Social Groups Regulation Strategic Opportunity Arising from Societal Response Regulatory rules may have asymmetric competitive consequences IP becomes greater source of value; IP litigation useful tactical tool HR and incentive programs bigger source of competitive advantage Compulsory insurance schemes extend the size of the market.

Transaction costs

Stronger intellectual property protection Government labor laws and tax incentives Government mandates compulsory insurance

Externalities

Information Imperfections

Market Power and Telecommunications Deregulation

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A standard example is the market situation in which production economies lead to a natural monopoly situation. A natural monopoly is one type of failure of the market due to market power and has traditionally been responded to with government price regulation and/or other regulatory rules. The problems associated with reducing market failures can be seen in the 1996 U.S. deregulation of telecommunications services in the United States.16 Because some parts of the telecommunications value chain have natural monopoly characteristics (e.g. the local loop), competition could be impeded by firms that controlled these bottleneck system elements (typically the incumbent local exchange carrier). The government through the FCC instituted a set of regulations designed to encourage entry in the face of the possible use of market power over bottleneck elements (e.g. by unbundling network elements). These rules were hotly contested by the incumbent local exchange carriers and the potential entrants all of which realized that the manner in which the regulatory rules were designed and implemented would likely have asymmetric effects on each firms relative competitive advantages. Strategies, in turn, were designed to take advantage of the residual market failures given current and anticipated regulatory rules and enforcement. Informational Market Failures and Automobile Tire Grading Because market failure can be used to equally understand market and nonmarket actions, the perspective allows a strategist to understand such forces in the same way. For example, consider how consumers have become increasingly empowered by a number of actions which have reduced informational market failures. Actions taking place in the market such as informative advertising by individual firms, the rise of third-party information providers, and technological changes such as the internet have reduced consumers information problems. Meanwhile, the government has frequently mandated private information provision (e.g. nutrition labeling) or provided the information directly, while many NGOs have collected and posted information for consumers. The market for automobile tires provides a nice example of the value to a strategy perspective that considers both market and non-market forces. Consumers typically have imperfect information when they purchase replacement tires for their automobiles. Inspection does not allow them to observe the underlying performance characteristics of a tire, nor can their own experience provide much of a guide to the (statistical) reliability and durability of the tire. This information imperfection market failure creates the possibility of imperfect competition and supranormal profits. One way firms have capitalized on this market failure by building a reputation for quality tires. This brand reputation allowed companies such as Goodyear to earn a premium over their costs relative to companies with lesser reputations. From a market failures
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First Report and Order in the Matter of Implementation of the Local Competition Provisions in the Telecommunications Act of 1996 CC Docket No. 96-98, Federal Communications Commission FCC 96-325, August 1, 1996. See also Victor, The Biggest Enchilada, National Journal, 7/20/96, pp. 1573-1576.

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perspective we see the value of a reputation-based strategy as dependent on the underlying information imperfection. In the mid-1960s the U.S. government passed legislation which included language requiring that the Department of Transportation develop a tire grading system which would allow consumers to have a metric for comparing the quality of tires. This proposed government grading system had the potential of reducing the information problem faced by consumers and, hence, threatened to reduce the value of reputation strategies built on this information problem. Fortunately for some tire companies, grading tires was notoriously difficult and effectively required regulators to have technical knowledge that they lacked. The tire companies refused to help the government and government tire grading standards were delayed for many years. Finally, in the late 1970s one tire company with a relatively weak brand, Uniroyal, decided to break ranks with its brethren and helped the government develop the necessary testing procedures and standards. Previous to this Uniroyal sold more to OEMs (auto manufacturers) than to consumers in the aftermarket. 17 As a result of Uniroyals help and a push from consumer activists the government finally issued their grading standards in 1979. It is only mildly surprising, perhaps, that Uniroyals tires scored among the top tires on the new government rating. It is of no surprise, however, that Uniroyal subsequently built an advertising campaign around its high government ratings. This tire grading example illustrates how profitable strategies can be built around a market failure and how the design and interaction of these strategies changes when government intervenes to reduce the market failure that animated previous strategies. The story also illustrates issues relating to active shaping of governmental outcomes which, too, results in rules that have asymmetric competitive bite. A Typology of Firm Actions Regarding Integrated Strategy Depending on the market setting, firms take current or future market structure as given or as something that can be actively shaped. Similarly, firms will sometimes treat existing government responses to market failure as given while other times the firm should engage in actively shaping the business environment. In Table 2 we provide a simple typology of approaches used by firms regarding market failures and government remedies to those failures. Where the market structure and/or the government responses are taken to be given, firms respond by positioning themselves to best take advantage of the underlying market failures (market structure) or residual market failures after public intervention. 18

