Financial Times, 04/10/1999

Why Economics has been fruitful for Strategy

Summary
A lot of researchers into strategy – not to say airport bookstores – deliver
prescriptions which imply that those companies not following them must be making
strategic mistakes. For the economist who believes in competition and efficient
markets, however, this approach presents difficulties. Economics is a powerful force
for analysing strategy because it studies the creation and distribution of resources.
This knowledge is crucial to creating and retaining profit, in its widest sense.
Economists are therefore comfortable with the side of strategy which seeks to explain
how and why businesses capture profit. But as Fiona Scott Morton explains there is
tension when it comes to handing out "normative" advice. Highlighting key findings
from recent economic research the author argues that there is no "best" strategy
because strategy must always be applied to a particular organisation, market or
product – the right choice for one company may therefore be the wrong one for
another.

The tools and techniques of strategy are changing. Instinct and experience remain important
influences but research in this area is moving away from normative flats of best practice
towards discipline-based approaches like economic modelling and the empirical testing of
ideas. What disciplines such as economics and sociology offer is a coherent mental model of
the world that permits structured 'strategic thinking' about difficult questions. Teachers of
many of today's top MBA and executive students draw heavily from principles of
microeconomics and its associated empirical work in classroom instruction. This article
explains why the economic approach to strategy has been fruitful and how it differs from
some other approaches.
Researchers in economics study the creation and distribution of scarce resources among
people, companies and governments. Many strategy researchers seek to understand a subset of
this area - the process by which individual companies create and retain profits (meaning the
monetary return to a resource, e.g. capital, land, over and above the competitive level, rather
than accounting profit).

Strategy's two sides

Strategy has two sides: the positive and the normative.

• The positive side, understanding how and why profits are captured by certain parties, is
straightforwardly a part of economics. It is therefore very natural that economists should
make substantial contributions to strategy.
• The normative side of strategy involves researchers urging companies to follow their advice
in order to earn higher profits, something which is also true of other academic disciplines like
sociology and psychology when these have been used in studying management and strategy.
The normative side is a less natural part of economics, and generates some tension between
different types of research.
First I will explain how economists apply their tools to the positive questions and highlight
the kinds of research insights that result. Then I will address the tension created by the strong
normative implications of much research in strategy.

The "Positive" approach

On the positive side we can ask the question, why are some companies successful? Answering
this inherently involves telling a story. How can a story-teller, or modeler, create a story that
is both convincing and true?
Economists create good stories by being simple, explicit, and plausible about three things: the
actors involved, their goals, and the choices available to them.
For example, we might want to set up a situation with two companies, one with higher
variable costs than the other, where each can choose whether or not to differentiate its product
for a new niche market. Serving the niche requires an investment in altering the product that
will make it more valuable to a small group of consumers.
Both companies have a single goal - profit maximisation. These actors, goals, and choices are
starker than reality; no new entrant is allowed in this model, managers may not have other
goals such as empire building, and the choice facing a company is "to differentiate or not to
differentiate."
It is important to understand that no model will ever be as rich as the business world, nor
would it be useful to create one that was. There is a trade off between the complexity, and
therefore reality, of the model and correctly interpreting and using the results. A good model
deliberately leaves out the interesting and important features of the world that are not critical
to the study at hand. The result is a crystal clear understanding of a small piece of strategy.
Interestingly, much of the debate about strategy approaches is really about the importance of
actors left out across different disciplines.
A crucial part of the economic approach to strategy is the notion of equilibrium. The intuitive
explanation of equilibrium is that ex post, if an actor could play the game again, he would not
choose a different action, each actor is doing his best, given everyone else's choices and the
options available to him.
To pursue the earlier example, the higher cost Company H is earning lower profits than its
rival on the standard product, and therefore finds differentiation an attractive option. Suppose
Company H will earn a higher profit by serving the niche, and so decides to invest. The lower
cost Company L will not differentiate because it expects Company H to enter a niche that is
not large enough for both companies. Now we have equilibrium: Company H will not stay out
when the niche is empty. Company L does not want to enter, given that Company H is already
entering. Each company is doing the best it can, taking the action of its rival as given (NB
Many games have more than one equilibrium: changing a rival's action in order to bring the
game to a different equilibrium is an exciting area of advanced strategy.)

