STRATEGIC MANAGEMENT AND ECONOMICS

There has been a minor revolution in strategic management research and writing. This
thanks to more tools and theories that can attack problems of strategic management.
Economic thinking is reshaping strategic management, and there is others who think
economics is the solution of strategy problem. The objective of this text is to examine the
connection between strategic management and economics in two ways:

1- Compilation of many papers that present an intersection between the two fields.
2- Own interpretations of the papers selected.

It starts with the evolution of the connection between economics and strategic management,
then continues with the important forces that induced this connection, after that, the future of
strategic management and economics and finally a guide to the papers.

A BRIEF HISTORY OF ECONOMICS WITHIN STRATEGIC MANAGEMENT

Strategic management (called ‘policy’ or ‘strategy’) is about direction of organizations

and business firms, and their reasons of success of failure. Firms are constantly in competition
for customers and revenues that makes them survive. They have to make choices to survive
like:

- Selection of Goals
- Choice of products and services to offer
- Design and configuration of policies to position itself in product markets and more…

These choices have critical influence on success and failure, so they must be integrated, and
that is the strategy. The strategic direction of business organizations is at the heart of wealth
creation, and is concerned with deliverin them through the study of their creation, success and
survival, as well as with understanding their failure, costs and lessons.

Then and integration appeared in the strategic management (into business policy) between
specialized knowledge and broader perspectives. Such perspectives as the firm as a whole and
the role of general manager.

The strategy appeared (60s), and was seen as more than just coordination or integration of
functions: added selectoin of the product market arenas in which and how the firm would
compete. Strategy was a collection of decisions and actions, and the method of expansion too.

The 70s were marked by the rapid expansión of consulting firms specializing in strategy,
profesional societies and journals publishin material on strategy. Three forces helped strategy
flourish:

1. Hostility and Instability of environment led to a disenchantment with planning, so

methods of adapting to and taking advantage to unexpected: building specialized
strenghts and expressing those in new products.
2. Continued expansion and further development of strategy consulting practices based
on analytical tools and concepts (experience curve).
3. Maturation and predominance of the diversified firm. Corporations seen as portfolios
of business units, forcing business managers to define their plans and goals in
competitive terms.
Lately “brewing” studies, which explored links between strategy and firm performance. Thanks
to this, heterogeneity within industries were demonstrated. Data collection and computers
were the reason of statistical methods test hypotheses

In the 80s economic thinking moved closed to center stage in strategic management as
disciplines were examinated for theoretical motivation for the empirical work. Porter’s
Competitive Strategy were a big influence, as this became accepted and used in teaching,
consultation and research projects.

Porter’s approach to strategy joined the fact that differences in performance tend to signal
differences in resource endowments, increasing importance of unique, difficult-to-imitate
resources in sustaining performance: resource-based view of the firm. In this decade, strategy
scholars increased their use of economic theory. The methods were used to investigate
strategic and organizational change.

Looking backward over these three decades (60,70 and 80s) the focus is theoretical
explanations of very complex phenomena. A link between basic disciplines (economics) and
practical issues involved in managing the firm.

WHY ECONOMICS IN STRATEGIC MANAGEMENT?

Most strategic management courses continue to rely on cases that are more
integrative than analytic. Five forces have driven the infusion of economic thinking:

1. The need to interpret performance data

In early 70s, researchers focused corporate performance on data, particularly

return on investment, for managerial actions. The problem is to interpret the
observer performance differentials, to know the meaning. The need to find an
adequate answer to these questions was one of the forces engendering
economic thinking among strategy researchers.

The story of market-share effect can be a good example. The relation between
it and profitability was interpreted as “market power” being market share the
‘structure’ and supernormal returns as poor social performance. The strategic
management community (BCG and PIMS) used market-share issue to carry out
the first business-level data base available for economic research.

The viewpoint was to see market-share as an asset that could be ‘bought’ and
‘sold’ for strategic purposes. BCG advised to invest in share in growing
industries and harvest in declining ones, while PIMS researchers and
consultants told managers they could increase share (and profit) by redefining
their markets so as competitors and their share position.

In late 70’s, Rumelt and Wensley began an empirical study using PIMS to
estimate the cost of gaining market share. Expecting to find the cost of share
gains, they were surprised to find no cost: it was no tpossible to interpret this
result without extensive forays into economic theory, like a ‘random process’.

This story exemplifies an argument over data analysis and equilibrium.

Equilibrium means that all actors have exploited the opportunities they face.
 Competitive equilibrium attributes the differences in wealth as uncontrollable
things.

Equilibrium assumptions are the cornerstone of most economic thinking and

way of modeling competition. If someone avoids it, the interpretation of data
might be wrong, but adopting it can be unwarranted, so the type of data plays
a role here.

