H 17 Cscoursetext

Competitive
Strategy
Professor Neil Kay
CS-A4-engb 1/2017 (1008)

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Competitive Strategy
Neil Kay, BA, PhD, FRSA
Professor Neil Kay is a Professorial Fellow at Edinburgh Business School and Professor (Emeritus)
Economics Dept., at the University of Strathclyde. He is the author of six books and numerous articles on
industrial economics and the economics of corporate strategies.
At Edinburgh Business School he has written the Competitive Strategy elective, which he teaches in the
distance-learning and on-campus modes. He is also a Senior Mentor for the DBA.
He is an Academic Associate for the Centre of International Business and Management (CIBAM) at the
University of Cambridge. In a long and distinguished academic career, he has taught at the University of
California Irvine, the European University in Florence, Heriot-Watt University and the University of
Strathclyde.
Professor Neil Kay has acted as adviser and consultant to private and public organisations, including a
series of missions in the Balkans on behalf of the United Nations Management Development Programme
to help reform post-communist management education and training at university level and on executive
short courses.
First Published in Great Britain in 2001.
© Neil Kay 2001, 2014
The right of Professor Neil Kay to be identified as Author of this Work has been asserted in accordance
with the Copyright, Designs and Patents Act 1988.
All rights reserved; students may print and download these materials for their own private study only and
not for commercial use. Except for this permitted use, no materials may be used, copied, shared, lent,
hired or resold in any way, without the prior consent of Edinburgh Business School.
Contents
Elective Overview viii

Module 1 Analysis of the Environment 1/1
1.1 Introduction 1/1

1.2 Industries and the Life Cycle 1/3
1.3 The Five Forces Framework 1/15
1.4 Game Theory Perspectives 1/29
Learning Summary 1/37
Review Questions 1/38
Module 2 Strategies for Competitive Advantage 2/1

2.2 Generic Strategies 2/2
2.3 The Value Chain 2/4
2.4 Cost Leadership 2/10
2.5 Differentiation 2/17
2.6 Focus 2/25
2.7 The Dangers of Hybrid Strategies 2/30
Module 3 The Evolution of Competitive Advantage 3/1

3.2 The Innovative Process 3/3
3.3 The Characteristics of the Innovative Process 3/6
3.4 Why Innovation can be Squeezed off the Firm’s Agenda 3/9
3.5 Solutions 3/16
Module 4 Vertical Links and Moves 4/1

4.2 Defining Vertical Relations 4/2
4.3 Trends in Vertical Relations 4/6
4.4 What Vertical Integration is Not 4/9
Competitive Strategy Edinburgh Business School v

Contents
4.5 The Costs of Markets 4/10

4.6 The Costs of Vertical Integration 4/23
4.7 Choice of Strategy 4/28
4.8 The Varieties of Vertical Relations 4/30
Module 5 Horizontal Links and Moves 5/1

5.2 The Diversification Game 5/3
5.3 Why Diversify? 5/13
5.4 Forms of Diversification 5/29
Module 6 International Strategy 6/1
6.1 The Diversification Game Goes International 6/3

6.2 The Question of International Competitiveness 6/6
6.3 Porter’s Diamond Framework 6/9
6.4 Using the Diamond Framework 6/19
6.5 Framing Company Strategy 6/24
6.6 Competing in International Markets 6/26
6.7 Competing Abroad: The Principles 6/31
6.8 Globalisation Versus Localisation 6/33
Module 7 Making the Moves 7/1
7.1 Example of a Combination 7/3

7.2 Evidence on the Performance of Combinations 7/5
7.3 Adding Value from Combination 7/8
7.4 Why Do Mergers and Acquisitions Perform So Badly? 7/13
7.5 Co-operative Activity 7/22
Appendix 1 Practice Final Examinations A1/1

Practice Examination 1 1/2
vi Edinburgh Business School Competitive Strategy

Contents
Practice Examination 2 1/6
Appendix 2 Answers to Review Questions A2/1

Module 1 2/1
Module 2 2/3
Module 3 2/5
Module 4 2/7
Module 5 2/8
Module 6 2/10
Module 7 2/12
Index I/1
Competitive Strategy Edinburgh Business School vii

Elective Overview
This elective is about strategic choices. What options do we face? Should we make
moves back up the supply chain, or down towards our end customers, or should we
stay where we are? Should we stick to our knitting, or diversify into other markets,
and if so which? What about establishing ourselves globally: should we do it, how
can we do it, can we afford to do it, can we afford not to do it? These are examples
of dilemmas and decisions that may be encountered in competitive strategy.
This elective looks at alternative directions (such as vertical moves, new markets
and technologies, international expansion) and alternative means for pursuing these
directions (such as internal expansion, contract, acquisition, alliance). Competitive
Strategy develops a set of analytical approaches and tools to help formulate and
evaluate these strategies on a topic by topic basis. The elective as a whole provides a
unified and integrated framework to assist in the process of strategy formulation.
Competitive Strategy Edinburgh Business School viii

Module 1
Analysis of the Environment

Contents
1.1 Introduction.............................................................................................1/1
1.2 Industries and the Life Cycle .................................................................1/3
1.3 The Five Forces Framework .............................................................. 1/15
1.4 Game Theory Perspectives ................................................................ 1/29
Learning Summary ......................................................................................... 1/37
Review Questions ........................................................................................... 1/38
The module will help set the context for much of the analysis and discussion in later
modules. It introduces the basic features of the strategic arena in which the firm
operates. We shall first look at the relevance and significance of life-cycle effects
over time. Then we shall see how the Five Forces Framework can provide a basis
for systematically analysing the environment in which the firm operates at any given
stage in the life cycle. We also look at how game theory can help provide useful
insights to aid strategic thinking, while at the same time warning against uncritical
use of this technique in strategic planning.
Learning Objectives
After completing this module, you should be able to:
 explain how critical points in the industry life cycle can transform the competi-
tive environment of the firm;
 understand the implications of different stages in the life cycle for competitive
strategy;
 describe the Five Forces Framework and explain its implications for strategy
formulation;
 use the Five Forces to analyse the context in which individual competitive
strategies are framed;
 explain the contribution and limitations of game theory in strategy formulation;
 describe how strategic moves can help a firm gain an advantage in the competi-
tive battlefield.
1.1 Introduction
In this module we shall set the context for much of our subsequent discussion of
competitive strategies. You might say that in this module we are beginning to look
at the early pages of the rule book for a game of strategy – what are the important
features of the strategic battlefield, what strategies are possible, what constrains
Competitive Strategy Edinburgh Business School 1/1

Module 1 / Analysis of the Environment
strategies, and so on. However, the rule book for competitive strategy as set out in
strategic management textbooks is not as straightforward and clear-cut as for other
games of strategy such as chess and checkers. This is a rule book where some rules
are quite clear, but others operate some of the time only. It is a rule book where the
interpretation of some rules is hotly contested, and a rule book where whole
sections may be difficult to read or are missing altogether.
Just to make things more difficult, there are competing rule books written by
different observers, many of which are constantly revised, and some of which are
more unhelpful than helpful. It has been remarked, perhaps with some truth, that
the worst thing that can happen to a firm is to be cited as an example of the rules
that should be followed for competitive success. This often merely precedes the
rapid fall from grace of these same firms in the marketplace.
The history of IBM over the eighties and nineties is a good example of the dan-
gers of trying to produce clear and precise rules for competitive success. In the early
eighties IBM frequently appeared on lists of the most excellently managed corpora-
tions. Ten years later, its obituary was being written many times, often with stern
observations about how the company had become a lumbering dinosaur that was
doomed to failure, decline and probable elimination. Ten years later, at the turn of
the millennium, IBM was being generally written up as a nimble and thriving
company back where it belonged at the forefront of the information revolution.
IBM illustrates the point that firms are often both more vulnerable and more
resilient than they appear at first sight. They can be more vulnerable than they
appear because the apparently rock-solid foundations of their current strategy may
be quickly blown away by external forces such as technological change. They can be
more resilient than they appear because the essence of a company is not bricks and
mortar but people and socially constructed systems. While these systems may often
display features that may be more rigid and difficult to change than bricks and
mortar, they can also show a flexibility and adaptability that is not captured by the
notion that some companies have discovered a recipe for success carefully passed
down by successive managerial generations. Recipes for success change, and the
firm that fails to come to terms with that point is perhaps the only type of firm that
is necessarily doomed to failure in the long run.
However, that does not mean to say that it is not possible to develop useful
analyses for competitive strategy, merely that we have to be careful about coming up
with the kind of ‘ten surefire recipes for success’ that clutter up book stands in
airport lounges. What can be possible is to establish which conditions are likely to
favour which kinds of strategies. It is a bit like earthquake prediction. We might
learn from studying the effects of earthquakes what house-building strategies could
be adopted in earthquake regions (e.g. build low, build with strong materials, or
avoid building anything). However, you have to look at each case in turn to decide
which strategy or mix of strategies should be adopted in each case. Also the rule
book can change; e.g. the prohibition ‘do not build high buildings in earthquake
regions’ has been at least partially modified in recent years through innovations in
building materials.
1/2 Edinburgh Business School Competitive Strategy

Just as the geological environment can have an impact on house-building strate-

gies, so the industrial environment can have an impact on the strategies of firms.
Indeed, the environments that may have an impact on strategy do not stop at the
boundaries of the industrial environment; social, political and legal environments
can all have an impact. However, our main concern in this module is with the effect
of the industrial environment on the framing of the strategies of firms.
As we shall see, one of the most important questions that arises in this context is
how much discretion firms have in framing strategy, just as house-builders might
consider the limited range of options open to them in building houses in earthquake
zones. Politicians might describe this as the question of how much ‘wiggle room’, or
room to manoeuvre, there is in framing options. As we shall see, the amount of
wiggle room for competitive strategy can vary across sectors, and from time period
to time period.
We shall start by exploring wiggle room over time in Section 1.2. This brings in
the notion of the industry life cycle, and raises the question of how the nature and
range of strategic options open to the firm can vary over the course of the industry
life cycle. Then in Section 1.3 we shall look more closely at the question of where
firms can wiggle in a particular industry at a particular point in the life cycle. These
two big questions will help set the context for the discussion that follows in all the
other modules.
1.2 Industries and the Life Cycle

Competitive strategy is about trying to achieve some kind of advantage over
competitors. In Module 2 we shall see how this generally involves trying to achieve
some form of cost or differentiation advantage over competitors. Ideally, the firm
should seek to try to achieve some position that is difficult or impossible for rivals
to imitate, such as Coca-Cola with its brand image in soft drinks, Boeing with its
advantage of experience and economies of scale in building civil aircraft, or Ama-
zon.com with its strategy of giving book readers information and cheap access
through the Internet.
The problem with such successful strategies is that they are based around trying
to create a unique source of advantage for the firm. Now ‘uniqueness’ is something
that poses real problems for analysis. If a firm can carve out and defend a unique
place for itself in the competitive marketplace, by definition this is something that
may not be applicable to other firms. It is difficult or impossible to develop a rule
book for creating uniqueness, whether we are talking about a building by Frank
Lloyd Wright or a competitive strategy.
As we noted in the first section, the good news is that there are often underlying
regularities in the environment that can aid decision making, whether we are talking
about house-building or competitive strategies. A good strategist, like a good
architect, is sensitive to the intrinsic design properties of his or her plans in relation
to the environment. This means knowing something about the environment,
whether it is seasonal cycles for the area in which a building is located, or life cycles
in the industry in which the product operates. In both cases, there may be regulari-

ties and patterns that planners can draw on to improve their decision making in the
respective contexts.
An important tool in the strategist’s armoury is the notion of an industry life cycle.
Industries may have a life cycle just like biological organisms, though we should be
careful not to stretch the analogy too far. The eventual decline and death of
biological organisms is inevitable, and indeed statistically predictable using actuarial
tables. However, the same cannot be said for social organisations such as firms, or
industries (which are simply groupings of firms or parts of firms). Nevertheless, for
those industries that do decline it is often possible to identify some features that
characterise this stage, just as it is often possible to identify features that characterise
other stages in industries’ growth and development.
The growth rate of an industry should not be thought of as necessarily a passive
element that firms have to adjust to. A firm may be in a position to influence the
industry growth rates and the course of the life cycle. Two main techniques for this
are the following:
 Pricing strategies in the introductory phase. An innovator may decide to go
for (low) penetration price and high initial growth, or for (high) skimming price
and slower initial growth. A penetration price is more likely if an innovator has a
deep pocket and is able to sustain initial losses, and if capturing a high market
share is seen as providing a major source of competitive advantage, for example
due to economies of scale. Amazon.com has pursued a penetration price strategy
in some of its Internet markets. A skimming price strategy is more likely if firms
wish to recoup expensive R&D expenditure and set-up costs, and if it is ex-
pected that competitors will soon enter this market anyway. Skimming prices are
often observed in consumer electronics markets.
 Life-cycle stretching and renewal. Firms individually or collectively may
extend the life of an industry through innovation and marketing improvements.
The invention of the bagless vacuum cleaner by Dyson revitalised a market
which had generally been regarded as rather settled and dull for many years.
However, apart from these special cases, firms may have limited opportunities in
practice to affect the course of the life cycle and instead may have to learn to adjust
to it. The life cycle will typically follow the major stages shown in Figure 1.1, but
some cycles may be more erratic and unstable than is suggested by the orderly
pattern in this figure. For example, some leisure industries such as professional
wrestling and cinema have waxed, waned and waxed again in terms of popularity
down the years, with trends often differing according to the national context.

Critical point: growth Critical point: now

in market now ends negative growth rate
Critical point: growth

is beginning to slow
B C
Sales
0
Growth Maturity Decline
Figure 1.1 The evolution of industries
1.2.1 Critical Turning Points in the Life Cycle

In addition to broadly definable and self-explanatory stages, Figure 1.1 also identi-
fies what may be critical points in the evolution of the industry. They can be
especially important where strategists base their plans on recent and current trends
and do not properly anticipate what is about to happen in this industry.
1. Critical point A. This point can represent a major turning point in the evolution
of the industry, precisely because it can signal subtle changes and appear very
innocuous at the time. After all, A is set about the middle of the growth phase,
so what is so potentially significant about this point?
The significance lies in the fact that in Figure 1.1 the industry has been enjoying
stable and predictable growth up to point A, and this has facilitated planning.
Now, suppose recent growth has been 10 per cent a year and this has been built
into strategists’ estimates of future growth and their investment plans. Extrapo-
lating these trends has led to sound investment plans so far, but look what is
about to happen at point A. Growth is beginning to slow down, from a regular
10 per cent a year, to much lower growth rates, say 8 per cent and declining. The
problem is that if the firms in this industry invest on the basis that they expect
growth to continue at the previously unsustainably high rate of 10 per cent, then
there will be overcapacity in this industry.
This overcapacity can suddenly change the nature of the competition overnight
and can lead to fierce and destructive competition, especially if firms still retain
the same growth targets that they have experienced in the earlier stages. But
suppose we have a ‘wise’ firm which has anticipated that the industry is going to
meet a turning point in the near future; surely this firm will be well placed to
weather the coming storm? Up to a point this may be true; the firm may be able
to take measures to protect itself, such as trying to differentiate its product, put-
ting up defences around its existing markets and not overinvesting in new plant.
However, even wise firms may be put under pressure for a variety of reasons:

 They still invest because they worry about the implications of losing market
share to rivals.
 Critical point A may be uncertain and difficult to identify in advance (is the
decline in growth this year a temporary blip or the start of a new trend?).
 The intensified competition represented by price wars and battles for market
share may still hit them badly, even if they have not overinvested.
Consequently, even though critical point A is still in the growth period of the
industry it may represent the start of a shake-out phase which may put wise and
myopic firms alike under severe pressure and push out weaker or unlucky firms.
At the same time some factors may counteract any tendency towards overin-
vestment and shake-out during slowdown in the growth phase. These include
the following:
 Risk-aversion in the face of high uncertainty leading to cautious investment
plans.
 It can take time before investment plans are put in place (e.g. possibly years
for new plant), so investment may still be lagging behind demand growth by
the time the turning point A is reached.
2. Critical point B. Point B represents a more obvious turning point in this
industry. The positive growth rates experienced by the industry so far have end-
ed and there is now zero growth (though ‘Maturity’ and the turning point may
not be represented by absolutely static sales, but may more generally be associat-
ed with a state in which the market grows no faster than the economy overall).
Up until now, firms could grow without necessarily taking market share from
each other. The importance of critical point B is that now the only ways that a
firm can increase market share are by reducing the number of its rivals (through
merger, acquisition or exit of rivals) or through taking market share from its
rivals. This is a zero sum game in which the gain to one player represent loss to
others, a consideration which can affect the nature and extent of rivalry in this
industry.
3. Critical point C. Critical point C can mark the start of a dog-eat-dog phase. In
Figure 1.1, if the firm wishes simply to maintain its current level of sales in the
decline phase, it can only do this by actually taking market share from other firms
in this industry. The same logic holds for its rivals in the industry. The fierceness
of the resulting struggle will depend on how easy it is for firms to exit the industry.
If there is little or nothing else it can do with the assets it has tied up in this sector
(i.e. there is little opportunity cost or sacrificed value from continuing the struggle
in this sector) then the battle may be long and bloody.
The real significance of each of these critical points is that history no longer serves as
a guide to future trends. At critical point A growth begins to slow down, at critical
point B growth ceases and at critical point C growth becomes negative. Does that
mean that strategists are wrong to base their plans on historical trends? No, because
what has happened in the recent past may often be a reasonably reliable source of
information about what is going to happen in the near future, and indeed it may be
the best information available. Strategists could make worse decisions by ignoring
these trends. Also, almost by definition, turning points are extreme and unusual events

that may be difficult or impossible to predict before they are encountered. The best
that might be hoped for is that the strategists are aware that the turning points will
eventually be encountered and that it is necessary to have appropriate strategies in
place beforehand. The worst time to think about building a lifeboat is when the ship is
sinking.
1.2.2 The Stages of the Life Cycle

The different stages of the life cycle can offer different opportunities and con-
straints in relation to strategic options. The actual nature and characteristics of the
stages depend on actual cases, but the following are frequently observed features
and tendencies together with some implications for strategy.
Growth stage
 Relatively low price elasticity of demand for each brand. If there is one or a
few differentiated brands then price elasticity of demand for each brand may be
low because of (a) limited substitutability, (b) user unfamiliarity with respect to
what is the ‘right’ price and ignorance of alternatives, and/or (c) early pioneering
users more attracted by novelty and less concerned about price. These issues will
tend to reduce user sensitivity to price and give the firm a degree of discretion
over pricing policy in the early stages. These influences may be eroded or weak-
ened as the growth stage unfolds.
 Relatively high price. Since the user is relatively insensitive to price, the
obvious temptation when the demand curve is not very price elastic is to price
high to maximise short-run profits. However, as noted above, the firm may price
low in order to maximise long-run profits. The problem with a high price in the
early stages is that it may (a) send a profit signal that makes the industry look
attractive to other firms and encourages entry, and/or (b) slow up growth, delay
exploitation of economies of scale and experience-curve advantages, and make it
easier for other firms to catch up.
 High level of advertising to create demand for new product. Advertising has
been characterised as informative (letting the potential customer know the product
exists, and its characteristics) and persuasive (encouraging the customer to switch
brands). Once the product is established, the firm may be able to concentrate
largely on persuasive advertising, but to begin with the firm may have to make
considerable investment in informative advertising. Since this can mean having to
inform the customer about the new product or service as well as specific brands,
many of the gains from this advertising may accrue as external benefits to subse-
quent entrants who can take advantage of the product awareness created by early
advertising. The online services provider AOL heavily advertised the advantages of
electronic mail and other Internet services in the early days, and many smaller
firms and later entrants were able to build on the product awareness created by
AOL.
 Profits low or negative to begin with, then increasing. Scale of the market
can be an important influence on profitability. In the early days, low demand
means low revenues and is liable to coincide with high investment demands (in

physical and human capital, and in advertising). Low scale of output also means
high operating costs since economies of scale and the experience-curve effects
cannot be fully exploited. How long the firm is willing or able to sustain a loss-
making position depends on a number of factors. One important factor can be
the expected time to achieve profitability (which in turn depends on expected
market growth and importance of scale effects on costs). The ability of the firm
to sustain a loss-making position is also important and can depend on the will-
ingness of the external capital market to see the firm through the initial loss-
making stages. This may depend on the industry as well as the perceived pro-
spects of the firm. Alternatively, a highly diversified firm such as General
Electric or 3M may be able to utilise its internal capital market to cross-subsidise
loss making in emerging areas that show promise.
 Variety of product designs. Fluidity of consumer preferences can create
opportunities for variety in design and these tendencies can be reinforced if there
is a need to get round patent protection of rivals. In some cases, new opportunities
may be perceived and exploited by employees of existing companies leaving to
form their own spin-off company (as the history of Silicon Valley and the electron-
ics industry shows). Rapid growth can open up new market niches and these
benign conditions can mean that a variety of formats may persist, especially if the
strongest rivals find it difficult to meet existing demand.
 Radical product and process innovation. R&D can be a major tool of
strategy here as firms search for ways to create sustainable sources of competi-
tive advantage. There may be parallel R&D activity in complementary
technologies, e.g. the emerging PC industry stimulated much R&D in peripheral
equipment such as printers and scanners.
 Major demands for new investment. Emerging industries may be able to take
little advantage of the current capital investment. Equipment will probably have
to be created from scratch, possibly plant also, and if the industry demands quite
new skills and techniques, then there may have to be corresponding investment
in human capital in the form of training and on-the-job experience. The call
centre industry is an example of an industry that has had to make significant
upfront investments.
 Product can be characterised by frequent bugs and defects. The novelty of
the tasks involved combined with strong pressure to meet rapidly expanding
demand can lead to a high rate of product failure. This is especially likely to be
the case with complex products as in the software industry.
 Capacity shortages, at least in the early phase. As we discussed above in the
case of critical point A, the supply side may be less flexible than the demand side
and this may lead to capacity shortages when the industry is rapidly growing
(though there may be a countervailing danger of capacity overshooting after
critical point A). If all stages in the industry (such as components, intermediate
products and final goods) face similar problems, this has implications for com-
petitive positions since it is a seller’s market at each stage; buyers may face real
difficulties in getting supplies of materials, components and raw materials, while
sellers find it relatively easy to find a buyer for their relatively scarce product. This

can have implications for strategy; for example, buyers may vertically integrate
backwards to secure supplies. We shall explore this further in Module 4.
 Ease of entry into this market. Fluid and rapidly growing markets, and the
relative lack of standardisation and brand advantage, can create opportunities for
entry.
 Few firms. At least in the early stages there may be only one or a few firms,
though ease of entry can change this position rapidly.
 Patchy or limited distribution. Distribution may be erratic or constrained; for
example, in the early days of cable television it was generally much easier to put
together the programmes than it was to deliver them to a geographically frag-
mented and heterogeneous market.
During the growth stage, the firm will have to make major choices that can affect its
future ability to compete in this market. Some actions, such as R&D strategy and
brand image, will influence the kind of market segment in which it may be able to
achieve competitive advantage. Other aspects of strategy, such as investment and
pricing decisions, may be oriented towards getting the firm into a strong position later
in the life cycle.
Maturity stage
 Increasing price elasticity of demand. Better-informed consumers, increased
competition and moves towards standardisation can all increase the price elastici-
ty of demand, put pressure on margins and increase sensitivity to costs.
 Falling price. Costs may fall for a variety of reasons, such as economies of
scale, experience curve effects, process improvements and competitive pressures
squeezing inefficiencies out of the system. When this is combined with increas-
ing competitive pressure on margins, prices may fall. The PC industry is a good
example.
 Brand advertising important. Many of the positions and players are well
established, consumers are now well informed about the industry and the play-
ers, so advertising is oriented to defending and improving on established market
bases. If firms are still influenced by the high growth rates that were possible
during the growth phase, brand advertising can be expensive and fierce.
 Profitability begins to decline. The later stages of the growth phase may have
seen firms moving into profitability, but now market entry and increasing stand-
ardisation both put pressure on margins.
 Increased standardisation. Erosion of patent protection, increasing infor-
mation about what constitutes the ‘best’ design, and tightening competition
pushing out inferior designs can all contribute to a convergence on an industry
standard. This tendency will be reinforced if there are network effects in which
there are advantages in having a single technical specification (such as in key-
boards, in which the QWERTY format won out).

Exhibit 1.1: Organic growth

The early stages of product life cycles are often characterised by high costs, prices and
risks. Each of these aspects is illustrated in the emergent organic foods industry. For
example, switching costs for farmers moving into organics can include a two-year
conversion involving changing to natural pesticides and fertilisers, and crop rotation.
Organic farming does not achieve the economies of scale and productivity levels
associated with traditional intensive farming. However, in some of the early years,
organic farming was achieving annual growth rates of up to 40 per cent in the UK.
Demand-side pressures, plus the higher risks and costs associated with organic farm-
ing, have been reflected in 25–30 per cent premiums for producers and higher prices in
the shops for organic produce. Even this price signal was not sufficient to match
domestic production to demand, with the UK importing most of its organic consump-
tion – a large proportion of the imports being produce suited to the British climate.
It is expected that much of the price differential between organic and conventional
farming will narrow naturally as crop rotation leads to a rise in soil fertility, and
economies of scale begin to be exploited by organics. But one issue that many feel could
constrain the growth of organic farming in the UK is early pressure from supermarkets
to hold down the retail price of organic produce. If this feeds back up the food value
chain in the form of pressure on wholesale prices of organics, it could deter many
farmers from switching to organics by increasing perceived risks and reducing expected
returns.
If UK supermarkets were to push the prices of organic products down towards

the level of conventional goods, what effect do you think this would have on this
industry?
 Mostly incremental innovations, emphasis on process innovation. The

moves towards standardisation tend to have knock-on implications for the type
of R&D activity that firms conduct. A radical product innovation might really
differentiate a product from the clones at this stage, but this may be seen by
firms as too costly or risky when compared to the cost, price and brand ad-
vantages of established designs. This is especially likely to be the case for radical
innovations which would require substantial new investment and advertising
effort and could burden the firm with uncompetitively high operating costs more
normally associated with the early stages of the life cycle.
 Replacement investment emphasised. The slowdown in growth and innova-
tive activity means that investment moves away from innovation and towards
replacing the existing capital stock as it wears out.
 Improved quality and reliability of design. Learning, experience and stand-
ardisation translate into improvements in quality and reliability of components
and final products. Introduction of new variants may lead to reappearance of
bugs and defects in the early stages, e.g. new generations of software packages.
 Capacity may settle to match demand. The maturity stage is most likely to be
characterised by a balance between supply and demand, though there may still be
excess capacity if firms have failed to anticipate critical point B and have over-

shot, or if firms are investing to attempt to capture market share and cancelling
out each other’s efforts.
 Entry becomes more difficult and less attractive. It can now be difficult for
potential entrants to match incumbents’ advantages of low-cost operation and
brand loyalty which the latter may have been able to build up over several years
of experience and marketing efforts. Increased focus on brand advertising can
also help erect and reinforce barriers to entry.
 Many firms. The market can now be quite crowded with a number of opera-
tors, unless economies of scale or other factors limit the number of firms that
can operate in this industry. The tightening competitive pressure may be reflect-
ed in the exit of some firms.
 Well-established distribution channels. The maturity of the market is
reflected in the establishment of routine and orderly channels for distribution of
the product or service.
In short, at this stage many of the major actors are in place and well established, as
are the sources of competitive advantage for many of the products in this industry.
Maturity can be characterised by incremental changes, though the tightening
competitive environment can still lead to some exits. There is increasing cost
sensitivity.
Decline stage
In many respects the decline stage reflects an intensification of pressures and
influences which were beginning to make themselves felt in the growth stage.
Decline is usually triggered by an external event outside the firms’ direct control
such as technological substitution (e.g. fibre optics for copper) or changing demand
patterns and government regulation (e.g. tobacco). This lack of direct control over
the causes of decline can create difficulties for the firm that wishes to manage and
anticipate events during this period. However, it can be a mistake to think that
decline here is necessarily marked by the progressive weakening and eventual death
that tends to be the fate of biological life cycles. For example, if the source of
decline is an innovation, it may be only a partial substitute (e.g. plastics for steel in
building products, DVDs instead of going to the cinema, disposable and electric
razors for traditional safety razors in shaving). In each case the new technology
effectively replaces the old in parts of areas served by the established technology,
leaving niches or segments in which the old technology still dominates.
With these qualifications, the main features of the decline stage tend to be the
following:
 High price elasticity of demand.
 Price continues to fall.
 Lack of both differentiation and growth creates little role or room for
advertising.
 Low or negative profits.
 Further standardisation. Some firms, though, may differentiate in an attempt
to stem the decline.
 Little innovation.
 Little investment. Instead there may be disinvestment and asset sales.
 Well-established design, few bugs.

 Overcapacity. The capacity overhang inherited from the growth phase may be
difficult to shift. The firms collectively may perceive it as in their interests to
remove excess capacity, but individually may be reluctant to do so, since the
gains from one firm unilaterally cutting capacity would mostly accrue as external
benefits to its rivals. At the same time, the capacity cutter itself could suffer a
loss of market share. Governments may intervene to try to clear this log jam, as
in the case of the European Commission, which has actively encouraged ration-
alisation and merger activity in the European chemicals industry.
 Entry unattractive.
 Fewer firms. However, exit may be slowed because there are high levels of
fixed and sunk costs that will not be recouped. Managerial specialisation and
inertia may contribute to this stickiness; for example, managers who have spent
their working lives in the steel industry may have emotional ties to the industry
and also highly specialised skills which may not be easily transferable to other
industries. Such managers would be likely to resist considering exit strategies as
far as possible.
 Distribution and access to distribution increasingly important for firms.
Overcapacity can make this a buyers’ market at all stages, with sellers discounting
and possibly vertically integrating forward to secure access to markets, and buy-
ers being able to play sellers off one against the other.
The decline phase can be marked by relative inertia in terms of technology, advertis-
ing strategy and customer base. If firms do not take action to get rid of overcapacity,
the industry will become still more unattractive, even for existing firms. Decline is
typically marked by low and declining returns. Many commodity markets such as
primary metals have entered the decline stage as substitution by new materials robs
them of many of their traditional markets and cuts off access to new markets.
Exhibit 1.2: Breathing new life into old sectors
It may seem self-evident that entrepreneurial opportunities are concentrated in high-
growth emerging markets. But it is also possible to enjoy spectacular success in mature
or even declining sectors with the right strategy.
Starbucks and Swatch are good examples of this latter possibility. Buying coffee was
perceived as a commodity-type activity until Starbucks turned it into a lifestyle purchase
with a quality and varied product set in the context of a coffee bar ambience. Starbucks
was able to enjoy high price premiums and profit margins compared to its industry
average.
Similarly, Swatch transformed the image of the budget watch as a functional device
into a fashion accessory. Before Swatch, industry efforts at this end of the market had
focused on performance improvements, e.g. in accuracy. Many people owned only one
watch, reflecting its status as a simple time-keeping device. Swatch emphasised fashion
and encouraged repeat purchases by consumers.
Both cases indicate how changing the perceived attributes of the product may trans-
form an industry and provide major opportunities for firms.
Compare the pricing decision for organic food (Exhibit 1.1) with that for a
Swatch.

Porter (1980, pp. 267–73) suggested that there may be a variety of strategies that
a firm in the decline stage can pursue.
(a) Dominance and leadership. One way the firm may try to make the best of decline is
to try to achieve a dominant position in the marketplace. In particular, a high
market share can give a cost advantage and may allow the firm to exercise some
control over price. Its ability to achieve dominance may be aided to the extent its
rivals are weakened by the process of decline and/or no longer have a strong
commitment to the industry and may be encouraged to exit. On the other hand,
if other firms are also trying to achieve dominance it can lead to costly and de-
structive competition; for example, it can trigger price wars. Dominance may be
facilitated if the firm can make a credible commitment to staying in this industry, e.g.
by upgrading plant, aggressive pricing strategies. The advantage of credible
commitments is that they may change the expectations and plans of rivals and
reduce the perceived attractiveness to them of staying in this industry. We shall
look further at credible commitments later in this module and in other modules.
Dominance can also be facilitated if the firm can assist in easy exit for its rivals,
for example, through acquiring others in the industry at terms that are reasonably
attractive to its rivals, offering to take over their brands and markets.
(b) Niche exploitation. This strategy identifies a niche that allows continuing high
returns and long-term opportunities for the firm. For example, the advent of
colour meant a declining position developed for black and white photography
generally, but a number of firms defended or created positions in film, books
and cameras dedicated to black and white photography for high-value artistic
and scientific work. Similarly, the Swiss watch industry maintained a strong pres-
ence in the luxury mechanical watch market after most other segments in the
watch market were saturated by electronic watches produced in the US and Asia.
A niche position can also facilitate necessary rationalisation because much or
most of the benefits of getting rid of excess capacity will accrue to the firm itself
rather than competitors.
(c) Harvest. A harvest strategy maximises short-term cash flow through devices such
as limiting variety of models or brands, concentrating on larger customers and
cutting investment, maintenance and service costs. It is not a strategy that is
indefinitely sustainable and eventually harvest turns into divestment or closure. It
is not a strategy that is suitable for all industries and it depends on the firm living
off the fat created in the past, such as goodwill, brand loyalty and customer iner-
tia.
(d) Exit. It may simply cut its losses and exit. The best time to do this is before
decline sets in; if it can anticipate turning point C (for example, by being sensi-
tive to early threats from an emerging technological substitute), then the firm
may still realise a good price for its assets. Once decline sets in, the decision to
sell should depend not on whether it is still making profits, but on whether or
not the gains from staying in the industry exceed the opportunity cost (sacrificed
value) were it to switch its attention and resources elsewhere.
(e) Internalise the threat. The firm may also have the option of internalising the source of
industry decline, i.e. bringing it in-house and treating it as an opportunity and not
merely a threat. This is not a strategy identified by Porter in the context of man-

aging decline, but it is an option that may be open to firms in some industries. It
was noted above that industries typically do not spontaneously implode; instead
decline is usually triggered by some external threat such as a technological inno-
vation (e.g. TV replacing cinema, plastics replacing steel).
If firms in the threatened industry are able to diversify into the new industry,
they may be able to make a transition from the old to the new cycle. Such diver-
sification internalises (and at least partly neutralises) the external threat to the
firm’s interests. This is what the Swiss watch industry did with the Swatch, a
fashion-oriented electronic watch aimed at the young people’s market and built
around the same technology that had wiped out many of the Swiss watch indus-
try’s traditional markets. Whether or not this is a feasible strategy depends on
whether firms in the threatened industry have residual strengths and competenc-
es that contribute to competitive advantage in the new regime, e.g. brand
recognition, reputation, distribution channels, technology. Since the external
threat itself often displays features that are radically different from those associ-
ated with the skills and competences in the old industry, firms may often
internalise the threat by acquiring new firms based in the emerging sector.
Which strategy the firm in a declining industry adopts in practice will be influ-
enced by the pattern of decline, the nature of its rivals, and its assessment of its
rivals’ likely reactions to its actions. We shall be looking at the issues and influences
that can encourage a firm to adopt a particular strategy in different contexts in the
next module.
The story of the life cycle is of firms’ discretion and freedom to manoeuvre being
subjected to a progressive squeeze over its course. When the product is about to be
introduced, the firm may be faced with almost a blank sheet of paper for many of
the strategic choices it faces. There may be considerable scope to decide the pricing
policy, design, image and market of the product. However, with time, rivals enter,
pressure is put on prices, variety is squeezed as one or a few designs win out, brand
image is established and difficult to change, and possible market niches become
filled up. These developments can all influence strategy and the ability of the firm to
exercise control over the environment around it.
Exhibit 1.3: Five Forces and niche markets

The Five Forces help provide a basis for analysing sectors in terms of forces that might
influence the returns that a firm might expect from investing in that sector. However,
the Five Forces are not necessarily static but can be influenced by technological trends
in a sector.
An example of this is given by recent trends in some sectors of manufacturing. In-
creased complexity of technology means that many larger companies find difficulty in
developing in-house the range and quality of competences associated with their core
technology. This may help create market room and opportunities for smaller, specialist
firms.
For example, Tokyo-based Disco Corporation claimed up to an 80 per cent world
market share and up to a 90 per cent Japanese market share in some years for high-
precision equipment for cutting and grinding silicon wafers into semiconductors. Disco’s
systems are used by most of the world’s semiconductor manufacturers. This is a highly

complex and skilled area, with high barriers to entry, few other firms having the
requisite skills and interest. Although Disco has had several rivals, rivalry and buyer
power have been muted due to Disco’s dominance and the lack of interest on the part
of bigger firms in moving into this area.
The case of Disco demonstrates how technological change may influence and change
the Five Forces in a sector by creating sustainable and defensible niche markets.
Summarise Disco’s competitive environment from a Five Forces perspective.
1.3 The Five Forces Framework

The life-cycle framework helps illuminate some features of the firm’s environment
which may be helpful in analysing the context in which strategy may be grounded. It
looks at patterns that may emerge during the development of the industry and the
long-run dynamics of this evolutionary process. However, in developing and
modifying its strategy the firm will also have to be sensitive to the specific features
and characteristics that make up its industrial environment at any point in time. The
Five Forces Framework provides a route that can help in such strategy formulation.
The Five Forces Framework was first set out in detail by Porter (1980). The logic
of the framework is based on the argument that there are five basic competitive
forces that together determine the profit potential of an industry. Where the forces
are intense, firms may have little opportunity (or wiggle room for strategy) to
achieve above-average returns in this industry. Where they are weak or absent,
above-average returns may be more easily achievable in an industry. ‘Industry’ in the
Five Forces Framework is taken to refer to a group of firms producing products
that are close substitutes for each other.
Before we look at the Five Forces Framework, to understand its significance
properly it is important to look at where it came from, and the nature of the
foundation it created for subsequent work in competitive strategy. Until Porter’s
work, Business Policy or Strategic Management was really a poorly structured and
loosely organised discipline. It was characterised by ad hoc use of tools designed to
deal with aspects of the strategic problem, and extensive use of checklists and case
studies. Indeed, this approach is still reflected in parts of the discipline today.
The lack of a coherent and integrated analytical framework led to a considerable
amount of woolly analysis and advice that was often contradictory or little better
than a truism. For example, as we note in Module 7, many of the checklists pro-
duced that purported to explain the reasons for firms’ pursuing merger, joint
venture or alliances looked remarkably similar and indeed were often effectively
interchangeable. But since the reasons given for pursuing these alternatives were
supposedly identical, this gave no basis for distinguishing the circumstances in
which the firm should choose to pursue, say, joint venture instead of merger.
At the same time, industrial economists had been collecting an enormous amount
of empirical evidence and material on which factors actually did affect competitive
strategy, which Porter’s Competitive Strategy was able to draw on. A prime purpose of
this collection of evidence was to provide input into decision making, but it was not

decision making for strategists to exploit competitive advantage, rather it was

decision making for public policy purposes to control potentially anti-competitive
behaviour on the part of firms.
What Porter recognised was that the forces that could eventually facilitate unde-
sirable anti-competitive behaviour on the part of firms, were in many cases the same
forces that could contribute to legitimate and value-enhancing competitive strate-
gies. Further, industrial economics had effectively provided an extensive databank
on where to find these forces, what they were, and their impact. Traditional eco-
nomics was based on the ideal of competitive markets and tended to regard
anything that disrupted the competitive fabric as a potential monopoly distortion
and intrinsically undesirable. Porter recognised that these same elements were the
basis on which successful firms competed and added value in the marketplace. The
result was that Porter was able to draw on the well-established analytical framework
provided by industrial economics,1 as well as the body of empirical evidence that
applied industrial economics provided.
The Framework was an immediate success and it has become widely used by
strategists and other managers involved in the planning process. It is important to
bear in mind that its basic structure and content reflect the forces that a considera-
ble volume of research has shown to be important in the analysis of competitive
strategies. There are some points that are important in using the Framework.
 In a sense the Framework is the visible tip of an iceberg with the empirical
research that backs up the Framework lying below the surface. Since industries
are continually evolving and new research results emerging, the Framework
should not be regarded as static but as something that is subject to continuous
modification and updating.
 Since the Framework signposts the lessons from a large variety of research
studies, it does not necessarily lead to clear and unambiguous conclusions. Most
practical research is based on a few simple and easily measured variables, while
the Framework tries to integrate all the major influences of relevance, some of
which may be qualitative and subjective. If some elements in the Five Forces
encourage one type of strategic option while others are consistent with an alter-
native, judgement has to be used to assess the overall balance of forces in the
framework. Two different analysts faced with the same body of knowledge about
an industry may come to different conclusions about the strength and nature of
the competitive forces in the industry.
 Even if it is possible to identify clearly the nature of an industry in Five Forces
terms, there may still be a variety of competitive strategies open to the firm that
wishes to operate in this sector. The Five Forces Framework is more about pos-
sible constraints on strategy, less about the particular directions that strategy can
take.
1 The framework was generally known as the structure–conduct–performance approach. Its theoretical
foundations were rooted in the traditional models of perfect competition, monopoly and oligopoly
market structures, with structure influencing conduct (such as pricing policy and advertising and R&D
activity) and with consequences for performance (such as profitability).

The Five Forces:

1. Threat of new entrants
2. Intensity of rivalry among existing competitors
3. Bargaining power of buyers
4. Bargaining power of suppliers
5. Pressure from substitute products.
A firm’s industry would be an unattractive environment characterised by low or
negative returns given the following conditions.
 New firms are about to enter the firms market.
 There is intense competition from rivals in the same industry.
 The firm faces a powerful set of buyers.
 It also faces a powerful set of suppliers.
 An external threat is about to send the industry into long-term decline.
In practice, few if any industries face such dire prospects. For one thing, the
gloomy prospects signalled by Forces 2–5 would probably be enough to dampen or
eliminate the threat of entry (Force 1).
By contrast, an industry would be an attractive environment for a firm if the
following conditions prevailed.
 There is little danger of entry.
 Competition from rivals is weak or non-existent.
 The firm’s buyers are dispersed and weakly organised.
 The firm’s suppliers are also dispersed and weakly organised.
 There is no serious threat to the industry.
The firm that is lucky or competent enough to be established in such a benign
environment can expect to make above-average returns. Firms whose industries at
least approximated such a rare combination of favourable circumstances probably
included IBM in the seventies and Microsoft in the nineties. Such conditions also
help to create and reinforce dominance, which in turn can invite accusations of real
or imagined abuses by the firm of its competitive advantage (hence the anti-trust
investigations of IBM in the late-seventies and Microsoft in the late-nineties).
In practice, industries are usually characterised by more complex combinations of
Forces. We shall look at the important elements that can influence each of the
Forces in turn.
1.3.1 Force One: Threat of Entry
There are a number of elements that can influence threat of entry.
(1) Economies of scale
These refer to declines in unit costs as the absolute volume of output increases in a
given time period. There are two elements to economies of scale, the cost gradient
and the minimum efficient scale (MES). The MES is the point at which the firm
achieves the lowest average cost (AC) of operation in the long run. Cost gradients
refer to the steepness of the slope of the AC curve below the MES level. For

example, if average cost per unit is 30 per cent higher at an output level that is half
of MES, there is a steep cost gradient. On the other hand, if average cost per unit is
only 1 per cent higher at an output level that is half of MES, there is a relatively flat
cost gradient. Figure 1.2 shows average cost curves with different levels of MES and
cost gradients.
Low MES, low Low MES, high

cost gradient cost gradient
Demand Demand
$
$
AC1 AC2
0 MES 0 MES
Output Output
High MES, low High MES, high

Demand cost gradient cost gradient
Demand
$ $
AC3 AC4
0 MES 0 MES
Output Output
Figure 1.2 Minimum Efficient Scale (MES) and the cost gradient in econo-
mies of scale
If an industry is characterised by a high MES and a steep cost gradient, economies
of scale may represent a strong barrier to entry. Interestingly, there appears to be little
obvious relationship between them: industries that report high MES may or may not
report steep cost gradients, while industries with steep cost gradients may or may not
have a high MES. Either feature of itself may not be sufficient to constitute an
effective barrier to entry; for example, brick manufacturing has a very steep cost
gradient but a very low MES, which allows room for a large number of firms in this
industry. Similarly, a high MES may still leave room for a number of firms in an
industry if a flat cost gradient means that smaller-scale firms do not face a serious cost
disadvantage (especially if the cost disadvantage can be more than compensated for by
smaller firms exploiting differentiation or niche opportunities).
In Figure 1.2, the low MES for AC1 and AC2 means that there is room for a
number of firms in this industry all exploiting MES. Whether or not a steep cost
gradient exists as in AC2 would only really matter for these smaller firms trying to
exist on the fringes of the market (perhaps geographically separated from the rest)
or those exploiting a market niche.

Cases where MES is only reached where a firm has a high or dominant market
share (AC3 and AC4 in Figure 1.2) may be associated with strong barriers to entry,
especially if the product is relatively standardised and costs and prices are important
elements of competition, as may be the case in the later stages of the life cycle. To
the extent the product is differentiated and market niches can be exploited, there
may be room for a number of firms, with one or a few firms vying for cost leader-
ship. The flatter the cost gradient (as in AC3 in Figure 1.2) the easier it may be for
smaller firms to develop competitive strategies that may compensate for their cost
disadvantage relative to larger firms in their industry.
The case of AC4 in Figure 1.2 is the one that is most likely to lead to dominance
by one or a few firms in this industry. Indeed, this structure is the one commonly
described as a natural monopoly by economists. One firm may be able to get a first-
mover advantage on its rivals (and potential rivals) by expanding output rapidly and
moving down the steep cost gradient of AC4. In doing so it may be able to exploit a
virtuous circle of cutting costs, enabling prices to be cut further, stimulating demand
and increasing output, which in turn leads to further cuts in costs. This process may
continue right down the AC curve with the firm establishing a dominant low-
cost/low-price position which its lower-output/higher-cost competitors cannot
emulate.
In practice, it is not difficult to find examples of natural monopolies, and as their
names suggest, they often invite intervention by governments to ensure that one
dominant firm does not fully monopolise the industry. They are industries that were
often nationalised by governments (e.g. railways and telecommunications). Airbus
Industrie was a consortium created by European governments because of concerns
that Boeing could finish up as effectively the monopoly operator in the world
market for civil aircraft. The global airline industry would almost certainly be
dominated by one or a few firms if national governments did not impose re-
strictions on competition, mergers and acquisitions in this sector.
At the same time, in recent years it has been increasingly recognised that it may
be possible for an industry to be a natural monopoly and have a number of opera-
tors in it. This may be achieved if the ownership of the physical infrastructure can
be separated out from the ownership of the operating companies that use this
infrastructure, much as the ownership of roads is generally separated from the
ownership of the truckers and other companies that use this structure. This is a
device that the UK and some other governments have used in cases as diverse as
electricity supply, telecommunications and the railways in recent years. However,
this may still involve the need for government intervention and may incur signifi-
cant administrative costs of regulation.
(2) Economies of scope

Economies of scope (also called synergies) can also influence threat of entry. We shall
see that they may contribute to competitive advantage, though in the present
context we are really concerned with their potential role as a source of barriers to
entry. Economies of scope may obtain if the combined costs of two goods are less
than the costs of separate and independent production and distribution of these two

goods. For example, the disposable pen manufacturer BIC is involved in distinctive
markets for pens, razors and lighters. However, it is able to share skills and other
resources in R&D, production, marketing and distribution throughout its varied
product lines because of similarities in making and selling low-priced disposable
products. Sharing skills and resources across product lines means that BIC’s overall
investment and operating costs are less than would have been the case if its three
main product lines were developed, manufactured and sold independently of each
other.
Exhibit 1.4: BIC and economies of scope

A traditional view of economies of scale and scope in economics is that higher levels of
output enable the firm to introduce capital-intensive techniques and mass production
methods that help to push costs down.
However, firms may be able to access sources of economies of scope in addition to
those associated with production resources. Intangible resources such as shared
competences may also generate cost savings across product markets. For example, BIC
produces disposable pens, disposable razors and disposable lighters. The markets for
these products are quite different and BIC faces a different set of competitors in each
market, e.g. Swedish Match in the lighter market and Gillette in the razor market.
Despite these differences, there are strong similarities in the nature of the technolo-
gies and marketing skills involved in each product market. Each of these product
markets utilises technological skills in making light, cheap, disposable plastic and metal
products. They tend to be marketed in highly fragmented retail outlets often around
impulse buying and point-of-sale marketing. These technological and marketing compe-
tences are at least partially shareable across BIC’s varied product lines and have enabled
it to move into new areas that draw on these characteristics, and exploit investment
and operational economies of scope or ‘synergies’.
How might BIC’s diversification into razors help reduce the threat of firms
entering its pen market?
The important thing to note about economies of scope is that their sources and
effects are the same as economies of scale. There are two main sources for both
economies of scale and scope. First, increased output can lead to fuller exploitation
of indivisible resources, such as a single plant, a piece of machinery, or a patent. The
more that this resource can be spread over higher levels of output, the lower the
cost per unit associated with this resource. Second, increased output can also
provide opportunities for increasing specialisation and division of labour. For
example, in a small firm with low levels of output, the same manager may have to be
in charge of marketing and market research, tasks that may require quite different
skills. As the output level increases, adding a second manager to the marketing
department may boost productivity because the two managers can be selected and
allocated roles according to their natural abilities, and do not have to incur switch-
over and co-ordination costs that a broad range of responsibilities may entail.
The difference between economies of scale and scope is essentially that the gain
from sharing resources over increased output levels in economies of scale is reflected

in a move along a declining long-run average cost curve, while the gain from sharing
resources over increased output levels in economies of scope is reflected in a shift
down in the average cost curve for each of the products that is involved in resource
sharing. This is shown in Figure 1.3.
Economies of scale
reflected in fall in the
long-run AC curve
Economies of scope
$ reflected in shift down
in long-run AC curve
AC4
AC5
0
Output
Figure 1.3 The difference between economies of scale and scope

For example, BIC may be able to exploit lower costs in the form of economies of
scale by increasing output levels for a single product, say, disposable pens. However,
it should also be able to exploit lower costs in the form of economies of scope for any
given output level of disposable pens to the extent it is able to share costs (such as
plastics R&D, production know-how, company advertising) across product lines.
The effect of such sharing will be to shift average costs down for each business. Any
competitor wishing to enter the disposable pen market will have to deal with the
ability of incumbent firms such as BIC to exploit cost advantages in the form of
economies of scope as well as economies of scale. Consequently, economies of
scope may represent a barrier to entry into a market, just like economies of scale.
(3) The experience curve

The experience curve differs from economies of scale and scope in that cost per
unit falls in relation to the accumulated output of a good or service, not in relation to
the level of output in a given period, as in the case of economies of scale and scope.
The experience curve is more likely to constitute a barrier to entry for industries
characterised by complex high-technology products made in relatively small
numbers with a fair degree of standardisation, such as some sectors of aerospace.
The greater the output, the greater the opportunities for productivity improvements
due to repetition and learning. Management may develop improvements and short

cuts in the organisation of production, and workers may improve their skills and
speed of work completion with practice and repetition.
Exhibit 1.5: The more you sell, the more you lose
One of the basic principles of economic theory is that profitability tends to be directly
related to volume and market share in many markets. Volume may lead to reduced
costs, while market share can give firms more control over prices.
These principles can seem rather shaky at times in the world of Internet retailing. In
its early days as an Internet retailer, Amazon was focused on selling books and, in some
years, its losses increased faster than its revenues. It seemed the more it sold the more
it lost.
Internet retailing can help economise on some traditional retailing costs (such as
investment and operational costs of retail outlets) and it can get sales, technical and
related information to a larger number of potential customers. But, in common with
many other Internet retailers, Amazon found that a fundamental problem is that
Internet retailing may substitute traditional costs with other costs, especially in ware-
housing, marketing (such as Superbowl advertising) and distribution (doorstep delivery).
If the product is a traditional one, such as a book or a toy, it may be questioned as to
whether the price that consumers will be prepared to pay will be sufficient to generate
profits as well as revenues for Internet sales.
Does the case of Amazon really breach ‘the principles of economics’?
Cost per unit falls as

accumulated output
and experience increases
Cost
per unit
0
Accumulated output
Figure 1.4 The experience curve
(4) Differentiation
If a firm can successfully differentiate its products from those of competitors (for
example through brand image), then this may constitute a real barrier to entry. This

can hold most strongly in areas where consumer health, safety and welfare may be
considerations. The important element here is the extent to which potential entrants
perceive that the incumbent is able to defend a differentiated position successfully.
The inroads made by own-brand supermarket labels into many consumer goods
markets in recent years have shown that differentiation may be a more shaky barrier
to entry in some contexts than was previously thought to be the case.
(5) Risky and costly capital requirement for entry

Entry into an industry may involve substantial upfront investment in tangible assets
(such as plant and equipment) and intangibles (such as R&D and advertising). This
can constitute a strong barrier to entry, especially if it is combined with a high risk
element. One way that firms may try to reduce risks and quickly acquire relevant
experience and competences in an industry is by acquiring an established firm
already operating in the industry. Any difficulties encountered by potential entrants
in finding a suitable acquisition target will merely serve to reinforce barriers to entry.
(6) Switching costs

Firms may be able to create real or perceived switching costs on the part of buyers
as far as transferring their custom to another firm is concerned. Not only can this
create advantage for the firm compared to rivals, it can collectively help create
barriers to entry on the part of potential entrants, who may find it difficult to prise
away customers from the incumbents. Examples of strategies that may help create
switching costs are supermarket loyalty cards, air miles, and various services offered
by banks to continuing customers such as standing orders and direct debits. The
more costly and troublesome customers perceive it to be to extricate themselves
from the existing arrangement with the supplier of the service, the more it may
constitute a barrier to entry.
(7) Access to supplies and outlets

Difficulties in access to earlier and later stages in an industry may be a barrier to
entry. For example, any firm seeking to enter the refining stage of the oil industry
will find that much of the supplies of crude oil are locked up inside the corporate
walls of the vertically integrated majors in this industry, as are many of the distribu-
tion channels for the refined product. This can leave relatively thin channels of
access to supplies and outlets for a potential entrant and may deter firms from
putting themselves into such potentially vulnerable positions.
(8) Other cost advantages

There may be particular cost advantages for a firm or firms in an industry relative to
potential entrants, such as a particular low-cost process (possibly patented or kept
secret), special access to or control of supplies (such as De Beers in diamonds),
cheap local resources, government subsidy etc. Whether or not such cost advantages
for incumbents represent effective barriers to entry depends on the importance of
the cost advantage, the extent to which entrants can compensate for the incum-

bent’s advantage, and the possibility of entrants competing on the basis of differen-
tiation rather than cost (whether across the board or in particular niches).
(9) Government policy

Government policy can create barriers to entry, especially in cases involving the
licensing of operators or the regulated industries. The airline industry is one in
which government policy in many countries has made entry difficult in the past, in
part because of the necessity to impose essential safety and competence levels, but
often also because of desires to favour national carriers and ‘fly the flag’.
(10) Exit barriers

An issue that has become important in recent years is the notion of exit barriers also
representing entry barriers. One way of expressing this is to note that an intelligent
lobster would always avoid getting into a lobster pot; the barriers to exit would
constitute a barrier or deterrent to entry. Similarly, rule one for hostage negotiations
is for the negotiator never to get into a situation where there is no escape route for
them, lest they themselves become a hostage. Parallel reasoning can hold for firms.
If an industry requires considerable investment that turns out to have little or no
value outside the industry, firms should at least be wary of committing themselves
and becoming trapped in a situation from which they may not be able to extricate
themselves easily or cheaply.
(11) Expected retaliation

If you are thinking of invading a territory, your decision whether to go in or stay out
is likely to be influenced by whether or not you think the incumbents are likely to
try to repel you, what form this resistance may take, and how effective it is likely to
be. This in turn depends on the factors that either do or could influence rivalry in
the industry. We shall look at this issue under Force Two below. It should be borne
in mind that while intense rivalry can make an industry a nasty and unpleasant place
to compete in, it may have the mitigating advantage that it can deter outside firms
from entering the arena.
1.3.2 Force Two: Rivalry

Rivalry may express itself in a number of dimensions in an industry: (1) its objec-
tives (e.g. profitability, market share, growth); (2) its channels (e.g. price
competition, competition through advertising and innovation); (3) its strength (e.g.
weak or strong, consistent or fluctuating). Whether rivalry in an industry exists and
is strong (and what form it takes) may depend on a number of factors, including the
following:
(1) Relatively high fixed costs

Capital-intensive industries in particular tend to be characterised by relatively high
fixed costs. It would cost a great deal for an aircraft to fly just one passenger or for
an oil rig to produce just a single barrel of oil. By contrast, the additional (marginal)
costs of adding a second passenger on a flight or producing a second barrel of oil

from an oil rig can be extremely low or even negligible. This has important implica-
tions for the threat of rivalrous behaviour because it means that the price may sink
to very low levels before firms shut down operations or exit the industry. Remem-
ber from basic economics that as long as the additional revenues per unit sold
exceed the additional costs (marginal costs) of producing that unit, the firm would
maximise profits (or minimise losses) by continuing production. Intensity of rivalry
can be heightened if the low marginal cost encourages firms to try to operate at (or
near) full capacity.
The oil industry has illustrated some of these features. Production levels tend to
be relatively sticky when the price falls (the short-run supply curve was relatively
inelastic). The high level of fixed costs associated with investment in some areas
such as the North Sea meant that the price can fall quite drastically before many
operators reach the shutdown point where price fails to cover the additional
(variable) costs of extracting oil.
(2) Low growth

A slowly growing industry is often more likely to be characterised by intense rivalry
than is a fast growing industry. Suppose firms in an industry typically have a growth
objective of 5 per cent a year and industry growth recently has been 7 per cent a
year. This means that many of these firms will be able to satisfy their growth
objective from the natural growth of the industry and without taking market share
from each other. Now suppose growth falls to 3 per cent a year. The only way that
the average firm in the industry may be able to achieve its growth objective will be
by taking market share from its rivals. This can lead to intensification of competition
as firms indulge in the zero sum game of trying to maintain their own growth levels
by taking market share from each other. Clearly it would be more sensible for the
firms in the industry to adjust their growth objectives to reflect the new reality, but
this may be difficult to achieve quickly if managerial and shareholders’ expectations
are slow to adjust. This can lead to the problems that we discussed under critical
points A and B earlier.
(3) High exit barriers

If you want to heighten rivalry and increase the chances of a fight, make sure your
rival is cornered with no effective escape route. In the case of firms, this would
mean incumbents facing high exit barriers and having little or no choice but to stay
in the ring and slog it out with its rivals. This is the issue that we noted above could
be a particular problem during the ‘decline’ phase of the life cycle.
(4) Differentiation and switching costs weak

Rivalry may be heightened if there is little to stop the customer switching from one
product or service in the industry. This is the case in petroleum retailing, an industry
which has been characterised by fierce price wars in the past, as well as continuing
attempts by major firms such as Shell and Exxon to use advertising to create some
degree of differentiation in what is essentially a fairly homogeneous market.

(5) Absence of a dominant firm

A dominant firm may assist in helping create the competitive rules and parameters
around which other firms must adjust, softening rivalry in the process. This may be a
strongly positioned firm at the same stage as the other firms, or a user firm or
institution whose interests may lie in maintaining a balanced pool of suppliers. For
example, many governments have pursued strategies of encouraging rivalry for
specific military projects, at the same time trying to ensure that rivalry is not so
destructive that competent high-quality suppliers exit the industry and prospects of
maintaining a balanced pool of suppliers are damaged.
1.3.3 Force Three: Bargaining Power of Buyers

Much of traditional industrial economics was concerned with the relations between
buyers and sellers in individual markets and the circumstances which would give one
group the power to influence the terms and conditions under which the other side
had to trade. Major factors which could augment the bargaining power of buyers
include the following:
(1) One or a few major buyers

Some industries are characterised by one or a few major buyers and this can lead to
substantial power and discretion on the part of the buyers over the suppliers. For
example, the global car industry has only a few major players. Where components
are made and supplied on a local basis, there may only be one feasible customer for
a particular supplier.
(2) The buyer earns low profits

This may appear surprising. How can a firm or group of firms being in a position of
financial weakness (low profitability) help generate bargaining strength (buyer power)?
However, Porter points out that this is not only possible but logical. The important
point is how low profitability on the part of the buying group may affect the
perception of the selling firm of their own freedom to manoeuvre, especially if a
further increase in price to the buyers could tip them into closing down operations
altogether. At worst, the selling group of firms may have little or no choice but to
price low to the buying group of firms if it wants to make a sale at all. However, it is
important to note that it is neither necessary nor sufficient for the buying group
actually to be making low profits for this stratagem to work.
What the group has to do is signal (real or imagined) low profitability to the sell-
ing group. And that is why you should always wear rags when you visit the bazaar or
when the double glazing salesman comes to call.
(3) The product represents a large proportion of the buyer’s overall

purchases
The bigger the purchase, the more sensitive the buyer is likely to be to the price,
whether it is the final goods to the consumer market or intermediate goods and
components to other firms. This is quite natural and rational, partly because of the

effect of even minor price fluctuations of expensive goods on the buyer’s welfare,
but also because the buyer is more likely to be well informed about the prices of
expensive goods. Shopping around and making product comparisons absorbs
resources, especially time. It will usually only be worthwhile incurring these search
costs for expensive products. Consequently, the buyer may be more demanding and
informed for goods that constitute a large part of their overall purchases.
(4) Standardised, undifferentiated product with low switching costs

for buyers
In these circumstances the buyers can play one seller off against the other. This can
be a feature of commodity markets or mature industries, as we noted in the discus-
sion of the life cycle above.
(5) Buyers can threaten backward integration

Suppliers may find buyers may be in a powerful position if these buyers are able to
take over production of the product themselves. For example, component suppliers
to the big car firms in the automotive industry may find that their ability to exercise
control over terms and conditions may be limited by the possible threat of their
buyers vertically integrating backwards. Indeed, many of the new opportunities for
suppliers in this industry come from the big car firms outsourcing activities they
formerly undertook themselves, so the threat of being able to take back in-house
production of components if they wish may be a credible one. Car producers can
also keep some production of a particular component in-house to ease full in-house
manufacture of the component should it become necessary. In turn, this can
increase the buyer’s power by making full backwards integration of the component
an even more credible threat.
1.3.4 Force Four: Bargaining Power of Suppliers

On the other side of the buyer/seller divide, sellers or suppliers may be able to
exercise power over the buying group of firms. The reasons for this may include the
following:
(1) The supplying group has only one or a few firms

This may allow the firm (or group of firms) to exercise control over the prices and
conditions under which it (or they) will deliver services.
(2) There are no close substitutes for the supplier’s products

Microsoft has had substantial power in supplying to the PC industry, not only
because there is limited competition to it within the industry, but also because there
is limited competition from substitutes outside the PC sector.
(3) The product is an important input into the buyer’s business

Microsoft Windows and Intel chips have both been integral components of most
PCs, giving the respective firms considerable power and influence in this industry.

(4) The buyer industry is not an important customer

If the buyer industry is the sole or most important customer, supplier power may be
weakened due to its dependence on the fortunes of the industry. If an electricity
supplier sells to many customers, it may be able to afford to be insensitive to the
effects of its policies on an individual buying industry. If the electricity supplier is a
hydroelectric power station selling most of its output to an aluminium smelter, it
cannot afford to ignore the effects of its policies on this user.
(5) The supplier’s products are differentiated or there are switching

costs for buyers
The supplier’s power will be enhanced to the extent that it can lock in customers.
For example, customer loyalty or inertia is an area where banks have been able to
exercise some degree of seller power.
(6) The supplier can threaten forward vertical integration

As with the threat of backward integration by buyers, the supplier group will be
more able to threaten ‘take it or leave it’ if they have a realistic alternative of moving
downstream into the buyer’s stage themselves.
Exhibit 1.6: Internet procurement and the supply chain

The introduction of online exchanges on the Internet offers the chance to introduce
stronger competitive forces into areas of corporate purchasing through electronic
‘procurement hubs’, ‘online exchanges’ or ‘trading communities’. The cheap and flexible
trading platform provided by the Internet allows geographically spread buyers and
suppliers to use dedicated websites to examine supplier catalogues, bid, or place orders.
This may reduce supplier power, particularly for local suppliers in high-cost countries,
by increasing the number and range of potential suppliers of a good or service.
This holds especially for products and services that can be commoditised and re-
duced to a set of specifications that can be transmitted via the Internet. This can include
non-production goods such as office stationery and some kinds of furniture, and
production goods such as nuts, bolts and clips. Some analysts believe that the resulting
price pressure in some supplier segments will lead to consolidation by suppliers due to
bankruptcy, exit, and search for economies of scale. This might lead to suppliers
regaining some of the power that they are in danger of losing with the introduction of
Internet procurement.
The exhibit discusses how online exchanges may reduce supplier power of high-
cost local suppliers in cases where they widen the pool of potential suppliers.
From the information given, can we say anything about how the other Five
Forces may change in such circumstances?
1.3.5 Force Five: Pressure from Substitute Products

The last of the Five Forces is pressure from substitute products. These depend on
the substitute being able to perform similar functions to the industry in question,
and its price/performance characteristics compared to that industry. In some cases,

there may be few if any close substitutes for the industry in question; in others there
may be a number of competing substitutes (e.g. the various fuel industries). In some
cases the substitute industry may involve quite different activities, technologies and
marketing channels from the traditional industry (e.g. videoconferencing as a partial
substitute for executive travel, Internet retailing for high-street retailing).
1.4 Game Theory Perspectives

Game theory has been hailed as a revolution in the analysis of competitive strate-
gies. In reality, it has in some quarters been one of the most oversold techniques in
the history of this subject, itself no stranger to overselling.
Having said that, it has produced important insights which can be of real value in
the analysis of competitive strategies. The important thing is to sort out what is
potentially valuable from what is patent nonsense. We shall start out by using one of
the most celebrated models in game theory to explore these points.
1.4.1 The Prisoners’ Dilemma

The Prisoners’ Dilemma has been used to analyse competitive strategies in a variety
of contexts. First, let us look at it in its original context as shown in Figure 1.5.
Joe and Pat have just committed a bank robbery and have been pulled in by the
police who suspect that they did the job, but do not have sufficient proof. They are
put in separate cells and not allowed to communicate with each other. The expected
outcomes of different combinations of confess/don’t confess are shown in Figure
1.5. If both confess they get ten years’ jail each. If one turns State’s evidence, turns
his partner in, confesses while his partner does not, he is freed but his partner gets
15 years. If neither confesses, all they can be done for is a stolen getaway car and
they get one year each. They are being quizzed by the police separately and have to
decide how to plead before they know the other’s decision.
JOE
Confess Don’t confess
PAT
Fifteen years
Confess Ten years each for Joe, Pat
freed
Fifteen years
Don’t confess for Pat, Joe One year
freed each
Figure 1.5 The Prisoners’ Dilemma

What should our two reprobates do? We can analyse what each can do, given the
other’s possible choices. Suppose Pat works out what he should do if Joe confesses. If
Pat was also to confess in such circumstances, he would get ten years, like Joe. But if
he didn’t confess he would get fifteen years. Clearly in such circumstances Pat
would be better off confessing. Now suppose Joe did not confess, what should Pat
do? If he did not confess in such circumstances he would get one year in jail. But if
he did confess he would go free. So if Joe refused to confess, Pat would be better
off confessing.
In short, Pat would be better off confessing, whatever Joe decides to do. In game
theory terms, confessing is a dominant strategy for Pat: no matter what Joe does, Pat
will be better of confessing. What about Joe? Exactly the same logic holds because
he faces exactly the same set of choices and pay-offs as Pat; the matrix in Figure 1.5
is symmetrical. Confessing would be a dominant strategy for Joe as well. That being
the case, confess/confess (the top left box of outcomes in Figure 1.5) would be the
rational outcome.
The trouble is that, while rational, this is not the best outcome for the two if they
could somehow collude and make a binding agreement not to confess. In that case,
they would only get one year in jail each instead of the ten years they have now got
for themselves by confessing. But if there is no reason to trust the other person, and
no means of communicating, the logic of the Prisoners’ Dilemma is that considering
both the options in turn suggests that the rational thing for both prisoners to do
would still be to confess. This holds even with them knowing they would be better
off if they both kept their mouths shut.
What are the implications for competitive strategy? These are almost endless if
we are to believe some of the literature in this area. We can demonstrate how the
model may be translated into the strategy field with a simple advertising decision in
Figure 1.6.
JoeCo
Advertise Don’t advertise
PatCo
$15m loss for

Advertise $10m loss each JoeCo, PatCo
breaks even
$15m loss for

Don’t advertise PatCo, JoeCo Lose $1m
breaks even each
Figure 1.6 An advertising Prisoners’ Dilemma

In the above example, PatCo and JoeCo have 100 per cent of the market. They
are considering advertising to arrest market decline. If they both decide not to

advertise, they both expect to incur a loss of $1m this year. If they both decide to
advertise, they simply neutralise each other’s marketing efforts and keep the same
market share and sales. Problem is, advertising costs money, so if they both adver-
tise their losses shoot up to $10m a year each. If one advertises but the other does
not, the firm advertising will increase its market share at the expense of the non-
advertising firm. In this case, the advertising firm’s increase in sales is sufficient to
cover more than its advertising costs and return it to breakeven. But in this case the
firm that has not advertised suffers a major loss in market share and now makes a
loss of $15m.
What should the two firms do? The answer is straightforward. If you look at the
pay-offs in each case, the structure and pay-offs for PatCo and JoeCo are exactly the
same as for Pat and Joe in Figure 1.5, except that for every year of jail in Figure 1.5,
we have $1m loss in Figure 1.6. The results parallel the results for our original
Prisoners’ Dilemma; both PatCo and JoeCo have a dominant strategy, which is to
advertise. If JoeCo advertises, PatCo would be better off advertising than not
advertising ($10m loss compared to $15m loss). If JoeCo does not advertise, PatCo
would still be better off advertising (breaks even rather than incurring a $1m loss).
The same logic holds for JoeCo given PatCo’s options. And just as in the original
Prisoners’ Dilemma example, both PatCo and JoeCo finish taking heavy losses
($10m each) when they would both have been much better off had they made an
agreement to avoid expensive and wasteful advertising ($1m loss each in that case).
The basic structure of the Prisoners’ Dilemma has been associated with a wide
variety of strategic situations, including advertising, pricing, innovation and invest-
ment decisions. It has an impeccable logic, it is based on rational decision making,
and it is a now a classic model of decision making, replicated even in introductory
textbooks. It shows how rational decision making can result in counterintuitive
behaviour and surprising results. So where is the problem with this most fundamen-
tal of game theoretic models?
The problem can be summarised in one phrase – life tends not to be like that.
More specifically, even situations that – superficially – appear to have a Prisoners’
Dilemma structure often betray this when they are examined more closely. And
even when every effort is made to make sure that the stringent assumptions of the
Prisoners’ Dilemma apply (as in laboratory experiments of the model), people more
often than not tend not to behave as the model predicts.
In the Prisoners’ Dilemma, the following specific conditions must be met.
 Simultaneous decision making by both players
 Accurate knowledge of the pay-offs attached for each set of choices
 No communication between the players
 No social ties and obligations
 No history to the game, no past until this situation, and no future beyond
outcomes identified in the game.
In reality, strategic decisions do not take place in a social vacuum. Suppose Pat
and Joe had taken a vow of silence such as the code of ‘omerta’ practised by the
Mafia. Same structure, different outcome – both would refuse to confess and would

get off with one year in jail (and in turn avoid being concreted in the latest freeway
project run by their associates). Or suppose both PatCo and JoeCo build up strong
brand loyalty through their respective advertising campaigns. Then what may appear
to be a foolish strategy leading to short-term losses could be in fact a sensible long-
term strategy that builds up barriers to entry to this market. Or PatCo and JoeCo
could both decide to wait and see what the other does before taking any action
themselves, in which case the crucial advertising war might never come about.
The point about these examples is that it can take just a single deviation from the
basic assumptions for behaviour to change dramatically. Worse, it can be difficult or
impossible to verify in advance whether the assumptions do hold where they relate
to subjective intentions, attitudes and values held by the parties (How would you
verify Pat and Joe have a code of silence? How could you be sure before the game
has been played that both PatCo and JoeCo will not adopt a wait-and-see policy?).
Even more seriously, the Prisoners’ Dilemma tends not to provide a good expla-
nation of behaviour even when every effort is made to make sure the assumptions
hold, as in laboratory experiments when its highly restrictive assumptions (simulta-
neous decision, no communication etc.) can be replicated. If it does not provide a
good explanation in this context, then there would seem to be even less hope for it
in real world contexts where its basic assumptions are more likely to be breached.
Unfortunately many basic textbooks still serve up the Prisoners’ Dilemma as self-
evidently a description of actual behaviour without giving it the reality-check it so
richly deserves.
And even within the Prisoners’ Dilemma frame of reference there are recognised
to be problems in predicting what will happen. The models we looked at in Figure
1.5 and Figure 1.6 were one-shot models; the players had to make one decision and
that was it. This may seem realistic in the case of Pat and Joe (unless they are serial
offenders), but it is less likely to be so in the case of firms facing each other in a
competitive battlefield. Firms rarely have one-off decisions to make about strategic
variables; instead they may play repeated games. For example, in the case of PatCo and
JoeCo, both firms may make decisions about whether or not to advertise every
month. Since one month’s decision cannot be treated in isolation (one firm advertis-
ing this month may invite retaliation next month), future possible outcomes may
influence present decisions. Unfortunately for predictions about behaviour, different
kinds of outcomes can be rational and possible depending on the nature of the
repetition.2
In short, the Prisoners’ Dilemma does not deserve to be regarded as more than a
very special case that may have limited implications for competitive strategy, even
though it makes a nice story. But it is also one of the simplest game theoretic
2 Those familiar with game theoretic modelling will know that at this point we might expect to move
into a discussion of finite versus infinite games, and the logic of backward induction in obtaining
solutions to finite games. However, at this point, it is felt that the discussion would run into diminish-
ing returns. They may also wonder why I have not already introduced the notion of Nash Equilibrium.
The reason is that competitive strategy is more about disequilibrating forces, less about equilibrium
situations. Nash Equilibrium is not something that is particularly useful for the analysis of competitive
strategy.

models, and many of the criticisms that have been levelled at it here can generally be
found to hold at least as strongly for more complex game theoretic reasoning. The
most interesting point about the Prisoners’ Dilemma is the one that is most often
overlooked; even when a situation looks superficially like a Prisoners’ Dilemma,
actual behaviour often is quite different from that predicted by the model. Repeti-
tion, familiarity, negotiation, trust, loyalty, kinship, social pressure and personality
are all real-life features that can lead to co-operative and mutually beneficial out-
comes in practice, contrary to the outcome suggested by the model.
Beyond that there is a further problem with game theory modelling in that it can
be used to explain just about any kind of behaviour. The economist Richard Rumelt
once argued that a game theory model could probably be produced to explain a
bank manager burning his trousers in the street as a rational strategy, and a game
theorist promptly obliged with just such a model. The problem with such explana-
tion is that, if it can explain just about any behaviour after the event, then how do
we know what game theory model to use to predict or advise on behaviour before
the event?
So a health warning should be attached to game theory models being applied to
analysis of competitive strategy. However, there are valuable lessons that can be
learned from game theoretic reasoning, though it tends to have the status of insights
and principles rather than being associated with any one model or set of models.
1.4.2 Strategic Moves

Even if it may be difficult to apply individual game theoretic models to competitive
situations, there are still important strategic principles which have been explored by
game theory. Indeed, many of these principles preceded the development of game
theory, which has merely formalised and demonstrated the applicability of these
principles in different contexts.
One important concept which game theory has developed is that of the strategic
move. A strategic move is something that is intended to alter the beliefs or expecta-
tions of others in a direction favourable to you. Its fundamental characteristic is that
you deliberately limit your freedom to manoeuvre. Game theory models can be used
to demonstrate the logic and implications of different types of strategic moves in
principle. For our purposes, it will be sufficient to outline some of the general
lessons that can be learnt from this analysis.
A central issue that game theory has helped to illuminate is that of credibility.
Suppose you are considering entering a market that is dominated by one firm. You
receive a warning from the incumbent that if you do move into its territory, you can
expect to face a ruinous price war. What should you do?
The answer to that is to consider what would be in the best interests of your
rival, once you have entered the market. Threats may be easy to make – cheap talk – but
expensive to carry out. Your potential rival may bluster and threaten in the hope
that it will deter you from entering. What you should do is consider whether your
rival will find it in his or her interests to carry out the threat once he or she is faced

with the fait accompli of you having entered. If it would not then be in his or her
interests to carry out the threat, it is an empty threat and should be disregarded.
There is the parallel problem of empty promises, such as the manager who prom-
ises a singer preferential treatment and star billing if he will only sign on with her.
The questions to ask are the same as those for empty threats. Would this person be
expected to say this, even if it is not true? What is to make them keep to their word
in the future?
Empty threats and promises may actually damage the credibility of those making
them, rather like the case of the boy who cried ‘wolf’. They are more likely to lead to
threats and promises made in the future being disbelieved if those making them
have been guilty of empty threats in the past.
So the intangible asset of credibility can be an important element in strategic
battles. If a firm can make its threats or promises credible, it may be more likely to
exercise control over a market and its rivals. How can credibility be won – and
maintained?
There are many ways that this may be achieved; the following are just some ex-
amples.3
Reputation
This is perhaps the most obvious way that credibility can be built up for a firm. One
of the most celebrated corporate libel cases involved McDonald’s, the fast food
chain, in what became known as the McLibel case. Two anti-McDonald’s activists
were taken to court in the UK by McDonald’s for allegedly libelling its reputation.
The case took six years to settle and the court verdict was mixed, though mostly in
favour of McDonald’s. Reputation had an obvious part to play in the McLibel trial
since McDonald’s was clearly defending its reputation as a responsible commercial
organisation. But one other thing that McDonald’s was doing in this context was
communicating a determination to protect its reputation at all costs – a reputation
for defending its reputation, if you like. Had McDonald’s ignored the attack on its
reputation by the ‘McLibel Two’, then other groups and individuals might have felt
encouraged to attack McDonald’s. By communicating a determination to incur
major legal costs and possible bad publicity, McDonald’s was attempting to send a
credible threat to any other groups who might consider attacking its image.
Yet this was a case in which it could be argued that the strategic move backfired.
McDonald’s was not prepared for the two penniless defendants to be prepared to
resist the legal threats from such a wealthy and powerful corporation. The trial itself
damaged the reputation of McDonald’s, with much adverse publicity concerning the
firm’s slaughter of its animals, treatment of its workers, and influence on children’s
minds. Rather than deterring future corporate campaigners, it could actually have
given heart to others who want to see increased corporate accountability in the
future.
3 Some of the following examples are based on Dixit and Nalebuff (1991).

