COMP6044   Just another ECS Blogs weblog

This week I start by looking at business strategy from the perspective of economics. There are basic economic principles underpinning the determination, choice and evaluation of business strategy.

As mentioned in my post on management studies from a few weeks’ back, right strategies (the ways in which organizations address their fundamental challenges over the medium to long-term) are crucial for businesses to survive and beat the competition. Strategic-minded thinking includes comprehensive consideration and reflection upon a business’ mission statement and its vision. For both economists and management theorists, therefore, the aims of a business determines its strategy. Equally relevant, however, for both disciplines are internal capabilities and industry structure/conditions.

Like management theory, economists adopt Porter’s five forces model of competition (Michael Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors, 1980) which set out to identify those factors which are likely to affect an organization’s competitiveness. These five forces are:

• The bargaining power of suppliers
• The bargaining power of buyers
• The threat of potential new entrants
• The threat of substitutes
• The extent of competitive rivalry

I will be returning to these five forces next week in the context of considering, specifically, how they apply to the effects of the Web. In the meantime, it is worth pointing out that the five forces model does have limitations. For example, it is a largely static model whereas conditions change over time requiring strategy to evolve over time. Notably, also, Porter’s model suggests that success is dependent on competition rather than the potential for collaboration and cooperation (such as with those downstream vertically from a supplier).

Value chain analysis is also closely linked to the five forces model (according to the definition of Sloman, Hinde and Garratt, value chain “shows how value is added to a product as it moves through each stage of production from the raw material stage to its purchase by the final consumer”). Analysis of the value chain involves evaluating how each of the various operations within and around an organization contributes to the competitive position of the business). Ultimately it is these value-creating activities, which can be primary or support activities, that shape a firm’s strategic capabilities.

Turning to growth strategy, it is worth making a nod here to vertical integration (this will become more relevant when considering the effects of the Web in facilitating disintermediation of value chains over the next two weeks). There are a variety of reasons why forward or backward vertical integration might lead to cost savings (such as through economies of scope and scale), including: production economies; coordination economies; managerial economies; and financial economies. The major problem with vertical integration as a form of expansion is that the security it gives the business may reduce its ability to respond to changing market demands.

Other points of comparison and dissimilarity between management and economics can start to be drawn. For example, a point of difference is economics’ focus on theories related to short-term/long-term profit maximization. There is much debate among economists about whether profit-maximizing theories of the firm are unrealistic (largely due to a lack of information or lack of motivation). This focus is where costs concepts and graphs (demand curves in particular) come in.

A more practical illustration given by Sloman, Hinde and Garratt in respect of the search for profits is the video games war where there are high costs, but also high rewards, from a long-term perspective. In considering the secret of success in the market, online gaming capability and global connectivity are significant factors. Moreover, connection to the internet has facilitated a move towards the use of consoles as ‘digital entertainment centres’, in which users can download content. These developments are likely to continue as long as broadband internet connectivity improves and remains fairly cheap to use.

Finally, in economics, there are various theories of strategic choice (such as cost leadership, differentiation and focus strategy). These strategies can be combined. For example, Amazon had a clear niche market focus strategy – to sell books at knockdown prices to online customers – and this has become a mass market with the spread of the Web and due to lower costs.

Next week, I want to move the focus firmly onto the impact of the Web on business competition as I move on from broad principles of management/economics to specifics. I will kick off with a consideration of Google’s business model.

In my last post I talked about how economics is necessary because of the scarcity of goods. What is interesting in looking at the economics of intellectual property is that intellectual goods aren’t scarce in the way that other goods are. So does that mean we don’t actually need economics when it comes to intellectual goods?

In short, the answer is no. Even though intellectual goods aren’t scarce like land or labour, they are made artificially scarce through government policy. This creates a market for them.

To see why intellectual goods aren’t scarce, consider this quote from Benjamin Franklin (17??)

“If nature has made any one thing less susceptible than all others of exclusive property, it is the action of the thinking power called an idea, which an individual may exclusively possess as long as he keeps it to himself; but the moment it is divulged, it forces itself into the possession of everyone, and the receiver cannot dispossess himself of it.

Its peculiar character, too, is that no one possesses the less, because every other possesses the whole of it. He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me.

That ideas should freely spread from one to another over the globe, for the moral and mutual instruction of man, and improvement of his condition, seems to have been peculiarly and benevolently designed by nature, when she made them, like fire, expansible over all space, without lessening their density in any point, and like the air in which we breathe, move, and have our physical being, incapable of confinement or exclusive appropriation. Inventions then cannot, in nature, be a subject of property.”

