Winter 2016 Syllabus

Economics 243: The Economics of Business Strategy
CGL 203, Mon-Wed-Fri 11:15am-12:10pm
Draft from Paris France of 10 Jan 2016. Note CGL = the newly opened classroom end of the Center for Global Learning building.

Preface:

The world’s two largest beer companies, AB InBev and SABMiller, are merging, while the Chinese government in encouraging steel mills to consolidate. But M&A is far from the only component of strategy. The macrobrewers have massive advertising budgets; think of the Superbowl. Meanwhile some steel firms spend heavily on R&D to differentiate their product from rivals; others spend none at all. How much should you advertise Bud Lite, given what believe the strategy will be for Miller Lite? When is R&D beneficial? As we’ll see, these are not straightforward decisions. For example, even a merger the scale of that between the world’s two largest beer companies may do nothing to improve profits.

This term we adopt the perspective of producers. Some models help explain the structure of an industry. But our predominant interest is how strategy can be employed to enhance profits. That is often (but not always) to the detriment of consumers, but except in passing, this course is not about regulation and antitrust law. To put it bluntly, we study ways in which firms can screw suppliers, rivals and customers.

You are familiar with the basic microeconomic model of competitive markets. Wheat farmers are price takers, facing a horizontal demand curve, and in the long run they earn zero (economic) profits. While they can be more (or less) efficient, advertising, R&D and other components of strategy are irrelevant. It’s all rather boring, and not our focus. Equally important, no business executive wants to operate in that sort of industry – if possible they want a monopoly.

One strand of analysis relaxes the Econ 101 assumption that consumers are all alike, including models of advertising, product differentiation and price discrimination. The other strand is where firms interact, with your depending on that of your rival, where we drop the assumption of atomistic producers. So for example, when two large firms in an industry merge, the behavior of their rivals will shift. We can then analyze what that does to prices and profits and advertising.

One lesson runs throughout the term: small variations in assumptions lead to different – sometimes diametric! – strategies. Put another way, there are no general models, only issues and approaches. That shouldn’t be surprising: we observe a wide array of strategies in the real world, and a lot of them don’t work. Post-merger, prices may rise, but market share of the newly merged firm typically falls. Even with two firms, we can observe cases of tacit cooperation that resemble monopoly, and cases of price wars that resemble perfect competition. So while there is economic science in building models – economists working in the field have garnered multiple Nobel Prizes, including Jean Tirole in 2014 – there is art in knowing which model is relevant and what its limitations are. A manager can’t just turn to a strategy handbook for the relevant formula and be done.

Finally, this is an applied economics class, not a theory class. While many of our 30-odd class hours this term will be devoted to helping you understand formal analytic approaches – towards that end we draw upon Stephen Martin’s text – our focus is on the real world. To that end we will read two books on the US beer industry, and a book on the global steel industry. You will be asked to do a number of homework assignments, but most of your formal work will consist of writing four short papers on steel and beer, and in structured blogging. Tentatively – if you collectively come prepared to class, and employ our models in your papers – we will have neither midterm nor final exams.

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 theory is a tool for understanding the real world of beer and steel and autos, and is not an end in itself.

Texts: order online or from the bookstore. The Warrian book is available as an inexpensive e-text.

  • 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

    Case studies (papers and blogs and class discussion) are central this term. Beer and steel provide a wealth of material. In the late 19th century the industry was at the forefront in applying the new science microbiology to practical problems, changing brewing from an art grounded in trial-and-error (“tradition”) to a science. In its day it was a high tech industry. Beer was also long a local or at most regional product. Anheuser Busch pioneered the use of systematic market research, and combined it with advertising in the new medium of TV to create a national brand. In the 1970s, the industry saw waves of product innovation, starting with Miller Lite and now including a host of microbrews. These and other strategic dimensions are traced in two of our books, Ogle’s industry history and the set of connected essays by Tremblay & Tremblay. We will pair these with a tour of one (if not both) of the local 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. (He came to W&L Fall 2015 as a speaker.) In steel the role of technical change is also prominent, from the Bessemer process in the 1870s, the post-WWII introduction of the basic oxygen process (BOF), both of which increased economies of scale. That was reversed by electric arc mills, and with cheaper transport came another production process: international trade. These changes led to the collapse of a longstanding tacit cartel and the restructuring of Big Steel (most of the incumbent firms in the US have gone through Chapter 11 bankruptcy), as well as the entire upstream (coal & ore) and downstream (construction materials) sector. This again gives us lots of themes.

    To reiterate, the essence of the economics of business strategy is using models to understand real-world industries.