Contracts
One obvious way that credibility can be created is by signing a contract committing
a party to a certain specified course of action. This may be effective, especially if the
contract involves the trading of an easily specified commodity – such as paper or
grain. The problem is that it can be difficult, expensive or impossible to specify fully
a contract in many commercial contexts. The agreement may be about a product
that is unique or highly differentiated from others in its class (such as an interior
decoration contract for a building), or one that is highly complex, innovative and/or
uncertain (e.g. to develop a new weapons system for a government). In such
circumstances there may still be room for misrepresentation, cheating and oppor-
tunistic behaviour. This leads to transaction costs and principal–agent problems which we
shall explore in later modules.
Specialisation
Polaroid is a company that pursued a strategy of specialisation in instant photog-
raphy for many years, even though many elements of its technology (chemicals,
electronics, optics) provided routes which could have allowed it to diversify if it so
wished. As Dixit and Nalebuff (1991, pp. 154–55) point out, specialisation provided
a credible statement of the company’s commitment to this market; potential rivals
knew that Polaroid would be likely to respond fiercely to any market entry, since an
attack on the instant photography market could signal an attack on Polaroid’s very
existence.
Specialisation is one variant of a range of strategies which communicate a credi-
ble commitment to a specified course of action by deliberately restricting the
options open to the company. In the Polaroid case, the company had no option but
to stay and fight off entrants, at least in the short term, because it had nowhere else
to go (later it would diversify – though ultimately unsuccessfully – as other innova-
tions nibbled away at its instant photography market).
This strategy is similar to that of burning your bridges in war; if your rival knows
that you have deliberately cut off your escape routes then this communicates a
determination to stay and fight, the ‘flee’ option having been consciously sacrificed.
Investment
Major investment by a firm in a particular business area can be a credible signal that
a firm is committed to that market. Rivals are less likely to think that a firm can be
easily chased out of a market if they have seen the firm just commit major resources
to it. However, the form the investment takes can be important. Suppose, for
example, a bus company invests in a fleet of new buses to service a regional market.
Since the buses are mobile assets that can be easily redeployed overnight, such
investment may not in itself be regarded as necessarily signalling a credible com-
mitment to that particular market. Easy exit does not make for credible
commitment.
What can signal a credible commitment is if the investment entailed a significant
element of sunk costs. Suppose a company invests $10m in new machinery to
produce a particular drug. The machinery cannot be used for anything else and

would only have a scrap value of $100 000 if the firm was to pull out of this market.
The firm’s investment in this market therefore represents a considerable level of
non-recoverable sunk costs. If the firm’s rivals know this, it will communicate the
firm’s commitment to this market; a sensible firm would not have tied up such
major resources if it did not expect to maintain a significant presence in the market.
And of course, once the costs are sunk, the firm will be more likely to be seen as
having little to lose from fighting its ground in this market, whatever its rivals throw
at it. All this can serve as a warning or deterrent to other firms that the firm is going
to be a persistent and serious competitor in this market.
Incrementalism
One way to build up credibility and trust is to build up a relationship over time.
Suppose two firms are thinking about forming a global alliance to develop a
particular market. It might be regarded as highly risky to commit to this whole
venture to begin with, especially if one partner could easily withdraw and leave the
other stranded. One solution can be to build up commitment slowly, say by co-
operating in developing one region of a national market, then slowly expanding.
Neither partner may have to commit themselves heavily to begin with, but as they
deepen and broaden their commitment, both may have more and more to lose from
the collapse of the partnership, and more and more to gain from its maintenance. In
this way, both firms can build up confidence that their partner is committed to the
venture.
Hostages
The companies Daimler-Benz and Mitsubishi developed a whole series of co-
operative agreements over many years involving a number of their subsidiaries and
businesses. Such arrangements or alliances are quite common now in industry; but
why did Daimler-Benz and Mitsubishi not simply seek out the best partner on a
business-by-business basis? Just because you have co-operated with a firm in the
past or the present does not necessarily mean that it is going to be the most suitable
partner in other areas in which you have interests. Why this clustering of co-
operative agreements around one preferred partner?
One answer is that clustering agreements with a preferred partner can provide the
credible reassurance that the partner is more likely to adhere to the letter and the spirit
of individual agreements if it knows the other has co-operative agreements that can be
used as ‘hostages’ in the event of any breach of faith. That is one reason why towns,
cities and universities twin with a restricted number of preferred partners. An institu-
tion, whether a university or a firm, may be less likely to act opportunistically
regarding one specific agreement if it could have damaging implications for other
agreements signed with the other party.
Social context
Diamond dealers in New York tend to make trades with each other based on verbal
assurances. If a diamond dealer were to break his word, he could find his reputation
and ability to function commercially irretrievably damaged. Hollywood producers

have also been known to make verbal assurances and promises, but a breach of faith
by them is less likely to damage their career permanently; indeed, it may even be
accepted as par for the course.
The important point is that credibility (for example, that a person’s statement can
be treated as honest and reliable) may be influenced by the social context in which
actions take place. The significance of social or environmental ties in creating and
communicating credibility may vary from market to market.
Learning Summary
In this module we have analysed some of the major features and elements of
potential relevance to strategy formulation in the various types of industrial envi-
ronments that the firm might encounter. The life cycle and Five Forces models help
provide organisational frameworks that can assist in the development and evaluation
of the strategic options open to the firm. The life-cycle model provides insights that
can chart the changing features of the industrial and technological landscape over
time. The Five Forces Framework helps establish the context in which the strategic
game may be played by firms and rivals at particular points in the cycle. Finally,
while game theory may be overhyped in terms of its ability to provide useful models
to analyse competitive situations, it has provided insights which may help identify
useful strategic concepts and principles. In the modules that follow we shall build on
the foundation that these approaches help to provide.

Review Questions
1.1 Recognised strategies that may help provide long-term solutions for dealing with the
decline stage of the industry life cycle include:
I. niche exploitation.
II. harvest.
III. internalising the threat.
IV. dominance and leadership.
Which of the following is correct?
A. I, III and IV.
B. All of the above.
C. I only.
D. I, II and IV.
1.2 Forces in the Five Forces Framework include:

I. rivalry.
II. entry.
III. economies of scale.
IV. buyer power.
A. I, II and III.
B. All of the above.
C. I only.
D. I, II and IV.
1.3 Which of the following is not likely to intensify firm rivalry in an industry?
A. Increase in the number of sellers.
B. Elimination of excess capacity.
C. Deregulation of the industry.
D. All of the above.
1.4 Which of the following is a strategic move?

A. Some first-mover advantage on the part of a firm.
B. Something which is intended to alter the beliefs or expectations of others in a
direction favourable to you.
C. The construction of a business plan.
D. Replying tit for tat when a rival attacks your market.
References
Dixit, A.K. and Nalebuff, B.J. (1991) Thinking Strategically: The Competitive Edge in Business,
Politics, and Everyday Life, New York, Norton.
Porter, M. (1980) Competitive Strategy: Techniques for Analyzing Industries and Competitors, New
York, Free Press.

Module 2
Strategies for Competitive

Advantage
Contents
2.1 Introduction.............................................................................................2/1
2.2 Generic Strategies ..................................................................................2/2
2.3 The Value Chain .....................................................................................2/4
2.4 Cost Leadership ................................................................................... 2/10
2.5 Differentiation ...................................................................................... 2/17
2.6 Focus ..................................................................................................... 2/25
2.7 The Dangers of Hybrid Strategies ..................................................... 2/30
This module introduces the various options which the firm can choose from in
formulating its competitive strategy. The role of the value chain as a tool for
strategic analysis is examined. Generic strategies of cost leadership, differentiation,
focus are identified. We examine the circumstances in which it is appropriate to
pursue a particular generic strategy. The need for clarity and consistency in strategy
is established. The dangers of being ‘stuck in the middle’ through trying to pursue
more than one generic strategy simultaneously are discussed.
Learning Objectives
 analyse competitive strategy in terms of generic strategies;
 explain the contribution of value chain analysis;
 explain how distinctive competences may help develop and sustain competitive
advantage;
 describe the main drivers of each generic strategy;
 explain the dangers of hybrid strategies.
2.1 Introduction
In the first module we saw the context in which competitive strategies must be set;
in this module we explore the scope that exists for designing and developing
competitive strategy in practice. We shall look at the notion of the value chain in
Section 2.3 before looking at each major generic strategy in turn, starting with cost
leadership in Section 2.4, moving on to differentiation in Section 2.5 and finishing

Module 2 / Strategies for Competitive Advantage
with focus in Section 2.6. The dangers of hybrid strategies, or being ‘stuck in the
middle’, are discussed in Section 2.7.
First, however, we shall examine the basic types of strategies generally available
to the firm, or what Porter (1985) calls generic strategies. Just as important in setting
out what the firm can do is the identification of what the firm cannot normally do. In
choosing its strategy, the firm both creates and limits possible lines of action for
itself in the future. The topic of these lines of action, or generic strategies, is our
concern in the next section.
2.2 Generic Strategies

One of the first points that we must bear in mind is that strategies may have a large
variety of objectives and outcomes, some of which may have no observable impact
on profitability. That does not mean that they are necessarily inconsistent with the
interests of shareholders, as we shall see in later modules. For example, vertical
integration may be a defensive strategy designed to prevent the firm being cut off
from supplies or outlets (Module 4). Or diversification may be pursued to prevent
the firm having all its eggs in one basket and finding its survival threatened if its
current market or technology is suddenly rendered obsolete (Module 5). Or a
multinational may avoid seemingly lucrative licensing possibilities because it is
worried about losing control over its proprietary know-how (Module 6). None of
these options may lead to direct improvements in the bottom line of companies’
balance sheets, though they may help anticipate and deal with nasty problems that
could appear on the corporate agenda at some point in the future.
However, with these qualifications in mind, competitive strategies are generally
expected to enhance profitability, and there are just two main ways a firm can do
this in any given product market. It can shift the demand curve up, or the cost curve
down. These effects are shown in Figure 2.1.
If average cost (AC) shifts down, then the firm will be able to increase profits
through reduced costs. If demand (D) shifts up, then the firm will be able to
increase profit by increasing the price. This process will be aided to the extent that
the firm can make the demand curve less elastic (and to the extent other products
are less likely to be seen as close substitutes). Competitive strategy can add to value
by driving a wedge between demand and cost, so enhancing profitability. Porter
(1985) identified three generic approaches to competitive strategy analysed in such
terms:
 Cost leadership strategy, where the firm tries to become the low-cost producer in its
industry. If it is able to do so and still sell at comparable prices to its competi-
tors, then it will achieve above-average performance.
 Differentiation strategy, where a firm tries to become unique in its industry in some
characteristics that are valued by consumers. The firm that is able to do so may
be able to extract a premium price, and if it is also able to operate at costs that
are comparable to its competitors, it will enjoy above-average performance.
 Focus strategy, in which the firm targets a narrow segment or niche within an
industry and designs its strategy for this segment only. There are two variants

here, cost focus in which the firm tries to achieve a cost advantage over its compet-
itors, and differentiation focus in which the firm seeks a differentiation advantage in
this segment.
D2 Demand curve shifted

to the right and made
less elastic
D1
$ AC1
AC2
Cost curves shifted down
0
Output
Figure 2.1 Competitive strategy adding value

Problems: sources of competitive advantage may be easier to identify than
achieve. In practice there may be a number of difficulties facing the firm trying to
pursue competitive advantage.
1. Trade-off between cost and differentiation. One of the problems in trying to
achieve competitive advantage is that there is quite likely to be a trade-off be-
tween differentiation and cost. A firm that tries to produce a standardised no-
frills product may lose features that are attractive to consumers, while the effort
to differentiate the product may incur R&D, advertising and/or production
costs. Consequently Porter emphasises that it is important for a firm to seek
what he calls parity or proximity with its competitors in the areas that are not
being pushed as potential sources of competitive advantage. In the case of a
strategy of cost leadership, it is important that the firm seeks parity or proximity
with competitors in terms of differentiation strengths. Otherwise, the product
may be regarded as so inferior to that offered by competitors that the firm has to
cut price to the extent that the advantages of low-cost performance are lost.
Correspondingly, in the case of a differentiation advantage it is important that
the firm retains parity or proximity with competitors in terms of costs. Other-
wise, the higher costs involved in achieving differentiation advantage may erode
any performance gain that differentiation may have earned the firm.
2. Stuck in the middle. A firm that tries to pursue more than one generic strategy
in the same area may become stuck in the middle, falling between two (or more)
stools. It may not be making the investment required to achieve a successful
differentiation strategy and it may carry too many frills to be a successful cost

leader. The message can become confused in the eyes of the consumer – is the
firm trying to sell a high-quality or a low-cost product? We shall look at these
issues further in Section 2.7.
3. One cost leader. Imagine you want to start a coffee shop and wish to create a
differentiation advantage for your business. There may be a multitude of ways
this could be done by creating a unique ambience, style, and combination of
products and services for your business. The same holds for others who wish to
open a coffee shop in the area. Now suppose you want to become the cost lead-
er in the coffee shop business in your area. By definition there can be only one
cost leader (or at best a few joint leaders). If nothing else, this suggests that cost
leadership may be more difficult to achieve than differentiation, and it may be a
strategy that can be sustained by a more restricted set of firms. We shall look at
the implications of this further in Section 2.4 below.
4. Sustainability. It is not enough for a firm to discover a strategy that gives the
firm an advantage against rivals, the advantage must be one that can be sustained
in the face of competitive reaction and opportunities for imitation. A firm may
take advantage of a consultant’s advice on how to reorganise and reduce costs,
but this is unlikely to lead to sustained competitive advantage if rivals have equal
opportunity to employ the same consultant and get similar quality of advice.
Sustainability can in fact be tricky to pull off, and indeed it may be difficult in
practice to identify any source of competitive advantage that may be sustained
indefinitely. Firms may have to be prepared to adapt continually and innovate if
they do not wish to be overtaken by hungry competitors counteracting and ne-
gating their current sources of competitive advantage. The best that may be
hoped for is that current sources of competitive advantage help the firm add
value now, while allowing it a cushion to search for ways to maintain or enhance
competitive advantage in the future. Sustainability may be created by barriers to
entry.
2.3 The Value Chain

The value chain is an essential element in searching for competitive advantage. It
breaks the firm down into component activities to identify actual and potential
sources of competitive advantage. The notion of strategic business unit or SBU is
also relevant in this context. SBU is a part of the firm which can be seen to have a
strong technological or market thread that allows it to be managed as a distinct
business in its own right. Value chain analysis:
 is applied at SBU level;
 identifies physically and technologically separable activities;
 separates out activities which may have an impact on cost or differentiation
advantage.
Figure 2.2 shows a generic example of a value chain. In this case the chain has
been broken into four main components – R&D, production, marketing and
distribution. Each element in the chain can be further subdivided into major sub-
categories, examples of which are given in Figure 2.2. In turn these sub-categories

may be divisible into further sub-sub-categories associated with the respective

activities in each case. The overall chain is simply summarised on the right of Figure
2.2.
The value chain can be used to look at linkages within the chain itself to check
how the chain is configured and how it is (or is not) contributing to competitive
advantage. It can also be used to look at linkages between value chains to see whether
and where shared activities may contribute to added value (this latter area is some-
thing we shall look at in some detail in Module 5). The firm’s value chain is unlikely
to exist in isolation, but will probably have links to the value chains of other firms.
These links may be vertical (to suppliers and buyers) or horizontal (collaborative
arrangements with other firms at the same stage). As we shall see in later modules,
these links with other firms may help to create or reinforce competitive advantage
for the firm. Perhaps the most striking example of this is contained in the notion of
clusters (Module 6) where competitive advantage may be stimulated by vertical and
horizontal interactions of geographically concentrated firms in the same or related
sectors.
e
sales forc
Distribution trucks
marketing department
market research D
Marketing
advertising M
plant P
Production equipment
R&D
labour force
R&D research
develop
ment
Figure 2.2 A representative value chain and some elements

There is an immediate warning flag that should be raised at this point. Some
writers have interpreted the value chain rather mechanistically and advocate a trawl
through the value chain to find activities that enhance (or could enhance) value in
the firm. This may be useful up to a point but it also carries dangers. Activities are
delivered by resources, and the resources that are involved in a firm’s businesses
may look rather mundane and ordinary when put under the microscope. It is rare
for a firm to employ managers, workers or physical assets that could not be relative-
ly easily substituted in the marketplace, though patents and intellectual know-how
can be examples of assets that may be difficult for other firms to replace. In
practice, a firm’s competitive advantage may be attributable to how the various
activities are organised together, and it may be difficult or impossible to identify a
critical activity as the source of this competitive advantage if they are all separated
out and looked at in isolation.

An approach that recognises this danger and tries to do something about it is a

version of the resource-based approach to the firm which tries to identify capabilities
as a potential source of competitive advantage to the firm. Capabilities are sets of
related activities which a firm does well compared to other firms. The advantage of
the capabilities approach is that it does not rely on a purely bottom-up analysis of
competitive advantage by trawling through all the activities in the value chain one by
one. Instead, it tries to identify the areas of activities that constitute the ‘distinctive
competences’ or ‘core competences’ of the firm and help provide it with enduring
and sustainable sources of competitive advantage. Examples of core competences
that have been identified by writers include Walmart in retailing and Procter &
Gamble in marketing.
The capabilities approach can provide a useful perspective that in the right cir-
cumstances gets to the heart of a firm’s competitive advantage. Ideally, a distinctive
capability or competence should display two important features.
 It should be firm-specific, that is it should be difficult or impossible for other
firms to imitate.
 It should not be application-specific, that is, the firm should be able to exploit it
in a number of different market contexts. This may give a bridge for expansion
into other areas, where the firm may build on its distinctive competence. Also, it
may give an escape route if the application on which the business is founded
nears the end of its life cycle, or a competitor develops and brings to bear supe-
rior competences in this area.
There are also some problems with too simplistic an application of the capabili-
ties approach; these include the following.
 The warning flag that we have just raised may also apply here, in that the firm’s
competitive advantage may reside in the configuration and organisation of the
entire value chain, not just in one element. For example, the whole of the value
chain of the Internet retailer Amazon.com is dedicated to communications with
potential customers about products they may be interested in, and then getting
the purchase to the customer as quickly and cheaply as possible.
 Distinctive capabilities identified by writers can be bland and over-general. It
may be correct to say that 3M’s distinctive capability lies in ‘innovation’. But this
does not tell us anything about the actual sources of competitive advantage.
 Identifying distinctive competences entails a high degree of subjectivity and there
may be no guarantee that a particular interpretation is the ‘correct’ one.
 A distinctive competence can turn into a distinctive liability if care is not taken to
monitor for signs of obsolescence in capabilities and competences. In the eight-
ies, IBM had distinctive abilities in selling mainframe computers to large
industrial customers and was slow to react to the possibilities and dangers of-
fered by the PC revolution.
 There is a temptation to identify distinctive capabilities with distinctive firms and
it is no surprise to find the approach applied to firms like Walmart and Coca-
Cola. The danger lies in assuming that the phrase ‘distinctive capabilities’ means
distinctive firms, and vice versa. It is less usual to find the approach applied in

industries like petroleum (where terms describing the oil majors as the ‘Seven
Sisters’ emphasise family resemblance rather than individual differences). It may
be more difficult to identify unique non-replicable distinctive competences in the
case of the large oil firms, but that has not stopped them from growing and
prospering down the years.
 If a firm does have a genuine distinctive competence, it may provide few direct
lessons for other firms since distinctive competences are by definition difficult or
impossible to imitate. The important thing may be for them to develop their
own sources of distinctive competence, if that is possible.
 Figure 2.3 shows the main kinds of interaction that can take place between
activities involved in the value chain. The interaction and linkages may take place
in a vertical direction (e.g. production/marketing) or a horizontal direction (e.g.
production/production). We shall be particularly concerned with vertical linkag-
es in Module 4 and horizontal links in Module 5. Vertical links are generally
concerned with the movement or shifting of some intermediate product through
the business unit, while horizontal links are generally concerned with the sharing
of some resources involved in similar activities in different value chains. Figure
2.3 shows an extreme case in which the two different value chains have strong
horizontal links in each of the major and minor categories of linkage discussed
above in Figure 2.2. In practice, value chains may only have partial links between
them. In extreme cases with strong sets of horizontal links between similar
products, the pairs of value chains may more reasonably be treated as a single
value chain.
sales force
Distribution trucks Distribution
market research
Marketing Marketing
advertising
plant
Production equipment Production
labour force
research
R&D R&D
development
D D
M M
P P
R&D R&D
Figure 2.3 Representative value chains and interrelationships

The pattern of value chain linkages may have implications for the structure and
organisation of the firm. If various businesses operated by the firm are effectively

stand-alone entities with few actual or potential linkages with each other, then we
may have a conglomerate strategy in which the firm operates in unrelated product
markets. The only linkages which the firm has to worry about co-ordinating in such
a case are vertical linkages within the value chain for each business. This is usually
achieved by creating a divisional structure.
Figure 2.4 shows the case of a three-business firm that does not have major
linkages between its businesses. The major co-ordination problem facing the firm is
how to manage the three independent value chains in the respective cases. This is
normally achieved by creating a divisional structure in which each of the value
chains is managed and co-ordinated by a divisional managerial team. Each division
in the above example would have its own R&D, production, marketing and distribu-
tion sections for the business in question.
H.Q.
DIVISION 1 DIVISION 2 DIVISION 3
Figure 2.4 Divisional structure for unrelated value chains

However, in cases where there are significant linkages between value chains, a
functional organisational structure may be more appropriate, as shown in Figure 2.5.
Here we assume again that the firm in question is operating three different business-
es. Unless there are extremely strong linkages across value chains (in which case it
may be more reasonable to see this as representing a single value chain), the decision
whether to choose a divisional structure (Figure 2.4) or a functional structure
(Figure 2.5) may not be an easy one. As we noted above, a divisional structure has
the advantage of helping co-ordinate vertical linkages within the value chain.
However, a divisional structure will cut across any actual or potential linkages that
may exist between value chains in the different divisions, and could lead to wasteful
duplication of activities or make it difficult to co-ordinate horizontal linkages. The
problem with a functional structure is the reverse. It is designed to facilitate the
exploitation and co-ordination of horizontal linkages since it puts managers and
other resources concerned with the same stages and same activities for the various
businesses together in the same units (R&D, production, etc.). But by filtering out
the various activities in the vertical chain into separate functional homes, it can
make it more difficult to co-ordinate and integrate these activities within the
respective value chains.

H.Q.
MARKETING PRODUCTION R&D
Figure 2.5 Functional structure for related value chains

The decision as to what form of organisational structure to adopt is essentially a
matter of judgement. As Figure 2.3 shows, it is often the case that a particular
resource has two roles to play in the firm, (1) a role within a value chain in which it has
vertical links with other resources within the chain, and (2) a role that connects it
with other value chains in which it may have shared interests with its counterparts in
other value chains elsewhere in the firm. There are likely to be unavoidable trade-
offs with a particular organisational structure facilitating certain kinds of linkages
while impeding others. The decision to choose a particular structure will depend on
what linkages are thought to be important in practice and which the firm wants to
encourage. Even firms that eventually become highly diversified tend to start off as
relatively specialised, and so most firms adopt a functional structure in their early
days. If their subsequent growth leads to their developing a highly diversified and
loosely connected set of businesses, a divisional solution may begin to appear more
attractive at some point in the firm’s evolution.
However, there may be other options available to firms that wish to resolve
possible tension between emphasising linkages within the value chain versus
emphasising linkages between value chains. One type of solution is shown in Figure
2.6. Suppose our three-business firm operates three different kinds of products
made with very different technologies, but selling to the same type of customer,
each business drawing upon the firm’s reputation in this market. A pure divisional
structure would help exploit vertical linkages in each value chain, but would not do
much to help co-ordinate the horizontal marketing linkages across the value chains.
On the other hand, a pure functional structure would help co-ordinate those
horizontal linkages that exist, but would also put widely differing technologies and
products into the same functional homes. It would also make it more difficult to
make vertical connections since the respective value chains are now split up into
various functional compartments.
One possible solution is to extract the area or areas of the firm that may generate
strong shared or common horizontal linkages and make this a separate unit respon-
sible for co-ordinating these linkages. Such a solution is shown in Figure 2.6 for our
firm with strong marketing commonalities between its three otherwise unrelated
businesses. In principle, such a solution allows the firm to get the best of both
worlds, helping to extract vertical links within divisions for the various value chains
in the firm, while also providing an administrative mechanism that facilitates the co-
ordination of horizontal connections (marketing linkages in this case). In practice
there may still be problems and costs associated with this solution. In particular, the
fact that a potentially critical function has been separated out from the rest of the
firm may make it difficult to co-ordinate this set of activities with the business of the

divisions. It also may make it difficult to treat each division as a profit centre in its
own right to the extent they now share a function (and set of overheads).
H.Q.
MARKETING
DIVISION 1 DIVISION 2 DIVISION 3
Figure 2.6 Mixed structure for partially related value chains

This does not exhaust the organisational solutions that may be available to deal
with the problem of multiple linkages involving the value chains in the firm. Matrix
structures in which individuals and sections report to more than one reporting
channel and line of authority in the firm (e.g. divisional, functional, territorial)
provide another solution that has been widely adopted by large diversified firms in
recent years. However, the basic problem remains the same. There may be multiple
linkages within and between the value chains that the firm is involved in, and the
trick is to try to make it as easy as possible for important links to be co-ordinated,
while making sure that as little damage as possible is done in terms of putting
barriers in the way of co-ordinating other links. Every solution tends to involve
trade-offs, and with the possible exception of the divisional structure for a con-
glomerate strategy it is rare to find a structure which does not have some co-
ordination costs to set against the co-ordination benefits which it delivers.
We shall now look in more detail at the various generic strategies that the firm
may pursue, starting with cost leadership.
2.4 Cost Leadership

Cost leadership is a strategy that may be feasible if a firm’s costs are lower than
those of its competitors. In searching for sources of cost advantage that may help
create and reinforce cost leadership there are several cost drivers (structural determi-
nants of the cost of an activity) that may impact on different parts of the value
chain. The main cost drivers identified by Porter are as follows:
 Economies of scale. If a firm can pursue scale to increase specialisation and
division opportunities and make better use of indivisible resources, then it may
be able to move further down the average cost curve than its competitors. The
car industry is a good example, where a substantial level of output (generally
500 000 to 1 million units) is required before production economies are fully
exploited.
 Learning and experience curve gains. Economies of scale refer to level of
output which a firm can achieve in a given time period. Learning and experience
curve effects refer to the cumulative output of a product which the firm has
achieved over time. In building their first 747, Boeing had to set up a new pro-
duction line, a new work plan, and new tasks for managers and workers. The
high costs of producing the first unit to roll out from Boeing’s production hang-

er reflected the novelty and unfamiliarity of many of the managerial and work-
force tasks involved. As time went on, management found short cuts and
improved methods of organisation, workforce skills and productivity improved
through practice and repetition, and opportunities for improved teamwork and
co-ordination were realised. The real cost per unit for Boeing 747s tended to fall
over time as these learning and experience curve effects were realised, helping to
generate considerable cost advantages for Boeing versus actual or potential com-
petitors. Such learning curve gains are often important considerations in cases of
complex high-technology products with a reasonably high degree of standardisa-
tion, and produced in batches or limited numbers.
 Capacity utilisation. Capacity utilisation can be an important driver of costs,
especially in capital-intensive industries characterised by a high level of fixed costs
and unpredictable or variable demand. The airline industry is a good example of an
industry where capacity utilisation is an important driver of costs (per passenger)
with each flight being characterised by high fixed costs (cost of plane, crew, fuel
etc.) and the marginal cost to the airline of each extra passenger being close to zero
(as long as there is a seat available). This sector is characterised by a high degree of
price discrimination, much of which is designed to bump up capacity utilisation (or
the ‘load factor’). This sector has been characterised by the entry of a number of
no-frills competitors in recent years, seeking to push cost per passenger down by
offering a no-frills service as well as trying to maximise the load factor.
 Vertical links within the value chain, and links with suppliers’ and buyers’
value chains. Cost drivers can impact on parts of the value chain but the overall
configuration of the chain and links between different elements of the chain can
also be important in helping to generate cost advantage in the case of vertical
integration. For example, many firms have adopted an open plan office system
to make sure that communication between different functional specialists in the
chain is as effective and as easy as possible. The right arrangement and links with
suppliers’ and buyers’ value chains can also be an important source of cost ad-
vantage, as evidenced by much of the concern with outsourcing in recent years.
We shall look at these issues further in Module 4.
 Horizontal links with other value chains – economies of scope. Links with
other value chains can be important in helping generate cost reduction through
economies of scope. For example, BIC’s disposable pens, razors and lighters can
share much of its competences in making and selling light, cheap, disposable
consumer products across these different product lines. We shall look at the
potential gains from sharing resources between value chains further in Module 5.
 Timing. Being first-in to the market can give the entrant or innovator certain
cost advantages. For example, there may be network effects that lead to de-
creased cost per user as the system grows and it may be difficult or impractical
for an entrant to duplicate or replicate (e.g. railways). At the same time, there
may be second-in benefits from waiting and learning from others’ costly mis-
takes. We shall look at these issues further in the context of innovation in
Module 3.
 Location. Different locations may have different resource costs. Land, labour
and capital costs may differ from region to region and country to country. There

may be advantages in locating all or part of the value chain in areas where a ma-
jor resource is relatively cheap (e.g. labour-intensive processes to low-wage
countries). The danger is that this may geographically fragment the value chain
and make it difficult to co-ordinate its various pieces.
 Institutional factors such as government regulation, taxation and subsi-
dies. Background institutional factors may also affect the cost base of the firm;
for example, many governments provide attractive fiscal packages to attract in-
ward investment. Conversely, other policies may have an adverse effect on the
cost base of the firm; for example, the UK government’s decision to tax fuel
heavily for environmental reasons in the late-nineties had an adverse effect on
many UK firms’ distribution costs.
 Discretionary policies. This is really a catch-all category reflecting the firm’s
choice of strategy and how it may impact on its costs. For example, some PC
manufacturers such as Dell sell computers direct rather than go through retailers
and so cut out the middle man (see Exhibit 2.2). Limiting the variety of products
produced is another device to reduce costs through standardisation (e.g. Apple
iPhone).
 External economies. A possible source of cost advantage not explicitly
separated out by Porter is that the firm may be able to take advantage of external
factors to reduce its costs, such as the existence of a well-qualified labour pool
due to the presence of other firms in a local area. External economies are an
essential ingredient in the creation of clusters, an issue we shall be looking at in
Module 6.
Each of these potential sources of cost advantage may impact on pieces of the value
chain. The successful cost leaders will squeeze as much cost advantage from the
overall value chain as possible without sacrificing elements that are valued by
consumers, though some trade-off may have to be made between standardisation
and differentiation.
Cost leadership is most likely to be successful where there are some factors that
cannot be easily replicated. For example, overseas location in a low-wage country
may succeed in keeping costs down, but in itself it will not be sufficient for overall
cost leadership if there is nothing to stop competitors setting up facilities in these
locations as well. Cost leadership is more likely to be sustainable where a standard-
ised product combines with economies of scale, learning and experience curve
effects, and the firm can achieve a high market share. Crucially it depends on firms
being able to extract a cost advantage over competitors and then being able to
attract and retain buyers on the basis of price. These conditions are likely to hold:
1. in the early stages of the product life cycle if the firm can steal an advantage over
competitors. This may be, for example, through getting down the cost curve or
the learning curve more quickly, either by exploiting first-mover advantages or
second-in advantages of learning from competitors’ mistakes.
2. in the later stages of the product life cycle if the product is a standardised com-
modity-type product with a high price elasticity of demand and buyers do not
face significant switching costs from one seller to another.

Exhibit 2.1: Walmart and cost leadership

Until the aggressive entry of Walmart into some European markets, cost leadership was
not a strategy that was seen as being a particularly strong or attractive option in
European food retailing. For example, UK consumers were not regarded as particularly
price sensitive, and lack of space and tight zoning regulations limited entry and competi-
tion. The German market is regarded as one of Europe’s most inefficient and has been
slow to invest in automated technology. But potential entrants could be deterred from
entering given the degree of regulation and protection that included the strong German
labour laws. France also has well-established local firms and a highly regulated market
which impedes organic expansion.
The entry of Walmart into Europe was seen as changing the rules of the game by
many analysts. Walmart’s competitive advantage is partly based on a very strong
informational and logistical system which allows it to keep down inventory levels and
respond rapidly and effectively to changes in stocking requirements. It also has a strong
customer service ethos which means that it does not have the poor-quality handicap
that can limit discount retailing in other countries.
In some cases, Walmart has responded to European barriers to entry by choosing to
enter by acquisition. It bought UK supermarket chain ASDA and fears of further
European expansion prompted a flurry of defensive mergers amongst European
retailers. With its track record of success and a deeper pocket than Europe’s largest
retailers, Walmart clearly had the ability and deep pocket to do well in the European
domain, and did so albeit with mixed results.
Which of the cost drivers identified in Section 2.4 are being exploited by
Walmart?
The dangers are of course that the firm’s strategy is based on a single trick: a low-
cost operation which other firms may learn to imitate or beat, either through
improved organisation or technological innovation. Since the strategy is essentially a
supply-side strategy (based on cost) it is inward-looking compared to a differentia-
tion strategy (which is based on the firm’s perception of the demand side and
consumer needs). Consequently this may encourage insensitivity on the part of the
firm in relation to significant trends such as shifts in distribution and consumption
patterns. And of course if there is room for only one cost leader then it is a strategy
that only one firm can achieve. The worst scenario for firms in a sector is that they
try to chase each other down the demand curve in a price war with each trying to
achieve supremacy as the cost leader.
Table 2.1 Cost leadership and credible threats

Other firm
Low price High price
Cost leader
Low price 120/30 140/50
High price 80/100 100/80

Bearing in mind the reservations we expressed concerning the game theory ideas in
Section 1.4, they can nevertheless be useful to show how a firm may increase its
chances of a sustainable cost-leadership strategy. This may work if it can make a
credible threat that it will maintain this strategy irrespective of the actions of its rivals.
In Table 2.1, the cost leader’s pay-offs are the first entry and its rival’s pay-off is the
second entry in each case. The best result for the other firm would be if it priced
low and received a pay-off of 100 and the cost leader was pushed into setting a
higher price (bottom left in Table 2.1). However, if the cost leader priced low, the
other firm would be best leaving this segment of the market to the cost leader and
pricing high (50 pay-off for the other firm versus 30 if it tried to match the cost
leader’s low price).
However, look at the pay-offs for the cost leader. If the other firm priced low,
the cost leader would be better off matching this strategy (pay-off 120 versus 80 if it
raised price). But if the other firm priced high, the cost leader would still be better
off setting a low price (pay-off 140 versus 100). The crucial thing here is that the
cost leader’s best strategy is to keep price low whatever the other firm does. As we saw in
Module 1, this can be termed a dominant strategy for the cost leader, that is it repre-
sents the best choice for the firm no matter what the competing firm does.
The important consideration for the other firm is that no matter what it does, its
rival (the cost leader) will keep prices low. So that means that the bottom row of
pay-offs (associated with the high price option for the cost leader) is irrelevant in its
calculation. This leaves the top row in which the other firm can choose to match the
cost leader’s low price (pay-off of 30), or go upmarket (and achieve a pay-off of 50).
Clearly the other firm would be better off going upmarket and pricing accordingly,
leaving the cost leader with the larger share of the pay-offs.
However, it is critical here that not only does the cost leader know that its domi-
nant strategy is to price low, the other firm must be fully aware that this is the cost
leader’s dominant strategy. If the other firm (mistakenly) suspected that it could
somehow squeeze the cost leader out of this strategy and undercut it, then a costly
price war could ensue with both firms finishing worse off than would have been the
case had the other firm read the situation correctly. Ways that the cost leader may be
able to persuade the other firm that it would be a tactical mistake for it to try to
achieve cost leadership would be through credible commitments that show it is irrevocably
committed to this low-price strategy, irrespective of what the other firm does. For
example, it could close down its R&D team except for those researchers working on
process improvements, it could standardise its production around one or two basic
lines, it could move all its production to a cheap low-cost location, and so on.
As we saw in Module 1, the ironic thing is that strategies that demonstrably tie the
firm’s hands and lock it into its preferred strategy may help to reduce the chances of
retaliation from competitors. These rivals will perceive they have little or no chance of
shifting the firm from its strategy, and so they will have to plan around it. Just as an
army may credibly threaten its enemy that it intends to stand and fight by burning its
bridges (and destroying its escape route) behind it, so a firm may credibly demonstrate
its commitment to a cost strategy by eliminating the alternatives to it. The important
thing, of course, is not only to burn the bridges but to make sure that the enemy can
see them burning as well. Similarly, if you have no choice but to fight your low-cost

corner, it is important that your rivals know this as well in case they indulge in a futile
price war.
Porter (1985, p. 118) summarises the major steps to be taken in undertaking a
strategic cost analysis of the value chain as follows:
1. Identify the value chain, and separate out and assign costs and assets attributable
to it.
2. Identify the relevant cost drivers and how they interact with each other.
3. Identify competitor value chains, costs, and sources of cost advantage. (This
should help test whether cost leadership is a viable strategy, or at least whether
there are further cost gains that the firm could seek out.)
4. Develop a strategy to reduce costs through cost drivers or by reconfiguring value
chain.
5. Guard against eroding differentiation.
6. Test for sustainability. (Can competitors replicate what you have done?)
A difficulty in carrying out the third step of the process is that rivals are unlikely
to open their books to you to help you work out their cost structure. Further, even
if you can observe that your competitors appear to be pushing down their costs and
prices, it may be difficult to identify the sources of these cost gains. Many cost
drivers, some of which are illustrated in Figure 2.7, tend to be achieved over time
and may be mutually reinforcing (X-efficiency in the diagram below refers to the
elimination of inefficient high-cost practices in the firm). If cost per unit for a
competitor falls, is it because of internal or external economies, innovative im-
provements, learning curve gains or simply the elimination of waste?
In practice, the firm may be able to find indirect methods of assessing its com-
petitors’ cost levels, e.g. market share, the size of its sales team, information on the
costs of publicly available inputs, and so on. At best, the firm may only be able to
get rough guides as to its competitors’ cost positions and how various cost drivers
contribute to the relative positioning of it and its rivals.

* External
* Economies economies
of scale £
£ * Innovation
AC1 ACx
AC
Q Q
* X-efficiency * Learning
£ £
curve
ACx
AC/unit
AC
Q Q
Figure 2.7 Various sources of cost advantage over time
Exhibit 2.2: Cost leadership as a niche: Dell and PCs

It is usual to think of cost leadership as dependent on achieving high market share and
exploiting cost drivers such as economies of scale and the experience curve more fully
than competitors. However, the computer manufacturer Dell achieved the position of
cost leader in the PC industry with a carefully fashioned direct sales strategy that
occupied only a niche in the overall PC market. While most PC manufacturers sold
indirectly through intermediaries such as retail stores, Dell sold directly to the customer
using telephone and Internet technology. There were a number of elements that helped
create and reinforce Dell’s cost leadership.
 Direct selling eliminates the retailer’s mark-up.
 Dell’s build-to-order allows customisation to user needs.
 Eliminating the weeks of delay a PC might be sitting in store means that Dell’s sales
can immediately incorporate the latest changes in components’ prices. These can fall
several times during the year.
 Direct selling gives immediate, direct and high-quality feedback on demand trends.
 The absence of ‘lumpy’ bulk orders from retailers and accurate feedback on demand
trends allows better forecasting and production scheduling, quicker turnover of
inventory, and lower costs of holding stocks. Dell has most of its components ware-
housed within 15 minutes of a Dell factory.
Although Dell achieved cost leadership (estimates suggested that it cost some PC
manufacturers up to twice as much as Dell to build and sell each PC) and had been one
of the fastest-growing PC manufacturers, it was not able to translate this into a domi-
nant market share. This raises two main questions. First, why was Dell not able to

translate this cost (and price) advantage into a higher market share, which in turn should
have reinforced its cost advantage? The answer is that consumers were willing to pay a
premium for products they could see and try out in retail outlets first. Dell’s strategy
eventually hit natural limits on the demand side.
A second question is, how was Dell able to sustain such an effective cost-leadership
strategy in its chosen niche when other manufacturers could have tried to replicate its
cost-leadership strategy? In fact, Dell was not the only direct PC seller. A problem was
also that it was difficult for any company to be active in selling both directly and through
retailers. If a manufacturer that used high-street retailers also became involved in direct
selling, such a strategy could compete with its own sales through shops. This could pose
problems for its established marketing strategy as well as its relations with retailers.
Why do you think Dell concentrated on direct retailing and avoided also selling
through high-street retailers? (Hint: what do you think the attitude of high-
street retailers would be to Dell trying to sell through them?)
2.5 Differentiation
Differentiation is a strategy that may be feasible if a firm can be unique at something
valued by buyers. This immediately raises the first issue we shall be concerned with
here, the sources of differentiation advantage.
Exhibit 2.3: Cleaning up in the toothpaste market

The toothpaste market is one that has significant scope for differentiation strategies.
Toothpaste in a tube is a market that is about a century old and was pioneered by
Colgate–Palmolive. However, until the introduction of Crest (a fluoride toothpaste) in
the fifties by Procter & Gamble, there were few differentiation drivers in this market.
Crest was marketed on the basis that fluoride prevented decay.
Since the introduction of Crest, a number of new toothpastes have been developed
and introduced based on claims to deliver certain benefits in terms of health or
appearance. In part, the changing emphasis reflects changing demographics. The timing of
the introduction of fluoride-based toothpaste reflected the fear of baby-boomer parents
of having cavity-ridden children, while some decades later manufacturers have been
working hard to develop products that help the same cohort reduce the chances of
teeth getting gum disease (such as pyrophosphate-based pastes) or turning yellow
(peroxide-based pastes). Also, baking powder is an active ingredient in many pastes that
helps to deliver a tingling sensation. Other pastes such as Sensodyne are marketed for
those with sensitive teeth. Close-Up introduced sex appeal and helped create the young
adult toothpaste market. Until Close-Up’s introduction, toothpastes tended to be
targeted on preventing tooth decay and the family market.
The toothpaste market is therefore now characterised by a variety of products filling
various gaps in the toothpaste market. There is little room in this market for a purely
cost-based/low-price strategy because any gain in terms of reduced price is overshad-
owed by the fear (real or imagined) that consumers will be sacrificing health or
appearance for modest financial savings. Consequently, successful differentiators such as
Crest, Colgate, Mentadent (Unilever) and Aquafresh (SmithKline Beecham) can expect

to make good margins in this particular market.
Do you think that differentiation in the toothpaste market is achieved with the
help of use criteria or signalling criteria? (see Section 2.5.1)
2.5.1 The Sources of Differentiation

Differentiation advantage may derive from several differentiation drivers. Individual
drivers may impact on different parts of the value chain. The main differentiation
drivers identified by Porter include these:
 Policy choices. Firms may make policy choices that are intended to help
differentiate them from competitors. For example, Kellogg’s used a well-
publicised policy of not supplying its cereal to any other firms, so customers
could be sure that supermarket brands were not Kellogg’s under another name.
 Linkages. Connections within the value chain and vertical links with other
(buyer and seller) value chains can help generate differentiation advantage. One
of the most dramatic cases of this has been the Japanese kanban or just-in-time
system, which has combined rapid throughput of intermediate product and low
levels of stockholding with an emphasis on high quality and low defect rates.
 Timing. Hoover’s early entry and dominance in vacuum cleaners enabled it to
associate its brand name with the activity (‘to hoover’), providing an invaluable
differentiation edge over competitors.
 Location. A differentiation advantage may be derived from location, e.g.
Bureaux de Change in airport terminals.
 Interrelationships with other value chains. This may allow sharing of value-
enhancing elements of differentiation between value chains, for example service
standards, reputation. BIC’s move from disposable pens into disposable lighters
and razors enabled it to share not only cost elements between the respective
value chains but also its reputation for cheap reliable throwaway products and its
point-of-sale marketing expertise. Its failure to repeat this success with its intro-
duction of a cheap perfume showed how differentiation features can be difficult
to transfer in some cases, and indeed may be positively counterproductive.
 Learning. Over time, experience may improve quality, reliability and ability to
deliver service to customers. This can be particularly important in the case of a
complex product with many strands and interrelationships, e.g. hotel chains,
cruise liners.
 Vertical integration and control. Integration may allow the firm a high degree
of control over the reliability and quality of the service it produces, though this
strategy has fallen out of favour to a large extent in recent years in the context of
widespread moves towards outsourcing. Up to the eighties, IBM was a classically
vertically integrated firm but the control it was able to achieve over products and
services was not sufficient to compensate for the slowness to anticipate and deal
with change that came with vertical integration. What is seen as important now is
not the extent of vertical integration but where firms retain vertical integration to

maintain control; for example, Nike outsources production but still retains con-
trol of new product development in-house.
 Scale. The geographical coverage and market share of Interflora, the long-
distance delivery system, give it a major advantage over potential entrants who
would find it difficult to parallel the scope and reach of its services.
These are some of the ways that differentiation may provide enhanced perfor-
mance to the consumer and so enable the product to be sold at premium prices.
However, premium prices may be achieved by differentiation not only through
enhanced performance to the buyer, but also if it leads to reduced costs for the buyer.
Examples of this latter form of differentiation include the following.
 Long-life bulbs and batteries (infrequent need for replacement)
 Corner shop (convenience for minor purchases)
 Car leasing (reduces costs of major breakdowns)
 Chopped wood (saves effort)
 Interior design (reduces search costs)
Thus, the distinguishing feature of this form of differentiation is the reduction in
the real or perceived costs to the buyer as far as the product or service is concerned.
This is not the end of the story, however. Firms may have a product that does offer
a superior and distinctive product or service to buyers. But how is this communicat-
ed to those buyers? Porter distinguishes two kinds of purchase criteria that buyers
can use to make their decisions. Firstly, use criteria which reflect the actual impact of
the product or service on buyer performance or cost. The differentiation drivers
discussed above indicate some of the use criteria that firms may target to pursue
differentiation advantage. Secondly, signalling criteria which reflect signals of value
that may encourage the buyer to infer or judge the quality of the service. Advertising
is one such signal. Advertising campaigns are often designed to persuade the buyer
that the product is a quality service. Also, advertising spend may be taken at least as
a crude indicator of quality; if the firm is seen to commit a great deal of resources to
an expensive promotional campaign, this may be interpreted by some buyers as a
signal of a credible commitment on the part of the seller to the quality of the product.
Buyers may reason that if the product is a dud then the market will eventually
uncover this fact anyway, so it would not be sensible to commit millions of dollars
in launching a product if the only benefit was to be a short-term boost for a grossly
overhyped product.
Use criteria may appear to involve more ‘real’ indicators of value than signalling
criteria, though in fact use criteria can involve intangibles such as style and prestige
value. However, signalling criteria can be as influential in buyers’ decisions as use
criteria, and in some cases they can be the critical factor that decides whether or not
the firm can successfully pursue a differentiation advantage. We shall consider this
point further in the next section in looking at a particular type of market where the
presence or absence of effective signalling criteria can be the major issue that firms
have to deal with.

Exhibit 2.4: Maintaining differentiation: Steinway and Yamaha

Piano competitions are a well-established feature of concert halls. However, one of the
longest-running and fiercest forms of piano competition involved the market struggle
between the two major manufacturers of concert hall pianos, Steinway and Yamaha.
Yamaha made several attempts to make inroads into the concert hall piano market in
the post-war period. Yamaha sought a recognition for quality in this most difficult and
demanding of markets that could have trickle-down benefits into the wider mass-market
segments, much like a successful performance in Formula One Grand Prix may be
perceived to have spillover reputational benefits in the other markets serviced by the
car manufacturers.
Yamaha had been extremely successful in producing good-quality instruments at
prices aimed at the mass market. It was the world’s largest maker of musical instru-
ments, though in the early post-war period it still mostly made pianos for the Japanese
market. Since then, it has achieved a dominant position in the volume end of the global
piano market. Yamaha also made some unsuccessful attempts to co-operate with
Steinway, including offering to be its agent in Japan, but these offers were rejected.
Yamaha eventually decided to challenge Steinway directly in its own market and start
building concert grands that would challenge Steinway’s dominance.
Yamaha grands have made inroads into markets where quality matters but where
there was still a sensitivity to price (i.e. relatively price elastic), such as educational
institutions and academies. However, Steinway managed to maintain its dominance in
the less price sensitive (lower price elasticity) concert hall market.
The difficulty facing an entrant like Yamaha was replicating Steinway’s command of
both use and signalling criteria in this exclusive market. Yamaha’s pianos for the volume
piano market were produced using assembly line methods. Even though it adapted
workshop methods to construct its grands, Steinway still had a strong reputation for its
hand-crafted grand pianos. Yamaha continued to innovate and make improvements in
quality but Steinway still managed to communicate quality in the marketplace (with the
help of endorsements from performers) and maintain a dominant market share, despite
the fact that the cheapest Steinway was significantly more expensive than a Yamaha
grand.
How do you think product life-cycle considerations affect competition in this

market?
2.5.2 Signalling Quality: The Market for Lemons

One of the most important aspects of communicating quality to potential buyers is
information. But sellers often know more about the real quality of their product and
the service they offer than the buyers, and this problem of asymmetric information can
cause problems in transactions, not only for the buyers but also for the seller. It can
lead to problems of adverse selection in that asymmetric information can distort and
bias trading in favour of those who are prepared to misrepresent the true qualities of
their product.
In a famous economic article, George Akerlof (1970) showed that if a market is
characterised by the product or service being of variable quality and buyers having

difficulty in telling high-quality products from low-quality products before purchase,

then ‘lemons’ (that is, duds, or products of inferior quality) may not only survive but
begin to dominate this market. Used cars can be an example of such a market. Two
cars may appear to be identical to potential buyers, but one has been well looked
after and expensively maintained, while the other has been roughly driven, poorly
maintained and with an owner who is prepared to misrepresent the history and the
true qualities of this ‘lemon’. If buyers cannot discriminate between the high- and
low-quality product, the price they will be prepared to offer will be influenced by
their perception of the average quality of the used cars offered for sale, and their
perception of their chances of being stuck with a lemon.
Since this market price will tend to underestimate the real worth of superior-
quality used cars, the sellers of such cars may remove them from this market in the
belief that they would not get a fair price. Alternatively, they may see little point in
carefully and expensively maintaining their cars if they plan to sell them in the near
future. Either way, this will increase the proportion of lemons in the used car
market, and further reduce the potential buyers’ perception of average quality,
reducing the price they are prepared to offer, and pushing out even more cars at the
higher-quality end of the market. This may become a vicious circle as in Figure 2.8,
with the low price pushing out higher-quality cars, reducing average perceived
quality, lowering the price, pushing out still more higher-quality cars, and reducing
average perceived quality even further. In the worst cases, it may be difficult or
impossible to create a market at all because the lemons have pushed out all the
quality products in this market.
The ‘lemons’ problem is something that can be a potential problem in many
markets, particularly those that involve a complex non-standardised product of
variable quality, and if trading relationships between specific buyers and sellers tend
to be merely occasional or one-off. These are characteristics which can fit a wide
variety of markets, from used cars, to holiday accommodation, to financial services.
However, there are a number of devices that can be used to at least partially
offset the lemons problem. The seller may be able to draw on the following.
 Reputation and word-of-mouth recommendations. This depends on the
extent to which future custom may be adversely affected by poor performance in
the present. In turn, this can depend on the nature of the market, e.g. it may be
important if the market is highly localised, as for many medical services.
 Warranties and guarantees. This can help signal quality; e.g. if the seller is
prepared to commit to, say, a three-year guarantee. The guarantee not only shifts
some of the potential costs of repairs on to the seller post-sale, it can act like a
hostage influencing the buyer’s perception of the quality of the product before
the sale takes place. If a product is really of poor quality, it would not be sensible
for sellers to commit themselves to a guarantee system that ties them into an
extensive series of product returns and repairs. However, guarantees may not
remove the lemon problem altogether but in the worst cases could just move it
one stage back; buyers may be concerned that the guarantee itself may be a lem-
on, with problems only appearing afterwards in the form of the fine print,
restrictive clauses, etc.

reduces market price
reduces perceived
pushes out higher-
average quality
quality products
increases proportion
of lemons in the market
Figure 2.8 How lemons and asymmetric information can destroy a

market
 Industrial and professional associations. Associations or clubs for sellers can
give some assurances of standards to the buyer by requiring certain standards or
evidence of competence and qualifications for entry, and/or providing mecha-
nisms for continuing to police maintenance of standards for their members. This
can provide some basic assurance to the seller, but in many cases it tends to send
only basic signals that a certain standard for certain specified criteria has been
reached, rather than fuller information about the true quality of the product or
services provided by the seller.
 Brand name recognition. Brand name recognition can help communicate
quality in many markets where lemons are a problem or potential problem. Big
name automotive manufacturers have moved into the used car market in recent
years, which on the face of it may appear strange given that there are many buy-
ers and sellers of used cars, while the market for new cars is highly oligopolistic.
A simple analysis of the relative structures of the used and new car markets
would suggest that we would expect the return on investment in the used car
market to be much less than in the new car market. Indeed, if the used car mar-
ket were perfectly competitive, firms would not be able to make anything other
than normal profits in this market. It is the fact that this market breaches one of
the important conditions of perfect competition (buyers here are not perfectly
informed about the qualities of the product) that creates an opportunity for
brand name operators to use their reputation to communicate assurance of quali-
ty to the buyer. In turn, this should enable these operators to sell their used cars
at premium prices compared to, say, Sloppy Joe’s Used Car Mart.
 Chains and franchising. These can help transfer brand name recognition and
communicate quality assurance in areas where consumers value a specified product
and reliable service, such as fast food outlets. This device trades off variety for
standardisation.
 Consumer guides and reviews. Whether you want to buy computer software
or a new washing machine, there is probably a review of the product somewhere.
It could be in publications dedicated to consumer interests, specialist publica-
tions or sections of publications. This may not resolve the information problem

facing the consumer if there is still an information problem of finding the rele-
vant review or reviews. Also, such reviews may reflect the personal preferences
of the reviewer, and may themselves be subject to reliability problems.
 Intermediaries. In some cases, intermediaries can use their professional
expertise to scrutinise, monitor and recommend services and facilities offered by
firms in their sectors (e.g. travel agents, financial advisers). This may reduce the
lemons problem, but as with guarantees it may simply push the lemons problem
one step further back in the process, at least in the worst-case scenarios. In some
cases the potential buyer may have reason to be concerned that the intermediary
is itself a lemon, for example if its advice could be compromised by fees or
commissions from the products and services it recommends.
Exhibit 2.5: How much is a brand worth?

Branding is one of the major techniques to help a company differentiate its product, and
can be treated as an intangible asset with an identifiable value to the company. Inter-
brand, the international brand consultancy, produces an annual league table of brand
values, and estimates the most valuable brands in the world as Coca-Cola, Google and
Microsoft.
Interbrand uses discounted cash flow techniques to measure the present value of the
future earnings attributable to the brand (adjusted for risk). In Coca-Cola’s case, the
brand value can be worth more than its plant, equipment and other assets put together.
The value of a brand is strongly affected by its ability to sustain its earnings potential
into future periods and for its value to be ‘stretched’ into other products. In some cases
local brands may compete successfully against a global brand like Coca-Cola. Indeed,
Coca-Cola has made moves into foreign and domestic markets using products which do
not feature its traditional brand name. And in some cases there may be inter-
generational barriers to transfer of brand loyalty (more bluntly, children like to be
different from their parents). This has contributed to the problems of a ‘traditional’
image for some brands such as St Michael (retailer Marks and Spencer in the UK) and
Levi Strauss (in the US).
Rebranding a good widely regarded as of inferior quality with a superior brand

name can have the effect of significantly boosting sales. So why is this not
practised more widely?
In addition, government or its agencies may also deal with some aspects of the
lemons problem through various devices including:
 licensing;
 regulation;
 anti-trust policy.
Such intervention tends to be a rather blunt tool and is usually intended to ensure
that a certain minimum level of performance is achieved. Each of these devices may
also be expensive to set up and administer. Many of the potential lemons that
actively concern government are those that affect the health or safety of individuals,
such as in the sectors of food, transport and pharmaceuticals. It might be thought

that anti-trust would only be relevant after the event once certain abuses of market
power have taken place, but it may also serve as a deterrent to firms tempted to
misrepresent their products to consumers.
In short, there can be a variety of devices that firms and government agencies
may be able to utilise to deal with the lemons problem. Which devices (if any) can
be used depends on the particular market in question, and its characteristics. Some
markets can even draw on all or most of the devices above (e.g. the market for
personal pension plans in many countries). The crucial points to bear in mind about
such devices is that in some cases they may be only partially effective in signalling
the true quality or characteristics of a product or service, and that they may be
expensive and time-consuming both to create and maintain.
2.5.3 Steps in Differentiation

Porter suggests that there are several steps that should be taken if a firm wishes to
pursue a differentiation strategy:
1. Identify the relevant buyer. This can be difficult in heterogeneous markets and
it may not even be the person or group that actually consumes the product. For
example, in prescription drugs markets it tends to be the doctor who recom-
mends and prescribes the product, while in academic textbook markets a similar
role is usually taken by the class lecturer. In such cases, the features that appeal
to the actual users may not be the same features that appeal to those who are
responsible for recommending the product.
2. Identify the firm’s impact on the buyer’s value chain. It is important to
establish what drivers actually do or could do to differentiate the product in ways
that add value, either by improving the performance of the buyer or reducing the
costs to the buyer. There is no point in producing a ‘better’ product if the im-
provements are not valued by the buyer, or if they are seen to impose
unacceptable costs on the buyer. Textbook writing can provide an example of
this. It is generally difficult for writers of textbooks for introductory and inter-
mediate courses to change their texts too far from the established content and
order of the standard syllabus, whether in economics, psychology or physics.
Even if it was believed that some radical changes in content could provide real
educational benefits for the users (students), radical changes could cause signifi-
cant disruption to schedules for the class to which it applies, and have spillover
consequences for other classes. That is why so many basic texts in economics
look so similar and are in effect close substitutes.
3. Identify the buyers’ criteria for purchasing. As we noted above, these can
involve use and signalling criteria. A main lesson of Section 2.5.2 is that meeting
use criteria for a set of buyers in a unique and cost-effective way may not be
sufficient for competitive advantage if there are deficiencies in signalling quality.
Use criteria and signalling criteria can be complementary in the search for com-
petitive advantage.
4. Identify actual and potential sources of uniqueness. Once the firm has
established the criteria that are perceived as adding value to the buyer, it can deal
with what it can offer to add value to the buyer in a unique way. Since competi-

tive advantage is measured relative to competitors, this exercise should be carried

out by analysing what the firm offers, or could offer, that its competitors do not.
5. Identify the cost of actual and potential sources of differentiation. Differ-
entiation tends to absorb resources and cost money. The supply-side costs of
differentiation should be calculated and set against the demand-side benefits of
differentiation.
6. Assess benefit versus cost of differentiation alternatives. Just as a normal
investment project would calculate the benefits of different investment pro-
posals, so the costs and benefits of alternative differentiation alternatives should
be considered. In some cases the alternatives will be substitutes competing for
the same or overlapping spaces in the marketplace; in other cases they may be
complementary with the firm being able to target different segments of the mar-
ket simultaneously.
7. Test for sustainability. Even if the strategy leads to a competitive edge in the
near future, could other firms easily imitate it? For example, loyalty cards (super-
markets) and air miles (airlines) may temporarily differentiate the product, locking
in customers and increasing trade for the first firm to introduce them. However, if
all the other firms in the sector follow suit, the original advantage is nullified and
proves unsustainable. The original innovator of the new feature may choose to
retain it (so that they do not actually lose out to the rest of the firms in the sector if
they alone were to abolish it), but the feature no longer provides a net source of
advantage in the competitive race. The trick is to find something that cannot be
easily replicated or imitated.
8. Reduce costs that do not affect differentiation. This last step is a reminder to
keep cost proximity with competitors in mind to push profit maximisation as far
as possible, as well as reducing the chances of the firm becoming vulnerable to
undercutting by lower-cost competitors.
2.6 Focus
Focus strategies depend on differences between segments of the same market and can
reflect search for cost advantage in a particular segment or limited set of segments
(cost focus) or search for differentiation advantage gains in a segment or limited set of
segments (differentiation focus). Unlike broad-based differentiation and cost leader-
ship strategies on the part of the firm where we start with the strategy then adapt it to
the needs of a particular segment, focus strategies start with the needs of the segment
and tailor the strategy accordingly. The logic is that there is a niche in the overall
industry which the firm can tailor its value chain towards uniquely satisfying, even if it
does not have a competitive advantage in the industry overall. The value chain is
optimised for that particular segment or set of segments only. In the European car
market, Rolls-Royce exemplified differentiation focus and targeted up-market buyers,
while Lada pursued cost focus based around a cheap, no-frills product.
‘Focus’ has been one of the most widely used words in modern competitive
strategy, so it is important to note that it can impact on corporate strategy in two
main ways. In some cases it may refer to the entire firm, as in the case of Apple,
while in other cases the particular focus may refer to just part of the firm.

The advantage of a firm-wide focused strategy such as is represented by the Apple case
is that it allows the whole of the firm’s value chain to be dedicated to satisfying the
purchase criteria for the buyers in the selected market segment. In essence, it
provides no more and no less than the straightforward gains from specialisation,
with the firm being able to identify and respond to the particular needs of its target
market.
However, there are a number of possible disadvantages of a firm-wide focused strategy.
These can include:
 Limited opportunities for economies of scope. Diversification could open up
possibilities for economies of scope to be exploited within a broader-based cost
leadership or differentiation strategy. The narrower base implied by a firm-wide
focus strategy may limit these opportunities.
Exhibit 2.6: Electronic flea markets

The Internet may open up methods of online retailing that may provide a source of
profit opportunities for firms, but as Exhibit 1.5 (The more you sell, the more you lose)
showed, it is not a guaranteed route to success.
One opportunity which the Internet opens up is for auction sites that can match
buyer and sellers in small-scale, niche or ‘thin’ markets. This is the sort of market that
could be characterised as a sort of electronic flea market – sellers with idiosyncratic and
sometimes specialist offers trying to find the buyer who might be interested in what
they have to offer. Companies like eBay can use the search possibilities offered by the
Internet to match buyers and sellers in thin markets, and take a fee as market maker for
doing so. The fee from one particular sale or even one market may be small, but eBay
can pursue profit by aggregating revenues from many different niche markets, and
exploit economies of scope across these different markets in its online auction system.
Such systems avoid the warehousing costs associated with online retailers such as
Amazon.com, and the physical distribution costs are typically borne by the buyer.
How do you think elasticity of demand for the products sold by eBay differs
from those sold by Amazon.com? What implications does this have for profit
opportunities in the respective cases?
 Limited growth opportunities. By definition, since the firm is tying itself to a
particular market segment or set of segments, its growth opportunities are
bounded by the growth potential of this niche. This may not be a problem in a
fast-growing segment, but it can be if and when this market reaches the mature
stage of the product life cycle.
 Vulnerability to external threats. A focused firm has no hiding place. If
imitators swarm in, or if technological change or change in buyers’ purchase
criteria threaten its technological or market base, then its very survival may be
threatened. This is what happened to Filofax, the firm that became synonymous
with the loose-leafed personal organisers that were ubiquitous during the eight-
ies. The firm had pursued a focused strategy since its founding in 1921 and only
really achieved spectacular growth late in life. However, external threats such as

the growth in popularity of electronic organisers led to running at a loss. It was

eventually taken over by a competitor in 1998.
Being taken over is in fact the fate of many smaller focused firms. Acquisition by
a larger firm may follow because the firm does not have the depth and breadth or
resources to get itself out of trouble, especially if it is under attack. It is at just such a
point in the firm’s history that it is likely to be least able to get access to the neces-
sary time or resources to fashion an effective plan for resistance or escape. At the
same time, a successful focused strategy does not necessarily protect the firm from
attracting the interest of larger firms. On the contrary, outside firms may perceive
further gains from partially integrating the value chain of a successful focuser with
their own value chains. For example, many small, specialised biotechnology firms
have been assimilated by larger firms in the pharmaceutical industry with a mind to
integrating the innovative capabilities of the target firm with the marketing and
distribution muscle of the larger firm.
For these reasons, many focused strategies reflect just one part of the overall
activities of the firm, either because internal growth objectives have pushed the firm
out of its original niche market, or because merger and acquisition has put together
a variety of generic strategies. When this happens, the firm may still be able to
customise its strategies to suit the dictates of individual market segments. For
example, if a firm is mostly involved in the production of commodity-style food
products (sugar, soya, etc.) with some minor interests in tinned products, it may
have a broad-based strategy of seeking cost advantage in its commodity businesses
while pursuing differentiation focus in its branded (tinned goods) sector.
However, there may still be opportunities for links with other value chains within
the firm beyond the segment or segments directly involved with the focus strategy.
Indeed, if there are no such linkages, the firm’s strategy is then effectively a con-
glomerate strategy in which there are no significant market or technological linkages
between the value chains in the respective businesses or sets of businesses. This can
happen even for a firm that is consistently operating within the industry, and in fact
in the food industry it is not unusual for some of the larger firms to be involved in
so many different sub-markets and technologies for them to be described as ‘food
conglomerates’.
If the demand for a focused strategy from some parts of the firm is such that
there is little (if any) value to be added to this segment through association with the
core businesses of the firm, divestment of the focused segment may be seen as a
value-enhancing option. This is what the chemicals firm ICI did with its pharmaceu-
tical business when it spun it off as a separate company, Zeneca. ICI had come to
the conclusion that the high-tech, R&D intensive drugs business was so different
from its core commodity-style bulk chemicals markets that both really deserved
completely separate and dedicated management teams.
Consequently, even if the firm is applying a focused strategy to a segment or
segments, there should be a presumption that the firm is able to exploit some value-
enhancing gains from linkages with the rest of the firm. These linkages could be at
the level of individual resources, or groups of resources in the form of competences

and capabilities. If there is no such gain then the strategy is not adding value, and
could even be destroying value.
This last point might seem to be puzzling. It could be obvious that a focused
strategy in part of the firm might not add much (or any) value through linkages with
the rest of the firm. But how could such a strategy actually destroy or reduce value? If
the focused strategy results in no real linkages with value chains in the rest of the
firm, then surely all this means is that combining the focused segment with the rest
of the firm has a neutral effect on value. So what is the objection to having it inside
the firm if it is doing no real harm?
This question goes to the heart of the logic of corporate strategy, not only in the
context of focus strategies but for other strategies such as diversification (Module 5)
and international strategies (Module 6). The answer to it comes in two parts.
1. Fallacy of free focus. First of all, it is a fallacy to argue that there is no harm in
having a focused strategy if it simply results in no connections with value chains
in other parts of the firm. This is the same flawed logic that would argue that
there is no harm in keeping your savings under the bed in the form of cash. In
both cases there may be an opportunity cost in the form of sacrificed value. The
cash that is sitting under the bed could be made to work harder, at least by earn-
ing interest in a savings account in a bank. Similarly, investing in developing and
maintaining a focused strategy in the firm may have the opportunity cost of the
value that could instead be extracted by diverting these managerial and financial
resources to pursue areas that could add the value of shared linkages with the
rest of the firm.
That is why focused strategies still generally reflect some residual shared element
or set of elements with the rest of the firm in terms of value chain linkages. If
there is no such set of linkages, then the firm is likely to be better off ‘sticking to
the knitting’ and concentrating on what it knows and does best. The general
existence of across-the-board shared linkages is confirmed by the tendency for
even large diversified firms to fall into recognisable industry categories, e.g. Ford
(automotive), Du Pont (chemicals) and GE (electronics and electrical engineer-
ing).
2. Linkages cost. So focus does not mean sacrificing linkages with the rest of the
firm; linkages still have to be exploited to some extent if it is to make sense for
the firm to be involved in this focused segment. We saw examples of linkages
earlier in Figure 2.3. However, these linkages do not add value spontaneously;
they have to be organised. Porter identifies three major costs of organising
shared linkages between different industry segments served by the firm.
 Cost of co-ordination. Linkages require commitment of managerial time and
resources and this may be difficult to achieve across business units. Figure 2.6
helps illustrate some of the problems; once cross-unit co-ordination is re-
quired, resources and activities not only have to contribute to value within a
business unit but also to shared activity across units. This can be a difficult
trick to pull off and can lead to quite complicated organisational arrangement
such as the mixed structure we looked at earlier in Figure 2.6. As we dis-

cussed in relation to Figure 2.6 this can lead to confusion and communication
problems.
 Cost of compromise. If linkages are to be exploited between the focused strategy
and the rest of the firm, it may entail some compromise. For example, a food
retailer may base its strategy around cost leadership in the fast food sector,
but also have an up-market seafood chain with a differentiated focus strategy
for this segment. The firm may see the opportunity for linkages across seg-
ments by exploiting economies through bulk buying. These linkages may
entail no compromise in some segments (e.g. bulk buying of sugar and salt)
but may entail significant compromise in other areas (e.g. bulk buying of
knives and forks). If the firm bulk buys the kind of cutlery that reflects users’
purchasing criteria in fast food, this may send the wrong quality signals to its
up-market seafood customers. If it bulk buys the kind of cutlery that its up-
market seafood customers would expect, this may be inappropriate and too
costly for its fast food business. Compromising by bulk buying cutlery of
moderate quality may satisfy the value chain needs of neither segment.
 Cost of inflexibility. Linkages can reduce flexibility. If the firm wishes to change
its strategy relating to one business, then it may have knock-on implications
for other businesses with which it shares linkages. This can reduce flexibility;
for example, it may make it difficult for the firm to divest or close down an
unprofitable business. One of the reasons that the post-war UK automotive
industry was slow to change and divest unprofitable businesses was that link-
ages such as shared dealer networks and common components were sought
in a wide variety of businesses, from cars to Land Rovers. Divesting one
business was seen as potentially pushing up costs in the remaining businesses
as economies of scope were sacrificed. While this may have been true, it also
tended to reduce focus, dampen innovativeness and inhibit adaptability at
segment level.
It should be noted that these considerations can apply within strategies and not
just between a focused strategy and the rest of the firm; for example, a cost leader-
ship strategy based on sharing a technology across business units can also encounter
costs of co-ordination, compromise and inflexibility in organising linkages. Howev-
er, these problems come into sharpest relief in the case of the relation between a
focused strategy and the rest of the firm.
Consequently, the logic of focus strategies is based on a simple trade-off. From
the point of view of adding value at business unit level, the value chain for that unit
should be customised and tailored as far as possible to satisfy the purchase criteria
for the buyers in that particular segment. From the point of view of adding value
based around interrelationships between business units, the firm should exploit as many
linkages between units as possible. The further focus is pursued, the less interrela-
tionships between units may be identified and utilised. The more interrelationships
between units are emphasised, the more focus may be compromised. How far the
firm should go in terms of trading off the benefits of focus against the gains from
interrelationships depends on the case in point.

2.7 The Dangers of Hybrid Strategies

Is it possible for a firm to pursue both cost advantage and differentiation strategies
in the same segment? Porter argues that it is not normally possible to do this since
the two generic strategies make incompatible demands on the firm. Differentiation
typically involves costly expenditure on the part of the firm both to create and
communicate qualitative differences with respect to competing products, such as
expensive components, systematic back-up and servicing, costly promotional
expenditure, etc.
Since it involves differentiation, it also means targeting (or creating) segment
demand that is less sensitive to price differences (that is, less price elastic) than is the
case for cost leadership cases where price can be the defining advantage. Such a case
is shown for the firm on the left in Figure 2.9. The firm has incurred costly expendi-
ture in order to differentiate its product and this is reflected in its average cost curve
(AC1) being higher than the case for the firm going for no-frills cost leadership at
the bottom of Figure 2.9. The strategy has been successful as can be seen from
Figure 2.9. As long as the firm does not overreach itself and try for too high a
market share, there is a region over which such a strategy can be profitable (up to
output X in Figure 2.9).
Similarly, there is room in this segment for the second firm wishing to go for a
cost leadership strategy. This means stripping out many of the attributes that help to
differentiate products in this market and going for a lean, low-cost strategy. In this
case the firm is able to achieve profitability once it has reached the breakeven point
of Z in Figure 2.9.
These two strategies result in the firms operating in distinctive regions of this
market. The differentiator aims for a relatively price inelastic niche where the
costliness of its differentiation strategy is rewarded with premium prices. The cost
leader has aimed for scale and market share to achieve the low-cost operation that
allows it to undercut competitors’ prices and still make a profit. Since differentiation
advantages have been sacrificed, it can normally expect to be operating in a more
price sensitive (price elastic) part of the market than differentiators. In this case, the
differentiator must not spoil its market by being greedy and trying to steal too high a
market share by pricing too low. By way of contrast, the imperative for the cost
leader is that high or dominant market share is essential if it is to achieve a cost
advantage over competitors.

This firm has identified

a market niche and This firm is stuck
is exploiting it in the middle
D1
AC2
$
$
AC1
D2
0 0
X
Output Output
This firm has gone for

cost leadership and
economies of scale
$
AC3
D3
0 Z
Output
Figure 2.9 Stuck in the middle

This leaves the third firm in Figure 2.9, the firm ‘stuck in the middle’. It has tried to
pursue both differentiation and cost leadership strategies simultaneously and so has
fallen between two stools. In trying to differentiate its product it has pushed its cost
curve AC2 up. At the same time, in trying to achieve cost leadership it has outrun the
limited market in which a differentiation advantage would have been appropriate,
while still not being large enough to exploit fully the economies of scale and experi-
ence curve advantages that a large market share would have helped it achieve. Even if
it did achieve the scale of output appropriate to a cost leadership strategy in this
market, the costly differentiation elements in its strategy would prevent it from
competing on the same cost terms as a firm pursuing a simple cost leader strategy.
Some care should be taken in interpreting Figure 2.9. Even though these firms are
competing in the same market, the demand and cost curves for each firm may be
quite different, and not just between the cost leader and the other two firms. Remem-
ber that differentiation may involve shifting demand as well as the cost curves, or even
creating completely new demand. The way to think of Figure 2.9 is that there may be
several firms successfully differentiating their product, each with their own individual
(relatively price inelastic) demand curves and (relatively high) cost curves compared to
the cost leader. The products in this market are likely to be only partial substitutes for
each other, unless two or more firms are pursuing identical differentiation strategies,
or two or more firms are vying for cost leadership.
Being stuck in the middle is a consequence of a lack of clarity and consistency in
formulating and maintaining a competitive strategy designed to deliver competitive
advantage to the firm. It can be a particular temptation during the growth phase of
the product life cycle when the weakness of the strategy may be concealed by the

softer competitive conditions that may prevail during this period. Once the market
approaches saturation, firms that have failed to develop a clear strategy that can
deliver competitive advantage may be particularly vulnerable in any shake-out phase.
However, there may be circumstances in which a firm can pursue both cost lead-
ership and differentiation in a market. We noted above in Section 2.6 that it could
be possible for a firm to pursue a cost leadership strategy in fast food while also
pursuing a differentiation strategy in seafood. These were effectively separate
markets, though the firm could exploit some gains in links between the respective
value chains. The downside was the possible costs of compromise that the linkages
could lead to. It may also be possible for a firm to achieve similar gains within a
market if different business units are given responsibility for pursuing differentiation
and cost advantage.
The difficulties which firms often face in balancing these different generic strate-
gies within the same market is that distinctive competences which have contributed
to competitive advantage in one part of the market may give no advantage in parts
of the market which require a different generic strategy. A firm which has built up a
reputation for quality and service may find that the rules of the game are rather
different in the mass market areas where cost and price are paramount. Similarly, it
may be difficult for a cost-oriented firm to develop the skills and attitudes needed
for differentiation.
The worst outcome in both cases is for the firm to transfer inappropriate skills
and competences into the other area of the market, with the differentiator unneces-
sarily ‘goldplating’ basic services in the price-conscious mass market end, and the
cost leader opting for false economies that send the wrong quality image when it
tries to go for differentiation. If such a mixed strategy is going to have a chance to
work it depends on the firm setting up distinctive units to pursue the different
generic strategies, and separating out the respective value chains to make sure they
do not become muddled or confused.
At the same time Porter identifies possible cases where it may be possible for the
firm to pursue a ‘stuck in the middle’ strategy in which it pursues differentiation and
cost leadership strategy using the same business unit and based on the one value
chain. These cases include the following.
 Competitors are also stuck in the middle. If a firm’s competitors are also
stuck in the middle then the firm may be able to get away with being stuck in the
middle as well. However, this may not be a recipe for a stable and sustainable
strategy since it may be attacked once existing rivals or entrants move towards
clearly based generic strategies.
 Cost is strongly related to scale. If cost is strongly affected by scale factors such
as economies of scale and scope and experience curve effects, then the firm may
open up a big market share advantage and still be able to offer services that com-
petitors find difficult or impossible to match. Microsoft, Intel and Amazon.com
are examples of firms that have pursued both differentiation and cost advantage in
their respective markets.
 Being first to innovate. If you are the only game in town, then by definition
you offer a differentiated service at a price no one else can match. However,

even if this advantage has patent protection it will eventually be open to imita-
tion by competitors, unless there is something that is difficult or impossible for
competitors to imitate. One area where this may be possible is in cases where
advantage depends on an organisational or technological recipe that is difficult to
unravel or imitate precisely, especially if this is backed by an effective branding
effort as in some parts of the fast food sector.
Learning Summary
This module has been concerned with the topic of basic or generic strategies, what
influences their choice, and the implications of that choice. We have examined how
to analyse the major strategic options open to the firm, and when and how cost
leadership, differentiation and focus may be pursued. The firm may be able to draw
on cost or differentiation drivers of competitive advantage to extract competitive
advantage in particular situations. It is essential that a clear, consistent and sustaina-
ble strategy is chosen. Otherwise muddle and confusion about what the firm is
trying to achieve may create competitive openings for rivals.
However, the choice of generic strategy is only one element in the set of choices
that the firm has to make in formulating strategy, and we shall be looking at strategy
in other contexts in subsequent modules. We shall start with innovation strategy in
the next module, vertical strategies in Module 4 and horizontal strategies in Module
5. We shall then look at international strategies in Module 6 before going on to look
at how strategies are pursued in Module 7. When the analysis of these modules is
combined with the analysis of generic strategies in this module, we shall have gone
some way to examining the issues and influences that underlie the direction and
content of strategy in the modern corporation.

Review Questions
2.1 A firm may obtain differentiation advantage if:
A. it offers something that no other firm offers.
B. it can operate at lower cost than any of its rivals.
C. it is perceived to be different by the buyers of its product.
D. it can be unique at something that is valuable to buyers of its product.
2.2 A firm may obtain cost advantage if:

A. it can exploit economies of scale in production.
B. the cumulative cost of performing all value activities is lower than competitors’
costs.
C. it can offer a low-quality product at lower cost than any of its competitors.
D. discounting allows it to undercut its competitors.
2.3 A successful differentiation strategy should:

A. increase price elasticity of demand for the product.
B. maintain price elasticity of demand for the product.
C. reduce price elasticity of demand for the product.
D. eliminate price elasticity of demand for the product.
2.4 The value chain:

I. is applied at SBU level.
II. identifies separable activities.
III. separates out activities with impact on cost and differentiation.
A. I and II only.
B. II and III only.
C. I and III only.
2.5 Benefit drivers for differentiation advantage can include:

I. product availability.
II. product cost.
III. product reliability.
A. I and II only.
B. I and III only.
C. II and III only.
D. ll of the above.
References
Akerlof, G. (1970) The market for lemons: qualitative uncertainty and the market mecha-
nism, Quarterly Journal of Economics, 84, 488–500.
Porter, M. (1985) Competitive Advantage: Creating and Sustaining Superior Performance, New York,
Free Press.

Module 3
The Evolution of Competitive

Advantage
Contents
3.1 Introduction.............................................................................................3/2
3.2 The Innovative Process ..........................................................................3/3
3.3 The Characteristics of the Innovative Process ....................................3/6
3.4 Why Innovation can be Squeezed off the Firm’s Agenda ..................3/9
3.5 Solutions ............................................................................................... 3/16
This is the first module in which we examine thoroughly a single area of strategy, in
this case innovation. Innovation is an area which has several basic characteristics
that strongly influence resource allocation in this area, in turn leading to numerous
hurdles to efficient management of this process, and finally encouraging a variety of
solutions to these hurdles. We show how the basic characteristics, the hurdles and
the solutions relate to each other. One of the important issues discussed here is that
there is no such thing as a free lunch in this context; the various solutions to the
problem of innovation may themselves be costly or generate further problems in
addition to those they are trying to solve. Innovation can be a complex, costly, time-
consuming, uncertain process with most of the benefits accruing to others rather
than those who are incurring the time, trouble and expense of pursuing it. While
firms may explore ways of trying to encourage innovative activity in the face of
these daunting characteristics, they tend to be features of the innovative process that
strategic planners must learn to live with.
Learning Objectives
 describe the major stages and features of the innovative process;
 explain why innovation can easily be squeezed off the firm’s agenda;
 describe the major hurdles facing innovative activity in the firm;
 analyse alternative solutions to the problem of innovation.

Module 3 / The Evolution of Competitive Advantage
3.1 Introduction
In this module we shall be concerned with the management of innovation and in
particular with solutions that firms have developed to help stimulate innovation in
the search for competitive advantage.
It might be helpful to start out with some basic points and then build on them.
 Point 1: to be a successful innovator it is best to be first with a good new idea.
 Point 2: survival of the fittest means that if your product is inferior to competi-
tors, it will lose out in the marketplace.
 Point 3: if you can convince the public that your product is a good idea and
affordable, people will rush to buy it.
Exhibit 3.1: Fax facts

Even if a product is a good idea, success may depend on chance factors, especially if its
success depends on the creation of a network. Fax or facsimile technology is based on
the electrical transmission of printed material and drawings and became a ubiquitous
feature of late-twentieth-century communication. However, although the fax machine
was invented in the nineteenth century, anyone trying to use it before the 1980s would
have found very few other individuals to communicate with. One factor that influenced
its breakthrough was that Japanese manufacturers and consumers discovered that it is a
very suitable medium for communicating pictures, which is essentially what the Japanese
written language is composed of. The Japanese also possessed the resources in R&D,
marketing and distribution necessary to get the invention into the commercial market-
place. Ironically, having been on the shelf for decades before the 1980s, the fax machine
is already in danger of being rendered at least partly obsolete since personal computers
can now be adapted to perform similar operations.
If it had not been for the particular problems posed for electronic transmission in
Japanese, the fax machine might never have had the chance to make its commercial
breakthrough. Individuals and businesses might instead have moved straight from
telegraph to computer as their preferred means of electronic communication of text. In
short, like the telephone, the fax machine was certainly a good idea but its development
was not inevitable and was certainly assisted by peculiar problems posed by using the
Japanese language for communication purposes.
Why would anyone buy the first fax machine?

