RSM 392H1: Competitive Strategy

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1 RSM 392H1: Competitive Strategy University of Toronto Rotman School of Management Undergraduate Seminar Professor: Kevin A. Bryan Class Notes: Value Capture Theory Why do some firms persistently earn high profits and others do not? We know from basic economics that in perfect competition, where firms can freely enter and operate with the same cost structure as incumbents, price will be competed down to marginal cost. Most competitive settings, however, involve a finite number of buyers, suppliers, and rival firms, with limited potential for entry because of learning curves, formal barriers, or information asymmetries. We believe that the difference in firm profitability comes down to active choices - strategies - employed by these firms. But how do we know whether a particular strategy will work? There are many models attempting to answer in the question - SWOT, Porter s Five Forces, Core Competencies, Blue Ocean Strategies, and so on. However, it is our principle in this class to only use analysis tools that Have a rigorous basis in economic theory Are able to be investigated quantitatively Are congruent with observed data in the world, and Impose as few assumptions as possible One such tool is called Value Capture Theory (VCT). 1 VCT has at its core a branch of game theory called coalitional game theory. The basic idea is the following. Firms will take actions to set the competitive table : acquire resources, choose pricing and compensation policies, choose what products to sell, and so on. Given these actions, a market made up of suppliers, buyers, rivals, and governments will perform economic activity which maximizes total economic surplus. The distribution of that surplus - how much value is captured by each player - will then be determined by a small set of relatively uncontroversial axioms. The fundamental concept that will come out of these axioms is that, when a market made up of many actors creates value, competition between players lowers how much value you capture, while competition for your skills, abilities, unique demand, and so on increases it. That is, competition can be either good or bad: you certainly want firms competing to have you as a supplier! In general, these fundamental competitive factors affecting the amount of surplus captured as profit or consumer surplus will only give us a range of possible outcomes. 1 For more details, see Brandenberger and Stuart JEMS 1996, Chatain and Zemsky SMJ 2011, MacDonald and Ryall Man.Sci. 2004, Brandenberger and Stuart Man.Sci. 2007, Gans and Ryall SMJ 2017, among others. 1

2 2 This model is conceptually, though not mathematically, challenging at first. The alternative to the mathematics is a purely verbal chain of logic, which quickly becomes very hard to follow even for a very smart manager. Learning how the model works makes it much easier to understand the logic by which some firms accrue high profits from particular strategies, and others do not. The model and its assumptions First, a few definitions. Assume that there are a set of N players in a market. A market is some collection of buyers, suppliers, rivals, producers of substitutes, potential competitors, and so on who have first-order importance for profit in a given industry. If these actors take every economic action that generates surplus, we denote the total value they create as V. What is economic surplus? Surplus is created when every transaction occurs where the opportunity cost of the resources - labor, materials, etc. - going into goods is less than willingness to pay of some consumer for that good. Note that the word price does not appear. A simple barter exchange between two people who value the other s good more highly is an efficient transaction. Further, the word cost does not appear, except as opportunity cost. Assume my supplier can produce aluminum for $3 of opportunity cost, but charges me $5, and I can use resources to turn aluminum into cans for an opportunity cost of $1. Economic surplus is created as long as a final consumer is willing to pay at least $4 for the cans. For every subset of players G from the full set N, we denote the total value G can create working on their own as V (G). We call player j s added value the difference between the value created by everyone working together and the maximum value that can be created by everyone other than j working together (A j = V V (N j)). We call the outside option O j of player j the maximum added value of j in some alternative market. We call the vector x a proposed allocation, where x j is the allocation that we propose player j will receive. We will make the following assumptions on x. Assumption 1. The proposed allocations given to all players sum to the total value created: j x j = V. Assumption 2. No player earns more than their added value: x j A j. Assumption 3. Every player earns at least their outside option: x j O j.

