Managerial Economics II Business Strategy Lecture 12 Vertical

Managerial Economics II: Business Strategy Lecture 12: Vertical Integration Prof. Sarah Wolfolds Cornell University Dyson School of Applied Economics and Management March 9 th, 2017 Cornell Business

Logistics 1. 2. 3. 4. Reminder that prelim was moved to March 23 rd Practice Prelim is now posted on Piazza Vidya’s office hours today are moved to 4: 30 pm – 5: 30 pm Problem Set 1 is due Tuesday – bring in hard copy or email to class gmail (aem. 2601. 0304@gmail. com) 5. Next Thursday, we will spend most of class reviewing 6. Reminder to respond to survey to ask Brian Friedman questions and let me know if you want to join for lunch 7. Any questions?

Class Objectives/Plan 1. Review of Last Class 2. Open Source Innovation 3. Vertical Integration 4. IKEA Case

Video Game Industry § In what sense and for what reasons is this a “winner-take-all” industry or not? § What factors have changed the dynamics of competition and the basis for competitive advantage in the industry during recent years? § What recommendation would you make for Nintendo going forward? 6

How to benefit from Innovation?

Leaders vs. Followers § Leaders – Protect with IP – Lead-time Advantage – Establish Industry Standards § Followers – Important Complementary Resources

Standards Wars 1. 2. Determine the potential for standards emergence—analyze network externalities 3. Pre-empt the market—build user base quickly: enter early, attract key customers, adopt Assemble allies—enlist partners (customers, complementors, competitors) to build a bandwagon penetration pricing 4. Manage expectations—use launch and pre-launch publicity and promotion to convince the market that you will be the winner How can the winner sustain the standard? • • Don’t fall behind on technology Ensure backward compatibility Meet threat of disruptive technology Reinforce standard with other resources What if you’re a loser? (a) ensure compatibility (b) go for niche

Mechanisms to Protect Innovation

1. Patents § Patents in the United States – Common for § Processes, machines, manufactured articles, composition of matter, and new variety of plants. – Generally do not cover § Abstract ideas, mental processes, laws of nature, and physical phenomena (minerals and plants). § Patents can take a while to be issued – Average time from application to issuance is 25 months. § But they can last a long time – Patent can protect property for 20 years from the date of the patent application (if filed after June 5, 1995). § Patents are expensive – Average processing costs are $15, 000 -$50, 000.

2. Copyrights § Copyright offer protections for artistic works – Books, motion pictures, and musical works. – Also includes software. § Why protect artistic works? – They are important to an economy. § 5. 24% of GDP ($535. 1) is from copyrighted material – Protections offer incentives to make these welfare increasing artistic works public. § Copyrights afford 6 principal types of rights 1. 2. 3. 4. 5. 6. Right of reproduction Right to create derivative works Right to distribution Right to public performance Right to display Right to digital transmission

3. Trademarks § Trademarks (service marks) = Protection granted to company brand names, images, logos, slogans, and product design and product packaging. – If you do not own the trademark you cannot sell goods or services under that name. § Exception – “Fair uses” of the trademarked item were criticism of the company, news reporting, parody, and interestingly, product comparison. § Why allow trademarks? – Brands are valuable! § Business. Week values the following brands: – – Coca-Cola: $69. 6 billion Microsoft: $64. 1 billion IBM: $51. 2 billion GE: $41. 3 billion § No term of protection § Debate around what’s reasonable to trademark?

4. Trade Secrets § TRADE SECRET = “Information, including a formula, pattern, compilation, program, device, method, technique, or process that derives independent economic value from not being generally known and not being readily ascertainable and is subject to reasonable efforts to maintain secrecy. ” – Uniform Trade Secrets Act (1979, amended 1985) § Examples: – Coca-Cola § § § Formula invented in 1886. Codenamed “Merchandise 7 x” Formula was in a safe in New York from 1919 -1925. Used as loan collateral. Formula was moved to Atlanta, and remains in a safe there from 1925 -present. – KFC chicken § § § Original recipe invented in 1940. The original handwritten recipe is locked in a safe. Only 2 executives have full access.

Intellectual Property – The Debate § How can there be any debate about intellectual property protection? – On one hand, society benefits when inventors are incentivized to innovate. § Capitalism assumes inventors bring their innovations to market for profit. – This suggests we should protect inventions. – On other hand, society suffers without full access to innovations. § Inventors with market power often charge a price premium for their innovation. – This suggests we should not protect inventions. – Example: Patent length § The longer the patent is the more the inventor benefits. § The longer the patent is the less society benefits. – Same debate exists for breadth of IP protection. – Optimal point maximizes benefit to all groups. § Finding this optimum is hard and we’re still working on it.