These are things that everybody knows, but unfortunately they are not necessarily
correct. As far as Point 1 is concerned, while it is easy to find examples that support
these statements, it is just as easy to find examples that do not. For example, 3M
was first with Post-it notes and this innovation has been one of the most commer-
cially successful in the firm’s history. However, De Havilland was first to introduce
the jet airliner, but lost its early advantage to Boeing. Other examples of first-
movers who subsequently lost out to more successful followers include RC cola
(diet cola), EMI (body scanner), Bowmar (pocket calculator) and Xerox (office
computer). In these cases the successful strategy turned out to be wait and see.

Point 2 is also faulty; as regards finding examples of something that has survived
despite being shown to be (allegedly) inferior to more efficient alternatives, you
probably have one at your fingertips – literally. It is the QWERTY keyboard format
which experiments have shown is inferior in terms of typing speed to some alterna-
tive formats. However, the QWERTY standard has not been seriously challenged by
these rivals and there is little prospect of this happening in the foreseeable future.
The QWERTY standard has proved robust and enduring even if it could be
demonstrated to be inferior to some alternatives. We shall explore the reasons for
this paradox in Section 3.2.
There are also difficulties with Point 3. Microsoft Windows was a good example
of translating public belief that a product was a good thing into commercial sales,
but often this is not enough. Who bought the first telephone? Or to put it more
precisely, why would anyone want to buy a telephone when it does not connect to
anyone else? It does not seem a very sensible thing to do, but if there is no incentive
for anyone to be first, why did any rational consumer ever buy a telephone? Exhibit
3.1 looks at a case where a fundamental reason which led to a good idea becoming
successful lay in the idiosyncrasies of the Japanese language, isolated peculiarities
which helped trigger the eventual success of the innovation globally – at least until
other forms of electronic communication largely replaced it.
In the next section we shall take an overview of the innovative process before
looking at some basic characteristics of it in Section 3.3. Section 3.4 covers what is
summarised as the innovation problem; the modern corporation may fail to give
adequate support to potentially value-enhancing innovative activity. Section 3.5
looks at some of the many and varied solutions to the innovation problem that
corporations have devised.
3.2 The Innovative Process

Invention usually refers to the act of devising or creating some new idea. The term
innovation is usually reserved for the commercialisation of that new idea by some
individual, firm or other organisation. The innovative process can refer to all the various
stages and activities that combine to produce an innovation. One obvious distinc-
tion in the context of innovation is between product and process innovation. Product
innovation offers a new good or service, while process innovation is concerned with
the development of a new production technique. They can be easier to distinguish
conceptually than in practice; for example, some product innovations may require
the introduction of new methods of manufacture.
Research and development is the function or group in the firm responsible for search-
ing for technological innovations. The core of the R&D group is usually composed
of QSEs (Qualified Scientists and Engineers), though in smaller firms the R&D
activity may be conducted on an occasional basis by professionals mainly involved
in other functions, such as production. The prime purpose of the R&D group is to
generate and refine technical knowledge that can lead to an innovation. However,
knowledge itself can be categorised into tacit and articulable categories. Articulable
knowledge is generally of the type that can be sent down a telephone line or faxed

(e.g. technical specifications or pictures of a bicycle), while tacit knowledge usually

cannot be communicated by such means but may instead have to be built up
through experience, experimentation and individual learning (e.g. how to ride a
bicycle). The process of innovation can involve both articulable and tacit knowledge
on the part of the organisation. For example, Boeing knows how to innovate in the
field of aircraft technology. When Boeing introduces a new aircraft, it may draw
upon articulable knowledge (such as patents, blueprints, plans, foremen’s instruc-
tions, strategic plans) and tacit knowledge (such as skills of the workers, researchers’
intuitions).
The R&D process itself can also be divided into different stages. One classifica-
tion of the different stages distinguishes between basic research, applied research
and development. Basic research refers to research with no specific commercial
objectives, though the field may be of actual or potential interest to the R&D
performer. Applied research refers to research directed to specific commercial targets
in the form of possible new products or processes. Development is concerned with the
conversion of these research findings into actual products and processes. This stage
may include the creation of working models or prototypes.
A further important influence on innovative activity in many sectors is the role of
standard formats or dominant designs. In the early stages of the development of an
industry, there may be many different basic designs and classes of product compet-
ing for the same consumers. Firms use alternative designs as major tools in the
search for competitive advantage. Eventually one particular format or design may
begin to emerge as the most popular (or dominant) design. Examples are the Model
T Ford (automobiles), MS-DOS (computers) and the Douglas DC-3 (commercial
aircraft). Once a dominant design becomes generally accepted in the marketplace,
the emphasis in competition tends to switch from design to price. Specialised assets,
economies of scale and learning curves tend to become more important.
Many cases of evolving technology encourage the development of dominant
designs, and once the design has been established it may be difficult to dislodge, at
least until the next technological revolution comes along or the product itself
becomes obsolete. There are a number of virtuous circles that can reinforce the
creation and maintenance of a successful design, just as there are corresponding
vicious circles that can prevent a better design from challenging dominance. First,
economies of scale may be exploited by a dominant design and allow it to price alterna-
tive designs out of the market even where the challengers offer improvements on
the incumbent. Second, learning effects can encourage the development of a dominant
design and help keep it in place once it has been established. Once one design has
an edge it allows increased exploitation of learning curve opportunities. R&D efforts
to refine designs and find ways to improve associated manufacturing processes tend
to become clustered around the dominant design since its market share means this is
where improvements are likely to have maximum commercial impact.
Third, network effects in the form of externalities can help to establish and maintain
dominance. These network effects can exist on the demand side or the supply side.
An example of a demand-side network effect or externality is the telephone. The
benefits of your having a telephone are directly related to how many people you

would like to talk to who also have a telephone. If very few are connected then
there may be little incentive for you to consider investing in such a product. The
more people are connected, the more people will find it useful to be connected; this
helps create a virtuous circle in which more users attract further users, and so on.
Indeed some networks may evolve to the extent that non-users may begin to lose
access to communication circles that begin to focus on the new format, as some
hold-outs to email have found out. There may also be network effects on the supply
side as product improvements and extensions become clustered around the design
with the greatest market share. The PC and the Apple Mac are alternative design
formats, but the dominance of the PC compared to the Apple Mac increased the
expected pay-off from designing new hardware and software for the PC compared
to the Apple Mac for firms like Intel and Microsoft. Figure 3.1 shows how some of
these virtuous and vicious circles may operate to perpetuate dominance of stand-
ards.
Economies Learning Few learning

curve Rising gains
of scale costs
SUCCESS FAILURE OF
OF DESIGN DESIGN
Network Network Few users Low supplier

of users of suppliers interest
Figure 3.1 Virtuous and vicious circles in the evolution of standards

These may help to show why a dominant design may emerge. However, if net-
work effects can be so important in some contexts, it raises the question of how
such products actually get off the ground at all; the sort of question we raised at the
beginning when we asked: why would anyone want to buy the first telephone? In
practice there may be a number of reasons why a design may get to a critical level of
acceptance where bandwagon effects really begin to operate strongly. Some con-
sumers may simply buy now in the expectation that others will buy later. Also, certain
consumers like to pioneer new products and will be less sensitive to the high prices
and bugs or glitches in design that come with a new product. Some new products
may be sold below cost to begin with just to get the ball rolling – just as sometimes
housing developers will sell the first houses in a new tract cheaply to give the
development a lived-in look and attract others. Others may have a strongly focused
need for connection with a limited number of users; for example, videoconferencing
is a system that is widely believed could benefit from network effects, but some
firms install it in the first instance primarily to communicate between branches and
headquarters.

In the next section we shall begin to look more closely at the characteristics of
the innovative process itself.
3.3 The Characteristics of the Innovative Process
Rational model
BASIC APPLIED INTRODUCTION

DEVELOPMENT
RESEARCH RESEARCH
A B C
Erratic model
Specificity Low High
Uncertainty High Low
Time Long Short
Cost of stage Low High
Cumulative cost High Low
Figure 3.2 Characteristics of stages in the innovative process

Figure 3.2 shows two different interpretations of how R&D proceeds from stage to
stage. The top one or ‘rational model’ shows a project going from basic research to
applied research, through development and into commercial introduction. It moves
sequentially and in an orderly fashion from one stage to another. Unfortunately,
R&D is rarely like this. The myth of the rational model may help to make project
presentations look professional at the planning stage, but the real world of R&D
rarely works out in such a controlled fashion. The myth can also be perpetuated by
path-breaking scientists and technologists when they come to recall how their
breakthroughs were made; successful decisions often look more logical and rational
in hindsight than in prospect. Also, hunch, intuition and plain luck are important
aspects of decision making which do not fit easily into historical accounts and may
be glossed over if the writer is trying to tell a coherent and sensible story.
However, we know enough now about R&D to know that the progress of an
R&D project may more usually approximate the ‘erratic model’ in Figure 3.2 than
the rational model. Projects can be bedevilled by unexpected problems, dead-ends,
detours, wrong leads, ‘bugs’ and misleading clues. Indeed, this is a natural and
integral part of technological searches; like any exploration, you only know exactly

what you will find and how you will get there by actually doing the project. There
may be some clues to point you in certain directions, but it is only after the search
has been concluded that you can precisely audit what it is you have found, and what
it took to achieve this find.
The erratic model is the best description we have of how R&D proceeds. R&D
will typically wander from one stage to another, generally making progress through
the stages towards final introduction, though with some backtracking, stalling and
losses of direction. The unexpected slings and arrows that outrageous fortune
throws in the way of the project lead to many being terminated before completion.
The erratic model can also have implications for some of the characteristics of
projects at different stages in the R&D spectrum as we shall see below.
Figure 3.2 shows five different characteristics of typical projects at different
stages in the R&D process. Each of them can have implications for innovation
strategy within the firm, and we shall discuss each in turn.
1. Specificity refers to the possible range of eventual commercial outcomes
(products or processes) associated with a successful project at this stage. For
example, if the current R&D might lead to only one or two commercial products
or processes it has a high degree of specificity associated with it. A project that
could lead to numerous commercial applications has a low degree of specificity.
R&D frequently has fairly low degrees of specificity associated with it; for exam-
ple, the R&D that produced the ubiquitous Velcro fastening material has now
been embodied in many different types of products including clothes, shoes,
briefcases and toys. Such low degrees of specificity have two important implica-
tions for the firm. First, R&D may provide high degrees of synergy between
products. By contrast with investment in a machine which will only generate the
product it was designed to produce, investment in R&D may lead to a variety of
outcomes. The R&D that produced Velcro is now shared by a large number of
actual products.
Second, there are the related issues of externalities and appropriability that low de-
grees of specificity may be associated with. An externality is a benefit or cost that
impacts on somebody other than the individual or organisation responsible for
the economic activity. In the case of innovation, externalities frequently take the
form of benefits to other firms; for example, Xerox was unsuccessful in entering
the office equipment business, but its key innovations such as the mouse and
icons finished up being incorporated in the Apple Macintosh, and then personal
computers generally. Such externalities often exist because of appropriability
problems, that is it may be difficult for the innovator to retain control over the
exploitation of its idea. Xerox is an obvious case in point here, but Apple itself
suffered in turn after successfully pioneering a new PC market based on a user-
friendly graphical interface involving icons and the use of a mouse. Microsoft
developed Windows and successfully mimicked many selling points of the Apple
Mac with disastrous consequences for the fortunes of Apple – at least for a
while.
Specificity is also likely to increase towards the development end of the R&D
spectrum. For example, the working principle of the laser was first demonstrated
by American physicists in the 1950s, since when it has been incorporated in a

multiplicity of applications, including shaping objects, surveying and measure-

ment, pollution control, communications, holography, surgery and military
guidance systems. Basic research in this area has produced a number of areas of
applied research (such as the use of the laser in 3D imaging, or holography), and
in turn applied research in each area may be embodied in a multiplicity of actual
products or processes (such as applied research in holography generating a
stream of derived products). By the time work is carried out at the development
stage, the R&D may be almost completely specific to the planned application,
though it may be possible in some cases to transfer lessons in developing one
product or process to subsequent development work. Although specificity may
increase as R&D work moves towards the development end of the spectrum,
there are also cases where it may remain high at the basic research end too; for
example, basic research in pharmaceuticals, where successful, may in some cases
lead to the commercial development of only a single drug.
2. Uncertainty is also a typical feature of R&D projects. It may be unclear what the
R&D project will actually find, whether there will be a market for the output, and
how much it will all cost to develop. These are all issues that help to produce the
erratic model in Figure 3.2. Some uncertainty can be reduced, e.g. the R&D team
may be given a fixed target to aim for, or a fixed budget for a particular project.
However, this may just trade off one form of uncertainty for another; if you fix the
target, you may lose control over the budget, while if the budget has no possibility
of adjustment there may be more uncertainty as to whether or not it can lead to a
commercially viable outcome. There is typically uncertainty concerning the likely
output of each stage in the R&D process, so uncertainty is likely to be cumulative;
the further back the project is in the R&D spectrum, the more uncertainty is likely
to exist as to whether the effort will result in anything worthwhile, what it will look
like and how much it will cost. When the laser was patented in the 1950s it was
described as a solution looking for a problem; there was little awareness of the
multiplicity of areas to which the laser would eventually contribute.
There is a further problem in that uncertainty here is typically characterised as
unmeasurable or genuine uncertainty as opposed to the alternative of measurable
uncertainty or risk. The latter is more commonly observed where there are a
large number of homogeneous cases and repeat observations are possible; for
example, actuaries are able to calculate the risk of a motorcycle crash involving a
rider in the 30–45 age group on the basis of treating the members of that class as
a group, and examining the incidence of crashes involving members of this
group in the past. It is more difficult to calculate the uncertainties associated
with an R&D project since of course what characterises innovation is that it is
different from what has gone before. Uncertainties cannot be simply quantified for
the group ‘innovation’ as they can be for the group ‘motorcycle riders, 30–45
years of age’. Genuine uncertainty is usually difficult or impossible to insure
against; for example, you can usually insure against the risk of your car being
stolen, but not against your R&D project turning out to be unsuccessful.
3. Time is another important issue in R&D activity. R&D can be time-consuming
and delay-ridden. As with uncertainty, delays can be cumulative the further back
in the R&D spectrum the project starts; a piece of basic research that turns out

to lead to commercial applications may take many years of subsequent applied

research and development work before commercial applications see the light of
day. The bugs, hitches and general delays implied in the erratic model all help to
contribute to the long time horizons that can be involved in research.
4. Cost of stage depends on the technology being developed, but in many tech-
nologies costs can be considerable, and frequently rise towards the development
end of the spectrum. The bugs and hitches of the erratic model only serve to add
to the final bill. Laboratory work in basic research can be relatively inexpensive
when compared to the expense of scale models and prototypes at the develop-
ment stage. Again there are exceptions; if you want to do basic research that
involves atom smashing, then you may be best advised to join an international
consortium specialising in such matters rather than approach your local bank
manager.
5. Cumulative cost of a project is a reminder that it can still cost a great deal to
take a project to market, even if the basic research end is relatively cheap. Cumu-
lative cost refers to the total cost of getting a project into commercial
introduction; for example, the output of basic research still has to go through
applied research and development stages before it begins to earn a return for the
firm. A firm could make a scientific breakthrough in using ceramics in aero-
engines, but it could cost many times more to develop, test and introduce actual
aero-engines that draw on the new principle. The snags and unexpected prob-
lems signalled in the erratic model all help to add to the final bill.
Consequently, R&D can be characterised by a number of features, each of which
may have implications for innovation strategy in the firm. It can be characterised by
technological synergy, appropriability problems, significant uncertainty, long time
horizons, and it may have substantial cost implications. Time and cost overruns are
normal features of the R&D planning process and can be exacerbated where
planners are employing a rational model without due allowance for possible erratic
behaviour in practice. The extent to which an R&D project may be represented by
these characteristics can depend on its place in the R&D spectrum. For example, in
Figure 3.2 we have three projects: A, B and C. As we move from C to A along the
R&D spectrum in our example, potential synergy, appropriability problems,
uncertainty, time to introduction and cumulative cost all tend to increase, while cost
associated with individual stages tends to diminish. Where a project is likely to lie on
the R&D spectrum may be affected by the stage of industry evolution; for example,
in the early stages of an industry many firms may emphasise applied research into
radically different types of products and processes; however, once a dominant
design has been established many research projects may never venture beyond the
modest changes associated with development work.
These characteristics can each pose problems for the management of innovative
activity in the firm. We shall discuss some of the implications in the next section.
3.4 Why Innovation can be Squeezed off the Firm’s Agenda

There are many reasons why innovation can be squeezed off the firm’s agenda. The
various characteristics of R&D discussed in the previous section can all pose further

problems for the management of innovation in the firm. We can start by noting that
the costliness of R&D means that it is mostly carried out in large firms, and most large
firms have an M-form structure. In Figure 3.3 we show a hypothetical example of just
such a firm, Engine Corporation, that makes car, aircraft and truck engines. This firm
has adopted an M-form structure divisionalised around each product group with all
the functions such as R&D, marketing and production associated with each product
group assigned to their respective divisions. Engine Corp’s mission statement in their
Annual Report reads: ‘We shall be a world leader in developing innovative engine
technologies in the transportation field. Our mission is to continually develop our
existing products and introduce novel ones that have major commercial potential in
order to ensure a substantial return for our shareholders.’
Engine Corporation
Headquarters
Aircraft Division Car Division Truck Division
M P R&D M P R&D M P R&D
Figure 3.3 R&D in the M-form

Now, suppose we have an R&D team working on aircraft engine developments
in the Aircraft Division. We shall call them the Skunkworks. They are answerable to
the Divisional Manager who in turn is answerable to headquarters. The company
has stated its objectives of becoming a leading innovator in the area of engine
technology and we are interested in exploring what kinds of impediment might
stand in the way of the Skunkworks playing its part in the attainment of Engine
Corp’s mission statement.
It may be helpful to consider the problem from the perspective of the manage-
ment of the R&D team in the Aircraft Division. In the M-form structure the
divisional manager typically has profit-oriented targets to achieve for his or her
division, usually on an annual basis. The M-form can create an internal capital
market in which divisional managers compete for funds allocated by headquarters.
So what kind of problems or hurdles can the various characteristics of R&D pose
for the pursuit of innovative activity in the firm?
We shall identify nine problems or hurdles for innovation in the firm. The first
six of these follow from the characteristics of the R&D spectrum already discussed,
while three others can be said to be general problems associated with the innovative
process as a whole. One of the interesting aspects of the innovation problems is that
firms have shown considerable ingenuity in trying to stimulate innovative activity,
but that the various solutions that have been adopted usually focus only on certain
of these problems and sometimes only on one particular hurdle. Also, some

solutions can deal with certain hurdles at the expense of making others worse. The
managerial problem here can often be likened to trying to squash one end of a
sausage-shaped balloon only to find it simply popping up at the other end. These
points should become clearer when we look at actual solutions in the next section.
The first three hurdles are attributable to the low specificity of Skunkworks R&D
discussed above. This characteristic can cause a variety of problems for a promising
technological development in aircraft engine technology. The most obvious are the
following:
Hurdle 1: Appropriability problems. The company may find difficulties in appropri-
ating the gains from Skunkworks activities. To the extent the Skunkworks output
benefits some other firm, and Engine Corp is not compensated for this benefit, it
would be treated as an externality and could normally be ignored by the firm.
However, if the benefits actually accrue to a rival they could even represent a net
cost to Engine Corp in that its competitive advantage could be threatened or
eroded. In such circumstances there may be reduced incentives for Engine Corp to
allow the Skunkworks to undertake such a promising project even if the overall
benefits of the new technology (including externalities) exceed the cost to Engine
Corp.
Hurdle 2: Neglect of potential internal spin-offs. It may seem surprising at first sight,
but similar considerations to Hurdle 1 may hold in cases where the R&D project
generates technological spillovers within the company. If the project could lead to
technological spin-offs or synergies with the two other divisions, this would enhance
the profitability of the company. However, such spin-offs would be seen as exter-
nalities from the perspective of the Aircraft divisional manager since they would not
impact directly on the profitability of his or her division. A rational manager would
ignore such external benefits if he is being assessed on the performance of his own
division only. In fact, if there is intense rivalry between divisions for funds from
headquarters, such externalities could even be regarded as threatening each divi-
sion’s place in the internal capital market pecking order; in such circumstances a
rational divisional manager might be reluctant to share know-how with colleagues in
other divisions if it helps the other division to obtain a larger share of the corporate
cake at his expense.
Hurdle 3: Duplicated research efforts. Not only can Hurdle 2 lead to valuable know-
how not being disseminated widely throughout the firm, it can also lead to the
duplication of R&D effort and consequent waste of R&D resources by divisions in
cases where they are involved in overlapping technologies. This was a problem
faced by Pilkington (see Exhibit 3.6). The M-form structure with its ‘natural decision
units’ naturally encourages compartmentalisation of decision making within divi-
sions anyway, and divisional loyalties are only likely to reinforce such insularity.
Hurdle 4: Uncertainty. This can pose significant barriers to the pursuit of innova-
tive activity in the firm. First, imagine you are producing a project plan for research
into a new product and the best you can say about possible outcomes is that it could
lead to a very successful outcome (but you are not sure what that outcome will be),
although it could also prove to be a complete dead-end. Such a proposal is unlikely
to survive close scrutiny by the balance sheet bean counters in the firm, and indeed

a project plan based on such airy speculation could look very unprofessional to
senior management. Unfortunately, airy speculation is what creative R&D is often
about in the early days. Second, there may be a problem of incentives to support
R&D as far as Skunkworks’ divisional manager is concerned. If the manager’s
reward for good divisional performance (say, a bonus) is perceived to be of less
significance than the penalties for poor divisional performance (say, termination of
employment), then it would be quite rational for the manager to avoid highly
uncertain activities that could lead to a dip in divisional performance in any particu-
lar year. This is usually termed risk avoidance, which is fine as long as we recognise
that what is usually called risk in this situation is what should more properly be
called immeasurable or non-insurable uncertainty. Not only might the divisional
manager wish to avoid uncertain outcomes as such, for this manager the ‘downside
risk’ (possibility of failure) weighs more heavily than the ‘upside risk’ (possibility of
success). In such circumstances he or she might be more likely to emphasise less
uncertain activities such as market expansion, sales promotions, cost cutting etc.
It has been suggested that one way to deal with the problem of uncertainty in an
R&D project is to judge it on the basis of the average value of an R&D project in this
area as revealed by past experience. However, as we have noted, it is difficult to
classify R&D projects into categories since the defining quality of innovation is that
it is different from what has gone before. It may be just possible in some circum-
stances to talk of the average value of R&D projects clustered in a particular area;
say for research into a related group of chemical compounds. However, when
scientists started exploring the possibilities of the laser, they could not draw on
measures that indicated the average value of research activity in their respective
category to date; the research effectively created a category where none existed
before.
There is also a second problem here in that it is important to clarify what could
be meant by average value of an R&D project in a class or category. The most
commonly used measures of average are the mean and the median. If we can talk
about the mean value of R&D in a category, say, for a class of chemical compounds,
then the average here would be given by some measure of total value divided by
number of projects. However, the median value refers to that project or projects
found halfway along a frequency distribution of projects arranged by value, such
that the projects to one side are higher value and the projects to the other side are
lower value. If you arrange 21 R&D projects in order of increasing value, the
median is the 11th project. However, for some activities the mean can be much
higher than the median and can be positive even when the median is negative; a few
high pay-off success stories in the category drag up the mean and contrast with the
(median) modest earner or loss-maker that is more typical of the category. For every
Rolling Stones, there are scores of struggling pop groups. For every new firm that
becomes a Microsoft there are thousands of start-ups that fail to make the grade.
R&D is an activity that frequently displays such characteristics. For every project
that produces a penicillin or a Prozac, there are thousands that never see the light of
day. Some may fail because they do not produce anything of technical significance,
others because the outcome does not have commercial appeal, and still others
because of regulatory concerns about their safety. Indeed, it has been suggested that

it is possible for a pharmaceutical researcher in a company to spend his or her entire

career without ever working on a project that leads to commercial product. While
this may or may not be true (if it is, no researcher is likely to own up to it!), it is
certainly the case that R&D in general is an activity frequently characterised by high
failure rates, and it may be rational for companies to tolerate this if they expect to
find the occasional blockbuster that more than compensates for all the failures that
have gone before.
The problem for Engine Corp is that even if the firm may be willing and able to
tolerate a high failure rate in R&D in the hope of striking gold once in a while,
divisional managers may not feel they can afford this luxury. They are more likely to
focus on the pay-off from a typical R&D project, which as we have seen may be
closer to the median than the mean. It is not much compensation for such a
manager to know that the occasional lucky strike will help the company survive if
the manager is being assessed on his or her own annual performance and it is more
likely that the R&D projects proposed within the division will fail to produce a
commercial return. So, after non-specificity, uncertainty gives us a second major
reason for the divisional managers in the M-form to feel less warmly towards R&D
activity than the senior management within the firm would like them to.
Hurdle 5: Cost. This can be a barrier to conducting R&D in the firm. Develop-
ment costs for R&D projects vary but in some sectors of high technology such as
automobile or aircraft development they can run into hundreds of millions of
dollars. However, divisions have limited discretion over their own budgets. Even if
after all these problems a divisional manager wanted to conduct such R&D, he or
she may simply not be able to afford it; the Skunkworks might find itself starved of
funds.
Hurdle 6: Long time horizons. We have seen that even at the development stage a
project can take some years to generate a commercial application. Move further
back through the R&D spectrum and the delays become cumulative and even more
problematic. However, as we have noted, divisional managers may be judged on
shorter time horizons than that associated with the R&D project. Even if they were
not, a good divisional manager may have career moves in mind that have more
immediate time horizons than those reflected in the R&D project; divisional
management typically requires high-level general management skills such as an EBS
Heriot-Watt MBA degree, and a high-flying divisional manager who wants to be out
of the division and in the boardroom in three years may be less than committed to a
project that might just come to fruition in five years. Other functions such as
production and marketing are likely to have a more immediate impact on the
profitability of the division, and so a rational divisional manager may place more
emphasis on these tools to enhance divisional profitability in the short run.
Hurdle 7: Asymmetric information. There may be possible principal–agent problems
in the firm.1 For example, the Skunkworks obviously knows more about the
technology and its possibilities than do senior management. And there is an
1 Such problems can occur where agents (acting on behalf of principals) have differing objectives and
incentives, and principals have limited ability to monitor agents’ true performance.

understandable tendency for R&D scientists and engineers to become personally

committed to the projects they are involved with: if you have been working on a
project for a couple of years then it can be a blow if the plug is pulled on further
funding for it. Also scientists and engineers may be driven by intellectual curiosity
and professional pride more than simply commercial objectives. While this may help
to create technically superb output in some cases, it may trade off against profit-
oriented objectives if all the company needed was a workable product or process
sensitive to market needs. The problem in this case is that the incentives for the
principals (senior managers) may not be fully aligned with incentives for the agents
(the Skunkworks team), and it is the latter who are in a better position to judge
whether or not what they are doing is fully consistent with profit-oriented objec-
tives. This may be part of the reason why estimations of how much a project will
cost and how long it will take to complete often turn out to have a downward bias
and to be gross underestimates. Those who are in a position to make educated
guesses often also have incentives to put a favourable gloss on the forecast. There is
also a danger here that if you come down too hard on the R&D scientists and
engineers and require them to produce more precise evidence to justify their
projects, projects will be driven towards the shorter-term development end of the
R&D spectrum where outcomes are more predictable but potentially less rewarding
over the long haul. Also, the brighter and more creative R&D scientists and
engineers might simply leave for pastures where they are allowed a freer rein.
Hurdle 8: Machiavelli’s problem. This was set out at the time of the Italian Renais-
sance by Machiavelli, that master of strategic planning: ‘all those who profit from
the old order will be opposed to the innovator, whereas all those who might benefit
are at best tepid supporters of him. This lukewarmness arises partly for fear of their
adversaries who have the laws on their side, partly from the sceptical temper of men
who do not really believe in new things unless they have been seen to work well.’
As Machiavelli pointed out, vested interests can pose a major barrier to innova-
tive ideas, especially if nobody has a strong incentive to champion an idea. A bright-
eyed young researcher who claims to have an idea that could threaten to render his
firm’s existing products (and its product managers) redundant might be well advised
to avoid taking short cuts through dark alleys. Even responsible and innovative
firms such as IBM can fall foul of Machiavelli’s problem; the firm’s post-war
dominance in computers was in mainframe technology and it failed to anticipate the
threat that personal computers would pose to its core business. By the time IBM
woke up to the threat in the late-eighties it found its dominance eroded and its very
survival threatened.
Hurdle 9: Compartmentalisation and need for integration. Innovation needs to integrate
complementary assets to get from the idea stage to actual commercialisation. The
complementary assets needed can vary from case to case but usually involve R&D,
manufacturing, marketing and distribution resources. Conventional hierarchical
arrangements tend to separate out these different functions; even though the M-
form structure may put in one division all the resources relevant to a particular
innovation, they are still likely to be separated by functional walls within divisions.
Getting R&D people to talk to the marketing experts and distribution to communi-
cate requirements to manufacturing can be problematic; hierarchies are good at

encouraging specialisation and division of labour but can be bad at integrating the
works of the resulting specialised functions.
The list of problems we have produced may appear daunting and, indeed, you
may begin to wonder how the modern firm manages to get innovation out of teams
like the Skunkworks and into the marketplace. While we have concentrated on the
problems faced by the large M-form corporation, the problems are if anything
worse for the typical small U-form corporation; the more specialised it is, the more
likely that spin-offs will benefit others outside the firm and not the firm itself, while
the smaller it is, the less likely that it will be able to afford the upfront development
costs or be able to survive the high degrees of uncertainty (and failure rates) that
innovation may involve.
If we were to summarise the problems that Engine Corp and Skunkworks could
face in trying to innovate, it would seem we have identified nine main types of
hurdle. That does not mean to say that this exhausts all the difficulties but these
certainly would seem to be enough to be going on with. It is also worth noting that
when firms talk about the difficulty of stimulating innovative activity within the
firm, they are usually referring to one or more of these hurdles.
Summary of innovation hurdles:
1. Appropriability problems of leakage of competitive advantage to other rivals
2. Neglect of potential spin-offs to other divisions inside the firm
3. Duplicated research effort from each division concentrating on its own prob-
lems
4. Coping with uncertainty and the likelihood of failure
5. Potentially high cost of the full process of innovation
6. The long time horizons involved
7. Asymmetric information – those doing work for the project can know more
about its true potential than those funding it
8. Machiavelli’s problem – innovation attacks vested interests with those who
might gain not being in place to argue its case
9. Compartmentalisation of R&D and need to integrate complementary assets
Each of these hurdles contributes to what might be summarised as the innovation
problem – the modern corporation may fail to support adequately potentially value-
enhancing innovative activity. One expression of this is that the firm has to find a
balance between creativity and control: too much control and innovative possibili-
ties might be screened off the corporate agenda too early; too loose a rein and
organisations may generate new ideas with little commercial potential, or fail to
realise the potential of ideas that they do generate. Exhibit 3.4, Exhibit 3.5 and
Exhibit 3.6 show how major R&D performers encountered these problems and
faced up to them. From the perspective of Engine Corp, the innovation problem
might be observed as a discrepancy between Engine Corp’s mission statement
(which emphasises the generation of exciting and commercially promising innova-
tion) and the more prosaic and disappointing reality. The sad fact is that, left to their
own devices, organisations will tend to avoid innovating because of the various
hurdles discussed above. Unless Engine Corp anticipates the potentially crippling
effects that the nine hurdles can wreak on innovative activity in the firm and takes

steps to deal with them, it is likely to find itself eventually fighting for its very
survival. As firms over the years have found out to their cost, it is simply not
sufficient just to recognise that innovation is a good thing; the hurdles have to be
identified and dealt with.
Exercise 3.1: Engine Corp

At this point it might be worthwhile just spending a few minutes jotting down a
few suggestions as to how you would deal with the innovation problem set out
here. Imagine you have been appointed Chief Executive of Engine Corp and you
have discovered that the Skunkworks and other divisional R&D teams are
simply not producing commercially viable innovations. An investigation suggests
that all the nine hurdles discussed above are felt to be frustrating Engine Corp’s
attempts to be innovative. Can you think of possible solutions that might help to
deal with some or all of the problems that Engine Corp is encountering? Specify
which hurdles your solution is targeted at.
Hint: finding four solutions is good, finding six or seven is excellent.
3.5 Solutions
This section can be regarded as providing a menu of solutions that might be of
relevance to Exercise 3.1. One of the problems in innovation is that any one of a
number of hurdles can be fatal as far as attempts to stimulate innovative effort in
the firm are concerned. There is no point in dealing with problems of appropriabil-
ity, cost and long time horizon if uncertainty still freezes innovative decision
making, and there is no point in forming a dynamic, innovative organisation if most
of the good ideas finish up being grabbed by a competitor. Organisations have to
take an overview of how they deal with innovation considered as a systemic process.
Also, solutions that deal with one problem may simply make another one worse.
For example, taking care to reduce uncertainty (e.g. by thorough evaluation of
technical and market opportunities) may help reduce uncertainty as to the technical
and market viability of a project, but it is likely to add to delays and time problems
in general.
Therefore, there are unlikely to be clear-cut solutions to the innovation problem
for a particular firm; the solutions that organisations have devised to deal with the
problem of stimulating the generation of commercially oriented innovative ideas
often involve trade-offs, with one aspect being dealt with at the expense of making
another worse. Solutions rarely come free but usually involve some version of the
economic principle of TINSTAAFL (There Is No Such Thing As A Free Lunch).
The most obvious price that has to be paid in many cases is the increased expendi-
ture of managerial time and resources to try to help overcome the hurdle or hurdles
that are proving particularly troublesome in the context under review.
In this section we shall look at a variety of solutions that firms have adopted in
practice in response to our nine hurdles. They vary quite widely in terms of their
resource implications. Some may be adopted at the level of individual projects or
R&D employee, while others may involve a complete restructuring of the firm.

What they all share is a concern for our innovation problem. In each case we shall
identify which hurdles are particularly targeted by the solution as well as provide
some discussion as to the likely costs or trade-offs associated with each solution in
practice. We shall use Engine Corp as our reference case for illustrative purposes.
The number of solutions and the variety of hurdles they deal with can look quite
daunting below. Do not be put off; in most cases the hurdles that the solutions are
focused on are fairly evident. As long as you understood the problems represented
by the various hurdles above, you should be able to work out the likely impact (if
any) of the solution on the respective hurdles from first principles. Indeed, it can be
useful to see the nine hurdles as constituting a useful checklist for testing the likely
impact of any proposed solution. The question ‘what does this solution do for this
hurdle?’ is one that has been applied right down the line in looking at the potential
contribution of each of the solutions below.
3.5.1 Some Solutions to the Innovation Problem
(1) Conduct R&D in-house

Why do firms generally conduct their R&D in-house within corporate walls but
usually have an external advertising agency do their promotional activity for them?
Both activities can be regarded as concerned with the provision of information and
forms of intellectual property, but why should they differ in how the firm typically
organises them? One consideration here is the first hurdle in the case of R&D:
appropriability problems. Keeping the R&D in-house rather than contracting it to an
outside agency makes it easier to keep the R&D secret until it is introduced into the
marketplace, or at least until it is near to introduction. The problems of non-specificity
and appropriability that may be associated with R&D contrasts with the high degrees
of specificity associated with advertising campaigns: once you have developed a
campaign for a particular brand of soap there is nothing much else you can do with it
except use it to sell that brand of soap, and firms can still appropriate the benefits of
externally contracted advertising campaigns using devices such as copyright. However,
the firm that reveals the outcomes of R&D that it has been working on to its rival may
find itself giving away valuable proprietary information. Locking it up behind corpo-
rate walls is a sensible response in such situations. The disadvantage of such locking-
up is that firms may not be aware of potentially advantageous trades in technological
information. If firms are not aware of what others are doing, then it becomes difficult
or impossible to create a market in ideas at the R&D stage.
(2) Internal funding of R&D

Not only do firms tend to conduct R&D themselves (Solution 1), they also tend to
fund it from internal resources. In this respect it differs from many other investment
projects; for example, a firm might go to the external capital market (such as a bank)
to raise funds if it wishes to build a new factory. Why do firms with promising R&D
projects tend not to discuss such ideas with outside sources of finance? If such
sources can be drawn on for physical investment, why not for investment in
technical know-how?

Appropriability problems (Hurdle 1) again are at the heart of this issue. If the
firm were to discuss the R&D project with potentially interested parties in the capital
market, there could be a danger that the idea would leak out to potential competi-
tors in the product market; firms which are rivals or potential rivals might catch wind
of this new idea and the firm could find its good idea being appropriated by others.
Complete secrecy is the obvious solution, and the easiest way to achieve this is not
just to do the R&D yourself (Solution 1 above) but to finance it yourself.
Hurdle 7 (asymmetric information) could also put off outside investors even if
the firm did decide to go to the outside capital market. Outside investors would
typically have less knowledge regarding the prospects for the project than the firm
itself, which could make outside investors wary of believing the firm’s promises.
Also, the outside capital market might heavily discount R&D projects that are highly
uncertain (Hurdle 4) and have long time horizons (Hurdle 6). For all these reasons,
the firm may prefer to fund R&D from its internal capital market. The downside of
this solution is of course that it may lead to promising projects never seeing the light
of day due to internal budget limitations.
(3) Corporate-level R&D
One solution that can be presented as dealing with a number of hurdles is to
amalgamate Engine Corp’s three R&D teams into one corporate R&D lab and make
it report directly to headquarters as in Figure 3.4. It is also the solution adopted by
T&N in Exhibit 3.2.
Engine Corporation
Headquarters
R&D
M P M P M P
Figure 3.4 Centralising R&D in the M-form

Headquarters’ responsibilities span all three divisions, cover long-term strategic
time horizons, and control the budget for the firm overall. This should allow it to
deal with hurdles such as spin-offs for other divisions (Hurdle 2), rationalise R&D
and avoid duplicated research effort (Hurdle 3), absorb individual project failure
more easily than could divisions (Hurdle 4), use the corporate budget to fund
projects that reach the development stage (Hurdle 5), and deal with the long time
horizons that R&D and headquarters strategy formulation both involve (Hurdle 6).
So is this an automatic solution to the innovation problem? Not necessarily, since
there are some caveats:

1. One trade-off is that this spoils the neat creation of natural decision units
associated with the M-form corporation. Divisions now only have individual
responsibility for production and marketing issues and share R&D, so it is now
more difficult to evaluate the divisions as self-contained units within an internal
capital market.
2. R&D is also more distanced from the divisions they relate to, which may make
R&D less sensitive to market opportunities being identified within divisions;
there is a danger of an ivory-tower insularity being created for corporate R&D.
This would increase Hurdle 9.
3. In turn, managers in divisions may be less aware of technological developments
that could be turned into commercial opportunities than they would have been
when teams like the Skunkworks were working beside them at divisional level.
4. Also, while Engine Corp is only modestly diversified into three businesses
drawing on the same core technology, many firms are diversified into a large
variety of businesses and technologies. Creating a corporate R&D lab in this
latter set of circumstances could create an unfocused entity with disparate and
unrelated expertise and skills. In short, this solution may solve some problems,
but at a price. In some cases firms may judge the price too heavy and prefer to
stick with R&D conducted at divisional level.
Exhibit 3.2: T&N and R&D

The UK-based vehicle parts manufacturer T&N did much of its R&D centrally at a unit
called Cawston House instead of allocating all R&D to its 3 divisions or 11 product groups.
There were strong similarities between T&N’s divisions in terms of materials, design,
manufacturing and measurement techniques. For example, almost all the firm’s products
moved against something else, so research into materials and lubrication might have
applications right across the group. About 15 per cent of the firm’s R&D budget went on
research into ‘enabling technologies’. The rest went into development-level work such as
applications engineering and testing.
Commercial relevance of Cawston’s R&D activities was pursued by ensuring that prod-
uct groups and not headquarters funded most projects. Each project was planned in detail
at an annual meeting of product group managers and Cawston managers. Detailed project
control was pursued through specifying commercial and technical objectives together with
costs, responsibilities and deadlines. Progress of the project was reviewed quarterly.
Discounted cash flow analysis on projects was done rarely since the company believed
they were highly dependent on subjective assumptions. The payback method was also
distrusted because the company simply did not believe the numbers. T&N was eventually
taken over by US-based Federal-Mogul Corporation.
Since product groups funded most of T&N’s R&D products, why not also give
them the responsibility and resources to undertake the R&D in the first place?
(4) Top-down budgeting

Conventional economic analysis suggests that the best way to budget for projects is to
assess them at project level, for example by working out their present value or

expected internal rate of return using discounted cash flow (DCF) techniques. If a
project has a positive present value, or if the yield beats the firm’s cost of capital, then
the project should be accepted. If this approach were to be adopted for R&D projects
it would lead naturally to a bottom-up approach to the determination of the R&D
budget in which the budget is the aggregation of all projects that pass the DCF test
(positive present value or internal rate of return that beats the cost of capital).
However, Hurdles 4 (unmeasurable uncertainty), 6 (long time horizons) and 7
(principal–agent problems) are particular problems here. It is difficult to make
accurate and objective estimates of innovative projects, and those who are best placed
to make estimates of project potential may have incentives to put a positive gloss on
future potential. Even if these problems could be avoided, the long time horizons
involved would also make the estimation of project value highly sensitive to assump-
tions regarding future interest rates and costs of capital; a small variation of 1–2 per
cent in the estimated cost of capital could make a considerable difference to project
value when long time horizons are involved.
One way that firms respond to these problems is to use a top-down approach to
R&D budgeting; the R&D Director or Manager is given an annual budget which
may be calculated on the basis of past experience and/or rules of thumb such as
percentage of sales. This Head of R&D for Engine Corp then allocates funds to
individual projects on the basis of what are seen as the most promising projects,
often using rank ordering methods; Hurdles 4 and 6 are likely to be a problem,
which means that more qualitative and intuitive yardsticks than DCF methods may
be used to judge projects, as in the case of Pilkington (Exhibit 3.6). Top-down
budgeting allows a stable allocation of funding for R&D to be created and it pushes
responsibility for R&D decisions further down the hierarchy and closer to where the
actual expertise in assessing projects’ technical potential lies. It can help reduce the
severity of Hurdle 7 in that the Head of R&D will have to deliver an acceptable level
of innovative performance over the long haul, but such top-down allocation has the
disadvantage that it may respond less flexibly to lean and productive spells as far as
innovative possibilities are concerned. There is also the danger that Hurdle 7 may
still be a problem if it allows R&D to become divorced from the rest of the firm and
less sensitive to market needs. Some companies have also modified top-down
budgeting by permitting internal markets in R&D between central R&D divisions
and operating divisions (see Exhibit 3.3 and Exhibit 3.4). It is also possible to
maintain fairly tight control at project level without going as far as introducing DCF
techniques (see Exhibit 3.2).
(5) Split the R&D function
Exhibit 3.3: Research at Siemens

The German electrical engineering giant Siemens is one of the largest corporate R&D
spenders in the world. Its R&D employees were mostly distributed in operating
divisions but with some in long-range research laboratories at corporate level. Histori-
cally, these central laboratories obtained two-thirds of their funds from headquarters
which financed this through a levy on the nine operating divisions. The rest came from
the divisions or government contracts.

However, divisions frequently resented paying what was regarded as a tax. Conse-
quently, Siemens reduced the contribution of headquarters to central R&D to one-third
with the divisions free to commission research from central R&D if they wanted to, or
even to contract for R&D outside Siemens. As a consequence central R&D had to begin
actively treating divisions as potential customers for its services. The new system in
Siemens encouraged the creation of an internal market in R&D between central R&D
and the divisions. Central laboratories staged annual fairs for each of the operating
divisions. They advertised their R&D project ideas to potential buyers from the divisions
with lectures and demonstrations. The potential divisional customers could pick
programmes and negotiate terms of the deal, including price. To prevent overselling of
R&D ideas, Siemens paid bonuses to laboratory managers who ran efficient laboratories,
which included cutting back staffing levels where required.
If Siemens’ internal market in R&D projects is such a good idea, why not open
up the market to external customers?
A more sophisticated variant of the third solution is to split R&D into ‘R’ and ‘D’
components with ‘R’ forming a corporate research department and all the ‘D’s going
to their natural divisional homes (see Exhibit 3.3). In Figure 3.5 this would mean that
the corporate research department would work on engine research projects, while
each of the three divisional development teams would work on projects that simply
adapt existing technology or convert the output of corporate research into innova-
tions. Since research tends to involve more inter-divisional spin-offs, be more
uncertain and have longer time horizons than development, this might seem one
way of splitting up R&D into more compatible homes than would be the case if it
was assigned either to divisional or headquarters level. Typically, the main objection
to such splitting up is a variant of Hurdle 9 – it can become more difficult to co-
ordinate and integrate R&D activity when it is broken up into four different
locations as in Figure 3.5.
Engine Corporation
Headquarters
M P D M P D M P D
Figure 3.5 Splitting R&D in the M-form
(6) Split budgets for operations and innovation

One solution designed to try to compensate for Hurdles 2 (spin-offs to other
divisions), 4 (uncertainty), 5 (high cost), 6 (long lead times) and 8 (Machiavelli’s

problem) is to give divisional managers two separate budgets, one for operational
activities and one for innovative activities. This has the advantage of reducing the
chances of divisional managers treating the resources for R&D as trading off against
resources for operational activities (and preferring the latter). It can institutionalise
and help maintain the allocation of resources to innovative activity at divisional
level. However, it does not necessarily solve the problem that divisional managers
would still be naturally inclined to spend more of their own time on short-run,
divisional-specific operational concerns. It also muddies performance assessment
criteria in the M-form. It is easy to compare divisional performance if you have a
single measurable criterion such as return on investment. It is more difficult when
you have more than one criterion, especially if one is difficult to quantify. How do
you compare the performance of a manager whose division has produced a high
return on investment and three modestly promising innovations, with a manager
whose division has produced a lower return on investment and one innovation that
just might be a blockbuster?
(7) Targets for new product generation

The hurdles identified in the previous solution can also be tackled by giving each
division a target for new product generation. For example, the 3M Corporation had
a good record of achieving the target it set of having 25 per cent of divisional
revenues generated by products no more than five years old. The advantages and
disadvantages are similar to those in Solution 6, the main difference here being that
the firm is targeting innovative outputs, whereas in the split budget case it was
targeting innovative inputs. This means that in this case it has to be assessed over a
reasonably long time period and implies a fairly stable managerial regime at division-
al level over that period.
(8) Parallel R&D approaches

Hurdles 5 (high cost) and 6 (long time horizons) may be partially interchangeable.
One way of posing the R&D problem identified in Figure 3.2 is to imagine you have
to find a needle in a haystack using manual labour. You have to decide what the
most efficient way to find this needle is. Suppose you are told you can take as long
as you like. In this case, it would make sense to employ a searcher to sift the hay and
make sure that hay that has been checked is separated and removed; there is no
backtracking or duplication of effort and little chance that the needle can be
overlooked (sequential search). There may be some advantages from having more
than one searcher as long as there are increasing returns (for example, one could
specialise in sifting and one in removing the hay), but what you want to avoid is
diminishing returns in which members of the team start to get in each other’s way
and duplicate each other’s efforts.
Now suppose you have been told that this needle is an extremely valuable histor-
ical relic and must be found as quickly as possible. It does not matter how much it
costs to find it – the priority is to find it. In such a case it would be sensible to
throw every available searcher into the haystack to assist in the search (parallel
search). You expect the wage bill for this strategy to be higher than in the case
where time is not a consideration: the searchers will be crossing each other’s paths;

the urgency of the task means they will have little opportunity to sit down and
communicate dead-ends and completed tasks to each other. Parallel search is
wasteful, haphazard and badly co-ordinated compared to sequential search, but it
does have the advantage that it may produce the needle more quickly.
This is an example of time–cost trade-off in search processes, and as a search
process R&D often faces a similar dilemma. Sequential R&D search can take
advantage of what has been learnt in the previous stage of the project while parallel
R&D search into similar promising areas may result in duplicated effort and limited
transfer of learning between parallel projects. In short, parallel R&D may help attain
a desired outcome more quickly, but at a price. Whether – and to what extent –
organisations are willing to indulge in parallel R&D and incur a possible time–cost
trade-off will be influenced by the urgency with which a rapid solution is sought,
that is whether more emphasis is given to Hurdle 5 or Hurdle 6.
(9) Second-in strategies

One way of responding to Hurdle 1 (appropriability problems) is to turn it from a
threat into an opportunity. It may be sensible for firms to scan their technological
environment carefully, monitor rivals’ innovations, and be prepared to respond
rapidly and flexibly by following the leader and imitating the innovation in cases
where it shows strong commercial potential. This can have the advantage of
allowing the follower to free-ride on much of the hard work done by the leader. It
can eliminate much uncertainty; the leader will have demonstrated that an innova-
tion here is technically feasible, and may already have gone some way to confirming
that it has market potential. If it involves some work informing and alerting the
public to the advantages and properties of the new product (for example diet cola,
disposable diapers) then the follower may be able to free-ride and benefit from the
leader’s promotion of the generic qualities of products in this class (e.g. diet colas as
slimming aids, convenience aspects of disposable diapers). The advantages of a
second-in strategy are that it takes advantage of Hurdle 1 (appropriability problems)
and can help reduce Hurdles 4 (uncertainty) and 5 (high cost). However, the cost
gains may be mitigated to the extent that the second-in has rapidly to instigate an
accelerated research programme to catch up with the leader and so incur some
time–cost trade-off penalties (see Solution 8 above). The disadvantage of a second-in
strategy is that it may be impracticable in a technological regime where there are
clear advantages to being first-in. These include regimes where appropriability can
be tighter (such as pharmaceuticals), or where there are cost advantages to being
first-in (such as cases where leaders can exploit learning curves or economies of
scale that laggards find difficult to match). The second-in strategy also has the
obvious disadvantage that if everybody in a group is waiting for someone else to
innovate, then no-one will. Such inertia could make the members of the group
vulnerable to entry into the market by a hungrier and more innovative newcomer.
(10) Licensing and joint venture

Co-operative strategies such as licensing and joint venture may help firms put
together the package of complementary assets needed for successful innovation in
order to reduce Hurdle 9. As we shall see in Module 7, there can be many reasons

for co-operative strategies, but one reason is that firms with innovative ideas do not
always have the scale and breadth of activity required to bring a project to market
successfully. Entrepreneurial and innovative developments are frequently found in
small-scale operations that can avoid the stifling effect of Hurdle 4 (uncertainty and
fear of failure) and 6 (long time horizons) found in larger organisations, and indeed
some curiosity-driven research is sometimes even on the scale that can be conduct-
ed on a part-time basis and in back rooms or garages. Since such operations typically
have little, if any, vested interests to sacrifice, they also avoid Machiavelli’s problem
(Hurdle 8). Although such research often turns out to be the basis for major new
technologies, it is when the firm or researchers try to move through downstream
R&D stages towards commercialisation that small innovative companies often find
problems.
Larger firms can be better placed than small firms to bear the high cost and pos-
sibilities of failure that may be associated with the downstream stage (Hurdles 5 and
4) while they may also be better placed to withstand the cumulative delays that may
be involved before the project begins to recover its development costs (Hurdle 6).
This opens up the possibility of symbiotic relationships between small innovative
firms specialising in the upstream reaches of the R&D spectrum and larger firms
with deeper pockets helping to move the project through the more costly develop-
ment and marketing stages. Such symbiosis may be expressed in the form of joint
ventures between large and small partners, or the small firm licensing its technology
to the larger.
The main barrier or disadvantage associated with such strategies is that co-
operative agreements are often seen as a second-best option by firms. If a firm can
undertake a venture on its own it will generally prefer to do so, since unified control
can help to maintain a consistent strategy and avoid the managerial and transaction
costs associated with co-operative strategies. Some of these costs will be discussed
further in Module 7. If a firm can manage to replicate the potential partner’s
advantages itself, it will generally attempt to do so. Clearly, it may be difficult for a
small firm to replicate the scale advantages a large partner could offer it, but it may
be more reasonable to expect a large firm to be able to mimic the entrepreneurial
characteristics of a small-scale entrepreneurial partner within its boundaries. This
has been described as intrapreneurship, and firms have adopted a number of ap-
proaches to try to create such an environment. Solution 7 above is an example of
one device designed to encourage intrapreneurship and we shall discuss others
below.
(11) Research clubs

Another form of co-operative arrangement that some companies working in related
fields have adopted is to form an R&D consortium. This may help deal with
Hurdles 1 (appropriability), 4 (uncertainty) and 5 (cost). By clubbing together and
forming a jointly owned R&D performing organisation they can reduce the entry
costs of participating in major research fields such as semiconductors and telecom-
munications. To the extent that many of those interested in a particular research
programme come under the umbrella of the consortium, it also helps to deal with
some appropriability problems by internalising benefits that could otherwise be seen

as externalities in the case of single firms. Also, a multi-member consortium may

have a deeper pocket and be able to pursue many more projects than could be
afforded by one go-it-alone firm. It can therefore help to spread the uncertainties
associated with R&D activity over a larger number of projects than could be
afforded by a single firm.
The main problems of such R&D consortia are similar to those experienced by
joint ventures. They can be costly to administer and it may be difficult to get unified
and consistent objectives that satisfy all the owners of the club. It can also be a
solution that can invite the suspicions and resistance of the anti-trust authorities if
the consortium is seen as being a backdoor method of forming a cartel, reducing
competition and impeding entry into the industry.
(12) Corporate diversification

Diversified firms are usually larger than their specialised counterparts and so may be
better able to cope with the cost (Hurdle 5) and absorb the uncertainty (Hurdle 4)
associated with downstream R&D stages. They may also be better placed to
withstand the delays (Hurdle 6) associated with major R&D activity. These are fairly
obvious advantages attributable simply to scale of firm discussed in Solution 10
above. However, there is a further advantage that diversification may bestow on
firms. Since the outcome of R&D is often so unpredictable, a firm may have a
better chance of exploiting the unexpected output of a research project if it is
diversified into a variety of different areas already, such as the 3M Corporation.
The most obvious cost associated with diversifying for these reasons is loss of
focus. As we shall see in Module 5, there are a number of reasons why a firm might
diversify, but diversification to cope with uncertain R&D output would have the
opportunity cost of the gains from more specialised advantages that the firm could
exploit by ‘sticking to the knitting’. Against the advantages of being able to capture
more of the output of R&D in-house must be set the disadvantage of stretching
into unrelated or loosely related fields in the hope of potential pay-offs that might
never materialise.
(13) R&D diversification

While corporate diversification (Solution 12) is one way of improving the exploitation of
R&D, R&D diversification involves pursuing a number of different projects simulta-
neously and this approach may also help spread the uncertainties of R&D output
(Hurdle 4). To the extent that non-specificities in R&D activity allow economies of
scope to be exploited in this activity, it may also reduce the cost of individual
projects, for example by sharing overheads of R&D plant and equipment. In
practice, much corporate R&D does take place within diversified laboratories often
pursuing scores of projects simultaneously. However, the price of reducing uncer-
tainty here can be considerable since it can be costly to maintain a large stable of
R&D projects. Also, beyond a certain threshold level there is no real evidence that
economies of scale in R&D exist in many sectors apart from chemicals; that is,
empirical evidence suggests that in most sectors cost per innovation does not appear
to fall as the scale of R&D laboratories increases.

(14) Matrix organisation

Matrix structures set up parallel lines of control that can help to deal with some of
the problems encountered in innovative activity. Matrix solutions vary, but one
solution for Engine Corp would have the company simultaneously split into
product- and functionally-based lines of administration. Skunkworks would have
two bosses, one product-based (the Aircraft divisional manager), and one based
around a function (the company’s R&D director or manager). The R&D manag-
er/director should help manage integration of R&D activities and mitigate Hurdles
2 and 3 by encouraging activities that could lead to cross-divisional spin-offs while
eliminating duplicated research effort. On the other hand, as we would expect, there
is a price to pay – the potential costs of matrix structures have been well document-
ed and can include the creation of an expensive administrative structure and
confusion of lines of authority.
(15) Organic structures

The traditional M-form and U-form structures are characterised by relatively rigid
hierarchies, formalised and demarcated tasks and responsibilities, high degrees of
specialisation, and top-down control. These tend to be the characteristics of
mechanistic structures. Innovation can be more suited to circumstances that encour-
age fluid and flexible responses, lateral as well as vertical communication, minimal
differentiation of jobs and tasks, and an ability and willingness to deal with novel,
uncertain tasks and problems. These tend to be the characteristics associated with
organic structures. Organic structures may be able to cope better with Hurdle 2
(cross-firm linkages), Hurdle 4 (uncertainty) and Hurdle 6 (long lead times that are
difficult to fit into mechanistic programmes), and they may be able to deal with
Hurdle 9 (integration of necessary complementary assets) on a case-by-case basis.
Exhibit 3.4 shows GE trying to create some organic features in its R&D organi-
sation. However, organic structures are less suited to dealing with situations in
which there are gains to be made in taking advantage of potential economies from
functional specialisation and learning by doing in relatively stable and slow-changing
environments. Again, there are trade-offs involved, which in crude terms may be
characterised as the choice between imposing control through mechanistic struc-
tures, and stimulating creativity with organic structures. Such a choice should not be
envisaged as being necessarily all-or-nothing since the mechanistic/organic distinc-
tion should more properly be regarded as lying along a dimension, rather than in
terms of polar types.
Exhibit 3.4: Research at General Electric (GE)

Like Siemens (Exhibit 3.3) General Electric (the US-based electrical engineering firm)
decided to dramatically cut headquarters’ support for central R&D and make them
more dependent on the support of operating divisions. The company’s central R&D was
located in wooded hills in New York State, and had received most of its funds from
headquarters and most of the rest from government contracts. The centre was
described as having the feel of a university campus with some of its researchers accused
of being detached from commercial realities. In a radical shake-up, headquarters’
contribution to central laboratories was cut to 25 per cent; the operating divisions

contributed 35 per cent; with the remaining 40 per cent split between government
contracts and Lockheed.
As well as specifying that R&D should pay off quickly, GE also specified how these
funds should be allocated – 15 per cent on product improvements, 35 per cent on
developing successors to current products, 35 per cent on next-generation products,
and 15 per cent on ‘blue sky’ or speculative ideas. The new financing arrangements
helped give priority to divisional needs and this was reinforced by the appointment of
business managers at central R&D to monitor R&D work done for their divisions and
help match technical work to commercial needs. Also, GE abolished the traditional
hierarchy at central R&D in which lab managers reported to branch managers, who in
turn reported to more senior managers. A loosely structured team of four individuals
now had overall responsibility and the new system emphasised informal communication
and flexibility with ideas passed between different teams in the various laboratories. This
particularly assisted GE in areas which might require the integration of ideas from a
variety of disciplines.
However, some analysts charge that the shake-up slowed technological innovation at
GE. Growth was largely driven by acquisitions rather than internal development, and it
lost ground in rankings of new patents issued.
Which of the ‘solutions’ (Section 3.5) to the innovation problem does this
exhibit illustrate?
(16) Quasi-autonomy
A solution to the innovation problem which has been tried in a variety of forms is
to give an individual or team which comes up with a promising idea quasi-autonomy
by spinning it off into a separate unit or company. The parent company may keep a
financial stake in the spin-off and provide some back-up where required, but
otherwise the scientists/managers effectively take control of the spin-off. Owners
and financial stakes may be drawn from the parent company, the scien-
tists/managers themselves (to demonstrate commitment and provide performance
incentives) and the outside capital market (to subject the idea to a market test).
Quasi-autonomy reduces the chances of Machiavelli’s problem (Hurdle 8) impeding
development, which might be the case if the project stayed fully inside the firm. It
should also mitigate Hurdle 7 (asymmetric information) since the scien-
tists/managers now have to put their money where their mouth is. If the project
fails, so does the firm, their financial stake and possibly their job opportunities.
An obvious difficulty for the firm is that this solution reduces its potential share
in the pay-off from a successful project as well as its control over the scien-
tists/managers and their activities. It may be thought worthwhile if it is reckoned to
increase significantly the chances of successful innovative activity, or if it is seen to
be a way of keeping a loose association with creative scientists who might otherwise
have left the firm altogether.
(17) Product champions

A method of directly tackling Machiavelli’s problem (Hurdle 8) that has been
adopted in a variety of organisations is the notion of a ‘product champion’. Unless

there is somebody committed to arguing the case for a new idea, the natural forces
which reinforce the status quo will tend to squeeze out even good new ideas. A
product champion who is enthusiastic about the idea and committed to its success
can make the essential difference between success and failure in many cases. The
advantage in having a persuasive and credible product champion to counteract
natural tendencies towards organisational inertia have been demonstrated convinc-
ingly in a number of studies. The product champion may also be able to devote the
time to perform the integrative function required to overcome the compartmentali-
sation of specialised functions associated with Hurdle 9. A difficulty here is that the
organisation still has to maintain a balance between encouraging innovation and
maintaining control; if there were considerable rewards for being a successful
product champion and few penalties for being an unsuccessful one, then managers
might spend too much time chasing speculative and impractical schemes at the
expense of taking care of normal business. It is also difficult to institutionalise and
plan for this role; it would be unlikely that anyone would be appointed to a formal
position whose office nameplate reads ‘product champion’. The existence or
absence of product champions can reflect the particular personalities and circum-
stances arising on a situation-by-situation basis. The best that organisations can
hope for is to create an environment conducive to the development of product
champions as an integral and recognised part of the corporate culture.
(18) Fixed-price versus cost-plus R&D contracting

As we noted in our first two solutions, firms tend to conduct their own R&D in-
house and finance it from internal resources. However, occasionally firms may find
themselves conducting R&D for another organisation. These are likely to be
circumstances in which the third party has a need for a new system designed with
certain specifications in mind, the funds to finance the search, but no in-house
capability to do the search itself. Examples of such circumstances include many
cases of defence procurement. In such cases the government may wish to offer a
contract to the firm with the perceived R&D capability (as sole or prime contractor),
possibly after a competition to secure the contract.
However, some of the hurdles discussed earlier can have a bearing on how the
contract is written. For example, the government might naturally wish to offer a
fixed price for the new system, but this can pose problems for the firm conducting
the R&D. Hurdles 4 and 5 (uncertainty and high cost) mean that there is typically a
real prospect of unexpected problems resulting in the firm significantly overshoot-
ing the fixed price and making a loss. In severe cases, the losses could be sufficient
to threaten the survival of the firm. This situation can be exacerbated by what has
been termed the ‘winner’s curse’ – the firm that won the contract may have been the
most optimistic in its projections and finished up offering to do the contract for an
unrealistically low price that the more informed firms were not prepared to match.
On the other hand, if the government decides to err on the side of caution and offer
the project for a price they think could be easily achieved by a reasonably competent
performance, it may turn out to be the case that many R&D projects funded on
these ‘soft’ terms could have been completed more cheaply.

The obvious alternative to fixed-price contracts is cost-plus: the firm is guaran-

teed to be covered for its overall project costs, with an amount added for profit.
This does not eliminate the uncertainty, it merely transfers it to the government or
its agency. The government may be better placed to bear the uncertainty and it can
lead to an increased number of firms being willing to bid for the contract. However,
Hurdle 7 (asymmetric information) can now emerge as a problem in this arrange-
ment. The firm now has less incentive to develop the system at low cost and on
time, since they do not directly bear the penalties of failure. If the firm wishes to act
opportunistically and misrepresent reasons for delay or cost overshoot, it may be
difficult for the government to verify the truth or falsity of the firm’s claims. In the
worst-case scenario, the firm may have incentives to drag out projects if there are
limited opportunity costs of alternative projects on the horizon and the government
is paying the bill for continuing to house and feed an R&D team that might other-
wise have to be split up. The cost-plus system involves principal–agent problems
that can reinforce the likelihood of cost overshoots and delays in R&D projects.
Whatever solution is chosen, problems are still likely to be encountered. As we
have seen in a number of other cases above, there are likely to be trade-offs
involved in the choice of system. In practice, the contracting system actually chosen
sometimes involves elements of both systems – for example, with firm and govern-
ment agency sharing the costs of overruns above a target price.
(19) Public funding of basic research – usually, but not always

Finally, as we noted above, Hurdles 1 (appropriability), 4 (uncertainty), 6 (long time
horizons to commercialisation) can be particularly strong in the case of basic
research, which can lead to market failure problems with firms underinvesting in
this stage or even ignoring it altogether. Indeed, if firms think they can pick up on
the results of basic research conducted elsewhere without having to do it them-
selves, it may be quite rational for a firm to retain a strong interest in current
scientific developments without itself feeling any pressure to do any. These are
traditional arguments for public funding of basic research activity, including, for
example, much of the research carried out in universities and government research
labs.
The disincentives as regards private firms conducting basic research appear so
clear and strong that it might seem irrational for any firm to indulge itself. Yet firms
frequently do conduct at least some basic research, for a variety of reasons. One
reason is incentives and rewards for valued R&D scientists and engineers. Such
individuals may feel frustrated in having to work on application-oriented research all
the time and may be more willing to stay in the corporate environment if they can
have some of their time set aside to work on curiosity-oriented research using the
firm’s facilities. Such leading-edge work may also be seen as helping to keep the
R&D professionals sharp and in touch with current developments in their field. 3M
allowed R&D staff to spend 15 per cent of their time pursuing their own projects.
The dangers of allowing R&D staff too free a rein to pursue basic research are
shown in the Nestlé and Pilkington Exhibit 3.5 and Exhibit 3.6.

However, basic research may also be seen as being potentially consistent with
profit-oriented objectives. Serendipity (the making of happy and unexpected
discoveries by accident) is frequently a characteristic of basic research activity. Basic
research may eventually lead to commercial applications in some cases even if these
applications cannot be specified in advance. Consequently, some firms may set aside
a part of their budget for basic research, though such allowance is usually a relatively
minor part of the total R&D budget (see Exhibit 3.5 and Exhibit 3.6).
Exhibit 3.5: Nestlé and R&D

The Swiss company Nestlé is one of the biggest spenders on R&D in the food industry
with an in-house R&D network in nine different countries and with its research centre
near Lausanne. However, it decided to overhaul radically its R&D activities. In the past,
many of its researchers had considerable intellectual freedom to work on ‘blue sky’
projects that attracted their intellectual curiosity. This led to a high output of scientific
papers but meant that much R&D work did not relate strongly to Nestlé’s commercial
activities. The new system introduced formal links between R&D work and the strategic
business units (SBUs) which were created as part of the company-wide reorganisation.
Each SBU has a research co-ordinator responsible for two-way communication with
R&D, which is encouraged to view the SBUs as clients. It has been estimated that the
new regime has shortened the time to product introduction for many R&D projects
which would have started well back in the R&D spectrum at the basic research stage
under the old regime.
Nestlé also put increasing emphasis on strengthening existing products rather than
launching new ones. An example of this approach was given by its most profitable
product, Nescafé instant coffee, around which it has focused a great deal of process
innovation and product variation. Nestlé found that new products were encountering
escalating marketing launch costs and increasingly rapid imitation by competitors.
Although Nestlé still aimed for a 50–50 split between basic and applied research, it was
possible that these trends could have reduced its chances of making a radical break-
through like Nescafé in the future.
Which of the five characteristics of R&D projects discussed in Section 3.2 are
illustrated in this exhibit?

Exhibit 3.6: Pilkington’s R&D

The UK-based glass maker Pilkington has a deserved reputation as an innovator. It
developed the float glass method of manufacture that revolutionised glass making
globally. However, the company decided that there was too much ‘blue sky’ speculative
research and not enough connection to the company’s commercial needs. There was
also a danger of duplicated research activity due to lack of co-ordination, with R&D
being carried out in the UK, US, Germany and Italy.
To deal with these problems the company set up a Technology Management Board
which included R&D, production and marketing executives. The Board supervised a
central R&D laboratory in the UK and the work of four other innovation groups
covering Pilkington’s various glass-making businesses. It met monthly to review pro-
grammes and allocate spending. By reallocating R&D projects so that its centres
specialised (e.g. float glass R&D in one of its UK centres, autoglass R&D in Germany)
and taking advantage of improvements in new R&D technology, the company was able
to cut its R&D staff by almost a half. The company calculated that the percentage of
‘blue sky’ research fell from about 60 per cent to no more than 20 per cent. The
estimated returns from R&D have increased substantially after these reforms. The
number of new products commercialised by Pilkington also rose, while the time to
completion was also substantially reduced in many cases.
Which innovation hurdles (Section 3.4) did Pilkington address with their new
strategy?
At the same time, a new phenomenon has emerged in recent years – some sec-
tors such as biotechnology have seen the growth of R&D performing firms with a
strong basic research element. One factor that has influenced this development is
the widespread perception in the capital market that the traditional long lags and
delays between the conduct of basic research and subsequent commercialisation of
applications are shortening. If basic research might result in a commercial applica-
tion in, say, thirty years’ time, it is unlikely to excite the capital market. These lags
helped reinforce the traditional division of labour between universities and firms,
with universities doing basic research and firms working around the downstream
end of the spectrum. However, if the same research could have commercial
opportunities in, say, five years, then the capital market is much more likely to sit up
and take notice of firms looking for investors willing to take an equity stake to help
them support work in such an area. While it has to be said that results in these areas
have not always been as impressive as hoped for (possibly reflecting Hurdle 7 and
asymmetric information between the firm and its financiers), the important aspects
here involve expectations. If the relevant parties believe that the lags are shortening,
this may be sufficient to trigger a more favourable attitude to basic research con-
ducted by private organisations.
3.5.2 Engine Corp Exercise: Discussion

It should be obvious from the above discussion that none of these solutions
represents a complete or an automatic answer to the innovation problem faced by

Engine Corp at the end of Section 3.4. Each tends to deal with only some hurdles
that contribute to the innovation problem and there are usually trade-offs or costs
attached to each. Engine Corp could find itself interested in a number of the
solutions, or only a few at most. Nor do these solutions exhaust all the possibilities,
though they do help to demonstrate some of the range of human ingenuity that has
been applied to one of the most important and difficult of organisational problems.
You should review how many of the solutions you thought of in Exercise 3.1.
Do not be too hard on yourself; many of the solutions may have been taken for
granted by you (such as conducting and financing R&D internally), while others are
responses to particular situations (such as second-in strategies and terms of R&D
contracting). You may also have thought of good solutions that do not appear
above. This does not indicate they are wrong; as we have just pointed out, the
innovation problem is so pervasive and serious that firms have tried many different
solutions with varying degrees of success. What the above list does show is that it is
one of the most important and difficult problems that the firm faces.
Learning Summary
Innovation is a central issue, possibly the central issue in strategic management. We
have seen that it is an area rich in fallacies, hurdles and solutions. Innovation has a
number of characteristics that create problems for those trying to encourage it; it is
low in specificity and high in uncertainty, it can take a long time to come to fruition
and it can be costly to develop. As well as offering the opportunity to protect or
create competitiveness, it can be a major and continuing source of threats for many
firms and sectors.
Strategy for innovation must be firm-specific, and even case-specific. What works
for one firm at a certain point in time may not work for other firms, or even for the
same firm at a different point in time. What works for one case or situation within
the firm may not translate easily into other cases. Many of the solutions to the
innovation ‘problem’ we looked at here are partial solutions, or may even create
additional spin-off problems. Strategy here involves trade-offs, with some solutions
helping deal with one hurdle or difficulty, but at a cost. There are few, if any, free
lunches in this area and the strategic dilemma in this context revolves around
deciding whether the cost and problems associated with a particular solution may be
worth the (highly uncertain) benefits it could deliver.

Review Questions
3.1 What is the best strategy for innovation?
A. First-in.
B. Second-in.
C. Last-in.
D. It depends on the situation.
3.2 Compared to sequential R&D projects, parallel R&D projects can typically:
A. save R&D costs and shorten delays in innovating.
B. shorten delays in innovating but with increased R&D costs.
C. add to delays in innovating but save on R&D costs.
D. increase R&D costs and add to delays in innovating.
3.3 In the evolution of dominant designs:

I. history matters.
II. inefficient solutions may persist indefinitely.
III. luck and chance may play important roles in the selection of particular formats.
A. I and II only.
B. I, II and III.
C. II and III only.
D. None of the above.
3.4 The QWERTY keyboard is a consequence of:

I. historical developments.
II. network externalities.
III. shareholder free-riding.
A. I and II only.
B. I and III only.
C. II and III only.

Module 4
Vertical Links and Moves

Contents
4.1 Introduction.............................................................................................4/1
4.2 Defining Vertical Relations ....................................................................4/2
4.3 Trends in Vertical Relations ..................................................................4/6
4.4 What Vertical Integration is Not ..........................................................4/9
4.5 The Costs of Markets .......................................................................... 4/10
4.6 The Costs of Vertical Integration ...................................................... 4/23
4.7 Choice of Strategy ............................................................................... 4/28
4.8 The Varieties of Vertical Relations .................................................... 4/30
In this module we explore strategic decisions relating to the vertical chain of

production of which the firm is a part. These relations may be handled in a number
of ways that include full-scale single firm ownership (vertical integration) and a
variety of possible contractual and co-operative agreements with other firms. We
not only look at legitimate reasons for vertical integration, we also show why some
common justifications for the strategy can be seen to be spurious or false on closer
examination. We see that alternative means for handing vertical relations can have
different benefits and costs attached to them, and that the appropriate choice of
strategy may depend on the particular circumstances in which the firm finds itself.
Learning Objectives
 describe the diversity and range of vertical relations in the firm;
 analyse and explain major trends in vertical relations in recent years;
 identify spurious arguments in favour of vertical integration;
 explain the hold-up problem and describe possible solutions to it;
 compare and contrast the costs and benefits of vertical integration.
4.1 Introduction
This is the first module in which we shall look at the direction that the firm’s
strategy will take, and here we shall concentrate on vertical relationships. It is also
one of the most controversial areas in corporate strategy today. However, until
recently it was not a topic that was seen as being of real interest in strategic circles.
Some firms such as large petroleum companies had always been vertically integrated

Module 4 / Vertical Links and Moves
right through much of the value chain as long as anyone could remember,1 while
other firms such as the car makers were more likely to deal with external suppliers
and distributors. The topic was generally regarded as a routine sort of problem area
that had standard solutions.
Not any more. In the last few years this topic has become one of the most dy-
namic and interesting areas of strategy. This is reflected in the spread of terms such
as downsizing, outsourcing, core competences, value-adding partnerships, virtual
corporation and hollow corporation to describe emerging issues in this area. And
the old certainties have often been replaced by heated debate. For example, it is as
easy to find critics of downsizing as it is to find supporters. Matters have moved so
quickly that many current texts in strategic management still make only passing
mention of vertical relations.
The good news is that there have also been a large number of studies stimulated
by the changes in this area and we now know a lot more about the important issues
and influences involved. We shall start by defining the major issue in the next
section and then look at trends in Section 4.3. In Section 4.4 we shall see how some
plausible arguments in this area actually turn out to be flawed on closer examination.
Section 4.5 looks at the costs of market organisation of economic activity. Then in
Section 4.6 we look at possible costs of integrating vertically, before considering in
Section 4.7 why firms might wish to choose different strategies. Section 4.8 explores
other types of vertical relations.
4.2 Defining Vertical Relations

Vertical relations can be distinguished from horizontal relations. Relations between
activities at the same stage of the production process are horizontal relations;
relations that involve moves between stages are vertical relations. Horizontal
integration occurs when horizontal relations are co-ordinated within a firm, while
vertical integration is the corresponding case of vertical relations carried out within a
firm. These are illustrated in Figure 4.1.
Horizontal relations tend to involve sharing some asset or resource (such as a
factory or a sales force) while vertical relations tend to involve the shift or transfer of
some intermediate product between stages in the value chain (we encountered the
concept of the value chain in Section 2.3). Vertical integration involves combining
separate stages within the firm. An example of vertical integration in the petroleum
industry is shown in Figure 4.2. Backward or upstream integration occurs when a
firm moves to own earlier stages in the production process, while forward or
downstream integration involves moving into later stages in the production process.
Many firms in the petroleum industry are vertically integrated throughout the chain
of production, from exploration rigs to petrol pump as in Figure 4.2.
1 In fact many of the large oil majors became vertically integrated before the First World War.

Horizontal integration Vertical integration
Stage 1 Y
Stage 2 W Z
Stage 3 X
Stage 4
Figure 4.1 Vertical and horizontal integration
Exploration
Backward or
upstream
Extraction
integration
Refining
Forward or
downstream Distribution
integration
Retailing
Figure 4.2 Vertical integration in the petroleum industry

So why do firms vertically integrate? Some analysts argue that it helps the firm to
exercise direct control over the production process. However, this does not really
take us very far since it amounts to little more than a definition of vertical integra-
tion. It is like saying you want to own a car (rather than lease) because it gives you
direct control over the car. This just describes what ownership does; it does not
compare the advantages and disadvantages of ownership versus market alternatives.
If we are to begin to make sense of this area, we have to be able to explain why
different methods of co-ordinating vertical relations may be appropriate to different
circumstances.
Suppose we assume that each of the 16 white circles in Figure 4.1 is a separate
firm. We can start our analysis by observing one feature of vertical relations that
Figure 4.1 helps to illustrate – vertical relations are compulsory, but horizontal
relations are optional. What we mean is that there is no compulsion on any of the
firms in Figure 4.1 to have contact with any other firms at the same stage. As we
shall see in Module 5, firms may afford to be selective about whether and where to
pursue horizontal links. For example, horizontal links involving firm X and other
firms in Figure 4.1 may be encouraged if there appear to be attractive opportunities
for co-operation with other firms at the same stage of production, or diversification
possibilities. But if the firm decides there are no horizontal links worth considering,
it can simply ignore horizontal links altogether.
However, any unit that wishes to survive as a commercially viable unit must be
able to find a way to get vertical access to both supplies and customers. For exam-
ple, our firm X in Stage 3 in Figure 4.1 must get supplies from Stage 2 and find a
way to win customers in Stage 4. This means that vertical relations can involve firms
in activities that are very different from its core business. The skills involved in
smelting and selling aluminium ingots are very different from the skills involved in
making and selling pots and pans further down the vertical chain. The business of
running a petrol service station bears little resemblance to the tasks involved in
drilling for oil.
Of course, this does not necessarily mean that the firm has a limited choice of
suppliers or customers. It may well have some flexibility over exactly where it finds
supplies and customers in the respective cases. For example, does it go for a cheap
or a high-quality supplier? Does it target home or foreign markets? But what it does
mean is that the firm may have to deal with various stages that require very different
management skills and capabilities. As we shall see in the next module, this is a
problem that is usually associated with unrelated or conglomerate diversification.
However, it may help us approach the problem of vertical relations if we understand
that a firm can encounter similar problems in this context without ever leaving its
home industry.
Before we look at trends and issues in more detail, we need to establish the range
of vertical relations that may be open to the firm. Here are some of the most
important types:
 Spot contract: contractual agreement for the immediate supply of a good or
service, usually for a specified price and quantity.

