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2007 Final Exam

Use jargon appropriate to the models you employ and when appropriate (for some questions it is not!) throw in a graph or even a formal 2×2 game. No need for algebra.

Remember our welfare criteria. While not relevant for all questions, do try to address our “so what” issues. From the perspective of IO, when are things better (and worse) and for whom? Again, you should do this using the appropriate concepts and jargon.

Key terms to keep in mind…depending on which essays your write, the ones you need will vary.

Two-part pricing Price discrimination Product differentiation Strategic entry barriers
Patents Basic Science Invention Innovation

Network effects Standards Dominant firm Monopoly
Bertrand Nash-Cournot ε advertising

Choose FOUR out of the following six.

Standard IO Issues

A. Red Lobster vs Cordon Bleu. No attached article. Restaurants often have small differentials in the price of their dishes, yet there are large differentials across restaurants. Lobster dishes and those made with unusual cuts of meat are uniformly more expensive; vegetarian dishes are typically noticeably less so. Employ our models of pricing (among others, as necessary) to explain both these components.

B. Diamonds: Culling Cullinan. See the attached article. Explain the industry dynamics noted in it, using appropriate theory.

C. Beer mergers: Another round? See the attached article. Haven’t they had one two many already? Use our models to look at the heady rush – does SABMiller have its rivals over a barrel? Why now?

D. Video games: World of dealcraft. See the attached article. What technology issues lie behind the merger?

E. The eyes have it. See the attached article. Discussion technical change, drawing upon this article for illustrations.

F. The pharmaceutical industry: Beyond the pill. See the attached article. Again, various technology issues are central to this article.

Diamonds: Culling Cullinan

Nov 29th 2007 | JOHANNESBURG From The Economist print edition

De Beers sells one of its most famous mines

RICHARD BURTON probably knew nothing of the small South African town of Cullinan when he bought yet another chunky diamond for Elizabeth Taylor in 1969. But the rock, still known as the Taylor Burton, was found there, together with a quarter of the world’s diamonds over 400 carats. The Cullinan mine has also produced what is still the largest rough gem in the world—the whopping 3,106-carat Cullinan Diamond—parts of which adorn England’s Crown Jewels. Now the mine itself, like so many of the diamonds unearthed there, is about to change hands. On November 22nd De Beers, the diamond giant that has owned the mine since 1930, said it was selling it to a consortium led by Petra Diamonds, one of South Africa’s emerging diamond producers, for 1 billion rand ($147m) in cash. Provided regulators approve the deal, the transfer should take place by the middle of next year.

De Beers is selling because the mine is no longer profitable, despite attempts to turn it around. But Petra reckons the mine still has another 20 years of production in it and plans to extract at least 1m carats a year. The unexploited “Centenary Cut” deposit, which lies under the existing mine, could yield a lot more. This is good news for the mine’s 1,000 or so employees and for the town, which has depended on the diamond business since Sir Thomas Cullinan discovered a prospect there in 1898 that contained kimberlite, a rock that can be rich in diamonds. The mine, established in 1903, is one of 30 or so kimberlite diamond mines in the world, and is believed to be still the world’s second-most-valuable diamond resource. Petra is a relatively small outfit, listed on London’s Alternative Investment Market, that specialises in buying mines that bigger companies see as marginal. Its trick is to extract better returns by rationalising production and processing, and keeping operating costs and overheads down. Petra has already bought two of De Beers’s loss-making South African mines—both of which are now profitable—and is finalising the 78.5m rand acquisition of the group’s underground operation in Kimberley (the town that gave kimberlite its name), which stopped working in 2005. It already operates four mines in South Africa and has promising exploration in Angola (a joint-venture with BHP Billiton), Sierra Leone and Botswana. Petra expects to produce over 1m carats by 2010—quite a jump from 180,474 carats in the year to June. The company has yet to make a profit, but expects to be making money by the middle of next year.

