Managerial Economics:Economics of

Strategy

Managerial Managerial Economics:Economics of Economics:Economics of

StrategyStrategyEconomics of StrategyEconomics of Strategy

Patrick McNuttPatrick McNuttwww.patrickmcnutt.comwww.patrickmcnutt.com

Abridged Abridged ©©

Lesson plan….• Day 1: Introduction and overview• Type, signalling and strategy• Plan is to follow Ch 1 to Ch 3 into Ch 16..avoid Part

IV• Day 1 & 2: Progress into Ch 2 to Ch 4 and Ch 5• Day 2 & 3: Focus on Part II Chs 6 to 9 and

conclude with Ch 10 and 11• Advise Part III for post-Workshop reading

At the frontier…..• Understand management as ‘they are’ not as theory hitherto

‘assumed them’ to be• Management can be ranked (by type) and are faced with

trade-offs => something must come ‘top of the menu’• Firms are conduits of information flows (vertical chain)• Reducing price does not necessarily lead to an increase in

revenues (elasticity)• Prices are primarily signals (observed behavior)• Companies understand the competitive threat as

interdependence (zero-sum)

Players?• Principal-agent relationship• Shareholders as principals and

management as agents• Who are decision makers?

Management ≈ firms ≈ companies =

PLAYERS

Costs of not being a Player• Agency costs across the

shareholders (esp institutional)• Bounded rationality and opportunity

costs with trade-offs• Make or Buy dilemma• FMA• Follower status ‘behind the curve’

The competitive threat!• Traditional Analysis is biased

towards answering: what market are we in and how can we

do better?• Economics of strategy (GEMS) asks:

what market should we be in?

Bridging Unit 1 and Unit 3: Strategic analysis

• Binary reaction; Will Player B react? Yes or No?

• If YES, decision may be parked

• If NO, decision proceeds on error

• Surprise

• Non-binary reaction: Player B will react. Probability = x%

• Decision taking on conjecture of likely reaction

• No Surprise

Lets’ begin! Unit 1: Why the economics of strategy?

• The Firm as a nexus of contracts• Vertical chains and agency• Shareholders and management• GHM Theory and incomplete

contracting• Type of management

Type of Management• Maximise shareholder value, meet

the profit constraint• Managerial discretion• Managerial limitations and Penrose

effect• Simon’s Bounded rationality

Game type and signalling• Decisions are interpreted as signals• Observed patterns• Recognition of market interdependence

(zero-sum)• Price as a signal v Baumol model of TR max• Scale and size: cost leadership• Dividends as signals v Marris model

Precis on a Marris model…• Understand balanced equation gc = gd to

identify parameters of profitability• Supply of capital: debt v equity• Demand for capital: R&D exp v dividends• Instrumental variables influencing growth

– visit Diageo case in Kaelo v2.0• KFIs: profits/output and output/capital• Tobins q and Marris v ratio

Figure 5 Marris’ Trade-off

U1 U2 U3 U4Valuation ratio Shareholders perference

xBest to management

V2 Valuation curve

G1 G2 Growth rate

V1

V(min)

y

0

Unit 2: Cost leadership as a type• Profitabiltiy v scale and (size and scope)• Production as a Cost-volume constraint• Understanding the economcis of

productivity as exemplar for incentives• Normalisation equation• Excess v reserve capacity [next slide]• Cost leadership checklist

q1 q2 Q

$

sac

sac

Bridge Unit 1 and Unit 2• Shareholder as principals expect max value• Management to minimise the agency costs• Positive Learning Transfer, PLT• Nomenclature on type: Baumol type, Marris

type.• Cost leadership type (link into Ch 11 on

stategic cost advantage)

Unit 3 Game Dimension• What is a game – loss of independence?• Action, Reaction and Reply• Non cooperative sequential games• Introduce oligopoly and n < 5• Single shot price reduction: (i) fail TR test

and revenues fall; (ii) near rival misreads the price as a signal

Describe game dimension• Players and type of players• Prices interpreted as signals• Patterns of observed behaviour• Leader-follower as knowledge• Accomodation v entry deterrence• Reaction, signalling and ‘best you can

do, goven reaction of competitor’

Type of Players• Incumbent type v entrant type• Dominant type v monopoly incumbent • De novo entrant type and geography

of the market• Potential entrant type and the threat

of entry• Newborn players

Limit Pricing Model• Outline the game dimension: dominant

incumbents v camuflaged entrant type

• Define strategy set for incumbents• Allow entry and define the equilbrium• Preference - entry deterrent

strategy v accomodation [next slide]

1

2

Enter

0,10

-7,2

5,8

Do Not Enter

Agressive

Accommodating

Entry Deterrent Strategy• Reputation of the incumbents• Entry function of the entrant• De novo and entry at time period t• Potential entrant and forces reaction

from incumbent• Coogans bluff strategy

Continuing with Unit 4: Define a price war

• Determine the Bertrand reaction function

• Signalling• Compute a critical Time Line from

observed signals• Find a price point of intersection

Visit Kaelo v2.0• Example: Critical Time Line in a Sony v

Microsoft game dimension• Play a PD game and investment game in

Kaelo v2.0• Altruism, fairness, selfish gene, dominant

strategy• Understand the link across the extensive

decision-tree to the payoff matrices [next slide]

5,8

0,100,10

-7,2

Do Not Enter

Enter

Aggressive Retailiation Accommodate

Player 1

Player 2

Nash Equilibria• Define the Nash equilibria [next

slide]• Analyse the Payoff matrix

(B,Y) > (A, X)• Commitment and chat• Strategic ToolBox in terms of

credible mechanisms

10,10

8,-50,0

-5,8

Strategy A

Strategy B

Strategy X Strategy Y

Player 1

Player 2

Prisoners’ dilemma• Introduce the Prisoners’ Dilemma

[next slide]• Low price (compete) v high price

(chat)• Play mean p64 of e-Storybook and

Table 7.2 of textbook, p236• Punishment strategies

10,10

13,02,2

0,13

Low Prices

High Prices

Low Prices High Prices

Player 1

Player 2

Games as Strategy• Segmentation strategy to obtain FMA• Relevance of chain-store paradox• The Umbrella dilemma• Value net and PARTS• Strategic ToolBox in terms of

sustainability• GEMS and Tx3 Framework [next slide]

Industry Analysis

Play-out Game Scenario B

e.g. change the game new

product development

Strategic Options (Identify the Games)

Play-out Game Scenario A e.g. market

entry competitors reactions

Play-out GameScenario C

e.g. change the game

Consolidation

Strategic Decisions

• Porter’s 5 Forces • BCG • Value Net

• S.W.O.T. • P.A.R.T.S. • McKinsey

• Game theory

Organizational Goals

Game theory Insights

GEMS and Strategic Analysis

• Knowledge of the identity of near rival:

Actionyou -> Reactionrival-> NashReplyyou

GEMS and Strategic Analysis• Knowledge of likely reaction of near

rival• Binary reaction; Will Player B react?

Yes or No?• Non-binary reaction: Player B will

react. Probability = x%

Game Embedded Strategy: GEMS

What Market should we be in?

Competition & Cooperation

Adaptation & Technology

Games & Feedback

Final Scenarios……• The Rationale

Markets evolve• The RationaleType, Technology and

Time• The Rationale

Know your market

• The StrategyNon-binary

• The StrategyGame metrics and

analytics• The Strategy

GEMS

Thank you for participating………

Sapere aude

‘That which one can know, one should dare to know’