 Long-term contract: contractual agreement involving a long-term relationship

between supplier and customer involving agreed responsibilities and obligations
on both sides. The extent to which the future exchange conditions can be speci-
fied in advance depends on the particular case, and it is common to leave many
elements on one side to be the subject of future discussion and negotiation as
the need arises.
 Vertical integration: the administration of technologically separate stages
within the firm.
 Franchising: contractual arrangement in which the retailer operates using the
franchiser’s brand name in exchange for a fee. The franchiser may also provide
training, capital and advertising benefits to the franchisee (we shall reserve a
closer inspection of franchising until Module 7 where we look at forms of co-
operative activity).
 Tapered integration: mixed market exchange and vertical integration. In the
backward case, a firm may buy and make some of the same inputs used by it. In
the forward case, a firm may supply its own retail outlets as well as separately-
owned outlets.
 Vertical quasi-integration: a form of long-term contract in which one partner
dominates the other to the extent that it has a high degree of control over the
decisions to be made by its partner.
 Value-adding partnership: co-operation by independent companies to manage
the flow along the vertical chain (as with franchising, we shall look at forms of
co-operative activity like this in Module 7).
As can be seen from the above there are many different types of vertical relation-
ship. It has been traditional to separate vertical relations into two main types: market
exchange, and organisation within the firm. Indeed, much of the discussion of
vertical relations in the past has been reduced to the question of ‘make or buy’.
Should the firm make its own components and supplies, or should it source instead
from external suppliers? Vertical integration is often taken as corresponding to the
‘make’ decision, while the ‘buy’ is usually assumed to be represented by a spot
contract between the firm and a supplier.
However, beyond these simple types, things get a bit more complicated. It is
sometimes difficult to distinguish one form of relationship from another; for
example, it may sometimes be difficult to decide whether co-operation between
firms represents quasi-integration or a value-adding partnership.2 And as we shall
see, most of the other types of vertical relations can involve mixes of contract and
administrative devices to co-ordinate activity. Some solutions may involve contracts
between separately-owned firms, but with one of the parties being able to exercise
almost as much direct control over the other as it would with vertical integration.
For example, a franchisee for McDonald’s may be legally a separate firm, but will
2 Some writers also tend to drop the condition of one firm dominating the other from their definition of
quasi-integration and see it as simply involving close co-ordination between firms, which would make it
little different from a value-adding partnership. This could be a mistake since it misses out a central
feature of many cases, e.g. the example of Nike discussed here.

face specified responsibilities, obligations and constraints if it is to continue to have

the right to trade under the company’s name. And Nike is a good example of quasi-
integration, with the company actually locating its own executives within the
factories of its separately-owned overseas suppliers in order to monitor production.
Examples such as these can lead to debates as to whether McDonald’s suppliers
and McDonald’s franchisees should actually be regarded as separate firms from the
brand-name company. However, the important issue for our purposes is why such
arrangements evolve, and what advantages they may have over alternative forms of
vertical relations. We will be looking at these issues for various forms of vertical
relations later in this module. First, however, we need to put vertical relations in
context by looking at how trends and issues have developed in this area.
4.3 Trends in Vertical Relations

The most striking and visible image associated with vertical relations is probably that
of giant firms straddling the globe and involved in all the stages of the production
and distribution process, from basic raw materials to the final consumer. Until
relatively recently the existence of these large firms was more or less taken for
granted and few questioned the logic that lay behind such strategies. However, as we
noted above, there have been some striking changes in terms of strategies and
attitudes in this context recently. It is worthwhile looking at how vertical relations
have changed over the years in this area to get a feel for the influences involved.
The lead in this area was set around the beginning of the twentieth century by US
corporations.3 By the time of the First World War, many of the larger food and
drink companies integrated forward to build up their marketing and sales organisa-
tion to assist in advertising their brands and ensure prompt and reliable service to
customers. In some cases they integrated backwards to ensure control over their
supply. Some even moved into owning their own fleets of ships and railway cars to
transport their raw materials and goods.
At the same time, vertical integration had become a feature of the oil and rubber
industries. These industries were responding to the emergence of the innovation
that perhaps best characterises the twentieth century – the motor car. Other
industries that by now featured highly vertically integrated firms included electrical
machinery, primary metals and instruments.
But while vertical integration was widely adopted by many firms in these areas,
there were also equally areas where firms tended to focus on a limited number of
stages in the production process such as furniture, paper, printing, leather, lumber,
apparel and textiles. The industries that were more likely to become characterised by
large vertically integrated firms tended to be high-volume, capital-intensive indus-
tries that needed to co-ordinate and schedule flows of inputs and outputs precisely
from one end of the vertical chain to the other. By way of contrast, the industries
that tended to avoid vertical integration were often labour-intensive and were
3 Alfred Chandler (1977) provides a full analysis of the growth of vertical integration in US industry, and
some of the discussion in this section is based on his account.

characterised by product variety and shorter production runs. Not only was giant
size unlikely to provide advantages in such cases, it could be positively harmful if
increased scale and complexity made the enterprise difficult to administer and co-
ordinate.4
So by the end of the First World War, the pattern that was to dominate much of
the twentieth century was clearly established. Vertical integration was now widely
associated with corporate success. Many of the world’s largest and most successful
firms had pursued this strategy; vertical integration, size and profit seemed to go hand
in hand. It was recognised that it was not a strategy that was appropriate for all
industries, but to some strategists that just suggested that this might be a problem of
the industry, rather than a problem of the strategy itself.
If there is one case that exemplifies the changing attitudes to vertical integration
in recent years, it is probably IBM. Like many of its predecessors in the more
traditional industries, IBM developed a vertically integrated strategy. It not only
made its own computers, it had its own internal sources of semiconductors and
software, and had its own sales and service organisation. IBM’s experience shows
the dangers of being locked into a vertically integrated strategy and becoming
insensitive to signals indicating the need to change. But questioning the logic of
vertical integration has not been confined to the computer industry; it is a question
now raised in many sectors. The question is often asked of backward integration
especially, and can usually be phrased along the lines of ‘Why are we doing this
activity? Could someone else do it better/cheaper for us?’ There have always been
areas where firms tended to deal with outside firms; for example, few firms make
the chairs or PCs that they use in their offices. However, once firms began to
scrutinise the costs of doing it themselves versus getting an outside supplier, less
obvious areas began to become candidates for outsourcing. Should the firm
maintain an engineering section to repair its own computers, or would it be bet-
ter/cheaper to contract out this activity to a specialist company on a long-term
contract? Should the company employ its own cleaners/window clean-
ers/typists/flower arrangers, or should it employ other companies to do this on a
contract basis?
Two complementary forces encouraged the drive towards outsourcing in cases
like these. First, if activities are fairly standard (such as cleaning and computer
repair) then competition between potential suppliers should eliminate excess profit
and drive prices down towards competitive levels. Unless there are special features
creating barriers to entry, it may be difficult for the firm to perform the activity
more cheaply than would an outside supplier. Second, firms need a large variety of
inputs and services to operate in the marketplace. The more activities they are
directly involved in, the further the managerial resources of the firm will be
stretched. By concentrating on their core competences, the management of the firm
can stick to what the firm is particularly good at and not dissipate their energies on
peripheral activities that do not add much value to the firm.
4 Chandler gives the example of firms in the American wool and leather industries to illustrate the
problems of large size in such sectors.

These points are well understood and recognised now. However, in some cases
the trend towards downsizing and outsourcing has gone well beyond the limits of
the types of cases we have described above. Some firms now rely on other firms for
inputs that could be regarded as central to their competitive advantage, such as in
the case of computer companies outsourcing the software and hardware they put
into their machines (an example of a firm that has deliberately decided not to pursue
an outsourcing strategy is shown in Exhibit 4.1). The basic question of whether and
where to integrate vertically has become a lot more interesting in recent years, but
that does not necessarily make it easier to answer.
In the next section we shall establish some basic ground rules concerning what
vertical integration is not, before going on to look at the considerations that may
influence vertical relations in practice.
Exhibit 4.1: The benefits of ‘insourcing’

A company that has gone against the stream of outsourcing and extended employment
by ‘insourcing’ is INA, a German multinational manufacturing industrial rolling and plain
bearings, linear systems and engine products. The company makes several thousand
products, mainly machinery based around bearing technology, from paper-making
equipment, to clutch and valve systems for cars, to parts for the space shuttle. The
company has deep knowledge throughout the vertical chain of R&D, production and
marketing characteristics necessary to develop and sell its products. The complexity,
skills and R&D content of the work have been increasing and now require the firm to
have a knowledge of issues ranging from environmental to safety considerations and
technologies ranging from coatings to computing. The products often have to be geared
to customers’ special requirements.
Insourcing (being your own supplier) is costly. INA has 250 full-time trainers at its
technical centre, and capital investments account for 10 per cent of its turnover
compared to about 5 per cent for European industry as whole. They tend to train up
their own engineers, take on 250 apprentices every year in Germany alone, and 70 per
cent of the workforce are skilled. Germany is also a high-cost country for employing
labour. The benefits are the control it gives it over work that it believes is too technical
and specialised (asset-specific) to be done by sub-contractors. The company realises that
the main danger it faces is loss of the flexibility that market alternatives provide. It deals
with that by having about 100 product groups oriented to customers and including
technical, sales and marketing people. Groups can be set and disbanded as needs change.
It also designs its own special machinery to give it the flexibility of response that its
work may require.
Which of the kinds of asset specificity discussed in Exhibit 4.3 do you think INA
is dealing with here? (HINT on site specificity – what implications do you think that
just-in-time manufacturing could have for site specificity?)

4.4 What Vertical Integration is Not

Before we look at what might influence the choice between external markets and
vertical integration in practice, we need to clear the decks to establish what vertical
integration is not:
1. Vertical integration is not justified simply because a potential acquisition
is highly profitable.
Consider again Figure 4.1. Suppose Firm W at Stage 2 is highly profitable. The
management of Firm Y have decided they want to bid to take over Firm W be-
cause it is clearly a successful company. Merging these two Stage 1 and Stage 2
firms would represent vertical integration.
However, if Firm W is highly profitable, this should be represented in the value
of the firm in the marketplace. The higher the expected stream of future profits
of Firm W, the higher the present value of the firm, and the higher the price
Firm Y should expect to pay to capture Firm W. If other firms share the same
valuation of Firm W and have access to finance, competition between these
firms to obtain control of Firm W should bid up the price offered for the firm to
the point where this just about matches its present value. The bottom line is that
unless there is some reason for Firm Y to place a higher value on Firm W than
the value placed on Firm W by other firms, there is no reason to expect that
Firm Y would win control of Firm W at a price that would make such an acquisi-
tion worthwhile.
Suppose, for example, that Firm Z is also interested in making a horizontal move
and taking over Firm W because combining the two would allow sharing of re-
sources and permit the exploitation of economies of scale. This would boost the
perceived value of Firm W to Firm Z compared to other firms that cannot add
value from acquiring Firm W. Unless Firm Y could also get something extra out
of acquiring Firm W, it should not expect to be able to compete against firms
that could. In short, existing profitability is not enough; vertical integration must
be able to add further value if it is to be worthwhile considering.
2. Vertical integration is not obviously anti-competitive.
It is natural to think of the large vertically integrated firms as presenting prob-
lems of monopoly control. Indeed, terms such as ‘the Seven Sisters’ used in the
past to describe the major petroleum companies hint that these firms might have
close relationships that could pose problems for public policy. In turn, this could
have implications for corporate strategy since firms should take into account
both the implications that vertical integration could have for their relations with
other firms in their sector, as well as the possible public response to such inte-
gration.
In fact, vertical integration itself does not pose obvious problems of monopoly
control. Suppose X horizontally integrated with the three other Stage 3 firms as
shown in Figure 4.1. In that case we would have a definite problem of monopoly
control, with the new combination being the sole buyer of Stage 2 output and
the seller of Stage 3 output to Stage 4. However, if X vertically integrated with a
single firm from each of the three other stages as shown in Figure 4.1, this would
leave the number of firms at each stage unaffected. There would still be four

firms at each stage and their market shares would be unaffected. On that basis at
least there would be no obvious reason for saying that vertical integration had
distorted competition in this sector.
The key word above is ‘obvious’, since we shall see below that vertical integration
may have side effects that could attract the interest of agencies responsible for
monopoly control. However, while vertical integration certainly creates a bigger
firm, the important point here is that this does not automatically imply concomi-
tant monopoly power in practice.
3. Vertical integration is not justified solely on technological grounds.
A technological justification for vertical integration would be one in which it is
argued that steel-making processes should be combined within one firm to save
on reheating costs from one stage to another. But what is to stop having one
firm at one end of a line producing molten steel and another firm at the other
end purchasing the steel and processing it before it has a chance to cool? This
might seem a dubious solution because both firms may have to invest in expen-
sive and relatively immobile equipment that would be difficult or expensive to
disengage and redeploy if the relationship turns sour. Either firm might see an
opportunity to hold the other to ransom and refuse to continue with the rela-
tionship unless the other caves into their demands and accepts a poorer deal in
return. In these cases, single-firm ownership through vertical integration could
be simpler and avoid the problems and traps that could be set if there were a
separate buyer and seller for the molten steel.
There is nothing wrong with such an argument, but the important thing to note
is that it does not relate to technological impediments to having a separate buyer
and seller at both stages, but to transactional problems. Vertical integration may
be adopted in such cases, not because it is impossible in principle to have a sepa-
rate buyer and seller for molten steel, but because it may be just too difficult or
expensive to maintain the exchange agreement between them. It is a matter of
transaction cost, not technology, and so it is to matters of transaction cost that
we turn in the next section.
4.5 The Costs of Markets

The costs of markets come in two main forms: from firms acting in their own
interests and actively against the interests of the firm with which they have a
contract, and a further layer of problems which firms may encounter as a general
consequence of problems of reliance on market exchange. This second layer of
problems arises from the arms-length and anonymous relations that the market
creates. We shall look at this second layer first.
4.5.1 The Invisible Hand and Some Problems

Adam Smith described the market as ‘the invisible hand’ in resource allocation that
can help solve problems in resource allocation without the intervention of some
overall authority in control of the whole process. But this invisible hand can also
lead to problems of control and planning for firms that rely on it. We can use Figure
4.3 to demonstrate this point using basic supply and demand analysis.

The figure shows short-run supply and demand curves for a commodity-type
market, in this case the stage in which a basic metal is produced. The market is in
equilibrium with supply just equal to demand at an industry output of 50 units per
week and a price of $20. The supply curve is relatively inelastic suggesting that the
producers cannot easily vary the amount available in the market in response to a
change in price. The demand curve is also relatively inelastic, indicating that
consumers tend to need only so much of the commodity in a given period and are
fairly insensitive to a change in price.
These are the types of supply and demand relations which could fit a number of
the world’s major industries such as copper, steel and aluminium, as well as non-
metals such as wheat, rubber and petroleum. The trouble is that these are also
characteristics which can pose severe problems for the planners of companies
operating in such environments. To see why, all you need are a pencil and a ruler.
Got your pencil and ruler? Right, imagine that a major new producer comes into
this market – perhaps they’ve opened up a new mine and the result is that the
normal weekly supply is augmented by an extra five units of volume a week. They
are going to add this to the world market regardless of the price. This means that
the supply curve will shift to the right by five units. Sketch that in for Figure 4.3.
The new producer has added only about 10 per cent to the world’s supply, but if
the market settles at the new equilibrium that your modified diagram should show,
the price of ingots will fall dramatically. This would be bad news for the suppliers at
this stage, who could find their profits collapse along with the price. If producers
tried to stem the tide and defend the price, the new supply would mean that there
would be excess supply at any price greater than the new equilibrium price. This
would mean too many ingots chasing too few buyers, a buyers’ market where they
could pick and choose suppliers and some suppliers may be excluded altogether
from the market because they cannot find a buyer. Either way, it is an unpleasant
scenario for the producers and sellers of ingots.
What could the producers do about this? It is too late once the new supplies have
come on to the market. One answer is to be a forward-thinking producer, forward not
just in terms of anticipating or defending against such problems before they happen,
but forward in terms of direction of integration. If a producer of ingots were to buy
up a producer at the next stage downstream before the disruption in the market
caused by the new producer, it could give them a guaranteed market for ingots
shielded from the ensuing chaos. Forward integration here could be a form of
insurance policy, in a situation in which no insurance company would write an
insurance policy. (In fact, something like an insurance policy could exist in this market
in the form of a long-term contract between a producer and supplier, guaranteeing
prices and outputs even if market conditions change. The problem is that even long-
term contracts cannot defend against structural and enduring changes in the market;
eventually the contract will expire and the producer will have to deal with the harsh
realities of life in the open market.)

Demand
Supply
40
30
$
20
10
0
10 20 30 40 50 60
Figure 4.3 Instability and uncertainty in a commodity-type market

Now, suppose there is another type of disruption in this market, only this time a
war has broken out in a part of the world that supplies the raw ore for the ingots,
which in this case removes five units of ingots from the world market at all prices.
This means you should shift your original supply curve to the left by those five units
at all prices. The situation is the reverse of the one we have just looked at. If the
price adjusts smoothly to the new equilibrium indicated on your diagram, then the
price shoots up to a much higher new equilibrium price. The buyers of the ingots
now face considerably increased charges for the product, while the sellers of ingots
are rubbing their hands at the windfall profits they now expect to make. If buyers of
ingots try to resist the market forces and offer less than the new equilibrium price
suggested in your diagram, then it will mean too many buyers chasing too few ingots
with some producers being left stranded without supplies in a market in which
ingots have suddenly become an increasingly scarce commodity. It is very much a
sellers’ market.
Exhibit 4.2: In-house organisation, international success

The Swedish truck maker Scania has been widely regarded as the benchmark producer
of trucks in the world in terms of productivity and profitability, often comfortably
beating its European, Japanese and US competitors on these grounds. Domestic
competition with Volvo has helped provide the basis for subsequent international
success. However, another interesting element in its strategy has been vertical integra-
tion, a strategy that tends to run counter to recent trends in outsourcing in the
automotive industry generally. It makes all its main components including engines, axles,
frames, gearboxes and transmission systems. The potential difficulties are compounded

by the fact that there is heavy emphasis on customising heavy vehicles to the needs of
customers, which tends to increase variety and differentiation in the final product and
puts demands on in-house capabilities.
The way that Scania has dealt with this problem has been to create a modular design
system based on standard parts and components to maximise the volume of production
of each element as far as possible and achieve economies in R&D, production and
distribution at this level.
The number of components involved in building a Scania truck is about 20 000 com-
pared to 25 000 at Volvo and 40 000 at Mercedes. Then flexibility and variety are
generated from the different combinations of components that are possible. By retaining
production in-house Scania is able to rationalise the number of components required
and explicitly design them to be integrated with the rest of the system. It sees its
focused strategy of concentrating on heavy trucks over 16 tonnes as an integral part of
this success story. Were it to venture into other market segments such as lighter
trucks, it would stretch the ability of this modular system to cope with the demands
that could be placed on it.
Is there evidence that Scania’s vertical integration strategy is vulnerable to some

of the costs of vertical integration discussed in Section 4.6, and has it tried to
reduce some of these costs?
Again, it will be too late to do much about this once the problem has arrived. A
solution for forward-thinking buyers of ingots in this market may be to think
backward – backward in the sense of backward integration. If there is a real possibil-
ity that supplies can be disrupted in this market by whatever means, then one way to
guard against the problems of price escalation or difficulties of getting supplies may
be to own your own supplies. Backward integration could provide a stable hedge
against the vagaries of the market that the future may hold.
Of course there is a downside to vertical integration in both cases. A firm may
vertically integrate backward just as a major new mine comes on stream, in which
case it will find that its new acquisition is now worth very little in a world which may
now have a glut of ingots. Or a firm may integrate forward just as a war breaks out
and leads to the world’s buyers clamouring for ingots, just as the firm has commit-
ted its production to its new acquisition. In such cases vertical integration can lock
the firm into internal arrangements when it could have done better by continuing to
trade in the open market for ingots. However, for risk-averse firms which are more
worried about the dangers of being open to major shifts in supply and demand in
the open market, vertical integration may provide some security and control over
the vertical chain of production.
Vertical integration can provide further advantages even if the market is not
subject to such wild swings as in our examples. It may be important to maintain a
continuous and balanced throughput in the production process to make sure that
the plant and machinery are used to full capacity, or as near it as possible. It may be
desirable to maintain control over the quality, grades and delivery of the raw
material (see Exhibit 4.2 for examples of this). Vertical integration may help in this

context by replacing continuous market bargaining with planning and administrative

processes.
Indeed, vertical integration can provide such obvious advantages that we might
begin to wonder why everybody is not doing it, all the time. Some reasons why
vertical integration may face limits have already been alluded to in our discussion of
downsizing and outsourcing above. But before we answer the question more fully,
we have to look at further problems of market transactions, this time in cases where
we do not have standardised commodity-type products. This is an area in which a
relatively new branch of study, transaction cost economics, has made a real contri-
bution.
4.5.2 Visible Relations and the Market

Industries in which standardised commodities are the norm provide only one type
of market transaction. For example, what about cases where suppliers may have to
design specialised components and products for one or a few producers, such as the
aerospace and automobile industries? Oliver Williamson (1985) set out the basic
framework which allows us to investigate the reasons why firms may choose to
vertically integrate in such cases. This approach is called transaction cost economics.
Basically, a transaction is an exchange of goods and services and transaction costs
are costs incurred in such an exchange. It is natural to think of transaction costs as
involving real expenditures of time and money. There are three major categories
that may be involved in this context: (a) searching for a trading partner, (b) negotiat-
ing the deal, and (c) monitoring and policing the agreement. Each of the categories
may involve legal and managerial time and resources, and so can represent real costs
to the firm.
An issue that can be of importance in this context is that of transaction costs in
the form of loss of intellectual property. If a stage needs access to sensitive or secret
information further up or down the vertical chain in order to operate or improve its
operations, then vertical integration may help prevent or reduce the chances of
‘leakage’ of sources of competitive advantage to the outside world. This can be
particularly important in the case of intellectual property, for example R&D
findings. Sometimes the threatened leakage can be in unexpected places. Boeing was
worried about possible leakage of R&D information to Japanese firms with which it
was co-operating when it turned out that what they were really interested in was
Boeing’s skills in project management. In turn, vertical integration may help a firm
acquire skills it thinks it needs, such as Microsoft taking over the various software
manufacturers that supplied the packages that could be used in Windows.
Resource costs and property right problems are obvious and traditional ways of
seeing transaction costs. However, transaction cost economics goes beyond these
traditional measures to look at the behaviour underpinning and influencing transac-
tions. Transaction cost economics builds on three important concepts. First, the
concept of bounded rationality, which simply means individuals may not have suffi-
cient knowledge or information processing power to optimise in a given situation.
Individuals are naturally limited in their cognitive powers and in their ability to
communicate and assimilate information. This is not something that is traditionally

recognised in economics, which tends to assume that individuals have all the
information they need to make the best possible decision from their point of view,
whether it is utility-maximising consumers or profit-maximising firms. Second, the
concept of opportunism, which means that individuals are prepared to cheat, lie and
generally misrepresent the situation in the pursuit of their own interests.
Third, we have the notion of asset specificity, or assets specialised by use or user. If
an asset has a high degree of asset specificity it means that it is of little use or value
outside its present application, or to someone else. Examples of assets with a high
degree of asset specificity could be a machine designed to make components for the
space shuttle or a taxi driver’s specific knowledge of London streets (asset specificity
can refer to human capital as well as physical capital). It may be difficult to find uses
for these assets outside their present applications. Examples with low degrees of
asset specificity could include an aircraft and an MBA degree. Routes can close
down and firms may go broke, but it should be possible to transfer aircraft to
service other routes, while a good MBA training should represent a marketable and
portable asset to its bearer. The major types of asset specificity are shown in Exhibit
4.3.
Exhibit 4.3: About asset specificity

Asset specificity can take many forms. Here are some of the most important
categories identified by Williamson.
1. Site specificity, where physical assets cannot be easily redeployed once they
have been built and put into position. Our steel example illustrates the problems
of site specificity.
2. Physical asset specificity, where specialised equipment is needed for produc-
tion to take place. An example of this would be the particular moulds developed
to produce a specially designed statue.
3. Human asset specificity, where the skills and knowledge acquired by an
individual cannot be easily transferred to another use or user. An example of this
would be much of the training given to a shuttle astronaut.
4. Dedicated assets, which involve expanding an existing plant on behalf of a
particular buyer. An example of this would be a footwear manufacturer who
expands facilities to supply Nike.
Bounded rationality is a generally acceptable notion, and the idea of asset speci-
ficity is uncontroversial. Where some people find difficulty in accepting transaction
cost economics is in the notion of opportunism. It does seem to offer a rather
gloomy and pessimistic view of human nature, and some people have argued that it
is not a fair representation of reality.
In fact, you can have almost boundless faith in human nature and still find the
concept of opportunism useful. Where it derives its real power in transaction cost
economics is when it is paired with bounded rationality. You could believe that most
people are essentially good and trustworthy, but unless you live in an isolated commu-
nity, I bet you still lock your door when you leave home. It is the fact that bounded
rationality may make it difficult, costly or impossible to uncover another person’s

motives, intentions or actions (or in some cases, not until it is too late) that makes
opportunism a concept with real mileage in transaction cost economics.
It is when bounded rationality and opportunism join with asset specificity that
real problems begin to appear in economic activity. We can see how this might
happen in the case of our steel example in the previous section. Suppose we have
our single producer of molten steel selling to the single buyer further down the line.
To begin with it turns out that the physical equipment used by both seller and buyer
is characterised by high degrees of asset specificity. If the buyer says it does not
want to take any more molten steel, there is no practical user available for the red-
hot steel pouring out of the producer’s furnaces. And if the producer says that it
does not want to sell to the downstream user any more, there is no effective other
source of molten steel for the user since it is tied into a physically integrated
production system.
Both the buyer and seller of the molten steel may also face problems of bounded
rationality, even though they may both receive assurances concerning the terms of
trade from their respective trading partners. The seller may affirm that it will supply
a given quantity of steel on demand at a specified price, while the buyer may testify
that they will pay for an appropriate amount of steel at a particular price. The
problem is that both are dependent on the other keeping to its part of the bargain
and bounded rationality means that there may be no way of guaranteeing that they
mean what they say. Add in the possibility that either partner may behave opportun-
istically and breach the agreement if it suits him, and now you have a recipe for a
highly problematic transaction. The hold-up problem is the most obvious source of
transaction costs in such a situation. Let us see how this can arise.
4.5.2.1 The Hold-Up Problem

Suppose both buyer and seller have made an agreement to buy and sell steel down
their integrated production line at an agreed price. The price may be specified, or
there may be a clause that allows the price to be adjusted over time in particular
ways, e.g. to take inflation into account, or to reflect market conditions. However,
once both buyer and seller have built their equipment and committed themselves to
the transaction, they both may be vulnerable to hold-up. The seller may decide to
take advantage of the buyer’s dependence on them and try to hold the buyer to
ransom by threatening to walk away from the deal unless the buyer pays a higher
price. On the other hand, the buyer could also threaten to close down the line unless
the seller agrees to accept a lower price. It could turn out to be rather like a game of
‘chicken’ in which both buyer and seller are pointing guns at each other and
threatening to pull the trigger.
However, such threats may lack credibility to the extent that both buyer and
seller rely on each other. Both are dependent on each other and threats to pull the
trigger (or walk away from the transaction) may not be believed by the threatened
party. At the same time, circumstances change and it may be that at different times
different parties to the transaction perceive that they have the upper hand. For
example, if the market for steel soars, the buyer may be desperate to get more
supplies of molten steel but may find that its supplier is experiencing difficulties in

getting its workers to work overtime unless of course an improved price is agreed.
Or the market for steel slumps, and the buyer tells the supplier that it is thinking of
pulling out of the market – unless, of course, the seller offers substantial discounts
on the prices already agreed.
Of course, the seller may be misrepresenting the difficulties of getting workers to
work overtime, while the buyer may be lying about the chances of its pulling out of
the market. But that is the problem with bounded rationality. It may be difficult or
impossible to verify whether or not parties are behaving opportunistically in such
circumstances. Even the existence of a written contract may not be sufficient
protection from hold-up. Court settlements can be costly and time-consuming and
there may be little comfort in having the option of taking your partner to court for
breach of contract if the hold-up threat means you could be bankrupt first.
It is also important to note that it is the conjunction of bounded rationality, op-
portunism and asset specificity that creates the problem in such circumstances. If
there was no bounded rationality, traders would know whom to trust and whom not
to. Or if individuals could be relied on not to be opportunistic, then both parties
could accept that unexpected circumstances could be resolved sensibly and amicably
with both agreeing to share out the costs (or gains) from unexpected developments
as they arose. And if there was no asset specificity, then either firm could withdraw
and seek alternative deals as soon as its existing trading partner indicated signs of
opportunistic behaviour. For example, if the product was timber and not molten
steel, then a producer may be able to find alternative outlets on the open market if
the buyer starts to try to renegotiate the deal, while the buyer of timber may similarly
be able to find external supplies if the seller turns out to be a less than reputable
supplier. Take away any one of the three issues of bounded rationality, opportunism
and asset specificity and the transaction cost problems are greatly reduced and may
even become trivial. Put them all together, and the transaction cost problems may
become severe and may even deter the parties from agreeing the transaction in the
first place.
In some cases, the transaction cost dangers may be most severe where only one
party to the transaction suffers from asset specificity. In the case of our molten steel
example, the firms may be reluctant to carry out their hold-up threats if there is a
danger of shooting themselves in the foot at the same time. However, suppose a
firm is the only one capable of producing a particular component demanded by
more than one user. Now the users and their activities are highly dependent on a
particular transaction but the supplier is not; asset specificity from the point of view
of the users, but not the supplier. The supplier might be able to play one firm off
against the other and extract major concessions from each given its advantageous
bargaining position. Alternatively, a firm may encourage more than one supplier to
build specialised equipment to supply the same component to it. The firm now has
multiple sources and so is not dependent on any one supplier for the component,
but each supplier is totally dependent on the user firm. In this case, it is the user
firm which may be able to play one trading partner against the other, improving its
own position and profitability at the expense of its suppliers.

On the face of it, it would seem to be most advantageous for a firm to be in a

position where it does not suffer severe problems of asset specificity but its poten-
tial partners do. That would give it the chance to extract maximum benefit using the
threat of hold-up. In fact, it is not as simple as that. If you see a person holding a
loaded gun, you would naturally want to avoid being anywhere near that person.
Similarly, if a firm tries to set up a transaction where it looks as though it will not
suffer from asset specificity but its partner could, it should not be surprised to find
potential partners thin on the ground. It could try to get round this problem by
promising to be a good and responsible partner that would not resort to hold-up
threats if a deal can be made, but we have been down this road before; given
bounded rationality, how can a potential partner trust these promises if it does
commit itself to an irreversible and asset-specific commitment to this transaction?
Ironically, this firm’s apparent source of strength (its potential bargaining power)
may turn out to be a form of weakness, and it may find it difficult to find a firm
willing to deal with it – at least without expensive and robust guarantees that
recognise and protect its partner’s interests.
It is important to recognise how asset specificity can change the relationship be-
tween buyer and seller once the respective parties have committed themselves to the
relationship. Suppose a car producer is inviting tenders to design a critical component
for a new car, and the new component will require the winner of the contract to build
new equipment to produce it. At this stage the car firm may have a number of
suppliers to choose from, but once the contract is agreed and the successful supplier
has built its special equipment, it may be too late to switch suppliers if the contract
turns sour. If the supplier now decides to hold up the car maker, it may take months
to get a replacement supplier to build the special equipment necessary to produce the
component. The situation in which one of the parties is able to choose from a large
number of bidders before the contract is settled, but only one (or a few) after the
contract is settled, is called the fundamental transformation in transaction cost economics.
Clearly, similar considerations may hold for the component maker in our example.
Before the contract is signed and they build their specialised equipment, there may
have been numerous companies they could have supplied with components. If the
equipment now is so specialised and asset-specific that it can only produce the
components that suit the specifications of the car maker, then clearly the fundamental
transformation also applies to the supplier, who now has no realistic alternative to
continuing to supply the car maker.
4.5.2.2 Is the Hold-Up Problem a Serious Issue?

A case can and has been made by some that the hold-up problem is not a serious
issue or, if it is, pursuing hold-up is a bad managerial strategy. Suppose a firm did
exploit a temporary advantage to renegotiate the contract at the expense of its
trading partner. This could increase its profits at the expense of its reputation. It
may not only be chances of dealing with the current partner that are threatened in
the future; it could be that other firms become reluctant to deal with it. Managers
talk at conferences, airport lounges and in clubs to managers in other firms. Exercis-
ing the opportunity for hold-up may be a good short-term tactic but can be a
disastrous long-term one.

A great deal will depend on the culture and attitudes of the other firms that the
hold-up merchant is likely to deal with. In some cultures a breach of trust may be
shrugged off with the attitude that a sucker should not be given an even break, while
in others betraying even a verbal commitment may be regarded as unforgivable.
Wide differences in attitudes to opportunistic behaviour between sectors can even
be observed between sectors in the same country; in general, misrepresentation is
not something that normally ends the career of the manager of a pop group, but it
can be a bad career move for a diamond dealer in some circles in the US where trust
is of paramount importance. Exhibit 4.4 shows the advantages that firms can obtain
in cases where the possibility of hold-up is seen as a minor or only occasional
problem.
Perhaps the most useful way to see the hold-up problem is in terms of not neces-
sarily representing something as crude and direct as a threat to terminate the
relationship unless the other firm pays up. Instead, the major problem in market
exchange relations characterised by asset specificity lies in the fact that the parties to
the transaction are likely to have different objectives and strategies. The car firm
may be desperate for components to prevent its production line stopping but its
supplier may be preoccupied trying to win a big new contract elsewhere. Or the
component supplier may need to keep its production line running steadily during a
downturn to prevent the need for redundancies, but the car firm may see this as
nothing to do with it. These may lead to transactional problems and production in
both firms may be subject to hold-up as a consequence. However, unlike transaction
cost economics we do not need to argue that either or both firms have to be
opportunistic for hold-up5 to occur. All that it needs is a quite natural difference
between the firms in terms of what they regard as being in their own best interest.
This can lead to a real fear that the interests of the firm may be adversely affected
through the actions of trading partners who do not have the same interests or
objectives.
Exhibit 4.4: The wisdom of eggs in one basket

The Japanese companies Toyota and Honda developed different practices to organise
their domestic chain of production. Both rely heavily on external suppliers but Toyota
has its own tight keiretsu network in which a single supplier delivers only the parts that
are needed just before they are needed – the kanban or just-in-time manufacturing
system which Toyota helped pioneer. This allows the supplier to exploit economies of
scale in parts production while cutting costs of holding stocks of components to a
minimum. Toyota also devolves responsibility for developing and designing the particular
components to the supplier on the basis of general specifications provided by Toyota.
Although the supplier enters into a situation characterised by high degrees of asset
specificity, opportunistic behaviour is not seen as a problem in this culture.
On the other hand, Honda does not have the same close network of keiretsu affiliates
5 You might think there is a difference between what is meant by ‘hold-up’ here and what is meant by
‘hold-up’ resulting from the previous discussion, and you would be right. The earlier use of ‘hold-up’
was more in the sense of a robbery, as in holding up a stagecoach; the second implied a physical
stoppage as in the production line being ‘held up’. They can be regarded as resulting from the same
source, but the objectives and attitudes of the trading parties are not the same.

and prefers to use a system of dual sourcing from different suppliers. This allows it to
hedge against unexpected problems with one supplier while allowing the firm to play
one supplier against another to improve quality and reduce costs. The potential perils of
relying on just one source of supply for immediate supply of a component have been
demonstrated when fire, earthquake or even tsunami have disrupted its supply chain.
However, none of this has been sufficient to deter Toyota from maintaining both its
kanban system and its keiretsu network since it still believes the long-term benefits
outweigh the costs.
What implications could the existence of economies of scale and asset specifici-
ty in supply of components have for supply chain organisation here?
4.5.2.3 Solutions to the Hold-Up Problem

So the hold-up problem can be a real problem, whether in its strong form with the
other firm making a direct threat, or in its weaker form with the firm vulnerable to
its production being held up because the other party’s interest and attention is really
elsewhere. There are a number of solutions to the hold-up problem; each has its
advantages and disadvantages:
Repeated contracting. One solution is to stick to the same preferred partner every
time the possibility of a new contract, say for a new component, comes up. The
advantage of this is that hold-up should be less likely because the other firm is more
likely to be conscious of the possibility of losing future contracts unless it performs
well and responsibly in the present situation. The disadvantage is that it may lock the
firm into this supplier and reduce the flexibility of choosing from a wider pool of
potential suppliers at the new contract stage, and with it the chances of obtaining a
potentially better or cheaper supplier in the process.
Exhaustive contracting. Another solution is to tighten up the contract so much
that it reduces the possibility and opportunity for hold-up. The advantage is that it
may give the firm a higher degree of security than would have been the case in a
loosely drawn contract. The disadvantage is that it is likely to be expensive and only
partly effective; bounded rationality means it may be difficult or impossible to
anticipate all eventualities and to be sure of the truth behind the other firm’s actions
and statements. Also, if the transaction is dominated by a legalistic approach, it may
impede the give-and-take that may be essential for flexible responses to evolving
situations. Exhibit 4.5 shows some of the difficulties in achieving exhaustive
contracting in practice.
Exhibit 4.5: Older and richer
The case of the singer George Michael is an example of the problems of vertical relations in
the pop business. Record companies tend to prefer long-term contracts with their artists
so that they can recoup their commitment of heavy asset-specific promotional and
advertising budgets for the artist. These expenditures may be necessary to build up public
awareness and interest in the performers. Even number-one singles may not recover their
promotional costs, but may be seen as necessary loss-makers to promote the album from
which they are taken.
In return, long-term contracts may give the artist stability and security, but they can

often be seen as restrictive especially if, as in the case of the singer, he wants more creative
freedom later in his career.
George Michael had built up a teen idol image in the eighties, first with the pop group
Wham! and then as a solo performer. But his Listen Without Prejudice album sold only 7m
copies against 15m for its predecessor. He refused to participate in many promotional
activities for the album and sued his record label Sony in a $3.5m action, claiming that it had
not supported his attempts to nurture a more mature image. His attitude was understand-
able, as was that of Sony, who had invested a great deal in cultivating a certain image for the
star. George Michael lost the court action and then almost disappeared from public view,
with no new albums for some years (record companies typically like a new album at least
every three years).
The impasse was resolved by Virgin Music and DreamWorks buying him out of the Sony
contract for $45m, with a $10m advance for Michael (in turn confirming that George
Michael’s skills were not assets that were restricted to supplying one record label with
material). When his next album, Older, was released it went on to critical acclaim, and
became one of that year’s fastest selling albums, number one in many countries. Even so,
some analysts expected that Virgin and DreamWorks would make only a modest profit on
this venture, despite their sharing in the risks of his switch of image. This was because of
high promotional costs and the attractive royalty deal he had been able to negotiate.
However, Michael was also seen as enhancing the reputation of the label, giving them more
bargaining power further downstream with retailers, and increasing their chances of
attracting other performers to the label.
Would banning long-term contracts help protect the interests of recording artists?
Standardised assets. One solution is to design the system so that off-the-shelf
standard components or materials can be used, instead of one that may involve the
creation of specialised equipment. For example, the car firm may decide to use
standardised plastic material for its dashboards instead of customised wooden facia.
The advantages are obvious in that it means there may be readily available alternatives
to the present supplier in the event of a hold-up problem. However, the disadvantages
are equally obvious in that if the firm relies on standardised components it may lose
at least some of the distinctiveness in design or performance that would provide a
source of competitive advantage.
Hostages. Another solution to the hold-up problem involves the provision or
exchange of what can be described as hostages. These come in many guises and
forms, but the basic logic is the same. The hostage may have to be sacrificed by the
firm if it tries to withdraw from the transaction or behave opportunistically. A
deposit for a house or a holiday is an example of a hostage familiar to many of us.
Common forms of hostage in construction circles are penalty clauses for late
completion. In the case of firms generally, a common form of hostage comes from
involvement in multiple transactions with the same firm, say the same producer
supplying more than one component to the car firm. The advantage of such hostages
is that both firms know that they have more riding on their joint relationship than a
single transaction, and they may avoid hold-up opportunities if they think it could
lead to retaliation against them in the other transactions they hold jointly with the
firm. The disadvantage can be similar to repeated contracting in that the firm may

become locked in and face a more limited choice over who to deal with than might
otherwise be the case.
Multiple sourcing. Multiple sourcing means that more than one supplier is
chosen for a component or material. The advantages are that asset specificity and
vulnerability to hold-up can be reduced or eliminated, if it means that there is an
alternative source of supply that can be turned to if one supplier tries to hold up the
firm. The disadvantages are that multiple suppliers mean multiple contracts and
associated costs of setting up and dealing with these contracts. It may also mean
higher cost of supplies if the scale of output of individual suppliers is now insuffi-
cient to reap economies of scale fully.
Vertical integration. Finally, it may be possible to eliminate the problems of
market exchange and its associated transaction costs by full-scale combination of
the two stages of production in one firm. This may be achieved by internal expan-
sion, merger or acquisition. The advantages of vertical integration are that it may help
to synchronise and align the objectives and actions of those involved in both sides
of the transaction so that they are not acting against each other’s interests.6 Conse-
quently the hold-up problem may be eliminated. And the disadvantages of vertical
integration? That is something we now need to look at in more detail in the next
section. However, before we do, we shall finish this section with a curious hybrid,
the case of tapered integration.
Tapered integration. On the face of it, tapered integration appears a curious
solution in that it involves partial integration backwards or forwards. The firm sells
the same product to its own in-house units and to external purchasers, or it produc-
es some of its own components and purchases some of these same components
from outside suppliers. The apparent strangeness of the solution stems from the
belief that it would be natural to expect that circumstances would encourage one or
other solution, but not both. If market problems lead to the firm replacing market
exchange with its own organisation, why does any market exchange remain? If
market exchange is good enough for some portion of a firm’s products or inputs,
why is it not good enough to handle all of the transactions involving these same
products and inputs? And why should the firm have to cope with the strains of two
distinct methods of organising the receipt or delivery of the same product or input?
Tapered integration appears at first sight to be a strange strategy for the firm to
adopt, but it can have certain benefits in dealing with the possibility of a hold-up
problem. The advantages include limiting the opportunity for external firms to exert
hold-up threats. The firm may now have the in-house capability to compensate for
hold-up with stepped up production of its version of the components or, in the case
of forward links, it may be able to divert downstream supplies in-house. It will also
be able to get a more intimate working knowledge of the stages it has bought
directly into, and this familiarity and experience should also help to limit the ability
of external firms to misrepresent the true situation to them. On the internal side of
6 This argument is based on the optimistic assumption that everybody in an organisation wants to row in
the same direction and at the same speed. This may be overly optimistic and in practice there are still
likely to be differing objectives and intentions on the part of individuals and groups within the
organisation. The point is that vertical integration should make these problems less severe.

things, the knowledge that there is an external alternative should have a beneficial
effect on incentives and help keep the firm’s own in-house units on their toes. The
disadvantages include the possible sacrifice of economies of scale by having at least
two separate sources of supply or methods of distribution for an activity, as well as
the fact already referred to that the firm has to deal with two very different methods
of organising the vertical chain when there is a tapered solution.
4.6 The Costs of Vertical Integration

Vertical integration is the most radical solution to the problems of market exchange
because it involves not simply compensating for or preventing some of the costs of
market exchange as a method of organising transactions; it involves changing the
method of organising transactions entirely. It represents the traditional and most
obvious alternative to simple market exchange, which is why it deserves more
attention than the other solutions to the hold-up problem. However, the costs and
disadvantages of vertical integration are not necessarily any more straightforward
than the complications of market exchange, even though it avoids the complications
and games that may be played out when there are different parties with different
objectives and interests. Essentially the costs are the administrative costs of bureau-
cracy whose main features are the following.
Different competences. As we implied above, if different stages in the produc-
tion process involve similar skills and capabilities, this may be more a matter of
chance than design. Vertical integration may involve the firm moving into areas in
which it has little or no competence and sacrificing gains from specialisation. Mining
bauxite is a different kind of business from smelting aluminium, which in turn is a
different kind of business from making pots and pans. A firm involved in all these
stages of the aluminium industry would have to be a master of many trades.
Dangers of specialisation. One of the ironies of vertical integration is that
while firms may sacrifice the advantages of specialisation, they may still be vulnera-
ble to its dangers. Because the firm is linked in a vertical chain it may still be
fundamentally affected by circumstances affecting just one element of the chain. For
example, copper and iron producers have been adversely affected in recent years by
technological substitution, such as plastics and optical fibre, while the petroleum
firms suffered a dramatic fall in the market price for crude oil. Since vertical
integration means the fortunes of all stages may be tightly tied in together, it is a
mistake to regard it as a form of diversification as some business texts do. It may be
diversification in terms of the skills required; it certainly is not diversification in
terms of trying to avoid dependence on one business.
Exhibit 4.6: Stuck at home

Kao, the Japanese equivalent of Unilever or Procter & Gamble, has a strategy that would
look strange to its Western competitors. It is vertically integrated from production to
final goods market, from factory to its wholesale distributors (hansha), who then sell on
to the retail end of the vertical chain. Kao also has a close relationship with its retailers,
even advising them on shop design, and with an emphasis on electronic links where
possible to enable retailers to place orders and feed back market information to it. It is

highly profitable and dominates the households products market in Japan.

However, Kao has had difficulty in transferring its success overseas, unlike other
Japanese firms such as the car firms who also rely on developing tight links with
distributors. It has found problems in entering foreign markets dominated by well-
established brands, and it has found difficulties in replicating its tightly linked vertical
chain in countries where there are entrenched distribution outlets that may include
supermarkets, pharmacists and specialist retailers. While the Japanese car manufacturers
found it possible to build their own overseas retail bases on the back of their low-cost
and high-quality products, this is not a trick that Kao has been able to replicate in its
sector.
If Kao has found it so difficult to compete against domestic firms in overseas

markets, does this not raise warning signals that it may be vulnerable to more
efficient foreign firms entering the Japanese market?
Lack of flexibility. Vertical integration can lock in a firm to a limited range of
sources and outlets. The firm may be faced with the loss of the choice the market
system provides, such as variety of choice and flexibility to choose the cheapest or
best option on a case-by-case basis. At least, that is how the market system ideally
works in a healthy, competitive environment. Of course, the environment in which
the vertically integrated firm operates may not be highly competitive, and to that
extent the opportunity costs of vertical integration may be reduced.
If vertical integration is something that the whole industry has pursued, then the
firm may be relatively insulated from competitive pressures, at least for a time. If its
major competitors are also locked into a relatively inflexible and slow-changing
vertically integrated strategy, then the firm can be lulled into a false sense of security
that it is actually doing quite well. However, there are two dangers that this might
lead to. The first is that the system as a whole may become inefficient and anti-
competitive. This is illustrated in Figure 4.4 where we have four large vertically
integrated firms (each bounded by the dotted lines) with their own in-house Stage 3
supplier in each case. There is an innovative and low-cost specialist firm trying,
unsuccessfully, to get a foothold in Stage 3, but it finds difficulties in doing so
because all of Stage 2 suppliers are locked up inside the larger firms, while all of
Stage 4 outlets are also locked up inside the larger firms. Unless the larger firms
changed their strategy of total vertical integration, it is difficult to see how their firm
could break into this market unless it too became a vertically integrated firm. And of
course, this may lead to its becoming the same kind of large, dull firm that it was
trying to compete against, thus eliminating the source of its original competitive
advantage (and the case of Kao in Exhibit 4.6 also shows how even a well-managed
firm may become locked in by its vertically integrated strategy).

Stage 1
Innovative
or low cost
producer
Stage 2
Stage 3
Stage 4
Figure 4.4 Vertical integration foreclosing entry

Such an outcome demonstrates that vertical integration can have anti-competitive
implications, even if it does not change the number and market share of firms at
each stage in the production process. Industry-wide vertical integration may impede
the entry of better-performing firms into the industry. While the anti-competitive
implications are clear, such outcomes may also not be in the best long-term interests
of the incumbent firms in the industry, since they may become weak and compla-
cent and not fit enough to resist or deal with radical changes to their sector when
they eventually do come. This was the experience of many firms in the primary
metals sector when external technological change began to erode their long-standing
markets in recent years.
Sacrifice of economies of scale. If you integrate forwards (becoming your own
customer) or backwards (becoming your own supplier), the resulting scale of activity
in the stage you are integrating into could be much less than if it was separately
owned and had many trading partners in its vertical chain. This could mean sacrifice
of economies of scale and relatively high cost of operation.
Dampened performance incentives. This can breed complacency on the part
of the in-house units who may see themselves as having a guaranteed future
irrespective of their performance. This is not a luxury that can be afforded if the
units and individuals are to survive as separate entities in the external market and
where poor performance may be punishable by bankruptcy. A competitive market
system has a direct method of financial rewards and penalties that encourages

continual improvement in products and downward pressure on costs. Vertical

integration may create a principal–agent problem where the principals (shareholders
and top management) may tell their agents (lower-level managers) what to do. The
problem is the agents are likely to know better than the principals whether any
subsequent failure in performance reflects bad luck, events beyond their control –
or sheer incompetence or laziness on their part.
The market alternative may not discriminate between bad luck and incompetence
in punishing poor performance, but at least a competitive system provides a
continuing stimulus to perform well which may be dampened within a large
vertically integrated bureaucracy. Exhibit 4.7 shows how Ford and General Motors
have tried to respond to these problems.
Exhibit 4.7: Tightening up in-house

Having seen the success of Japanese car makers such as Toyota in relying on extensive
networks of independent sub-contractors, giant US car manufacturers in recent years
have also become sensitive to the potential costs of having a sleepy in-house supplier of
components or parts. External suppliers are expected to become more tied into
specialised (asset-specific) situations in which both parties share the costs and risks of
R&D into new components. Successful suppliers can expect economies of scale from
winning large orders, though stiff competition amongst potential suppliers at the bidding
stage has led to rationalisation and squeezes on profit margins of external suppliers.
These developments have also helped put pressure on internal suppliers of compo-
nents. General Motors (GM) renamed its Automotive Components Group as Delphi,
and Ford rechristened its Automotive Products Operations as Visteon.
The name changes also echoed changing emphasis in strategy. Delphi was increasingly
expected to compete against specialist external contractors for GM’s business and seek
customers other than GM; Delphi’s sales outside GM’s own North American operations
increased rapidly. Ford set out similar ambitions for Visteon and regrouped the supplier
into six operating divisions intended to focus on the particular business opportunities
that existed in the marketplace.
The intention in these cases was to help the in-house supplier become more com-
mercially sensitive, exploit core competences, pursue focus strategies where possible
and rationalise where appropriate. One problem encountered on the way to these goals
was strained management–union relations; margins and pay in the supplier side of the
automotive industry are often tighter than for the big car assemblers, reflecting compet-
itive conditions, and the more the big car companies seek to mimic the conditions that
obtain for their external suppliers, the more workers at this stage in the vertical chain
feel their interests threatened.
Both GM and Ford eventually spun off their subsidiaries as independent companies.
Are there any potential difficulties signalled by Section 4.6 that might have to be
taken into account in Delphi’s and Visteon’s search for external customers?
Large size. Clearly vertical integration creates a bigger firm because it combines
what would have been two separate firms within one bureaucracy. However, this
can be a major understatement of the effect that vertical integration can have on the
size of firms. We can see this by reference to Figure 4.5.

Suppose we have two firms at Stage 1 and three firms at Stage 2 (the ovals in
Figure 4.5). All five firms are working at full capacity and have fully exploited the
economies of scale that exist at the respective stages. Firm B and firm E are only
able to take some of the output of firms A and D respectively; the remainder of the
output of Stage 1 is mopped up by firm C. Now, suppose there are at each stage
severe problems of transaction costs which could be resolved by vertical integration.
A D
B C E
Figure 4.5 Vertical integration and the problem of indivisibilities

If firm B and firm A merge, this eliminates transaction costs in the case of firm
B. But firm B only has the capacity to take some of the output of firm A, and firm
A has to offload the excess to a third party, here firm C. If it wants to eliminate the
transaction costs associated with firm C, it has to merge with this firm also. But firm
C needs to take more than firm A can supply if it is to work at full capacity, which
here means output from firm D. So our new enlarged firm (A+B+C) has to merge
with firm D as well if it is to eliminate these transaction costs. Finally, firm D still
needs to sell some of its output to firm E if it wants to run at full capacity. So that
means our new firm (A+B+C+D) must also merge with E to eliminate transaction
costs and prevent some of the stages in our vertically integrated firm running with
wasteful spare capacity.
The significance of all this is that when vertical integration is combined with
indivisibilities such as the scale of plant necessary to exploit economies of scale,
then it can lead to a considerably increased scale of firm. In our example, instead of
merging just two firms, five firms have to be merged if we wish to eliminate
transaction costs. Add more stages, and these problems can be compounded. The
important point is that it is the fact that the indivisibilities imply a different level of
output at each stage that cause the major step jump in size of firm. If Stages 1 and 2
fully exploited economies of scale at the same level of intermediate output between
the stages, then there would not be the same problem since transaction costs could
be eliminated by merging pairs of firms, one from each stage.
This explanation accounts in part for the sheer size of the traditional multi-stage
vertically integrated firms in the petroleum and primary metal industries. At the
same time, we should not be left with the impression that such firms develop a
watertight vertically integrated system that has no contact with firms operating at
the same stages in which it also operates. That is not necessarily the case; for
example, many petroleum firms actually buy in crude oil from rivals from time to
time in order to maintain a balance and throughput in the system. This leads us to
the next problem of vertical integration, vertical relations with rivals.

Vertical relations with rivals. Suppose in Figure 4.5 that the only real problem
of transaction has been concentrated in relations in A and C and that these two
firms resolve these problems by merging and becoming vertically integrated. The
problem is that these transaction costs issues may be resolved only by creating
others. Now that A and C have merged, firm B finds that its supplier (A) is also now
a rival (C). Its supplier A might make reassuring noises that it will treat B and C
evenhandedly, but in a world of bounded rationality and opportunism, why should
B believe that A would not give preferential treatment to its own customer? Note
that this is bad news for A as well as B, especially if B begins to take protective
action to pre-empt any opportunistic action by A. It was possible problems such as
these which led the US chemicals company Hercules to make a deliberate decision
not to integrate forward into the final product stage in case it upset and worried
some of its existing industrial customers.
Note that our new firm A+C may have a mirror image problem with firm D in
Figure 4.5. Firm D may be worried that a major customer C is now obtaining
supplies in-house from A. For example, it could be concerned that if C had to
choose between A or D, say in a time of declining demand, it would naturally prefer
its own in-house supplier, especially if pressure was brought to bear by headquarters
management.
These problems of vertical relations with rivals also help to explain why vertical
integration may quickly spread through a sector once the process is triggered by one
or two major firms. It may or may not be a good idea, but if its suppliers and custom-
ers are doing it, a risk-averse firm may decide that a safer strategy may be to follow the
leader and vertically integrate rather than leave itself vulnerable to a trading partner
now becoming a direct rival.
All these issues together suggest that it is not sufficient to look at vertical integra-
tion as something that simply involves two firms merging or one firm simply
extending its operation into another stage. The process can involve many firms and
can even transform the structure and conduct of an entire industry. It is not enough
simply to compare the costs and benefits of vertical integration for a firm to those
of market exchange. What we have to do in practice is analyse the alternative
strategies open to a firm in principle, in the context of the actual environment in
which it operates. If a firm’s major competitors are vertically integrated, then this
may suggest a different array of costs and benefits if it chose to integrate vertically,
than would be the case if there were universal market exchange and no vertical
integration between the various stages of its industry.
4.7 Choice of Strategy

So far we have concentrated on the problems of various alternatives for organising
the vertical chain of goods and services, and now we should be in a position to draw
together the threads to explore the question of the strategy to choose in particular
circumstances. To some extent this question is the obverse of the previous discus-
sion; if market exchange finds difficulties in dealing with certain kinds of
transactions, then vertical integration may become a relatively more attractive

solution, and vice versa. However, certain circumstances are more likely to throw up
certain kinds of problems than others, so it will be useful to go through some of the
major influences here. It should be noted that none of these influences guarantees
that a particular set of circumstances will automatically lead to one strategy being
adopted compared to another. They are merely background factors which may have
to be taken into account in framing options for the future.
4.7.1 Features Encouraging Market Alternatives

The above discussion suggests that certain features would tend to encourage a
market solution to vertical relations, with contracts being set and agreed between
buyers and sellers at the stages to which they apply. These include the following
situations:
1. Stable and predictable demand and supply conditions
2. Standardised product
3. Many firms at each stage
4. Few other vertically integrated firms
5. Transaction-specific investments not required
6. Well-established and widely distributed knowledge of technology
7. Slow-changing or static technology
8. Easy to monitor contractual obligations being fulfilled
9. Little chance of being cut off from supplies or inputs
10. Different scales of production necessary at each stage
11. Different competences required at each stage
12. Reputation important in this sector
13. High chance of repeated buyer–seller relationship
Some of these conditions should seem to have a ring of familiarity about them,
and indeed the first nine tend to be associated with the textbook case of competitive
markets in economics. Clearly, few markets approximate this ideal state in practice;
the point is that the closer that markets approach these conditions, the more we
would expect that a system of market contracts instead of vertical integration should
be the preferred alternative. Point 10 is not necessary for competitive markets to
exist, while the last three points (11, 12 and 13) suggest that there is some kind of
imperfection in the market that we would not expect to find under textbook
competitive conditions. What these features all share is a tendency to help to make
agreements between firms in the marketplace work. And since we know that
markets tend to have the highly desirable virtues of variety of choice and competi-
tive pressure on performance, these features may help facilitate the achievement of
such virtues.
4.7.2 Features Encouraging Vertical Integration

The point to bear in mind is that vertical relations should not be the first port of call
for firms when they are looking for an effective way to organise the vertical chain of
production. But if the market alternative begins to be associated with transaction
costs, then it may be time to start looking for alternatives. It should be noted that it
is not sufficient for transaction costs to exist for vertical integration to be adopted.

First, it may be possible to patch up the market alternative, for example by drawing
on one or more of the solutions to the hold-up problem discussed in Section 4.5.2.3
above. Second, even if the transaction remains bedevilled by transaction costs, this
may still be a cheaper or better solution than resorting to vertical integration.
Vertical integration is still a solution which will involve administrative costs. The
question is, will these costs be less than the transaction costs of market exchange
solutions, including market solutions where the firm has taken steps to try to guard
against or reduce transaction costs? With these points in mind, the features encour-
aging vertical integration tend to be the other side of the coin from those
encouraging the market alternative and will include some at least of the following:
1. Unstable, unpredictable demand and supply conditions
2. Differentiated product
3. Few firms, at least at one stage
4. Few firms not vertically integrated
5. Transaction-specific investment required
6. Technological know-how concentrated in pockets in the sector
7. Rapidly changing technology
8. Difficult to check that contractual obligations are being fulfilled
9. Real fear of being cut off from supplies or inputs
10. Similar scale of production necessary at each stage
11. Similar competences required at each stage
12. Difficult to establish or maintain reputation and trust in this sector
13. Low possibility of repeated buyer–seller relationship
These features will tend to push vertical integration higher up the firm’s strategic
agenda. However, it is also important to note that vertical relations can take many
forms and involve many different types of activity. We deal with some of these
issues in the next section.
4.8 The Varieties of Vertical Relations

The vertical integration problem is often characterised in terms of the decision to
internalise the production of a particular component or raw material, or seek
supplies in the external market. The decision is often expressed in terms of ‘the
make or buy’ decision for the production department. However, vertical relations
cover much more than this issue. We can only give a flavour of the variety of
problems that may be encountered in this area, but it should be sufficient to show
how the problem can depend on the nature of the function or department in which
the particular transaction is located.
Production transactions. This is the area which has been studied most exten-
sively and the general conclusion is that asset specificity plays a major part in the
firm’s decision to make a particular component itself or contract for it with an
external supplier. In general, the higher the degree of asset specificity, the more
likely the firm will be to make it itself; the lower the degree of asset specificity, the
more likely that the firm will contract for it with an outside supplier. This is what
transaction cost economics would predict.

R&D transactions. R&D transactions are often characterised by low degrees of

asset specificity in that their content would be of great interest and value to rivals of
the firm if they could acquire its technological secrets. However, for this very reason
firms often tend to undertake the R&D they need themselves in their own R&D
labs, to prevent leakage of a major source of their competitive advantage. In fact
R&D (say, design for a new engine) may be a package of some elements which are
not specific to the firm (and may be pounced on by rivals) and more specific
elements which have to be customised to the firm’s own design requirements. These
latter elements may be difficult to contract for or get off the shelf in the market-
place. So firms may want to exercise control over R&D both because they are
worried about the non-specific elements leaking out, and because they want to make
sure the aspects that are potentially specific and customised to the firms are suffi-
ciently focused and directed to the tasks.
Advertising transactions. On the face of it, advertising would seem an obvious
candidate for firms to do the activity themselves; it is difficult to think of anything
more specific to a particular firm than an advertising campaign. After all, what could
you do with a campaign for Coca-Cola other than sell that particular product? What
are the alternative uses of a TV commercial for M&Ms other than in selling that
sweet?
Nevertheless, it is common for firms to contract out their advertising campaigns
despite the fact that it seems to be an area that would be ideal for hold-up problems to
exist. We could imagine a scenario in which the advertising agency ‘loses’ the copy for
a major new advertising launch and says it would search really hard for it only if its
fees are doubled. Or at the same moment, the client could claim that times are hard
and that it can only afford to pay half the fee for the same campaign. Both hold-up
merchants could be misrepresenting the situation, but that does not change the
apparent vulnerability of the respective parties to hold-up.
We know why there may be an advantage for firms to contract out advertising to
separate specialist firms. Advertising involves particular competences that may have
little resemblance to the skills involved in running most businesses, such as a bank
or a car firm. Unlike R&D, it may not have to make intricate connections to the
firm’s production processes and existing product range, and it might be unfortunate
but not disastrous if a rival were to find out the details of a new advertising cam-
paign for a new product before the launch (the same is unlikely to hold if a rival
finds out the technical details of the new product before the launch).
This leaves the hold-up problem as the major potential problem in outsourcing
advertising. The simple reason that firms apparently do not fear this here is because
reputation typically counts for so much in this industry. An agency’s client base will
have been built up over years as its reputation grows. Any attempt to exploit hold-
up advantages could dissipate that reputation overnight. Similarly, any client that
tries to hold up an agency would be unlikely to repeat the trick as word gets round
the industry that it is unreliable.
These three examples help illustrate the fact that it is difficult to generalise about
vertical strategies and that they have to be treated on a case-by-case basis. Other
functions of the firm can be treated in a similar manner; for example, in the finance

area firms now often outsource standard transactions such as those dealing with
accounts payable, but hire internal experts in acquisitions and cross-border risks.
This is consistent with the transactions cost perspective which suggests that
standardised transactions involving a low degree of asset specificity are more likely
to be outsourced. However, as our other examples here show, there is no single
strategy that works in all cases. The trick is to analyse the situation and the alterna-
tives carefully and work out as far as possible all the implications of different
solutions.
Learning Summary
One single powerful conclusion here – there may be no one solution to the problem
of the ‘best’ strategy to adopt in the case of vertical relations, but we now know a lot
about the problems that firms may face in coming to terms with the vertical chain
that it is part of. There may be a variety of solutions open to the firm in deciding to
organise and participate in its vertical chain. Some of these solutions may turn out to
be fashionable fads, while others may provide workable solutions for a while before
being overtaken by events. At least one thing has become clear in the last few years
in this area of strategy; the old assumptions that certain kinds of sectors favoured
market exchange and others favoured vertical integration have been subjected to
rigorous testing and probing by firms. Vertical integration has been shown to
conceal various problems that outsourcing and downsizing have been developed to
deal with. This is now a fast-moving and dynamic area of strategy in sharp contrast
to its decades as a rather dull backwater.

Review Questions
4.1 The hold-up problem may lead to:
A. horizontal integration.
B. lateral integration.
C. vertical integration.
D. quasi-vertical integration.
4.2 Tapered integration involves a mixture of:

A. horizontal integration and market exchange.
B. horizontal integration and vertical integration.
C. quasi-vertical integration and market exchange.
D. vertical integration and market exchange.
4.3 In transaction cost economics, the four main types of asset specificity are:
A. site specificity, physical asset specificity, human asset specificity and dedicated
assets.
B. informational specificity, physical asset specificity, site specificity and human
asset specificity.
C. informational specificity, technological specificity, site specificity and physical
asset specificity.
D. human asset specificity, technological specificity, site specificity and dedicated
assets.
4.4 Which of the following problems may encourage vertical integration?

I. Opportunism
II. Bounded rationality
III. Asset specificity
A. I and II.
B. I and III.
C. II and III.
4.5 Vertical integration may directly affect:

I. costs.
II. market concentration.
III. market access.
Which of the following is true?
A. I and II only.
B. I and III only.
C. II and III only.
References
Chandler, A.D. (1977) The Visible Hand, Boston, Harvard University Press.
Williamson, O.E. (1985) The Economic Institutions of Capitalism, New York, Free Press.

Module 5
Horizontal Links and Moves

Contents
5.1 Introduction.............................................................................................5/1
5.2 The Diversification Game ......................................................................5/3
5.3 Why Diversify? ..................................................................................... 5/13
5.4 Forms of Diversification ...................................................................... 5/29
In this module we look at diversification and its place in strategy formulation. We

look at why firms might want to diversify and show that many of the supposed
advantages of diversification may often be achieved more easily or cheaply through
alternative means. We look at what diversification can actually deliver for the firms,
as well as reasons why it frequently fails to produce the expected gains. We also see
that the pattern of diversification (e.g. related, conglomerate) can be as important as
the direction and degree of diversification.
Learning Objectives
 analyse the gains from specialisation and diversification using the value chain;
 distinguish between the sources of different kinds of costs and benefits associat-
ed with diversification;
 explain why firms diversify;
 analyse alternatives to diversification;
 consider the implications of different forms of diversification;
 explain the persistence of the conglomerate strategy for many firms.
5.1 Introduction
In this module we shall look at corporate diversification. If there is one topic which
is associated with variety as to where corporate boundaries are set, it is diversifica-
tion. Firms can only vertically integrate so far, and as we shall see in Module 7,
expanding firms’ boundaries into joint ventures often tends to be regarded as an
option of last resort. Even multinational expansion is something which tends to
rank low in firms’ preferences. As we shall see in Module 6, firms typically prefer to
concentrate their assets at home rather than disperse them globally in the form of
overseas subsidiaries. However, diversification is less subject to such constraints and
limitations, and this has led to a profusion of directions and patterns of competitive

Module 5 / Horizontal Links and Moves
strategy in this area. At one extreme we have the conglomerates such as BTR
(Exhibit 5.7) which managed a diverse array of about 1000 businesses, while at the
other extreme we have specialised companies such as Intel which effectively limit
themselves to developing and manufacturing the engines that drive modern com-
puters. The purpose of this module is to provide a basis to help us understand how
such a rich diversity of strategies may evolve and the principles that can underlie
individual diversification strategies. As we shall see, concepts such as value, efficien-
cy and opportunity cost are central to diversification questions. Principal–agent
problems, transaction cost issues and value chains will be seen to play important
roles here also.
In Section 5.2 we shall begin to look at the logic of alternative strategies by play-
ing a Diversification Game that helps introduce basic elements underlying
diversification. We build on the lessons learnt here to look in Section 5.3 at general
issues surrounding the question of why management would want to diversify, and in
Section 5.4 we look at the different forms that diversification strategy can take.
However, before we start the discussion, there are three questions for you to think
about. The second and third questions clearly relate to one form of diversification
strategy (the conglomerate), but the link between the first question and the topic of
diversification may appear less obvious; we hope it will become clearer by the end of
the module. So, here are the three questions. Read the paragraph that follows them,
think, then scribble down your responses. The answers follow almost immediately.
 What proportion of US manufacturing firms with assets of over $20m in 1917
(the largest 236 enterprises at the time) have survived until the present day?
 Conglomerates tend to be large firms. What proportion of the world’s largest
firms are conglomerates?
 With the new emphasis on ‘focus’, are conglomerates disappearing?
We need to clarify what we mean by ‘survive’ and ‘conglomerate’. Survival here
includes the firm remaining independent, or merging with another firm. This is
consistent with treatment of the firm as a going concern. If a firm has failed and has
no further economic value as a going concern, then it may be closed down and its
assets scattered to their next best uses. This is death in the financial sense to the
firm. However, mergers and acquisitions usually involve the perpetuation of the
firm or firms being taken over, frequently as divisions or groups within the enlarged
combination. In this sense the firm typically survives merger and acquisition. And
the ‘conglomerate’ corporate strategy is characterised by diversification into new and
unrelated businesses.
The answers to the questions may appear surprising. Most people (including
economists) when asked the first question give a survival rate ranging from 20 to 70
per cent, and 40 per cent is a fairly typical guess. (What was your guess?) In fact the
answer is about 97 per cent. For example, the 1955–75 period was quite typical.
Only one of the 500 largest firms in the US went bankrupt in this period, and that
was a firm specialising in Cuban sugar following Castro’s rise to power in 1959. The
answer to the second question depends on where you draw the line of the world’s
largest companies, but the answer is likely to range from 0 to 4 per cent. Most large
firms are not conglomerates and this has always been the case even when it was very

fashionable to be a conglomerate. As far as the third question is concerned, the

answer is no. With some highly publicised exceptions such as Hanson, most
conglomerates are not disappearing from the industrial scene, either as firms or even
as conglomerates (Exhibit 5.7 looks at how one conglomerate is responding in
practice to the pressure to focus). It is true that many are incorporating such ideas to
help refine their strategies. However, as we shall see, this is usually to help them
fine-tune their conglomerate strategy – it does not indicate that these firms are
abandoning conglomerateness.
So most large firms survive indefinitely. Most are not conglomerates, but if they
are they tend to stay as such. It could be argued that the firm that has been merged
with another or acquired some time ago may be a very different entity today from
the firm that existed some time ago. Agreed, but the same could be said of firms
that stayed independent; the Ford that built the Model T was a very different
creature from today’s high-technology multinational Ford. Module 2 taught us that
firms can be best regarded as collections of competences; if the answer to the
survival question tells us anything about the life and death of these collections of
competences, it is that they can be much more robust and enduring entities than the
products and services they produce. It may be possible to talk about product life
cycles, but the survival question warns us that the idea of a firm life cycle may not
follow that model. Even conglomerates do not necessarily die, or even wither away.
The common thread that runs through the three questions we have started with
is diversification. We shall begin to look at this issue more fully in Section 5.2 by
introducing our Diversification Game. We shall also explore how and why firms
may survive and even thrive through turbulent times, and why conglomerates may
be a persistent, albeit infrequent, feature of the industrial landscape.
5.1.1 Major Points Here

 We can talk of life cycles for people and products. However, it is not the case
that firms and other organisations necessarily have life cycles.
 Conglomerates can be big firms but most big firms are not conglomerates.
 Despite the fashion for focus, most conglomerates have survived and survived as
conglomerates.
 We do not have obvious explanations for any of these answers to our three
questions.
5.2 The Diversification Game

The first thing to realise about diversification is that like vertical integration (Module
4) it is both a direction and a method. It is a direction because the firm expands along
particular horizontal lines; whether the direction involves exploiting market and/or
technological similarities to its existing business depends on the case in point. It is a
method because the firm exploits these opportunities through internal organisation
rather than through agreements with other firms such as licensing, joint venture or
strategic alliances. Consequently, any analysis of an individual firm’s diversification
must help explain two things: why has the firm chosen this direction and why has it

chosen this method to pursue this direction? The notion of opportunity cost will be
extremely helpful here because it serves to remind us that strategy is about choice
and alternatives. For example, why has a firm chosen conglomerate diversification if
it could diversify into closely related technologies and markets? Why has it gone to
the trouble of diversifying into a new market all by itself if a joint venture with
another firm could help provide complementary marketing expertise to ease its
entry? As with vertical integration, diversification can only really be understood by
comparing it to the alternatives in each case.
5.2.1 Horizontal Directions in the Diversification Game

We shall look at the question of direction first with the help of a simple game. Figure
5.1 shows a game with ten firms or players. Each firm operates a single business. At
the start of the game we assume the firms are equal in all other respects; the
businesses are the same size, taken one at a time they have the same growth
prospects and the same resources available to explore expansion, etc. Not only does
this ensure a fair game, it allows us to concentrate on the implications of different
diversification alternatives without being distracted by possible differences at
business level. The firms also face similar market structures in that they pair off into
five different markets. The two firms are the sole occupants of their market in the
respective cases, and both firms produce identical products in each case. The firms
are also considering diversifying by merging with or acquiring another firm. (More
advanced games would allow for the possibility of internal expansion.)
Helmets Trousers Jackets Handbags Umbrellas
1 2 3 4 5
6 7 8 9 10
Market Motorcycle Motorcycle Motorcycle Accessories Accessories

Technology Carbon-fibre Leather Leather Leather Plastics/metals
Figure 5.1 The Diversification Game seen from Firm 3’s perspective
Figure 5.1 shows the game seen from the perspective of one of the players, Firm
3. Firm 3 makes leather motorcycle (M/C) jackets and could expand here in one of
five ways. It could stay in the same business by merging with the other M/C jacket
firm, it could diversify its product line into M/C trousers, it could move out of
leather technology into M/C helmets, it could move out of the M/C market into

leather handbags, or it could move into a business unrelated to its present skills –
umbrellas. For simplicity, Figure 5.1 concentrates on showing Firms 6 to 10
inclusive as outlining the range of possible targets for Firm 3, though of course
Firms 1, 2, 4 and 5 could also be targets.
The question Firm 3 has to consider is how to choose between these alternative
moves. We can help it by adding three rules of the game. The first two rules are
inspired by strategic management considerations, while the third is designed to
ensure fair play.
 Rule 1: Competitive advantage. Each player must seek competitive advantage
over the other. In our simple game we assume particular moves may enhance
competitive advantage in one of two ways; the move must help shift at least one
demand curve or one cost curve in a way that adds value to the firm’s activities.
As Porter (1987) points out, diversified firms do not compete; only their individ-
ual business units do. If diversification is to have benefits it must be in terms of a
positive impact on the ability of at least one of its businesses to compete in the
marketplace.
 Rule 2: Only one move at a time. Diversification is an expensive, time-
consuming business that soaks up valuable managerial resources. There is only
so much managerial time available at any moment to help the firm expand. Once
management have successfully helped absorb and integrate the new business
within the firm, they may be released to explore and achieve further diversifica-
tion opportunities. This feature of firm growth was first explored in detail by the
economist Edith Penrose and her work helped lay the foundations of what has
come to be known as the resource-based approach to corporate strategy. Here
we assume the management only have the time to work on one diversification
opportunity at a time.
 Rule 3: Fair play. As we would expect in a properly conducted game, there is a
referee to ensure that fair play takes place. Here fair play is interpreted to mean
that a particular move does not allow a firm to achieve a dominant position that
would allow them to exercise monopoly control over customers or suppliers.
Each move has different implications for competitive advantage. The most obvi-
ous move is perhaps Firm 3 merging with or acquiring Firm 8 – the specialisation
move whose impact on value chains is shown in Figure 5.2. Figure 5.2 breaks the
value chains into four main areas (R&D (including design), production, marketing
and distribution) and gives examples of categories of resource that might be
exploited in each case (such as plant, equipment and labour force in the case of
production).

sales force
market research
Marketing Marketing
advertising
plant
labour force
research
R&D R&D
development
FIRM 3 ... merges with ... FIRM 8
Figure 5.2 The value chain and gains from specialisation

If Firm 3 were to combine with Firm 8, it would open up a potentially rich set of
linkages between the value chains of the two firms. Since they are producing
identical products and selling to identical markets, each element in the respective
value chains is effectively duplicated in the other case. For example, they are
drawing on the same types of plant, equipment and labour force in production,
opening up the possibility of production economies if the two firms merge. Howev-
er, to the extent that the firms have been duplicating their R&D, marketing and
distribution efforts, there are further economies that might be expected from
merger in these areas also; they will not need two R&D teams doing similar or
identical work; they will not need parallel marketing exercises such as market
research duplicating each other’s efforts; there will be no need for two sets of sales
teams knocking on the same doors, and so on. We shall look further at the types of
economies that might be expected in more detail in the next section, but for the
moment it should be sufficient to note that specialisation by its very nature can
release significant gains by exploiting rich linkages between similar value chains as in
the Firm 3 and 8 case. While this may help the firm improve its product and back
up differentiation efforts (for example by facilitating increased specialisation and
division of labour), the most obvious and immediate impact of such a move would
be in terms of potential cost savings.
However, the specialisation option can also have a direct impact on the demand
side. Firm 3 has moved from a 50 per cent share of the leather jacket market to 100
per cent. Where before we had a duopoly now we have a monopoly. The firm may
now be able to exercise more control over prices. Where before the firm might have
kept its prices down because it feared its rival would undercut it and steal market
share, now the specialisation move has eliminated this threat by eliminating its rival.
Seen from the point of view of Firm 3, a specialisation move can enhance value by
allowing the firm to manipulate both demand and cost considerations to its ad-
vantage. Here the combined firm would be able to sell its product (leather M/C
jackets) at a higher price and using less resources than if the two firms had remained
separate.

D D D D
M Partial links between
M M M
the value chains in the
P P case of both helmet P P
R&D R&D and handbag moves R&D R&D
Firm 3 ... plus ... Firm 6 Firm 3 ... plus ... Firm 9
The M/C market Leather technology
Good fits between both D D Jackets to umbrellas, a

value chains in the case M M conglomerate type move
of jackets to trousers P P generating no real linkages
R&D R&D
Firm 3 ... plus ... Firm 8

Leather M/C jackets D D
D D
M M M M
P P P P
R&D R&D R&D R&D
Strong linkages throughout
Firm 3 ... plus ... Firm 7 the value chain in the case Firm 3 ... plus ... Firm 10
Leather M/C garments of specialisation Jackets and umbrellas
D = Distribution
M = Marketing = Marketing and distribution linkages
P = Production
R&D = Research and Development = Technological linkages
Figure 5.3 Linkages exploited in the Diversification Game

The specialisation option is shown in simplified form in the middle of Figure 5.3.
To indicate the potential gains from resource sharing across the value chains of both
Firms 3 and 8, the marketing and distribution linkages are indicated with a broad
light link while the technological linkages are indicated with a broad dark link.
However, specialisation is not the only option open to Firm 3. For example, it could
combine with Firm 7 and create a combination which provides leather M/C
clothing (jackets and trousers) on the bottom left of Figure 5.3. Such a move would
still generate linkages across the relevant value chains, but the linkages would not be
as strong as in the specialisation case. For example, some research into leather-
working may be shared across both value chains, but some design may be specific to
jackets or trousers; some tools may be used to work both products, but there may
be separate assembly lines for the two products; the same sales force may sell both
products, but advertising fliers may be developed for both products, and so on. If
the firm were to diversify into M/C helmets (top left, Figure 5.3), then there may be
no significant technological linkages, though there could still be significant linkages
on the marketing and distribution side. Similarly, if it diversified into leather
handbags, there may be no significant marketing and distribution linkages between
M/C jackets and ladies’ handbags, but the firm might still enjoy linkages across the
respective value chains on the technological side. However, if the firm moved into a
new market and away from its leather-based technological expertise by diversifying

into umbrellas, (bottom right, Figure 5.3), then there may be no significant linkages
across the respective value chains in any category.
5.2.2 Preferred Moves in the Diversification Game

So what should the firm do? Figure 5.3 suggests some simple and clear conclusions
if the firm is playing by our three rules. The firm should specialise as far as possible
if it is seeking competitive advantage. There are four main reasons for this: (1)
resource effects, (2) market power considerations, (3) allergic reactions, (4) rivals’
valuations. We shall look at each in turn.
(1) Resource effects

The five options shown in the figure differ in the linkages across value chains that
they help exploit and the implications for generating competitive advantage for Firm
3. The unrelated option (Firm 3 plus Firm 10) shows no significant linkages. The
market-based diversification (3 plus 6) and technology-based diversification (3 plus
9) at the top of Figure 5.3 are better moves in these respects, but both of these are
beaten by the diversification at the bottom left which offers the prospect of market
and technology-based linkages to exploit. This in turn is beaten by the rich linkages
that could be obtained across value chains if the firm continued to specialise and
merged with Firm 8. The message from analysing the linkages from alternative
moves in our Diversification Game appears clear. If a firm seeks competitive
advantage by exploiting linkages across value chains, then the firm should stick as
close to home as possible. Specialise if you can; if you have to diversify, stay as close
to home as possible, and try to avoid unrelated diversification as long as related
alternatives exist. If our Firm 3’s first move was into umbrellas, there would be high
opportunity cost (sacrificed value) in terms of the more richly linked opportunities
which Firm 3 would be giving up.
(2) Market power

Market power considerations only tend to reinforce these points. If the firm is
seeking more control over its market, the specialisation option is clearly the most
direct and powerful route to achieving this. However, while the related diversifica-
tion moves may not offer such complete control, they may still offer some chances
to enhance market power in some areas; the market-based (M/C) diversification
may help the firm become a major player in the M/C market and exert increased
influence over the retailers it sells to, while the leather-based diversification may
push the firm up the league of leather-using firms and afford it more bargaining
power in its dealings with leather suppliers. Again, the unrelated diversification into
umbrellas offers no gains on these grounds since this move does not change the
buying and selling characteristics in the respective markets. Therefore, if we add
market power considerations to the other effects of combining value chains, the
case for specialising as far as possible is only strengthened in our Game.