In the 1990s De Beers decided that it was no longer a good idea to try to monopolise the diamond market. It started focusing on higher returns rather than market share, and has been revamping its mine portfolio, selling off mines that are no longer profitable and investing in more enticing operations, such as its mine off the west coast of South Africa, its Voorspoed operation in the Free State province, and two new mines in Canada. This has opened the way for a new class of diamond firm that operates in the vast middle ground between the world’s handful of large producers (De Beers, BHP Billiton, Rio Tinto and Alrosa) and a multitude of much smaller exploration firms. The Cullinan deal should entrench Petra in this middle tier, alongside firms such as Kimberley Diamond and Trans Hex. But even if it does reach its target of 1m carats a year, Petra will still not be able to match the sparkle of the giants. Last year De Beers produced 51m carats from its mines in Botswana, Namibia, South Africa and Tanzania, which amounted to 40% of the world’s diamonds by value.

The eyes have it

Dec 6th 2007 From The Economist print edition

Medical technology: The techniques used to replace worn-out eye lenses are getting better, making the process simpler than ever: Bausch & Lomb

Paul Ursell, an ophthalmic surgeon who works at St Helier hospital, just outside London, is one of the first people in Britain to use a new piece of equipment called the Stellaris (pictured). This is an all-in-one lens removal and replacement kit, looking rather like a robot, that is designed to treat people whose natural lenses are going cloudy, thus making them blind. It is the latest development in the technology of replacing damaged eye lenses with artificial substitutes. These improvements are simplifying and speeding up the surgery involved.

The ability to remove lenses darkened by cloudy imperfections, known as cataracts, and replace them with artificial lenses, is more than half a century old. It started with the chance observation during the second world war, by Harold Ridley, a British eye doctor, that pilots whose eyes had been penetrated by acrylic-glass shrapnel from cockpit canopies did not suffer an immune reaction.

Perspex lenses have long since been replaced by acrylic ones. But now the whole process of inserting those lenses is changing too. One of the biggest innovations has been the introduction of microsurgery. Originally, inserting a new lens meant cutting a flap in the eyeball some 11mm across. Today’s microsurgery requires a cut of less than 2mm. Such small wounds heal by themselves, and do not need to be stitched. The whole process is thus less traumatic, and patients are often able to return to work the day after an operation.

Two technologies in particular have helped to reduce the size of the incisions needed. The first, phakoemulsification, uses a tiny ultrasound probe to remove the lens. An ageing lens goes yellow, cloudy and hard. Mr Ursell likens its texture to that of a gravy cube. Exposing such a lens to high-frequency sound waves breaks it up into an emulsion that can then be sucked out of the eyeball. The second innovation is injectable lenses. Progressive improvements in the design and material of artificial lenses mean it is now possible to roll them up, inject them into position in the eye through a narrow slit, and then have them unfold naturally into place.

The tools to perform these tricks have been available for a while. The novelty of Stellaris—which is made by Bausch & Lomb, a company based in Rochester, New York—is that all the pieces of kit are pulled together into a single snazzy piece of equipment. The system can extract lenses, keep the eyeball inflated, and inject lenses in several different ways. The Stellaris has options to use an older or a newer surgical technique, depending on the surgeon’s preference.

The newer form of surgery arranges the instruments into two tools which enter the eye through identical tiny slits. One tool provides the ultrasound waves that are used to break down the cataract, and also contains a vacuum to hoover out the pieces. The other tool provides fluid to maintain the pressure while the lens is being extracted. That prevents the eyeball collapsing.

In short, a useful innovation. But lens replacement is not yet perfected, largely because replacement lenses themselves still have room for improvement. Standard replacement lenses have no ability to focus, so the wearer is often stuck with excellent distance vision but must use glasses for reading. That can be addressed with multifocal lenses, which have concentric rings of material that offer alternate bands of near and distant vision. But these can cause problems of their own with the patient’s night vision and sensitivity to contrast.

What excites ophthalmologists most, and what every lens-making company wants to achieve, is an “accommodating” lens that can change its focal length in the same way that a natural lens does. A few such lenses are already on the market. The Crystalens from Eyeonics of Aliso Viejo, California, is one example. The Tetraflex by Lenstec of St Petersburg, Florida, is another. These products use the existing eye muscles to change the shape of the lens and move it backwards and forwards in the eye during focusing. Such products are soon likely to replace multifocal lenses.

