Morgan State University Chapter 10 Creating and Capturing Value in the Value Chain Essay

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Business Finance

Morgan State University


Please read chapter10 and 11 then answer the questions: 

Chapter 10. Creating and Capturing Value in the Value Chain

Cooperation between firms

Explain how cooperation between firms can help in creating value. Give examples and comment on examples given by your class members.


Chapter 11. Strategic Management in a Changing Environment

Competence traps

Explain why success at exploitation often causes companies to become inwardly focused and rigid and to fall into “competence traps.”  Give examples and comment on examples given by your class members.  If you give a little thought you might find that almost every business falls into this trap by thinking, “if it is not broken, don’t fix it.”

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Chapter 10: Creating and Capturing Value in the Value Chain Chapter 10 Creating and Capturing Value in the Value Chain 10.1 Introduction The focus has been on how competition among incumbent firms and the advantages they might have over potential entrants have an impact on profitability of incumbent firms. This chapter extends the analysis to the value chain in which the industry is embedded. 10.2 Value Creation, Value Capture, and Buyer or Supply Power In keeping with the framework for industry analysis, we are interested in how the characteristics of segments in the value chain and the links among them affect the division of value (PIE). We want to identify what determines the value that the manufacturing segment, the retailing segment, and the final consumers in this chain each capture. The value extraction problem faced by the incumbents is to maximize the share they are able to capture by reducing the share captured by other segments in the chain. Broadening our perspective to include other segments of the chain also enables us to think about value creation. By including the entire chain, we can think about the factors that affect how much value is created. In particular, we will consider how relationships between firms in different segments of a chain can create value. Although it is convenient to think about value capture and value creation separately, they are related activities. For example, if a firm has market power in its segment, the value its chain creates and the share it captures are typically higher when all other industries in the chain are fragmented. Often, however, pursuing capture has an adverse effect on value creation. Because firms pursue both value capture and value creation, companies within a chain can both compete and cooperate with each other. Value capture tends to be adversarial; holding total value constant, we see that one segment’s gain is another segment’s loss. Value creation, however, is often cooperative. 10.3 Capturing Value Traditionally, a value chain is said to have suppliers “upstream” and buyers “downstream.” This perspective is particularly appropriate for considering pricing because the party charging a price is logically upstream to the one paying it. However, some industries participants have a more complicated relationship. Fortunately, even when one might argue about which segment is the supplier and which is the buyer, the way these are assigned doesn’t affect how much value is generated or how it is distributed among the segments. Furthermore, we usually don’t need to think about the issues in relationships among buyers and suppliers separately because they are opposite sides of the same coin. In any given relationship, what matters for value capture, for example, is the relative ability of the firms to affect the transaction price. “Value” means the value of the product to its final consumers minus the opportunity cost of the resources required to produce it. This restates the definition of Potential Industry 1 Strategic Management Earnings (PIE), and the terms “PIE” and “value created” are used interchangeably. In particular, although every segment in the chain typically adds something to PIE, a segment that adds more value does not always capture more value. “Supplier power” is the ability to capture PIE by demanding a payment in excess of opportunity cost. “Buyer power” is the ability to capture value by demanding to pay less than the price one is willing to pay. The key characteristic of buyer or supplier power is the ability to affect the terms at which the parties exchange goods. Firms producing a commodity product take the market price and other transaction terms as given. If there is some cost asymmetry among these firms, however, the lower cost firms will be more profitable. Competition implies that the market price will be equal to the marginal cost of production. When there are cost differences among firms, the higher marginal cost will determine price. To focus on buyer and supplier power, cost differences are set aside by assuming that all firms in a segment have the same costs. 10.4 Creating Value Competition limits buyer or supplier power. “Supplier power” is another term for “market power in output markets.” “Buyer power” is another term for “market power in input markets.” Because the competition within each segment of the chain affects buyer and supplier power, the nature of competition in all segments of the value chain affects value capture. When there are multiple supplying industries, the analysis must be performed for each of them. There may be spillovers from one buying industry to another. Unless the supplying firm can prevent resale, selling to one industry in which the purchasing firms have buying power can depress the price the firm can charge to all industries. To simplify the analysis, assume that each layer of the value chain contains only one industry. Value Capture without Buyer or Supplier Power Suppose each stage (except the final consumers) in some value chain is a competitive industry. Since a perfectly competitive firm cannot capture the value it creates, in this case, the final consumers capture it all, even though consumers have no market power and therefore no buyer power. Value Capture by a Single Powerful Supplier (or Buyer) Suppose a firm in one stage in the chain has buyer or supplier power. Because it has significant market power, this firm can set its output price. If firms in the other stages are competitive, competition among them drives their price to marginal cost, and the powerful buyer can do no additional damage. Consumers, however, are worse off because both their share of the value created and the total value created have declined. Consumers can still capture some value even without the benefits of a competitive supply chain. This happens because the powerful supplier is assumed to charge a single price for its output. If, however, the company can price discriminate in some way among 2 Chapter 10: Creating and Capturing Value in the Value Chain consumers who place different value on the product, it will increase the share of total value it