3 Assumption 4. The proposed allocation must be stable. This means that, for every subgroup G, the total surplus given to the members of G must be at least as much as those members could earn if they left the big group N and went out on their own. That is, for every subgroup G, j G x j V (G). Assumption 5. If there are a range of payoffs x j that satisfy all of the above for player j, then the exact payoff j gets depends on their relative bargaining power, to be defined below. 2 3 These assumptions ought to be relatively uncontroversial. Assumption 1 just says that, if a group creates economic value, it must go to somebody; economic value doesn t disappear into thin air. Assumption 2 says that a player can t get more than its added value. Since added value is defined as the increased value created when j is a member of a market, it does seem economically sensible that j can t get more than this amount. For example, if a network N generates 80 dollars of value, and the network can generate 60 dollars of value without j, then j s added value is 20 dollars. Imagine we propose j earns 30 dollars of surplus. This means everyone else is earning a combined 50. But everyone else could ignore j, interact only with each other, and earn a combined 60 dollars. Assumption 3 says that a player gets at least its outside option. Imagine player j has added value of 20 dollars in its current value network, and 10 dollars of added value to its next best value network. Imagine the current value network offers j only 5 dollars of surplus. The next best value network would offer j 6 dollars to switch. That is, competition for firm j ensures that it earns at least its best outside option. Assumption 4 says that every subgroup of players earns at least as much in the full network as it could earn just transacting with each other. Imagine players i and j can, working together with only each other, generate 5 dollars of economic surplus. They surely must receive at least a combined 5 dollars of surplus in the full network (x i + x j 5). Otherwise, i and j can credibly threaten just to transact with each other only. Assumption 5 notes that assumptions 1 through 4 may not pin down an exact payoff for every player. That is, the x j that satisfy those assumptions may be a range. So how much will player j earn? We assume only that economic fundamentals in those assumptions pin down the range, and whether you wind 2 There are also technical assumptions we need to ensure that there exists at least one vector of allocations x that satisfy Assumptions 1 through 5. This is called the core existence problem, and we omit the mathematical details from these notes. We should be clear that these assumptions rule out analyzing, e.g., negative externalities within a model of this type. See Gillies (1959), Solutions to general non-zero-sum games. The mathematically inclined may notice that Assumptions 1 through 4 are not independent; for instance, Assumptions 1 and 4 imply Assumption 2. We nonetheless state the assumptions in a way that makes it as easy as possible to capture the underlying economic intuition.

4 4 up in the high or low end of that range depends on your skill in bargaining. There are many reasons a firm will be good at bargaining - it may be very patient compared to counterparties, or may have good salespeople, and so on. So how much profit will a given player j earn? The five assumptions above imply that every player earns profit in a range [L j, U j ] The upper bound U for player j is simply their added value: A j = V V (N j). That is, competition among players providing similar types of value to the market will lower the maximal surplus you earn. The lower bound L for player j is the largest of three values. A firm must earn at least its outside option O j by Assumption 3. Since the total surplus must go to somebody by Assumption 1, if all other players are earning their added value and there is still something left over (V i j x i > 0), then j must earn that value. Finally, every subgroup can credibly threaten to transact only with themselves. All players other than firm j will always be willing to do so if they are paid more than their added value in the full value network. Therefore, by Assumption 4, player j must earn, for every subgroup G that includes j, at least V (G) i j;i G A i. Breaking this down, if there is a subgroup of players that creates V (G) of value, and there is something left over after player j offers everyone else inthat subgroup their upper bound payoff in the full value network, then the threat of forming this subgroup is enough to guarantee firm j the remainder. (Don t worry, we will see an example of how to compute this, and how to interpret it economically!). That is, competition for your skills, resources, and so on by outside markets (Assumption 3), or subsets of players within your market (Assumpions 1 and 4), increases how much you are guaranteed to earn. This means that there are five ways that a firm can increase its profit! It can increase its added value, increase its best outside option, decrease the added value of other players, increase the value of subgroups of players that it is a member of, and increase its bargaining power. A frequent mistake in strategy is to think the only way firms can earn profit is by increasing their added value: by offering some value that other firms can not replicate. It should be clear from the value capture model that this is not true. And remember: these bounds are generated from assumptions which are very general, and quite uncontroversial! What should a firm s goal be? Figure out clever strategies that do at least one of the five things above. Even better, figure out strategies that continue to have that beneficial effect even when other firms in your market respond to them with their own clever strategies. The reason firms earn persistently high profit is not by listing strengths and weakness (SWOT), avoiding competitive industries (Blue Ocean), avoiding harmful competition in general (Five Forces), or developing a unique method of generating value (core competencies). If we want to seriously understand differences in firm performance, we