Pause for a moment, to see why this condition is fundamental: if economists didn't have it,
models could produce results where one party makes a mistake and the other's strategy works
well in response to the mistake, but not under other conditions. In that situation neither
strategy should be generalised and recommended to managers!
Economists focus their research on strategic interactions where all parties are achieving the
most they can, and use the notion of equilibrium to avoid extolling mistakes or good luck.

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Models and Evidence

In short, economists have powerful tools: formal modelling, the assumption of maximizing
behaviour by agents, and the notion of equilibrium.
Using these techniques produces crisp, testable conclusions. That is, of course, very
important because we are trying to tell a believable story, which in turn depends on both the
features of the model and the evidence. Do we see this strategy in the world around us? To
answer that question, we first need a model with a clear prediction, and then look for data.
In a 1990 research paper, The Economics of Modern Manufacturing, Technology, Strategy,
and Organisation - Paul Milgrom and John Roberts develop a model of complementarities
among management practices. Their idea is that the profitability of a particular practice
depends on what other practices are in place in the company; for example, giving workers lots
of training is more profitable when the human resource strategy also empowers workers to
control quality. If true, we should see companies using groups of complementary practices
together.
Iain Cockburn, Rebecca Henderson, and Scott Stern, authors of the 1999 research paper
Balancing Incentives: The Tension between Applied and Basic Research, test whether
pharmaceutical companies that reward academic publication strongly are also the companies
that provide a large incentive to researchers for generating useful patents. This would be the
right way to structure incentives if drug discoveries by a cutting-edge researcher were more
valuable than other drug discoveries. They find a positive relationship that validates the
theory.

Nobel prize winner Ronald Coase in his 1937 work, The Nature of the Firm, discusses how
markets vary in their ability to handle particular transactions efficiently. If a free market
functions well, there is less need to locate a transaction from that market inside the company.
His theory implies that an inefficient market for a necessary transaction will cause the
company vertically to integrate that function into the company. Kirk Monteverde and David
Teece in their 1982 paper, Supplier Switching Costs and Vertical Integration in the
Automobile Industry, investigate which auto parts General Motors makes inhouse and which
are out sourced. They find the parts that are more complicated, where performance is harder
to specify in a contract and which are therefore harder successfully to buy out the market, are
those it keeps inhouse.
The above examples are models and evidence of internal company strategy. Economics has
worked longer, and had more of an impact on competitive strategy, which studies how a
company interacts with its competitors. Harold Hotelling's 1929 paper, Stability In
Competition, sets out the famous model of a "line of consumers". This show's that when two
companies can choose where to locate along the line they both want to locate in the middle
nicely reflecting the location in the centre by candidates for political posts seeking to capture
votes from those standing between themselves and the extreme of their parties. Once prices
are introduced the situation becomes more complex. Locating close together now creates price
competition. So companies will find they can charge higher prices and earn more profit by
differentiating, or separating. This is why we see more product variety in breakfast cereal than
in politicians.
In his 1991 book, Sunk Costs and Market Microstructure, John Sutton shows that in industries
where advertising is important, companies affect the number of competitors in the industry.
By using advertising to increase product demand, they increase the sunk cost of entry for
others and therefore lower the number of company that can "fit” in the industry. Such
industries lend to have higher concentration and less competition than similar sized industries.

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He tests this theory on a wide range of consumer products industries in different countries and
rinds that it holds.
Garth Saloner in a 1987 paper, Predation, Mergers, and Incomplete Information, describes a
merger situation where a buyer engages in predatory pricing against its rival and target fit
order to convince the target that the buyer is a very efficient company. If the target believes
competition going forward will be fierce, it will lower its estimate of future returns for
shareholders, and will agree to be acquired at a reduced price. In a 1986 paper, Predatory
Pricing and the Acquisition Cost of Competitors, Malcolm Burns studies American Tobacco's
predatory behaviour at the turn of the century: he examines the prices of American Tobacco's
acquisitions and its behaviour during these. Burns concludes the cost to American Tobacco of
using predation, and developing a reputation for using it, was offset by merger acquisition
cost savings, so the strategy was successful.

