Fall 2015 Syllabus

Economics 243: The Economics of Business Strategy
Huntley 321, Mon-Wed-Fri MWF 1:25p-2:20p
Draft of 11 Sept 2015

Preface:

Sergio Marchionne is currently proposing that the Fiat Chrysler Group and General Motors merge; the Chinese government wants to consolidate an array of money-losing firms in steel and other sectors to try to stem losses. As budding economists you are familiar with the basic microeconomic model of competitive firms, which makes them price takers and in the long run leads to zero (economic) profits. No business executive wants to operate in that sort of industry! At the same time, fewer and bigger firms is no guarantee of profitability. Indeed, most mergers fail, at least for employees, shareholders and customers. (The CEO and their investment bank may however do very well for themselves.) So when do mergers make sense? More generally, what strategic options are available to firms in an industry comprised of 2-3 players? This is but one of many topics that we take up this term, in our application of economics to business strategy.

Prerequisites:
Economics 101 (Principles of Microeconomics). You do not need to be an economics major, indeed this is a good course for those interested in Business Administration. We do use basic algebra on a regular basis, but for this course theory as a tool for understanding the real world, not an end in itself.

Texts:

Warrian, Peter. A Profile of the Steel Industry. Business Expert Press, 2012. ISBN: 978-1606494172

Ogle, Maureen. Ambitious Brew. Mariner Books, 2007. ISBN: 978-0156033596

Martin, Stephen. Industrial Organization In Context. Oxford University Press, 2010. ISBN: 978-0199291199

Tremblay, Victor & Tremblay, Carol. The US Brewing Industry. The MIT Press, 2009. ISBN: 978-0262512633

Empirical Applications: Case Studies
This will very much be an economics course. However, I have chosen to structure it around two industry case studies. One is the market for beer, with an emphasis on the US. The other is the steel industry, with a more global perspective. Both industries have seen tremendous technical change, though for beer much of that was in place by 1920 and the start of prohibition. This included the development of microbiology to control quality, working with suppliers to develop new inputs (better barley cultivars), automated packaging, and perhaps most important, refrigeration. In the postwar era innovations included new methods of distribution, and the aggressive use of TV which allowed firms to build national markets. More recently we see innovation in product characteristics that is the key to the rise in microbreweries or “craft” beer. We have two books to help us understand these changes and tie them to the economics of strategy, an industry history, and a set of connected essays by two economists. We should be able to pair this with a tour of one (if not both) of the the Lexington / Rockbridge County microbreweries, Devils Backbone and Blue Lab Brewing.

For steel, we have a book by Peter Warrian, who has spent his life in and around the industry, and who has agreed to come to W&L as a speaker (date TBA). In steel the role of technical change is more prominent, with the post-WWII introduction of the basic oxygen process (BOF) and of electric minimills that led to substantial new entry. These changes led to a restructuring not just of Big Steel (most of the incumbent firms in the US went through restructuring via Chapter 11 bankruptcy), but of the entire downstream sector. It has also led to a shift of segments of the industry to an R&D-intensive business strategy. So we see more of technology and upstream / downstream linkages, and less of marketing and distribution.

To reiterate, for me the essence of the economics of business strategy are applications of this sort. I will bring my own knowledge of the automotive industry into class, alongside experience with retailing and the HVAC industry (commercial/residential heating and air conditioning).

Theoretical Issues:

Even if the focus is empirical, much of our time in class will in fact be spent on theory. This is an area of active research in economics, reflected in the 2014 Nobel Prize in Economics to Jean Tirole. However, it takes a, uh, refined taste to appreciate pure theory. For us it will be an organizing tool, a means to bring order to the overwhelming complexity and detail of our case studies. Furthermore, there’s a lot of theory. The cost of doing case studies is that we will spend less time on theory. Sad, isn’t it? We’ll have to cut down the number of topics as well.