5 may need to understand complicated chains of logic. A formal theory, backed by basic economics, helps us do that. 5 A few simple applications Note that the assumptions in the previous section are very general: we don t assume, for instance, that firms are playing Cournot and choosing prices, or that firms have to set fixed prices rather than price discriminate, etc. The goal of value capture theory is to use the most minimal set of economically reasonable assumptions about who will earn what. It turns out that, in the case of perfect competition and monopoly, value capture theory gives precisely the same payoffs x j to every player as what standard economic analysis would suggest. 3 However, in cases where there are a finite number of firms, suppliers, or buyers, value capture theory often implies rather counterintuitive results for who earns what - well, counterintuitive until you think through the logic your new VCT-driven intuition implies! Let s see two very simple stylized models, fully worked out, then two simple real-world examples. We will formally calculate upper and lower bound payoffs for a firm of interest, and consider how seemingly-smart strategies may actually lower profits. Pure Bargaining. Let there be one buyer and one firm that can make at most one widget. The firm can make at most one widget at an opportunity cost of 1. The buyer values widgets at a willingness to pay of 10. How much surplus is created and who earns it? The amount of surplus created, V, is the value of all efficient transactions in this market. The efficient transaction converts resources with an opportunity cost of 1 into a widget with a consumer valuation of 10. So V = 9. Who captures this? Note that both players have an added value of 9: without the firm, there can be no widget, and without the buyer, the firm just has a valueless block of metal. So both the firm and the buyer have an upper bound profit of 9. To check their lower bound, we will check three things. First, what are the outside options of the buyer and firm if they don t participate in this particular piece of value creation? We have assumed nothing here, so in this case it is zero for both. However, imagine there was a consumer in a different industry who could turn the raw resources owned by the firm into a good they value at 4. In that case, competition for for the firm s resources between that consumer and the firm s current buyer would ensure the firm receives at least 4, hence earn a surplus of at least 3 (4 minus the opportunity cost of resources, 1). We also need to see if there is necessarily any surplus left over for either player if 3 Technically, it gives the payoffs a perfectly price discriminating monopolist would induce.

6 6 everyone else gets their full added value. In this case, total value V = 9, and the added value of the buyer is 9, so since 9 9 = 0, nothing is necessarily left for the firm. Likewise, since the added value of the firm is 9, nothing is necessarily left over for the buyer. So again, the lower bound caused by this factor is zero. Finally, are there any subgroups G who would like to compete for the firm, or for the buyer? In this case, with only two total players, there are no subgroups composed of at least two players. Therefore, on this factor, again the lower bound of both players is zero. Summing up, then, both the firm and the buyer will earn something in the range [0, 9]. Why? Well, though the firm is a monopolist, the buyer is also a monopsonist. No other firm is competing with our firm for the buyer s custom, but also no other buyers are competing with our buyer to get the widget. That is, this is a situation of pure bargaining. Where will we wind up within these intervals? This will depend on bargaining power, broadly defined. For instance, if the firm is about to run out of money, they may find it tough to bargain the price up. If the industrial custom is that firms make take-it-orleave-it offers to buyers, they wll of course make a take-it-or-leave-it offer of $10 for the widget. What you should understand here is that even though the firm is a monopolist, the balance of competition for and against the firm means that pure competitive factors do not pin down the firm s profit. You should also think through what strategic factors might affect the bargaining power of the firm and the buyer. Perfect Market Competition. Let us consider a nearly identical situation to the previous example. Here there is one firm that can make at most one widget, at an opportunity cost of 1. However, there are now infinite buyers with a willingness to pay of 10. How much surplus is created and who earns it? As before, the efficient transaction converts resources with an opportunity cost of 1 into a widget with a consumer valuation of 10. So V = 9. Who captures this? Note that the firm still has an added value of 9. However, if any single buyer disappears, there remain infinite buyers with willingness to pay of 10, hence there still remains the possibility of creating 9 dollars of surplus. That is, the added value of any individual buyer is 0, and hence the maximal surplus earned by any buyer is zero. To check lower bounds, we again check three factors. As before, we have assumed no pure outside option for any player. Checking whether there is necessarily any surplus left over when everyone other than the firm gets its full added value, however, you see that there is: all buyers combined have added value of 0, and there is a surplus of 9 that must go to someone, hence the firm s added value is 9! Though we could directly check each factor for the buyers, their lower bound turns out to be straightforward: since each buyer s