17

This information taken from F. Oberholzer, D. Yao, and E. Raabe, Goodyear and the Threat of Government Tire Grading HBS 707-494, 2006 and Breyer (1984). 18 Music firm reactions to file sharing provides an interesting combination of government/legal and market interactions involving nonrivalrous consumption, property right laws designed to protect intellectual property, new technologies that greatly reduced the cost of copying and dispersion of IP, transactions cost and enforcement issues, and the importance of complements as opportunities for earning profits.

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The passive positioning response is quite common, but may not take full advantage of the strategic opportunities presented by the market and/or non-market environment. For example, Some firms have adopted market saavy strategies that go beyond a passive acceptance of the market environment and attempt to actively shape market structure. Shaping market structure includes actions taken in the market which have the potential for altering the importance of various underlying market failures and are directed to the players in the relevant market (e.g. buyers, rivals, suppliers, etc.). Examples include vertical integration, advertising, or innovation strategies. For example, a number of actions taken by Pepsi and Coca-Cola in the soft drink industry has altered the market structure of the industry. As discussed above, Coca-Cola and Pepsi engaged in heavy advertising competition which increased differentiation in the industry and raised barriers to entry. Through acquisition, they also acquired significant holdings in the downstream bottling industry which allowed the Coca-Cola and Pepsi to restructure the exclusive territories of the bottlers as well as force investment in new plant needed to support the parent companies product extension strategies. 19 Similarly, where public intervention (or reintervention) is possible firms can also take an active role in shaping the outcomes of these interventions. Shaping the business environment includes actions that are taken in the market but that are partly targeted to those outside the market as well as actions that are taken outside the market (e.g. using non-market mechanisms such as legislation, self-regulation, etc. (Maxwell, Lyon, and Hackett 2000). Telecommunications deregulation, discussed above, is a good illustration where market participants had quite sophisticated integrated market and nonmarket strategies which involved attempts to shape the business environment.

Table 2: Market Failures and Integrated Business Strategy Company Approach Passive Production or exchange primitives Govt and NGO responses to market failure Positioning

Active + Shaping market structure

Source of Failure

Positioning

+ Shaping business environment

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David B. Yoffie and Yusi Wang, Cola Wars Continue: Coke and Pepsi in the Twenty-First Century, HBSP case (2002), 702-442.

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F. Operating Outside the Traditional Value Chain A number of considerations are introduced by players in the non-market environment that are not typically critical to purely market settings. We briefly comment on some of the more salient of these considerations. Stakeholders and the Importance of Noncustomers Nonmarket challenges (and opportunities) frequently come from outside a firms traditional value chain. Both the origination and resolution of such challenges may involve players that have limited economic interests in the firm, such as individuals that are not and will likely never be customers or suppliers to the firm. Intentions and Process Considerations In a society where the market mechanism is well respected, outcomes play a dominant role in direct interactions among market players. This focus on outcomes does not carry over to groups whose direct economic interests are not engaged. In interactions that involve such groups, firms need to be concerned about process and intentions as well as outcomes (Frey and Oberholzer-Gee 1996).20 Activist groupsparticularly ones that have united in response to a particular threat understand that collective action problems may prevent an effective remobilization in the future. Given the unpredictability of the future and a focal firms potential actions, the intentions of the firm and the manner in which the firm deals with affected individuals provide evidence about how likely it is that the firm will be responsible going forward.21 22 Social Legitimacy Our focus on market failures assumes that the general role of a firm in the marketplace is accepted by society. To maintain social legitimacy a firm must not take some actions deemed unacceptable by society. The firm would, for example, be criticized for taking on functions traditionally allocated to the government. More commonly, firms lose some legitimacy when they abuse their political power or do not fulfill their economic role, say, by producing dangerous products (when they could produce safer products) to make short-term profit, engage in price-gouging which takes advantage of a natural disaster.
20