Nash equilibrium, where each actor does the best he can with what they know
and control, permits a broad range of intriguing outcomes. For example one
could model the gradual imitation of an innovation as a process and learn what
the leader already knows: large profits would be earned. Firms might enter and
then exit, and competition would gradually increae.

2. The experience curve

BCG developed the experience curve doctrine, and was a powerful force within
strategic management. The idea of some costs followed a learning-by-doing
pattern were ignored by economists because it contradicted the standard
economic models of equilibrium. BCG added four critical ingredients:

a) The pattern is not only applied on direct labor, but to all deflated cost
elements of value added, and this expanded version is called experience
curve.
b) Provided convincing data showing experience effects in a broad variety of
industries.
c) They argued that experience-based cost reduction was not restricted to
the early stages: it was indefinitely.
d) They explored the competitive implications of the experience effect. BCG
said that there is no naturally stable relationship with competitors until
one of them have a considerable amount of market share and until the
product’s growth slows. Under stable conditions, the profitability should
be a function of his accumulated experience.

The impact of the experience curve on the strategic management community

was the division between the study of management process and competitive
action and market outcomes. The experience curved focused attention on
competitive advantage (What it is, how it is gained and where it should be find)

3. The problem of persistent profit

Some firms simply do better than others, and they do so consistently.

Competition should erode the extra profits earned by successful firms, leaving
each firm just enough to pay factor costs.

One of the factor in the 70s to find an explanation of this persistence was the
success of the Capital Asset Pricing Model (CAPM), developed by financial
economists. CAPM had practical usefulness and gave the idea of markets were
efficient.
 In search for explanations of enduring success, the most obvious theory was
that of industrial organization economics returns. Traditional entry-barrier
theory made the concepts of scale economies and sunk costs appear.

Porter changed the perspective from the industry to the firm into a theory of
competitive strategy, describing a wide range of phenomena that interfered
with free competition, allowing abnormal returns. Lately, in Competitive
Advantage introduced two types of firm-specific advantage:

 Cost-Based
 Differentiation-based

A second effort is the resource based view of strategy. This focus is from
product-market barriers to competition and factor-market impediments to
resource flows: abnormal returns are unique resource combinations, rather
than market power. The creation of those resources is seen as
entrepreneurship.

So now strategic management consists of identifying the existence and quality

of resources (difficult to imitate), building product-market positions, and
contractual arrangements.

4. The changing nature of economics

The economist neclassical model of the firm divorced from the most
elementary conditions of real firms, and now is known as ‘theory of the firm’. 5
terms appeared:

 Uncertainty
 Information asymmetry
 Bounded rationality
 Opportunism
 Asset specificity

Transaction costs economics rests on uncertainty, bounded rationality and

asset specificity, while agency theory on opportunism and information
asymmetry.

Transaction cost economics

This have the greatest affinity with strategic management. A theory,

which seeks to explain why one particular clause appears in a contract, is
clearly of great interest to strategic management scholars.

Williamson said that transactions should take place in that regime which
reduces the most the costs imposed by bounded rationality and opportunism.
This introduced the efficiency (economists previously ignored this concept).
 Within strategic management, transaction costs is the ground where economic
thinking, strategy and organizational theory meet, because of its focus on
institutional detail.
Agency Theory

This concerns the design of incentive agreements and the allocation of

decision rights among individuals with conflicting preferences or interests. This
theory is not compatible with transaction cost theory.

This theory has developed in two branches:

 Principal-agent: Design of optimal incentive contract between
principals and their employees (or agents). The standard problem has
the agent shirking unless rewards can be properly conditioned on
informative signals about effort.

 Corporate control: In many firms, managers have inappropriately

directed free cash flow towards wasteful investments or uses, and
there are two cures: High levels of debt and hostile takeovers. This
branch also recognizes the existence of bad management, identifying
remedial instruments and giving proper incentive arrangements.

Game-theory and the new IO

Mathemathical game had its economic applications in late 70’s.

Modern game theory raises deep questions about the nature of rational
behavior. A rational individual is on who maximizes utility in the face of
available information, to generate ‘sensible’ equilibria.

Game theory as applied to industrial organization has two basic themes of

most interest to strategic management:
 Commitment strategies: Investment in specific assets and excess
capacity.
 Reputations: Games where a firm or actor can have various ‘types’ and
others mst form beliefs about which type is the true one.

Evolutionary economics

Nelson and Winter married the concepts of tacit knowledge and

routines to the dynamics of Schumpeterian competition. Firms compete
primarily through a struggle to improve or innovate, applying better methods.

This learning-by-doing means that the current capability of the firm is a

function of history, making it impossible to simply copy best practice even
when it is observed. In other words, a firm can’t change strategy or structure
easily or quickly.

5. The changing climate within business schools