7 added value is 0, the most they can earn is 0, and since they can always just do nothing, the least they can earn is also 0. Summing up, the firm s profit range is [9,9], and the buyer s profit range is [0,0]. There is no range at all! Why? Again, the firm is a monopolist, so no one is competing against the firm to provide the buyers value. However, every buyer who doesn t get a widget is competing for the firm s services. This competition for the firm ensures that the firm captures a lot of surplus - in this case, all of it. 7 Should I make my fax machine work with others? Consider a market made up of two consumers, Sony, and an entrant Faxr. Each consumer has willingness to pay of 2 dollars for a Faxr fax machine, and 1 dollar for a Sony fax machine. Sony and Faxr both have a capacity constraint at their factory and can only produce one fax machine each, with production costs equal to zero. Note that V, the maximal social value that can be produced, involves Sony and Faxr both producing one machine each, one buyer getting the Sony machine, and the other getting the Faxr machine. In that case, 3 dollars of value is created. How much will Faxr earn? The upper bound on Faxr s profits is its added value. Note that if Faxr does not exist, the most economic value that can be created is 1, when Sony makes a machine and sells it to either consumer. So Faxr s added value, and hence their upper bound on profits, is V V (N J) = 3 1 = 2. What is their lower bound? Recall that the lower bound is the biggest of three objects. First, what is Faxr s outside option? We have not assumed they have any outside option, hence O j = 0: they produce nothing. If all other players get their added value, is there anything necessarily left for Faxr? You can compute that Sony s added value is 1, consumer 1 s added value is 1, and consumer 2 s added value is 1, hence the sum of added values of all other players is 3. Since the total value created V = 3, there is not necessarily anything left over for Faxr. Finally, are there any subgroups that Faxr is a member of which can ensure they earn positive profits? The subgroups Faxr is a member of are (Faxr, Sony, Buyer 1), (Faxr, Sony, Buyer 2), (Faxr, Buyer 1, Buyer 2), (Faxr, Sony), (Faxr, Buyer 1) and (Faxr, Buyer 2). The total value created by those subgroups working on their own to maximize economic surplus is, respectively, 2, 2, 2, 0, 2, and 2 (check to make sure you can see why!). The summed added value of all members of these groups aside from Faxr is 2, 2, 2, 1, 1, and 1. Note that for the last two subgroups, (Faxr, Buyer 1) and (Faxr, Buyer 2), the value of the subgroup V (G) is higher than the summed added value of all members of the subgroup aside from Faxr! In particular, V (G) i j;i G A i = 1 in both cases. This means that Faxr must be guaranteed a lower bound profit of 1 in the big group.