Class Objectives/Plan 1. Review of Last Class 2. Open Source Innovation 3. Vertical Integration 4. IKEA Case

How to become innovative 1. Cross-functional new product development teams—highly effective in integrating with specialized functional knowledge 2. Product champions—provide the direction and motivation needed to link invention with commercialization, drive integration, and counteract organizational inertia 3. Buying innovation—if start-ups are best at initiating innovation and established companies are rich in complementary resources—innovation most effective where the latter acquire the former 4. Open innovation—the sharing of ideas and technical know-how among firms 5. Corporate incubators—specialized business development units within established firms

Open Source Introduction 19

Open Source Introduction 20

Open Source Introduction 21

Open Source Introduction 22

Open Source Introduction 23

Open Source Introduction 24

Threadless Please watch the following video and think about: 1) What are Threadless’ resources and capabilities? 2) Should Threadless open a new store front, expand to established stores, or neither? Update: did both! • First, opened up retail locations in Chicago (~2010) • Then, partnered with Gap and other retailers (~2012) • Changed payment of artists to include percentage of sales January, 2014: closed retail location, laid off staff • Focusing on retail partners and other products 25

Class Objectives/Plan 1. Review of Last Class 2. Open Source Innovation 3. Vertical Integration 4. IKEA Case

Threats to Sustaining Competitive Advantage Imitation of Resources External Substitution of Resources Threats to Long Term Competitive Advantage Hold Up Internal to the firm or v its supply chain Slack

Corporate Strategy

Vertical Integration: History Trend towards Integration: - Management techniques - Technology Trend towards outsourcing: - Turbulence - Digital Markets

Why choose make or buy? § Coase: compare relative costs! Buy: Transaction Costs - Search costs Negotiation and contract costs Monitoring Costs Enforcement costs in case of dispute Make: Administrative Costs

Sources of Transaction Costs 1. Uncertainty 2. Bounded rationality 3. Opportunism 4. Small number of buyers and sellers 5. Frequent transactions (leads to reliance) 6. High asset specificity, durability, and intensity

Types of asset specificity § What is asset specificity? ØThe extent to which assets in that exchange have a higher value in that particular relationship than next best option § Types of asset specificity: 1. Site specificity – buyers and sellers locate fixed assets in close proximity 2. Technical specificity – one or both parties invest in equipment for that relationship 3. Human capital specificity – employees develop specific skills to that relationship

Classic example of buy make The “holdup problem” § Originally, General Motors relied on Fisher Body to deliver essential components for GM cars. – – GM depended on Fisher Body entirely. Fisher Body, aware of that dependence, raised prices. GM paid the higher price. Eventually, though, Fisher Body raised prices too much and GM bought the company. § If the supplier has a valuable input, they have bargaining power. § If the firm asks the supplier to build a specialized machine that only can be used to make their product, the firm has bargaining power.

Benefits of Vertical Integration § Avoid these transaction costs

Benefits of Vertical Integration § Avoid these transaction costs § Technical economies from integration

Benefits of Vertical Integration § Avoid these transaction costs § Technical economies from integration § Coordination

Drawbacks of vertical integration • Differences in optimal scale

Drawbacks of vertical integration • Differences in optimal scale • Prevents developing distinctive capabilities

Drawbacks of vertical integration • Differences in optimal scale • Prevents developing distinctive capabilities • Difficult administratively if strategically different

Drawbacks of vertical integration • Differences in optimal scale • Prevents developing distinctive capabilities • Difficult administratively if strategically different • Lacks high-powered incentives

Drawbacks of vertical integration • Differences in optimal scale • Prevents developing distinctive capabilities • Difficult administratively if strategically different • Lacks high-powered incentives • Compounding of risk

Drawbacks of vertical integration • Differences in optimal scale • Prevents developing distinctive capabilities • Difficult administratively if strategically different • Lacks high-powered incentives • Compounding of risk • Limits flexibility in response to demand or technology

Drawbacks of vertical integration • Differences in optimal scale • Prevents developing distinctive capabilities • Difficult administratively if strategically different • Lacks high-powered incentives • Compounding of risk • Limits flexibility in response to demand or technology • Difficult to reverse

More than just make and buy Arms-length transactions Long term relationships Contracts Alliances Joint venture Buy

How to choose? § Key issues in designing vertical relationships: – No generic solution: depends upon the resources, capabilities, and strategy of the individual firm – How is risk to be allocated between the parties? – Are the incentives appropriate?

Class Objectives/Plan 1. Review of Last Class 2. Open Source Innovation 3. Vertical Integration 4. IKEA Case

IKEA § What are IKEA’s resources/capabilities? § How does IKEA manage its vertical relationships? § What’s happening with IKEA’s Indian carpet suppliers? § Would you pull out of India, join Rugmark, or have IKEA deal with its own relationships?

IKEA: Update § IKEA Foundation § So what did IKEA decide to do? § Why?

End of Lecture: § Tuesday: Incentives – Grant Chapter 6, “Organizational Structure and Management Systems: The Fundamentals of Strategy Implementation” – Kerr (1975), “On the Folly of Rewarding A, While Hoping for B”* – *Posted on Piazza § Assignments: – Problem Set 1 Due Tuesday