captures. Strategic management scholars frequently claim a large supplier is powerful. But the power relationship comes from a difference in market power, not a difference in size. A firm may buy only a small share of some supplier’s output, but the supplying firm might have no power because the industry is competitive. “Large” can mean that the supplying firm provides an input that represents a large share of the purchasing firm’s cost. Although a supplier with supplier power will charge a higher price for the same input than a supplier who does not have supplier power (and therefore will have a larger share of cost), cost share is irrelevant to market power. Even though an input represents a significant share of the cost of a product, if the industry is competitive, firms have no supplier power. Value Capture When Buyers and Suppliers Are Powerful More commonly, firms in several stages in a value chain have at least some buyer or supplier power. As a result, more than one stage of firms shares the value captured. When, more than one stage of the chain has firms with some power, two kinds of effects come into play: double marginalization and bargaining over transaction price. Double Marginalization Suppose stage 1 is competitive and stage 2 is a monopoly, but stage 3 is a niche market. Firms in stage 3 have some supplier power but no buyer power. Each niche firm has some supplier power because it has some customers for whom purchasing from another distributor is not a good substitute. Because the first stage remains competitive, the monopolist’s buyer power is still unimportant, and (stage 3) its supplier power still enables it to capture some value. Its buyers also have some supplier power, which affects the share the monopolist can extract. However, each firm in stage 3 will add a greater markup; its supplier power will allow it to add a positive price-cost margin on top of the margin our monopolist creates. These two margins are the source of the name “double marginalization.” In this case, two industries are now capturing some of the value. As a result, the share the monopolist captures has declined. The decline in share also implies that imperfect competition in another stage will adversely affect the absolute amount of value the monopolist captures. Firms prefer to have market power in their own industries to mitigate the effects of competition on value capture. Firms also prefer their buyers to have no supplier power. Bargaining between Powerful Buyers and Suppliers When a powerful supplier faces a powerful buyer. Both the supplier and the buyer can influence the terms at which they transact. Whether a firm can capture a larger share depends on its bargaining position. A firm’s bargaining position arises from the details of the bargaining situation. The firms will bargain over the transaction price, and each 3 Strategic Management will probably capture some of the value. There are three common characteristics of bargaining between two firms. • First, both parties want the transaction to go forward. More generally, there are gains from trade when some buyer values the product more than the seller does. • Second, the final price cannot be one that makes either firm worse off than it would be if the transaction did not go through. This is why the firm’s alternatives set the price range: The buyer will pay no more than the increase in value that owning the product will allow it to realize, and the supplier will not accept less than its incremental cost of supply. • Finally, the negotiated price reflects the relative bargaining power of the two firms. Outside option value as a primary determinant of bargaining power, but other factors can also come into play. Negotiating skill can also affect bargaining power. Whatever the precise outcome, a supplying firm with supplier power would prefer that its buyers have no power. As with double marginalization, power elsewhere in the chain reduces the value that the powerful incumbent firms can capture. Reducing Power in Other Stages Because competition among buyers or suppliers is the most important weapon against supplier or buyer power, any strategy that encourages increased competition in other stages can be profit enhancing. Vertical integration could mitigate the power of other stages. In principle, the credible threat of vertical integration should suffice. To make the threat of competition credible, a company can pursue a strategy of “tapered” integration; it builds some capacity in another stage but not enough to serve its entire demand for inputs or to handle its entire output. If, however, bringing the activity in-house involves important scale or learning economies, the firm may find the in-house operation much less efficient than the outside alternative. Because in-house production is often at a competitive disadvantage to supply by another stage, encouraging independent competitors is usually a better alternative. Qualifying multiple suppliers, or ensuring that potential suppliers could easily be qualified, reduces supplier power. Even if a firm has a favorite supplier, maintaining a second source of supply lessens that supplier’s ability to threaten the firm and enables it to capture more PIE. In some settings, holding an auction for inputs not only invites firms to prove that they are qualified, but it may also induce competition more effectively than negotiating with the suppliers separately. The firm also might benefit by maintaining flexibility about the inputs it uses in its production process if the supplier of one of those inputs has significant market power. Creating Value Firms can create tremendous value by working closely with their buyers and suppliers. However, a cooperative working relationship to maximize value creation is not always easy. Managers responsible for crafting and maintaining relationships with other firms have to design a relationship that coordinates resource acquisition and deployment across 4 Chapter 10: Creating and Capturing Value in the Value Chain firm boundaries. Since both firms want to capture value, their managers have divergent interests. The organizational design problem is to construct a relationship that best addresses the coordination and incentive problems to maximize the value created and captured through the relationship. Interfirm relationships can take many forms – vertical integration is at one extreme and market transactions are at the other. Between these two extremes, are various “relational contracts.” Relational contracts differ in duration scope, and complexity. Joint ventures usually involve formation of a third entity and are complex contracts with substantial scope and relatively long duration. A supply contract may be much simpler, more limited in scope, and of various durations. A manager thinking of setting up a relational contract needs to understand specifically how the relationship will create value. Why will transacting within a relational contract make the firm better off than it would be with a simple market transaction? The costs of the relationships are