(3) Allergic reactions

Just as an organism can develop an allergic reaction to a foreign substance introduced
into it, so a firm may display an adverse reaction to new activities that are unrelated or
loosely related to its existing competences. If we burrowed deep into the value chains
displayed in Figure 5.3, we would find that some resources could be shared between
value chains while others would differ; for example, some tools and some R&D could
be used in both businesses where there are technological linkages, while some would
have to be customised to individual businesses. Some trucks and advertising might be
shared where there are distribution and marketing linkages, while some would have to
be specific to the individual businesses. The danger is that resources tend to come in
bundles (e.g. a strategic planning team here, a marketing team there, a plant facility
over there) and expertise that works well in one context might turn out to be inappro-
priate or downright disastrous in another when it is transferred along with other
resources. BIC’s diversification into perfumes (Exhibit 5.1) could be regarded as a case
of allergic reaction, with technological and marketing skills built up in low-cost
disposable products proving difficult to transfer to a luxury, image-conscious market.
Suppose, for example, the fair play umpire had forbidden Firm 3 to merge with
Firm 7 or 8. Firm 3 now turns its attention to Firm 9 and considers diversifying into
handbags. It is true that it has technological capabilities that could be shared
between leather M/C jackets and handbags, but these are very different markets.
Even the M/C riders who do carry handbags are likely to buy them in different
outlets from their M/C gear and be persuaded by different kinds of advertising in
different contexts from that appropriate to M/C gear. The firm that is good at
selling to the M/C market may flounder if it tries to break into the fashion-based
ladies’ accessories market. Ironically, allergic reactions are even more likely to be
found where there are apparently some resource linkages that may be transferred
across value chains in different categories (e.g. a fast-food business combining with
a gourmet food business). Since resources do tend to come in bundles, it may be
difficult to separate out the elements that could be usefully shared across value
chains from those that should not be. For example, the fast-food marketing team
may bring a sensitivity to market research techniques that could benefit the gourmet
food’s business, but it may emphasise cost aspects to the detriment of the quality
image the gourmet chain has been built on. This leads to what Michael Porter (1985)
and others have identified as the failure of synergy in corporate expansion. Ironical-
ly, it is often what firms know rather than what they do not know that can be the
problem. Applying the wrong ideas or inappropriate expertise can be worse than
just leaving things alone in many cases.

Exhibit 5.1: Resource effects and allergic reactions: the case of BIC
BIC Corporation is based in New York and is the well-known manufacturer of writing
instruments, lighters and razors. Traditionally about half of the company’s turnover was
accounted for by pens, with the rest being split between lighters and shavers. There was
also a small involvement in sport (principally sailboards), while an unsuccessful move
into perfume was discontinued. Its main rivals in writing instruments are Gillette and
Scripto Tokai; in lighters they are Scripto Tokai, Swedish Match and low-cost Far East
producers; and in shavers they are Gillette and Schick. BIC’s main activities have no
obvious relationships to each other when seen as products. Pens, lighters and razors are
not substitutes for each other, nor are they complements. However, there are poten-
tially strong linkages between the three areas in terms of resource effects. On the
technological side all three businesses depend heavily on skills in manufacturing low-cost
plastic and light metal disposable products.
There are also strong similarities between the businesses on the marketing side; all
three areas sell products with similar selling characteristics based on price, quality and
disposability and fragmented retail outlets. However, these resource effects themselves
were not sufficient to justify diversification in all cases, with BIC’s attempts to draw
upon its expertise in these areas to make and sell perfume proving unsuccessful.
Would it not have made more sense for BIC to have specialised within the same
market (e.g. adding electric razors to its disposable razors business) rather than
diversifying into new markets (e.g. from razors into lighters)?
(4) Rivals’ valuations

Suppose for some reason our Firm 3 was told that it could not make a move that
involved specialisation or related diversification, perhaps because the authorities were
already worried about the concentration of power in a few hands in these markets.
This would leave the umbrella market and Firm 10 (or Firm 5) as the sole move open
to Firm 3. Admittedly, it has nothing really to commend it in terms of adding value
since it does not lead to resource sharing or increased market power after combina-
tion. However, on the face of it there do not appear to be strong arguments against it
either; if the firm cannot do anything else, a combination with Firm 10 would at least
appear to be a neutral move, assuming the firm was aware of the possibility of allergic
reactions and simply left both businesses to be run independently.
In fact, there are reasons why we would expect such a move to be impractical,
even in our simple Game. There are other players in our Game and they will also be
considering moves: for example, Firm 4 (leather handbags). Firm 4 could make a
variety of moves, but one move open to it would be diversification into umbrellas
(Figure 5.4).

D D
M M Handbags and umbrellas
P P selling to similar markets
R&D R&D
Firm 4 ... plus ... Firm 10

The accessories market
Figure 5.4 The view from handbags

Unlike Firm 3’s move into umbrellas, Firm 4’s move into the same market could
enhance value through resource sharing and increased market power. For Firm 4,
the move represents a move deeper into the ladies’ accessories market and possible
resource sharing in marketing and distribution as well as enhancing its share of the
accessories market. Consequently Firm 10 (umbrellas) is potentially more valuable to
Firm 4 than it is to Firm 3. If Firm 3 and Firm 4 were to become involved in a
bidding war for Firm 10, we would expect Firm 4 to be prepared to outbid Firm 3
since umbrellas would add more value in combination with handbags than they
would with M/C jackets. Even if Firm 3 had somehow got to Firm 10 first and
merged with it, Firm 4 should be able to make a subsequent offer to Firm 3 that
would make it attractive to Firm 3 to sell the umbrellas business to it. Since the sale
to Firm 4 should enhance the value of the umbrellas business, a deal should be able
to set a price for the umbrellas business that would allow both Firm 3 and Firm 4 to
benefit from the trade. (In our Game we are ignoring possible transaction costs
from deal-making, though in practice managerial and legal costs could make it more
difficult for the two firms to agree a deal at a price that would benefit both firms
once these costs are taken into account.) The fact that rivals to Firm 3 could value
the umbrellas business more highly than Firm 3 should lead to a trade in assets with
firms emphasising relatedness of businesses in their corporate strategies.
5.2.3 Methods of Expansion in the Diversification Game

Remember expansion by diversification or specialisation involves a method as well as
a direction. We have begun to look at directions, but why should the firm choose this
method of organising expansion opportunities rather than making some agreements
with other firms to share resources? Just as in the case of vertical integration, there
is nothing that the firm could organise within its own boundaries in the way of
market power or resource effects that could not in principle also be achieved by co-
operating with other firms. Market power is the most obvious example; you may not
have to merge with another firm to achieve the benefits of market dominance if a
nice cosy agreement with the other firm (say, to raise prices or impede other firms’
entry) could be made instead. However, these are not necessarily straightforward
options since fair play umpires may be keeping a watchful eye open for such anti-
competitive behaviour. Also you may not be able to trust your partner. As long as
they are separate rivals, they may breach any collusive agreement if they see it is in
their interests to do so, as we saw in the case of opportunistic behaviour in Module
4. Consequently, firms may decide that merging operations within one firm may be

the most effective way of trying to exercise control over their markets. But such
control is likely to be diluted to the extent that the businesses are only loosely
related. At one extreme the specialisation move in Figure 5.1 may lead to a consid-
erable increase in market power (if it is allowed to go through), while at the other
extreme the move into umbrellas may have no effect at all on the control that the
firm can exercise over customers or suppliers.
Every type of gain from resource effects may also be achieved by co-operating with
other firms without the need to expand boundaries by diversifying. For example, the
technological and sales resource effects for the leather M/C garment move in Figure
5.3 might be realised by Firms 3 and 7 combining into one firm and directly
managing the sharing of resources. Alternatively, each individual resource may be
shared even though the firms remain separate. One sales force could represent the
other’s products on a fee or commission basis, truck space could be rented between
the two firms, marketing advice provided on a consultancy basis, market research
sold, production sub-contracted, and R&D licensed. Even intangibles such as
reputation may be exploited by separate firms sharing resources, as when washing
machine and washing powder manufacturers jointly advertise and effectively
endorse and sponsor each other’s products. The reason why expansions such as this
one are more likely to be pursued by diversification rather than separate firms co-
operating is quite straightforward – it is because of transaction costs. Firms 3 and 7
would have to agree, set up and monitor contracts for exchange services in each
individual resource category. As we saw in Module 4, uncertainty concerning future
conditions and possible opportunism on the part of the partner can make contracts
to exchange even one resource expensive in terms of transaction costs. Multiply
these effects by all the individual resources for which contracts have to be arranged
in this case, and you have a recipe for exhausted managers and happy lawyers. On
the other hand, leather M/C jackets and trousers are likely to be so similar in terms
of their technological and selling characteristics that leather M/C management
should be able to slip into trousers from jackets (and vice versa) without too much
trouble. Therefore diversification is likely to be relatively straightforward in this case
while co-operative alternatives are more likely to be characterised by high levels of
transaction costs.
On the other hand, supposing we were discussing an expansion possibility that
involved only a single link such as the washing powder/washing machine tie-in
discussed above. Washing machines and washing powders are technologically quite
different and are also typically sold in different outlets; one is an expensive durable
bought at infrequent intervals while the other is bought on a regular basis. While
there will be transaction costs in setting up any advertising tie-in between the two
goods, these transaction costs will be limited to the advertising campaign since
otherwise the two companies would continue to be run separately. On the other
hand, if the two firms decided to merge to co-ordinate this linkage, this diversifica-
tion would be more similar to the umbrella option in our Diversification Game in
Figure 5.3 than it would be to any other option in terms of the resource effects.
Given the radically different nature of the powder and machine markets, this move
would run a real risk of allergic reactions. Consequently, the transaction costs of
limiting the move to co-ordinating the single linkage through a tie-in campaign

between the two firms are likely to be modest compared to the likely cost of allergic
reactions resulting from an ill-judged merger between two very different businesses.
Comparing possible allergic reactions and transaction costs in the different cases
we have looked at here suggests some simple conclusions. Co-ordinating resource
sharing to generate enhanced value and in turn competitive advantage can be
handled in different ways, for example through diversification or sets of co-
operative agreements between two firms: the gains may be similar in the two
different cases; what differs is the likely cost of achieving these gains. If diversifica-
tion is chosen and co-ordination of linkages pursued within a single combined firm,
then the chances of allergic reactions tend to increase the less related the two firms
are to each other. On the other hand, if co-operative agreements to co-ordinate
linkages are the means chosen, then transaction costs of co-ordination are likely to
increase the more related the two businesses are to each other. Diversification is
therefore likely to be the more effective means of pursuing expansion when
businesses are closely related (as in the trousers/garments example), while some
form of co-operative agreement between separate firms is more likely to be appro-
priate when the businesses are very different (as in the washing powder/washing
machine example). At least this seems to be the case when we look at simple Games
as in the cases above. However, we shall see in Module 7 that firms may be forced
into more complex Games in which diversification moves are not an option; co-
operative solutions such as joint ventures may be the only option if linkage co-
ordination is to be possible at all.
This also leaves us with a puzzle. We have seen that conglomerate diversification
(such as jackets/umbrellas) is difficult to justify as a direction, because of opportunity
cost reasons; if you must diversify, the message of the Diversification Game seems
to be that you should diversify into related opportunities as far as possible. Howev-
er, in our Game, the diversification option also appears condemned as a means of
expanding into unrelated or loosely related areas. For example, the washing pow-
der/washing machine businesses are so unrelated in technological and selling
characteristics that this combination would effectively be a conglomerate one. As we
have seen, once the possibility of allergic reactions from merger are taken into
account it would usually be simpler and cheaper to exploit the solitary reputational
linkage through co-operative tie-ins and keep the two firms separate. The conglom-
erate therefore seems doubly damned, first as a direction and second as a means of
pursuing that direction. Some of the best minds in strategic management and
industrial economics have wrestled with this problem and we shall return to it in
Conclusions.
5.3 Why Diversify?

Why should firms diversify? This may seem a very simple question but our Diversi-
fication Game has shown that it is a bit more complicated than it appears at first
sight. This is because mixed up in this question are some more precise questions.
Why choose to diversify in the first place? So far we have identified some reasons
such as resource effects and market power that may help to generate or reinforce
competitive advantage. We shall look at these effects in more detail here. Also, why

choose a particular form of diversification such as related or unrelated diversifica-

tion? The Diversification Game has helped to demonstrate that it is not enough to
show that a particular move can generate gains from resource effects and market
power. The move must also take into account the opportunity cost of alternative
moves, especially those that would allow the firm to exploit deeper linkages.
Further, why diversify rather than co-operate? Co-operation with another firm is
generally available as an alternative means of exploiting linkages across businesses.
As we have noted, there may be circumstances where it may be more efficient to co-
operate than to diversify. With these points in mind, we shall look at a number of
candidate explanations for diversification, starting with market power.
5.3.1 Market Power

It was noted above that diversification can enhance the diversifier’s market power,
and we can see how this could happen in Figure 5.5. Firm 3 has moved into leather
M/C trousers, and then into M/C helmets and leather handbags. Out of the ten
businesses in Figure 5.1, six sell to the M/C market and six use leather technology.
Firms 3’s moves mean that it now controls half of the businesses in the M/C
market (the original Firm 3 and now 6 and 7) as well as half of the businesses using
leather technology (the former Firms 3 and 7 again, and now Firm 9). The potential
implications here are best examined from the point of view of a retailer in the M/C
market and a leather supplier, both separate from the firms that participate in the
Diversification Game. At the start of the Game, each M/C retailer could buy M/C
goods from six firms, and each of these firms had one-sixth of the M/C market.
Similarly, a leather supplier had six firms that they might supply to, each firm
holding one-sixth of the demand for leather in this Game.
However, after Firm 3’s moves shown in Figure 5.5, the M/C retailer finds that,
if it wishes to stock M/C goods, half of the potential supplies in this market are
controlled by this firm. Similarly, the leather supplies firm now finds that what had
started out as Firm 3 now takes up half the demand for leather in this market. Could
this change things compared to the old days when no one firm had such a dominat-
ing presence?
Clearly yes, but how this firm could or would exercise dominance depends on the
circumstances, such as the characteristics and attitudes of the firm, the other players
in the Game, potential entrants, and the reactions of Game umpires. For example,
in the M/C goods market the firm in Figure 5.5 might try to cut out Firm 2 (M/C
trousers) from its existing retail outlets by tying retailers to itself (‘buy my trousers as
well if you want my jackets’), while in the leather supplies market its buying power
could also help it to negotiate special deals (‘if you want the large sales that I could
absorb, you had better offer me a good discount/preferential treatment/best quality
etc.’). In practice there are many ways that power could be exercised by diversifica-
tion, but each tends to come down to the increased share of the firm in particular
markets.

M/C market link
Helmets Trousers Jackets Handbags

D D
M M
P P
R&D R&D
Leather technology link
Figure 5.5 How diversification can aid control of markets and technolo-
gies
5.3.2 Synergy
If resources can be shared across value chains for different businesses (as in the
jackets/handbags merger of Firms 3 and 9 in Figure 5.3) they may give rise to cost
savings described as synergy in strategic management and economies of scope in
economics. If the businesses are effectively the same (as in the jackets/jackets
merger of Firm 3 and Firm 8 in Figure 5.3), then these resource effects are de-
scribed as economies of scale. There can be two main sources of gains in such cases.
 Indivisibilities. Resources tend to come in lumps – a factory, a truck, a ma-
chine, an economist etc. If you were to cut each of these resources in two
physically, they would not be able to do their job any more. The fuller the use
that can be made of these indivisible lumps, the lower will be the cost to the firm
of using these resources. These gains may be achieved by increasing utilisation of
an existing resource; for example, if Firm 3 has invented an improved method
for stitching leather, then merger with either Firm 9 or Firm 8 in Figure 5.3 may
help to share the technology across the respective value chains. Alternatively, the
gains may help the firm to employ a resource that is more efficient at the levels it
is now operating at; for example, if Firm 3 merges with either the leather jacket
or leather handbag firm, then in each case it may be able to replace two small-
scale leather-working factories with a single, larger and more cost-effective facili-
ty.
 Specialisation. Expansion of the firm may permit increased specialisation of
resources which in turn can lead to enhanced value for the combined firm. For
example, each of the leather-based firms at the start of our Diversification Game
may find it too expensive to employ a specialist designer; the job of production
management and design is carried out by a single individual in each case. The
merger of Firm 3 with Firm 9 or 8 could allow the creation of a specialist pro-
duction manager and a specialist designer for the enlarged firm. This can have a
number of benefits: (a) individuals can specialise at what they are best at, (b)
there would be reduced transition costs resulting from the individual having to
switch back and forward between quite different activities; they can now concen-

trate on one activity, (c) it can facilitate learning and improvement of skills and
experience if they can concentrate on one set of tasks. Similarly, there may be
gains from specialisation in the case of physical resources. For example, the plant
manager’s office may have doubled as a conference room for each firm at the
start of the Diversification Game. By merging facilities in the case of Firm 3’s
merger with either Firm 9 or 8, it may be possible to create a single plant manag-
er’s office and single conference room for the combined businesses, both
customised to the purposes for which they were exclusively designed. There
should also be a gain for reducing transition times between tasks; for example,
the plant manager would no longer have to clear his office for a conference.
These are similar to the gains from specialisation of individual managers and
workers, with the exception of the learning gains that humans can also achieve.
However, with the development of smart machines, who knows – maybe one
day we shall be talking of learning gains from machine specialisation as well.
While specialisation is generally seen as a potential source of enhanced value in its
own right, like the gains from indivisibilities discussed above it really is an effect that
also comes back to the fact that resources tend to come in lumps. However, there is
one issue here that might seem strange at first sight. The gains from indivisibilities
and specialisation of resources are the type of gains that have been well explored in
numerous studies in economics. Usually these effects are reported in respect of
economies of scale in the production process. The types of resource that are usually
seen as counting in this context are machines and workers. However, in studies of
corporate strategy, the kind of resource that is usually identified as important
appears much vaguer and indeed intangible. In particular, it is common to talk of
synergy from diversification resulting from ‘competences’ or ‘capabilities’ that
management can transfer across activities as the firm diversifies. At first sight these
are very different resources from the machine and worker examples that are usually
encountered in economics. Examples of these are shown in Exhibit 5.1 and Exhibit
5.2 which illustrate BIC’s competences in manufacturing and selling simple disposa-
ble consumer products and Daewoo Electronics’ competences in manufacturing
and selling simple consumer electronics. Exhibit 5.3 also shows how diversification
within an industry can help spread competences over larger volumes of corporate
activities.
The differences in fact stem from the level of the analysis in the respective cases.
Competences and capabilities – say in selling, producing or inventing – are resources
of the firm just like machines and workers. By sharing them across businesses, the
firm may enhance its value in just the same way that the traditional firm could
exploit economies from indivisibilities and specialisation of machines and workers.
The difference really lies in the level of the analysis. Economics has traditionally
focused at the level of individual products – like a jacket or a helmet – and looked at
cost and price considerations in the respective cases. Strategic management focuses
instead at the level of the individual firm and looks at the resource questions that
matter at this level. The bigger and the more diversified the firm, the less likely that
economies from sharing tangible resources such as plant and equipment are going to
be important at the level of corporate strategy, and the more likely that intangible
resources such as managerial capabilities are going to be of relevance.

Exhibit 5.2: Identifying Synergy: the case of Daewoo Electronics

Identifying synergy is not just about identifying areas the firm should move into. It is also
about identifying the areas it should not move into. Daewoo Electronics developed as
one of Korea’s major electronics firms with an emphasis on consumer electronics, part
of the Daewoo group conglomerate. Its strategy was based on its observation that 80
per cent of the global consumer electronics market consists of simple products with
basic functions that are relatively easy to manufacture with low defect rates. This was
declared to be Daewoo Electronics’ core market. Consequently Daewoo chose to
concentrate on conventional consumer electronics products, such as televisions. This
influenced Daewoo Electronics’ decision to acquire Thomson Multimedia, a French firm
with interests in TV, video, and audio equipment. At the same time, the company made
a deliberate decision not to move into more complex higher-technology areas of
multimedia PCs and advanced liquid crystal displays.
In what way could Daewoo Electronics’ diversification strategy make it vulnera-

ble to external threats?
5.3.3 User Gains

The most obvious gains from diversifying are directly to the diversifier itself in the
form of resource effects or enhanced market power. However, diversification can
also help generate competitive advantage for the diversifier by providing benefits for
the user. From the perspective of the user these gains tend to be reflected in one of
two main ways:
 cost advantage: e.g. one-stop shopping with the convenience of one supplier of
M/C goods to retailers rather than three;
 differentiation: e.g. enhanced compatibility of products, with M/C jackets,
trousers and helmets in matching styles.
Both these possible sources of user gains are illustrated in Exhibit 5.3. From the
perspective of the diversifying firm these user gains should allow it to achieve
differentiation advantage and sell its products at a premium above those of its
competitors.
Exhibit 5.3: Exploiting synergy and user gains in packaging

The merger in the packaging industry of the European company Carnaud Metal Box
(CMB) with the US company Crown Cork and Seal gave the combined company the
leading position globally in the industry; as separate companies they had ranked joint
fourth. The merger was seen as providing a number of sources of competitive advantage
for the combined company as a supplier of food, beverage and aerosol containers on a
global basis. Anticipated gains included:
 Complementary product markets. The companies had little product overlap and the
merger promised marketing, distribution, purchasing and R&D synergies between
the products.
 Complementary global markets. Before the merger Crown had a dominant presence in
North America while CMB had a significant presence in the rest of the world. The

new company would have increased opportunities to exploit economies of scale as a

single supplier of individual products at global level.
 Market power. Being number one would allow the firm a stronger base from which to
defend its markets and fund the search for new ones.
 User gains. The global scope of the combined company gave it enhanced opportuni-
ties to act as single supplier for major multinationals such as Coca-Cola. This would
offer user gains for the customer in terms of transaction costs with single source
contracts replacing multiple suppliers. These user gains would represent a source of
differentiation advantage for the new company.
However, the Carnaud acquisition did saddle Crown Cork and Seal with a high level
of debt. Unexpected delays in regulatory approval for the merger in Europe added to
costs of merger and delayed extraction of expected benefits. Sluggish demand, a
packaging price war in Europe, and rise in material costs had also added to the compa-
ny’s problems.
Could the two firms have exploited the gains expected from merger without
actually having to merge?
5.3.4 Internal Markets

Just as the vertically integrated firm in Module 4 could create internal markets for
intermediate products, the diversified firm is in a position to create internal markets
such as internal labour markets, internal markets for R&D know-how (as in Exhibit
5.4) or know-how in general, and so on. Where a trade to the advantage of both
parties may be possible between businesses (say, an invention in working leather for
jackets that might be useful in working leather for trousers), the deals may be more
easily and efficiently concluded in cases where the transfers are internal to one firm
than in cases where they involve different parties. The form of transaction cost
depends on the case in point, but the advantages of internal markets over external
markets are generally regarded as having three major sources.
 Asymmetric information. Managers inside the firm will generally have access
to more and better information about the potential trade than outside individuals
and organisations. They are therefore better placed to evaluate the true worth of
a possible trade.
 Control of opportunistic behaviour. As we saw in Module 4, if a manager
inside a firm were to act deceitfully and dishonestly in his dealings with another
division within the same firm, then senior management could impose direct and
severe sanctions, up to and including terminating the individual’s employment
contract. However, a contract made between separate firms does not have the
same direct controls attached to it. Ultimately, the only sanctions that might be
applied to opportunistic behaviour in such cases might be the threat to sue, a
last-resort action which may be expensive and of limited effectiveness.
 Divisionalisation gains. The growth of the diversified firm has been seen by
some as creating possible efficiency gains in terms of organisational structure. In-
stead of organising the firm around functions (such as marketing, R&D and
production) in what has been termed a Unitary form or U-form structure, the

firm could now be organised around divisions (created around products, pro-
cesses or territory) in a Multi-divisional or M-form structure. For example, our
firm in Figure 5.4 could split its business into a handbags division and an um-
brellas division. The major advantages that M-form structures have been
identified as having over U-form structures for the large diversified firm include
(a) the creation of profit centres (the divisions) to aid assessment and compari-
son of performance, (b) putting together resources that have most need to co-
ordinate their activities into natural decision units, and (c) the separation of strat-
egy formulation management responsibilities at headquarters level in the firm
from the functional responsibilities at divisional level.
Exhibit 5.4: Information trading within UK engineering companies

Senior executives in major diversified companies are increasingly playing the role of
go-betweens in bouncing ideas developed in one part of their companies around
other parts. One sector in which this tendency has been observed is the part of the
UK engineering industry concerned with global sub-contracting in which a large
variety of components may be developed to fit other people’s businesses. Such
companies tend to be involved in a large number of overlapping and duplicated
activities in the area of technological development. These can create opportunities
for technological trading and swapping between divisions. For example, one division
of McKechnie developed a plastics moulding technology to make fuel pipes for
vehicles, and other divisions of the same company adapted the technology to make
connectors for HP printers and to make a plastics ‘trim’ product for sealing baths.
The chief executive of this company has stated that a major part of his job is looking
for opportunities to transfer technology across divisions in this way. In the case of
Siebe, a gas detection safety system developed by its factory controls division for
plant installation was adapted as a wearable device by another Siebe division con-
cerned with personal safety products.
The chief executive of one of the UK’s largest engineering companies has estimated
that perhaps a ‘few dozen’ such ideas are swapped between divisions in his company
in this way each year, but that there is scope to push this figure into the hundreds.
One device it has introduced to encourage such transfers is ‘red flashes’, a one-page
news bulletin in which information about new technical ideas developed in one
division are distributed company-wide.
However, there may also be disadvantages in substituting external markets with
internal markets, especially in terms of principal–agent problems in which the
shareholders are the principals and management are the agents. The most important
include the following:
 Opaque performance. A problem with creating an internal market is that it
reduces the transparency of performance since the performance of divisions may
be concealed within consolidated accounts at the level of the firm. This may
encourage principal–agent problems of the type we saw in Module 4. If a small
specialised firm is performing poorly, it is difficult to hide this fact from the
beady eye of the external capital market, including shareholders and banks.
However, if management of a diversified firm seeks to conceal poor perfor-
mance of its running of parts (or indeed all) of this firm, outside sources of

finance such as shareholders might find it difficult to evaluate how well or badly
such an agglomeration of businesses is being run. This can act to help conceal
negligent, incompetent or inefficient management.
 Lock-in. One of the great virtues of the market mechanism is its flexibility. If
opportunity cost considerations mean that assets have negative value in their
present use, the market mechanism provides very effective devices for reallocat-
ing assets to their best uses. However, internal markets can be stickier and more
sluggish than external markets. Suppose, for example, in Figure 5.4 the bottom
falls out of Handbags, and this division becomes unprofitable. The best use of
the resources would be to close Handbags and disperse the assets to their next
best applications. However, there may be a principal–agent problem in that
management of the firm may be reluctant to do this because of the synergy that
Handbags currently exploits with Umbrellas. If Handbags disappeared, Umbrel-
las could become less profitable; Handbags’ closure could be followed by
Umbrellas folding, with management losing their firm and their jobs. The result
is that inefficient, unprofitable and obsolescing businesses may be propped up
well beyond their sell-by date in an internal market in ways that would not be
tolerated if the businesses were subjected to the cold, dispassionate scrutiny of
the external capital market.
 ‘Not invented here’ syndrome. Divisions may place more value on ideas
developed by themselves and less on ideas developed elsewhere, even if these
ideas have been developed by other divisions within the same company. Markets
may not develop spontaneously within the firm; they may have to be actively
created and maintained, sucking in expensive senior management time and re-
sources as in Exhibit 5.4.
These are general effects that might be expected from creating a large and more
diversified firm operating a series of internal markets. However, one of the most
widely considered markets in the context of the diversified firm has been the internal
capital market. By throwing corporate boundaries around the various businesses
operated by the conglomerate, it was argued that this would allow the firm to avoid
the transaction costs associated with the blunter and less sensitive instrument of the
external capital market, had these firms remained independent, smaller and more
specialised. The conglomerate could exploit advantages in terms of information,
control and divisionalisation from treating the firm as a mini-capital market. For
example, if a division had a good idea that needed development funds, senior man-
agement within the firm should be better placed to evaluate its potential than some
outside source of finance less well acquainted with the firm, its management, its
markets and its technologies – and less well placed to observe and penalise opportun-
istic behaviour. These ideas were introduced in the 1970s to explain the growth of the
conglomerate firm in particular.
The problem with this justification for the conglomerate is that if it works well
for conglomerates it works even better for related diversification. Remember our
distinction between directions and methods at the start of this module; the internal
capital market justification for the conglomerate is a justification of the conglomer-
ate as a method. Essentially it says that in certain circumstances internal markets are
more efficient than external markets, so if you have to choose between the con-

glomerate and a series of independent firms, you might be better off with a con-
glomerate.
But this argument focuses on conglomerates as a method of organising resources;
it does not tell us why this direction is chosen. In fact, if the conglomerate can exploit
internal markets this way, so also can related diversifiers, and indeed related diversi-
fiers generally have more opportunities to create internal markets than do
conglomerates. Figure 5.7 helps illustrate this using elements from our Diversifica-
tion Game. Suppose we rewind our Game back to the beginning and start off with
our ten original firms. To extend the possibilities of conglomerate expansion we add
two more firms from the fast-food industry to our Game; individually these two
firms start off as equal players to all the others just as in our original version, and we
again assume they have a 50/50 share of this market. However, there are no
potential selling or technological linkages that anyone can identify between fast food
and the other firms in the Game. In this version of the Game we shall start with
Firm 1 (M/C helmets).
Helmets Jackets Handbags

D D H.Q.
D
M M M
P P P
R&D R&D R&D DIV 1 DIV 2 DIV 3
The related diversifier can Organisational structure for the

exploit a variety of linkages related diversifier to help create
in its internal markets internal capital markets
The conglomerate strategy Similar (divisionalised)

exploits only financial linkages organisational structure
in its internal market for the conglomerate
Umbrellas Helmets Fast food

H.Q.
D D D
M M M
P P P
R&D R&D R&D DIV 1 DIV 2 DIV 3
Figure 5.6 Diversification and creation of internal markets

In Figure 5.6 our M/C helmets firm has become a conglomerate by diversifying
into umbrellas and fast food. None of these markets bears any similarity to each
other in terms of selling or technological characteristics and there are no significant
linkages to exploit between businesses. This is a conglomerate. One way its exist-
ence can be justified is in terms of the creation of an internal capital market – the
method explanation discussed above. The conglomerate could form an M-form
structure around the three unrelated businesses as divisions and pursue the ad-
vantages of an internal capital market as discussed above.

However, this is still not enough to justify the conglomerate as a direction for
expansion. Our M/C helmets firm could have chosen instead to diversify into, say,
leather M/C jackets and then leather M/C handbags as shown in Figure 5.6. This
expansion strategy is based on relatedness, first on the selling side (M/C market)
and then the technological side (leather). Firm 1 could still expand into these
markets and form an M-form structure around the three businesses. It could still
create an internal capital market allocating funds to divisions in terms of their
potential returns, just like the conglomerate. However, it has the potential to create
and maintain more internal markets than did the conglomerate. For example, it
could create an internal market in technology, with R&D in leather ideas being
swapped across the leather-based divisions. It could create an internal market in
transportation, with truck space in servicing M/C retailers being traded between the
two M/C market divisions – and so on. In short, anything the conglomerate can do
in terms of creating internal markets, related diversification can usually match, and
then add further internal markets of its own.
So diversification based on M-form structures can indeed help to build internal
markets that may be more efficient than external markets in some circumstances,
but this is something that the related diversifier is better at than the conglomerate.
The creation of internal markets may help provide a reason for the method of
diversification, but the direction it points towards is very much related diversification,
not the conglomerate.
5.3.5 Growth
One frequently cited argument for diversification runs as follows: because of
separation of ownership and control and asymmetric information (managers know
more about the running of the firm than owners), there is typically a principal–agent
problem with managers having some discretion over pursuing their objectives at the
expense of owners’ objectives. Owners would normally wish the firm to maximise
profits, but managers may wish the firm to maximise growth – growth brings with it
certain managerial rewards. Managers may see prestige, security of tenure and salary
as more directly linked to firm size than firm profitability, and indeed empirical
evidence has tended to reinforce these perceptions in some cases. This possible
conflict of objective suggests that managers might pursue diversification for growth
rather than profitability reasons, and this has been put forward as a reason for the
growth of conglomerates by some analysts.
This is something we shall return to below when we look at possible reasons for
the evolution of the conglomerate, but our simple Diversification Game helps make
one strong point here. If the management is pursuing moves designed to enhance its
growth prospects these are exactly the same moves that should help enhance its
competitive advantage (and profitability) as far as possible. This is because moves
that generate the maximum competitive advantage (such as the creation of a
specialised leather M/C jacket monopoly by Firm 3 acquiring Firm 8) will release
more resources than one which exploits weaker linkages. Whether the firm then
uses these resources to benefit owners rather than pursue more growth depends on
whether there is a principal–agent problem here. If management is growth maximis-

ing, it may well use these resources for expansion rather than shareholder dividends.
However, just as in the case of internal markets, this explanation may help reinforce
the case for related diversification and staying as close to home base as possible. It
does not provide a clear reason why conglomerate diversification should be pursued
when related opportunities are available.
5.3.6 Risk and Uncertainty

The first point to note here is that diversification can clearly reduce risk in many
contexts. If a record label is worried that many pop groups or singers do not recoup
their promotion costs, it can spread the risk of failure by supporting a number of
acts. If a firm is worried that suppliers may be unreliable, it may reduce the risk of
being stranded without essential supplies by diversifying its suppliers and buying
from more than one source. As far as corporate diversification is concerned, if the
management of a single-business firm is worried about its dependence on the
fortunes of one business, it might consider diversifying into other businesses to
spread risks.
These arguments might be seen as reasonable but there are two sets of problems
with them:
 Opportunity costs of diversification. Diversification moves the firm away from
its core business and competences. For example, suppose our Firm 3 in the Diver-
sification Game was worried about the risks of being a specialist in leather-based
technology and so diversified into M/C helmets. On the face of it this provides the
dual benefit of reducing the risks of exposure to changes in the fortunes of leather-
based products (say, from synthetic alternatives), while still generating marketing
and distribution synergies with the new business. But there is a price to pay: the
synergies from helmets are less than could be expected if the firm had continued
to concentrate on its core technology and expanded into leather M/C trousers or
deeper into jackets (taking over Firms 7 and 8 respectively). As we saw earlier,
even if a diversification move appears profitable, it may turn out to be a mistake
once opportunity cost considerations are taken into account. And as we shall see
below, there may be cheaper ways of dealing with risk in some cases.
 Owners may spread business risks by diversifying their portfolios. Suppose
the shareholders of Firm 3 were concerned about their vulnerability to the vagar-
ies of the leather M/C jacket business. Then instead of concentrating all their
investment in Firm 3 they could spread their shareholdings in a number of firms
to reduce their dependence on Firm 3’s business to levels they feel comfortable
with. The principals (or owners) could then instruct their agents (managers) to
maximise value by concentrating on what they are best at – which in the first
instance is the leather M/C jackets business. Any expansion should continue to
reflect value considerations; for example, leather M/C trousers should be pur-
sued before M/C helmets. While managers might be uncomfortable at remaining
so exposed to the fortunes of particular markets or technologies, owners should
be able to sleep at night knowing they have effectively insulated themselves from
such risks by diversifying their portfolios. If managers do persist in pursuing
diversification to spread risks, then it would suggest that there is a principal–

agent problem here, with managers not necessarily acting in the best interests of
the owners of the firm.
S0
Sales Corporate diversification
reduces firm’s vulnerability
to variation in Umbrella sales.
But are there cheaper ways
of dealing with risks?
0
T1 T2
Figure 5.7 Variability of sales in umbrellas

We can explore these points further with an example. Suppose Firm 10 (the
umbrella firm) finds its sales are erratic as shown in Figure 5.7. On a month to
month basis, sales appear to fluctuate quite wildly. However, if we look more closely
we can see that over the long haul the sales appear to fluctuate around a stable
average of about S0 umbrellas a month, while the peaks above this level appear
roughly to balance the troughs below it. Such a pattern suggests the product has a
solid base demand with some random elements built onto it. This is the sort of
pattern we might expect from a product in the stable, mature stage of the product
life cycle subject to some unpredictable influences – such as, in this case, the
weather. Sales peak during wet periods and slump during dry periods.
Clearly the firm could reduce its vulnerability to volatile umbrella sales by diversi-
fying into unrelated markets such as leather M/C jackets. To the extent that the
sales of M/C jackets are independent of the sales of umbrellas, we would expect a
smoothing of the sales and profit stream from the merged business. But bearing in
mind the opportunity costs of such diversification by Firm 10 in our Diversification
Game, is this the only way that the firm could deal with the risk of poor sales of
umbrellas? In fact there could be a number of simpler and cheaper solutions. The
important issue in each case is to identify which, if any, problems are caused by
volatile sales.
 Liquid assets. Liquid assets are assets that may be quickly realised by the firm,
such as cash reserves. If troughs in production could disrupt the fortunes of the
firm or even threaten its viability, one way of dealing with this eventuality would
be through the firm setting aside funds that could be drawn on in lean periods
(sales troughs) and then replenished during the good times (sales peaks). This
should help smooth out sources of funds available to the firm.
 Short-term finance. The firm may not even have to keep a fund in the form of
liquid assets to help it through the lean periods. If variation in sales follows the

pattern shown in Figure 5.7, then showing sales records to a bank or another
possible source of finance should help demonstrate how troughs and peaks bal-
ance each other out in this case. On this basis, the firm may be counted a good
bet for short-term finance such as overdraft facilities to help it through a sales
trough.
 Stockholding. Variation in sales may be problematic because it disrupts
production. Dips in sales may leave machines idle while surges in demand may
not be able to be met because of limited machine capacity. If the peaks and
troughs in sales tend to balance out over time as in Figure 5.7, then one way of
smoothing production and allowing the plant, machines and workers to be fully
utilised is to absorb surplus production during slack periods in the form of
stocks. These stocks can then be run down at the same time that machines are
worked at full output during times of peak demand.
 Insurance. Insurance is not something which can be arranged for all sources of
variability in sales because of the opportunism problem; if all dips in sales could be
insured against, the umbrella firm could claim a particular fall was due to unfore-
seen circumstances, when it might be due instead to managerial laziness or
incompetence. Again, this a particular form of principal–agent problem which
may interfere with such agreements or even make them impractical. However, if
the events causing the variation in sales can be independently confirmed (say
theft of goods in transit, or dip in sales because of a dry quarter), then it may be
possible to pass these risks on to an insurance company.
 Long-term contracts. Another way the umbrella firm could pass on the risk of
variability is by arranging a long-term contract with the retailer in which the latter
agrees to have the umbrella firm as sole supplier. It might even be possible to per-
suade the retailer to accept a fixed quantity of umbrellas each month. Why should
the retailer tie its hands in this way? Usually because the retailer values the relation-
ship with the supplier highly and does not want to lose it, for example through the
supplier going bankrupt. There may be other benefits to the retailer, for example it
may accept the contract in exchange for a discount on sales. In practice, such long-
term contracts may be difficult to arrange for a manufactured good like umbrellas
where the retailer may make intermittent sales and which is subject to the vagaries
of fashion; they are more commonly found in markets for components or com-
modities; for example, some contracts for the supply of coal from mines to
adjacent power stations have been found to have a 35 to 50-year lifespan.
 Vertical integration. As we saw in Module 4, one way to reduce risks and
guarantee sales would be to integrate forward and become your own customer.
While vertical integration carries its own risks and problems, in some cases it
may allow the firm to stay closer to its core skills than does diversification.
None of these solutions is free. Liquid assets have an opportunity cost in that they
might be used for more profitable investment opportunities. There will be a price to
pay for short-term finance, insurance and long-term contracts that may be reflected in
interest charges, insurance premiums, and price discounts respectively. There will be
warehousing and maintenance costs incurred from storing stocks. And vertical
integration may bring with it its own special sets of problems as we saw earlier.
However, each of these solutions has one fundamental advantage over corporate

diversification; it allows the firm to concentrate on its core competences and avoid the
opportunity costs associated with diversifying away from these core competences
simply to reduce risk. For the firm in Figure 5.7, the costs of the various options
available for dealing with risk are typically likely to be less than the opportunity costs
of diversification to reduce risk. Therefore, if managers say that they are diversifying
to reduce risks, this is not necessarily something which should impress shareholders
reading the annual report. Shareholders can usually diversify more cheaply than can
corporations, while many risks can be eliminated or reduced more cheaply by manag-
ers without the need to incur the substantial opportunity cost penalties associated with
diversification.
However, there is one class of risks that we have not looked at yet. The risks that
we have looked at so far have been of a particular type – they add a source of
variability but they do not disturb the underlying prospects for this business. At the
end of period T2 in Figure 5.8, the average sales of umbrellas are the same as they
were at the start of the period. But suppose our source of variability threatened this
cosy and stable set-up. Suppose a competitor (Firm 5) introduces an improved
umbrella in time period T2; it might be made of improved materials, be a better
design, be cheaper, etc. Whatever the difference, it establishes the fact that this firm
now has a clear competitive advantage over our umbrella firm, Firm 10. Sales of
Firm 10’s umbrellas begin to slump alarmingly as shown in Figure 5.8. How do the
alternative options discussed above for dealing with risk compare now?
Technological bomb:
competitor invents
an improved umbrella
D D
M M
P P
R&D R&D
Handbags Umbrellas
Umbrella sales
Many methods for ... but only corporate

dealing with risk diversification works
work well here ... well here
0
T1 T2
Growth Maturity Decline
Figure 5.8 Some options for dealing with variability and uncertainty
Unfortunately, if decline persists indefinitely, liquid assets and external finance
will eventually dry up, mountains of stocks may build up and not deplete, insurance

and long-term contracts will become scarce or unobtainable, while vertical integra-
tion will just dig you further into a deepening hole. Each of the alternatives to
diversification discussed above reflects the assumption that Firm 10’s umbrella
business is going to continue as a viable concern for the foreseeable future. Howev-
er, in Figure 5.8 the innovation by the competitor leads to such continued and
deepening haemorrhaging of Firm 10’s sales and income that this assumption is no
longer tenable. This is a firm that is in deep trouble. The only route that offers some
possibility that its survival could be protected would be diversification. For example,
if Firm 10 had merged with Firm 4 (Handbags) as in Figure 5.4, then Handbags
could help provide a life raft that management could clamber into as Umbrellas
slowly sinks below the waves. This is shown in Figure 5.8 with the strategic bomb in
the case of the Handbags/Umbrellas diversification hitting only the Umbrellas
business.
Exhibit 5.5: Big enough to handle surprises – the case of General

Electric
General Electric (GE) has been described as the world’s most diversified company. Its
base is in electronics and electrical engineering but it covers a wide span of activities
even within this spectrum ranging from domestic appliances to aero-engines. Its former
chairman Jack Welch argued, ‘Once you’ve got scale like we have, the chances of it all
going wrong are minimal. A global recession in all businesses could slow us down. But
we’d be less slowed down than 99.9 per cent of the institutions in the world.’ He
conceded that ‘glitches’ were bound to occur with not all divisions performing well at
the same time, but that the variety of businesses operated by GE was a source of
stability. A fundamental precept of GE is ‘boundariless management’ in which individuals
are encouraged to swap and share ideas across the company. Ways in which this is
encouraged include the use of stock options (to encourage individuals to associate their
own interests with that of the performance of the company as a whole), frequent cross-
divisional moves of personnel (to facilitate cross-fertilisation of ideas), and an ‘anti-
hoarding’ rule that those with a good idea must spread it through GE as quickly as
possible (or face threat of dismissal).
If different divisions within a firm (such as McKechnie, TI and GE) can benefit
from an internal market trading and sharing R&D ideas, what is to stop different
firms in the outside marketplace trading in R&D ideas and obtaining the same
benefits?
There is a further point that needs to be recognised here. When external threats
hit firms they may not focus just on individual businesses, but on particular linkages.
For example, if Firm 3 has merged with Firm 8 in Figure 5.3 it will be able to extract
gains from marketing/distribution and technological linkages, as we discussed in
Section 5.3. However, the linkages that can help generate enhanced value when the
environment is relatively stable can also pose a source of joint weakness when the
environment begins to throw up nasty threats. For example, if the M/C business
begins to decline (say because of an ageing population), then both jackets and
trousers could be attacked along the M/C market linkage. If a rival develops an
improved synthetic substitute for leather, then both jackets and trousers can be

attacked along the shared technological linkage. Such dangers can be seen in the
case of BIC where BIC faces Gillette and Scripto Tokai as competitors in two out of
three of its main businesses; if BIC can exploit linkages in these areas, so also can its
rivals, and if Gillette or Scripto Tokai were to make a sudden breakthrough in
disposable technology, BIC could be vulnerable to attack in all its main business
areas. Seen in this perspective, large diversified companies such as General Electric
(Exhibit 5.5) begin to reveal hidden strengths in the form of resilience to specific
threats to particular aspects of their business. Its use of stock options may also be
seen as another way of stimulating information trading, the issue discussed above in
Section 5.3.4. For the first time we seemed to have found a conceivable reason for
firms playing the Diversification Game to want to avoid linkages, and in turn this
would seem to raise possible justifications for strategies such as the conglomerate
that help the firm avoid dependence on particular linkages. We shall consider this
possibility further in Section 5.4.
Thus, corporate diversification can help provide a basis for defending the firm
against unpleasant surprises such as technological innovation by its competitors.
However, there are further questions we can ask of this strategy; it is not going to be
let off so easily.
 Why not specialise until you are forced to change to another business?
This is not a bad idea, and indeed if firms can get away with it, such serial spe-
cialisation may well be the optimal strategy by allowing firms to focus on their
core competences until they have to switch. The problem is that the worst time
to try to make such a switch is when you are forced into it. Diversification can
take time and considerable managerial and financial resources to achieve, and
even then success for individual diversification may be uncertain. The firm in the
decline stage of Figure 5.8 will find its internal resources dwindling as the busi-
ness fades, while outside financial institutions are likely to have second thoughts
about providing financial props to allow the firm to bridge between the old and
new activities. If this firm wished to diversify to hedge against the possibility of
failure in the umbrella business, it should have done so when it had the time and
resources, certainly before the decline stage had set in. You do not start to build
the life rafts when the ship is beginning to sink.
 If some corporate diversification is designed to safeguard managerial
jobs, can this also be in the interest of owners? On the face of it, this would
seem to be a classic principal–agent conflict, with management protecting their
own interests at the expense of owners. If diversification has an opportunity cost
in diverting resources from more specialised attention to core competences, then
it clearly may conflict with the interest of owners. Where such diversification
may also be in the interests of owners is where there are transaction costs associ-
ated with bankruptcy. In particular, the demise of the specialised firm as in
Figure 5.8 may lead to the break-up of the management team. Corporate diversi-
fication may increase the chances of preserving this team, which may be counted
as a valuable – indeed critical – asset in its own right.
 If risks such as technological innovation by competitors are often one-off
surprises, how can management know in advance when they should di-

versify? This is another good question and one that is impossible to answer
precisely. In one sense it goes to the heart of the strategic management problem.
A chief executive once described his strategic management problem as coping
with surprises. Harold Macmillan was once asked what his biggest problem as
UK Prime Minister had been and he replied, ‘Events, dear boy, events’, which is
really another way of saying the same thing. In the context of corporate diversifi-
cation, it may be difficult for management to anticipate the timing and form of
future threats to individual businesses, but it may be possible to identify business
environments that are more likely to throw them up. Just as a police force may
not be able to anticipate the timing and nature of particular muggings, they may
still be able to identify neighbourhoods that are more likely to produce them.
Similarly, management may be able to identify environments that are more likely
to throw up threats to their individual businesses, such as those associated with
rapidly changing technologies. In such cases, diversification to avoid dependence
on businesses that face a high risk of technological obsolescence may be given
high priority. The one warning that can be added here is that environments that
have seemed placid and stable for decades have a nasty habit of suddenly turning
turbulent and unstable. This is a lesson which has been learnt by firms in a large
variety of sectors ranging from Swiss watches to British banking. The specialised
firm that is caught flat-footed in such circumstances may face real threats to its
survival.
On the face of it, conglomerate diversification offers the most obvious way of
anticipating threats to the viability of individual businesses. After all, having as many
unrelated markets and technologies as possible would seem the most direct way of
avoiding dependence on a limited set of competences. However, in the next section
we shall see that this is not necessarily the case. Corporations have developed new
tricks that allow them to match the ability of conglomerates to absorb outside
threats without incurring the severe opportunity costs associated with such extreme
diversification.
5.4 Forms of Diversification

We can summarise what we have learnt so far as follows. Firms may diversify for a
number of reasons. These include market power, resource effects, user gains,
creation of internal markets, growth motives and dealing with the possibility of
attacks on the viability of individual businesses. Diversification may help the firm
deal with these problems in ways that are more effective or cheaper than alternative
solutions (such as co-operating with other firms). However, most of these motives
for diversification still suggest that the firm should stay as close to home as possible
even when it diversifies into other businesses. In our Diversification Game, this
would lead to our Firm 3 preferring richly linked strategies such as the merger with
Firm 8 over more weakly linked businesses. It is only when the risk of threats to the
viability of linkages are brought into the reckoning that linkages may be seen to have
price tags attached to them that could suggest they should be avoided or restricted
in some circumstances. Does this give us a justification for the conglomerate?

No. In recent years firms have discovered strategies that have allowed them to
extract many of the benefits of simultaneously exploiting the gains from linkages
between businesses together with the risk-spreading benefits of multiple markets and
multiple technologies that the conglomerate strategy offers. The name of this
strategy is related–linked and it was really first discovered in the mid-seventies by
Richard Rumelt, then a Harvard Business School researcher. To see the logic of this
and alternative strategies, we shall open up a new Diversification Game in Figure
5.9. In this version of the Game, we only keep Firms 3, 6, 9 and 10 from the
previous Game; we have dropped leather M/C trousers entirely and the fair play
umpire has forbidden moves that would monopolise markets, so it is only possible
to consider a single move involving one firm from each of the remaining three
sectors. However, we have also added Firms 11 and 14, leather riding saddles
(possible technological links with leather M/C jackets), Firms 12 and 15, M/C audio
equipment (possible marketing and distribution linkages with leather M/C jackets)
and Firms 13 and 16, fast food (no significant linkages with any other businesses).
This gives us a total of seven firms in this version, which we shall call Game 2 (the
fair play rule means that we can select only one firm in each business, so we drop
Firms 14, 15 and 16 in this case). As before, the new firms are otherwise identical in
terms of their economic characteristics to all the other players in the Game. We can
now instruct Firm 3 to pursue expansion possibilities and in this case the firm will
be allowed to make two moves. Figure 5.9 shows some of the expansion possibili-
ties open to Firm 3 here.

Saddles M/C audio Fast food

equipment
11 12 13
These new players
join the players from
Game 1 in Game 2;
remember firms 2
and 7 (leather M/C
trousers) drop out
14 15 16
BELOW:
some moves that firm 3
can make in Game 2
Market Horse riding Motorcycle Restaurant

Technology Leather Electronic Retailing
Helmets Jackets Audio

M/C jackets pursues market-based
D D
diversification, exploiting selling
and distribution linkages M M
P P P
R&D R&D R&D
Umbrellas Jackets Fast food Here, M/C jackets becomes

a conglomerate, moving into
D D D new markets and technologies
M M M
P P P
R&D R&D R&D
Technology-based diversification, Handbags Jackets Saddles

M/C jackets exploits production D D D
and R&D competences M M M
P P P
R&D R&D R&D
Helmets Jackets Handbags The related–linked strategy;

D D D here M/C jackets exploits
M M M different linkages in its moves
P P P
R&D R&D R&D
Figure 5.9 Game 2 with some diversification options for M/C jackets

Apart from the conglomerate strategy (umbrellas, jackets and fast food) there
does not appear to be much to choose between the strategies shown on the bottom
half of Figure 5.9. The non-conglomerate strategies all pursue related diversification
based on a single market or technological link between businesses. The bottom
strategy (helmets, jackets, handbags) differs from the other two single-link diversifi-
ers in that it switches links from marketing/distribution to technology in the course of
its diversification strategy. However, apart from that switch, there seems to be no
clear difference between these three strategies in terms of the extent and degree of
linkage. On this basis at least there is nothing to choose between them. So we shall
add a new feature to our game. We shall let our firms be subjected to attack from
the outside. Worse, from the point of view of our firms, the form of attack will
often be kept a surprise until the last minute. This follows from sound strategic
principles. From the point of view of the attacker, the element of surprise can be an
essential weapon, whether we are talking about military or corporate battles.
These possibilities change the nature of our Game compared to the first version
where our businesses and competences continued indefinitely. If there was any
turbulence it was limited to random elements, such as the weather, that did not
disturb the underlying viability of the businesses. Here we are introducing the idea
that there may be threats to the continued viability of these businesses or compe-
tences due to some radical change in the firm’s environment. What form is such an
attack likely to take, or, to put it in military terms, what kinds of ‘bombs’ can be
dropped on the firm’s activities? In practice they can take many forms, but the most
important in real-life corporate battles tend to be the following.
 Innovation in the form of new products or processes. Of the various sources of
strategic bombs, the most important is innovation. As we saw in Module 3, if
you look around, you will find very few products or activities that have been
untouched in the past few years, either by changes in the nature of the goods or
services themselves, or less visible improvements in the processes which make
and distribute these goods or services. Innovative opportunities seen from the
point of view of the firm that develops them can represent bomb threats seen
from the point of view of its rivals.
 Change in consumer tastes, e.g. fashion changes, sports fads, health scares.
These may be important sources of bombs also, but on closer examination many
changes in consumer tastes are not spontaneous but turn out to be stimulated by
technological innovation; for example, decline in cinema-going stimulated by the
growth in television.
 Changes in government restrictions, e.g. safety controls, deregulation,
privatisation. As far as changes in government restrictions are concerned, the
major sea change in recent years has been in the direction of deregulation, which
tends to generate more openings and incentives for innovation.
 Resource depletion, an industry can simply begin to run out of its raw material.
Resource depletion is likely to be a very slow-ticking bomb at worst with firms
usually having plenty time to prepare for the worst. In fact, the worst in terms of
running out of the resource almost never comes; if a resource becomes scarcer it
will rise in price, stimulating the search for economies in resource usage. There is

still plenty of oil in the ground but the price hikes of the past have encouraged
innovations in engine technology that have enhanced fuel efficiency and have
brought higher-cost fields into production. There is also plenty of copper left to
be mined, but both its price and usage have declined in recent years as past scar-
city (and high price) of the metal stimulated the search for cheaper and more
effective substitutes such as fibre optics.
So while bombs do not have to be innovations, innovation is the most important
source of bomb material, and many other threats to the viability of competences
and businesses turn out to involve innovative activity. Suppose we were to lob a
bomb in the form of, say, technological innovation in the direction of our diversifi-
ers in Figure 5.9. How much damage could a single bomb do? Interestingly, the
answer depends on the pattern of linkages, not just the extent of linkages.
Suppose a bomb was fashioned by a rival and designed to attack our technology-
based diversifier (handbags, jackets and saddles) in Figure 5.9. How much damage
could a single well-designed bomb inflict? We could easily envisage a bomb hitting
individual businesses in Figure 5.9 with rivals developing a better style of handbag, a
more fashionable jacket, or an ergonomically improved design of saddle. In such
cases the impact of the ‘bomb’ on our firm’s strategy would be limited to the local
region of the individual business under attack. But suppose a competitor fashions a
bomb that directly attacks the technological competences of our firm. This could be
because it has invented a process that greatly reduces the cost of processing leather,
improves the quality of the leather processed, or it could be because it has invented
a synthetic substitute for leather that replicates all its characteristics but at a much
lower cost. Such an innovation could give its developer the power to compete
successfully against all our firm’s chosen businesses by producing leather (or leather
substitute) based products with lower cost and/or improved quality. Our technolo-
gy-based firm is now being holed right along the length of its strategy by this single
bomb. Its very survival is now threatened, just as in the case of the umbrella
specialist being hit by a technological bomb in Figure 5.8.
Much the same considerations hold for our market-based diversifier. Each indi-
vidual M/C business could be hit by a business-specific bomb, but it is also possible
that its marketing and distribution competences could be disabled or damaged by a
single bomb. Suppose, for example, it was decided that motorcycling was too
dangerous an activity and that for their own protection a government regulation was
introduced restricting motorcyclists to the slow lane of all major roads. Such a
regulation could severely damage the sales of all motorcycle-related businesses,
including the three run by our market-based diversifier. Again the same phenome-
non appears; the link may be a double-edged sword that can not only generate
internal gains but also create shared vulnerability to a single external threat.
The only strategy that appears insulated from such threats is the conglomerate.
Individual businesses may be attacked, but there are no marketing/distribution or
technological competences running across its businesses that may expose the firm to
a single bomb threat. Clearly this is one advantage the conglomerate has over the
market- and technology-related diversifiers. If the firm is operating in environments
characterised by a high level of bomb threats, then this does suggest that a case can

be made for the conglomerate; even though there may be significant opportunity
costs in terms of sacrificed linkages if the conglomerate route is chosen, manage-
ment may regard this as a price worth paying if it reduces the chances of the firm
being sunk by a single bomb. But before we conclude that this is a sufficient
justification for the conglomerate, remember that we have one strategy left to look
at. This is the strategy at the bottom of Figure 5.9 and is a case of related–linked
strategy. It is called this because the various businesses are linked together but not
necessarily directly as in the cases of the other two related diversifiers in Figure 5.9.
Helmets is linked to jackets by markets, and in turn jackets and handbags share
production and R&D linkages, but helmets and handbags? This last pair of busi-
nesses operate in very different markets and draw upon very different sets of
technological expertise. Yet the firm in this case exploits the same degree of linkage
throughout its strategy as do the other diversifiers. The twist it has added is to
switch the linkage it is exploiting. This is the related–linked case in which the
businesses operated by the firm are linked to each other at least indirectly (in this
case jackets indirectly links helmets to handbags).
Helmets Jackets Handbags Umbrellas

D D D D
M M M M
P P P P
R&D R&D R&D R&D
Related–linked expansion; now no more than two of

the firm’s businesses are vulnerable to any threat to
specific competences
Figure 5.10 Growth using the related–linked strategy

If a related–linked firm decides to

divest loss-making businesses that act
as connectors to the rest of the firm ...
D D D D D
M M M M M
P P P P P
R&D R&D R&D R&D R&D
... then it may turn itself into

a conglomerate by default
D D D D
M M M M
P P P P
R&D R&D R&D R&D
Figure 5.11 Fragile related–linked strategies

If our jackets firm chose this route to pursue related diversification, there is one
impressive trick that the related–linked strategy has up its sleeve. It is difficult to
find a single bomb that would disable all its activities, in the way that the other two
related diversification strategies could be disabled. The worst damage that a bomb
aimed at its competences could do would be to damage two businesses; helmets and
jackets in the case of the M/C market, or jackets and handbags in the case of the
leather technological link. Now, in itself this may only seem a marginal improve-
ment over the other two related diversifiers and it does not match the degree of
insulation from particular external threats afforded by the conglomerate. However,
if we run this strategy forward a couple of moves we can begin to see the clear
advantages this strategy may offer. Figure 5.10 shows the same firm now diversified
into umbrellas, while the top strategy in Figure 5.11 shows it adding a fifth business,
again switching the link being exploited. But the more links the related–linked firm
adds, the less exposed it becomes to the impact a single bomb could make on its
business. By Figure 5.11, a single bomb could only impact on two of its five
businesses, even if it were aimed at a competence and not a single business.
This is a degree of insulation from external threat which is almost as good as the
conglomerate, and indeed the more that the related–linked firm expands using this
strategy, the closer it approximates the degree of protection offered by conglomer-
ateness. Yet this is clearly not a conglomerate strategy since every business is
(indirectly at least) linked to every other and, as we can see, there is a solid level of
linkage exploited as we move through the strategy, just as in the case of the market-
based and technology-based diversifiers. This is a strategy which seems to enable
management to exploit the advantages of related diversification without incurring

the dangers of exposure to a single external threat. If it is possible for management

to have their cake and eat it in strategic terms, we seem to have found the strategy
that helps them do it.
The related–linked strategy is one of the unsung successes of corporate diversifi-
cation. Rumelt’s study (1986) found that it had been adopted by many of the most
successful large firms in the US economy. Exhibit 5.6 shows how one UK firm
pursued such a strategy, and it is an approach that has been echoed by many firms
in very different industrial environments. If there is an ideal strategy that could be
identified as a basis for diversification, the related–linked strategy would appear
difficult to beat. So why do conglomerates exist when they appear to have no
justification in economic or strategic terms? There are a number of possible reasons,
but it is first important to note reasons which do not stand up to closer investiga-
tions. Most risk situations can be handled more cheaply by other means. Also,
conglomerates usually do not exist for synergy, deep pocket, market power reasons,
or to absorb the risks to individual businesses. Anything the conglomerate can do in
these respects, related diversification (especially related–linked diversification) can
match and improve on. Answers to the riddle of the conglomerate must lie else-
where and include the following.
 The disguised related–linked firm. We already have one answer to the puzzle
of the conglomerate. Many firms which appear to be conglomerates because of
the diversity of their businesses turn out on closer inspection to be related–
linked firms rather than genuine conglomerates. This was confirmed by Rumelt’s
study, which found highly diversified firms often had webs of linkages built up
from short-range links running through the firm.
 Restructuring of related–linked firms. Although it has an attractive logic to it,
the related–linked strategy can be very fragile and it does not take much to turn
it into a conglomerate, especially if the firm is under pressure to divest loss-
making businesses. Suppose, for example, a related-linked firm has three busi-
nesses A, B and C, with A linked to B with a market link and B linked to C with
a technological link. If B was divested, then there would be no links between A
and C, not even indirect ones and the firm would now technically be a conglom-
erate.
Exhibit 5.6: How gunpowder and chewing gum are linked
How can gunpowder be linked to chewing gum? There are no obvious market or
technological links between the two products. In fact, the growth and diversification of
the Hercules Powder Company through the twentieth century and beyond shows how
they can be linked, albeit indirectly through a diversification strategy.
The Hercules Powder Company was formed in 1913 when a US Federal anti-trust
suit broke up E.I. Dupont de Nemours after DuPont had been regarded as near to
monopolising the explosives business. Hercules Powder Company was one of the
resulting spin-offs. At the time it had 1000 employees and produced explosives, black
powder and dynamite.
The two World Wars did provide boosts for its core business, but at the end of each
war it faced a drastic decline in demand for explosives. To guard against these threats
and its dependence on limited market and technological bases, over the course of the

century it embarked on a series of linked diversification moves exploiting various

market and technological strengths.
One technological base was cellulose chemistry. Nitrocellulose is a basic raw material
in the production of explosives. Hercules had developed a soluble nitrocellulose product
soon after the First World War with applications in lacquer, film and protective coatings,
and its base in cellulose chemistry eventually led to developments in artificial fibres and
plastics. It developed a cellulose gum, CMC, which was found to have applications in foods,
lotions, drugs, cosmetics and oil-well drilling.
In turn, its new interests in protective coatings became a market base for further
expansion, including rosin-based paints and lacquers, and the new rosin-technology base
became a platform for a number of new products, including chewing gum.
In short, the development of Hercules’ chewing gum interests could be traced back
through a technology link with protective coatings, the protective coatings market in
turn linked products based on both rosin and cellulose technologies, while the cellulose
chemistry link could be traced back to the origins of the company in explosives.
Later the company pursued diversification into advanced materials and composites,
aerospace instrumentation and communications, fragrance and food ingredients,
polypropylene fibres, and high-performance structural plastics. In each case, the
diversification moves still tended to exploit one or more links with established market
and technological bases within Hercules.
What kind of diversification strategy would best characterise Hercules’ devel-

opment?
 No alternatives. There are some industries which have faced external threats in
the past for which it has been difficult to find closely related products. Tobacco
and petroleum are two cases in point in which attempts to expand and escape
from a threatened industrial base led the firms into unrelated fields when value-
enhancing related opportunities proved difficult to find.
 Rapid growth. Synergy takes time and patience to release. Up to a point there is
a positive relationship between synergy and growth; as we have seen, it can gen-
erate and release internal resources that can help develop and manage further
growth opportunities. However, if you are seeking really fast growth rates in the
immediate time period and the capital market (shareholders, banks) is willing to
bankroll your plans, then synergy becomes much less important in the overall
scheme of things. Strategic planning can become dominated by availability of
acquisitions rather than with how they fit your existing business or businesses;
this is how many acquisitive firms in the past turned into conglomerates. They
concentrated on what was available rather than on what would be a good fit for
their existing businesses.
 Path dependency. Restructuring, the absence of alternatives and rapid growth
may explain why some firms become conglomerates but they do not help explain
why they remain such. One answer is path dependency, as we discussed in Mod-
ule 3. As we saw in that module, nobody would introduce the QWERTY
keyboard today if we were designing the best possible system from scratch.
However, we have the keyboard, it works well if not optimally, and the transition
costs of getting from where we are to a supposedly better system exceed any

benefits that might be gained from such a revolution. The same may hold for
conglomerate management. Such teams build up skills in managing unrelated
businesses, and shifting the strategy to one which emphasises linkages across
divisions, as in the related–linked case, would involve a major change in top
management skills and substantial transaction costs in buying and selling busi-
nesses until the new strategy is created.
 Conglomerate focus. The final reason for the continued survival of the
conglomerate strategy is that management learn and adapt. They may not be able
to change their spots easily, but they can do the next best thing – they can shuf-
fle them around. Figure 5.12 shows how many conglomerates had modified their
strategy by first divesting unprofitable businesses or businesses with an unprom-
ising future, and secondly encouraging the remaining divisions and groups to
pursue related diversification. Both types of actions are designed to enhance the
performance of the firm and please the capital market. However, as Figure 5.12
and Exhibit 5.7 show, these actions are designed to reinforce the conglomerate
strategy, not to alter it. The conglomerate may be an unlikely and indeed an unu-
sual beast, but it is a surprisingly resilient and persistent one.
D D D D D
M M M M M
P P P P P
R&D R&D R&D R&D R&D
This conglomerate has been hit by ... so it has divested these loss makers and
threats to two of its businesses ... instructed the three remaining groups to
diversify only into related fields
D D
M M
P P
R&D R&D
D D D D
M M M M
P P P P
R&D R&D R&D R&D
Figure 5.12 Downsizing and conglomerate persistence

Exhibit 5.7: BTR – can a conglomerate pursue focus?

The conglomerate BTR was the UK’s most diversified industrial group, operating in 60
different countries and possessing a diverse array of 1000 businesses, ranging from
electrical components to railway trains. It was highly profitable but slow-growing
compared to the average for the UK engineering sector, and there were concerns
expressed in the capital market on this score. The firm’s past history as a fast-growing
acquisitive conglomerate reflected an earlier abundance of profitable opportunities
during periods when such strategies were actively supported by the capital market. The
firm responded to these concerns by redesigning its strategy. It decided to position itself
firmly as an industrial manufacturing company with a large engineering presence in
market-leading technology.
This meant divesting its consumer and non-manufacturing businesses with sales of
non-core businesses such as rail and electrical power, chemicals, building products and
textiles.
These were intended to support selective investment in its core high-technology
business, particularly automotive, packaging and batteries. It pursued synergy by filling
gaps with acquisitions and encouraging the transfer of technology between businesses.
However, while this strategy represented an increased emphasis on focus and synergy,
BTR remained a conglomerate, albeit a more focused one. Eventually it merged with
Siebe to form Ivensys.
Compare BTR’s strategy to pure conglomerate and related–linked strategies.
Learning Summary
Diversification can be a deceptively attractive strategy. Superficially, it seems to offer
the prospect of helping management pursue a number of different objectives,
including growth, profit and risk spreading and, apparently, with little in the way of
a downside. It is easy to understand why even conglomerate diversification received
such an uncritical reception when it first became prevalent in the sixties.
Diversification has received a worse press in recent years in the light of its fre-
quently disappointing performance, even in the case of diversification moves which
have some relationship to the current activities of the firm. As has been seen in this
module, diversification can be doubly cursed: first, it may fail to deliver its promised
gains, at least at a reasonable cost; second, in many cases the objectives of diversifi-
cation may be as easily or more cheaply attained by alternative means.
At the same time, diversification is still a strategy that is of major importance in
the strategic armoury of the firm. The important thing is to maintain a proper
balance in the assessment of what diversification can reasonably deliver in terms of
enhancing the competitive advantage of the firm. As we have seen in this module,
answering that question requires looking not just at the direction of any diversifica-
tion move, but also at the form and pattern of the diversification strategy at the level
of the firm.

Review Questions
5.1 A firm operates a single product and is worried about the risk of product obsolescence.
It is considering the following methods of dealing with this risk:
Which is likely to be the most effective solution for dealing with this danger?
A. Long-term contracts.
B. Insurance.
C. Diversification.
D. Futures contracts.
5.2 The advantages of an internal capital market can be exploited by:

I. conglomerates.
II. diversified firms.
III. vertically integrated firms.
A. I only.
B. I and II only.
C. II and III.
5.3 Which of the following is unlikely to be a successful long-term solution for a firm in a
declining industry?
A. Vertical integration.
B. Industry exit.
C. Diversification.
D. Divestment.
5.4 The exploitation of economies of scope necessarily involves:

A. more than one product.
B. natural monopoly.
C. significant cost gradients.
D. large national markets.
5.5 Decline in unit cost with cumulative production is the definition of:
A. economies of scope.
B. economies of scale.
C. the learning curve.
D. technological change.

References
Penrose, E. (1995) The Theory of the Growth of the Firm, 2nd edn. Oxford, Oxford University
Press.
Porter, M. (1985) Competitive Advantage, New York, Free Press.
Porter, M. (1987) From competitive advantage to competitive strategy, Harvard Business
Review 65 (3), 3–59.
Rumelt, R.P. (1986) Strategy, Structure and Economic Performance, Boston, Harvard Business
School.

Module 6
International Strategy
Contents
6.1 The Diversification Game Goes International ....................................6/3
6.2 The Question of International Competitiveness.................................6/6
6.3 Porter’s Diamond Framework ..............................................................6/9
6.4 Using the Diamond Framework......................................................... 6/19
6.5 Framing Company Strategy ............................................................... 6/24
6.6 Competing in International Markets ................................................. 6/26
6.7 Competing Abroad: The Principles ................................................... 6/31
6.8 Globalisation Versus Localisation ...................................................... 6/33
In this module we look at the implications of internationalising the firm’s activities.

One of the fundamental issues that emerges at the very beginning is that multina-
tional expansion may make far less use of the firm’s existing resource base than
alternative methods of expanding, both domestically and internationally. As with the
previous modules, we see the importance of properly assessing the advantages and
disadvantages of specific strategies (such as multinationalism) against all other
alternatives. We discuss the Diamond Framework, which provides a systematic basis
for evaluating strategic alternatives for firms facing international competition,
whether it is venturing abroad itself, or facing threats from foreign firms in its home
territory.
Learning Objectives
 analyse multinational expansion as a form of international diversification;
 explain the major sources of international competitiveness;
 explain Porter’s Diamond Framework;
 show how the Diamond Framework could be used to analyse the sources of
competitive advantage for nations and for firms;
 explain the principles driving exploitation of competitive advantage in an
international context.
So far we have looked at competitive strategy in terms of vertical and horizontal
moves by the firm, and the kind of options open to it in these contexts. However,
international moves by the firm comprise another dimension of competitive
strategy, and indeed when we identify successful firms it is natural to think of firms
that are successful in an international context. After all, if something works at home,

Module 6 / International Strategy
why should it not work abroad? And if a firm is only successful at home, what is to
protect it once the large international firms with their financial and managerial
resources start to express an interest in its domestic market?
So the international dimension can be extremely important in competitive strate-
gy. However, before we look at strategies, we have to distinguish between
international firms and firms that are multinational. A company is international if it
serves foreign markets. It is multinational if it also locates operating facilities abroad.
Boeing is an international company that dominates the world market for civil
aircraft along with its European rival, Airbus. However, Boeing services its global
markets from its home base in Seattle and heavily concentrates its managerial and
physical resources in that region, and so hardly qualifies as a multinational. On the
other hand, IBM is an international company which is also multinational, that is, it
has facilities in different locations around the world.
However, perhaps one of the most startling features of many of the best-known
and most successful of the world’s largest firms is their stay-at-home character. The
economist John Dunning (1993, p. 47) looked at the vital statistics of a selection of
the world’s largest industrial companies, including the percentage of their assets and
sales that were located abroad. With the exception of the big oil companies, most of
the giants for which figures were available had a majority of their sales in their home
domestic market and located most of their assets, including factories, in their home
country.
Internationalisation and multinationalism have been increasing for many of these
firms in recent years and there has indeed been a trend towards increasing globalisa-
tion of industry, consistent with many of the headlines in the national and
international press. However, the basic principle still holds that firms typically
concentrate a high proportion (often the majority) of sales and assets in their home
country. The first lesson to be taken from this is that it is not necessary to be highly
multinational (or indeed even very international) to be an extremely successful
company. If this holds at the level of the world’s largest companies, it holds even
more strongly for small and medium-sized companies, where the tendency to stay
close to home base is even more prevalent.
Why should this be? To understand the issues involved we need to explore the
circumstances that will help to create multinational enterprise. One way to approach
this is to look again at the Diversification Game from the last module. This time we
shall tweak the rules to let the Diversification Game go international in Section 6.1.
This section, along with Section 6.2 (which deals with the question of international
competitiveness), helps set the context for the introduction of Porter’s Diamond
Framework in Section 6.3. The diamond framework is widely used by corporate
strategists and public policy makers to explore the circumstances which can help
stimulate and maintain international competitiveness. We show how the Diamond
can be applied in Section 6.4 and how it can be useful to help frame company
strategy in Section 6.5. We shall draw on the resource-based approach developed in
earlier modules to help analyse the logic of international strategies throughout this
module, and in Section 6.6 and Section 6.7 we shall see how its principles can be
combined with Porter’s Diamond perspective and the transaction approach (Module

4) to set out principles for competing in international markets. We shall finish up

with a look at one of the big issues in international strategy today, what is called the
‘globalisation versus localisation’ question.
First, however, the Diversification Game takes a trip abroad.
6.1 The Diversification Game Goes International

In the Diversification Game in Section 5.2 we had five pairs of firms as outlined in
Figure 5.1. One of the first moves we considered was a specialisation move, with
Firm 3 merging with another leather motorcycle (M/C) jacket firm (Firm 8) in
Figure 5.2. This move allowed the firm to exploit economies of scale and the
sharing of resources in R&D, production, marketing and distribution. Recall that
there were a number of advantages from the firm specialising rather than diversify-
ing if this option was open to it. A major problem with diversification was that it
could lead to the sacrifice of the rich resource linkages which may be possible under
specialisation, though it could have the possible advantage of saving the firm from
overdependence on a limited set of competences that may be vulnerable to obsoles-
cence.
Figure 6.1 shows the situation facing our Firm 3 (in the middle) and our Firm 8
(on the right) as set out in our earlier Figure 5.2. As Figure 6.1 indicates, if Firm 3
were to merge with Firm 8, it would generate a high level of linkages in all our major
categories. We were not really considering international or multinational options in
the last module, but we rectify that now. Suppose that instead of expanding domes-
tically, Firm 3 is thinking about expanding multinationally. It plans to do this by
buying up a foreign firm (Firm 17) in a second country. Firm 17 already has an
established manufacturing and distribution presence in that country. Now, what
links could Firm 3 expect to be able to exploit as a result of going multinational?
sales force
trucks
Distribution Distribution Distribution
marketing dept
market research
Marketing Marketing Marketing
advertising
plant
Production Production equipment Production
labour force
research
R&D R&D development R&D
Firm 17 ... multinational expansion ... Firm 3 ... and domestic expansion ... Firm 8
Figure 6.1 Resource implications of domestic versus multinational

expansion
The obvious answer is, not many. Firm 17 and Firm 3 have separate operating
facilities in the respective countries, which is how a multinational is in fact defined.
So there is no potential gain from sharing resources on the production side. They

service separate markets and have separate distribution channels, so there is no

obvious resource sharing to be achieved on those grounds either (though we shall
suggest later that there may be some marketing economies that some multinationals
may exploit in practice).
The one area where an obvious gain could perhaps be made in the long term is
R&D. If it is possible for the two plants in the different countries to share technol-
ogy, then one set of technical blueprints may do where two were needed before.
This is shown in Figure 6.1 where Firms 3 and 8 can achieve economies from
sharing research and development.
We have used the example of multinationalism through merger in this example,
but it should be noted that similar points hold if Firm 3 had pursued a multinational
strategy through internal expansion. If it had started up a new plant in the second
country to service that country’s market, it would also have required new marketing
and distribution channels to sell the product in that country. Multinationalism is
quite simply a bad deal in terms of resource linkages, certainly compared to the
domestic specialisation option that Firm 3 could exploit with Firm 8 in Figure 6.1.
At least this may go some way towards removing our earlier puzzle of why firms
appear to prefer to stay at home and concentrate their sales and assets in home
markets. However, this merely suggests another puzzle. If multinationalism is
apparently such bad news for firms in resource-based terms, why would any firm
wish to go multinational?
We could also note that in practice firms may be able to service foreign markets
by means other than going multinational; for example, they may be able to export to
those markets. However, if anything this only helps to compound the puzzle of
multinationalism when we consider the possible resource implications as in Figure
6.2. If our manufacturer of M/C jackets were to export to this foreign market, then
exporting would allow the concentration of production in the home base and
possible exploitation of economies of scale in production. Even if the firm can
exploit few physical economies of scale from further expansion of production, there
should still be administrative economies compared to the alternative of having to
administer separate production facilities in different countries as in the multinational
alternative.
Of course resource costs such as cheap labour in the production process could
encourage the jacket firm to relocate its production to an overseas location. Some
multinationals do this, and we shall see it is a valid strategy. What this does not
explain is the tendency for many multinationals to expand some production abroad
while still keeping a strong production base at home. If international location of
production were simply a matter of resource costs of production, we would expect
to see production of a good concentrating in the single lowest-cost location.

Distribution Distribution Distribution
Marketing Marketing Marketing

plant
Production Production equipment Production
labour force
research
R&D R&D development R&D
Firm 17 multinational enterprise ... Firm 3 ... and exporting
Figure 6.2 Resource implications of multinational versus exporting

strategies
Alternatively, transport costs might seem to be an argument against exporting and
in favour of saving on transport costs and locating production near foreign markets
through multinational expansion. However, transport costs tend to be important in
cases where a product takes up high volume (e.g. expanded polystyrene) or signifi-
cant weight (e.g. iron ingots) in relation to value added. This was a more serious
issue for many global markets in the days when many traded goods and services
were bulky and heavy basic commodities in relation to value added. It is less of an
issue for many of today’s sectors with their emphasis on high technology, high
value-added products such as computers, instruments and pharmaceuticals. While
transport costs undoubtedly exist in each of these sectors, in themselves they are not
sufficient to explain why some firms choose to fragment and disperse their produc-
tion capabilities into a variety of different locations scattered around the world.
However, we are not finished with the potential problems of internationalism yet.
Compare the exporting option in Figure 6.2 with the domestic option in Figure 6.1.
The domestic option has the happy virtue of allowing the firm to share resources in
all main categories, when exporting only really allows for resource sharing on the
production and R&D side. Of course, it may well be the case that the firm has run
out of room to expand domestically and that market saturation has encouraged it to
seek overseas markets in pursuit of further growth. But suppose the firm were to
concentrate on domestic markets instead of expanding into overseas markets, say by
diversifying into leather trousers (merging with Firm 7 as in Figure 5.3). In this case
the firm could exploit linkages in R&D, production, distribution and marketing as
we saw in Module 5. Some resources will be specific to jackets and trousers respec-
tively, but to the extent that they can be shared it will allow the firm to exploit
economies of scope across the board.
Will the production and R&D economies from exporting into strange new mar-
kets be sufficient to beat the economies from diversification that the firm could
achieve from concentrating in its home markets? Clearly this will also depend on the
demand side and how the markets for the domestic alternative compare with
opportunities in export markets. But it is sufficient to point out at this juncture that
it is not enough to establish international opportunities to justify international

expansion. These opportunities will only be worth pursuing if they beat alternative
domestic investment opportunities, taking into account the ability of the firm to
compete against foreign firms on their home ground.
We shall try to unravel some of the mysteries of internationalism and multina-
tionalism below. To begin with we need to set the context by exploring the national
and international context in which firms’ corporate strategies are framed. We shall
start by considering Michael Porter’s approach to the competitiveness of industry in
an international context.
6.2 The Question of International Competitiveness

In his Competitive Advantage of Nations, Michael Porter (1990) made some crucial
points about the idea of ‘competitiveness’ of industry seen from a national perspec-
tive.
 Is competitiveness of industry based on exchange rate? But over sustained
periods Germany combined economic growth with an appreciating exchange
rate.
 Is competitiveness based on cheap labour? But Sweden sustained long
periods of economic growth on the back of relatively expensive labour.
 Is competitiveness based on cheap natural resources? But Japan achieved
rapid economic growth in the post-war period with very little in the way of in-
digenous natural resources.
We should be careful of swinging too far the other way and saying that exchange
rates, labour markets and access to natural resources do not matter. Germany,
Sweden and Japan have all faced problems in recent years and there has been a
considerable debate about the nature and sources of the problems they face.
However, the basic point that Porter is making is a sound one, that it may be
simplistic and indeed misleading to identify a cheap currency or cheap resources as
necessary or sufficient for competitive advantage. If (as we saw in Module 2) low
cost is not necessarily the only or even the best strategy for firms to achieve
competitive advantage, we should not be surprised to find that the same holds at the
level of countries.
Indeed, Porter makes the point that we have to be careful in using the notion of
competitive advantage at the level of countries at all. He argues that countries do
not compete, firms do. Politicians talk of the problem of improving the competi-
tiveness of their country or trading bloc compared to others in the global
marketplace, but firms inside a country may often identify their fiercest and most
direct competition as other competitors in that domestic marketplace. Not only is
the home base of even a major multinational likely to figure strongly in that firm’s
strategy (as we saw above), it may feature other competitors sitting on their shoulder
and breathing down their neck (with apologies for the mixed metaphor!). So a
Hollywood film maker is more likely to be worried about other Hollywood film
makers, while a French haute couture firm may be most conscious of other French
haute couture firms. It is not simply a case of American firms competing against
European firms or German firms competing against Japanese firms.

