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Summary Theories of Strategy - Sum Questions & Answers

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Theories Of Strategy

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Universiteit Van Amsterdam (UvA)

This document contains 4 extensive sum questions, extensive answers, concluding general sum rules (last page), ready for the exam.

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Theories of Strategy

University of Amsterdam

Exam Document

Contains:

4 extensive sum questions

Extensive answers

Concluding general sum rules (last page)

Ready for the exam.

, Question 1

Consider the following situation (from Rumelt, 2003):

Firms F1 and F2 operate in different industries. F1 has 1 unit of production capacity and F2 has 3 units
of production capacity. Their net profits per unit capacity are 90 and 100 respectively. A new market
opportunity appears in which F1 and F2 are the only possible suppliers of a new product. There are
three buyers (B1, B2, B3) in the new market, each having a willingness-to-pay of 120, and each wanting
to buy only one unit of the new product. Each unit of production capacity is separately and freely
movable between uses.

Answer the following questions with the help of the framework presented in Brandenburger & Stuart
(1996):
a) What is the ‘value created’ in the new market?
b) What is the ‘added value’ of the 5 different players?
c) What do you expect will be the price in the new product market? (Explain your answer!)
d) Does firm A or B have the competitive advantage in the new market? (Explain your answer!)
e) What is the nature of this competitive advantage? (I.e. which type of rent does it represent?)

A.
The ‘value created’ in the game is (by definition) the maximum value that can be created. This is when
three products are sold, one of which is from S1.

Value created = willingness to pay – opportunity costs =
(120-90) + (120-100) + (120-100) = 70

[Note that F2 could supply all three buyers by itself. In that case, the value created would be 20+20+20=
60. However, by assumption we will always get the coalition that creates the most value, which in this
case will always include F1. Another way to think about this is that because F1 has the lower opportunity
costs it can always undercut the price of F2, so it will always be able to sell its 1 unit. Therefore, when
three products are sold, one of them will be from F1 and the other two from F2.]

B.
The added value of the different players is calculated by taking the player out of the game and calculating
the drop in the total value created:

B1 = B2 = B3 = 20
F2 = 40
F1 = 10

-If any of the buyers is taken out of the game, only 2 products will be sold: one from F1 (who has the
lower opp. costs – see the reasoning above) and one from F2. So the value created in the game after
taking out one of the buyers drops to 50. Therefore the added value of any of the buyers is 70-50=20.
-If F2 is taken out of the game, only 1 product will be sold (by F1), so the value created will be (120-
90)=30, and the drop in value created is 70-30=40.
-If F1 is taken out of the game, F2 can still supply all three buyers. In that case, the value created is
3x(120-100)=60, so the drop in value created is 70-60=10

C.

, The simplest way of answering this question is by assuming that F1 and F2 enter the market with all their
capacity (scenario 1 – see the table below for a summary):

Scenario 1
If both F1 and F2 enter the market with all their capacity, demand would be 3 and supply 4. In this
scenario, buyers would be able to play the sellers off against each other and bid the price down: the price
would be 100, equal to the opportunity cost of the marginal (least ‘efficient’) seller, which is F2.

In this scenario, the total value created is 70 and the price is 100. Buyers’ shares are 3*20, F2’s share is 0,
and F1’s share is 10.

[Note that you can also think of the price of 100 as the equilibrium price that will result from unrestricted
bargaining. To see this, think of the interactions between the players as an auction and just start with a
price anywhere between 90 and 120 (inclusive), and then ask yourself how the players would react (i.e.
how they would bid the price up or down, if at all). For instance, start with a price of 120. There is
demand of 3 and supply of 4, so the firms will start bidding against each other. F2 will offer to sell for
119, which would allow it to sell all three products, leaving F1 with no products sold. But then F1 would
react by offering to sell for 118 to sell its one product. F2 will then offer 117, etc. – until the price has
gone down to 100. At this point, F2 makes zero economic profit, so if the price would go even lower, F2
would drop out of the bargaining and use its capacity in its outside option. So we could think of F1
offering to sell at, say, 99, but then only one product would be sold, because F2 would leave the bidding.
So now the bargaining shifts the other way, and the three buyers will start competing with each other for
the one product of F1. B1 will offer to buy for, say, 99,01. Then B2 will offer to buy for 99.02, B3 for
99.03, etc. This will bring the price back to the equilibrium price of 100. In other words: all prices above
100 will be brought down to 100 by the firms competing against each other for scarce customers. And all
prices below 100 will be brought up to 100 by the buyers competing against each other for the scarce
supply (because F2 will not sell for less than 100, there is effectively only a supply of one as long as the
price is below 100).]

[Note: the text above summarized what you should, at a minimum, be able to do on the exam. If you
get this right, you will already have a passing grade on the question. But there may a twist in a sum
that requires you to think beyond the very basics. This is what you would need to do to get the full
points for the question. In this particular example, there are in fact two twists, which makes the
problem relatively complicated. The text below discusses the complications that arise when you become
aware of these two twists.]

There are two interesting complications in this question, which revolve around:

(1) the fact that capacity is ‘separately and freely movable between uses’
(2) that there may be collusion (this is not explicitly ruled out in the question).

Because of this there are other possible scenarios that are discussed below. The outcomes of these
scenarios in terms of the shares of the different players are summarized in the table at the end.

(Without collusion)
If we assume that players have full information, are fully rational, and that everything happens at once
(there is only one game, and only one price emerging from that game), F2 will never enter with all its
capacity. This is the case because it can increase its share of the value created (how much of the total
value created it appropriates) by entering with less than 3 units of supply. So, on the assumption of full
information and rationality, scenario 1 above is not what will actually happen. Instead, we get other
scenarios.

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