Thomas Jefferson, letter to Isaac McPherson, 13 August 1813
http://press-pubs.uchicago.edu/founders/documents/a1_8_8s12.html

An important difference between intellectual property and non-intellectual property (such as money, houses or land) is that the former tend to be what economists call non-rival while the latter tend to be rival. A rival good cannot be used by one without diminishing the ability of another to use it. My consumption of a pizza prevents you from consuming the same pizza. My use of an idea, a design or technique, on the other hand, does not diminish your ability to use that same idea (so long as in implementing the idea I do not use up the only resources available to implement that idea). We can both use the idea of a pizza to make our own individual pizzas without interfering with each other. Such intellectual goods are non-rival – they can be enjoyed by more than one person at the same time without losing value.

This difference is not absolute, however. Some non-intellectual goods are non-rival. Traditional public goods, such as clean air, are non-rival, but they are certainly not intellectual goods. However, most goods that are traditionally the objects of property rights, (money, houses, land) are rival. Similar qualifications apply to intellectual goods, which can sometimes be rival in certain ways. We might call them non-rival in consumption; your ability to consume an intellectual good is not affected by my consuming the same intellectual good. However, your ability to use the good in other ways may be affected by my use of it. My ability to profit from stockmarket tips (which I would classify as intellectual goods) depends on how many other people are using the same tips. My ability to profit from selling you a book depends on whether or not you have already read it.  More generally, the ability to profit from an intellectual good is compromised if others are able to consume it for free. However, with these qualifications in mind, two generalisations can be made. Intellectual goods tend to be non-rival, at least in consumption. In contrast, the kind of non-intellectual goods that are typically the objects of property rights – houses, land, vegetables – are rival.

A popular defence of intellectual property takes the maximisation of innovation as the relevant end. This version is assumed in the economic literature and reflected in the wording of United States law on intellectual property:

“to Promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries.”

Another kind of defence takes the protection of individual creator’s rights as the most important thing an intellectual property regime exists to do. According to this view, people have the right to control the things they create with their mind. This includes preventing others from using their ideas.

I’ve been reading Samuelson’s Economics, a classic introductory textbook. So far I’ve got a better understanding of what economics is about. The essential definition according to Samuelson is that it is ‘the study of how societies use scarce resources to produce valuable commodities and distribute them among different people’. This includes, but is not limited to, the following questions:

• How the prices of labour, capital and land are set, and how they are used to allocate resources
• How the financial markets behave and how they allocate capital to the rest of the economy
• Distribution of income and how the poor might be helped without reducing growth
• Impact of government activities on growth
• Studying swings in production and unemployment and how policies can encourage growth
• International trade
• Growth in developing countries and how to encourage efficient use of resources

Returning to the above definition, we can see that without scarcity – i.e. if there were always enough goods to satisfy every person’s every desire – there would be no need for economics, because everybody could just take what they want and need without depriving anyone else. The desire for efficiency is also essential to economics; if we didn’t care about satisfying as many needs and desires as possible, then we wouldn’t need economics to tell us how to most efficiently distribute scarce resources. The economy is producing efficiently ‘when it cannot increase the economic welfare of one person without making someone else worse off’.

A QUESTION/ DIGRESSION

As an aside, I disagree with / don’t understand this definition. Imagine an economy where most of the resources are in the hands of one person (call him Bill). Imagine, reasonably, that in such an economy no-one’s economic welfare could be increased without making Bill worse off. According to Samuelson’s definition, then, this society is efficient. But surely, you want a notion of efficiency which allows decreases in welfare of one person so long as they result in proportionally greater increases in the welfare of others. If Bill’s income tax for the year is £1 million, and that revenue allows government spending, which stimulates GDP, perhaps it could make 10,000 people £20 richer – a net gain for society. Wouldn’t this be a more efficient use of resources?

From a Google search, I think the notion of ‘pareto-optimal’ captures my pre-theoretical intuition about efficiency – where a pareto-optimal situation is one in which no individual’s welfare can be improved without making another individual’s welfare proportionally even worse off. Imagine that taxing Bill £1 million makes 9,999 other people £10 richer. But this would not count as pareto-optimal, because Bill would have lost more than the combined gains of others (£1 million vs £99,990). That’s what I had imagined an economist’s notion of efficiency referred to, before reading Samuelson. But perhaps I’m jumping the gun here!

…back on topic:

Microeconomics is the study of individual entities such as markets, firms and households. It considers how individual prices are set, the determination of prices of land, labour and capital, and market efficiency.

Macroeconomics came around in the 1930’s when John Maynard Keynes decided to look at the overall performance of the economy. He analysed what causes unemployment and downturns, investment and consumption, the management of money and interest rates by central banks, and why some economies thrive and others fail. These days the distinction between the two is less important, with microeconomics being applied to studying unemployment and inflation.

Economists observe current economic phenomena as well as historic data and make theoretical predictions and broad generalisations on that basis. They also use econometrics, which is the application of statistical analysis to economic data, allowing them to identify the relationships between different factors.

The kind of economy one has depends on three things:
• What goods should be produced
• How should they be produced
• For whom will they be produced

Factors of production are things that are used to create goods and services, and come in three categories:
• Land (and other natural resources)
• Labour – human time
• Capital – goods which can be used to create new goods