After that, light-sensitive silicone lenses may be next. These can be customised after surgery by playing a low-intensity beam of light onto their photosensitive material. This causes it to polymerise and then change shape, which means the ophthalmologist can tweak the lens to alter its power. Raging against the dying of the light, in other words, now has powerful technological allies.

Beer mergers: Another round?

Oct 11th 2007 From The Economist print edition

A tie-up between two American brewers leads to talk of further mergers

THE ordinary beer-drinking Joe may still be a touchstone of opinion in America but his thirst is not what it was. On October 9th SABMiller, one of the world’s bigger brewers and America’s second largest, announced a joint venture in the United States (and Puerto Rico) with Molson Coors, the country’s third biggest. The pair are teaming up to take on both Anheuser-Busch, America’s leading beermaker, and the country’s drinkers, whose consumption of all these firms’ main brews has virtually ceased growing.

The deal creates a huge operation with revenues of $6.6 billion. MillerCoors, as it will be known, will command some 29% of the American market. By extracting annual savings of $500m by the third year, it expects to be able to compete more fiercely with Anheuser-Busch and its flagship Budweiser brand. The American brewer has nabbed around half of the American beer market and pumps out 102.6m barrels of suds a year.

But beer drinking in most rich countries is growing slowly or is in decline. One estimate suggests that American spending on beer might grow by just 1.5% this year. And that increase will come courtesy of imports or boutique “craft” beers. Rich drinkers prefer to tipple on premium ales or wine and spirits. Sales of the mass-market varieties, on which America’s big brewers rely, are stagnant.

Faced with dwindling sales in established markets, most big brewers have searched for growth elsewhere, namely in Latin America, Asia, eastern Europe and Africa. Although competition is often fierce, Belgium’s InBev, the world’s leading brewer by volume, and SABMiller have become adept at operating where margins are slim. The strategy appears to be working. In the past five years the shares of both SABMiller and Inbev have prospered while Anheuser-Busch’s have languished. Anheuser-Busch still relies on its home market for around 80% of its admittedly handsome profits.

SABMiller is the product of a previous assault on the American market. In 2002 when SAB, a South African brewer, bought America’s Miller for $5.6 billion, the intention was to take on Anheuser-Busch in its own backyard. But Budweiser’s brewer easily withstood the attack, boosting its market share and margins.

That may change, now that it finds itself in a bar brawl against bulkier opposition. Stiffer competition and changing tastes might squeeze earnings at home, and the company lacks a thriving global business to fall back on. Building one now would be difficult, since the juiciest targets in emerging markets have already been snapped up.

So talk of a deal between InBev and Anheuser-Busch is more than just idle conversation at the bar. The American firm struck a deal last year to import InBev’s profitable premium beers such as Stella Artois and Beck’s. An even closer relationship might suit both. The American firm’s portfolio is light on the sort of profitable, high-end beers in which InBev specialises. By the same token, despite its fine array of niche brands, InBev lacks an internationally recognised powerhouse like Budweiser. The fight for Joe’s attention (and dollars) can only intensify.

Video games: World of dealcraft

Dec 6th 2007 From The Economist print edition

The biggest-ever video-game deal shows how the industry is changing

THE bride and groom, a guitar-wielding rock vixen and a muscle-rippling dragon-slayer, make an odd couple—so it is hardly surprising that nobody expected their marriage. But on December 2nd the video-game companies behind “Guitar Hero” and “World of Warcraft”, Activision and Vivendi Games respectively, announced plans for an elaborate merger. Vivendi, a French media group, will pool its games unit, plus $1.7 billion in cash, with Activision; the combined entity will then offer to buy back shares from Activision shareholders, raising Vivendi’s stake in the resulting firm to as much as 68%.

Activision’s boss, Bobby Kotick, will remain at the helm of the new company, to be known as Activision Blizzard in recognition of Vivendi’s main gaming asset: its subsidiary Blizzard Entertainment, the firm behind “World of Warcraft”, an online swords-and-sorcery game with 9.3m subscribers. The deal was unexpected, but makes excellent strategic sense, says Piers Harding-Rolls of Screen Digest, a consultancy. Activision has long coveted “World of Warcraft”, and Vivendi gets a bigger games division and Activision’s talented management team to run it. As well as making sense for both parties, the $18.9 billion deal—the biggest ever in the video-games industry—says a lot about the trends now shaping the business.