What distinguishes the theory that lies behind the economics of business strategy? An example gives a taste. In contrast to the competitive model that is the core of Econ 101 and Econ 210 [micro theory], since the turn of the (20th) century economists have worked on US antitrust policy, building academic models (and, at much higher pay, serving as consultants in antitrust cases). It was to their models that Michael Porter, Harvard Business School professor and the doyen of business strategy, looked. What he did was conceptually simple: he turned these models on their heads. Instead of asking how we the public can restrain monopoly, he asked how you the business executive can enhance market power and keep profits from being eroded by competition. For the economics of strategy, then, we examine markets with 2-3 firms, and facets of behavior beyond the simple price-quantity tradeoff that is the stuff of firms in competitive markets. As you will discover, even when a firm faces only one competitor, the nature of markets can lead to a wide range of outcomes, from collusion that mimics monopoly to beggar-they-neighbor price cutting that leads to outcomes equivalent to perfect competition. We know that the real world is complex; the same is true for most of the theory we study this term. Modest changes in assumptions lead to quite different outcomes; indeed, there is typically no general theory. Nevertheless, the structure of the models will help us focus on what facets of the competitive environment matter, and allow us to develop typologies that help us make sense of our cases.

The theories we take up are not limited to two firms interacting in their price and product strategy. We also examine other margins along which firms make strategic choices. One is the strategic decision over product characteristics, whether to differentiate yourself from your competitors, or mimic them. Another is bundling and volume discounts; when do they allow you to effectively divide your customers (or get them to divide themselves) into discrete groups to whom you can then charge different prices? (This is “price discrimination.”) Should you sell products directly to customers or use retailers, and how does that affect your pricing? Finally, there’s technology, which as we will see has an impact on many strategic choices.

Specific theoretical take-aways come under the following three general headings. We will develop these analytic components in conjunction with case studies. More on those below.

  • Interactions of (two) firms:
    • understanding the link between the price elasticity of demand and market power;
    • tracing how a focus on different strategic variables affects outcomes in markets with small numbers of players (Cournot vs Bertrand);
    • using a couple simple models to understand what might limit new entry; and
    • combining these to understand why mergers may in general not improve profits.
  • Product characteristics:
    • what happens when firms compete on the basis of product characteristics rather than price?
    • can firms “bundle” products to increase profits? what other strategies allow firms to not only target consumers who value their product more, but also get them to pay higher prices?
    • how does the choice of distribution policy affect outcomes?
    • when does advertising benefit consumers? producers? both? neither?
  • Technology:
    • what is the nature of technology? in concrete terms, when are patents or other protection of intellectual property useful? again, who benefits – producers, consumers, both?
    • what is the nature of technology? why are there so few options available to consumers for products such as software?
    • how does technical change interact with the larger structure of industries?

Research Tools:

I will introduce you to several core research tools in economics, particularly the key databases of academic papers. You should hopefully develop the reflex of turning to EconPapers and EconLit. Those are not the only resources for strategy, but I’m not a management researcher nor do I do “finance” so will not attempt to introduce you to the various databases of B-school case studies, financial statements, and stock/bond prices. Then there are market research reports – they can run $4,000 each with subscriptions of $10,000 a month. Oh, and a final resource is legal briefs, but most of those (such as one I did on the steel industry) are written under nondisclosure agreements, so when they are available they are heavily redacted. In a big company, consulting house or law firm you would have access to much such specialized and/or proprietary information.

Classes:

The course will consist of a combination of class discussion (for the case studies) and lectures (for the theory). You will thus need to go through readings in advance, while the core theory is sometimes easy enough that I will expect you to learn it on your own and will use class to focus on subtle or technically challenging aspects. Be prepared, and don’t assume that all the readings will be easy. Some you can rush through before class – I’ll provide pointers on how to do that! – but some will be dense.

Blogging:

Blogging and commenting on the blogs of your peers is a course requirement. Based on experiments the past several years, I will do things differently this term. In particular, I will (i) mandate specific blog topics and (ii) limit the number of posts per week. This should (iii) make it easier for you to do a post, (iv) make it easier for me to hold you responsible for quality, (v) better tie blogging to the syllabus and by limiting the number and focus of posts (vi) make it easier for you all to engage with your peers (and me) in give-and-take via blog comments. In many cases the assignment will be to present one or two key points in a reading. [Blogs are not the best format for long, nuanced discussion.] Your peers can then challenge you, provide additional examples, or expand your claim with additional detail.

My aim this term is to help you write short, focused pieces that you will be proud to have others read. It’s useful practice: short memos (and in marketing, actual blogs) are a form of output pervasive in the business world. I will provide each of you access to this blog (which includes posts and comments from previous terms), and show you how to format for (visual) clarity, how to incorporate graphs from Excel and FRED, and otherwise provide guidance on what might make for a good post.