8 8 Let s step back a second. What is the economic intuition here? Imagine that Faxr is only earning, say,.5. We know that both Buyer 1 and Buyer 2 earn a maximum of 1 dollar of surplus, since their added value is 1. So Faxr and the buyer who gets their fax machine combined are only earning 1.5 dollars of surplus. In that case, Faxr should contact its buyer, and offer to just sell to it directly. On their own, the pair can produce 2 dollars of surplus by working directly with each other. That two dollars can be split as, for example, 1.4 dollars for the buyer and.6 for Faxr, leaving both parties better off that the proposed allocation when they were working in the big group. Indeed, since the buyer gets at most 1 dollar of surplus in the full market, and Faxr alongside any buyer can create 2 dollars of value working with each other, then unless Faxr gets at least 1 dollar of surplus from the market they will always want to credibly threaten to just sell directly to a buyer. Another way to see this intuition is to note that with two firms, two buyers, and no ability to expand, Faxr may not need to compete with Sony for buyers, hence may be able to charge up to the full 2 dollars of value their fax machine generates. However, competition by the two buyers to be the one who gets for Faxr s better machine means they can always charge at least 1 dollar even if Sony gives away their fax machine. The mathematics makes these numbers clear, but you will know you really understand value capture when you can translate the pure mathematics back into the economic insight in this way. It is the ability to do this translation that ensures you really are developing your intuition! What have we shown? We have shown that Faxr will get somewhere between 1 and 2 dollars of surplus. But now the CEO of Faxr proposes to you a clever strategic idea. They will make their fax machine interoperable with Sony parts. Because of a network effect, where the more people owning interoperable goods, the more I value my good, let us assume that if and only if both fax machines are sold, the total surplus generated is 4 instead of 3. That is, Faxr s machine and Sony s machine are both more valuable because they can share inexpensive parts that work on either machine. What will Faxr s profit be now? Faxr s added value, and hence upper bound, is now 3 instead of 2: the value created when Faxr works with everyone else is 4, by assumption, and the most value Sony and the two consumers can create without Faxr is 1. But Faxr s lower bound profit has gone down. How? Their outside option is still 0. You can compute that the added value of Sony is 2, Buyer 1 is 2 and Buyer 2 is 2, hence the summed added value of all players other than Faxr is 6. 4 Therefore, if all other agents get their added value, there is not necessarily anything left for Faxr. 4 For example, the total value created V = 4, but if Sony doesn t exist, the most value that can be created is to have one of the buyers buy from Faxr, generating V = 2. Sony s added value is therefore 4 2 = 2.

9 Finally, it turns out there is no longer any subgroup Faxr can usefully threaten to break away as part of. For the six subgroups (Faxr, Sony, Buyer 1), (Faxr, Sony, Buyer 2), (Faxr, Buyer 1, Buyer 2), (Faxr, Sony), (Faxr, Buyer 1) and (Faxr, Buyer 2), the total value of the subgroups remains 2, 2, 2, 0, 2 and 2. But the summed added values of members in those subgroups other than Faxr is now 4, 4, 4, 2, 2 and 2. That is, V (G) i j;i G A i 0 for all subgroups that include Faxr. These three facts mean that Faxr s lower bound profit is zero, and their potential profit range has shifted from [1, 2] to [0, 3]. What happened? When Faxr wasn t interoperable, each individual buyer was relatively unimportant. When Faxr is interoperable, however, each buyer helps contribute to the value of the network: the added value of a given buyer rises from 1 to 2. This means that there are economically reasonable allocations where a given buyer earns as much as two dollars of surplus when everybody works together. If each buyer earns two dollars of surplus, what can Faxr offer a buyer when they threaten to deal directly with each other? Faxr and the buyer combined only produce two dollars of surplus, so there isn t necessarily enough surplus in the subgroup to entice these well-off buyers to leave. Without this credible threat, Faxr s minimum guaranteed profit is zero. That is, when the two fax machines are networked, consumers no longer care as much about getting Faxr s good fax machine, but rather about being part of the network! Faxr s CEO s intuition was therefore half right. Making their machine interoperable did in fact increase both the total value created and Faxr s added value. But it also, by reducing competition for Faxr s high-quality machine relative to Sony s, make Faxr s worst-case outcome lower. So, should Faxr make their fax machine interoperable? It depends on whether you like the range [1,2] or the range [0,3] better. By Assumption 5, you should prefer the range [0,3] if you have a lot of bargaining power: you are likely to end up near the top of the range. But if you have limited bargaining power compared to Sony and the consumers, you may prefer the range [1,2]. At least, in this case, you should only think interoperability is a good idea if you also have a lot of bargaining power. Just generating more added value is not necessarily enough! One more thing to notice: if you play around with some assumptions, such as how many buyers there are relative to the production capacity of sellers, you can arrive at very different conclusions. Try it! Now think about how easily you may have been convinced by purely verbal descriptions of concepts like our profits will rise if we make our product work with an existing platform. You now know that statements like that cannot be true in general, and you now have an ability to quantitatively investigate these issues before translating what you learn back into words. This is a very powerful tool to have at your disposal! 9 Should Jiffy Lube offer brake service? Jiffy Lube offers very low cost oil changes performed by low-skilled workers. A mechanic s shop can also fix your brakes, but because their labor is higher-skilled, their costs to change your oil are higher. In particular, assume the following. There is one consumer who