The first is a push into new markets, especially online multiplayer games, which are particularly popular in Asia, and “casual” games that appeal to people who do not regard themselves as gamers. “World of Warcraft” is the world’s most popular online subscription-based game and is hugely lucrative. Blizzard will have revenues of $1.1 billion this year and operating profits of $520m. “World of Warcraft” is really “a social network with many entertainment components,” says Mr Kotick.

Similarly, he argues, “Guitar Hero” and other games that use new kinds of controller, rather than the usual buttons and joysticks, are broadening the appeal of gaming by emphasising its social aspects, since they are easy to pick up and can be played with friends. Social gaming, says Mr Kotick, is “the most powerful trend” building new audiences for the industry. He is clearly excited at the prospect of using Blizzard’s expertise to launch an online version of “Guitar Hero” for Asian markets. Online music games such as “Audition Online”, which started in South Korea, are “massive in Asia,” says Mr Harding-Rolls.

A second trend is media groups’ increasing interest in gaming. Vivendi owns Universal Music, one of the “big four” record labels. As the record industry’s sales decline, it makes sense to move into gaming, a younger, faster-growing medium with plenty of cross-marketing opportunities. (Activision might raid Universal’s back catalogue for material for its music games, for example, which might in turn boost music sales.) Other media groups are going the same way. Last year Viacom, an American media giant, acquired Harmonix, the company that originally created “Guitar Hero”. It has been promoting its new game, “Rock Band”, using its MTV music channel. Viacom has also created online virtual worlds that tie in with several of its television programmes, such as “Laguna Beach” and “Pimp My Ride”. Disney bought Club Penguin, a virtual world for children, in August. And Time Warner is involved in gaming via its Warner Bros Home Entertainment division, which publishes its own titles and last month bought TT Games, the British firm behind the “Lego Star Wars” games.

Time to level up

The third trend is consolidation, to plug gaps, address new markets and achieve economies of scale. Electronic Arts, for example, until this week the largest independent games-publisher (Activision Blizzard will be bigger), recently bought two studios, BioWare and Pandemic, to strengthen its position in role-playing and action games. Greater scale can help to spread costs and risk as new games become costlier to develop. A new title for Microsoft’s Xbox 360 console or Sony’s PlayStation 3 (PS3), both of which have high-definition graphics, can cost as much as $30m, says Mr Harding-Rolls. Bigger firms can afford to develop tools that make it easy to produce different versions of the same game for different platforms, says Robbie Bach, the head of Microsoft’s entertainment and devices division. They can also make savings on distribution.

This week’s deal shows how the software business is changing; and things are happening in hardware too. Microsoft’s Xbox 360, Sony’s PS3 and Nintendo’s Wii are fighting for supremacy. In September the Xbox 360, which was launched in late 2005, a year ahead of its two rivals, was overtaken by the Wii as the most popular of the present generation of consoles (see chart). Mr Bach says he is unfazed. “It’s not even a statistic I track all that closely,” he says. The Wii’s popularity stems from its low price and its innovative motion-sensitive controller, which can be pointed and waved to control the on-screen action and encourages novices to give gaming a try. But the Wii lacks the high-definition graphics of its two rivals, so it could soon start to look dated. The real battle is between the Xbox 360 and the PS3, Mr Bach suggests.

Sales of the PS3, which have been sluggish, seem to have taken off after Sony removed some features and dropped the price. In Japan the PS3 even outsold the Wii in November, according to Enterbrain, a market-research firm. As more games become available for the PS3 next year, sales are expected to rise even further, says Mr Harding-Rolls, so that by 2011 the PS3 will have caught up with the Wii. In short, each of the consoles will be in front at various points in the “console cycle”.

In the previous cycle, dominated by Sony, programmers could address most of the market simply by writing games for the PlayStation 2. But if all the consoles matter, games companies have to produce games that run on all of them. That strengthens the case for consolidation. In other words, expect more deals.