There are two other important observations that Porter makes before we begin
to look at the link which provides the basis for international competitive success.
 For a given country, there are typically few industries or segments of industries
which perform strongly in an international context.
 For a given industry, or especially segments of industry, there are typically few
countries which perform strongly in an international context.
This may seem rather surprising at first sight. For example, there is a general belief
that the Japanese are so efficient that they can beat firms from most other countries
at any activity they care to turn their hands to. In fact, their international success is
quite concentrated in a selective number of highly visible industries such as automo-
tives and consumer electronics. There are other areas where Japan has not been so
internationally successful, such as the food and the advertising industries. The case
of Kao (Exhibit 4.6) shows how even a successful Japanese company may face
difficulties in transferring its domestic advantage into the international arena.
The second point also becomes more apparent the more deeply we delve down
into specific sectors within industries. There are only a few countries that are
internationally successful in the automotive industry, and the numbers that have a
major international presence dwindle when we look at sectors within each industry.
We saw in Exhibit 4.2 how Sweden became a dominant player in the heavy trucks
segment, building on strong domestic competition between Scania and Volvo.
One thing that should also be noted before we start is that we may have to ques-
tion received wisdom about the sources of competitive success if we are to
understand the sources of international competitiveness. Consider this dilemma.
You are a maker of widgets choosing between producing and selling in Country A
or in Country B. The countries differ in the characteristics indicated in Table 6.1 as
far your business is concerned, but are similar in all other relevant characteristics,
such as size of domestic market and access to capital. Now, where should you locate
your business?
Table 6.1 Where to compete: soft versus tough environments

Country A Country B
Firms You would be the only firm Many fierce and capable rivals
Consumers Easy to please, undemanding Well informed and
sophisticated
Government Lax regulations and controls Tight regulations and controls
Factors Abundant and cheap resources Scarce and expensive
resources
On the face of it, there would seem to be little room for debate. If you were to
sketch demand and cost curves for the opportunity, you would find that examples
of market structures described in the textbooks appear. Country A represents a
monopoly opportunity while Country B is characterised by highly competitive
conditions. In Country A you would be a monopolist by definition since you would
be the sole firm. You would also be able to exercise more control over this market

due to the placid nature of consumers in this market (suggesting the demand curve
may not be very elastic). An acquiescent government would let you get away with
your monopoly profits while cheap resources would push your cost curve down
compared to cases such as Country B.
In the case of Country B, the highly rivalrous nature of the industry would put
pressure on profitability while well-informed consumers could play one firm against
another in terms of price (suggesting a highly elastic demand curve market) or
performance. The tight regulatory regime could be expected to push up costs and
make it difficult to keep excess profits even if you could find them in this hostile
environment. And if all this did not finish you off, you still have to cope with the
high cost of factors of production in Country B compared to Country A.
So there would appear to be no contest between Country A and Country B;
simple textbook economics suggests that it has to be Country A. That’s fine, and it
is what we would expect. The problem is that when we look at firms that are
internationally successful in practice, they frequently come from countries with
some or all of the characteristics of Country B. In fact, Michael Porter goes further
and claims that they may be more likely to come from countries like B than coun-
tries like A.
Take, for example, the role of rivalry. Which part of the world has one of the
most fiercely competitive and rivalrous film industries in the world? Hollywood.
And what is the most successful film-making country in the world? The United
States. Now the role of demand: what do you think of when asked to name coun-
tries with successful fashion industries? Probably France and Italy. And whose
country’s consumers are amongst the most fashion-conscious in the world? France
and Italy. As far as government regulations are concerned, Porter points out that
Sweden’s early lead in setting high product safety and environmental standards
benefited its firms in a variety of industries in foreign markets when other countries
began to introduce their own regulations. Finally, factor conditions: name one
developed country with no significant reserves of the metals that go into making
motor cars, or the petroleum it uses as fuel. I would nominate Japan. And what
country has revolutionised the global car industry in the post-war period? Japan.
Of course it would be dangerous to believe that a single element is behind com-
petitive success in these industries. Indeed, as we shall see, it will tend to be a
combination of elements that contributes to international competitiveness or failure
at industry level. But before we consider this further, does this mean that we can
throw out our old economics textbooks? Why does it seem that the conclusions and
predictions of standard economics no longer apply in this area?
In fact there are two issues at work here, and we can summarise them as space
and time. First, consider space. Standard economics tends to look at firms and
sectors in isolation (‘partial equilibrium analysis’). That helps to sort out issues and
prevents the complications of trying to see how everything depends on everything
else. But sometimes issues in other spaces or territory can be very important.
Suppose, for example, Country A and Country B were territories that had been
economically separated from each other because of a feud. Over that period, the
markets for widgets behave just like the textbook pictures of monopoly and

competition that they appear to be at first sight. Now the two countries make peace
and open up trade in widgets between themselves. If you are the sole widget maker
in Country A, you probably would not know what hit you as a flood of imports
from tough streetwise widget makers come streaming over the border from Country
B (as we shall see later in Exhibit 6.3).
The second issue is time. Standard economic analysis that appears in the text-
books tends to be concerned with given technology and, when it talks about the
long run, it only means a period over which fixed costs such as plant and machinery
become variable, not usually a period long enough to allow for technological change
to be incorporated in plans. Major technological and organisational upheavals and
transformations tend to lie too far in the distance to be dealt with by standard
economic tools. The problem is that it is these longer time dimensions that can be
associated with the forces which may create and sustain competitive advantage and
which we need to look at in this context. Today’s comfortable monopolist may be
tomorrow’s bankrupt firm.
So there is nothing wrong with standard economics tools as long as we recognise
their limitations and do not expect them to give sound answers to questions in time
and space that they were not designed for. In the next section we shall look at the
forces that may come into play when we search for the sources of sustainable
competitive advantage in an international context.
6.3 Porter’s Diamond Framework

Michael Porter argues that competitive strategy for a firm should be framed in the
context of the attributes of its national environment that may help generate or
inhibit competitive advantage. These attributes fall into four main categories, which
together go to make up Porter’s Diamond Framework: (A) factor conditions; (B)
demand conditions; (C) linked and related industries; (D) firm strategy, structure and
rivalry. Consistent with the discussion of the previous section, the important driving
forces of the Diamond can be analysed in terms of space and time.
 Space considerations. The space covered by the relevant Diamond is essential-
ly contained within the home base (usually the nation) to which the firm belongs.
Home base can exert significant influence over each of the four categories of the
Diamond Framework for a particular firm. An important unit of analysis here is
the cluster (a group of firms in linked or related industries that trade or compete
with each other). A cluster typically occupies an even more localised space than
the nation state, and in practice may be found within regions, cities, districts or
even single streets (e.g. Madison Avenue, New York for advertising, Harley
Street, London for medical specialisms).
 Time considerations. Time or dynamic considerations reflect the fact that the
normal logic of competitiveness may be turned on its head once we look at the
time periods long enough to allow for major innovative and organisational
changes. We saw some examples of this in our discussion of Table 6.1, and we
shall see how the Diamond Framework develops these points into an approach
that can help in the framing of company strategy.

We shall look at each of the four attributes in turn in terms of how space and
time considerations may influence international competitiveness.
(A) Factor conditions

These can have a critical influence on competitive advantage. Porter distinguishes
between factors in terms of:
1. Degree of sophistication. At one end of the spectrum of degree of sophistica-
tion we have basic factors which tend to be inherited (such as natural resources) or
easily created (such as unskilled labour) and at the other we have advanced factors
(such as a research scientist) which are more sophisticated.
2. Degree of specialisation. At one end of this spectrum we have generalised
factors which can be turned to many different kinds of tasks (such as a village
hall) while at the other end we have highly specialised factors whose value lies in
a limited set of tasks or one specific task (such as a brain surgeon).
It is natural to think of basic factors as more likely also to be generalised factors,
and advanced factors as being more likely to be specialised, as in some of our
examples here. However, some advanced factors can be generalised and designed to
help the user adapt to a variety of tasks (e.g. an MBA degree) while some basic
factors can be highly specialised. Nevertheless, while degree of specialisation may be
linked to the notion of asset specificity discussed in Module 4, specialisation does
not guarantee specificity. For example, our brain surgeon may be in high demand all
over the world for her skills and therefore have a low degree of asset specificity in
terms of not being tied to one potential user, even though there may be a limited
range of tasks that she may be called on to perform.
One of the most important issues that Porter introduces in this context is the
notion of selective factor disadvantage. Selective factor disadvantage occurs when relative
scarcity or other problems of a certain factor stimulate technological or organisa-
tional innovation to deal with the problematic factor, and this innovation turns out
to help generate subsequent competitive advantage in an international context.
Table 6.2 shows some examples of selective factor disadvantage and their subse-
quent benefits in terms of competitive advantages for the firms that encountered
and dealt with them.
The point about selective factor disadvantages is that they can pose short-term
problems for firms that experience them, stimulating an innovative response that
can result in eventual competitive advantage. For example, the ideographic (picture-
based) Japanese language posed more obvious difficulties for communication
purposes than did phonographic systems such as the English alphabet based around
26 letters. This added to communication barriers or costs. Because fax technology
was more suitable for sending pictures than conventional cables or telegram
systems, it was developed earlier in Japan than in the rest of the world and then
subsequently gave the Japanese an edge in the international market for this technol-
ogy.

Table 6.2 Selective factor disadvantage

Japanese language → fax technology
Distances in US → communications and transport
innovations
Short Swedish building season → prefabricated technology
Suppose you have a short building season in northern climes. As Porter notes (see
Table 6.2) the Swedes have shown how this can be turned to advantage if it stimu-
lates you to become a leader in prefabricated building technology. On an even larger
and broader scale, the great distances between US centres of population impeded
communication and transport between centres of population in the nineteenth
century. This stimulated waves of technological innovations in telephone, railway,
car and aircraft technologies that in turn provided a basis for global competitive
advantage in these sectors that the US was able to sustain for decades to follow. As
Exhibit 6.1 shows, another factor disadvantage has been at work in helping generate
streams of other kinds of technological innovations by the US.
Exhibit 6.1: Scarce resource, abundant innovation

We noted in the main text that the factor disadvantage of distance helped stimulate a
stream of technological innovations by the US. There is another class of innovation in
which the US has excelled, influenced by another factor disadvantage. Innovations in this
class range from industrial processes (the assembly line for the Model T Ford) to
consumer goods (the washing machine, the dishwasher) to innovations that could be
both consumer good and industrial process (the sewing machine).
There are many social and economic explanations as to why the US has been such a
creative and innovative society, but selective factor disadvantage can help to explain why
this innovative activity was focused in particular directions. Imagine John Wayne riding
through Arizona in a stagecoach. What is the scarce resource in this picture? Is it land?
No, we have the wide-open spaces. Is it natural resources? No, we have the mineral
wealth of the US. The scarcest resource is John Wayne himself, or more broadly labour
in the production process. Problems of scarcity of labour as the US grew pushed up
wages and salaries.
As well as attracting waves of immigrants, these high labour costs made it worthwhile
to search for labour-saving innovations that increased productivity (such as the assembly
line) and economised on this expensive factor. And high labour costs were translated
into high incomes when the worker left the factory door and became a consumer.
These high incomes created early markets for (and innovations in) labour-saving
consumer goods that many US consumers could afford but which in the early days still
represented unattainable luxuries for most of the rest of the world (such as the washing
machine). This gave the US an early lead in many industrial processes and consumer
markets that they were subsequently able to exploit in global markets.
Japan is poorly endowed with natural resources including fuel. In what way
could its absence of oil reserves be regarded as a selective factor disadvantage?
Compare with the US.

In each of these cases there was a factor disadvantage which created immediate
costs or barriers to industrial activity and triggered a search for innovative solutions
which not only alleviated or neutralised the original source of disadvantage, but
turned out to be a source of international competitive advantage. A shorter-term
audit of industrial potential would simply have noted issues that added to communi-
cation costs in Japan, travel costs in the US and building costs in Sweden. All this
was true, but these same issues contributed to the eventual success of sectors that
encountered these problems to begin with.
As might be expected, the opposite can hold in some cases where a nation pos-
sesses a factor in abundance. One of the most obvious examples of this was the
US’s technological base in gas-guzzling fuel technology which caught it out in the
seventies when fuel-efficient Japanese cars made major inroads into world markets
on the back of the energy crisis. Since petroleum had been traditionally cheap and
plentiful in the US, it was not well placed to compete in a world in which oil was an
increasingly scarce commodity, though the fall in the real price of oil over a period
of years following the sharp increases of the seventies muted these disadvantages to
some extent.
So factor disadvantages, including scarcity, can turn out to stimulate eventual
competitive advantage, while factor advantages, including abundance, can eventually
lead to declining competitive advantage. The problem is that not all sources of
factor disadvantage turn out to have this eventual benign effect, any more than
factor abundance need turn out to be an eventual source of declining advantage.
Despite active searches for industrial substitutes by other countries, the world’s
producers of platinum and diamonds still trade successfully on the global markets in
these areas. And if factor disadvantage was a guarantor of eventual success, the
Arctic should be one of the most dynamic economies on Earth.
The trick is to find an area (such as fax technology) which both reflects a factor
disadvantage and which may stimulate innovation which will give an eventual
advantage in the world’s markets. Such things are extremely difficult to forecast in
practice. The important point is to recognise that short-term costs (and benefits)
associated with particular kinds of resources may reverse themselves once the future
unfolds. Failure to recognise this may mean companies do not position themselves
to exploit opportunities or that they fail to anticipate threats.
(B) Demand conditions

Demand conditions play an integral part in Porter’s Diamond in determining
whether or not a country has achieved or can achieve a competitive advantage in a
particular area. At first this would appear to be hardly surprising since clearly the
market for a good or service will be an integral part of determining the extent and
nature of any competitive advantage. However, what is exceptional about Porter’s
Diamond compared to traditional approaches is the emphasis it gives to the role of
home or domestic demand.
We can immediately link this argument to the observation we made above about
home-loving firms. Remember it is typically the case that much or most of a firm’s
resources (including its strategic planners) are based in its home market and much

or most of its sales are to domestic consumers. We should not then be surprised if
we find that the qualities of the domestic market have a significant effect on the
framing of firms’ competitive strategies for good or ill.
So the home market may dominate in terms of the quantity of information feeding
back into the framing of competitive strategy. But it may also be important in terms
of the quality of the information that feeds back into the planning process. If those
involved in the formulation of strategy are based in the same country as the firm’s
headquarters and home market, they are likely to be heavily influenced by the
characteristics of that domestic market. The senior R&D and marketing personnel
responsible for developing, say, a new domestic heating system will have a vision of
the types of house that the system is designed for. Such a vision is likely to be
coloured (consciously or unconsciously) by their own direct experience and observa-
tions of housing design, consumer characteristics, planning regulations and climatic
conditions in the home market.
Porter argues that there are three main features of demand conditions that can be
important in a dynamic context in terms of helping develop and reinforce competi-
tive advantage.
1. Composition of home demand. As we have just noted, the composition of
home demand can provide pressures and opportunities since the signals coming
from home demand can be clearer than the weaker signals coming from foreign
markets. Porter notes that the main issues here include:
(a) Segment structure of demand: the distribution and variety of patterns of demand
within a sector.
(b) The existence of sophisticated and demanding buyers: sharpening up and honing the
competitive skills of firms that could prove useful in competing against firms
that have had an easier life. L’Oréal (Exhibit 6.2) illustrates this point.
(c) Anticipatory buyer needs: providing an early warning system and experience of
trends that may emerge in the future in foreign markets.
2. Demand size and pattern of growth. There are a number of features here that
can reinforce the effects of home demand composition on competitive ad-
vantage.
(a) Size of home market can help generate economies of scale and learning curve
effects.
(b) Number of independent buyers, including at wholesale or retail levels can generate varie-
ty of information and market feedback, and reduce the chance of inertia for
firms that attend to this source of information.
(c) Rate of growth of market demand: advantages of a growing market include possi-
ble entry room for innovative new firms – otherwise incumbents may have
an inbuilt advantage if the customer base does not change and expand.
(d) Domestic market saturates early: this may stimulate fierce rivalry amongst domes-
tic firms that can enhance cost competitiveness and innovativeness and in
turn enhance their fitness to compete on a world stage.
3. Internationalisation of home demand. These aspects can help pull a nation’s
products abroad.
(a) Mobile or multinational buyers: the internationally mobile customer may seek to
buy or be receptive to buying the products that they consumed at home.

(b) Influences on foreign needs: historical or cultural factors may influence the pattern
of demand in foreign markets.
Exhibit 6.2: L’Oréal
L’Oréal is a French company which shows how technical advantage can encourage
multinational expansion in an industry usually associated more with marketing competenc-
es – cosmetics. Although this industry is usually thought of as associated with luxury
products where consumers are not usually seen as being particularly price-sensitive, there
is a mass market segment where prices and costs are important. The French, with their
cluster of industries around fashion, design and cosmetics, have a strong marketing image
and established reputation in the luxury end of the market. The US, with its expertise and
emphasis in volume production and consumer marketing, has the skills that have helped its
firms create a strong presence at the mass market.
L’Oréal is a company that has adapted technology designed for its luxury brands such
as Lancôme to producing its mass market brands at low cost. This cost cutting has allowed
it to introduce new brands at progressively lower prices without severely hurting margins.
Like Scania (see Exhibit 4.2) it has sought to reduce the number of basic components that
the various product lines draw on (in this case, caps, bottles, boxes, etc.) while maintaining
the variety in the final product range. It is also exploring ways of simplifying ingredients,
though this is more difficult because of its implications for the make-up of the final
product.
It bought Maybelline, an American cosmetics firm selling to the US mass market. This is
part of L’Oréal’s strategy of expanding overseas to exploit its expertise in mass volume
cosmetics production as well as finding outlets for its existing brands. This also brings it
head to head with US-based mass marketers of cosmetics, such as Procter & Gamble.
While many companies make their brands culturally neutral to make them internation-
ally acceptable, L’Oréal’s strategy is to embody their country of origin as a brand
characteristic, and it continued that strategy with Maybelline.
L’Oréal also decided to set up a second creative base in New York, with R&D, market-
ing and advertising functions. The idea was to take advantage of the different cultural
perspectives in the US context. Paris and New York both use the same basic R&D but
compete in marketing. L’Oréal also developed a strategy to introduce hair care products
by Redken (one of its US brands) into the French market, even though this would bring it
in to direct competition with the L’Oréal Preference brand. L’Oréal believed the benefits
from the brand competition would outweigh any disadvantages from Redken cannibalising
L’Oréal.
Analyse L’Oréal’s strategy in the context of its national Diamond. Do you think
this is a sustainable strategy?
The various elements of demand may interact and have a cumulative effect in
particular cases. Table 6.3 gives examples, some taken from Porter’s analysis of how
these different elements have helped stimulate competitive advantage in particular
contexts.

Table 6.3 Demand conditions and competitive advantage

Demand Example Competitive
condition advantage
Segment structure ____ Tunnelling mountain → Switzerland
of demand
Sophisticated and ____ Stereo equipment → Japan
demanding buyers
Anticipatory buyer ____ Fast food → US
needs
Size of home market ____ Icebreakers → Finland
Number of ____ College textbooks → US
independent buyers
Rate of growth of ____ Personal investment → US
market demand advice
Domestic market ____ Some areas of → Japan
saturates early consumer electron-
ics
Mobile or ____ International hotel → US
multinational buyers chains
Influences on foreign ____ Commonwealth → UK
needs links for higher
education
(C) Linked and related industries

An interesting point developed by Porter is that internationally competitive indus-
tries and sectors tend not to emerge in isolation but instead are associated with
other internationally competitive industries within their nation or region. These
industries or sectors may be linked vertically or horizontally to each other.
We have seen that demand conditions may have a strong influence on competi-
tive advantage through proximity of national and local markets. Similarly, linked and
related industries can also exert a strong influence on the competitive advantage of a
sector through the proximity of innovative and enterprising companies in neigh-
bouring sectors. Competitiveness and high performance in one sector can have spill-
over benefits into linked and related sectors in the domestic market through a
variety of means:
 User sector firms imposing high specifications on supplier sector.
 Reputational spillovers.
 User sector firms demanding cost competitiveness from supplier sector.
 Supplier sector protecting their brands by raising user sector performance.
 Technology spillovers between related sectors.
 Related sectors sharing marketing and distributional channels.
 Spillover of highly-trained and well-qualified labour pool between sectors.

 Best practice diffusion by example and observation.

 Proximity reduces transaction costs between sectors.
The fundamental point is that sectors may benefit in a variety of ways that en-
hance performance or reduce costs from having an internationally competitive
sector nearby. These may include forcing a related or linked sector to raise its
standards by direct pressure or example, indirect benefits in the form of externalities
or spillovers, or simply the ability for high-performing sectors to reinforce each
other’s performance because proximity reduces communication problems and
transaction costs.
(D) Firm strategy, structure and rivalry

The final major element in the Diamond Framework is the role of firm strategy,
structure and rivalry. These can include a wide variety of social and cultural aspects,
and indeed this links with work by Francis Fukuyama, who has shown the im-
portance of these issues in economic activity. Like Michael Porter, Fukuyama shows
the importance of national, regional and even local connections in this context. For
example, while we saw the importance of the concept of opportunism in Module 4,
Fukuyama (1995) shows that trust (which can effectively be defined as the belief
that another party will not act opportunistically) can also be an important influence
on economic activity, and the way it exercises this influence depends on national
and cultural characteristics.
Fukuyama gives the example of the way that trust manifests itself in Japanese and
Chinese societies. In Japanese society, trust tends to be well distributed throughout
society; breaches of trust are so rare and severely regarded that it is natural to
assume that the other person can be trusted unless proven otherwise. This facilitates
the growth of large organisations such as the Japanese multinationals since it
diminishes or eliminates the principal–agent problems (of the kind we discussed in
Module 3) that can prove a barrier to the growth of firms. On the other hand,
Chinese society tends to place high value on family and kin relationships and embed
trust in these relations. This favours the growth of family-owned businesses but it
means that Chinese-owned firms can face blocks to further growth once the size of
the firm outruns the ability of family to control it. Reluctance to sacrifice family
control to professional managers can limit the ability of Chinese firms to grow and
go multinational. A simple cultural difference like this can have a profound effect on
the organisation and competitiveness of sectors and firms. And as we shall see, they
can also influence the kind of sectors in which a country is more likely to develop a
competitive advantage. Important themes in this context include the following.
1. Strategy and structure of domestic firms. As an example of this, Porter
argues that the value placed on technical skills in Germany has helped create and
support its competitive advantage in optics and some chemical and machinery
sectors. Italy displays some similarities to Chinese culture in placing a heavy
reliance on family and kin relations in economic organisation, which has helped
to encourage and reinforce Italian competitiveness in fragmented sectors such as
furniture, footwear and woollen fabrics.

2. Goals and objectives. Goals and objectives can be important at the level of the
individual, the company or the nation, and can be heavily influenced by the cultur-
al context. For example, Porter notes that Germany has a tradition of long-term
holding of shares by institutions and a more cautious approach to risk taking. This
tends to lead to an emphasis on mature industries in Germany (such as commodity
chemicals). On the other hand, the US has an extremely active share trading sys-
tem and a culture that tends to encourage the taking of risks; failure such as
bankruptcy is not given the social stigma attached to it in some countries. This
tends to encourage an emphasis on start-ups in general, and in particular sectors
that are characterised by start-ups, such as biotechnology.
3. Domestic rivalry. This is one of the most important aspects in the Diamond
Framework. When the industrial structure of internationally competitive indus-
tries is dissected, it often turns out to be based on strong domestic rivalry
between firms. The firms themselves may even be located close to each other
within a small region or district of a country, as in the case of Silicon Valley in
northern California and Hollywood in southern California. In some cases they
may involve a few large firms, as in the case of the Swiss pharmaceutical firms
and Scania/Volvo (Exhibit 4.2). Rivalry both exerts competitive pressure on
firms to upgrade their performance and provides direct and visible examples of
best practice that are easier to observe at a local and neighbourhood level than
from a distance. In this respect it has some of the qualities that we discussed
above which help in the formation and maintenance of clusters of related and
linked industries. The case of Ficosa (Exhibit 6.3) illustrates the importance of
rivalry in a domestic context helping to stimulate and improve the competitive-
ness of local firms.
Exhibit 6.3: Ficosa
Spain is a country that has not been associated with multinational activity until relatively
recently. However, a number of Spanish firms have begun to expand overseas in recent
years. Barcelona’s Ficosa International is a case in point: it grew as a $305m auto-parts
supplier making components such as windscreen washers and mirrors. It had factories
throughout Europe and Latin America. It ranked among the top three in Europe for
components, with sales to GM, Volkswagen and Ford accounting for about 60 per cent
of revenues. However, it had no multinational presence, and indeed about 96 per cent
of its sales were to the Spanish market.
A catalyst for many companies such as Ficosa was the accession of Spain to the Euro-
pean Union. Until that point, many Spanish firms such as Ficosa had been protected
from foreign competition by various trade barriers. Once Spain’s internal markets had
been opened up through joining the European Union, Spanish firms found themselves
suddenly facing fierce competitors invading their domestic markets from other parts of
the EU. Staying still was not an option since the fitter market entrants would eventually
have wiped out domestic competitors like Ficosa.
Ficosa responded by learning from the competitive pressure of their new rivals and
observing their strategies. In turn it became a multinational itself, producing and selling
in other European Union countries such as the UK and France. This was also a demand-
ing and useful learning experience as it faced further fierce rivalry from established
players in the markets. The firm then expanded further with factories in Central and

South America and Asia, with impressive results in terms of performance. One of its
most interesting strategic decisions has been to locate an engineering facility in the heart
of the North American automotive Diamond – Detroit.
Is Ficosa asking for trouble in locating an engineering facility in Detroit, one of

the fiercest competitive arenas in the global automotive industry?
This has two very important implications both for public policy and corporate
strategy. First it suggests that the idea of creating ‘national champions’ (single firms
with international aspirations and a dominant position in their home market) may be
mistaken. The idea behind national champions is quite consistent with the standard
economics textbook picture of market structures that we discussed earlier. If a firm
is dominant in its domestic market, the textbook picture suggests that this can give it
the substantial financial resources (from market power on the demand side and
economies of scale on the supply side) that may be deemed necessary to compete on
the global stage.
The problem is that this is not how firms achieve international competitiveness.
The process of creating a national champion removes the spur of domestic competi-
tion and rivalry that can be an essential component in the competitive process. In
pursuing the short-run strengths of domestic monopoly power and static economies
of scale, the price may be the dynamic pressures and opportunities provided by the
existence of a multiplicity of firms.
The second associated issue is that it suggests that both firms and policy makers
should at least be wary of the supposed advantages of domestic mergers. The
apparent gains from merger may be more than offset by the loss of competitive
dynamism over the long haul. Since, as we shall see in the next module, mergers
tend to be disappointing in terms of their recorded performance anyway, this
suggests that it may be a strategy which may have even deeper problems than are
visible at first sight. At the very least it implies that merger activity should be
carefully worked out and justified before it is taken in the first place, especially if it
threatens to reduce radically the extent and degree of rivalry in a domestic context.
(E) The jokers in the pack: chance and government

Porter adds that both chance (e.g. wars and inventions) and government can play
roles in the relationships which evolve in the Diamond in the context of creating an
international competitive advantage. The effects may be partial and not sufficient to
create and sustain a competitive advantage in practice. The effect of government
may be benign, especially if it is designed to reinforce and fine-tune some positive
aspects of the Diamond such as relevant labour pool training and skills. However,
problems can be encountered in cases where government is overly interventionist
and pursues clumsy attempts to direct resources and corporate strategies.

6.4 Using the Diamond Framework

Porter’s Diamond Framework provides an interesting and persuasive account of the
influences at work in the development of national advantage. But can it help firms
in the framing of their competitive strategy? The answer appears to be that it can
provide useful guidelines, and indeed governments as well as firms have been
exploring the implications of the Diamond in recent years. While firms may be
concerned with the framing of their competitive strategy, policy makers in govern-
ment have explored the implications of domestic clusters and whether and how they
can do anything to help their formation, and maintain their robustness once they
have formed. They can also try to identify generic or background elements in their
nations that may be of general relevance for corporate strategy and industrial policy.
The Diamond is a tool which draws on many issues and can have a number of
abstract elements such as culture, legal context and corporate objectives. However,
the operation of the Diamond can result in highly visible real-world clusters of firms
in particular regions of the world. The task is to construct and use the Diamond
framework in ways that will help to illuminate and inform strategy and policy. There
are a number of issues that are relevant to building a Diamond that may be helpful
for analysing a particular sector in its national context, as well as other issues of
relevance to the formation and maintenance of clusters in general.
6.4.1 Identifying and Using a Diamond

The Diamond is similar to Porter’s Five Forces Framework in that it combines the
rigour of economic analysis with the comprehensiveness of the checklist approach
common in areas such as strategic management. For example, selective factor
disadvantage may not appear in the standard economics textbooks, but it is founded
on the basic economic principle that scarcity of resources can stimulate searches to
find ways to economise on that resource. As in the case of the Five Forces Frame-
work, the items that appear on Diamond checklists tend to have an underlying logic
in terms of economic theory and empirical findings. Its fundamental merit is that it
is an organising framework that is as inclusive as possible of the elements that
influence corporate strategy and the formation of clusters. The forces that are
important in this context can operate over very long-run periods and it can take
years or decades for their effects to work through.
The scope of individual Diamonds can be exhaustive and far reaching and this
can create problems as well as opportunities for such analysis. Here are some of the
issues (and difficulties) that are raised in using a Diamond approach.
6.4.1.1 Interdependence of the Four Main Elements

An essential feature of the Diamond is that no one element can be isolated as ‘the’
element that has (or will) create competitive advantage for a sector in a particular
country. In practice, a number of elements will contribute and interact with each
other. For example, the origins and growth of the Italian ski boot industry were
supported by a number of strongly interacting elements in different categories, as
Exhibit 6.4 illustrates.

Exhibit 6.4: Italian Ski Boots

Michael Porter in his Competitive Advantage of Nations gives the Italian ski boot industry
as an example of an industry which built up an international competitive advantage over
many years with the support of all four elements in the Diamond Framework.
Porter points out that the roots of the Italian ski boot industry predated the devel-
opment of skiing as a major leisure activity and built on local skills in a related and
supporting industry, the making and selling of leather hiking shoes. The Italian
consumer is sophisticated and fashion conscious, and this fed into strong and effective
home demand signals as the industry developed. At the same time, the strong craft-
based tradition in Italian industry along with the growing domestic demand contributed
to a widening and deepening of the factor base. This in turn fed into firm strategy,
structure and rivalry considerations, with many entrants and growing rivalry helping
stimulate rapid innovation in related and supporting industries such as in plastic
moulding and boot component industries. Eventually the saturation of domestic
demand encouraged Italian ski boot firms to internationalise, with the various condi-
tions encountered in their home Diamond developing their competitiveness and
enabling them to compete effectively in global markets.
What was the critical element in its Diamond that led to international competi-
tiveness for the Italian ski boot industry?
6.4.1.2 Essential Contribution of All Four Main Elements

As well as drawing from a variety of sources, Porter argues that each of the four
main categories in the Diamond should usually actively contribute to competitive
advantage if it is to be generated and maintained, though just as it may be possible
to have a three-legged chair in certain cases, so the absence of a strong fourth
element in the Diamond can sometimes be compensated for. For example, the
absence of strong domestic rivals may be at least partly compensated for if the
country has an open economy and the domestic firms face strong competition from
international rivals. In the special case of selective factor disadvantages, resource
deficiencies may actually turn out to have a longer-term benefit. But, just as a two-
legged chair is clearly unsupportable, so the most balanced outcome would be to
have a strong four-cornered arrangement in the Diamond with all four main
elements working to reinforce each other’s effects.
The case of Korea (Exhibit 6.5) illustrates how weaknesses in the different ele-
ments of the Diamond have helped inhibit the further growth and development of
that country.
Exhibit 6.5: Korea’s competitiveness

Korea is an interesting test case that helps illustrate the potential relevance of Porter’s
approach both to corporate strategy and public policy. When Porter published his
Competitive Advantage of Nations, Korea was a rapidly expanding economy that had based
its approach to growth on an export-oriented industrial strategy.
However, it was difficult to explain this success using the Diamond approach. It was
true that Korea placed a high value on education which would give it a solid foundation on

the factor side.

But its export-oriented approach to markets was often not based on strong and so-
phisticated domestic demand. It often had shallow industrial foundations and weak clusters
with no strong linkages to supplier industries. Corporate strategy was based around a
conglomerate strategy at the expense of focus and exploitation of links, within and
between firms. Government policy was heavily interventionist, reducing the discretion and
flexibility of corporate strategy.
Porter argued that unless Korean policy makers and strategists became aware of how
the country and its industrial base was at odds with the Diamond Framework, they would
eventually face problems in sustaining the impressive growth rates that they had achieved.
Since Korea had been one of the most successful economies in recent years, some
concluded that the Diamond was not picking up the essential elements that had helped to
fuel this strong economic performance – in short that the problems lay more with the
Diamond Framework and not with Korean policy and strategy.
The Asian financial crisis had a variety of contributory features and manifested itself in
different ways in different countries. However, the Korean economy suffered badly during
this period and many questions were raised about the appropriateness of aspects of its
industrial and corporate strategies, often along the lines earlier indicated by Porter. While
this does not of course guarantee that Porter’s Diamond Framework has no flaws, on the
whole the Asian crisis did tend to strengthen the hand of those who saw the Diamond as
helping to provide a universally sound basis for corporate strategy and industrial policy.
Porter’s Diamond Framework helps analyse the potential weakness of the Korean
industrial strategy. But what practical steps would be open to Korean policy
makers to remedy this situation?
6.4.1.3 Continuous Upgrading and Improvement

It was noted above that an essential feature of the Diamond is its emphasis on
dynamic aspects, in particular the processes that take place over time and influence
the evolution of particular sectors and firms. A further implication is that firms and
sectors may need to upgrade their skills, competences and technologies continuously
if they are to maintain their competitive advantage. This is particularly important in
the context of the Diamond since we rely on ‘snapshots’ of sectors and countries to
make sense of the structures and processes that are important at any point in time.
The important thing to remember is that, like snapshots, representations of the
Diamond at any point in time give a static picture. In practice the competitive and
technological environments of firms may be in a state of constant flux and we
should bear in mind that the essence of the Diamond is that firms’ strategies should
be designed to respond to, anticipate, and even initiate such changes.
6.4.1.4 Subjectivity and Multiplicity

There are two related points that should be emphasised concerning the Diamond
approach. First, while some of the elements may be pinned down with a degree of
objectivity (e.g. nature of the factors, size distribution of firms), other factors may
have to be assessed subjectively (such as cultural influences). Some elements (such

as nature and degree of inter-firm rivalry) may be judged on the basis of a combina-
tion of subjective and objective elements. Further, there may be a large number of
elements that may be of potential relevance to a Diamond and it may not be
obvious what weighting should be given to different elements or indeed to elements
which may be thought potentially important but in which the sector is weak or
deficient.
This reflects one of the features of the Framework which is both a strength and a
weakness, that is the comprehensive nature of the Framework compared to tradi-
tional economic analysis. It means that constructing and interpreting a Diamond
may be a matter of art as much as science. While sound logic and economic reason-
ing may be available to guide interpretation of the effect of individual elements
considered in isolation, judgement and skill have to be used both in identifying and
selecting relevant elements for inclusion in a Diamond, and in interpreting the
combined effects of the elements once they are included. This reflects the role of
the Diamond as an organising framework, but at its worst it can mean that two
different individuals could construct different Diamonds for the same industry, and
even interpret the significance of similar Diamonds quite differently. This may be
unavoidable and simply means that, like a stethoscope, the Diamond is a diagnostic
tool whose effectiveness depends on the skills of those who are using it.
6.4.2 Diamond in Action: US Competitive Advantage in Economics

Textbooks
We can use the Diamond Framework to show the implications for competitive
strategy in one particular industry. This case should not only help show some of the
reasons why this competitive advantage has evolved in the way it has, but also the
issues and difficulties that a firm has to face if it wants to break into this market.
The US dominates the world market for many academic textbooks and the case
of economics is illustrative. The standard for modern economics textbooks was
effectively set soon after the Second World War by Paul Samuelson with Economics.
Nowadays there are many other economics texts that offer alternative perspectives
in teaching introductory economics, though they still tend to follow the same basic
structure and discuss similar topics. The books of course differ in their style,
material and examples, but it still tends to be the case that the really successful texts
are American. Some countries, such as the UK, have produced alternative texts but
their success tends to be partial and limited to national boundaries, while another
strategy is to customise the US text by having authors in different countries adapt
the standard US text to their own country’s circumstances. None of this tends to
challenge the competitive advantage of US publishers seriously.
One way to examine why this should be the case is to undertake a Diamond
analysis of US publishing in economics textbooks.1 This should help illustrate the
sources of US competitive advantage as well as helping explore whether this
1 The interpretation here is aided by the author’s experience of university teaching in the UK, France
and Italy. He also spent two years as visiting associate professor in the University of California teaching
economics and MBA classes and has had five books published in the US as well as elsewhere.

advantage is sustainable and defensible, or whether firms operating could make

inroads into this market with the right strategy.
Table 6.4 The Diamond and US competitive advantage in economics textbooks

(A) Factor (B) Demand (C) Linked and (D) Firms’ strategy,
conditions conditions related industries structure and rivalry
Leading authors Large domestic market Advertising and Advertising-oriented
software industries
English language Anticipates wider Glamorous industry
trends
Major universities Sophisticated distribu- Risky venture
tion channels
Numerous rivals
Table 6.4 provides an interpretation of US competitive advantage in economics

textbooks using the Diamond framework. Clearly many of these advantages will
accrue to other kinds of textbooks also, allowing US publishers to achieve econo-
mies of scope in textbook publishing. Other aspects of the Diamond will also
accrue to many other US industries (e.g. the tendency for the US to have large
domestic markets), while other aspects of this particular Diamond may not prove so
important or useful in other US industries.
A noteworthy feature of this Diamond is that the US has strengths in all four
main elements, some of which are recorded in Table 6.4.
Factors: The US is well endowed with factors which textbook publishing in general
can draw on. It has many of the world’s leading universities employing many of the
academics who go on to become leading textbook writers. It has a network of
universities, libraries and research institutions that a writer can draw on for support.
It should not be forgotten that having English as a language is also helpful since this
is a working language for major parts of the academic and commercial world.
Demand: There are a number of demand-side features in the home market that have
contributed to the success of US firms in this sector, most obviously the sheer size
of the domestic market. This can enable successful textbooks to be cost competitive
and also make it worthwhile to add quality features such as colour graphics and
supporting software to help differentiate their product. Another ingredient is that
US universities tend to operate in a highly competitive system that depends on
developing a reputation for high teaching standards for mass education in ways that
some other countries are only now beginning to become aware of. The adoption of
a new first-year textbook can be regarded as a major strategic decision in US
universities and it may have to go through a rigorous examination process and be
exhaustively compared to competing texts before it is adopted. The degree of
sophistication and excellence of US universities serves as a good breeding ground
for authors; it serves also as a severe testing ground for texts.
Linked and related industries: If you want to develop and sell a successful introductory
textbook for first-year students, it helps if you can draw on the services of marketing
experts to design and launch it, and computer experts to help provide software

packages as backup. The US has a strong presence in these sectors. The actual printing
side tends to involve fewer strategic elements and more standardised elements. As we
noted in Module 4, this can mean that this stage is more able to be outsourced on a
simple contract basis and may be less likely to be considered a potential source of
competitive advantage.
Firm strategy, structure and rivalry: There are also a number of mutually supporting
aspects here which may help reinforce US competitive success. Launching a new
textbook involves a high degree of uncertainty. Even if you think all the important
pieces have been put into place, it is essentially a new product and therefore subject
to the problems that innovation may face and which we discussed in Module 3. It is
therefore an activity that is well suited to a risk-taking, entrepreneurial and market-
ing-oriented culture like the US. It is regarded as a glamorous industry in the US, so
it can choose from a pool of high-quality and able graduates. There are numerous
fiercely competitive publishing houses seeking to establish a presence or increase
their market share in various parts of the textbook market.
Finally clusters. Much of US publishing is clustered in major centres such as New
York, a phenomenon that has been even more apparent in the related industry of
advertising. The name ‘Madison Avenue’ not only labelled a street but conjured up
an image of an entire highly geographically concentrated industry.
As we noted above, subjectivity and multiplicity of factors mean that there is no
guarantee that this approximates the ‘correct’ representation of the Diamond for
this sector, even if it were possible to identify the correct Diamond in practice.
However, it does seem to capture some of the important elements at work in this
sector. The implications for strategy differ depending on whether you are a firm
inside the US-based cluster, or a firm outside it and looking in. That is the type of
question we shall turn to in the next section.
6.5 Framing Company Strategy

Porter’s Diamond has a number of implications for company strategy.
1. Possibility of competitive advantage depends on home Diamond. The
Diamond Framework emphasises the importance of a nation’s characteristics in
both enabling and limiting strategic possibilities for the firm. Whether a firm can
establish and maintain a competitive advantage in a particular sector can depend
on whether its domestic context helps or hinders in this respect. For example, a
US publisher considering its strategic options in the textbook market will do so
in a supportive cultural and social environment, will face a highly developed and
appropriate demand side, and be able to draw upon an extensive pool of re-
sources both in its own and related sectors. This is a rich combination that no
other country comes close to matching. A non-US publisher considering com-
peting in this sector will have to consider how its particular strategy could
overcome these barriers, whether by drawing on US competitive advantage (say
through a licensing strategy with a US partner assigning territorial rights for cer-
tain titles), or by finding areas that US publishers find it difficult or not
worthwhile to compete in (such as niche markets or areas that may depend on

high levels of local or national knowledge, e.g. business law, applied economics,
or economics of national economies).
2. Choice of strategy influenced by home Diamond. A firm should frame its
strategy with its home Diamond in mind, both in terms of how it might facilitate
certain kinds of strategies and discourage others.
3. Continuous innovation. As we noted above, the Diamond needs continuous
upgrading and improvement if its sources of competitive advantage are not to be
eroded and the same holds for firms operating within a particular Diamond.
Porter suggests that firms seeking to maintain their competitive advantage
should maintain the pressure for innovation in ways which include the following:
 Seeking sophisticated buyers
 Seeking buyers with most demanding needs
 Overshooting most stringent regulations or standards
 Sourcing from leading home-based suppliers
 Seeing leading rivals as benchmarks.
Such solutions do not guarantee competitiveness; for example, the US military is
one of the most demanding of customers in terms of performance and reliability,
but many US aerospace manufacturers have found it difficult to translate any
competitive advantage they may have in this market into competitiveness in non-
military markets. In mass production consumer markets, price and marketing
skills can matter more than performance. (There may be little demand for a
$10 000 washing machine on automatic pilot, and it is less traumatic if a washing
machine breaks down in its spin cycle than if a fighter plane does.) Nevertheless,
Porter’s Diamond does suggest ways in which companies can actively exploit a
healthy home Diamond to help them maintain competitiveness.
4. Perceiving and anticipating industry change. The Diamond can help a firm
position its strategy with future opportunities and threats in mind. Porter sug-
gests a variety of ways in which this may be pursued:
 Seeking buyers with anticipatory needs
 Exploring emerging buyer groups
 Seeking locations with early regulations
 Identifying trends in factor costs
 Linking with research centres
 Studying new competitors
 Having outsiders in the management team.
Again, each of these follows from the general argument above that it is essential
to upgrade firms’ performance continually if they are not to fall prey to compla-
cency and inertia. At the same time, an uncritical emphasis on emerging signals
and apparent trends can also be dangerous. For example, many who bet on the
fortunes of dot.com companies in the nineties had their fingers burnt by the turn
of the millennium. Trend lines can turn down, and indeed the real prizes for
entrepreneurship often go to those who can anticipate or perceive real turning
points in technologies or markets. However, these are, of course, often difficult
to identify except with the wisdom of hindsight.

5. Difficulties of replicating a Diamond’s advantages. Porter’s analysis helps to

illustrate how difficult it may be to replicate the advantages that a foreign Dia-
mond may give its local firms. The creation of a healthy cluster can take decades
to achieve and can reflect numerous interdependences between different ele-
ments of the supporting Diamond. Even if the creation of a healthy cluster is
made a matter of national policy, it may be difficult or too time-consuming to
reproduce the various elements that go towards making a particular successful
Diamond in another context.
The most practical solution in many cases for a particular region is for policy
makers and strategists to try to create their own unique Diamond and differenti-
ate its characteristics from competing Diamonds in other contexts. This is a
strategy which can allow firms in a region to draw upon the particular strengths
of that region rather than fighting a futile battle trying to mimic foreign features
and characteristics.
6. Awareness of foreign Diamonds. The bottom line is that firms should be
aware of the merits and deficiencies of their Diamond and those of their com-
petitors when framing their competitive strategy. For example, there may be little
point in your seeking to pursue a strategy based on cost advantage if firms locat-
ed in a particular foreign Diamond have certain advantages (e.g. natural
resources, technology, large domestic market) that make it difficult or impossible
for you to compete on a cost basis. The relevant Diamonds for a particular sec-
tor may constitute a rich and complex set of changing circumstances located in a
variety of countries and exerting influence over what is possible and desirable for
different firms in different locations.
This brings us to the question of how and where firms may compete in global
markets in practice. We shall look at this question in the next section.
6.6 Competing in International Markets

What does it take to compete effectively in international markets? We can approach
this problem by using what Dunning (1993) called the Eclectic Paradigm.
One issue which the paradigm was initially called upon to explain was the post-
war expansion of US multinationals into Europe, but it has subsequently been
found to be generally applicable to the analysis of the strategies of international
firms. In the Eclectic Paradigm the issues can be examined by reference to three
main questions. We shall look at these questions using the example of US multina-
tional expansion into Europe.
Question 1 _________________________________________________
Why were US firms able to compete successfully in European markets?
Answer: The US firms had ownership advantages in various sectors sufficient to
overcome the disadvantage of playing away from home against native European
firms. Remember from Figure 6.1 and Figure 6.2 that the US firms would have
the costs of setting up or accessing marketing capabilities and distribution
channels if they went international, in this case in a context where European
firms were already ensconced. Unless the US firms had some competitive

advantage that allowed them to incur the costs of market entry where incum-
bents had strong reputations and were well down the learning curve, there was
no point in considering going international.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Exhibit 6.6: Ownership advantages

The kind of ownership advantage that a firm may possess in an international context
is most clearly technical know-how, since that may be the asset most easily trans-
ferred and shared between international locations. This helps explain why many
multinationals come from high-technology sectors and are themselves R&D-intensive;
high levels of R&D economies may help to compensate for the costs and problems of
going international.
However, there are other kinds of ownership advantage that may be drawn on to
help support competition in an international environment. These include:
 marketing know-how and resources
 organisational advantages
 access to finance
 purchasing know-how
 favoured access to resources (e.g. ownership of oil reserves)
 brand recognition (e.g. McDonald’s).
Some firms may exploit more than one category; for example, McDonald’s has strong
technical and marketing competences but its overseas expansion was also supported
by high brand awareness created by the internationalisation of American popular
culture such as movies. In general, ownership advantage tends to stem from informa-
tional or skill advantages possessed by the international firms, though access to other
resources such as finance and natural resources can also play a part.
We have seen from Porter’s analysis some of the ways that a particular Diamond
could help create and sustain competitive advantage. The particular form that US
competitive advantage took depended on the sector, but typically manifested itself
in a cost or differentiation advantage versus the European firms. Exploiting
informational economies plays an important role in ownership advantage. While
sharing technical information such as R&D blueprints over a global output can
spread the costs of that activity, so also can sharing marketing information (for or
by the firm) on a global basis. For example, the costs of TV commercials for a new
car may be spread on a global basis simply by customising voiceovers into different
national languages.
Question 2 _________________________________________________
Why did US firms produce in Europe rather than the US?
Answer: There was some location advantage that European production gave
over keeping all production at home. Remember again that Figure 6.2 suggested
that firms would typically prefer to service overseas locations through exporting
unless there was a feature or set of features which interfered with this option.
In the case of US firms in the early post-war period transport costs were an

issue in some sectors, while access to lower-wage European labour also helped
encourage some US firms to locate in Europe.
However, as we noted above, transport costs have become less significant in
some areas of traded goods and services in recent years, while the differential
between some European and US wage levels is not so marked as it was in the
early post-war period. Government policy is one area that has become of
importance in recent years and has helped both to encourage and sustain direct
investment by multinationals in Europe. There are numerous tariff and non-tariff
barriers that exist between trading blocs, including the US and Europe, that are
designed to encourage foreign firms to make direct investments and so export
capital, technology and jobs to the host nation rather than simply the good or
service itself.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Exhibit 6.7: Location advantages

There are a variety of possible influences that may encourage a firm to locate some
of its activities overseas, including:
 access to cheap or high-quality resources
 transport costs
 need to service local market quickly
 to learn from the local Diamond or increase sensitivity to local market require-
ments
 government impediments to imports (e.g. tariffs, quotas, non-tariff barriers).
Question 3 _________________________________________________
Why did US firms not exploit their ownership advantage through co-operative
agreements with European firms?
Answer: Because there was an internalisation advantage in US firms going it
alone. Consider again the resource implications of Figure 6.1. What is the
strength of the multinational in this case? Answer: its technical know-how. What
is its weakness in trying to service this overseas market through multinational
expansion? Answer: it has to set up new marketing, distribution and production
facilities. Who, if anyone, is likely to have such facilities in place already? Answer:
of course, local firms in the host market.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Exhibit 6.8: Internalisation advantages

Such advantages include:
 search costs for a suitable partner to co-operate with
 negotiating costs
 policing costs
 lack of able and suitable local partners
 residual problems of opportunistic behaviour

 reducing vulnerability to fluctuations and uncertainty of external variables

 control and secrecy of ownership know-how advantages (intellectual property)
 control over brand image
 problems of controlling delivery, quality of inputs
 reducing chances of losing access to inputs or outlets
 being able to indulge in monopoly practices such as predatory pricing using
transfer pricing and cross-subsidisation.
These internalisation advantages represent transaction costs of co-operative alterna-
tives, with the exception of the last item, which reflects the ability of some
multinationals to indulge in anti-competitive behaviour by concealing internal
subsidisation of overseas activities to underprice and force out local rivals.
On the face of it, co-operating with a well-established domestic firm in this new
market could give the best resource match possible for overseas expansion. The
firm seeking foreign markets could supply technical and R&D know-how that could
be married with a host country firm’s marketing, distribution and production
capabilities. The two firms might do this through a licensing or joint venture
agreement. This could put all the resources needed to service the new value chain in
this overseas market in place, with the firm seeking this new market sharing R&D
resources and economies of scope with its domestic market, and the local firm in
the new market possibly exploiting marketing, distribution and production econo-
mies with its existing product base and the product associated with this new
technology.
Why should a local firm help an intruder break into its home market? Well, if
there are other local firms in this market, it could give it access to technical know-
how and provide a potential competitive edge in its domestic competition with these
other firms. Clearly both firms only get a share of the profits from the new venture,
but then in principle they are required only to commit to providing their share of
the resources required, releasing resources (including finance) for investment
opportunities elsewhere.
So it appears there is an impeccable logic in resource terms for a firm seeking a
domestic partner in its possible overseas markets. It could compensate for its
deficiencies in marketing, distribution and production in this new market. Even if it
were able to export to this new market and so exploit production with its home
base, a co-operative venture with a local firm in the new market could still allow the
firm to share marketing and distribution with the local partner. The problem is that
while a co-operative solution may appear attractive in resource terms, it may appear
less attractive in transaction cost terms. In fact, this is a solution which can be so
unappealing when analysed in transaction cost terms that firms seeking overseas
markets usually avoid it unless they have no other choice.
We have looked at transaction costs in Module 4, and obvious sources of transac-
tion costs in international co-operative agreements would be the resource costs of
making an agreement with another partner. There may also be difficulties in finding
a suitably qualified local partner with the in-house capabilities necessary to handle
the new technology. However, the most serious potential transaction cost to the

international firm is often the possible leakage of its technical know-how (its source
of ownership advantage) to a third party. In an opportunistic world, this may wipe
out the firm’s competitive advantage over others if it gives access to the intellectual
property that has been a foundation of its strategy.
We shall look at co-operative arrangements further in the next module, but it is
sufficient for the moment to note that transaction costs may be major sources of
internalisation advantage. These may encourage the firm to keep its technology
private and expand as a multinational into the overseas market rather than seek a co-
operative venture with a local partner. Exhibit 6.9 shows problems firms may face in
dealing with a local partner if they do not or cannot open a wholly owned subsidi-
ary.
Exhibit 6.9: Foreign car companies in China

Foreign car manufacturers have made major direct investments in China, though mostly in
the form of joint ventures with Chinese firms rather than through wholly owned multina-
tional expansion. However, the joint ventures were often expensive and frustrating for the
foreign partner, who had to supply finance and technology and who had to buy the bulk
components and materials locally. Peugeot withdrew from a joint venture in which
production had fallen dramatically in the course of the venture. Many planned joint
ventures failed to take off and those that did could take months or even years to go into
production because of protracted negotiations and disagreements between the foreign
firm and its Chinese partners. Audi found a Chinese joint venture partner subsequently
introducing its own-brand version of a car that resembled one of Audi’s own cars.
Foreign manufacturers were forbidden by the Chinese authorities from having a
majority stake in these joint ventures. Why did the foreign firms put up with these
problems? Quite simply because of the expected growth of the Chinese market.
Chinese vehicle production had traditionally been concentrated in trucks and buses, but
the fastest-growing segment of the market was now cars.
Left to their own devices, most, if not all, of these foreign car manufacturers would
have preferred exporting or multinational expansion to create a presence in the
Chinese market. This would allow them to retain control over production, distribution,
and crucially, technology. Many foreign firms may finish up tutoring their future rivals.
However, the Chinese authorities wanted to attract foreign direct investment in a form
that would encourage transfer of technology and skills to their indigenous firms and
workers. So the foreign firms were faced with a single choice. If they wanted access to
the (potentially lucrative) Chinese market in the future, a joint venture with a local
partner was the only way they could pursue this objective.
Which of the internalisation advantages of Exhibit 6.8 are likely to be encoun-

tered by firms conducting joint ventures in China?
So if foreign firms had no ownership advantage over local firms, we would observe a
world without international firms. If international firms could find no location advantage
from producing in the overseas bases, we would have a world with international trade,
imports and exports, but no foreign direct investment by firms in overseas locations.
And if firms could find no internalisation advantage from keeping their technical know-
how to themselves, we would have a world characterised by co-operative ventures

between foreign firms and local partners, but no multinational expansion. We have
seen how our earlier analysis of resource linkages, transaction costs and the Diamond
may be useful in looking at the contribution each of these three elements makes.
Ownership, location and internalisation advantages are all necessary for multinational
enterprise to exist in particular cases. Take away any one element and another strategy
becomes more effective. Indeed, the fact that we do observe some domestic firms
competing successfully in their home markets suggests that foreign firms may not
have an ownership advantage in some cases. The fact that some firms service overseas
markets by exporting from their home bases suggests that there may be no location
advantage in these cases. And the fact that international co-operative ventures exist
between firms suggests that the associated transaction costs of these ventures are not
sufficient to give an internalisation advantage from the multinational alternative in
such cases.
So the Eclectic Paradigm is useful in combination with our earlier analysis. It may
help sort out the issues that may give international firms a competitive advantage
over domestic firms. It may help suggest why firms may make direct investment in
foreign locations rather than export. It may help explain why this foreign direct
investment may take the form of multinational expansion rather than co-operative
ventures with local firms.
However, it should still be noted that the Eclectic Paradigm is not the whole
story, since it assumes that firms’ most attractive investment opportunities may be
found in overseas markets. As we noted above, international expansion will tend to
become a major option only after the firm has exhausted specialisation and diversi-
fication opportunities in its home base to the point that the weaker resource
linkages, associated with overseas expansion, begin to look relatively attractive.
Firms’ first preferences are to stay at home for very rational and sensible resource-
based reasons.
6.7 Competing Abroad: The Principles

We can now tie a number of threads together and consider the implications for
competitive strategy on an international basis. Porter (1990) suggests a number of
principles that are important for firms to bear in mind if they are to compete
successfully abroad. We shall consider how they make sense, not only in terms of
Porter’s own Diamond and value chain analyses, but in resource-based and transac-
tion cost terms as well. They are not hard-and-fast rules and exceptions can always
be found, but they stem from looking at Porter’s Diamond Framework with the
help of the resource-based and transaction cost perspectives.
 Seek sophisticated overseas buyers. This is a simple extension of the logic of
Porter’s analysis of the benefits of sophisticated home demand in a Diamond
Framework. If the firm also seeks sophisticated customers overseas it can
strengthen its ability to compete at the highest level in an international context.
Settling for unsophisticated and poorly informed consumers may be easier in the
short term but a bad basis on which to try to build future competitiveness.

 Source basic factors globally. As we noted in Module 4, if an input is a basic

standardised commodity such as copper or rubber then it is easy to write a con-
tract for its delivery and, as we saw in Module 2, such factors on their own are
unlikely to generate sources of competitive advantage for the firm. So there is
every opportunity to outsource such factors to the best or cheapest supplier,
especially in a competitive market. There are also usually fewer obvious dangers
or difficulties for competitive advantage in sourcing such factors internationally
than there would be for complex or innovative factors.
 Keep strategic assets close to home. Diamond considerations and the
advantages of domestic clustering for strategic resources encourage many multi-
nationals to emphasise home locations for strategic assets such as R&D
laboratories. This helps to keep close contact with strategic assets and get as
much as possible in terms of quantity and quality of information out of these
assets. If the local Diamond and cluster are healthy, these assets can continue to
participate in and benefit from local interactions. It is also easier to manage the
interdependences with other strategic assets in the value chain if they are under
your nose. It may be easier to protect against unplanned leakage of information
to competitors if the assets can be watched more carefully at home.
 Selective tapping of foreign technology. While transaction cost problems of
potential leakiness of technical know-how can also discourage them from co-
operating with foreign firms, these same properties mean that firms may be able
to pick valuable scraps of technical information through co-operating with or
simply observing foreign firms.
 Attack rivals directly to learn from them and neutralise them. It may be
tempting to avoid direct competition with strong competitors in home and over-
seas markets, but Porter’s Diamond analysis suggests this may be a mistaken
strategy in the long run. Head-to-head competition can be a valuable learning op-
portunity to observe what generates competitive advantage for your best rivals,
and may also help inhibit these rivals from growing even stronger. This may ex-
plain L’Oréal’s move into the US market (Exhibit 6.2).
 Locate regional HQs at best Diamond. In deciding where to locate a regional
HQ overseas within a nation or trading bloc, an international firm should be
sensitive to the possibilities afforded by local Diamond and cluster opportunities.
Locating within a healthy local cluster may help provide the firm with valuable
information about what makes the local system work.
 International acquisitions and alliances for access and learning. In the next
module we shall look at the downside of merger and co-operative strategies in
more detail. In spite of the downside, they can be useful ways of gaining access
to foreign markets when all else fails or proves too expensive. They may also be
useful, not just in terms of their obvious benefits for the areas directly covered
by the merger or co-operative activity, but as a means of learning new skills and
bodies of knowledge, such as technical know-how or the kind of skills that the
other firm has acquired from existing in its local Diamond (and, of course, it is
the transaction costs of possible leakage of such knowledge and skill that can
also make the other firm reluctant to enter into such a collaborative venture).

 Globalisation versus localisation. The world is not a homogeneous entity but

comprises many different cultures, societies, and legal and political systems.
From the point of view of firms this can also be reflected in products having
different technical and market characteristics in different countries and regions,
or even firms having to follow different conventions or rules to operate and
deliver their goods and services in these different contexts. This is such an im-
portant issue that we shall look at it in some detail in the next section.
6.8 Globalisation Versus Localisation

The issue of globalisation versus localisation can be best set out in resource-based
terms and using a value chain analysis. Consider the specialisation option in Figure
5.2 in Module 5. It has the strong virtue of allowing the firm to share resources and
competences in marketing, distribution, production and R&D. Even once the firm
has fully exploited economies of scale through specialisation, continuing to special-
ise can help the firm to avoid diseconomies if it were to wander into areas which
required resources and competences which it did not possess. As we have noted, the
best solution for the firm in resource-based terms is what is called ‘sticking to the
knitting’, by keeping as close to home as possible, by staying in the same product
line and the same home market (though as we have also noted, there may be other
considerations such as market saturation and threats to its market or technological
competences that may encourage it to diversify or seek overseas markets). If it has
to diversify, resource-based considerations suggest that it should try to use as much
of its existing resources (including core competences) as possible.
Now, if for one reason or another the firm seeks to go abroad, we have also seen
how it will certainly need new bundles of marketing and distribution resources to
service these overseas markets (if it is exporting) and even new production facilities
(if it is using multinational expansion). However, the discussion of ownership
advantages above suggested that even the multinational may share certain resources
in different global markets and the most important category of resource in this
context is information – technical information about how to produce a product,
advertising information to the consumer such as TV commercials, marketing
information to the firm about how to sell the product, organisational information
about how to run the type of company, and so on. Clearly the multinational would
extract most benefit in simple resource-based terms if it could simply directly
translate the information represented by its existing bundles of competences,
expertise and experience in these various areas into its general operations in world
markets.
And this is where the source of possible tension lies. What is sensible in resource-
based terms may not be ideal in market terms. Resource-based logic suggests that
the firm should organise and manage itself the same way, try to make the same type
of product using the same technology and sell that product the same way in
different world markets. But market-oriented logic may suggest that what works in
one country may not work in another. This may have implications for the way the
firm manages and organises itself, the technology it uses, the type of product it sells,

and how it sells these products. The ideal solution from the point of view of
market-oriented logic may be to customise all or some of these issues and be
sensitive to the conditions and needs of the different global markets that the firm is
servicing. But, of course, the more the firm differentiates its activities to reflect local
market conditions, the more it runs the risk of sacrificing economies from shared
resources and competences across different world markets, and the more it may risk
leaving at home the competences and sources of ownership advantage that encour-
aged it to consider going multinational in the first place.
Indeed, a world in which each national market is strongly differentiated from
each other is a world in which local market conditions dominate and incumbent
domestic firms are likely to find it easy to fight off challenges from multinational
entrants. Multinational ownership and competitive advantage depend strongly on
finding competences and capabilities that are transferable across national bounda-
ries. This explains why General Motors has pursued a strategy of ‘global’ cars and
also how this strategy has not always been easy to reconcile with its other aim of
producing cars suitable for European market conditions.
Can the tension between resource-based and market-oriented logic be resolved
and, if so, how? The answers depend on the nature of particular sectors and
markets. The personal computer is one product that is able to exploit resource-
based advantages that can accrue from being able to sell a standardised product the
same way in different markets, though of course there may be some loss of stand-
ardisation of components such as keyboards, technical manuals and basic software
to suit national characteristics. On the other hand, educational materials for schools
have to be market-oriented and tailored to the curriculum and specifications of
national systems.
Some industries even have some sectors that are characterised by global brands
and others dominated by local characteristics and preferences.
There are also sectors which have some segments characterised by global brands
and others which reflect national characteristics. Hotels, clothing (such as Hilton,
Nike) all have global brands but still other products in each of these sectors reflect
the national characteristics, resources and preferences of different host countries.
It would seem that the existence of local characteristics and local brands repre-
sents barriers to multinational expansion preventing the incursion of foreign firms
into domestic markets. Up to a point that is correct, and differentiated world
markets can certainly make it difficult for firms to transfer competitive advantage
into overseas markets. However, there are at least three issues which may still
encourage the evolution of international firms even in markets traditionally domi-
nated by local tastes and brands:
 Surface differentiation. It is important to dig deeper into cases where brand
names differ across countries. In some cases this may represent a product with
quite different specifications from that which exists elsewhere, while in others
the brand name may be all that distinguishes the national product from that
produced and sold in other countries. In the latter case, the international firm
may still be able to draw heavily on its established base of technical and market-
ing know-how in different national contexts.

 Access to factors of production. Firms may go international, not just to get

access to foreign markets but to get access to cheap or better factors of produc-
tion. South East Asian countries attracted production bases for making local
tourist souvenirs for many other countries, reflecting low labour costs in some
parts of that region.
 Cultural globalisation. Tastes and preferences are not static but change and in
some cases there may be some convergence. French commentators may com-
plain about the lowering of food standards represented by the spread of fast
food chains in France but, as the example of L’Oréal’s US acquisition shows,
internationalisation of brands can work both ways and may also reflect a taste for
increasing sophistication and variety of choice on the part of consumers. Even if
local tastes predominate in a sector at the moment, cultural and social tastes can
change through international communication and contact, including travel, TV
and movies.
In short, the tension between globalisation (of brands) and localisation (of tastes
and preferences) does represent a challenge for firms that wish to transfer their
national sources of competitive advantage into foreign fields. If national conditions
and circumstances are very different from each other, then it may be difficult to
compete abroad on existing sources of competitive advantage built up in a domestic
context. At the same time, local differences may be only skin (or brand) deep and a
determined firm may be able to use a great deal of common technical skills and
competences in marketing to compete in different national contexts. Finally, it is
important to bear in mind that international firms may not just respond to a given
set of tastes and preferences, they may be able to change these national tastes and
characteristics as well.
Learning Summary
There is one theme which was started in Module 3, carried through Module 4, and is
still coming through strongly in Module 6. The theme could be summarised as ‘what
everybody knows, is not always so’. Just as common knowledge and wisdom about
innovation and vertical integration often turns out to be misplaced or misleading, so
going international by creating a multinational business can turn out to be less
natural and more problematic than appears at first sight. International business in
general, and multinational enterprise in particular, can stretch the firm’s resources
and draw it into areas where it may have little experience.
A parallel theme emerging here and echoed in the earlier modules is that the
objectives being pursued by particular strategies may often be pursued by alterna-
tives. For example, growth may be better pursued in some cases through domestic
diversification rather than going international. And multinational enterprise is not
the only way to exploit profit opportunities from going abroad; exporting, licensing
and joint venture are all examples of strategies that may achieve the same objectives
as multinational enterprise, in some cases better or more cheaply.
Multinational enterprise is of course a major feature of the global economy and it
is growing in significance and scope with every year that passes. In many cases it is

the best or only option open to the firms that wish to achieve, maintain, or enhance
competitive advantage. However, this module has shown that it is usually not the
only game in town. Strategic planning must make a balanced assessment of ad-
vantages, disadvantages and alternatives in the case of multinational enterprise
whenever it is being considered as an option.
Review Questions
6.1 Which of the following assets is usually easiest to share between a parent company and
its overseas subsidiary?
A. Marketing know-how.
B. Market research.
C. Technical know-how.
D. Legal know-how.
6.2 Which of the following is not one of the basic four components of Porter’s Diamond?
A. Firm strategy, structure and rivalry.
B. Related and supporting industries.
C. Government intervention.
D. Factor conditions.
6.3 Dunning’s Eclectic Paradigm suggests that multinational enterprise is a consequence of:
I. ownership advantage.
II. internalisation advantage.
III. location advantage.
A. I, II and III.
B. I and II only.
C. I and III only.
D. II and III only.
6.4 Selective factor disadvantages may lead to:

I. technological innovation.
II. international competitive advantage.
A. I only.
B. Neither I nor II.
C. II only.
D. Both I and II.
References
Dunning, J.H. (1993) Multinational Enterprise and the Global Economy, Harlow, Essex, Addison-
Wesley.
Fukuyama, F. (1995) Trust: the Social Virtues and the Creation of Prosperity, London, Penguin.
Porter, M. (1990) The Competitive Advantage of Nations, New York, Free Press.

Module 7
Making the Moves

Contents
7.1 Example of a Combination ....................................................................7/3
7.2 Evidence on the Performance of Combinations .................................7/5
7.3 Adding Value from Combination ..........................................................7/8
7.4 Why Do Mergers and Acquisitions Perform So Badly? ................... 7/13
7.5 Co-operative Activity .......................................................................... 7/22
In the final module we look at alternative methods for pursuing the various strate-
gies analysed in previous modules, such as merger, acquisition, and various forms of
co-operation. We show how the various sources of added value and competitive
advantage in such cases can be reduced to two main categories; demand-side effects
from enhanced market power and supply-side effects in the form of economies of
scale and scope from shared resources. We examine why the claimed benefits from
merger, acquisition and co-operation frequently fail to materialise. We also look at
the logic underlying the phenomenal development of alliances and networks in
many high-technology sectors.
Learning Objectives
 demonstrate how gains from combining resources can be achieved through a
variety of strategies;
 describe the major sources of added value from combination;
 explain why mergers often perform so badly;
 compare and contrast costs and benefits of merger and co-operative alternatives;
 account for the proliferation of alliances and network arrangements in recent
years and explain why they may represent attractive alternatives for many firms.
So far we have concentrated on the role of strategies and the direction they may
take. In this module we turn to the question of the various methods that firms may
adopt to pursue their various strategies.
The various issues that we looked at in Module 4 (vertical moves), Module 5
(horizontal moves) and Module 6 (international moves) can all be summarised under
one umbrella issue – there may be gains to be had by combining different bundles of
resources and co-ordinating their activities. If the act of combination is done
internally within the firm, it can result in vertical integration (Module 4), diversifica-
tion (Module 5) or the multinational enterprise (Module 6). However, there are

Module 7 / Making the Moves
various ways that these strategies can be achieved (such as internal growth, merger
and takeover) and there may also be alternative means (such as licensing, franchising
and joint venture) of pursuing the gains from combining and co-ordinating re-
sources that do not require the resources to be internalised within a single firm.
This module is concerned with these alternative means of pursuing the gains
from combination. One of the fundamental themes in this elective has been that
you must always bear the alternatives in mind in selecting a course of action. For
example, it is not enough to argue that a conglomerate move would improve your
profitability. Would you make even more profit if you stayed closer to home and
took over a firm related to your current business? Why would you be better at
running this firm than someone else? Or suppose you argue that international
expansion offers attractive opportunities for growth. What is wrong with your
domestic market that you want to move into overseas? If your domestic market is
saturated, would domestic diversification make better use of your resource base than
adventuring into foreign lands?
The notion at the heart of all these modules has been that of opportunity cost –
the cost of the net gains sacrificed from the best alternative forgone by undertaking
this action. If you use your resources to undertake strategy A, they may not be
available to pursue strategy B. So the loss of the possible benefits that Strategy B
could have brought to your firm should be included as a true cost of Strategy A.
Strategies should only be seriously considered if it looks likely that they will deliver
net gains, even after taking opportunity costs into account.
A similar set of arguments operates in the context of methods or modes of pur-
suing strategies. There are not only alternatives in terms of the strategic direction
that firms can pursue; there are also alternative means for pursuing these directions.
When one means is chosen over another, it sacrifices the benefits that could have
accrued from the best alternative for pursuing such a direction (assuming that real
alternatives exist). It is not enough to argue that a method of co-ordinating re-
sources is sufficient or good enough to pursue a particular move. It must also
provide net gains after the opportunity costs of alternative means of pursuing that
move have been taken into account.
In this module we shall link back first to Module 5 with an example of how one
method of combination (merger) may add value in Section 7.1. Then in Section 7.2
we shall consider the evidence on how major methods of combining resources
actually perform. As we shall see, the news may be surprising and is certainly often
at variance with what is hoped for or claimed in advance. In Section 7.3 we shall
explore how combination could add value, and in Section 7.4 we consider why
merger and acquisition often fails to do so. This is something we also explore in
Section 7.5, where we look at various kinds of co-operative alternatives such as joint
ventures. There is a twist to this issue in this section, because we use discussion of
why joint venture is such a costly method of combining resources (and so often
fails) to show why it has, paradoxically, become such an important part of many
firms’ strategic armoury in recent years.

7.1 Example of a Combination

Before we begin to explore the issues involved fully, we shall look at a couple of
examples where there may be gains from combining resources.
Helmets Helmets
D D
M M
P P
R&D R&D Helmets Helmets
D D
M M
Helmets Jackets P P
D D R&D R&D
M M
P P
R&D R&D Helmets Jackets
D D
M M
P P
R&D R&D
Figure 7.1 Merger and possible resource-based advantages

Figure 7.1 contains simple examples of the possible gains from merger. It is
adapted from Figure 5.1 of the Diversification Game in Module 5 where we had
different possible horizontal moves that firms could make. In the top case of our
example here (a specialisation move), we have Firms 1 and 6 from our earlier
analysis combining to monopolise the motorcycle (M/C) helmet market. In the
bottom case we have a diversification move with Firm 6 from Module 5 (M/C
helmets) combining with Firm 3 (M/C jackets) to form a firm diversified within
M/C accessories. What would be the point of such moves in terms of their possible
implications for competitive advantage?
The implications are quite clear for the helmets/helmets combination. Remem-
ber that we assumed that there were only two firms in each market segment (in this
case helmets) in our game. The new firm in the top right of Figure 7.1 now has
monopoly power on the demand side. If it is also able to reduce costs by sharing
resources between the formerly separate parts of the new combination, then it may
be able to exploit further economies of scale as well. Remember also that Firms 1
and 6 would have had separate marketing, distribution, production and R&D
departments before they came together, and combination within one firm may allow
for sharing of management, workforce, equipment, etc. As we discussed in Module
5, these resource savings can come from a variety of sources contained within the
respective marketing and technological links shown for the new firm. So possible
monopoly power and economies of scale should enable the firm to add value over
and above the sum of the value of Firms 1 and 6 had they stayed separate. At least
this gives us no reason to think they would actually be worse off.

Exhibit 7.1: Combining components

The global automotive components industry underwent fundamental restructuring over
many years with mergers and acquisitions playing a large part in these changes. The
prime driving force was changes in strategy on the part of major car makers. Japanese
firms such as Toyota (Exhibit 4.4) had demonstrated the benefits of single sourcing of
components, and other car makers were following suit. Car makers were also aware of
the advantages of designing a globally standardised product, as we saw in Module 5.
Many now pursued single sourcing using long-term contracts with fewer suppliers to try
to achieve the benefits of economies of scale on a global basis. These trends forced
merger and acquisition moves on the part of component suppliers both to rationalise
and to give them the necessary global coverage.
The increasing complexity of automobile development and cost pressures further
encouraged car makers to concentrate on their core competences of overall product
design, development and assembly, and leave the specific design of components and even
whole sub-systems to suppliers. These expanded responsibilities encouraged further
combination by suppliers to give them the increased technical scope they required, and
to achieve the economies in R&D that went along with their enhanced technical
contribution.
An example of the changes is given by Ford, which had traditionally used a pool of
about 700 component makers (mostly based in North America) and then set about
reducing the number of suppliers to a globally spread pool of suppliers totalling less than
a third of that number.
The increased scale, concentration, responsibilities and technical ability that went
along with these mergers and acquisitions in components also had the effect of offsetting
some of the buyer power which the car makers had traditionally enjoyed, with only a
handful (or less) of suppliers now having the scale and competence required to deliver
key components and sub-systems in some cases.
Analyse the likely changes in the Five Forces facing component manufacturers as
a consequence of mergers and acquisitions here.
The potential gains from a helmets/jackets combination are perhaps not so obvi-
ous but the new firm may also expect to add value from resource- and demand-side
effects. On the resource side there may be economies of scope or synergies from
the sharing of marketing resources and distribution channels that had previously
been duplicated by having two separate firms. On the demand side, the bigger firm
may now have more bargaining power with retailers; for example, it might insist that
if a motorcycle retailer wants to stock its helmets, then it has to take its jackets as
well. Again, demand side and resource side of the move both give reasons for us to
expect that combining the resources and market position of Firms 3 and 6 would
lead to an enhanced competitive position.
We can simply summarise the gains from merger in this case. As we would ex-
pect from the discussion in Module 2, gains from merger here fall into two
categories, those that lead to sharing of resources and a fall in costs and those that
may increase the market power of the firm, which here means shifting the demand

curve(s) to the right and possibly reducing demand elasticity. We can adapt Figure
2.1 from Module 2 to help analyse the effects of combination in Figure 7.2.
D2 Demand curve shifted

to the right and made
less elastic
D1
$ AC1
AC2
Cost curves shifted down
0
Output
Figure 7.2 Adding value from combination

Adding value here amounts to driving a deeper wedge between the demand and
cost curves, widening the gap between them to allow increased profits to be made.
Before we go any further, we should also note that merger is not the only way that
the firms could achieve the gains from combination. For example, they could agree
to pool resources and selling efforts in a co-operative venture. They could agree to
have their sales forces sell each other’s products, press for retailers to stock the
other firm’s products as well, and so on. One common way for these gains to be
pursued is in a joint venture where two or more firms co-manage a jointly owned
combination of resources. We shall look at the implications of these and other
alternatives later, but first we have to consider a major issue. What does the perfor-
mance record of the major alternatives here (merger, acquisition and joint venture)
actually look like?
7.2 Evidence on the Performance of Combinations

Perhaps one of the most surprising things about merger, acquisition and joint
venture is how badly they tend to perform in practice, and yet how popular they
remain with strategic planners.
There have been numerous studies looking at the performance of various meth-
ods of combining resources, especially merger, acquisition and joint venture.
Surveys of merger and acquisition activity have tended to conclude that, on average,
there is no strong evidence that they lead to increases in profitability and efficiency,
and indeed the evidence tends to point in the opposite direction, with merger on
average reducing efficiency. The news is even worse for the acquirer in takeover, with

the evidence suggesting that gains from combination are heavily skewed in favour of
the shareholders or owners of the firm taken over. This is a strange world where it is
usually much better, financially speaking, to be a target or ‘victim’ than it is to be a
successful takeover raider or ‘winner’ in a takeover battle. The case study literature is
full of disappointing experiences, such as that reported by Sony and Matsushita in
Exhibit 7.2.
Empirical evidence on joint ventures is, if anything, even more disappointing.
Some studies have shown about 70 per cent of joint ventures falling short of
expectations or being disbanded, while others have found the average joint venture
failing to last beyond half its planned lifespan.
If we were to provide pieces of advice on combinations on the basis of the em-
pirical evidence on performance, they could be simply summarised. If they are
thinking about merger, they should think very carefully before going for it. If they
were planning an acquisition, the expectation is that they would not make a net gain
from this and very possibly lose out. If they decided to turn to joint venture instead,
we could modify our advice to read ‘don’t do it’. After all, they may think they are
the ones to beat the average failure rate, but presumably every set of managers
thought the same before they embarked on their venture opportunity, so why
should they beat the odds?
However, there are some pitfalls on the way in terms of judging whether or not a
particular combination has or has not added value.
 Measurement difficulties. How do you know if a merger, acquisition or joint
venture has been a success? Most obviously you look at its effect on perfor-
mance. Here the test should be whether this combination added value compared
to what would have been the case had it not taken place. Clearly this can mean
taking a variety of firm- and sector-specific issues and trends into account. How-
ever, the immediate effects are usually easier to observe and this can make it
difficult to separate out and measure the benefits from combination if they do
not fully emerge until some years down the line – especially if these effects are
lost in the wash of other merger and joint venture activity by the firm during that
period.
 Other motives. The intention of the combination may not be to increase
profitability; other motives may be operating here. For example, management
may pursue merger because they desire the status and rewards that go along with
a larger firm and may be less sensitive to the possible effects on performance. In
that case ‘success’ of the venture to management may be measured in doubling
turnover not profit. Even if management are consistently acting in the interests
of shareholders, this may not be represented on the bottom line of the balance
sheet. For example, if management acquire a supplier to prevent a rival cutting
them off from essential supplies, this may not directly increase profits but could
instead reduce the chances of a future reduction.
 Wrong criteria. Even if a combination actually adds value it may appear to be a
failure according to some criteria. Many joint ventures are deemed to be failures
because they do not fully achieve their stated objectives and allotted lifespan. It
is also true, as we shall see, that many such combinations break up in bickering

and disappointment after a relatively short time. However, it may be that the
gains to either or both partners are not fully reflected in the performance of the
joint venture. For example, if a co-operative agreement between an innovative
firm and a firm that is strong in marketing and distribution breaks up well before
its planned end date, the innovator may still have acquired valuable know-how
about selling techniques, while its partner may also have learnt something about
why its former partner is such a good R&D performer. Both may be able to
apply the know-how gained to their advantage in other activities.
 Opportunity costs. It is usually only possible to make limited judgements on
whether or not a particular combination has added value. The notion of success
or failure is (understandably) usually restricted to trying to estimate whether it
has been worthwhile undertaking this combination compared to the alternative
of doing nothing. However, as we have noted, the true measure of the value of a
particular combination in strategic terms should allow for the opportunity cost
of alternatives forgone. Even if a merger makes a profit, could internal growth
have achieved the same ends and even better results eventually? Even if an ac-
quisition helps you enter a foreign market, would it have been simpler and
cheaper to license a local firm in that market? Clearly it is difficult to measure
these opportunity costs in practice, but what this does mean is that where viable
alternatives to merger, acquisition and joint venture have not been taken up, the
true cost and real failure rate of the chosen options may be even higher than is
observed and reported.
Exhibit 7.2: Sony and Matsushita in Hollywood

The experience of the Japanese electronics companies Sony and Matsushita in taking
over Hollywood film studios stands testament to the dangers of misplaced merger and
acquisition activity.
Sony acquired Columbia and Tristar, soon followed by Matsushita taking over MCA.
The moves were based around vertical integration with the companies being taken over
often using the hardware that the electronics companies produced. The saturation of
consumer electronics markets and fierce rivalry from domestic and other Asian
competitors encouraged the firms to pursue growth into other areas. The fact that the
entertainment business was seen as an area with excellent growth prospects and had
vertical links with their current interests also appealed to both firms.
Unfortunately, the acquisitions turned out to be highly problematic for both compa-
nies. Sony reported multibillion dollar losses almost entirely attributable to problems
with Columbia and Tristar. MCA had initially more success with its acquisition, with hits
such as Jurassic Park and The Flintstones, but still found real difficulties in dealing with and
keeping its US-based managerial team, as did Sony. Matsushita hit real problems with
Waterworld where lack of tight financial controls led to it becoming one of the most
expensive projects in film history. Matsushita exited Hollywood in the mid-nineties.
Sony also believed that owning a studio would help give the company leverage to
help set the industry standard for the next wave of digital technology. But this strategy
also turned out to be redundant when industry subsequently agreed to an open
standard in digital video technology that no single company could monopolise.