often under-estimated. When a unit is on its own in the market, its profitability and revenues become signals of its performance and quality. When a unit is embedded in a complex relational contract, getting clear indicators of performance and quality are much harder. Many managers have a bias toward exerting control and thus, often think vertical integration is the best solution. Vertical integration – or any relational contract between firms in the value chain – does not solve all the existing problems and usually creates new ones. Opportunities for Creating Value: The Coordination Problem Generally, vertical relationships can add value by reducing transaction costs. Most transactions are repeated so relationships can create value by encouraging companies to make investments that are valuable only if the relationship continues. Investments of this type are called relationship-specific investments because they are assets that are more valuable within an ongoing relationship than they are outside it. Relationship-specific investments have two general characteristics: • They create value so both parties in the relationship want to make the investment. • The value they create is specific to the relationship (i.e., they are less valuable outside the relationship). The combined effect of these two characteristics is that such investments create the potential for “hold-up” (i.e., ex ante expropriation of the value created) by either party. This implies that firms will not make the investment – and not create the value – without contractual protection. Contracting to Create Value: The Incentive Problem The hold-up problem exists because the incentives of the two firms are not aligned. Both want the investment made because it creates value, but once one firm makes the investment, the other has an incentive to capture as much of the value as possible. As with other incentive problems, the appropriate contract can solve the hold-up problem. 5 Strategic Management However, a contract that protects both firms must anticipate all contingencies and would be difficult, if not impossible, to write. Thus, except in the simple cases, formal contracts that govern a relationship are incomplete. Unanticipated event often occur, especially as the duration, scope, or complexity of the relationship increases. One way to avoid the hold-up problem is to focus on the long-term gain from the relationship. Firms in a relationship will make relationship-specific investments as long as the gain from continuing the relationship is greater than the gain from exploiting the opportunity for hold-up. Another way to avoid the hold-up problem is implicit contracts (i.e., accepted ways of dealing with issues) based on trust. Trustworthy behavior can reduce transaction costs by reducing risk. Agreements sustained by an atmosphere of trust encourage firms to refrain from constantly assessing the tangible perceived benefits and costs. A firm with a reputation for trustworthy behavior can contract with others more easily. It is one thing to say that “an atmosphere of trust” can be beneficial; it is another to create and maintain that atmosphere. What supports this kind of relationship between firms? A societal context where legitimacy rests on goodwill and reciprocity and commitment to resolve problem are valued would promote an atmosphere of trust. Some have argued that the Japanese culture fits this description, but that the individualistic values of Western culture do not. However, adoption of these kinds of relationships in the U.S. and Europe challenge these assertions. Implicit contracts can develop between firms, but are difficult to develop and maintain. Trust is central to these relationships, and trust takes time to develop. Implicit contracts go through three phases: • In Phase I, the pre-conditions for initiating the relationship are established (e.g., reputation of managers and firms for trustworthiness). • In Phase II, the parties to the relationship enter a trail period during which rules and procedures are established, clear expectations are formed, and some initial level of trust and feeling of reciprocity is built. • In Phase III, there is a key transition of level of operational integration (i.e., the relationship becomes an integral part of each firm’s operations) and strategic integration (i.e., the relationship is a central asset in their strategic objectives). Implicit contracts do not negate the need for explicit contracts. Explicit contracts are necessarily incomplete and imperfect, but they ensure both parties agree to certain terms and provide essential protection at the beginning of a relationship. Explicit contracts are important also because the firms’ interests may change over time effecting the balance between benefits and costs of taking temporary advantage of their partner. Both explicit and implicit contracts are useful ways to alter and to end the relationship. Appendix: Price Discrimination 6 Chapter 10: Creating and Capturing Value in the Value Chain Offering every buyer the same price limits a powerful supplier’s ability to capture value. The seller could extract more value if it could charge a higher price the price inelastic buyer and a lower price to the price elastic buyer. To do this, the seller needs: • To distinguish between those willing to pay a higher price and a lower price. • To be able to charge different prices. • To prevent resale of its product. Focus in the appendix is on the case where a powerful supplier faces buyers who have no power. A total absence of buyer power is not necessary for price discrimination, but allows the bargaining problem to be set aside. Ideally, a firm would like to perfectly price discriminate, that is, be able to charge each buyer a price exactly equal to her willingness to pay for the product. But the information requirements are so high that perfect price discrimination is rare. Firms have many ways to adjust its product and price offerings to achieve some price discrimination, including: • Finding an observable characteristic (e.g., quality consciousness) that is a rough proxy for buyers’ valuations and offer different prices or products based on that characteristic. • Constructing purchasing requirements (e.g., discount coupons) that get consumers to self-sort according to their willingness to pay. • Tying a primary durable good priced at or near cost with complementary consumable goods priced to extract value based on usage (e.g., deskjet printers and ink cartridges) • Bundling two or more goods tha...
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Chapter 10: Creating and Capturing Value in Value Chain
Cooperation between firms happens majorly because of various reasons. First, to gain access to other
firms’ resources or knowledge because exchange of skills and knowledge is freely done since one firm
possesses expertise and capability to keep updated with advancements in technology. Secondly, to gain
entry into foreign markets or develop new products. In this case, a pa...

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