Presentations:

During this term I will assign blogging topics and will then ask the author to lead off the associated in-class discussion. You may choose to use a 5-slide powerpoint [3 content slides, title slide, bibliography slide]. In general, however, I will not require formal presentations.

Papers:
Case studies are best matched by papers. Tentatively I will have you write one short and one medium length paper each on beer and steel. I will pencil in due dates on the schedule, and provide topics in advance.

In my experience many of you have little experience writing papers outside of Freshman Writing, particularly if you are a sophomore. For a good grade I require clear, forceful writing: the topic stated up front, sparse prose (no passive voice!) and an actual conclusion. To make learning to write less traumatic, I give you the option of rewriting one of your papers this term (which in most cases is the first paper). I only record the second (better!) grade.

Exams:
None. Given the focus on papers, I will experiment with not having either a midterm or a final exam. If however I find you are not in fact reading and grappling with the Martin textbook and the related theoretical component of the course, then I reserve the right to add a standard 3-hour final exam that will focus exclusively on your comprehension of theory.

Grading: [still editing, will tie to specifics of schedule]

Weights will vary depending on the evolution of the class. Tentatively:

blogging, one-page papers and homework assignments 40%
2 short papers on our case studies 20%
2 medium-length papers on our case studies 40%
less points deducted for poor preparation and otherwise failing to contribute to class.
in total 100%.

Office hours:

I do not hold fixed office hours. Instead, I suggest time slots but leave the onus on you to make appointments. My office is HU125B (next to the wheelchair entrance on the lower level of Huntley), but I often prefer to meet at Lexington Coffee on Washington Street (in which case your beverage is on me). I check email frequently, and prefer that as a means of communication. My cell is 460-6288, a local call; please don’t text me, except (for example) to note that you’re running late (or to check whether I’m running late) to a scheduled appointment.

As necessary (a function of enrollments) I will devote one or two class periods during the term to office hours. In addition, I urge you to make regular appointments with the staff of the Williams School Communication Center, whose offices are in the basement of Huntley. Note this requires planning, as you need to book an appointment in advance, and need to submit a draft from which they can work.

Submitting work:

I treat it as your responsibility to print out and convey to me a physical copy of all your work. I suggest but do not mandate that you submit digital copies. Those serve as a backup, and also mean that I will have access to your latest draft if I am out of town for a meeting. (A downside for you is that it provides a time stamp for when you submitted work, whereas if you ask that a friend put your paper under my door…)

Web site:

I put links to readings on the schedule on this WordPress site; we also blog here. I thus make each of you an “author” so that you can post and edit content. (I maintain my personal blog at http://autosandeconomics.blogspot.com, and with your permission will edit and repost select class posts there.

Honor code:

I take it as a given that you will uphold the Honor Code. Even though you’re seniors, and know that all coursework is covered, it’s still a good reminder to pledge things you submit. I will go through citation standards and paper formats as the term progresses. (See also the relevant Leyburn Library pages.)

Note that in the business world you don’t send an important memo to your boss (to hand to his/her boss, sometimes without acknowledging you!) without input from colleagues (and in all likelihood your boss). Let me reiterate: you will benefit from the editing skills of the staff of the writing center, and you should cultivate a network of peers, relatives, even other faculty to help you refine your work. You have hopefully learned from your classmates, faculty, summer co-workers and relatives these past four years. Feel free to incorporate all that!! The best work stands on the shoulders of giants (Google’s motto).Note

Special accommodations:

As per university policy, if you have been approved for special accommodations, please speak to me in private at the start of the term.

Note

Giants: “If I have seen further it is by standing on ye sholders of Giants.” Letter by Newton to Hooke, 5 February 1675/6.
But in fact Newton was quoting Robert Burton’s The Anatomy of Melancholy (1624): ‘Pigmies placed on the shoulders of giants see more than the giants themselves’.
…who used Bernard of Chartres in the early 12th century
…who may have used the Roman grammarian Priscian.

Source: Robert K. Merton, On the Shoulders of Giants: A Shandean Postscript. Free Press (1965). Leyburn QC16.N7 M38 1985 [This is also a cautionary internet tale: I spent time tracking down this sequence in Japan in 2007, and found that many seemingly independent sources in fact cited Merton: if he got any of this wrong, lots of other people are then also wrong!]