10 10 needs oil service and brake service. They value the oil change at 15 dollars, and the brake service at 25 dollars. Jiffy Lube can change oil at an opportunity cost of 5 dollars, but can t fix brakes. An auto mechanic can offer oil changes at an opportunity cost of 10 dollars, and brake repair at an opportunity cost of 20 dollars. What is the maximal economic surplus that can be generated? The consumer should get oil changed at Jiffy Lube, and brakes fixed at the mechanic. This generates (15 5) + (25 20) = 15 dollars of surplus. How much will Jiffy Lube earn? Their added value is 5: if they don t exist, the consumer can get both services from the mechanic, generating surplus of 10. So Jiffy Lube s upper bound profit is 5. Economically, they earn 5 if they price at 10 dollars per oil change. If they try to price higher, the mechanic can undercut them and take their business. What is Jiffy Lube s lower bound? Try checking as in the previous example, and you will see that all three factors which make up the lower bound give a value of 0. Hence Jiffy Lube s profit will be somewhere in [0,5]. Jiffy Lube s CEO makes the following (wrong) argument. The most Jiffy Lube can earn if the only make oil changes is to charge each consumer their full willingness to pay of 15, earning 10 dollars of profit. But it is possible to build a full service Jiffy Lube by hiring slightly better labor. If they did so, they could change oil at a cost of 7, and fix brakes at a cost of 19, both cheaper than the mechanic. They could therefore earn up to 14 dollars: 15-7=8 dollars for the oil change, and 25-19=6 for the brake service. Fourteen is more than ten, hence Jiffy Lube should go full service. What is wrong with that argument? Let s check what Value Capture Theory says. What is Full Service Jiffy Lube s upper bound on profit? The total value V generated by Full Service Jiffy Lube and the Mechanic is 14: consumers will get both services from Jiffy Lube as in the CEO s (wrong) intuition. The total value V generated if Full Service Jiffy Lube doesn t exist is 10, when the consumer gets both services from the mechanic. Since 14-10=4, the upper bound on Full Service Jiffy Lube s profit is only 4! You can check as before that the lower bound on Jiffy Lube s profit is 0. So going from limited service Jiffy Lube to Full Service Jiffy Lube lowers profit from [0,5] to [0,4]! What happened? It is true, as the CEO noted, that the consumer will now get both services from Jiffy Lube. However, it is not true that Jiffy Lube can charge 25 for brake service or 15 for oil changes: if they charge more than 20 for brakes, the mechanic has an incentive to undercut them, and likewise if they charge more than 10 for oil changes. This means that the brake service Jiffy Lube now offers only earns them one dollar. And in order to be able to offer that service, the most profit they can earn from oil changes falls from 5 to 3, as costs rise with the now-more-skilled labor. This formalizes the idea that tradeoffs can be useful. Is it not necessarily good for Jiffy Lube to be good at all things. By becoming better at offering

11 brake service, they reduce their competitive advantage on offering oil changes, and the net of these two things turns out to lower Jiffy Lube s profits. Choosing a labor strategy that makes it hard to offer brake service can be a good thing! 11