The pharmaceutical industry: Beyond the pill

Oct 25th 2007 | New York The Economist print edition

Drugs firms are casting about for new business models

“The future is not terribly bright for most drug companies,” says a new report from Sanford Bernstein, a respected New York investment firm. Such blunt talk is unusual on Wall Street, but it is no exaggeration. Drugs firms, once rich and the favourites of investors, are urgently seeking cures to a variety of ailments.

One is the erosion of patent protection. Not only are the copy-cat manufacturers of cheaper generic drugs becoming emboldened by cost-conscious politicians and legal rulings in their favour, but big pharmaceutical companies are also facing an unprecedented wave of patent expirations over the next five years. Pfizer alone will lose some $13 billion in revenue a year when Lipitor, its blockbuster cholesterol drug, goes off-patent as early as 2010.

The industry’s best hope lies in innovation, its traditional strength. But it is finding it extremely difficult to come up with new blockbusters. As the Bernstein report notes, the global industry saw 24 new drugs approved by the US Food and Drug Administration in 1998 on the back of $27 billion spent on R&D. Last year, the industry spent $64 billion, but only 13 new drugs were approved by the regulator.

And even new drugs can no longer reliably command the huge premiums they once did. Peter Lawyer, of the Boston Consulting Group, reckons the global drugs market doubled in value to $600 billion in revenues in the decade to 2005, chiefly from growth in America. But there is little chance it will double again by 2015, he argues. If America were to adopt European-style controls on drugs prices, as some Democratic presidential candidates are proposing, half of the industry’s profits would disappear.

Drugs are also being pulled from the market. Usually this is for safety reasons, such as those which last year forced Pfizer to kill torcetrapib, an experimental cholesterol drug, after spending $1 billion on it. Traditionally, drugs firms did not yank products that were safe even if they sold poorly. But now that has changed. Jeffrey Kindler, Pfizer’s boss, decided to wield the axe as part of his drive to reduce costs and last week pulled Exubera, an inhaled insulin product, off the market. For this, Pfizer took a $2.8 billion charge.

So what can Big Pharma do? Mr Lawyer thinks the deterioration in the American market will force drugs firms to come up with new business models that go beyond the industry’s traditional and largely vertically integrated approach to developing, manufacturing and selling drugs. A sign of this happening is a recent move towards outsourcing. When times were good, drugs firms refused to outsource manufacturing because doing so, they argued, would result in quality problems and risk giving away trade secrets. That strategy is being rethought. AstraZeneca, a big British drugs firm, recently announced that it will start shifting manufacturing operations to Asia as part of a cost-cutting drive.

Firms are not only changing how they make drugs, but how they market them—especially in America. On one estimate, big drugs firms spend less than a fifth of their revenues in America on R&D, but over a third peddling pills. Raymond Hill, of IMS Health, a consultancy, says that firms too often “differentiate pills using sales reps” rather than by superior innovation. That, he says, needs to be reversed.

Bosses of drugs firms now publicly acknowledge the problem. Daniel Vasella, chairman of Novartis, a Swiss drugs giant, agrees that his industry must innovate or risk falling into a low-margin ghetto of commodity pricing. Last week he announced a shake-up to help Novartis do so. “We must rethink all assumptions, from innovation to marketing to sales and promotion,” he says.

To hedge risks in prescription drugs, Dr Vasella wants to grow his firm’s generics division, as well as increase its presence in diagnostics, non-prescription drugs and biotechnology. Novartis recently decided to launch a generic version of Epo, a popular drug pioneered by Amgen, an American biotechnology firm, in Europe—the sort of cheeky move usually seen only from generics firms.

Lots of big drugs firms are moving into biotechnology to fill their product pipelines. Earlier this year Astra Zeneca bought MedImmune, an American biotechnology firm, for about $16 billion. A takeover battle may soon erupt over Biogen Idec, another large American biotech firm.

Roche, another Swiss firm, has made a hostile bid for Ventana, a medical-diagnostics company in Arizona, and other firms are moving in on makers of medical devices and non-prescription drugs. Terry Hisey of Deloitte Touche Tohmatsu argues in a new report that such deals go beyond hedging risks in their traditional businesses: he reckons it heralds a dramatic new “convergence of drugs, devices and diagnostics” which could lead to innovation and new opportunities for growth. If he is right it would be good news indeed for an industry sorely in need of rejuvenation.

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