Why do you think the merger experience of Sony and Matsushita has been so
disappointing?
There are two important messages we should take from the empirical evidence
on combination activity. First, they frequently tend to disappoint in terms of adding
value, especially from the point of view of making an acquisition and most especially
from the point of view of joint venturing. Second, the strategic motives and
implications of combination may be more complex than simple short-term profit-
maximising motives, and this may be reflected in the apparently poor performance
of combinations when they are judged in those terms. But before we get to these
issues, we need to explore the basics of how combination could actually add value in
the first place. We turn to this in the next section.
7.3 Adding Value from Combination

Many textbooks on strategic management contain checklists on the gains that may
be made from various methods of trying to pursue competitive advantage, such as
merger, joint venture, and alliance. The checklists have a tendency to look very
similar and, indeed, the various elements in one checklist typically recur in similar
forms in other checklists. One checklist may tell us that merger may be useful to
help obtain R&D economies, share distribution channels, transfer technology,
combine production facilities, etc., while another checklist may inform us that joint
venture is useful for exactly the same things.
The reason for the similarity in checklists is that it is easy to confuse why a par-
ticular strategic direction is chosen and what a particular option does, with the
merits of the alternative means and methods of pursuing that direction. An analogy
may be drawn with doing laundry. An individual may wish to have his socks, shirts,
towels etc. cleaned and may be considering doing it himself in-house (and buying a
washing machine) or contracting it out (to a launderette). The alternatives represent
different modes or methods of achieving the same objective (laundering) and the
reasons this individual may choose to buy a washing machine or contract out will
depend on the relative merits (costs and benefits) of the alternative methods of
pursuing this objective.
If we asked this individual why he bought a washing machine, he might answer
‘to do my washing’, which may be correct but is hardly informative and indeed
could be regarded as a downright stupid or sarcastic answer. What we are more
likely to be interested in is why this individual bought a washing machine rather than
use a launderette, and here the answer should more properly deal with questions of
cost, quality control, convenience, etc.
Similar principles apply if senior management were asked why they have merged
with another firm and they give a reply like ‘to share technology’. That may tell us
what the merger was designed to achieve, but not why management chose to adopt
this method rather than try to achieve the same advantages through internal
expansion, joint venture, licensing, etc. The proper answer as to why merger was
chosen should refer to the relative merits (costs and benefits) of this method

compared to its alternatives. The reason why the answer ‘to share technology’ may
not appear as stupid or sarcastic as ‘to do my washing’ is that the purpose of a
merger may not be as obvious as the purpose of a washing machine. However, this
does not make it any more appropriate an answer.
So checklists of what, say, merger or joint venture can achieve tell us as much
about why merger or joint venture is chosen as a laundry list does about why
someone has bought a washing machine. In practice, we need to compare possible
methods of adding value, whether we are doing laundry or competing in the
marketplace.
We can make a start to this process by noting that we can conveniently reduce
the ‘laundry list’ that any strategic move should be designed to achieve in terms of
adding value to just two items. As we noted above, competitive advantage is
achieved by reducing costs or increasing market power. The first thing we need to
do in looking at the potential gains from combining resources of different business
units (whether through internal expansion, merger, acquisition, joint venture, or
other means) is to produce the corporate version of the laundry list. What is that
combination intended to achieve? Only after that should we go on to consider the
merits or demerits of alternative methods for pursuing these potential gains.
It should also be remembered that resource-based gains from combination are
obtained at the level of individual resources. If we want to consider the potential
impact of combination on competitive advantage then we have to look at the level
of the individual resources and activities that make up the respective value chains.
The potential gains from combination then depend on the resources at the corre-
sponding stage in the respective value chains having some similarity (or potential
similarity) in terms of their contribution to activities in the chain. At this level the
resources may be ‘allergic’ to each other (display negative synergy), just as they may
generate synergy.
Take, for example, the case of combining sales forces in the merger case dis-
cussed in Figure 7.1, and shown at value chain level in Figure 7.3. Suppose this is
the helmets/helmets merger example. Resource gains in this case should be reflect-
ed in cost savings/productivity gains for the combination. Whether or not those
occur will depend on the current disposition and characteristics of the respective
sales forces and how actual changes are managed. In particular it depends on the
nature of the similarities and the differences between the two parts of the combina-
tion, their resources and their product lines. How may these gains be achieved?
There are a number of ways and they may include some or all of the characteristics
below.

Similarities and differences between

the sales forces to be combined may
lead to gains or losses
sales force
market research
Marketing Marketing
advertising
plant
labour force
research
R&D R&D
development
Firm 3 ... combines with ... Firm 8
Figure 7.3 Synergies and allergies from combination

1. Similar outlets: eliminating duplication. Suppose, for example, the motorcy-
cle helmets produced by the previously separate firms are effectively identical
products and perfect substitutes in consumers’ eyes; there are no brand ad-
vantages that one helmet has over the other. If the two sales forces duplicate
each other’s products, territories and outlets, then there may be substantial gains
possible from eliminating that duplication through combining sales forces and
now having only one sales representative visiting an individual retail outlet.
2. Similar products: eliminating competition. There may also be gains on the
demand or revenue side for the combination as well, since eliminating competi-
tion means that our new combined sales force may be able to push up margins
on the products delivered to retailers, and worry less about price and other forms
of competition from a rival.
3. Similar activities: increasing sales. It might seem that there would be poten-
tial gains also if the two sales forces had completely separate territories and
outlets. After all, this would allow the combination to double its geographical
coverage compared to what had been possible with the smaller firms. However,
this is where the concept of added value is critical. If all that happens is that the
new combination does the same things as before with no resource savings or
increased revenues, then the new combination will be at best the sum of the
value of its formerly independent parts.
However, suppose the two helmets are differentiated from each other and have
quite different brand images. The sales representatives in the combination can
now represent two sets of helmets during each visit to a retailer, potentially in-
creasing their sales productivity in the process. This represents both increased
sales revenues for the firm in the aggregate and reduced marketing costs per unit
of helmets.

4. Similar activities: improving capabilities. Suppose (before combination) one

firm has superior selling capabilities such as superior selling practices and train-
ing methods compared to its rival. Combining sales forces may allow these
capabilities to be accessed and diffused to help the rest of the combined sales
force catch up with these superior practices, improving the quality or reducing
the cost of selling. The result should be reflected in increased aggregate sales
revenue and/or reduced marketing costs per unit of sales.
Let us pause for a moment and consider some of the implications of these ef-
fects. Combining the two separate sets of activities and resources represented by the
two sets of sales forces could result in a number of potential benefits in this one
category of potential resource linkage. These include (1) elimination of duplicated
activity, (2) increased control over buyers, (3) increased productivity and range of
output of resources, and (4) diffusion of superior or best-practice capabilities
throughout the combination.
The gains may be thought of in terms of supply-side gains (sharing resources and
reducing costs) or demand-side gains (shifting demand curve and/or increased
market power). The particular form the gains take will depend on the actual linkage
in question; for example, increased market power here is reflected in increased
bargaining power with respect to buyers (as in Exhibit 7.1), while market power
effects from combining purchasing departments could be reflected in increased
bargaining strength with respect to suppliers.
We can also note that a helmet/jacket combination as in Figure 7.1 may also have
delivered gains in some or all of these categories, generating economies of scope or
synergies in the process. Such a combination might also combine sales forces to sell
both helmets and jackets, and adopt best practices in one sales team to improve
selling practices in the other. To the extent that some aspects of resources and
activities would be specific to the task of selling the respective products (helmets
and jackets), some aspects of resources such as selling skills and sales manuals would
only be partly transferable and so the gains may not be as direct or as strong as in
the case of the single product (helmet/helmet) combination which may be able to
exploit fully economies of scale. In general, the less similar the activities involved in
the combination (here helmets/jackets), the weaker and more indirect the potential
gains in terms of economies of scope from sharing resources, and possibly the
weaker the effects in terms of enhanced market power (if they exist at all).
The most obvious way to achieve gains through resource sharing or enhanced
market power is through merger of the two firms, or acquisition of one firm by the
other. There are two comments worth making at this juncture.
1. The whole value chain matters. Suppose we are considering the hel-
met/helmet combination in which the helmets are effectively identical products.
As we noted, there may be no resource savings from combining sales forces
since there is no territorial overlap, but there might be substantial gains further
back up the value chain if the production side (e.g. plant and equipment) could
be combined to allow exploitation of economies of scale of these identical prod-
ucts. Now suppose the two sets of helmets produced by the two firms are made
using quite different materials and/or technologies. This may mean that there are

no (or only limited) economies from combining the production of these two dif-
ferent types of helmets. On the other hand, the productivity of the combined
sales force may be significantly enhanced if they can now sell the two different sets
of helmets with one visit to a retailer.
The point is that where the economies may be obtained through combination
depends very much on the case in hand. If even a simple example such as hel-
mets/helmets may display a variety of possible ways of adding value in practice,
then this point holds even more strongly when we look at less straightforward
cases of diversification involving partial and erratic linkages between product
markets.
2. Alternative methods of combining activities. Merger and acquisition is not
the only ways such enhanced value may be pursued. An obvious alternative is
internal expansion. Where the benefits are built on increased scale of output,
organic growth may allow the firm to achieve the necessary size eventually with-
out the problems of integrating different systems that may be incompatible.
Where the benefits reflect reduced duplication of activity, the firm may be able
to achieve the same ends by concentrating on competing against its rival and
encouraging or forcing its withdrawal from this market. Indeed, merger and
acquisition strategies designed to give the firm scale and power in a particular
market might achieve this in the short term at the expense of eventual entry by
more able rivals (with consequent sacrifice of the gains that merger or acquisition
was designed to achieve). This could be the case if merger or acquisition is infe-
rior to internal expansion in terms of adding value in particular cases, weakening
the firm’s competitive potential and making it vulnerable to attack.
Alternatively, co-operative arrangements may also be able to achieve the same
gains without the need for combination within one firm. The firms could form a
co-owned and co-managed joint venture in distribution to rationalise that activity
and reduce the extent to which their efforts are duplicated, to increase their bar-
gaining power with retailers, to distribute each other’s helmets, and/or to spread
the benefits of best practice more widely. Even intangible elements such as the
benefits of brand image could be achieved without the need for merger if one
firm sells its product under the banner of the other through a joint venture. Of
course the competition authorities (or whoever is responsible for the control of
monopoly behaviour and restrictive practices in the country) might take a close
interest in any anti-competitive implications such co-operation may raise. How-
ever, the same might hold for any anti-competitive implications arising from
increased size or power due to a merger or acquisition alternative. In principle,
the intended outcomes of merger or acquisition may also be achievable through
internal growth or co-operative arrangements.
Which leads us to a natural question. Why is it that merger and acquisition per-
forms so badly, even ignoring the opportunity costs of better means that may have
been available to pursue particular gains from combination? We consider this issue
in the next section.

7.4 Why Do Mergers and Acquisitions Perform So Badly?

If we want to explore this question from the point of view of competitive strategy, it
really breaks down into two parts. First, why the gains are often so poor – why do
mergers and acquisitions so often fail to realise the added value that had been
promised from the combination? Second, why does one party to the transaction (the
shareholders of acquiring firms) often seem to do badly compared to their counter-
parts on the other side of the transaction? The answers will tell us a lot about the
nature of this method of pursuing competitive strategy.
7.4.1 Why the Gains from Merger or Acquisition May Be So

Disappointing
There are a number of possible reasons for the frequent disappointments in terms
of adding value.
Compatibility problems
One of the most frequently reported problems in merger and acquisition activity is
compatibility. The parts of the combination are simply not suited to each other.
This is something that may be a fairly obvious problem in the case of conglomerate
acquisitions where the skills built up in running one part of the business are not
readily transferable to other parts. It may also be observed in some vertical mergers
(such as Exhibit 7.2) where different stages may involve different skills and compe-
tences. These issues can also result in principal–agent problems in which the agents
(divisional managers) may be able to conceal the true reasons for poor performance
from corporate-level management (the principals in this case).
However, such cases may at least have the saving grace that management may
limit the extent to which they try to apply capabilities and resources to areas of the
firm for which they are not appropriate, or where there may be difficulties meshing
and integrating them with the existing set-up. Even firms that offer similar or
identical products have their own unique identity and character, whether they are
fast food chains or oil companies. This holds for human capital as well as physical
capital, and for procedures and practices as well as technical manuals. Some of these
differences may be explicit, such as specifications of equipment and materials; other
aspects may be intangible and reflect custom and practice, the way things are done.
In some respects the differences that are physical can be the easy ones to deal
with. The firm can assess the technical capabilities and differences of the various
parts of the merged firm and work out an appropriate schedule for investing in
plant and equipment that will allow them to exploit economies of scale on the
production side, if this is an objective of merger. Reconciling and integrating more
intangible differences can prove more of a problem. Firms develop their own
standards, jargon, operating procedures and even philosophy for getting things
done. However, the particular standards, jargon, procedures and attitudes that
compose a firm may reflect its own history and the particular combination of
managers, choices and events that make up its past. Changing the equipment used
by a firm can be a lot easier than changing the complex set of social and knowledge-

based characteristics that make up that firm. The trouble is that these latter sets of
characteristics may be less visible than physical characteristics, and managers may
find difficulty in changing them, even in cases where they are aware of the differ-
ences in the first place.
This has potentially at least two adverse consequences. First, the component
parts may continue to go their own way and do things the way they did before the
merger. This would limit co-ordination of resources across the combined firm and
mean that the new firm could fail to achieve its perceived potential in terms of
adding value by harmonising and standardising activities across the firm. Second,
attempts to co-ordinate and harmonise activities across the board may prove costly,
especially if the skills and competences to be transferred are not appropriate to the
other parts of the firm. The outcome may be the effective failure of the merger or
acquisition to add value.
Optimistic bias
Remember in Module 3 how it was the unexpected bugs, hitches and problems that
could contribute to delays and escalating costs for R&D projects? Something similar
holds for merger and acquisition activity. It is often easy to identify where meshing
of market and resources from combination could lead to enhanced value if all goes
smoothly. The pitfalls and problems that lie in wait on the way to extracting that
value are often less easy to identify in advance.
Strategy matching, interdependent strategies

One feature of mergers and acquisitions is that they often appear in waves, not only in
the economy, but sometimes in a particular sector even when there is not much
activity of this nature in the rest of the economy. For example, we noted in Module 4
how fears of being cut off (foreclosed) from inputs and outlets could encourage a firm
to integrate vertically. But if this firm integrates vertically, it may reduce the range of
inputs and outlets available to the rest of the firms and heighten their fears that they
may face greater chances of being cut off. This may help create a vicious circle of fear
and vertical integration, with fear of foreclosure triggering some vertical integration,
raising fear of foreclosure amongst non-integrated firms, triggering more vertical
integration, and so closing the circle.
Alternatively, a firm may observe its close rival pursuing a particular strategy
(Strategy X) through merger or acquisition (it may be diversifying into a related field,
vertically integrating, or expanding internationally). Our firm may be uncertain as to
whether its rival’s strategy is wise (adds value) or foolish (does not add value), but it
knows that it can match its rival by doing a similar merger or acquisition move, and
so maintain its competitive position relative to its rival. The implications for our
firm can be shown in Table 7.1.

Table 7.1 Whether or not to play follow the leader

RIVAL FIRM
Strategy X turns out to be foolish Strategy X turns out to be wise
OUR FIRM
Does not Our firm gains competitive edge over Our firm loses competitive edge over
match rival rival rival
Matches rival Our firm maintains its competitive Our firm maintains its competitive
position relative to rival position relative to rival
The choice for our firm is that if it does not match its rival’s Strategy X, then it may
lose competitive advantage to its rival if Strategy X turns out to be wise, but gain it if
Strategy X turns out to be foolish. On the other hand, if our firm matches rival’s
Strategy X, they are both in the same boat and our firm can expect to get no net
advantage over its rival, whether or not Strategy X turns out to be wisely founded.
What should the firm do? If it is a risk avoider, it will choose the option with the least
worst possible outcome, which would be to match its rival’s strategy, otherwise
known as the maximin solution. It knows that it will not be able to better its rival
through mimicking this strategy, but at least it knows it will not lose ground to it by
doing this. Since survival may depend on not allowing your rival to nose in front in
the competitive race, matching your rival’s Strategy X can be a rational thing to do,
even if you have no idea whether or not Strategy X itself is wise or foolish until after
the event.
It is important to note that strategy matching (whether to prevent foreclosure as
in our first example, or to maintain competitive positioning as in our second) may
be seen as providing our firm with potential benefits which are not necessarily
reflected in added value (increased revenues or reduced costs) from combination. As
such it may not fit neatly into the basic two-item checklist represented by Figure 7.2.
But it can represent an exception to the usual competitive advantage rule in cases
where security and uncertainty considerations encourage the firm to build defences
against worst-case threats to its survival or well-being.
Insulation from environmental surprises

As we discussed in Module 5, firms may try to avoid dependence on single-market
or technological links by diversifying into other markets and technologies and
generating a related–constrained or even a related–linked strategy. However, as with
strategy matching, the benefits of such insulation may not necessarily be reflected in
enhanced value on the balance sheet. The gains are in terms of at least partially
offsetting the adverse consequences of any surprise threats that the environment
throws up and may not be observed in terms of enhanced revenue streams or
reduced costs. There would be no surprise in such merger and acquisition activity
not showing up in terms of enhanced profitability since that is not the purpose of
the exercise.

Agency problems – managerial motives for merger

Perhaps an obvious (but frequently overlooked) reason for merger and acquisition
being disappointing in terms of profitability is that in some cases they may not be
undertaken for those reasons. The cases we have just looked at (strategy matching
and environmental insulation) are examples of this, though ones in which the
managerial team are still trying to protect the competitive position of the firm.
However, as we have seen in earlier modules, there may also exist principal–agent
problems in which the agents do not necessarily act in the best interests of the
principals. One manifestation of principal–agent problems in this context is that
agents (strategic planners) may see merger and acquisition, not as a means for
adding value for the principals (shareholders), but as a means for pursuing manage-
rial motives that may not be consistent with adding value.
So what motives may play a part in dissipating value here and what is the role of
mergers and acquisitions in this process? The benefits to management may be seen
here as following on from having a bigger firm. A managerial team or chief executive
may have empire-building objectives because of the enhanced status and power a
larger firm is seen to bestow. Also, if managerial remuneration and rewards are more
closely tied in to the size of the firm rather than its performance, then it would be
quite rational for management to push for increased growth and size, even if combi-
nations to achieve this may dissipate rather than enhance value.
The Prisoners’ Dilemma

We saw above that strategy matching may be sensible to prevent foreclosure.
However, there may be other cases where the firms finish up choosing the same
value-destroying merger and acquisition strategy even when it is clear to both firms that
they would be better off if they could agree not to pursue such strategies. Prisoners’ Dilemma
type situations (as in Table 7.2) may be unusual in practice (as we argued in Module
1) but, if and when they occur, they can have dramatic and unfortunate effects for
the players. Note that the situation in Table 7.2 is different from the case in Table
7.1 where the rival firm has definitely played Strategy X, but there is uncertainty
about whether it is wise or foolish. Here there is no uncertainty about whether a
strategy was wise or foolish, but both firms have a choice of strategy, in this case
whether or not to move downstream. The first entry in each box is the estimated
annual profit (say in millions of dollars) from making a downstream acquisition. The
real benefit that either firm could extract from making a downstream move is that it
gives it a base on which it could build to foreclose the other firm’s market. The
downstream stage involves very different skills and competences for the two
upstream firms and neither firm has the suitable expertise to manage this stage;
indeed, they would destroy rather than add value at this stage. ‘OUR FIRM’ is the
first entry in each box.

Table 7.2 The Prisoners’ Dilemma and possible effects of merger &
acquisition
RIVAL FIRM
Acquires Does not acquire
downstream downstream
OUR FIRM
Acquires downstream −10/−10 25/−15
Does not acquire −15/25 20/20
downstream
Table 7.2 shows that the two firms would make a profit of $20m a year each if
they keep things as they are and do not move downstream. If either firm moves into
the uncharted waters downstream, they will make losses on the resource side from
having to manage an unfamiliar set of activities. However, this is more than com-
pensated if the other firm does not follow and it is able eventually to cut its rival out
of much of the downstream market. The firm that moves makes a profit of $25m
and the firm that stays put now makes a loss of $15m, as Table 7.2 shows. The fact
that the combined profits of the pair have fallen from $40m ($20m + $20m) to
$10m ($25 − $15m) reflects the poor fit of the upstream and downstream stages and
the fact that overall efficiency has been reduced by this move.
However, if both firms decide to move downstream, their moves cancel each
other out in competitive terms and they are left with poorly fitting activities in
which there is little carryover in competences from one stage to another. Efficiency
on the part of both firms is impaired by the moves and they now make losses of
$10m each as Table 7.2 shows. Clearly they would have been better off individually
and collectively (profits of $20m each) if they had agreed to stick to the stage that
their competences were based in rather than move downstream (losses of $10m
each).
The problem is that they may not trust each other to stick to such an agreement,
and indeed the Prisoners’ Dilemma structure of this problem suggests it would be
rational for neither to abide by such an agreement, even if it was made. If our firm’s
rival moves downstream, then it would be rational for our firm to follow and make
a loss of only $10m compared to the $15m loss it would make if it stayed put. If the
rival decides not to move downstream, our firm can make a profit of only $20m by
doing the same, but could beat that with a profit of $25m by integrating and
building a base downstream that may help to cut its rival out of some of that
market. Whatever its rival does, our firm’s most profitable strategy is to move
downstream. Exactly the same logic holds for the rival firm, with the result that
both firms move downstream and start to make losses in a sector where they had
previously been making profits.
A Prisoners’ Dilemma structure to a situation can result in merger and acquisition
destroying value, even in cases where the management are aware of these dangers in
advance.
To summarise, there are enough reasons for merger and acquisition to fail to add
value in practice for us not be surprised when such an outcome occurs. Indeed,

perhaps it could be expressed the other way – that there may be grounds for
surprise and delight when a merger or acquisition beats the odds and actually turns
out to have led to enhanced value!
7.4.2 Why Do Acquirers Do Even Worse than Those Being Acquired?

We have a second puzzle to deal with. Merger and acquisition may be a dubious
enough way to try to add value, but the acquirer tends to get a much worse deal
than the acquired firm in takeovers. Indeed, if there is one group that the evidence
suggests does rather well out of mergers and takeovers, it is not the shareholders or
other owners of the acquiring firm, but their counterparts who sell their firm to the
acquirer. Why should acquiring firms do so badly? There are a number of reasons.
The Grossman–Hart Problem

Grossman and Hart (1980) showed that dispersion of ownership of the firm
amongst a number of shareholders could create difficulties for takeover bids. If
there are a large number of dispersed shareholdings in the firm, then each share-
holder may reason that anything any individual does will not affect the chances of
the bid going through or failing. Each may reason that, rather than sell out, it may
be better to hang on and free-ride on a full share of the increased value of the asset
once the bid goes through. But if each shareholder reasons the same way, then the
bid will fail at least until the price gets to the point where sufficient shareholders
reason it will be better to sell than to hold on. And of course this may be at a price
that redistributes all the gains from merger from the acquirer to the shareholders of
the target firm. The problem is set out in Exhibit 7.3.
Exhibit 7.3: The Grossman–Hart Problem

The Grossman–Hart problem can be illustrated by a simple example. I have a fine old
vase that is slightly cracked and I think is worth only $50 if I sold it down the local
market. A local trader offers me $90, repairs it, and sells it for $150. Both of us have
benefited from the arrangement, I am $40 better off than I would otherwise be and
the trader is $60 better off (less the cost of the work he put into upgrading it). This is
simply a straightforward example of the benefits of trading where both parties to the
transaction share in the gains from exchange.
Now, suppose that a firm, Lazy Inc., has a large number of shareholders, none of
whom owns a significant percentage of the shares in the firm. Lazy Inc.’s shares are
worth $50 in the market at the moment (like the vase, the firm is regarded as slightly
cracked and in need of renovation and this is reflected in its rather low market
value). I am the holder of a single share in Lazy Inc. and I read about the Chief
Executive of a takeover raider telling his financial backers that Lazy Inc. has great
potential and that if he were able to take it over he could expect to triple its value to,
say, $150 a share (for simplicity we assume there is no uncertainty about this
valuation and it is information that is shared by the public as well). Then he makes an
offer of $90 per share for Lazy Inc. shares. This would give me a $40 profit and also
leave him a $60 profit on my share – less the share of the costs of the work he puts
into upgrading the firm) once he increases its value to $150 just like the vase.

On the face of it, this looks like a mutually advantageous deal for both parties, just
like the example of the slightly cracked vase. Except that I have an option which I did
not have in the case of the vase; I could hold on to my share in the hope that enough
other shareholders sell out to allow the raider to gain control of the firm and
increase its value to $150. I could then free-ride and get a full share of the expected
$150 value of the firm. But if all other shareholders think the same way, no-one sells
out at least until the raider has been forced to push the price so high that enough of
Lazy’s shareholders think it is more sensible to sell out than to hold on. The result is
either to deter sound bids (because the potential bidder believes the price they will
have to pay to gain control of Lazy Inc. will be pushed unacceptably high), or to
redistribute significantly (perhaps completely) any gains from merger from the
acquirer’s shareholders to the shareholders of the target, Lazy Inc.
A point worth noting is that the Grossman–Hart problem would not operate if I
were the single owner of Lazy Inc. In such a case the ownership issue is similar to the
case of my owning the vase and we would expect the takeover to take place if a
mutually agreeable price could be settled on (unless there are other factors such as
my having an emotional attachment to the firm).
There are ways of trying to deal with the Grossman–Hart problem, or at least
alleviate its worst effects. These depend in part on the rules and conventions used to
deal with takeover bids in different regimes. From the point of view of corporate
strategy, the important thing is the effect of dispersal of share ownership. It might
be thought that dispersing share ownership would help to reduce the price of the
target firm because it would weaken the bargaining power of its owners compared
to cases of concentrated ownership. In fact, the Grossman–Hart problem means
that dispersed ownership may actually increase the price to be paid for the acquisition
and result in a worse deal for the acquirer.
The ‘Winner’s Curse’

The ‘Winner’s Curse’ is something that obtains in a number of contexts, one of
which can be acquisitions. Suppose that a firm is ‘in play’ and that a number of
potential bidders are interested in acquiring it. The potential bidders value what they
think this firm is worth and its future prospects. Unfortunately, there is a high
degree of uncertainty regarding the present value of this firm considered as an asset
(the potential bidders cannot directly observe the inner workings of the firm, there
is uncertainty about future market and technological trends, and so on). Inevitably
the potential bidders make errors, some of an overly-optimistic nature and others of
an overly-pessimistic nature, thus biasing their estimates of the present value of this
asset.
If the realistic present value of the firm lies below one or more of those based on
overly-optimistic assumptions, the winning bid is likely to be based on an overesti-
mation of how much its new acquisition is really worth. Firms with overly-
pessimistic estimations are more likely to drop out of the bidding war early on; firms
with overly-optimistic estimations are more likely to hang in there longer. The result
could be eventual disappointment for the ‘winning’ firm when it discovers that it
had an inflated estimate of the true worth of its prize in the first place.

Even when there is no bidding war, the Winner’s Curse may still hold. For a
particular firm there may be a number of potential bidders who look at it and decide
that it is simply not worth acquiring (they have overly-pessimistic or realistic
estimates of the underlying value of the firm). Now, if another firm comes along
that for one reason or another places an overly-optimistic valuation on this potential
acquisition, they are clearly more likely to bid for it, and (equally clearly) eventually
rue their decision if they succeed in their takeover bid.
So the Winner’s Curse can distribute gains from acquisition from the owners of
the acquiring firm who ‘win’ the bid to the owners of the acquisition who find they
have been paid more than their asset is realistically worth. This can hold whether or
not the combined firm is worth more than the sum of the value of the two separate
parts pre-acquisition.
How serious a problem is the Winner’s Curse? It certainly seems to play a part in
some auction systems, whether it is a firm buying another firm that turns out on
closer inspection to be a disaster area, or your Uncle John buying that old vase that
turns out on closer inspection to be slightly cracked. There is also a range of
outcomes for the bidding firms, with the firms showing the greatest possible gains
being prepared to bid highest. If their estimate is correct, the Winner’s Curse will
not apply.
There may also be safeguards against the Winner’s Curse in practice. Consider,
for example, other cases where there are uncertainty and differing valuations in a
bidding system. This could be for second-hand cars sold at auction, or competing
insurance companies offering differing premiums to insure your possessions. If the
Winner’s Curse always operated, then purchasers of second-hand cars would always
offer more than the car was really worth, while insurance companies would always
offer lower premiums than the risk really warrants.1 Car auctions would dwindle
away because the word would get round that you always have to pay more than the
car is really worth, while insurance companies would go broke because they always
underprice their premiums relative to the true underlying risks in a particular
category.
The fact that car auctions and insurance companies still operate suggests that the
Winner’s Curse is not generally a serious enough problem to cause trading to break
down in these sectors. Probably the best defence against the Winner’s Curse is
natural caution and risk aversion in the face of uncertainty. The group of potential
bidders for an asset may possibly throw up an individual (or group of individuals)
who may be vulnerable to the Curse in this context. At the same time, the potential
cost of the Curse may be defrayed by bidders adding risk premiums to their esti-
mates of the asset’s worth. Whether the winning buy eventually turns out to have
been a good or bad decision will depend in part on whether such devices dampen
bids sufficiently to avoid the trap of the Curse. And as we saw in Section 2.5.2, there
may be countervailing downward tendencies on the price because of the ‘market for
lemons’ problem.
1 Remember in this case that the winning bid is the one that offers the lowest price (or premium) to the
person seeking insurance.

Hubris (or excessive self-confidence)

Management involved in a takeover may become so caught up in the thrill of the
chase and the excitement of deal making that they allow their bids to become
unrealistically inflated. Lack of balanced judgement may result in bid prices being
pushed up beyond what should be regarded as reasonable. The Winner’s Curse is
something that may happen naturally, simply because errors creep into estimates
and forecasts. However, hubris can actively increase the chances of a cursed bid by
biasing bids upwards.
So far we have some general conclusions about strategic moves in terms of both
direction and method; as far as direction is concerned, stick as close to home as
possible if you want to add value, and choose internal growth over merger and
acquisition (if you have the time and the opportunity) when you are making your
move. The further away from your existing competences that a move takes you, the
greater the chances that the move will destroy rather than add value. If you have to
use merger or acquisition instead of internal growth to pursue that move, then the
various problems discussed above may lie in wait for you.
Some of these problems may also be encountered in the case of internal growth;
for example, management wishing to pursue growth and size of firm rather than
profitability may do so by internal growth as well as acquisition. However, it is
usually the case that merger and acquisition brings these problems into sharper
focus (e.g. a managerial team wishing to pursue growth objectives may be too
impatient simply to rely on internal growth). Also compatibility problems are less
likely to be a feature in cases of internal growth where the new parts of the system
can be designed from scratch, while some problems such as the Grossman–Hart
problem and the Winner’s Curse refer specifically to acquisitions.
In practice, merger or acquisition may be chosen over internal growth for a varie-
ty of reasons as in the following cases:
 Growth objectives of management
 Where speed is important, for example to pre-empt competitive response of
rivals
 To gain competences and resources that could not be easily developed internally
 In the absence of room for entry through internal growth (e.g. the existing firms
may have the supplier and customer bases locked up)
 In order to eliminate a competitor.
There is a further issue that lurks behind all this and follows from the discussion
of the previous module. Merger or acquisition may be seen as a ‘quick fix’ to
problems that internal growth may find more difficulties in dealing with, at least
within the time scale envisaged by the management. However, even if merger and
acquisition delivers relatively immediate pay-offs (which may be debatable in view of
the evidence and the problems we have discussed), this still leaves the issue of
whether such a strategy is suited to delivering sustainable competitive advantage
over longer time horizons. This may be questioned in resource-based terms (merger
and acquisition may put together ill-fitting and poorly matched bundles of resources,
as we have seen). It may also be questioned in terms of the loss of sharpness and

competitive edge that merger and acquisition may lead to if it eliminates a competi-
tor and reduces rivalry (as we noted in the discussion of Porter’s Diamond in the
previous module). So while merger and acquisition may have unfortunate side
effects in the short term, these may be compounded by the erosion of competitive
advantage over even longer periods.
It might be thought that merger and acquisition may have sufficient problems to
put them bottom of the list of value-enhancing strategic alternatives in many cases.
However, there is another method of combining activities that can often score
worse than either of these options on those grounds. Its name is joint venture and
we shall look at it in the next section along with other co-operative approaches to
the combination problem. In particular we shall explore why joint venture, despite
its difficulties and costs, has become one of the most important weapons in
competitive strategy in recent years.
7.5 Co-operative Activity

There are a number of ways that firms can co-operate in practice.
 Licensing
 Franchising
 Informal co-operation
 Sub-contracting
 Alliances
 Network participation
 Joint venture
A licence is effectively permission for another firm to indulge in an activity that would
otherwise be forbidden by law. It usually involves the transfer of intellectual
property rights in technology for specified periods and territories, in the form of
patents, designs, trademarks etc. A wide range of technologies and brands may be
produced under licence, from computers to books. A franchise also involves the
transfer of intellectual property from one party to another for specified periods and
territories, usually based around the rights to use the franchisor’s name and trade-
marks, as in the case of McDonald’s and Kentucky Fried Chicken. There has been a
rapid growth in franchising activity in recent years and it covers industries as diverse
as hotels, fast food and dry cleaning. The main difference between licensing and
franchising is that licences usually relate to part of a business (the technology for a
specified product or products), while franchising tends to involve the transfer of
know-how ranging over the entire business, from purchasing through production to
presentation and selling.
By its nature, informal co-operation is difficult to pin down and define in formal
terms; it really depends on the context in which it takes place. But the logic of it is
clear enough and can be summarised as ‘you scratch my back and I may scratch
yours’. For example, an engineer may ask another engineer in a rival firm for advice
with a technical problem he or she is encountering. The rival engineer may help in
the knowledge that he or she can also expect reciprocal help in the future if and
when they run into technical problems.

Know-how ‘trading’ through informal co-operation has been found in a wide

range of industries including aerospace, waferboard manufacturing and steel
minimills. Senior management may or may not know and approve of the custom. It
can be to the benefit of both parties, especially if together they are only small parts
of a wider competitive set-up. However, there tend to be natural limits to the
practice and it is vulnerable to opportunistic breaches and severe transaction costs
for anything other than minor projects and problems.
We have discussed sub-contracting in the context of vertical relations in Module 4.
Sub-contracting involves separating out part of a production process to be dealt
with under contract by a separate firm. Until recently this would have been regarded
as a straightforward example of market contracting in which one firm specifies a
good or service to be supplied by another firm. However, we saw in Module 4 how
sub-contractors in some cases, such as in the automotive industry, are assuming
more responsibility for R&D and design activities, with the relation between buyer
and supplier now frequently evolving into long-term co-operation.
Joint venture is a form of co-operative activity that has increased rapidly in num-
bers in recent years. Definitions vary, but generally speaking a joint venture tends to
have five main characteristics.
 Two or more ‘parent’ firms agree to co-operate.
 The new entity (the ‘child’) is created for a specified task and possibly duration.
 The child has its own decision-making capability.
 The child is co-owned by the parents.
 There is provision for continuing parental supervision and control over the
venture.
Unlike many textbooks on strategic management we do not have to wade
through the tedious exercise of working out what a joint venture might achieve. We
know what it might achieve – exactly the same things as merger or acquisition. What
we are really interested in is how a joint venture differs from a merger, and the
circumstances that might encourage firms to pursue this option rather than merger
or acquisition.

boundaries of firms
market link
technical link
MERGER JOINT VENTURE
business unit
contract
hierarchical relationship
Figure 7.4 Merger versus joint venture

Figure 7.4 shows how a joint venture can differ from a merger. The top of the
diagram shows two different ways of co-ordinating assets in a new venture, using
merger and joint venture respectively. Two single business firms (the white circles in
both cases) agree to co-operate in a new venture (the green circle in both cases).
One firm has the marketing and distribution resources that the new business needs,
while the other has the production and R&D skills that it requires. On the left the
two firms agree to merge and form a three-division firm out of their existing
businesses and the new venture as shown above, with the ‘child’ the green box. This
solution has a simple and conventional hierarchical structure and fully internalises
control over the venture within one firm.
Now, suppose instead that the two firms agree to form a joint venture to exploit
the new business opportunity. This is also shown in Figure 7.4 (the new venture is
again the green box) and it involves three particular considerations when this
alternative is compared to the merger option.
1. Contractual issues. The joint venture contract between the parties may absorb
considerable amounts of managerial and legal resources just to set up. The rights,
responsibilities and obligations of the parties will have to be discussed and
agreed. The necessary documentation can run to many hundreds of pages in
some cases. However, this is only the start of the problem because each party
will normally need to police and monitor each other’s performance and actions.
The possibility of opportunistic behaviour may be seen as greater in joint ven-
ture compared to mergers because firms other than your own are involved,
adding to the costs of monitoring.
2. Complex hierarchy. Note that in Figure 7.4 we have a more complex hierar-
chical arrangement for joint venture than for merger. The child is effectively the
servant of two masters in this case (and this can become even more complicated
in cases where there are more than two parents). If such an arrangement were
ideal for decision-making purposes, we can be sure that more firms would adopt
it and not wait until it was forced on them by the dictates of joint ventures. In
fact, it can lead to conflict and confusion since there is no reason that the objec-

tives, priorities and perceptions of the partners as to the outcomes of the joint
venture should be the same. Like merger, joint venture may also face the incom-
patibility problem in that procedures and cultures may be very different in the
two parents, leading to further co-ordination problems, miscommunication and
misunderstanding. However, joint venture partners have no direct control over
each other’s practices, unlike merger where at least the firm may be able to im-
pose some harmonisation of standards and procedures directly.
3. Appropriability problems. There is a further danger lurking in the thicket of
joint ventures: fear of losing competitive advantage because it leads to intellectu-
al property leaking out. A great advantage of merger is that it is more able to
keep important secrets and techniques private by internalising all the critical
assets. However, the joint venture may provide direct or indirect access to a
partner’s techniques and processes. In the joint venture example above, the firm
providing technical expertise may learn how its partner organises its selling and
markets its products, while in turn the latter may pick up R&D and how to or-
ganise production from its partner. Either firm may permanently acquire
competences that it lacked or was weak in.
On the face of it, appropriability problems might not seem too severe for joint
ventures. After all, one partner’s loss is the other’s gain. Indeed it may lead to a
net gain if the partner is able to turn the know-how acquired to areas that its
partner would not have reached. Also, many firms explicitly go into joint ven-
tures to acquire know-how and competences that they are lacking. However,
while firms may actively seek to raid their partners’ store of know-how, they are
also likely to want to guard against the partner doing the same to them. Conse-
quently the venture may be characterised by the parents’ reluctance to reveal or
commit sensitive resources to it. Also, firms may naturally fear revealing the
basic competences that drive their competitive advantage, especially if there is a
danger that their present partner could become a future rival in these areas, as
Exhibit 7.4 illustrates.
Exhibit 7.4: Honda + Rover + BMW

The German car maker BMW stunned the Japanese firm Honda by buying Rover, the
UK car maker. Honda and Rover had earlier built up an alliance with a number of
strands, most of which involved Honda transferring technology to Rover.
The Honda/Rover alliance included:
 Honda and Rover owning equity shares in each other
 Rover producing gearboxes for its T-series under licence from Honda
 Honda supplying V6 and 1.6 litre engines to Rover
 Rover producing body panels for the Honda Accord
 Rover to be licensed producer of the planned replacement for the Rover 200–
400/Honda Concerto
 Rover’s Land Rover Discovery badged in Japan as Honda Crossroad.
Rover had been one of the weaker European car makers, ‘stuck in the middle’ in
Porter’s terms, not big enough to reap full economies of scale from being a volume

producer and not successful enough in adding value by finding an upmarket niche.
Honda’s collaboration with Rover had given the Japanese firm access to the European
market, but the takeover by BMW meant that its partner was now owned by a major
global competitor who was already well placed in the markets that Honda wanted
access to, and now had access to technology that Honda had supplied to what was now
BMW’s UK subsidiary.
Even if they had wished to, the complex set of interrelationships involved in the
alliance made it difficult for Honda to withdraw from all elements of the collaborative
relationship immediately, though they promptly signalled their intention to phase out
their alliance with Rover. Honda stated that its alternative strategy now was to build a
more independent operation in Europe, drawing on its own resources.
Why did Honda fall into what seems an obvious trap of becoming so closely
linked to Rover, with so many interdependences that were difficult to unravel?
So joint venture has at least three sets of disadvantages compared to merger or

acquisition – two sets of transaction costs (arising from the joint venture contract
and the residual problems of appropriability problems that contract cannot elimi-
nate), and the administrative costs arising from the dual control system of joint
management. Individual joint ventures may vary to the extent that they are vulnera-
ble to each or all of these problems. However, the basic structure of joint venture
leads to these being reported as recurring problems in joint ventures in practice. If
they are potentially more problematic and costly even than mergers, why would any
firm want to consider such a solution in the first place? As we noted in Module 6,
there are some cases of joint venture where the firm is forced into a joint venture
with a local partner if it wants access to that country’s market; Exhibit 7.5 and
Exhibit 7.6 both illustrate these pressures even in the case of developed countries.
However, we have seen an escalation in joint venture activity between firms in
developed countries where these conditions do not apply. So what can explain these
kinds of joint ventures?
Exhibit 7.5: Telecommunications connections

Over time, the fragmented global telecommunications industry coalesced into three
major groupings or networks, each with multiple partners. The groupings were:
Concert, based around an alliance set up by BT and MCI, with numerous joint ventures
involving associated national operators; WorldPartners, a grouping based around the
US’s AT&T; and Global One, a partnership between France Telecom, Deutsche
Telekom and Sprint. There were also some smaller groupings and some firms that had
not yet found a grouping or had decided that they could go it alone because they already
had global reach (like Cable & Wireless) or were focusing on niche markets.
The driving forces underlying the formation of these groupings were rapid technolog-
ical change and trends toward deregulation. Historically, most telecommunications
operators had been national monopolies and even with notional deregulation most
telecommunications markets could not really be regarded as fully deregulated. However,
an agreement brokered by the World Trade Organization led to expectations that the

majority of countries would eventually open their telecommunications markets to full

competition. Under the agreement, national firms would find that foreign firms would be
free to enter their markets and even take them over.
The global basis of the groupings permits them to provide an integrated service for
international customers such as multinationals across national markets and provides a
single point of billing. It also helps spread R&D costs and exchange rate risks, transfer
technical know-how internationally, and overcome market access barriers.
However, the membership of the various groupings was also subject to continual flux
with firms exiting and entering networks as their relative merits (real or perceived)
waxed and waned. This instability was expected to continue for the foreseeable future
as the major groupings sought to expand their global presence into more national
markets, and as further deregulation and innovative activity (such as the Internet as a
communications tool) added to the pervasive uncertainty.
Exhibit 7.6: Synchronised flying

The airline sector is similar to some others such as telecommunications and postal
services in that it displays what are termed network economies. The more places and
routes an airline services, the more attractive it is to users who wish the advantages of a
single carrier. In turn, the more users and revenue it attracts, the more able it is to
expand into new routes. As with telecommunications, merger and acquisition in pursuit
of these network economies has been impeded in many cases by the tendency of
governments to treat their own carriers as national champions ‘flying the flag’.
The solution adopted by many airlines has been to pursue alliances to share particu-
lar areas of their value chain where combination is seen as having the potential to
release economies and/or possibly facilitate an increased degree of market control.
Areas of co-operation include code sharing (jointly marketing and selling seats on each
other’s planes), flight scheduling, catering, baggage handling, ground services, mainte-
nance, lounge facilities and pricing.
Some alliances involved multiple partners in a global network and in some cases
helped diffuse know-how from the stronger members and improve standards amongst
the weaker members of the group.
However, alliances were also characterised by their high failure rate, while others
were seen as having anti-competitive implications with reduced competition and more
control over prices. BA had an earlier alliance with United Airlines which broke down,
and the alliance between KLM and Northwest became embroiled in a legal dispute. The
survival rate of alliances was typically less than half. Differences in operating procedures,
histories and cultures often made such international co-operation difficult to sustain.
And the fact that airlines commonly retained their brand identity and livery often led to
fears over brand confusion and dilution when users found they were flying with different
operators from the one they thought they had contracted with.
Could collaborative activity in exhibits 7.5 and 7.6 lead to changes in the Five
Forces?
The answer to that really comes in two parts.

1. Why joint venture and not other forms of co-operation? The reason that
joint venture may be preferred to other forms of co-operation, such as licensing
and franchising (which may pose their own forms of appropriability problems),
is that there are often still major strategic decisions to be made involving the
venture. These other forms of co-operation are more appropriate for cases
where the fundamental market and technical characteristics that will help gener-
ate competitive advantage are fully known in advance and can effectively be
specified in a contract.2 Joint venture is frequently adopted in areas where there
is still major uncertainty concerning market and/or technical possibilities, such
as technological innovation, new market entry and searching for natural re-
sources. That is why the child is given a decision-making capacity to deal with
future issues as market and technical information unfolds in the course of devel-
oping the venture.
2. Why joint venture and not merger and acquisition? Joint venture does
essentially the same thing that merger and acquisition does; that is, it provides a
hierarchical structure and decision-making apparatus that allow the business to
respond creatively and exercise influence over future events. As we have seen,
joint venture has a long list of disadvantages relative to merger and acquisition,
but it has one critical advantage. It can be designed to cover only the selected
range of the resources that are of relevance to this venture opportunity, and
these in turn may relate to only a small part of the relevant partner’s activities.
Before we look at the benefits of this trick, we can note that there are two basic
ways that joint venture can perform it.
(a) Selected pieces of the value chain: consider the two value chains in Figure 7.1 and
Figure 7.3 and recall that our firms were pursuing means of adding value by
combining their sales forces. They could do so by merging the two firms. Now
suppose they were to form a joint venture in sales only, and keep the rest of their
activities separate. This would allow them to set up a decision-making facility to
co-ordinate potential gains from sharing sales forces, while localising most of the
costs of co-ordination to that region of the firm. In principle, there is no reason
why other regions of the value chain could not be picked off and joint ventures
set up by the two firms in, say, distribution, production, purchasing or R&D.
This selective approach to targeting bits of the value chain is shown in Exhibit
7.6 and Exhibit 7.7.
(b) Selected businesses of the firm: now consider the case shown in Figure 7.5. This is
adapted from the case of the related–linked strategy in Figure 5.11. Here we
assume that we have two five-business related–linked firms considering pooling
expertise from two of their businesses into a new venture (the dark circle on the
left). As Figure 7.5 indicates, the top firm can offer technical expertise to the
new venture, while the bottom firm can offer marketing skills and competences.
In this case again, merger is one way of marrying the resources and helping cre-
ate decision-making capacity for the new venture. Now suppose, instead, they
2 This characteristic also holds for much traditional sub-contracting, though as we noted above it may be
less true of recent developments where sub-contracting may take on some of the behavioural features
(if not the formal structure) of joint venture.

form a joint venture in the new business, keeping the rest of the firms separate.
This would help them set up a decision-making facility to co-ordinate resource
sharing over the relevant region of the firm, again localising most of the costs of
co-ordination to that region of the firm.
Figure 7.5 Merger as sledgehammer

Joint venture is almost certainly more costly than merger or acquisition over the
range of the activity to which it is applied. In the case of our sales joint venture, it would
probably be easier and cheaper from the perspective of co-ordinating the joint sales
force if the two firms had merged. But if the sources of potential gains are concen-
trated in those regions of the respective firms, then joint venture has the virtue of
avoiding the additional problems of merging entire systems with the knock-on side
effects that we discussed above. Similarly, applying the joint venture option to the
new opportunity (the dark circle in Figure 7.5) may make for an uncomfortable life
for the managerial team in charge of the joint venture between the two parent firms
(the two linked firms described in the rest of the figure). Again, seen from the
perspective of this particular business it would almost certainly have been easier and
cheaper to manage if the two parents had merged and the venture was simply a
division reporting to a single corporate headquarters. And, again, the saving virtue
of joint venture in this context is not what it does but what it does not do. Unlike
merger, it does not combine what would be eleven businesses into a diverse and
complex system that could face major problems of management and co-ordination.
These points also help to explain why joint venture has become so important in
recent years. Joint venture is not just an alternative to corporate diversification
through merger and acquisition, it is also a consequence of it. As long as firms are small
and specialised, exploitation of new opportunities through merger and acquisition is
likely to be the preferred route to growth, especially if internal expansion opportuni-
ties are limited. However, the evolution of the large diversified corporations in the
sixties created the conditions under which joint ventures were seen as increasingly
attractive options compared to merger and acquisition alternatives. In many
instances it simply was no longer practical to consider combination within one firm

when both the interested parties were themselves already large diversified multina-
tionals with different ranges of interests, objectives and managerial cultures.
Finally, we can consider alliance and network participation. These last two forms
of co-operation differ from the previous cases in that both can involve a variety of
specific acts or forms of co-operation, some of which have been discussed above.
An alliance between two firms involves a formal or informal agreement to co-operate
on a variety of matters, as in the Honda–Rover alliance in Exhibit 7.4. Some
alliances involve swapping equity to help cement the alliance and increase the
involvement and commitment of both parties to their joint success. They are
analogous to the twinning or partnership agreements that are formed between cities
and institutions such as universities.
Exhibit 7.7: Oil pools

One of the effects of relatively soft competitive conditions is that it may permit
inefficiencies to persist and firms may fail to exploit value-adding possibilities adequately.
Oil price hikes and shortages led to oil being seen as a scarce commodity. Downward
pressure on oil prices put increasing pressure on the margins of even the vertically
integrated majors, encouraging them to find ways to squeeze more value out of the
various activities that they were involved in.
Combination through merger was one solution that was actively pursued by strategic
planners and these included Exxon–Mobil, BP/Amoco/Arco and Total/Fina/Elf. However,
full merger could trigger the interest of the relevant monopoly and competition
authorities. It also had the disadvantage of being a blunt tool that would combine all of
the assets of the participating firms when it might only be parts of the value chains
where combinations and co-ordination might release value.
In practice, the various oil companies tended to pursue a co-operative approach that
emphasised resource sharing along targeted pieces of their value chains, resulting in
economies and reduced duplication of activity. For example, Exxon and Shell co-
operated on North Sea development, Chevron and Texaco jointly marketed their
output under the Caltex brand, while one of the most extreme examples was Shell Oil
(the US arm of Royal Dutch/Shell) which decided to focus on fewer segments of the
vertical chain and formed joint ventures in refining, chemical operations and natural gas
with Amoco, Exxon, Petoleos Mexicanos and Tejas Gas.
One of the biggest collaborative deals was a European refining and marketing joint
venture between BP and Mobil with assets of $5bn and sales of $20bn and covering
about 5000 service stations. The partnership was estimated to result in reduced
duplication of activities, with the shedding of about 3000 jobs and cost savings of $400–
$500m a year.
Does any of the analysis of Section 7.4.1 help explain why oil companies are
suddenly exploring similar strategies (especially merger, but also joint ventures)?
Alliances can have both a resource-based and transaction-cost logic. The ad-
vantage of alliances from a resource-based perspective is that both sets of
managerial teams can build up familiarity and understanding in terms of how the
other firm works. We have noted in the context of mergers and acquisitions how
differences in practices, rules and procedures can cause incompatibility problems.

This holds even more strongly in the context of co-operation if the firm selects a
new partner for every new co-operation agreement. The firm can take advantage of
previous learning and does not have to learn from scratch how a partner goes about
its business for every form of co-operation that falls under the alliance umbrella.
The transaction cost logic for alliances is that they should inhibit opportunism. It
may be easier to behave opportunistically for one-off acts of co-operation where the
partners do not have any other co-operative agreements with each other. In that
case, cheating on the partner may have little or no knock-on effects on the rest of
either firm’s business. However, if there is a series of individual co-operation
agreements that go to make up the alliance (in operation and/or in prospect) then
opportunistic behaviour in one part of the alliance may provoke a hostile response
by the partner that is reflected elsewhere in the alliance, and may even threaten the
stability of the alliance agreement in worst-case instances. We saw in Exhibit 7.4
how Rover deciding to switch its relations to BMW led to Honda deciding to
withdraw from the various component elements of its alliance with Rover, as
quickly and as far as possible. The individual agreements that go to make up the
alliance may effectively act as jointly held hostages, encouraging the parties to the
alliance to behave well in its constituent parts, and to be open in their relations with
their partners.
A major cost of alliance is that the alliance partner may not be the ideal choice of
partner for each constituent agreement considered in isolation. There may be more
advanced or lower cost firms that the firm could have co-operated with had alliance
advantages not encouraged it to stick with this partner. Also, alliances may dull
competitive edge if they limit competition and make it more difficult for able firms to
find niches where they can enter a sector.
If alliances can have the features and attractions of twinning or partnership ar-
rangements, then network participation can display some of the features and attractions
of joining a club. Networks (such as the cases in Exhibit 7.5 and Exhibit 7.6) may
exist where three or more firms are directly or indirectly linked by a series of co-
operative agreements. It may be set up by formal agreement, or it may simply evolve
without any central set of objectives, direction or planning. The essential quality of a
network is that there are access and transaction cost benefits from joining, over and
above the benefits which one-on-one co-operative agreements or alliances can
provide. Like alliances, networks can reduce transaction costs by inhibiting oppor-
tunism. In the alliance case, inhibition reflects multiple transactions linking the two
firms. In the network case, inhibition reflects multiple transactions linking the
network. Just as breaches of a gang’s code may invite retaliation from the rest of the
gang, so networks may punish anti-social and opportunistic behaviour by one of its
members by making it more difficult to do business as part of it.
Networks vary widely in the scope of activities that they exercise influence over,
and in their strength and effectiveness. At one extreme it may involve weak and
occasional interactions and be little more than a mailing list involving large numbers
of participants. At the other extreme it may involve as few as three firms, each with
major co-operative agreements with both of the other members, as in Exhibit 7.5
and Exhibit 7.6 above. If Firm A begins to act opportunistically in its agreement

with B, then the victim may be able to retaliate by using its relations with C as a
weapon. At its bluntest B may say to C, ‘Look, if you want to continue to do
business with me, then help me by using the leverage of your joint interests with A
to persuade him to behave more reasonably.’
Of course, the threat may not be so explicit as that, and indeed the point of the
network can be to stop things reaching that state of near breakdown. Networks can
encourage more open flows of information and reduce transaction costs precisely
because everyone knows that potential sanctions should reduce the chances of other
firms acting opportunistically in the first place.
Networks differ from other forms of co-operation in that in some cases they
need not involve a deliberate decision to join. Indeed many firms may be unaware
that they are part of a network and may find it difficult to identify its boundaries and
members even if they are. If C and A had only just formed a co-operation agree-
ment, and they both already had separate co-operation agreements with B, this
single act could suddenly make B part of a network even though the change did not
directly affect this third party.
But, like alliances, networks can exclude as well as include, and there may be no
guarantee that those excluded from a network are less fit firms than those that are
included. Consequently, networks may soften competitiveness to the immediate
disadvantage of those excluded and the eventual disadvantage of network members
themselves.
Learning Summary
Combining the efforts of two or more separate firms can be done in two main ways:
combining them into one separate entity through merger or acquisition, or through
a co-operative agreement such as joint venture or alliance. The area of combination
can be limited to parts of the firm (e.g. selling one division to another firm; joint
venture between two divisions of separate firms) or may involve the whole of both
firms (e.g. mergers and firm-level alliances).
Whatever the method chosen, there are two main effects that such combinations
can have in terms of the competitive advantage of firms. It can have a stimulating
effect on the demand side, and/or it can help generate economies of scale or scope
on the supply side through sharing resources. Despite the impressive laundry lists
that have been produced to describe what each method of combination can achieve,
most such laundry lists are close substitutes for each other and can be reduced to
these same two basic elements.
There is considerable evidence to suggest that merger, acquisition and joint ven-
ture are frequently very disappointing in terms of their performance. We have seen
how and why stated objectives may be at variance with observed performance in
such cases. We have also seen how such poor performance could be explained and
anticipated in many cases by a fuller analysis of the likely objectives and effects of
combination.

The Elective as a Whole: Conclusions

This elective has been concerned with the really big questions in the firm. What
shape should the firm’s strategy have? Where should its boundaries end, and market
links with other firms begin? What directions should it pursue in the future? How
should it pursue these directions? There is usually no one answer to these questions;
more often strategic planners have a set of alternatives to choose from. These
alternatives are not always made explicit by the planners and often choices are made
from a limited menu. Formulation of strategy must be based on a proper evaluation
of the implications of a strategy, and also the alternatives to it.
We set out basic concepts in the first two modules. When we turned to particular
topics in the subsequent modules, we began to see how preconceived notions
concerning different types of strategies may be wrong and misleading. Innovation
(Module 3) is an area rich in fallacies; ‘what everyone knows’ is not always so. Past
enthusiasm for vertical integration (Module 4) has been replaced in many quarters
by arguments in favour of outsourcing and downsizing. Diversification (Module 5)
often fails to achieve its stated objectives and indeed these objectives may often be
more easily achievable through alternative means and more focused strategies.
Multinational enterprise (Module 6) can be expensive, underutilise the firm’s existing
capabilities, and lead the firm into areas where it has little or no expertise. Exporting
and various forms of co-operative solutions may be more efficient means for
achieving the same ends as going multinational in many cases. And mergers and
joint ventures (Module 7) have such a poor record in achieving their stated objec-
tives that a wealth warning to shareholders (‘warning: merger and joint venture may
be injurious to your wealth’) should probably be attached to any strategic plans or
prospectuses in which they figure.
Of course, each of these strategies has a major place in the strategist’s armoury.
The point about each of them is that it is often easier to see the advantages rather
than the disadvantages, and often alternatives are ignored or not fully taken into
account. The overall theme in this elective is that in formulating strategy it is
essential to identify and fully analyse all the alternative means for achieving a stated
objective. That does not guarantee the best strategy will be chosen in particular
cases; much of this will be down to the skill, experience, wisdom and luck of the
strategist. But it does increase the chances that the best strategy will be chosen, and
reduce the chances that an inappropriate one will be opted for. And that is what
formulating strategy to generate competitive advantage is all about.

Review Questions
7.1 You are considering a possible acquisition. Which of the following may be legitimate
reasons for going ahead?
I. The proposed acquisition would guarantee supplies of a raw material.
II. The proposed acquisition is highly profitable.
III. There may be gains from sharing technological ideas with the acquisition.
A. I and II only.
B. I and III only.
C. II and III only.
7.2 Two firms think there may be benefits from sharing their technology, production
facilities and distribution channels. Of the following modes of organisation, which one
might be appropriate for generating such gains?
I. Strategic alliance
II. Joint venture
III. Licensing
IV. Merger
A. I, II and III.
B. I, II and IV.
C. II, III and IV.
7.3 Which of the following do appropriability problems in co-operative agreements mean?

A. It may be difficult to protect intellectual property rights.
B. It may be difficult to decide the appropriate form of contract.
C. One firm may find it difficult to appropriate gains from the agreement.
D. It may be difficult to prevent key staff from leaving.
7.4 Which of the following does the Winner’s Curse mean?

A. The acquiring firm pays too much for its acquisition.
B. The acquiring firm may find it difficult to subsequently dispose of its acquisition.
C. The workers in the acquisition will be reluctant to work hard for the new
management.
D. The acquisition will demand too much of senior management’s time.
7.5 Which of the following does the empirical evidence on corporate mergers suggest?
A. Firms maximise profits.
B. Mergers frequently reduce shareholder value.
C. Firms are revenue maximisers.
D. There are no constraints on the pursuit of managerial objectives.
References
Grossman, S.J. and Hart, O.D. (1980) Take-over bids, the free-rider problem and the theory
of the corporation, Bell Journal of Economics, 11, 42–64.

Appendix 1
Practice Final Examinations

Contents
Practice Examination 1 ........................................................................................2
Practice Examination 2 ........................................................................................6
Examination Answers ........................................................................................10
Competitive Strategy Edinburgh Business School A1/1

Appendix 1 / Practice Final Examinations
Practice Examination 1
Question 1: A hold-up in Mobsterville

Bugsy Capone is mayor-for-life of Mobsterville, a theme town built around leisure and
recreational attractions that celebrates the life and times of famous rogues and villains.
Earlier this year, Bugsy decided to commission a special roller-coaster ride, Hoods 'n'
Cops Chase, and offered Patsy Brown, an independent contractor, the contract to build
and run the ride.
Patsy calculated that it would cost about $80 000 a year in variable costs to run the
ride, and a $1.1 million investment to build it. He also reckoned that the minimum
acceptable annual rate of return on his investment is 10 per cent, given his investment
opportunities elsewhere. It is expected that the ride will attract about 120 000 users a
year at $4 a time. Bugsy suggested they could split the revenue equally (Mobsterville is
in Mobster County, which means that nobody worries about taxes).
They shook hands on the deal.
Patsy has finished the attraction, and it is now boxed up in trucks ready for delivery.
Unfortunately, Bugsy has just told Patsy that losses on other rides means that, regretful-
ly, he is now forced to take 75 per cent of all revenues from the ride – take it or leave
it. Patsy is outraged and claims this offer is not worth considering because he would not
even cover his costs. He threatens to take Hoods 'n' Cops Chase elsewhere. He phones
around and reckons that his best alternative use for the ride would be Goonsville, a
neighbouring theme town in Mobster County where he could expect to earn $20 000 a
year. He could trust the Goonsville offer because the town is run by Patsy’s mother,
Red-eyed Lill.
1 Is Patsy right that the new offer would not cover his costs? What should he do?
2 How could Patsy have tried to reduce his vulnerability to hold-up at the start of the
contract and how might each type of solution affect the costs and revenues associated
with the project?
3 Bugsy is exploring the possibility of Mobsterville building and running all new attractions
by itself. Assess any possible advantages and disadvantages to Bugsy of such a switch in
strategy.
Question 2: The Daimler-Benz/Chrysler merger
The announcement of the Daimler-Benz/Chrysler merger took the rest of the car
industry and its analysts by surprise. The two companies had secretly negotiated what
would then be the world’s largest industrial merger. The merger would constitute a
major upheaval in the fiercely competitive global car industry and caused some conster-
nation amongst rivals of the two companies. News of the deal was greeted warmly by
the capital market, while employees’ reaction in the two companies generally ranged
from cautious approval to outright enthusiasm.
All in all, reaction in the US was seen as remarkably positive considering that the
merger was regarded by some as effectively a takeover of a landmark US company by a
A1/2 Edinburgh Business School Competitive Strategy

foreign firm.
The merger had been hailed by Chrysler as a ‘marriage of equals’ by the two compa-
nies but Daimler-Benz would be the dominant partner with its shareholders taking 57
per cent of the combined company against 4 per cent for the American side. The group
was to be incorporated in Germany, which meant that it would retain a German system
of separate management and supervisory boards (with German law requiring employee
representation on the supervisory board). Daimler executives would take 10 of the 18
seats on DaimlerChrysler’s management board.
The current chairmen of Chrysler (Eaton) and Daimler-Benz (Scrempp) would be-
come joint chairmen and chief executives of Chrysler-Benz. Neither joint chairman
would have defined responsibilities but would be involved in the full range of the merged
company’s activities around the world. There would be joint headquarters in the US and
Germany and board meetings would alternate between them. The working language in
the boards would be English.
Eaton was to retire in three years and it was intended that Scrempp would then take
sole charge, and that there would be a single company headquarters in Germany.
Daimler-Benz
Daimler’s main auto products were in luxury cars, and trucks and vans. It also had
interests in aerospace, rail systems, microelectronics and financial services. Daimler had
given up attempts to move outside the transport industry after recent diversification
attempts led to huge losses. Strong growth in the US had been the main influence in its
recent sales growth.
Deutsche Bank had been a major shareholder and had sometimes been actively
involved in major strategic decisions in the past, such as encouraging Daimler to
diversify into other industries where its engineering expertise could be applied.
The current chairman, Scrempp, cut the company back to its automotive core after
one of the biggest losses in German industrial history. Scrempp was said to have a taste
for the American way of running a business after previously managing Daimler’s US
truck business. The company also was recently hit by problems caused by delays, bugs
and necessary re-engineering of some new products.
Chrysler
Chrysler was essentially a volume car producer. Chrysler had been rescued from
threatened bankruptcy by US taxpayers but the present managerial team turned the
company around and it was now viewed highly favourably by the stock market.
Much of the credit for the turnaround was given to the combination of the practical
managerial skills of the chairman, Bob Eaton, and shareholder pressure and direction,
particularly that of a major investor, Kirk Kerkorian. Management had reduced devel-
opment time for new models from four to five years to around two years. It had
become the lowest-cost car producer in the US, specialising in low-priced cars and
sports utility vehicles. Eaton had growth targets of 20 per cent sales growth a year
which was difficult to achieve given market saturation in the US.
The merger
During negotiations the companies agreed that they were talking only about merger and

that alternatives such as joint ventures were not on the table. This was significant
because collaborative arrangements had become a major feature of the auto industry in
recent years. The merger would create a large industrial group to be called Daim-
lerChrysler, covering every aspect of the motor industry.
The existing brands would be retained; there was little competing overlap between
the products of the two companies. It was expected to facilitate the selling of Mercedes-
Benz Chrysler models outside their home markets; for example, Chrysler’s Dodge Ram
pickup truck would be sold in South America through Mercedes-Benz distribution
channels. However, it was not planned to have joint showrooms in established markets.
Global purchasing by both companies would immediately be integrated, leading to a
cost reduction in the first year of about 0.5 per cent (around $300m). There would be
combination of some administrative offices and some rationalisation of R&D projects;
for example, Daimler expected to cancel development of a minivan since Chrysler
already had one of the world’s most popular types of minivan. Later benefits were
expected from sharing technical know-how in manufacturing and engineering.
More generally, it was expected that Daimler would benefit from Chrysler’s exper-
tise in cost-efficient production, while Chrysler would benefit from Daimler’s extensive
engineering resources, including environmentally sensitive fuel cell technology. It was
possible, though not certain, that eventually the basic engineering structure of cars could
be shared. The companies stated that there would be no job losses and said that they
expected to add to capacity in Europe and the US.
Daimler-Benz calculated the premium it is paying for Chrysler over the market price
of shares at 28 per cent, or about $8bn. Some analysts thought this understated the
premium. The two companies calculated the value of synergies from merger at $1.4bn in
year one, rising to $3bn annually within three to five years.
Apart from obvious differences between the two companies in cultural background,
language and traditions, there were also differences in managerial styles and expecta-
tions. The financial rewards enjoyed by Chrysler’s senior management were significantly
higher than that of their German counterparts and reflected US levels of salaries and
stock options. As far as ownership is concerned, it was expected that there would be a
general widening and dilution of shareholdings in the combined company, compared to
the two companies prior to merger.
It was widely believed amongst industry experts that the merger could be a trigger
that helps stimulate further rationalisation and mergers in the motor industry. The
industry had experienced problems of considerable overcapacity and severe competitive
pressure on prices; new entrants had only helped to add to these problems in recent
years.
1 How might the Five Forces of this industry be affected by merger?
2 What are possible advantages and disadvantages of the deal to the management of the
two companies?
3 Could the two companies have exploited similar gains without merging? Why do you
think management chose the merger solution?

Question 3
An Asian firm producing specialised building products is exploring the possibility of
expanding into other Asian countries. US firms currently control 90 per cent of this
segment in these other Asian countries. Our firm has 80 per cent of its domestic
market but no significant presence in international markets at the moment.
1 Show how Porter’s Diamond could be used to help identify the strategic issues the
company should consider in evaluating whether and how to pursue international
expansion.

Question 1: Frozen profits in ice cream

Jen and Berry are the only two ice cream manufacturers on the island of Vanilla, and
much of the island’s tourist marketing is based around the quality of their ice cream.
Every ice cream parlour in Vanilla has an exclusive supply contract with either Jen or
Berry. Unfortunately, the retailers have repeatedly threatened to switch suppliers unless
the wholesale price is reduced, and now Jen and Berry both find they are operating on
very thin margins indeed.
Both have been considering the idea of starting their own ice cream outlets on the
island. This would be costly and anyone who did this would immediately lose access to
existing retail outlets, who would now see them as direct competition. Assuming that
they do not go into retailing themselves, a respected market analyst reckons the
discounted present value of Jen’s business over the next three years to be about 3m
Vanilla Pesos (VP) and Berry’s business is thought to be worth VP4m. If Jen alone
started her own ice cream retail chain, she would increase her market share and this
would help boost the value of her business to VP4m, while Berry’s would slump to
VP2m. If Berry alone opened up retail outlets, he would increase his value to VP5m,
while it is expected that Jen’s value would slip to VP1m. If both opened up retail outlets,
their market shares would be expected to stay the same and their respective market
values would be expected to be about VP2m (Jen) and VP3m (Berry). All these values
are over the same three-year period.
1 If Jen and Berry accept the market analyst’s calculations, what should they do? Look at
the problem in game theory terms.
2 Jen and Berry both think the ice cream outlets are making exorbitant profits at their
expense and plan to buy them out. Good idea?
3 Jen and Berry would both like to go international to capitalise on reputation but neither
thinks they could go it alone. Berry has suggested forming a joint venture to Jen. What
could determine whether this is a good idea or not?
Question 2: Innovation at Swatch
Background
The ‘Swatch’, an innovative fashion watch, was developed in the context of an alarming
and continuing slump in Switzerland’s share of the world market for watches during the
post-war period. Electronic watches and strong competition from Asian firms meant
that the Swiss share of global sales had slumped in the decades following the Second
World War. The loss in sales was particularly marked in the low-to-medium priced
market segments. The industry’s capabilities in the high-skilled mechanical segment of
the watch market did not make it well placed to compete with or absorb the emergent
high-technology electronic threat. The Swiss reputation for reliable timepieces became
less of a source of competitive advantage when cheap electronic watches could also

perform reliably.
Swatch (the name is an amalgam of ‘S(wiss) watch’) was developed by ETA, a subsidi-
ary of Ebauches S.A. which in turn was a subsidiary of ASUAG. ASUAG was highly
specialised in the watch industry with a strong base in mechanical watches, and in
common with many of the other Swiss watchmakers had been suffering in terms of
profitability, sales and cash flow. It was Swizerland’s biggest watchmaker, and contained
well-known brand names such as Longines. The other major watch corporation was
SSIH which held the Omega and Tissot brands.
What was to become the Swatch was the outcome of a new project initiated in the
context of a wider programme of corporate renewal at ETA initiated by Ernst Thomke,
ETA’s chief executive. Although he had done an apprenticeship in watchmaking at ETA,
Thomke had been recruited by ETA from outside the firm and the industry. He had left
ETA to study science and medicine at Bern, then he joined Beecham, a UK pharmaceuti-
cal firm, where he became managing director of its Swiss subsidiary.
Thomke embarked on a programme of cost cutting, rationalisation (from 12 factories
to just 3 centres) and reduction of model variety and range. However, he also sought to
restore the firm’s innovativeness and raise the confidence of its engineers. Managerial
layers were scrapped, bureaucracy reduced, communication enhanced, experimentation
encouraged and challenging targets and specifications for new products introduced.
What was to become the Swatch emerged out of the setting of an ambitious specifica-
tion for a new type of watch.
Swatch research and development
Swatch emerged out of an identified need for a product in the low-to-medium price
range. The product should be quartz analogue, competitively priced, with a sales target
of 10m units in the first three years. It should be high-quality, shock-resistant and
waterproof, with the battery the only replacement part and the dial and hands the only
model variants.
ETA’s established engineering teams argued that this specification would be impossi-
ble to achieve. However, two young engineers, Mock and Müller, both less than 30,
decided to take a look at the problem. They mounted moving parts directly onto a
moulded case. The idea was developed by teams of engineering, marketing and financial
specialists as well as consultants from outside the industry.
ETA did not have its own marketing department. It now created its own marketing
department and sought advice from marketing specialists in the clothing, shoe and
sports industries.
Swatch technology
There were a number of technological innovations. These included mounting parts
directly onto the plastic case. (In conventional watches the case was simply a cover.)
The number of components was reduced from nearly 100 for a conventional analogue
quartz watch to about 50. Parts were riveted and welded together, not held together
with screws. Because of this, it was possible to fully automate watch production;
previously there had been separate stages for mounting of the movement and the
finishing.

Swatch marketing
Conventional marketing in the industry emphasised performance of the product, here it
was the brand name ‘Swatch’ with its youthful, playful, fashion-conscious connotations.
The price was set high enough for significant margins but low enough for impulse buying.
It was distributed through jewellery stores, boutiques and department stores as a
fashion item, rather than through mass retailers. Marketing emphasised placing Swatch in
high-profile and prestige events such as the Olympics.
Introduction of the Swatch
ASUAG and SSIH merged in the same year as the introduction of Swatch to form SMH.
It changed the way that consumers regarded watches; they were no longer either
expensive items to last a lifetime or cheap functional timekeepers. Instead, consumers
often treated them as an additional purchase and fashion accessory rather than as a
substitute for conventional watches, some consumers buying more than one Swatch. It
rapidly became a major marketing success.
Subsequent Swatch developments
The main Swatch design centre was in Milan with about 20 designers producing over
100 new models every year, all based around the standardised size and shape. Sports
and arts sponsorship were important elements in Swatch development. Swatch had its
own marketing department in each major market, with complementary functions such
as finance, logistics and after-sales service being handled by SMH’s local branches.
The success of Swatch stimulated a number of subsequent product developments
using the Swatch name. While ETA retained production of Swatch, a separate Swatch
subsidiary was set up to design and distribute Swatch watches and a wide range of
accessories including footwear, leather goods, clothes, jewellery, perfume, glasses, pens,
lighters, cigarettes, leather goods and sports goods. But the Swatch accessories line
closed down because of disappointing performance and a perceived negative impact on
the Swatch brand image.
The Swatch brand was extended to include a number of timekeeping developments
over the next few years; watches for skiers and scuba divers, wall clocks, children’s
watches, chronometers, alarm watches, stop watches, and even a mechanical swatch.
The company introduced a Swatch pager, which integrated watch and telecommuni-
cations technology and introduced several technological innovations but still sold at
what was regarded as an attractive price. However, Swatch’s attempts to produce
pagers and mobile phones have subsequently turned out to be failures.
Its most radical project at this time was a joint venture with Volkswagen to launch
the Swatch-mobile, a battery powered car with a range of just over one hundred miles
and a cost of about $6300. Volkswagen withdrew from the joint venture, and Swatch
decided to continue to work on the project while still seeking another partner. It
eventually developed the SMART car with Mercedes-Benz, but continuing technical
problems then led to Swatch to sell their stake in the project to Mercedes.
Swatch has been pursuing its transformation into a leading (wristwatch-based) mobile
phone and Internet company, taking advantage of perceived technological convergence
between wristwatches and telecommunications.

1 Why was Swatch’s strategy such an immediate success?
2 Is Swatch still pursuing the right strategy? Consider with respect to generic strategy,
diversification and alliance strategies.
3 How were innovation hurdles overcome in developing Swatch?
Question 3
Filmic is a movie-mad country with a strong domestic film industry, its films being almost
entirely oriented for domestic consumption. Souve is one of a number of small special-
ised firms making cheap plastic and metal replicas of characters from various Filmic
movies such as Jar Wars (trouble in the bottling industry) and IT (the Intraterrestrial).
Like most of its competitors, Souve gets its basic raw material mostly from local
suppliers and sells in retail outlets like newsagents and toy stores. Souve and some of its
rivals are considering moving into buying supplies and selling products on the Internet.
1 Discuss how you would evaluate the possible implications for Five Forces and
competitive strategy in this industry.

Examination Answers
Question 1: A hold-up in Mobsterville

1 Patsy is understandably upset and in the heat of the moment may not be thinking
clearly. When he says that the revised offer would not cover his costs, he is not
distinguishing between the ex ante opportunity costs involved in creating the ride
and the ex post opportunity costs once the ride has been built. This situation
illustrates the transactional hazards that may arise from creating relationship-specific
assets (the Hoods ’n’ Cops Chase). In this case the asset specificity associated with
the ride generates a surplus that can be captured by an opportunistic operator
(Bugsy) able and prepared to use hold-up threats.
When Patsy was considering the deal to begin with, the annual costs of the project
were (1) total variable costs ($80 000) plus (2) the ex ante opportunity costs of the
investment in the ride (10 per cent of $1.1 million, or $110 000). So the total annual
costs come to $190 000. This also indicates the minimum amount of revenue that
Patsy must receive to be willing to deal with Bugsy; as long as revenues are below
this figure, Patsy would not have found the deal worthwhile. The difference
between revenue actually received and the minimum required to make it worthwhile
to enter into the relationship with Bugsy is Patsy’s surplus. Here revenues of $4 ×
120 000, or $480 000, were originally to be split equally which means that Patsy’s
$240 000 revenues would have earned him $50 000 surplus.
Bugsy’s revised offer would halve Patsy’s expected annual revenues to $120 000, and
given his original cost estimates of $190 000 he certainly would not have entered
into the deal with Bugsy had this been the original offer on the table. This is why he
feels the new offer would not cover his costs. However, what matters now is the
opportunity cost of the investment in the present ($20 000 a year), not the oppor-
tunity cost of Patsy’s investment opportunities before he built the ride.
The minimum annual revenue that Patsy should now be prepared to receive from
Mobsterville before switching Hoods ’n’ Cops Chase to its next best use (Goons-
ville) is still total variable cost plus the opportunity cost of the investment (now
$80 000 + $20 000). Any revenue above this is the surplus from the investment,
which in this case is $20 000 a year. The offer from Bugsy does more than cover
these costs, and it also follows from this that it is a better offer than the best
alternative (the offer from his mother). On these figures, he should take the offer.
However, Patsy should also be aware that Bugsy still has a stronger hand in this
situation. If Bugsy knows that his offer gives Patsy extra revenues of $20 000 over
the next best alternative, he could squeeze this surplus of $20 000 by subsequently
demanding an increased share of the receipts. This could force Patsy’s surplus
downwards to the point where it is just worthwhile for him to stay in the relation-
ship with Bugsy, that is where his annual revenues are $100 000 a year and there is
no surplus. While it is still in Bugsy’s interests to make Patsy an offer he can’t refuse,
this offer may be worse than the one Patsy faces just now.