    Theoretical Issues:

    It takes an, uh, refined taste to appreciate pure theory. And lots of math. The key ideas, however, can be conveyed with graphs and simple 2×2 games. For us theory is an organizing tool, highlighting themes so as to bring order and a measure of simplicity to the overwhelming complexity and detail of industries in the real world.

    You will need to work on learning these in their basic forms, with the occasional homework to reinforce their importance. Specific take-aways come under the following three general headings.

    • Interactions of (two) firms:
      • understand the link between the price elasticity of demand and market power;
      • trace how a focus on different strategic variables affects outcomes in markets with small numbers of players (Cournot duopoly vs Bertrand duopoly);
      • use simple models to understand what might limit new entry; and
      • combine these to understand why mergers may in general not improve profits; and
      • understand why firms operate in only one portion of a value chain – Ford doesn’t make steel, and Macdonald’s doesn’t run restaurants, it franchises them.
    • 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 strategy affect outcomes?
      • when does advertising benefit consumers? producers? both? neither?
    • Technology:
      • what is the nature of technology?
      • what role is played patents, trademarks and other intellectual property rights?
      • what role do standards play? – Microsoft provides the operating system for 90+% of personal computers, while cell phones of whatever brand are “G” (now 4G).
      • 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, EconPapers and EconLit. Those are not the only resources for strategy; I’ll push you to look at annual reports, too. There are other resources, such as and legal briefs and market research reports that can run $10,000 a month. At this point of your studies you don’t gain much from the latter, while most briefs are written under nondisclosure agreements as most legal disputes are settled out of court.

    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. Much of the core theory is easy enough that I will expect you to learn it on your own. We 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 are dense.

    Blogging:

    Blogging and commenting on the blogs of your peers is a course requirement. Based on experiments the past several years, 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 to engage with your peers (and me) in give-and-take via blog comments.

    Blogging is good preparation for journalism and for writing business memos: posts need to be short and focused. They’re also public, so you should aim for pieces that you will be proud to have others read. You will likely spend an inordinate amount of your career presenting your analysis of one or another problem. Being able to do that well will enhance your career. I will provide each of you access to this WordPress blog (which includes posts and comments from previous terms), and show you how to format material for (visual) clarity, how to incorporate graphs from Excel and FRED, and otherwise provide guidance on what might make for a good post.

    Presentations:

    I will often but not always ask blog authors to lead a short in-class discussion. In general I will not require formal (powerpoint) presentations.

    Papers:

    Case studies are best matched by papers. You write one short and one medium length paper each on beer and steel, for a total of four papers. I will pencil in due dates on the schedule, and provide topics in advance.

    Many of you have little experience writing papers outside of Freshman Writing. A good grade require clear, forceful exposition, with the topic stated up front, sparse prose (no passive voice!) and an actual conclusion. Skill in doing that comes from practice. To make this more constructive and less traumatic, I give you the option of rewriting one of your papers this term. I only record the second (better!) grade. However, you must let me know you wish to rewrite a paper by the next class after I return it, and you must propose an acceptable date (that is, acceptable to me) by which you will hand in the revised paper. You can’t come to me the last week of class, after getting back your fourth and final paper, and expect me to let you rewrite your first paper of the term to help pull up your grade.

    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 (i) book an appointment in advance, and (ii) bring with you a draft from which they can work. They get very busy late in the term, so remember that you can sign up weeks in advance. Be considerate: a no-show is unfair both to them and to your classmates.

    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 or reading Ogle or Warrian or the Tremblays in a timely fashion, then I reserve the right to add a midterm or a standard 3-hour final exam.

    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 30%
    2 short papers on our case studies 30%
    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 will hold office hours MWF from 2:30-3:45 pm in Huntley 125B. You can also make an appointment for TuTh between 9 am and 3 pm, often (but not always) at Lexington Coffee on Washington Street. (Your beverage is on me). I check email frequently, and prefer that as a means of communication. My cell is (540) 460-6288, a local call. I don’t like texting, except for example to let me know you’re running late for an appointment, or when you are unsure whether it is at my office or the coffee shop.

    Submitting work:

    I put links to readings on the schedule on this WordPress site; we also blog here. I 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.

    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 as upperclassmen you surely know that all coursework is covered, it’s still good practice to pledge everything you submit. I will go through citation standards and paper formats as the term progresses. (See also the relevant Leyburn Library pages on how to cite and on the bibliographic aid Zotero.)

    Note that in the business world you don’t send an important memo to your boss 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 Williams Communications Center, and from discussing ideals with peers, relatives, even (gasp!) me or other faculty. 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 the many seemingly independent sources directly or indirectly relied on the same single source, Merton. If he got any of this wrong, lots of other people are then also wrong! But most sources didn’t go directly to Merton, and typically only quote Newton.