This document summarizes the first four theoretical lectures of the course "Competitive Analysis and Strategy", held by Prof. Iwan Bos.
A summary of the cases solved in class is NOT provided in this document - lectures only!
This document prepares for the mid term exam of this course, where o...
Competitive Analysis and Strategy
1. Session 1 – Horizontal boundaries of the firm and diversification
Horizontal boundaries of a firm
- refer to a firm’s size (what share of the market is the firm serving?) and its scope (what
variety of products and services does it produce?)
- These characteristics crucially depend on the existence of scale and scope economies
- Economies of scope also provide the primary rationale for diversification
Reasons for diversification
- Efficiency reasons
→are likely to lead to performance benefits
1. Economies of scope: often only for related businesses [most important reason!]
▪ Reducing average cost by sharing resources (distribution, R&D, advertising)
and spreading costs over different industries (note: economies of scale refers
to reducing avg. cost if firms expand in given market (same
industry/market!))
▪ Applying (underutilized) firm capabilities (“leveraging core competencies”) in
other product markets/industries: ‘dominant general management logic’,
e.g. marketing know-how
▪ Example: BIC →they manufacture pens, but also make shaving gear
→applies design expertise in different markets)
2. Economizing on transaction costs in buyer-supplier relationships (vertically
related businesses)
▪ If two businesses require strong vertical coordination and in particular if
transactions involve relationship specific investments
3. Internal capital markets work better than (imperfect) external capital markets
▪ External finance may be costly or may not be available for investment in a
profitable opportunity: higher risk premiums if it is difficult to convey
information about the fact that the desired investment is profitable
▪ Internal finance is then cheaper because there is more knowledge about the
profitability of the investment →information does not have to be conveyed
to externals
▪ Can in principle apply to unrelated businesses
▪ But: firm needs to have more/better information than the market (otherwise
externals would not ask for risk premium). In practice, excess cash flow often
leads to unprofitable investments → firms do not want to pay back money to
shareholders and want to grow instead (no scrutiny by outside investors, e.g.
oil industry example)
4. Risk diversification (only limited efficiency advantages)
▪ Stable revenues and profits. But shareholders can create stability themselves
by diversifying their own portfolio. Firm diversification does not create much
value
▪ Risk reduction does reduce likelihood of bankruptcy and bankruptcy costs for
shareholders. And large firms may be ‘too big to fail’ (bank-insurance giants,
which get help by government)
▪ Note: risk reduction can also be achieved through geographic diversification
within the same industry: sharing resources and capabilities across
geographic markets
5. Diversification by acquiring undervalued firms (not very likely to be efficient)
▪ Acquiring firm should have better knowledge than the market (same as
under 3.)
, ▪ And firm should be able to avoid bidding war and ‘winner’s curse’
Winner’s curse:
▪ The winner of competing bids to acquire a target pays more than the
intrinsic value of the target, because all bidders can bid at least up to this
intrinsic value
▪ Can be avoided if the acquiring firm benefits from specific synergies that
other acquirers cannot reap (e.g., scope economies)
→ diversification is more likely to have advantages if it involves related
business: joint use of, and investments in, value creating resources and
capabilities (economies of scope)
- Managerial reasons
→are likely to reduce a firm’s performance
1. Empire building: managers value firms size and diversification rather than
profitability (opportunistic behavior →act in their own interest)
→often determines prestige, salaries, and outside job opportunities
→Diversification reduces risk of poor results and job loss (bankrupcy)
2. Hubris (overconfidence)
▪ Previously successful CEOs overestimate their ability to manage other
businesses (or their ability to spot undervalued firms) and engage in
unprofitable diversification and acquisitions
➔ Threat of hostile takeovers and tying salaries to share performance can reduce risk of
managerial opportunistic behavior
Costs of diversification
1. Influence costs:
- Lobbying for investment funds by different business units and divisions and misrepresenting
information → inefficiency of internal capital market
2. Diseconomies of scale:
a. Bureaucracy and high agency costs: more difficult to align goals of employees with
corportate goals because individual performance has little influence on the
organization → leads to ‘slack’ and makes costly monitoring systems for employee
performance necessary
b. Large firms have higher cost base as they have to pay higher wages to attract more
employees
c. Spreading specialized resources/capabilities too then → if the capabilities of
specialized resources are too thin
d. Conflicting out: firms’ clients may not want it to do business with competitors
(danger of leakages of sensitive information)
Diversification and performance
- In practice, diversified firms often underperform in terms of profitability
- Related diversification tends to work better than unrelated diversification (goes back to
importance of scope economies →sharing capabilities is more likely if there is some kind of
relation between industries)
- Conglomerate (diversification) discount:
o Market valuation of diversified firms is lower than individual business units might
they be listed on the stock market separately
o Shareholders see no value created in having different business units under the
umbrella of a conglomerate
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