Wal-Marts focus on outcomes rather than process arguably led to a rejection by the citizens of Inglewood, CA. of their initiative that would have permitted Wal-Mart to build a supercenter in Inglewood. See Wal-Marts Business Environment HBSP case 706-453. 21 See Baron (2003) discussion of equilibrium sustainability of a private politics resolution. 22 Merck withdrawal of Vioxx provides an example of where a cost-benefit approach is unsatisfactory for public debate which focused much attention on intentions and process. If intentions are seen as bad then the companies are often seen as violating the public trust.

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G. Managing an Integrated Strategy The analysis thus far has focused on integrated strategy design. We now briefly turn our attention to some issues regarding integrated management and implementation. An Enacted Environment? A major problem facing a firm is that its perceptions of the business environment are likely to be very subjective and very selective. In social psychological terms the environment is enacted (Weick 1979). There are many reasons for thismost managers in firms have limited frameworks and limited information about the environment.23 Further, their perceptions of the environment are not tested with the frequency that they are in the market. Weaknesses in appropriate training and oftentimes strong anti-government biases, combined with infrequent encounters make it difficult for managers to learn how to deal with their external non-market environment. Furthermore, because such managers may have trouble making sense of the non-market environment, the salience of challenges (and opportunities) from that environment decreases, arguably increasing the difficulty the firm has in anticipating and reacting to non-market forces.24 Our perspective on this organizational implementation issue starts from the viewpoint that the firm is underweighting non-market factors and we believe this to be generally true. However, these same issues may plague some companies in reverse. For example, companies whose life has been steeped in the regulatory environment (e.g., original regulated monopolist such as a local electric utility or some insurance companies) may be overly fixated on non-market factors and may see the struggle over regulation, litigation, and enforcement as the primary concern of the firm rather than factors more directly related to market competition. Because the market failures approach is consistent with a conventional business managers strategy sense making, extending the managers horizon to business environment concerns via the market failures bridge is likely to relax the cognitive demands on the firms strategists (and hence be more successful). Implementation of a strategy for nonmarket decision making, however, is still likely to require some investment in creating a firms informational environment and communication environment in a way to reduce the subjectivity of the cognitive frames used by decision makers.

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Also see, e.g., Prahalad and Bettis (1986) discussion of schemas and dominant logic. Non-market environment specialists such as government affairs people will likely not suffer from the same biases. However, their ability to steer the firm in the right direction is encumbered by a stilted information flow form the rest of the organization and by preconceived notions of the market-oriented managers to which they ultimately report.