2 Patsy’s experience should signal the transaction cost problems of potential

vulnerability to hold-up when investing in specialised assets such as the Hoods ’n’
Cops Chase. There are a number of ways that independent contractors might try to
deal with such a situation. The following are some examples:
 Formal Contract: Patsy could have demanded a formal contract. However, this
would have involved legal and managerial time and resources for both parties in
negotiating the contract. Also, this solution might not be effective if it turns out
that the expected value from suing Bugsy for any supposed breach in contract is
less than the expected costs of litigation for Patsy.
 Cultivating exit opportunities: Patsy could have searched out and maintained
contacts with other theme towns in case there were problems with the Mobster-
ville deal. However, this would incur opportunity costs of the resources
expended on this activity, including his own time.
 Less investment in specialised assets: Patsy might have designed his ride to be less tied
to the theme of Mobsterville and more a general purpose ride that could be suit-
able in a variety of leisure and recreational settings. However, this would have
reduced the value of the ride since it would no longer be specifically designed for
Mobsterville. Patsy could also have designed the ride to be easily dismantled,
light and portable to help him find alternative uses and users cheaply and quick-
ly. However, this could add to design and production costs and could reduce
demand and revenues if the new design diminished the attractiveness of the ride.
 Hostages: Patsy could demand (or Bugsy offer) a hostage to ensure Bugsy’s good
behaviour in this deal. For example, Bugsy could loan Patsy his genuine Model T
Ford which he uses to entertain special guests every St Valentine’s Day. This
might reduce the chances of Bugsy breaking his word since an enraged Patsy
would not be the best caretaker for his prize exhibit. However, there are oppor-
tunity costs of alternative uses for this asset that Bugsy sacrifices by lending it
out (and possible increased insurance costs from the transfer).
 Avoidance: Patsy might decide that it is not possible to capture any rents from this
project because there are no solutions that effectively deal with the hold-up
problem, whether singly or in combination. In that case, he would walk away
from the deal and the whole project is sacrificed.
3 Bugsy is considering vertical integration as an alternative to market exchange.
The main advantage of this strategy is that it may enhance the value of these
projects to the extent that it avoids transaction costs of market exchange arising
from opportunistic behaviour. Examples of these costs are discussed in the answer
to Question 2, and in extreme cases they can lead to the ‘avoidance’ strategy
discussed above with deals falling apart. These may be dealt with through unified
governance with Bugsy now owning and directly controlling the construction and
running of new attractions. This should directly deal with dangers of opportunistic
behaviour and associated transaction costs since the only person Bugsy could cheat
in organising these new attractions is himself.
The disadvantage of vertical integration is that it may sacrifice benefits of using the
market. These include potential loss of efficiency gains from economies of scale and learning
curve benefits; e.g. Patsy could be a specialist manufacturer of roller-coaster rides who

can achieve low production costs for each new ride through specialisation of labour
and being able to employ specialised machinery and equipment in production.
Routinisation of tasks would allow increases in productivity through learning effects.
Since Bugsy would have to employ craftsmen to produce a variety of different
attractions, he would not be able to take advantage of specialised skills or equipment
to the same extent, and there would be limited opportunities for learning curve
effects. Also, vertical integration can sacrifice efficiency gains from market pressure: if
independent contractors are operating in a competitive environment they will be
pressurised to push costs down and be creative just to survive. By choosing to do it
all himself, Bugsy cuts himself off from access to external sources of high-quality
and/or low-cost services. Lifting the direct influence of market pressures from the
creation and production of each attraction could result in inferior and costly
attractions.
Question 2: The Daimler-Benz/Chrysler merger

1 There are really two aspects to this question: (1) the direct effects of the merger
itself and (2) the effects of subsequent rationalisations and consolidations which
may be triggered by the merger.
1. Threat of entry: The merger may not directly affect this to any great extent.
However, if it helps trigger a round of rationalisations which mops up excess
capacity, this might help clear the ground for subsequent entry by new players.
Against this, the expected dominance of the industry by a few global players
exploiting economies of scale and scope will tend to create barriers to entry.
2. Internal rivalry: This may be heightened because overcapacity may actually worsen
as a consequence of merger. Also the companies’ growth motives suggest inten-
tion to increase market share and may intensify rivalry and threat of retaliation.
Against this, reduction in the numbers of major players could act to reduce the
intensity of rivalry.
3. Buyer power: To the extent that the products are not close substitutes, buyer
power is not directly affected. However, if it helps trigger further mergers in
cases where there are substitute lines, buyer choice and power would be reduced.
4. Supplier power: This is directly reduced through combined purchasing. Further
mergers and rationalisations could again reduce supplier power since they will be
faced with fewer and larger buyers for their products.
5. Substitute products: No obvious direct effects here.
2
Possible advantages
 The present value of management’s calculation of the gains from synergies (less
the premium paid for Chrysler) suggest the deal is very attractive (unless future
gains are heavily discounted).
 Daimler activities may benefit from the managerial skills that have made Chrysler
one of the world’s most cost-efficient motor companies, and Chrysler gets access
to Daimler’s engineering skills. For example, it may help Daimler seek cost prox-
imity with competitors while still pursuing a high-quality differentiation strategy.

 Chrysler’s greater emphasis on commercial vehicles complements Mercedes-

Benz’s greater involvement in cars.
 Positions the new company as a global player in anticipation of trends towards
rationalisation and globalisation in this industry.
 Growth opportunities that do not sacrifice focus.
 Less vulnerable to regional downturns.
 Less chance of going bankrupt; size and product/geographic spread may make it
more resistant to being acquired.
 Politically acceptable: no job losses planned.
Possible disadvantages
 The advantages of marriage (e.g. potential synergies) may be more visible than
possible disadvantages. Empirical evidence suggests managerial expectations of
the returns from merger tend to be overly optimistic.
 Absence of greater synergies achievable had the companies’ products been direct
substitutes for each other.
 Cultural differences between the two firms including different systems of
managerial incentives and employee representation on the German supervisory
boards.
 Although Chrysler’s had been one of the best-managed firms in the auto
industry recently, Daimler is the dominant partner and Eaton will soon retire;
these factors could limit the extent to which the high-performing US side can
influence the German side.
 Appears to worsen, rather than reduce, the problems of overcapacity in the
industry (plans to increase capacity as a consequence of merger).
 Administratively complex and cumbersome.
 Improvement in competitive position may be eroded if it encourages rivals to
retaliate and prompt further consolidation within the industry.
 Are the economic opportunities in the US sustainable or a reflection of tempo-
rary economic circumstances?
 The dilution of ownership in the company might exacerbate principal–agent
(shareholder–management) problems. The potential influence of investors such
as Kerkorian may be weakened in the combined company, though note that
major shareholding and influence on the part of Deutsche Bank did not prevent
Daimler from making strategic errors.
 In the end the disadvantages of merger appear to have overwhelmed the
advantages. Analysts criticised its post-merger performance and apparent failure
to integrate the two very different systems. DaimlerChrysler seemed to run two
independent product lines, eventually Chrysler was sold off to Cerberus Capital
Management, and the former Daimler-Benz part rebadged itself as Daimler AG.
3 Management decided to reject alternatives to merger although, in principle, many of
the gains sought from merger could also be organised through a variety of collabo-
rative arrangements. Major options here include franchising, licensing, joint
ventures, sub-contracting and alliance.

 Franchising: There appear to have been limited options from franchising since the
showrooms and dealerships are being kept separate. However, the sharing of
distribution channels in emerging markets might have been achieved through
franchising arrangements.
 Licensing: Technology such as fuel cell technology could have been the subject of
licensing between the two companies.
 Joint venture: Various activities such as R&D could have been pursued in joint
ventures and this could in turn lead to further gains such as economies of scope
from purchasing jointly-developed and jointly-specified components.
 Sub-contracting: The firms could have acted as sub-contractors for each other in
areas in which they have low-cost or high-quality components or sub-systems.
 Alliance: Finally, different forms of collaborative arrangements at business level
(such as those discussed above) could be brought under the umbrella of an alli-
ance at corporate level.
Collaborative arrangements can help transfer managerial expertise across companies.
Here, transference could include Chrysler’s competences in production techniques
and Daimler’s competences in high-quality engineering. A number of companies
have acquired competences this way, such as Rover through its association with
Honda prior to being taken over by BMW.
The advantages and disadvantages of collaboration depend on the particular mode
employed, but in general the advantage of collaborative arrangements is that they
allow each company to retain a more focused orientation and consistent direction
without the confusion and administrative problems of trying to merge together and
integrate two very different firms with different types of management and cultures.
Collaborative arrangements can also be precisely targeted just on those areas where
gains are anticipated. The disadvantages of collaborative arrangements reflect the
transaction costs of negotiating, administrating and policing each individual agree-
ment. Appropriability problems will add to transaction costs in cases where transfer
of sensitive technological or marketing information is involved.
It seems that in this case the companies decided that the net gains from merger were
still positive, even after taking into account the opportunity cost of the best possible
combination of collaborative arrangements.
Question 3
1 Porter’s Diamond could be used to establish the possible sources of competitive
advantage for the company in trying to penetrate these other markets. This could
help the firm to decide what type of strategy it should pursue in this context, and
the form of market entry that should be adopted if it decides to go ahead.
Sources of competitive advantage
Porter’s Diamond is relevant in at least two contexts here – analysis of the sources
of competitive advantage for the Asian firm deriving from its home base, and
analysis of the sources of competitive advantages deriving from the home base of its
major potential rivals, which in this case are US firms. Some examples of questions
that should be asked in both Diamonds are:

 Firm strategy, structure and rivalry: Do national cultural norms and institutional
arrangements support this industry? Does this industry attract outstanding na-
tional talent? Is there investor support for the industry? Are there capable
domestic rivals?
 Demand conditions: Are the home nation’s buyers for these products the most
demanding and sophisticated? Do home-nation consumers’ needs anticipate
those of other nations? Are the home-base distribution channels advanced and
sophisticated compared to other nations?
 Factor conditions: Does the nation have particularly advanced or appropriate
factors of production needed in this industry? Does the nation have advanced
and relevant factor creation mechanisms, such as university engineering depart-
ments?
 Related and supporting industries: Does the nation have world-class supplier indus-
tries? Are there strong positions in relevant supplier industries?
Comparison of the Asian firm’s Diamond with that of the US firms’ Diamond
should allow the firm to assess whether and where it may have opportunities for
exploiting a sustainable competitive advantage compared to US firms in these Asian
markets. It should also be noted that there is an absence of domestic rivals to the
Asian firm, it lacks experience in international operations, and that the US firms
already dominate these other markets. These are all disadvantages that the firm will
have to overcome if it is to successfully compete in these new markets.
Choice of strategy
The generic strategies available for market entry to this firm are:
 Differentiation
 Cost leadership
 Focused differentiation
 Cost focus
 Do nothing
The choice of strategy to be pursued should reflect the firm’s possibilities for
exploiting potential competitive advantage in these new markets. A strategy should
be chosen that allows the firm to capitalise on its sources of competitive advantage
while not placing it at a disadvantage compared to its rivals. For example, the US
firms may be pursuing broad-target differentiation strategies based on multidiscipli-
nary R&D that our firm has no hope of replicating or matching. In these
circumstances the firm may decide that it would be foolish to engage in head-to-
head competition using a similar strategy. Depending on the particular sources of
competitive advantage open to it, it might instead opt for cost leadership or cost
focus, or focused differentiation in cases where it may be able to exploit niche
opportunities. Or it could decide that there is no basis on which it could compete
with the US firms, in which case it would choose to do nothing in this context and
avoid market entry.

Form of market entry

There are a number of modes or forms of entry into foreign markets the firm could
choose from if it decides to proceed. These include:
 Exporting
 Greenfield start-up
 Acquisition
 Joint venture
 Alliance
 Licensing
 Franchising
The form of entry chosen should fit the sources of competitive advantage to be
exploited by the firm and the particular strategy chosen. Particular issues to be
considered when looking at each form of market entry include:
 Transferability of competitive advantage
 Appropriability of competitive advantage
 New capabilities required for market entry
 Transaction costs (market modes)
 Co-ordination costs (in-house and mixed modes)
Question 1: Frozen profits in ice cream

1 Jen and Berry appear to be in a Prisoners’ Dilemma if they accept the market
analyst’s advice at face value, and do not, or cannot co-operate.
Berry
Retail Don’t retail
Jen
Retail 2 3 4 2
Don’t retail 1 5 3 4
A Prisoners’ Dilemma? Jen and Berry’s problem

If Jen and Berry make their decisions independently, then it becomes a question of
working out what each should do, given the other person’s possible decisions. In each case
above, Jen is the first entry in each box and Berry is the second.

If Berry decides to move downstream into retailing, these figures suggest that Jen
would double her value by matching that move (VP2m instead of 1m), while if
Berry did not move into retailing, Jen would still be better off moving into retailing
(VP4m instead of VP3m). So whatever Berry does, on these figures moving into
retailing would seem to be a dominant strategy for Jen.
Similarly, Berry appears to be better off moving into retailing whatever Jen does. He
increases his value by VP1m if he retails when she does the same (3m instead of
VP2m), and if she does not move into retailing, he would have a value of VP5m if
he does go into retailing compared to VP4m if he does not. Moving into retailing is
a dominant strategy for Berry also.
However, this suggests a Prisoners’ Dilemma. If both choose to go downstream and
open up their own retail outlets, they would both be worse off than if they decided
to stay where they are. Jen then has a value of VP2m compared to VP3m if both
had not moved into retailing. Berry has a value of 3m compared to the VP4m he
would have had had they both stuck upstream.
So is this mutually unsatisfactory move into retailing inevitable? No, for a number of
reasons. For example:
 Jen and Berry may make a binding agreement not to move into retailing. There
may be a number of reasons that the agreement may be trusted by both parties –
it might be a legal contract, they may be brother and sister, they may both have a
reputation for honesty in commercial dealings, they may both have a reputation
for homicidal vengeance if duped, etc.
 They still may not trust each other, but both may decide to wait to see what the
other will do and then match it. The Prisoners’ Dilemma requires simultaneous
moves and this may not be necessary or realistic. If they are both prepared to
wait indefinitely, neither will move into retailing.
 They may see the situation as a repeated game running beyond the three-year
time horizon of the analyst’s predictions, in which case the non-cooperative
move into retailing may not be the rational move for both to choose.
These are some of the more obvious objections to the Prisoners’ Dilemma outcome
in this context, though there may be many others (e.g. they may be distrustful of the
analyst’s predictions, and prefer to avoid risk by doing nothing).
2 There are two main problems possible with this.
Firstly, if the market for ice cream outlets is efficient, the price that Jen and Berry
will be expected to pay for an outlet will reflect the discounted present value of
further profits. The more profitable an outlet, the higher the price they will be
expected to pay to secure it, all other things being equal. Even if there are imperfec-
tions in the market for ice cream outlets, Jen and Berry should know that much of
the juicy profits that they can expect to get later have to be paid for in the form of a
correspondingly high upfront purchase price.
Secondly, they are manufacturers; what do they know about retailing? Different
capabilities, different skills and the fact that it is being planned through acquisition
give further cause to pause and question whether this is likely to be an ill-advised
move on their part; empirical evidence on acquisitions suggest they often fail.

3 The first thing that should be established is what both parties can get out of the
joint venture. Joint ventures usually focus on complementarities, with both parties
bringing different resources and skills to the table. This helps patch up holes or gaps
in the value chain that might obtain from going it alone. For example, one party may
have the finance and the other an innovation. Or one may have technological
competences and one may have marketing competences.
In the case of going international, joint ventures are commonly formed between one
firm from the home or source country, and one from the host country. This is again
because of complementarities, the firm from the source country providing the
product and the firm from the host country providing market and distribution
resources and country-specific knowledge and experience.
Sometimes firms do bring similar items to the table in an international joint venture;
for example, oil companies may share capital and risk in an early stage of the value
chain – oil field exploration.
The question is what a Jen and Berry joint venture could do. In part this depends on
the nature of the intangible asset of reputation and the relationship of Jen and
Berry’s products to each other. An Isle of Vanilla international venture between the
two could possibly:
 share capital, managerial resources and risk;
 help avoid destructive head-to-head competition;
 extend the range and variety of products compared to go-it-alone alternatives.
This would be more likely to obtain if Jen and Berry had distinctive and comple-
mentary products that helped extend or even complete each other’s product range.
The downside of an Isle of Vanilla international venture between Jen and Berry is
that it could:
 be difficult and costly to manage (e.g. contractual issues, complex hierarchy and
appropriability problems discussed in Module 7);
 lose advantages of focus if reputation is firm-specific (i.e. if the reputation for
quality is associated with Jen and Berry individually, less so the island itself);
 be unnecessary if neither partner can provide missing capabilities the other lacks;
 still need to add further capabilities; how to enter foreign markets – form
overseas subsidiaries, license, franchise, or form more joint ventures with local
firms?
At worst, a Jen and Berry joint venture would be unnecessary, costly and still leave
gaping holes in the international value chain that still have to be plugged.
Question 2: Innovation at Swatch

1 Swatch based its strategy on two key sets of competences:
 Technical (R&D and production) competences in making timepieces cheaply;
 Marketing (transforming and maintaining the image of watches as a fashion
item).
What Swatch achieved was a judicious mix of:

 Pricing strategy (pricing low enough to deliver mass market and mass production);
 Cost sensitivity (low-cost and mass production using innovative techniques);
 Differentiation (making Swatch one of the world’s most recognisable and distinc-
tive brand names).
The combination allowed it to achieve very attractive profit margins on its sales in a
sector that had been regarded as being in the mature phase of the product life cycle.
It could be argued that, at least for a time, Swatch achieved what Porter sees as a
very difficult trick to pull off – differentiation advantage and cost advantage
simultaneously. It differentiated successfully and was also able to achieve cost
advantage over major competitors (producing watches of comparable quality) with
the introduction of full automation, economies of scale and learning curve effects.
In the fashion segment of the watch market, Swatch was able to achieve first-mover
advantages with this strategy. While Swatch did (and does) have high levels of
technical competences, these are not sufficient to explain how it has managed to
sustain competitive advantage in this segment for two decades. A Five Forces
Framework analysis of this sector would suggest that market entry by potential rivals
is very difficult to achieve. Even if competitors could replicate or beat Swatch’s
technological capabilities, they would have an immense job to compete against the
Swatch brand image and marketing muscle, and the cost advantages that its market
dominance has given it.
2 It is interesting to note that, although Swatch was able to draw on the Swiss
reputation for making timepieces, many of the competences that it needs are based
in other countries (the Milan design centre), or in other non-Swiss companies (e.g.
Mercedes). A Porter Diamond analysis might raise questions about what residual
sources of competitive advantage are derived from its Swiss base. As far as its
strategy in the fashion end of the watch market is concerned, the strategy appears
sustainable given its sources of competitive advantage, unless there is unexpected
change in this sector in terms of fashion preferences or technology.
It is possible to raise more questions about its diversification strategy, the most
radical developments often being pursued with the help of co-operative arrange-
ments with other firms. The diversification strategy could be justified by
management in terms of either moving the company away from a highly specialised
market base, or in terms of possible synergy gains and growth motives. But high
degrees of specialisation (focus) may be a high-value strategy, especially if the
specialised base is defensible and sustainable, while diversification can both move
the firm away from its core competences, and require the acquisition of key compe-
tences which it does not possess. Pagers, mobile phones and cars are all markets in
which Swatch has had major disappointments, and the key question here is why
Swatch should expect to succeed in these markets against well-established firms.
The extent to which Swatch could transfer its existing marketing and technical
competences and add value is the critical one here. Its image was very much as a
fashion watch maker and it is not clear that this easily stretched into other areas
such as cars, while many of the technical competences required in its diversification
moves were foreign to it and required the co-operation of other companies.

The strategy of pursuing diversification with the help of alliances may be the only
practical way that Swatch could pursue complex high-technology diversification.
Dangers here include:
 Swatch’s partners may decide to go it alone after learning all they need to know
from their association with Swatch.
 Strategic directions such as wrist-based Internet technology may turn out to be
marketing or technological dead ends.
 Co-operative ventures are very difficult to make work anyway, and many end in
tears.
What has to be done is to compare them with alternatives. If it is not possible or
realistic for Swatch to develop the competences in-house (because they are (a) too
complex, (b) too varied, or (c) someone else has them and is not going to give them
up), then merger or acquisition may be the only alternative to co-operative arrange-
ments if the venture in question is to be pursued. But it is unlikely to expect merger
with (for example) Mercedes just to exploit a venture that may have a limited shelf
life. Merger is (usually) for ever, and this would be a sledgehammer to crack a nut in
the cases discussed here.
We would expect merger or acquisition to be seriously considered if the areas of
common interest covered a major portion of the range of interests of at least one of
the companies in question (Swatch or the other firm), and if the areas of common
interest were expected to be enduring.
3 In Section 3.4, nine major types of innovation hurdle were identified.
1. Appropriability problems of leakage of competitive advantage to other rivals. This was
certainly a problem in terms of the technical solutions (it would be relatively easy
to buy a Swatch and take it apart to find out what made it tick, as it were). How-
ever, Swatch was able to largely appropriate the other type of intangible asset,
brand image.
2. Neglect of potential spin-offs to other divisions inside the firm. There is no evidence that
externalities led to ETA underinvesting here. To the extent the other divisions
retained old technology (e.g. those making prestige mechanical watches), there
would be few technological externalities expected. ETA was in any case subse-
quently able to internalise much of the gains from Swatch technology through
the strong growth in Swatch’s market share.
3. Duplicated research effort from each division concentrating on its own problems. There is no
evidence that anyone else was doing anything like this in the firm, so it does not
appear to have been a problem here.
4. Coping with uncertainty and the likelihood of failure. Since the Swiss watch industry was
on an apparently inexorable downward slide anyway, there could be little to be
lost by taking a risk.
5. Potentially high cost of the full process of innovation. The full cost of development was
significant (not quantified here) but the two young engineers Mock and Müller
were able to suggest feasible solutions at an early stage, encouraging confidence
in the approach.
6. The long time horizons involved. Thomke deliberately compressed the time horizons
for both technical introduction and marketing success as far as possible, setting

what some felt were unreasonable targets in order to quicken the pace of innova-
tion.
7. Asymmetric information – those doing work for the project can know more about its true
potential than those funding it. Thomke was a skilled engineer/scientist, which
helped in the evaluation of outcomes as well as the specifications of targets.
8. Machiavelli’s problem – innovation attacks vested interests, with those who might gain not
being in place to argue its case. Traditional watchmakers may have resisted these in-
novations and some of Machiavelli’s problem may have lain behind some of the
resistance to Thomke’s ideas and targets. However, the ability of vested interests
to resist had been weakened by the dramatic slide in their fortunes over the post-
war period.
9. Compartmentalisation of R&D and need to integrate complementary assets. Much of
Thomke’s reorganisation strategy (de-layering, improved communications) was
designed to facilitate integration of complementary skills and the need for this
was demonstrated in the multidisciplinary teamwork required to develop the
Swatch, which was also largely able to draw on in-house R&D resources, a luxu-
ry which it was not able to enjoy for some of its more recent innovations.
Question 3
1 The industrial environment in which Souve operates appears a rather closed and
insular system. As far as the technological and logistical shifts being contemplated
by Souve are concerned, there are likely to be very different considerations involved
in a move into B-to-B (business to business) Internet transactions with its suppliers,
and B-to-C (business to customer) Internet selling, especially if, as seems likely, the
former involves bulk buying of metal and plastic commodities with standardised
specifications, and if the latter involves cheap, differentiated products sold in
numerous geographically dispersed outlets.
The following suggests some considerations that might be important in the light of
the possible technological switches being contemplated in this industry.
Force 1: Threat of Entry
From Module 1, we know there are a number of possible elements that can influ-
ence threat of entry into a market if they are present, though of course only some
(or none) may be relevant in a particular case. The possible elements include:
 Economies of scale
 Economies of scope
 The experience curve
 Differentiation
 Risky and costly capital requirement for entry
 Switching costs
 Access to supplies and outlets
 Other cost advantages (e.g. patents)
 Government policy
 Exit barriers
 Expected retaliation.

On the face of it, adopting Internet technology should reduce the chance of entry to
the extent that it raises barriers to entry by making it more difficult for a firm to
enter and compete. For example, the Internet technology could raise perceived entry
costs where it increases economies of scale (e.g. network effects), involves more risky and
costly capital requirements for entry, and requires high levels of sunk costs that help create
exit barriers. (This is not an exhaustive list of the possible effects.)
It is conceivable that the new technology could actually reduce entry barriers if
potential entrants prove more skilled at using it than the incumbents.
Note that it is important to distinguish between entry barriers that already exist (e.g. if
the nature of the end product is not fundamentally altered by the new technology,
then product differentiation may be a structural feature that deters entry both before
and after the introduction of the new technology), and those that are altered by the
new technology (e.g. economies of scale).
Force 2: Rivalry
As with threat of entry, we saw in Module 1 that there are a number of possible
elements that can influence rivalry in a market if they are present. The possible
elements include:
 Relatively high fixed costs
 Low growth
 High exit barriers
 Differentiation and switching costs weak
 Absence of a dominant firm.
If the new technology increases fixed costs and reduces marginal costs, this could
increase rivalry. If it results in one firm (such as Souve or an entrant) becoming
dominant in the industry it could dull rivalry.
Force 3: Bargaining Power of Buyers
The main elements that may influence the bargaining power of Souve’s buyers, if
they are present, include:
 Few buyers
 Low profits
 Product represents a large proportion of the buyer’s overall purchases
 Standardised undifferentiated product with low switching costs for buyers
 Buyers can threaten backward integration.
On the face of it, it is not clear how Internet technology might affect these ele-
ments. The effects are likely to depend on the objectives of Souve in this context.
The buyers in this market have been the retailers that Souve and its rivals have sold
to. The impact of using Internet technology for selling purposes depends on the
objectives of the firm here. If it is planning to bypass the existing retail chain and
sell its product directly to the final consumers, Souve would be competing directly
with its existing suppliers, possibly weakening its bargaining powers.
This would not necessarily be a great idea since it could anger and alienate its
existing retail network, possibly disrupting its existing distribution arrangements.

Also the experience of online retailers such as Amazon.com suggests that online
selling is not a guaranteed route to success, especially if the product is a cheap,
highly differentiated product with a strong impulse-buying element.
On the other hand, if Souve was to use Internet technology to upgrade its trading
relationships with its existing retailers (and rivals were slow to follow), then it might
improve the quality and speed of information involved, allowing it to improve the
quality of the service, extract a competitive advantage relative to rivals, making
buyers more dependent on it, and increasing Souve’s bargaining power at the
expense of its buyers.
Force 4: Bargaining Power of Suppliers
Again, there are a number of elements which, if present, may strengthen the
bargaining power of Souve’s suppliers. These include:
 Supplying group has few firms
 No close substitutes for the supplier’s products
 Product is an important input for the buyer
 Buyer industry is not an important customer
 Suppliers’ products are differentiated or there are switching costs for buyers
 Supplier can threaten vertical integration.
The most obvious effect of Internet trading in this context is that it could turn a
local supply situation into a regional, national or even international one. This could
change the number of supplier firms from ‘few’ to ‘many’ and reduce the bargaining
power of suppliers accordingly. This will be reinforced to the extent that the basic
raw materials are standardised commodities that can be easily specified and traded
this way.
However, there could be reciprocal gains for the suppliers if it opens up the number
of outlets for their products and reduces their dependence on one or a few local
suppliers.
To the extent that both these sets of effects obtain, the industry could move from a
situation of local bilateral monopolies, or at least local bilateral oligopoly (few local
buyers and suppliers) to one that approaches the competitive ideal in which neither
suppliers nor buyers (such as Souve) have much room to manoeuvre.
Force 5: Pressure from Substitute Products
There are no obvious direct influences here.
Comment
It should be borne in mind that these are just some possible influences on the Five
Forces in this industry and possible implications for Souve. Its strategic options
would depend on a much more detailed analysis of its capabilities in the context of
the constraints and opportunities represented by the Five Forces.

Appendix 2
Answers to Review Questions

Contents
Module 1 .............................................................................................................2/1
Module 2 .............................................................................................................2/3
Module 3 .............................................................................................................2/5
Module 4 .............................................................................................................2/7
Module 5 .............................................................................................................2/8
Module 6 .......................................................................................................... 2/10
Module 7 .......................................................................................................... 2/12
Module 1
Exhibit 1.1: Organic growth

Prices are signals, and the important consideration here is what signals supermarkets
are sending to their suppliers if they squeeze the prices of organic produce which is
presently in a growth stage. The higher cost of organic produce relative to conven-
tional food means that suppliers typically require higher prices before they are
willing to enter this sector, and the lower price elasticity means that many consum-
ers may be willing to pay higher prices. If the supermarkets attempt to pass any
squeeze on retail prices back up the vertical chain and put pressure on the price
differentials between organic and conventional produce it would immediately
depress returns of organics relative to (cheaper to produce) conventional foods,
while simultaneously stimulating demand. More crucially, it might depress expecta-
tion of future returns from present investment in organics (if producers see this
price trend continuing). The likely result would be to help create slower growth,
future shortages and difficulties in obtaining supplies of sufficient quality (with
resulting upward pressure on prices), reduced entry into and increased exit from this
sector.
Exhibit 1.2: Breathing new life into old sectors

Organic foods and Swatches have some similarities in that they both revitalised what
had been mature markets (through health considerations for organics and fashion
considerations for Swatches) and might be expected to face lower price elasticity for
their products than their immediate substitutes (conventional foods in the case of
organics, and conventional budget watches in the case of Swatch) as far as the final
consumer is concerned. But a major difference between the two cases reflects

Appendix 2 / Answers to Review Questions
producer control over price – farmers, including organic farmers, typically operate in
a market with numerous rivals, close substitutes, strong price competition and
elastic demand curves, while Swatch has sole control over the supply and prices of
its products. So organic farmers are likely to have little or no control over their price
(competitive market pricing) while Swatch has significant discretion over the price it
charges for its watches (monopoly pricing situation).
Exhibit 1.3: Five Forces and niche markets

Threat of new entrants: low. Intensity of rivalry amongst existing competi-
tors: weak. Bargaining power of buyers: weak. Bargaining power of suppliers:
we do not have direct information on Disco’s suppliers, but to the extent that the
company uses standard components and raw materials, supplier power would be
weak. Pressure from substitute products: none.
Disco therefore faces a highly favourable competitive environment.
Exhibit 1.4: BIC and economies of scope

The diversification should have allowed it to exploit economies of scope between
pens and razors (and lighters) given the technological and marketing similarities
between these products. This should shift the average cost curve down for each of
these products, including pens. This could deter firms from entering the pen market
since BIC is now in a stronger (cost) position to resist and more able to defend its
market position.
Exhibit 1.5: The more you sell, the more you lose
The short answer is no. The key in the exhibit lies in the phrase ‘the price that
consumers will be prepared to pay’. In order to achieve higher volume, a firm with a
differentiated product and facing a downward-sloping demand curve (like Amazon)
will have to reduce price. Then, even if cost per unit (or average cost) falls with
volume, revenue per unit (or average revenue) will also fall as volume increases.
Amazon in fact made its first reported profit in 2001, seven years after it was
founded. Not only had it gone on to achieve significant economies of scale in book
selling, it was also able to exploit large economies of scope through its diversifica-
tion moves into many other areas of merchandising.
Exhibit 1.6: Internet procurement and the supply chain

Threat of new entrants: This may be reduced to the extent that strengthened
competition eliminates the weak, selects the strong, makes the sector more efficient
and able to fight back against any new rivals. Conversely, it may be increased to the
extent that potential entrants have competences and skills that enable them to use
the new technology more effectively than incumbents. Intensity of rivalry would
expect to increase now due to wider geographical spread and larger pool of com-
petitors. Bargaining power of buyers should increase due to increased range and

variety of suppliers to choose from. Pressure from substitute products depends

on the industry in question.
Review Questions
1.1 The correct answer is A. Each of these strategies can be used in response to industry
decline, but Harvest is essentially a short-term strategy that may provide only
temporary respite.
1.2 The correct answer is D. Economies of scale is not one of the Five Forces. The Five
Forces are rivalry, entry conditions, supplier power, buyer power and substitute
products.
1.3 The correct answer is B. Increasing the number of sellers and deregulation are both
circumstances likely to sharpen competitive edge in an industry. However, the
elimination of excess capacity can dull rivalry; it is the failure to match sales to
capacity (excess capacity) that often lies behind price wars and other periods of
fierce competition.
1.4 The correct answer is B. A strategic move is intended to change the beliefs or
expectations of others in a direction favourable to you, for example if you make a
credible threat or credible promise with regard to some course of action.
Module 2
Exhibit 2.1: Walmart and cost leadership

This is an interesting question, not just because of what it tells us about Walmart but
because of what it might suggest about the defensibility and sustainability of its
strategy. It certainly appears to be taking advantage of economies of scale and probably
also learning and experience curve effects. Institutional factors such as the lower degree of
government regulation and union protection in the US (compared to Europe)
probably played a part by making the US market (and Walmart) more competitive
compared to domestic European chains. But an essential element in helping
Walmart achieve cost leadership has been vertical links within the value chain, especially
with suppliers’ value chains, and its strong informational and logistical system
designed to push costs down and keep them low. While in principle it is open to any
supermarket chain to try to replicate Walmart’s success, in practice it is very difficult
to catch up and match the managerial skills and experience that Walmart has built
up over the years.
Exhibit 2.2: Cost leadership as a niche: Dell and PCs

Concentrating on direct retailing certainly limited the potential market for Dell,
since (as the exhibit notes) many consumers want to see and try out products before
they buy them. A problem for Dell was that direct selling put them into direct
competition with high-street retailers who might be reluctant to stock and sell
supplies from someone they see as a rival. It is difficult for any company to be active
in selling directly and through retailers; the more effective direct selling is, the more

it could cannibalise its own sales through shops (and vice versa). Retailers may be
rightly suspicious of how committed a direct retailer would be to shop selling.
Exhibit 2.3: Cleaning up in the toothpaste market

Probably both. Use criteria (e.g. prevention of decay) may attract consumers to
certain categories of toothpaste (e.g. fluoride-based), while signalling category (e.g.
advertising) may encourage choice of one or other brand (e.g. Crest).
Exhibit 2.4: Maintaining differentiation: Steinway and Yamaha

This is a market where both product (classical music) and process (concert perfor-
mance with traditional musical instruments) is characterised by slow and infrequent
innovation, and long product life cycles (think of a piece by Bach played on a
Stradivarius). Quality, real or perceived, is also of critical importance here and
Steinway is well down the learning curve and has a well-entrenched position using
use and signalling criteria. The absence of major changes in the product life cycle
limits openings and opportunities for potential entrants, and helps entrench the
incumbent’s (Steinway’s) position.
Exhibit 2.5: How much is a brand worth?

It is true that associating a weak or poorly performing good with a well-regarded
brand may be one route to an immediate (though possibly short-term and unsus-
tainable) boost in sales for that good or service. The problem is that, if the poorer
reputation of the weaker brand is deserved, it can feed back to weaken the value and
reputation of the core brand. A converse example of brand stretching into other
products that is actually intended to improve the image of the core brand has been the
tobacco industry’s attempts to associate their brand names with lifestyle products.
Exhibit 2.6: Electronic flea markets

eBay provides access to ‘idiosyncratic’ and ‘specialist’ demands, suggesting there
may be no ready substitute for the product it is offering, and in turn implying a
relatively low price elasticity of demand in many cases. On the other hand, there are
ready alternative sources of supply for Amazon.com products in many cases,
suggesting a higher price elasticity of demand for its products. This should give eBay
more power and discretion than Amazon.com as far as pricing is concerned, and
eBay should have more scope to achieve high margins on unit sales.
Review Questions
2.1 The correct answer is D. It is not sufficient to be different or unique to exploit a
differentiation advantage, the crucial thing is that the difference must be valued by
the potential buyers.
2.2 The correct answer is B. Cost advantage is not obtained by simply offering a lower
cost product if quality suffers. It may be obtained by being able to maintain parity in
terms of differentiation, but being able to do so at a lower cost.

2.3 The correct answer is C. Differentiation should reduce the extent to which the
product is regarded as having close substitutes and so reduce the price elasticity of
demand.
2.4 The correct answer is D. The value chain is applied at strategic business unit (SBU)
level. It is concerned with separating and identifying activities with emphasis on
those that can help generate cost or differentiation competitive advantage for the
firm.
2.5 The correct answer is B. Product availability and product reliability can both
constitute important differentiation drivers. However, impact on product cost is
likely to constitute a cost driver and does not itself provide a basis for differentia-
tion.
Module 3
Exhibit 3.1: Fax facts

Sorry, this is a bit of an unfair question, but it is a good one nonetheless! So, why
would anyone buy the first fax machine – if there is no-one else yet to fax messages
to? And why would anyone buy the first telephone, form the first football club –
and so on. The question highlights the point that certain products and services need
a network of other producers or users in order to operate effectively. In some cases
(such as the telephone and fax machine) the effectiveness and value of the product
increase as the number of users increases. That is why it may be difficult to stimulate
sales in the early stages where the network is small and fragmented. As for why
anyone would be prepared to be first to buy in cases where network effects are likely
to be important (as in faxing), there must be an expectation that you will soon have
someone to communicate with.
Exhibit 3.2: T&N and R&D

As the exhibit makes clear, there tended to be strong technological similarities
across R&D projects in T&N. Delegating responsibility for the conduct of R&D
could increase potential duplication of effort and reduce the potential for technolog-
ical synergies among R&D projects.
Exhibit 3.3: Research at Siemens

The problems of opening up an external market in such cases usually boil down to
transaction costs and appropriability problems (see Section 3.5, solutions 1 and 2 on
in-house R&D and internally funded R&D). Siemens was big and diversified enough
to have a working internal market for R&D ideas of the kind described here.
Exhibit 3.4: Research at General Electric (GE)

The solutions illustrated here include Solution 1 (conduct R&D in-house), Solution
2 (internally fund R&D), Solution 3 (corporate-level R&D), Solution 4 (top-down
budgeting), Solution 7 (targets for new product generation), Solution 12 (corporate

diversification), Solution 13 (R&D diversification), Solution 15 (organic structure)

and possibly Solution 19 (public funding of basic research – though some of the
public support is likely to have been for less radical research).
Exhibit 3.5: Nestlé and R&D

Just about all of them! (1) the fact that the R&D may have a low degree of specificity
(and be of interest to other possible users of the research) is illustrated by some of it
being publishable in scientific journals; (2) the (technical and market) uncertainty is
implied by the failure of many radical projects to result in commercial applications
in the past; (3) the long time horizons are illustrated by the example of research that
would have taken years to complete previously (though in the example cited it is
being shortened considerably); (4) the emphasis on basic research may be expected
to be associated with relatively low costs at the early laboratory stages (though there is
no direct evidence on what these costs are); and (5) there are also indicators of
concerns about the high cumulative cost (researchers and escalating launch costs).
Exhibit 3.6: Pilkington’s R&D

There appears to be evidence of management addressing Hurdle 3 (duplicated
research), Hurdle 4 (uncertainty of R&D with less blue sky research), Hurdle 5 (high
cost), Hurdle 6 (long time horizons), Hurdle 7 (asymmetric information with tighter
controls), and Hurdle 9 (complementary assets with the multifunction Technology
Management Board). Other hurdles may have been tackled by Pilkington’s new
strategy, but we do not have enough information to judge this here.
Review Questions
3.1 The correct answer is D. There may be advantages in some circumstances in being
first-in so that you can run away from your competitors, while in other circumstanc-
es it may be better to take things slowly, learn from your competitors’ mistakes, and
then overtake them.
3.2 The correct answer is B. Parallel R&D may increase the chances of getting to the
R&D goal more quickly by having a number of teams working towards the same
target. However, it can lead to increased duplication of effort, and simultaneous
R&D makes it more difficult for each team to learn from each other’s effort, so
increasing costs.
3.3 The correct answer is B. With dominant designs, opportunities for future change in
a system are constrained by the particular developmental path the system has taken
in the past. Historical processes and chance events can influence outcomes and lead
to the development of solutions which are stable but inferior to others that become
available.
3.4 The correct answer is A. The QWERTY keyboard emerged as a consequence of a
series of historical accidents and circumstances, and the advantages of network
externalities helped to maintain dominance once it had become the standard.

Module 4
Exhibit 4.1: The benefits of ‘insourcing’

Insourcing here involves physical asset specificity (special machinery) and human asset
specificity (company-specific training). It almost certainly involves dedicated assets, with
capacity probably being expanded to deal with the company’s own in-house
demands. Whether or not site specificity exists depends on whether internal supplies
could be easily re-routed to external users if necesary. If both INA and alternative
users of its in-house supplies use just-in-time manufacturing methods, this might
make it difficult for in-house suppliers to service distant markets and this could
increase site specificity.
Exhibit 4.2: In-house organisation, international success

The exhibit suggests that vertical integration by Scania may incur costs of different
competences (different stages and variety of components), sacrifice of potential
economies of scale (only making components for itself) and dangers of specialisation (in
heavy trucks). The modular system of component design is one way of trying to
achieve economies of scale in component production, and reduce the managerial
problems associated with managing a large variety of components. While lack of
flexibility, dampened performance incentives, problems of large size or vertical relations with rivals
might also be problems in practice, there is no evidence for this in the exhibit.
Exhibit 4.4: The wisdom of eggs in one basket

If suppliers are producing components with a high degree of asset specificity (i.e.
dedicated to their customer, whether it is Honda or Toyota), then Honda could
expect to face higher supplier prices (reflecting higher supplier costs) if it sacrifices
economies of scale by splitting production of components between different
suppliers (though there may be compensating gains on the cost side due to competi-
tion among suppliers). If economies of scale are not significant or asset specificity is
low, Honda could expect less cost disadvantage on these grounds with respect to
Toyota. (If low asset specificity means standardised assets, it may be possible to
exploit economies of scale in component production by supplying multiple users.)
Exhibit 4.5: Older and richer

A case can be made that long-term contracts help create mutually advantageous
agreements between artist and label that otherwise would not be possible. It is clear
that the record label benefits from the agreement by protecting its investment, but it
may also be the case that the performer can benefit from the support, promotion
and exposure that the record label would not be prepared to fund if such protection
was not in place. While there may be genuine problems (e.g. overly restrictive
clauses) with individual contracts, in general the arrangement may be mutually
beneficial to label and performer. Also, once a performer becomes successful, the
balance of power in the relation may change (they do not need the label’s support
any more) and they may seek to renegotiate the contract or escape it altogether.

Exhibit 4.6: Stuck at home

There is no evidence that the foreign firms are ‘more efficient’ than Kao; the reason
Kao could not successfully attack the incumbent domestic firms reflected barriers to
entry. The type of barriers that Kao found to entering foreign markets (entrenched
distribution relations and established brands) are likely to represent sources of
competitive advantage in its own domestic market, and in turn represent barriers to
entry for foreign firms.
Exhibit 4.7: Tightening up in-house

The most obvious problem is that this may involve vertical relations with rivals. The
most obvious alternative customer for a car firm’s internal automotive components
subsidiary is another car firm. But these potential customers may be reluctant to
become dependent on commercial relationships with a firm that is also a rival.
These are contributory factors behind the decisions of both parent companies to
finally spin off their component manufacturers completely. Less dependence on
single in-house suppliers could facilitate economies of scope (and shareholder value)
through having multiple customers and greater scale of output.
Review Questions
4.1 The correct answer is C. The threat of hold-up means that the firm may be left at
the mercy of an individual or firm outside its direct control. The firm may respond
to this threat by bringing the relevant assets under its direct control, that is vertical
integration.
4.2 The correct answer is D. Tapered integration involves the firm producing some
quantity of an input itself and purchasing the remainder from other firms.
4.3 The correct answer is A. In transaction cost economics, the four types of asset
specificity are site specificity, physical asset specificity, human asset specificity and
dedicated assets.
4.4 The correct answer is D. Opportunism, bounded rationality and asset specificity
may all contribute to transactional problems in vertical relations between firms.
Vertical integration may be adopted to try to eliminate or reduce the resultant
transaction costs.
4.5 The correct answer is B. Vertical integration may help to reduce costs and secure
market access, but it does not itself directly affect market concentration. Unless
there is also some horizontal integration, there will still be the same number of firms
at each stage in the industry after vertical integration as there was before.
Module 5
Exhibit 5.1: Resource effects and allergic reactions: the case of BIC
The answer to the question here is, almost certainly no. The question really confuses
market similarity with resource similarity. The skills and competences required to

make and sell disposable lighters are more similar to those required to make and sell
disposable razors than are those associated with making and selling electric razors. Even
though BIC’s razors and lighters are in quite different markets they involve quite
similar resources and should provide major opportunities to exploit linkages across
the respective value chains.
Exhibit 5.2: Identifying Synergy: the case of Daewoo Electronics

Daewoo Electronics does have a coherent and clearly thought out diversification
strategy with which the company could build up and exploit a well-defined set of
core marketing and technological skills. But its strategy of offering no-frills basic
TVs and other electronic products also condemns it to competing in the highly
competitive cost-sensitive and low-margin segments of electronics goods, a segment
which is also characterised by continuing external threats in the form of high levels
of product and process innovation.
Exhibit 5.3: Exploiting synergy and user gains in packaging

In principle yes – see Section 5.2.3. The two firms could have made contracts to
share their marketing, technological, production and distribution resources as
appropriate, for example using leasing, rental, consultancy and licensing arrange-
ments to combine assets of the two partners or to have them act as agents on each
other’s behalf. Even market power could have been exploited by joint action and
co-operation between the firms. In practice, it would have been extremely costly to
set up and monitor all the contractual arrangements that would have allowed the
firms to combine resources without merging and these arrangements might not have
been fully effective.
Exhibit 5.5: Big enough to handle surprises – the case of General Electric
The problems here include potential transaction costs and appropriability problems
arising from bounded rationality and opportunistic behaviour (see Section 5.3.4). By
revealing it in the open market, the firm may lose control of its intellectual property
and find it difficult to monitor and police agreements with external users even
where contracts are concluded.
Exhibit 5.6: How gunpowder and chewing gum are linked

It is quite clearly a related–linked strategy, in which a series of market and techno-
logical links connect all businesses of the firm to each other, even if only indirectly.
Exhibit 5.7: BTR – can a conglomerate pursue focus?

BTR’s strategy was an example of conglomerate focus of the type illustrated in the
bottom case in Figure 5.12. By pursuing synergistic links it contrasted with the pure
conglomerate case, an example of which is shown at the top of Figure 5.12. Because
it was still diversified into whole groups of businesses which may have no links
between them, it contrasted with the related–linked strategy in which the various

businesses of the firm are linked, albeit indirectly. An example of a related–linked

strategy is shown at the top of Figure 5.11.
Review Questions
5.1 The correct answer is C. Faced with the prospect of terminal decline, diversification
is the only method here which deals directly with the problem at issue, that is, it
reduces dependence on a business which might disappear at some point in the
future.
5.2 The correct answer is D. An internal capital market simply means that a firm can
move capital from one business area to another within the firm, horizontally or
vertically. This is something any firm with more than one activity is in principle able
to do.
5.3 The correct answer is A. Vertical integration is not a long-term solution to this
problem since it would simply lock the firm into decline. The other solutions may
help it flee the disaster area.
5.4 The correct answer is A. Economies of scope may be obtained if the costs of the
combined production of two or more goods are less than the costs of producing
these goods separately.
5.5 The correct answer is C. The learning curve reflects how unit costs decline with
cumulative production.
Module 6
Exhibit 6.1: Scarce resource, abundant innovation

Japan’s poor endowment in terms of oil reserves could be regarded as a selective
factor disadvantage in that it helped encourage ways of economising on this scarce
and expensive resource (e.g. stimulated search for fuel-efficient technology) and
anticipate trends that will be important in the wider or even global context (e.g.
scarcity of fuel reserves in the face of successive fuel crises). This contributed to a
competitive advantage for Japanese firms using fuel-efficient technology in some
cases. By way of contrast, US gas-guzzling technology reflected the relative abun-
dance of cheap fuel in the US economy. These influences helped enhance the
competitiveness of Japanese technology versus US technology when fuel crises
arose.
Exhibit 6.2: L’Oréal

The national Diamond certainly appears supportive of firms in the cosmetics industry:
(a) Demand – strong and sophisticated home demand; (b) Linked and related industries – a
rich set; (c) Firm strategies – highly rivalrous domestic environment; (d) Factor conditions –
we do not have direct information on factor conditions, but the French cosmetics
industry is well established with internationally recognised strengths in design and
research. So we would expect all four aspects of the French national Diamond to help
support and reinforce competitiveness of French firms as a whole in an international

context. Of course, this does not guarantee that individual strategies such as L’Oréal’s
cost-based multinational strategy will themselves be successful. But note how cleverly
it is deliberately trying to extract value by locating creative teams in the heart of the US
Diamond (New York) in this context, and also note how it is unafraid of the dangers
of possibly cannibalising its own products (contrast with Exhibit 2.2).
Exhibit 6.3: Ficosa

It looks as though they have been listening to Porter’s advice about the potential
long-term gains in competitive advantage from seeking out tough competitive
environments and avoiding soft environments. See Section 6.2, and especially Table
6.1 and associated discussion, as well as Section 6.7. In one sense Ficosa are seeking
out trouble rather than a quiet life, but they are more likely to upgrade their level of
competitiveness by locating where the action is.
Exhibit 6.4: Italian Ski Boots

The short answer is that there was no one element in the Diamond that was decisive
in leading to international competitiveness; all were contributory influences. The
lesson of Porter’s Diamond Framework is that generally all four elements should be
working together if competitive success is to be achieved and sustained. That
appears to have been the case here.
Exhibit 6.5: Korea’s competitiveness

Assuming that Porter’s diagnosis is accepted, there are some features of the Korean
national Diamond that are and will be difficult to improve, such as the absence of
strong and sophisticated home demand, and the weakness and shallowness of
industrial clusters. What is potentially more malleable is corporate strategy and
government policy. Conglomerate strategies could be refashioned to give overdiver-
sified corporations a more focused orientation (through downsizing, divestment,
selling corporate business to more closely related corporate homes), while the
government could draw back from heavy-handed interventionism in industry. There
are some signs that Korea is active in both these directions.
Exhibit 6.9: Foreign car companies in China

Potentially, just about all of them! It would seem to be potentially more profitable,
and give the firm more ability to control activities, if it internalised (i.e. set up a
wholly owned and controlled local branch factory in China to service the Chinese
market), rather than joint venturing with a local partner. The only internalisation
advantage that does not seem in evidence here is ‘reducing chances of losing access
to inputs or outlets’. Here internalisation would actually increase the chances of losing
access to outlets (the Chinese market) in most cases. This one internalisation cost is
sufficient to swing the balance in favour of the joint venture option for many firms.

Review Questions
6.1 The correct answer is C. Marketing, market research and legal know-how are likely
to be country-specific to a degree at least. While technical know-how may also have
to be tailored to an individual country’s needs in some cases, it is usually more likely
to be transferable with little or no modification.
6.2 The correct answer is C. The four basic components of Porter’s Diamond are: firm
strategy, structure and rivalry; demand conditions; factor conditions; related and
supporting industries.
6.3 The correct answer is A. Dunning’s Eclectic Paradigm suggests that all three
influences are necessary for the evolution of multinational enterprise. If foreign
firms had no ownership advantage, they would find it difficult to play away from
home against local firms and their home advantage. If there were no internalisation
gains, licensing local firms would appear as an obvious alternative to multinational-
ism. If there were no location advantages, firms would find it attractive to service
global markets from one centralised base.
6.4 The correct answer is D. Porter’s analysis of selective factor disadvantages shows
how they may stimulate technological innovation in compensation, with resultant
competitive advantage in global markets. Japan provides a number of good exam-
ples with its generally poor endowment of natural resources stimulating
compensatory technological searches, in turn leading to world-beating innovation in
many cases; for example, in fuel-efficient technologies to economise on scarce fossil
fuels.
Module 7
Exhibit 7.1: Combining components

The major changes in the Five Forces due to increased concentration, economies of
scale in production and R&D, and enhanced technical competences of the suppliers
are likely to (a) diminish buyer (car maker) power, (b) diminish supplier (e.g. raw
material) power, (c) increase barriers to entry and in turn reduce threat of entry, and
(d) change nature of rivalry in this segment (now more likely to be based on
technical abilities rather than price).
Exhibit 7.2: Sony and Matsushita in Hollywood

The problems that both companies faced were similar. Combining electronics
hardware with entertainment software tended not to add value over and above what
could be achieved with more straightforward market agreements and contractual
arrangements.
The electronics business involves a different set of skills and competences than the
entertainment business. American managerial style and culture is quite different
from Japanese. In short, there was little that the Japanese side brought to the
acquisition that could not readily be found elsewhere (except possibly a deep

financial pocket), while the capabilities of the Japanese acquirer were not really
relevant or transferable to the making of films.
There are a number of specific possible reasons why they could have found the
acquisitions so difficult to manage, many of which are discussed in Section 7.4.1.
But compatibility problems (especially likely with this kind of vertical integration),
optimistic bias, and even strategy matching/Prisoners’ Dilemma may be contrib-
uting to the problems here.
Exhibit 7.4: Honda + Rover + BMW

What might seem a weakness in retrospect can appear to be (and indeed may be) a
source of strength and competitive advantage in prospect. Honda and Rover had set
up an alliance with multiple linkages which made both firms mutually dependent on
the other and could normally be seen as providing hostages and reassurances,
reducing transaction costs and protecting both firms from opportunistic behaviour
on the part of the other (see Section 7.5). Such arrangements have helped oil
transactions in many other cases, but here the takeover of Rover by BMW means
that the safeguards (multiple Honda/Rover linkages) that had been put into place
now turned out problematic in view of the fact that Rover was now owned by a
major competitor of Honda. But given that even seasoned industry watchers were
taken by surprise by this sudden turn of events, it is difficult to blame Honda for
not anticipating it.
Exhibit 7.6: Synchronised flying

The key here is to remember that collaborative activity can do just about anything
that merger and acquisition does. It is a substitute means for achieving the ends that
merger and acquisition is intended to achieve – remember the laundry list example
from Section 7.3. So, like merger and acquisition activity, collaborative activity could
achieve economies of scale, economies of scope, change balance and nature of
rivalry in the market, and increase market power and barriers to entry in this sector.
Exhibit 7.7: Oil pools

While many things may influence the formation of individual combinations (for
good or ill), the concurrent timing of these combinations does raise the possibility
that some of them could at least in part be influenced by strategy matching and/or
the form of the Prisoners’ Dilemma discussed in Section 7.4.1.
Review Questions
7.1 The correct answer is B. Acquisition may be the best (and in some cases, the only)
method of securing access to supplies or transferring technological ideas and so
adding value. However, profitability is not in itself an acceptable reason for acquir-
ing another firm. High profitability would normally be reflected in the present value
of the acquisition and the resulting price that has to be paid for an acquisition,
effectively removing the profit incentive for merger.

7.2 The correct answer is D. Each of the alternatives is a mode of co-ordination and
each may be suitable for combining the various resources outlined here, depending
on circumstances. They are substitute methods for doing the same range of things,
and in practice choice of mode depends on the respective costs in each particular set
of circumstances.
7.3 The correct answer is A. One of the recurrent problems reported in co-operative
agreements is that they may give partners access to technological and managerial
secrets that the firm would otherwise be more able to conceal from outside scrutiny.
This can cause appropriability problems, which in this context can mean that
intellectual property such as inventions and trade secrets can leak out. In turn, this
can lead to the erosion of the firm’s competitive advantage.
7.4 The correct answer is A. The Winner’s Curse occurs because in an auction bidders
can make two mistakes, either undervalue and then possibly bid too low, or over-
value and then possibly bid too high. Optimistic bidders are likely to overvalue, bid
higher than others, and win the auction. Consequently, winners may be those who
have made a valuation error.
7.5 The correct answer is B. The empirical evidence on mergers and acquisitions has
found many cases where they do not add to shareholder value and can even reduce
it. This is one of the clearest findings from the evidence. This does not mean that
there are no constraints on managerial behaviour, only that these constraints may be
loose in many cases. The evidence does not allow us to draw any clear conclusions
about what kind of objectives firms pursue.

Index
3M 1/8, 2/6, 3/2, 3/25 BIC 1/19–1/21, 2/11, 2/18, 5/9, 5/10,
acquiring firms, disadvantages for 7/18– 5/16, 5/27
7/22 Boeing 1/3, 1/19, 2/10, 3/2, 3/3, 4/14,
acquisitions 6/2
and vertical integration 4/9 bounded rationality 4/14, 4/17, 4/18
bad performance 7/13–7/22 branding 1/9, 2/22, 2/23, 7/12
contrasted with joint venture 7/27– BTR 5/2, 5/39
7/30 budgeting 3/19–3/20
acquisitions, international, and business units 2/29
competition 6/32 buyers
administration, and joint venture 7/26 and competition in international
adverse selection, and quality 2/20 markets 6/31
advertising 2/19, 4/31–4/32 and cost drivers 2/11
and industry life cycle 1/7, 1/9, 1/11 and Diamond Framework 6/13
airlines 2/10, 7/27 and Five Forces Framework 1/17,
allergic reactions 5/9, 5/12, 7/9 1/26–1/27
alliances, as co-operative activity 7/30– identification as step in differentiation
7/31 2/24
alliances, international, and competition capabilities 2/6, 7/11
6/32 capacity
Amazon.com 1/3, 1/4, 1/22, 2/6, 2/26, and industry life cycle 1/8, 1/10, 1/11
2/32 utilisation 2/11
anti-competitive behaviour 5/11 capital markets 5/21
appropriability capital requirements 1/23
and innovative process 3/7, 3/9 Carnaud Metal Box (CMB) 5/17
and joint venture 7/25, 7/26 cartels, and research clubs 3/25
as innovation problem 3/11, 3/15, chance, and Diamond Framework 6/18
3/17, 3/23, 3/24, 3/29 China 6/16–6/17, 6/30
articulable knowledge 3/3 Chrysler, and Daimler-Benz 1/2–1/4
asset specificity 4/15, 6/10 clusters 2/5, 6/9, 6/24
and hold-up 4/17, 4/18, 4/20 Coca-Cola 1/3, 2/6, 2/23
assets, complementary 3/14, 3/21, 3/24, combinations 7/1, 7/5–7/12
3/26, 3/28 commitments, credible 1/13, 2/14, 2/19
assets, strategic 6/32 commodities, and industry life cycle 1/12
asymmetric information 2/20, 5/18, company strategy, and Diamond
5/22 Framework 6/24–6/26
as innovation problem 3/13, 3/15, compartmentalisation, as innovation
3/18, 3/27, 3/29, 3/31 problem 3/14, 3/21, 3/24, 3/27
auction, and Winner’s Curse 7/20 compatibility problems 7/13–7/14, 7/21
average cost (AC) 1/17–1/19, 2/2 competences 2/6, 4/23
backward integration 1/27, 4/2 competition
bad bargains, and Winner’s Curse 7/21 and adding value from combinations
bargaining power 7/10
buyer’s 1/26–1/27 and Swedish motor industry 4/12
supplier’s 1/27–1/28 and vertical integration 4/9–4/10
basic research, and public funding 3/29– in international markets 6/26–6/31
3/30
Competitive Strategy Edinburgh Business School I/1

Index
lack as cost of vertical integration dedicated assets 4/15

4/25 defects, and industry life cycle 1/8, 1/11
competition policy demand conditions
and joint ventures 7/12 and Diamond Framework 6/12–6/15
and quality 2/22, 2/24 US economics textbooks 6/23
competitive advantage 2/1–2/33 demand side
and cost leadership 2/16 and adding value from combinations
and demand conditions 6/15 7/11
and Diamond Framework 6/24 and differentiation 2/25
and differentiation 2/17–2/25 demand, and industry life cycle 1/7, 1/9
and Diversification Game 5/5 design, and industry life cycle 1/8, 1/10,
and value chain 2/4–2/10 1/11
evolution 3/1–3/32 Diamond Framework 6/9–6/26, 6/31,
generic strategies 2/2–2/4 7/21
in international sector 6/6–6/7 and company strategy 6/24–6/26
United States 6/22–6/24 factor conditions 6/10–6/12
competitive positioning, and strategy use 6/18–6/24
matching 7/15 differentiation 5/17, 6/35, 7/10
competitive strategies 1/2–1/3 and cost leadership 2/12, 2/13
complementary assets, as innovation and Five Forces Framework 1/22,
problem 3/14, 3/21, 3/24, 3/26, 3/28 1/25, 1/27, 1/28
compromise, linkages and focus 2/29 and generic strategy 2/3
conglomerates 5/2–5/3, 5/33, 5/36 and hybrid strategies 2/30–2/33
consumer electronics 6/7 steps 2/24–2/25
consumer goods 6/12 differentiation advantage 2/17–2/25
consumer guides 2/22 sources 2/18–2/20
consumer markets 6/25 differentiation drivers 2/18–2/19
consumer tastes 5/32 direction 5/3, 7/21
contracts 1/34, 4/20 discretionary policies 2/12
contractual issues 7/24 distribution
co-operative activity 7/22–7/32 and industry life cycle 1/9, 1/11, 1/12
co-ordination, linkages and focus 2/28 and value chain 2/4, 2/8
corporate diversification 3/25, 5/1 linkages 5/7, 5/9
corporate R&D 3/18 diversification 1/13, 2/2, 2/28, 3/25,
cost 5/11–5/13, 5/13–5/29, 7/29
and innovative process 3/6, 3/9 Diversification Game 5/3–5/13, 6/3–
as innovation problem 3/13, 3/15, 6/6, 7/3–7/5
3/18, 3/21, 3/23, 3/24, 3/25, 3/29 divisionalisation gains 5/18
cost advantage 1/23, 2/3, 5/17 dominance 1/12, 1/25, 2/14
cost drivers 2/10–2/12 dominant designs 3/4–3/5
cost leadership 2/2, 2/4, 2/16, 2/31, downsizing 4/32, 5/38
2/32 downstream integration 1/28, 4/2
costs, and differentiation 2/25 duplication 7/10
costs, fixed 1/24–1/25 as innovation problem 3/11, 3/15,
credibility, and game theory 1/33 3/18, 3/26
Crown Cork and Seal 5/17 Eclectic Paradigm 6/26–6/31
cultural globalisation 6/35 economics textbooks, and US
customer base 1/12 competitive advantage 6/22–6/23
Daewoo Electronics 5/16, 5/17 economies of scale 1/20–1/21, 2/16,
Daimler-Benz 1/36, 1/2–1/5 2/32, 3/4, 4/25
decline 1/6, 1/11–1/14, 5/28
I/2 Edinburgh Business School Competitive Strategy

Index
and Five Forces Framework 1/17– fundamental transformation 4/18

1/19 funding, internal, of R&D 3/17
as cost driver 2/10 game theory 1/1, 1/29–1/37, 2/13
economies of scope 1/21, 2/26, 2/32, Prisoners’ Dilemma 1/29–1/33
7/11 strategic moves 1/33–1/34
and cost drivers 2/11 General Electric 1/8, 3/26, 5/27, 5/28
and Five Forces Framework 1/19– General Motors 4/26, 5/3
1/21 generic strategies 2/2–2/4
economies, external, and cost drivers Germany 6/6, 6/16
2/12 Gillette 5/10, 5/27
efficiency, and diversification 5/2 global markets 5/17
engineering industry, and diversification global sourcing 6/32
5/19 globalisation 6/33–6/35
entry, threat of 1/17–1/24 Google 2/23
environment, analysis 1/1–1/37 government 2/12, 5/32, 5/33, 6/18
European Union, and trade barriers 6/17 policy 1/24
exchange rate, and international regulations 6/7
competitiveness 6/6 Grossman–Hart problem 7/18–7/19,
exhaustive contracting 4/20 7/21
exit barriers 1/24, 1/25 growth 2/26, 5/22, 5/37
exit, and declining market 1/13 and industry life cycle 1/5–1/6, 1/7–
expansion 5/11–5/13, 7/12 1/10
expense, and buyer 1/26 motives 5/29
experience curves 1/21–1/22, 2/10, 2/32 patterns 6/13
external economies 2/12, 2/15 growth, low 1/25
externalities 3/7 guarantees, and quality 2/21
factor conditions 6/10–6/12, 6/23 harvest strategy, and declining market
factor disadvantage 6/12 1/13
fashion industry 6/8 Hercules Powder Company, related–
fax technology 3/2, 6/10 linked strategy 5/36
Ficosa, and rivalry 6/17 hierarchy, and joint venture 7/24–7/25
film industry 6/8, 7/7 hold-up 4/16–4/23
firm strategy and structure 6/16–6/18, seriousness 4/18–4/19
6/23, 6/24 solutions 4/20–4/23
firms, number, and industry life cycle home demand, and Diamond Framework
1/9, 1/11, 1/12 6/13
Five Forces Framework 1/1, 1/15, 7/4, home-grown products 5/21
7/27 Honda 4/19, 7/25
elements listed 1/17 horizontal links 2/5, 2/7, 2/11
fixed costs, and Five Forces Framework horizontal moves 7/1
1/24–1/25 horizontal relations 4/2, 5/1–5/39
flexibility 4/24–4/25 hostages 1/36, 4/21
focus 2/25–2/29, 5/38 hubris 7/21
Ford 4/26, 5/3 human asset specificity 4/15
foreclosure, and mergers 7/15, 7/16 hybrid strategies 2/3, 2/30–2/33
foreign competition 6/26 IBM 1/2, 1/19, 2/6, 2/18, 3/5, 4/7, 6/2
foreign needs 6/14 implementing strategies 7/1–7/32
forward integration 1/28, 4/2 improvement, and Diamond Framework
France 6/8 6/21
franchising 2/22, 4/5, 7/22 INA, and vertical integration 4/8
Fukuyama, Francis 6/16–6/17

Index
incrementalisam, and strategic moves Internet retailing 1/22, 2/26

1/36 Internet services 1/7
indivisibilities, and synergy 5/15 intrapreneurship 3/24
industrial associations, and quality 2/22 investment 1/35
industry change, and Diamond and industry life cycle 1/8, 1/10, 1/11
Framework 6/25 Italian ski boot industry 6/20
industry life cycle, and competitive Italy 6/8, 6/16
strategy 1/4 Japan 6/6, 6/8, 6/16–6/17
inflexibility, linkages and focus 2/29 joint ventures 3/24, 5/1, 7/12, 7/23–
informal co-operation, as co-operative 7/24
activity 7/22 Kao 4/23, 6/7
innovation 2/32, 3/2, 3/21, 3/32, 6/25 Korea 6/20
and industry life cycle 1/4, 1/8, 1/10, L’Oréal 6/13, 6/14, 6/32, 6/35
1/11 labour 6/11
as threat 5/32, 5/33 costs 6/6
problems facing 3/9–3/16 markets 5/18
innovative process 3/3–3/9 leadership, and declining market 1/12
characteristics 3/6–3/9 learning curve 2/10, 2/15
problem-solving 3/17–3/31 learning effects 3/4
inputs, as innovation target 3/22 learning, as differentiation driver 2/18
insourcing, and vertical integration 4/8 leisure, and industry life cycle 1/4
institutional factors, and cost drivers licensing 2/23, 3/23, 7/22
2/12 life cycle, industry 1/4, 1/7–1/15
insurance 5/25, 5/26, 7/20 linkages 2/18, 2/28–2/29
integration, as innovation problem 3/14, linked and related industries 6/15, 6/23
3/21, 3/24, 3/26, 3/28 liquid assets, and diversification 5/24,
integration, backward 1/27 5/25
Intel 1/27, 2/32, 3/5, 5/2 localisation, and international markets
intellectual property 4/14, 7/25 6/33–6/35
interdependence, disadvantages 7/14 location 2/11, 2/18
interest, and diversification 5/26 location advantage 6/30
intermediaries, and quality 2/23 location advantages 6/28
interna[tiona]lisation advantage, and lock-in 5/20
competition in long-term contracts 4/5, 4/11, 5/25
international markets 6/30 losses, and industry life cycle 1/7, 1/11
internal expansion 7/12 Machiavelli, on vested interests 3/14
internal growth 7/21 manoeuvrability, importance 1/3
internal markets 5/18–5/22, 5/29 market alternatives, as strategy choices
internal spin-offs 3/11 4/29
internalisation advantage, and market conditions, and vertical
competition in integration 4/10–4/14
international markets 6/28 market entry, and industry life cycle 1/9,
internalisation of threat, and declining 1/11, 1/12
market 1/13 market orientation 6/34
international competitiveness 6/6–6/9, market power 5/8, 5/11–5/12, 5/14–
6/18 5/15, 5/17, 5/29
international markets 6/26–6/33 marketing 1/4, 2/4, 2/8
international moves 7/1 marketing linkages 5/7, 5/9
international strategies 2/28, 6/1–6/36 Marks and Spencer 2/23
internationalisation 6/13 matrix structures 2/10, 3/26
Internet procurement 1/28 Matsushita, and acquisitions 7/7

Index
maturity, and industry life cycle 1/6, outlets, access to 1/23

1/10–1/11 outputs, as innovation target 3/22
maximin solution 7/15 outsourcing 4/7, 4/32
McDonald’s 1/34, 4/5, 4/6, 6/27 overcapacity, and industry life cycle 1/5,
McKechnie 5/19, 5/27 1/11
mean values 3/13 ownership advantages 6/27, 6/28, 6/30,
measurement 7/6 6/33
mechanistic structures 3/26 partial equilibrium analysis 6/8
median values 3/13 PC industry 1/8
mergers penalty clauses 4/21
bad performance 7/13–7/22 performance incentives 4/25
contrasted with joint ventures 7/24, physical asset specificity 4/15
7/27–7/30 piano market, and differentiation 2/20
method Pilkingtons, R&D and innovation 3/31
and diversification 5/3 Polaroid 1/35, 3/12
avoidance of hubris 7/21 policy choice, as differentiation driver
M-form structure 5/18, 5/22 2/18
Michael, George 4/20 Porter, Michael 1/15, 6/9–6/26
Microsoft 1/19, 1/27, 2/23, 2/32, 3/3, price discounts 5/26
3/5, 3/7, 4/14 price elasticity 1/9, 1/11, 2/30
minerals, depletion as threat 5/32 price, and industry life cycle 1/4, 1/7–
mobile buyers, and Diamond Framework 1/8, 1/9, 1/10, 1/11
6/13 pricing 1/9, 3/28–3/29
motives, and success of combinations principal–agent factors 1/35, 4/26, 5/25
7/6 and diversification 5/2, 5/20, 5/22,
multinational buyers 6/13 5/28
multinational corporations 2/2 and mergers 7/13, 7/16
multinational firms 6/2, 6/4 as innovation problem 3/14, 3/19
multiple sourcing 4/22 Prisoners’ Dilemma 1/29–1/33, 7/16–
multiplicity, and Diamond Framework 7/17
6/21 process innovation, and industry life
national champions 6/18 cycle 1/10
natural resources 6/7 Procter & Gamble 2/6, 2/17
Nestlé, R&D and innovation 3/30 product champions 3/27
network economies 7/26–7/27 product markets 5/17
network effects 3/4 production factors 6/35
network participation 7/31–7/32 production transactions 4/30
niche exploitation 1/13 production, and value chain 2/4, 2/8
niche marketing 1/14, 2/16, 2/25 productivity 7/11
Nike 2/19, 4/6 products, new 3/22
oil 5/32, 5/37 professional associations 2/22
oil industry 1/25, 4/2, 6/2, 6/12, 7/30 profits 1/7, 1/9, 1/11, 1/26
opaque performance 5/19 public funding 3/29–3/31
operations, budget sharing 3/21 purchase criteria 2/19, 2/24
opportunism 4/15, 4/16, 4/17, 5/18 quality 1/10, 2/20–2/24
opportunity cost 2/28, 5/2, 5/3, 5/8, quasi-autonomy 3/27
5/23, 5/25, 7/2, 7/7 quick fix, mergers as 7/21
organic foods, and industry life cycle QWERTY keyboard 3/3
1/10 R&D transactions, as vertical relation
organic structures 3/26 4/31
organisational structure 2/8–2/10, 5/18

Index
reactions, unfavourable, and self-confidence, excessive 7/21

diversification 5/10, 5/12 shareholders, and diversification 5/26
recommendation, and quality 2/21 short-term finance, and diversification
regional headquarters, location 6/32 5/24
regulation, and quality 2/23 Siemens, and R&D 3/20
related–linked industries 6/15 signalling criteria, and differentiation
related–linked strategy 5/29, 5/33–5/36, 2/19
7/28 site specificity 4/15
reliability, and industry life cycle 1/10 size, as cost of vertical integration 4/26–
repeated contracting 4/20 4/27
replication, and Diamond Framework social context, and strategic moves 1/36
6/26 Sony, and acquisitions 7/7
reputation 1/34, 2/21 sophistication, and Diamond Framework
research and development (R&D) 3/9– 6/10
3/16, 3/17, 3/20–3/21, 3/22–3/23, space 6/8–6/9
3/28–3/29 specialisation 1/35, 4/23, 5/15–5/16,
and diversification 3/25–3/26, 5/18, 5/28, 6/10
5/27 specificity, and innovative process 3/6,
and industry life cycle 1/8, 1/9 3/7–3/8
and innovative process 3/3–3/4, 3/6– spin-offs, as innovation problem 3/15,
3/9 3/18, 3/21, 3/27
and value chain 2/4, 2/8 spot contracts, and vertical relations 4/4
research clubs 3/24 standardisation 1/9, 1/27, 2/11
resource allocation 4/10–4/12 standardised assets 4/21
resource costs 2/11, 6/4, 6/29 standards, and innovative process 3/5
resource depletion 5/32 Steinway, and differentiation 2/20
resource effects 5/8, 5/12–5/13, 5/29 stockholding, and diversification 5/25
resource linkages 6/5, 6/31 storage, and diversification 5/26
resource sharing, and multinational firms strategic analysis 2/15
6/3 strategic assets 6/32
resources, and international markets 6/6, strategic business units (SBUs) 2/4
6/33–6/34 strategic decision making 7/27
restructuring, and related–linked strategy strategic management 3/32
5/36 strategic moves 1/33–1/34
retaliation 1/24 strategy and structure, firms’ 6/16–6/18
reviews, and quality 2/22 strategy choices 4/28–4/30
risk, as reason for diversification 5/23– market alternatives 4/29
5/29 vertical integration 4/29–4/30
rivalry 4/28, 5/10–5/11 strategy matching 7/15
and Diamond Framework 6/16–6/18 structure-conduct-performance approach
and Five Forces Framework 1/17, 1/16
1/24–1/26 sub-contracting 7/23
international aspects 6/7, 6/32 subjectivity 6/21
US economics textbooks 6/23, 6/24 substitution 1/17, 1/27, 1/28, 2/5, 2/25
sales, and adding value from sunk costs, and strategic moves 1/35
combinations 7/10 suppliers
Scania 4/12, 6/7, 6/14 and cost drivers 2/11
Scripto Tokai 5/10, 5/27 and Five Forces Framework 1/17,
second-in strategies 3/23 1/27–1/28
segment structure 6/13 supplies, access to 1/23
selective factor disadvantage 6/10 supply side 2/13, 2/25, 7/11

Index
surprises, insulation from 7/15 as innovation problem 3/11–3/13,

sustainability 3/15, 3/18, 3/19, 3/21, 3/23,
and differentiation 2/25 3/24, 3/25, 3/26, 3/29
and generic strategy 2/4 unfavourable reactions, and
Swatch 1/12, 1/14 diversification 5/10, 5/12
Sweden 6/6, 6/7, 6/8, 6/10 uniqueness, as step in differentiation
Swiss watches 2/24
and declining market 1/13 United States 6/17, 6/22–6/24
switching costs 1/23, 1/25, 1/27, 1/28 film industry 6/6
symbiosis, and licensing/joint ventures upgrading, and Diamond Framework
3/24 6/21
synergy 3/11, 5/37 use criteria, and differentiation 2/19
and combinations 7/9, 7/12 user gains 5/17, 5/29
and innovative process 3/7, 3/9 value chain analysis 6/31, 6/33
as reason for diversification 5/15– value chains 2/4–2/10, 2/11, 2/18, 5/2,
5/17 7/11, 7/28
T&N, R&D 3/19 value, and diversification 5/2
tacit knowledge 3/4 value-adding partnership, and vertical
tapered integration 4/5, 4/22–4/23 relations 4/5
technological innovation 1/13, 5/29 vehicle industry 6/7, 6/17, 6/30, 7/4,
technological linkages 5/7, 5/9 7/25
technology 1/12, 4/10 vertical integration
technology, foreign 6/32 and diversification 5/25
telecommunications, and joint venture and industry life cycle 1/12
7/26 and transaction cost economics 4/14–
threats 2/14, 5/33 4/15
threats, external 2/26 as differentiation driver 2/18
TI, and diversification 5/19, 5/27 as generic strategy 2/2
time 3/6, 3/8, 6/9 as solution to hold-up 4/23
as innovation problem 3/13, 3/15, as strategy choice 4/29–4/30
3/18, 3/19, 3/21, 3/23, 3/24, costs 4/23–4/28
3/26, 3/29 scope 4/9–4/10
timing 2/11, 2/18 vertical links 2/5, 2/7, 2/11
tobacco, threats to 5/37 vertical moves 7/1
toothpaste, and differentiation 2/17 vertical quasi-integration 4/5
top-down budgeting 3/19–3/20 vertical relations 4/1–4/32
Toyota 4/19, 4/26, 5/3, 7/4 principles 4/2–4/6
transaction cost economics 4/14–4/15, trends 4/6–4/8
4/16–4/23 varieties of 4/30–4/32
transaction costs 1/35, 5/2, 5/12–5/13, vested interests, as innovation problem
5/21, 6/29, 6/31, 7/26 3/14, 3/23, 3/28
transactions, varieties of vertical relations viability, and diversification 5/29
4/30–4/32 Volvo 4/12, 6/7
transport costs 6/5, 6/27 Walmart 2/6, 2/13
turning points, and industry life cycle warranties, and quality 2/21
1/5–1/7 Winner’s Curse 7/19–7/20
U-form structure 5/18 as innovation problem 3/28
uncertainty 3/6, 3/8, 5/23–5/29 X-efficiency, and cost leadership 2/15
Yamaha, and differentiation 2/20

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Competitive

CS-A4-engb 1/2017 (1008)

Edinburgh Business School

Tel + 44 (0) 131 451 3090

Elective Overview viii

1.1 Introduction 1/1

Module 2 Strategies for Competitive Advantage 2/1

2.1 Introduction 2/1

Module 3 The Evolution of Competitive Advantage 3/1

3.1 Introduction 3/2

Module 4 Vertical Links and Moves 4/1

4.1 Introduction 4/1

Competitive Strategy Edinburgh Business School v

4.5 The Costs of Markets 4/10

Module 5 Horizontal Links and Moves 5/1

5.1 Introduction 5/1

Module 6 International Strategy 6/1

6.1 The Diversification Game Goes International 6/3

Module 7 Making the Moves 7/1

7.1 Example of a Combination 7/3

Appendix 1 Practice Final Examinations A1/1

vi Edinburgh Business School Competitive Strategy

Practice Examination 2 1/6

Appendix 2 Answers to Review Questions A2/1

Competitive Strategy Edinburgh Business School vii

Competitive Strategy Edinburgh Business School viii

Analysis of the Environment

Competitive Strategy Edinburgh Business School 1/1

1/2 Edinburgh Business School Competitive Strategy

Just as the geological environment can have an impact on house-building strate-

1.2 Industries and the Life Cycle

Competitive Strategy Edinburgh Business School 1/3

1/4 Edinburgh Business School Competitive Strategy

Critical point: growth Critical point: now

Critical point: growth

Figure 1.1 The evolution of industries

1.2.1 Critical Turning Points in the Life Cycle

Competitive Strategy Edinburgh Business School 1/5

1/6 Edinburgh Business School Competitive Strategy

1.2.2 The Stages of the Life Cycle

Competitive Strategy Edinburgh Business School 1/7

1/8 Edinburgh Business School Competitive Strategy

Competitive Strategy Edinburgh Business School 1/9

Exhibit 1.1: Organic growth

If UK supermarkets were to push the prices of organic products down towards

 Mostly incremental innovations, emphasis on process innovation. The

1/10 Edinburgh Business School Competitive Strategy

Competitive Strategy Edinburgh Business School 1/11

1/12 Edinburgh Business School Competitive Strategy

Competitive Strategy Edinburgh Business School 1/13

Exhibit 1.3: Five Forces and niche markets

1/14 Edinburgh Business School Competitive Strategy

Summarise Disco’s competitive environment from a Five Forces perspective.

1.3 The Five Forces Framework

Competitive Strategy Edinburgh Business School 1/15

decision making for strategists to exploit competitive advantage, rather it was

1/16 Edinburgh Business School Competitive Strategy

The Five Forces:

Competitive Strategy Edinburgh Business School 1/17

Low MES, low Low MES, high

High MES, low High MES, high

1/18 Edinburgh Business School Competitive Strategy

(2) Economies of scope