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H. Limitations An integrated strategy that is built around market failures is most useful if marketoriented actions by non-market actors will generally be initiated to remedy a market failure and will generally be designed to remedy said market failures. The implications of market interventions that have different non-efficiency objectives (e.g., redistribution or pure rent-seeking) on the value of the market failures perspective is considered below. Redistribution and Market Failures While strongly market-based countries do not typically intervene into markets for redistributive reasons, there are two contexts in which redistribution may matter. First, where intervention is being considered for efficiency reasons, distributional issues may play a role in the ultimate resolution of the policy debate. Such issues have the potential for skewing remedies away from some that may better resolve the underlying market failure. Second, redistribution may be a principal motivation in unusual circumstances involving unanticipated shocks to an industry (e.g. airlines and 9/11 terrorist attacks) or where economic failure of one or more firms has significant externalities on the rest of the economy (e.g., bailout of banks) or is substantial enough to affect a very large number of workers (e.g. Chrysler bailout25). While there are salient examples of such interventions, they are not the norm and do not occur with sufficient frequency to be a focus of integrated strategy. The market failures approach is not ideally suited to distribution-based interventions. Although it highlights efficiency losses associated with redistributive actions, it is of only modest use in helping a manager anticipate such interventions. (Interventions that are jointly motivated to improve distribution and efficiency will be anticipated through a market failures approach.) Rent-Seeking and Market Failures One important limitation of the public interest perspective on government intervention that underlies the discussion so far is the use of rent seeking. The mechanism to mitigate market failures is political and hence it is possible that both or either of the public interest or private interest may be served. So, for example, the existence of a perceived (and unmitigated) market failure opens a policy window for rent-seeking or for redistribution. Sometimes intervention is directly initiated with the goal of increasing private rather than public benefits .26 Rent-seeking activities are strategy-essential when they affect a firms core strategy (e.g. the activity alters the value of various market strategies by changing the contours of the market failure which underpins the strategy) or are strategy inessential when they affect profits but not the core market strategy. An example of the latter would be lobbying activities to reduce corporate taxes. An example of the former would be the creation of trade barriers which create artificial pockets of government created market power.
25 26

Reich (1985). See, e.g. George J. Stigler (1971).

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Hence, understanding how market failures affect strategy becomes valuable for linking rent-seeking opportunities to business strategy. In addition, at least for more publicly salient interventions, rent seekers must still justify interventions through efficiency (or sometimes redistributive) arguments in order to convince legislators or bureaucrats to take action and this action will need to address the alleged market failure.27 Thus, one can think of market failures (and redistribution) as marking the field for rent-seeking possibilities as well as marking the field for public interest based possibilities.28 Rent-seeking prospects through public intervention, too, can be identified with a market failure analysis. Because supernormal profit opportunities should be linked to market failures, rent-seeking opportunities are directly linked as well. Thus, the analysis of underlying market failures assists a firm to anticipate actions taken by public and private actors that will alter the effectiveness of a particular strategy. To the extent that marginal voters needed to pass a bill have limited stake in the outcome, their decision is likely to be weigh public interest (mitigation of market failures) quite heavily. Then, an analysis of market failures, possibly supplemented by distribution factors, provides a means to predict how such a marginal voter will vote.29

H. Conclusion: Sustainable Integrated Strategies In this paper we have argued for an integration of market and non-market strategies. A common thread that can be used to integrate these strategies is a market failures perspective. Market failures are necessary conditions for supranormal profits in market settings and are also animating forces which initiate and guide non-market interventions into the market. Thus, market failures provide a way of analyzing both market and nonmarket forces and provide a filter through which managers can focus on essential nonmarket environment forces. An integrated market failures perspective also points the way towards sustainable integrated strategies which, by partially solving an existing market failure, both increase individual firm profits and net consumer welfare. Any strategy that increases individual firm profits is likely to come under market attack by ones competitors. But strategies that increase profits while not improving consumer benefits are likely to attract additional nonmarket attacks. Thus, our analysis provides a natural way for firms to consider how and when their strategies have win-win characteristics for both themselves and society.

27

Breyer (1982, p. 10)Such a normative approach is worth pursuing, despite the fact that political and bureaucratic factors obviously play na important role in the outcome of regulatory programs. Cite to evidence that market interventions are correlated to extent of market failures. 28 There are several instances of interventions (e.g. trade barriers) which are arguably unrelated to market failures. These interventions would not be anticipated through a market failures-based approach. 29 We do not address government failures such as corruption.

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