Beware the Cookie Cutter

Although only discovered and tested as the discipline advances, economic principles hold
across time and across companies. A manager can and should use them to find the best
strategy for his or her particular situation. An alternative source of advice is the normative
literature, the latest management "fads" seen on bestseller lists and in airport bookstores.
Prescriptions in these books are too simplistic. They assume most companies will benefit by
following the advice, whereas economists tend to think a company may have a good reason
why it is not already following the advice. Rather than urging everyone to adopt a universally
applicable strategy, the assumption underlying economic research is that, in general, the
observed behaviour of a group of companies is optimal. The researcher can understand the
world better by finding out why one strategy was better than another for a company, not by
determining which strategy was best and depicting the alternatives as a mistake.
The economic approach to strategy therefore emphasises heterogeneity. This means
companies vary along one (or more) important dimensions that can be explicitly incorporated
into the model. Characteristics such as physical assets, culture, brand image, and capabilities
that distinguish your company from others also determine that the best strategy for your
company is, again, different from that of others.
The cookie-cutler approach will not work because finding a successful strategy is complex. It
must work with the other features of the company. There is no "best" strategy because a
strategy must be applied to a previously existing organisation, market, or product. However,
although "best" will be something different in each case, the strategy is not divorced from
economic principles. Instead, those principles allow a manager accurately to tailor the strategy
to fit his or her company.
For the world of business this implies that when we look at an industry (or across industries)
not all companies make the same strategic choices. Are some companies making mistakes?
Not necessarily. Perhaps the right choice for one company is the wrong one for another.
Sharon Oster in an article, The Diffusion of Innovation Among Steel Companies the Basic
Oxygen Furnace, found that some steel companies adopted the basic oxygen before others.
Were those not adopting making a mistake in not pursuing the new technology? The author
shows in fact that these companies had more efficient forms of the old technology and faced
higher input costs if they had used the new technology.
Although the basic oxygen furnace was manifestly superior these companies did not benefit as
much from adopting it as new entrants, like Japanese companies because the former owned
old plants with no other use. They maximised their profits, conditional on these old
investments, by not adopting. (One could then go on to ask the more difficult question was
sinking those investments the right choice at the time?)

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Andrea Shepard, in her 1993 article Contractual Form, Retail Price, and Asset
Characteristics in Gasoline Retailing has investigated why some retail petrol stations are
vertically integrated with the oil producing company and why others are independently
operated. In some cases the petrol station has a repair shop. Because the quality of repairs is
very hard to measure, it would be very difficult for a company to compensate, and offer good
incentives, to the repair shop workers. The stations will be more profitable when the incentive
to provide high quality services is strong, so the stations are franchised or independently
owned. My own 1997 work on turn of the century British merchant shipping, Entry and
Predation: British Shipping Cartels 1879-1929, shows the incumbent cartels would start a
price war against some entrants but not against others. Why wasn't there one best strategy?
Some entrants were financially stronger than others and the cartel correctly realised a price
war against a strong entrant would not pay off. Instead they only fought weak entrants who
could easily be driven out of the market.
This short list of work highlights an important feature of economic research in strategy:
principles are enduring and do not change with management fashions, but companies are
unique and must apply those principles to discover the optimal strategy for them.
Strategy is unusually normative for a social science field; the idea is not only to analyse how
the world works, but to offer strategic recommendations to managers. It must therefore be the
case that some managers are making mistakes and need advice from an outsider on what is the
right strategy. This part of strategy has a tense relationship with an economics discipline that
believes in differences between companies, efficient markets, and few wasted opportunities.

The twenty dollar bill

A famous old joke illustrates this: two economists are strolling down the sidewalk together
talking, when one of them catches sight of a twenty-dollar bill lying on the ground. One says:
"Look, there's a twenty-dollar bill on the sidewalk over there." The other replies: "Don't be
silly, there's no twenty-dollar bill. If there were, someone would have picked it up by now."
Competitive markets imply that economic profit, or excess risk-adjusted profit, is competed
away wherever possible. Of course, there are moments when it is not possible for competitors
to compete it away. For example, patents and regulations may allow a company to capture
profits for some time. At other times there should not be excess profit because of the vigorous
action of entrepreneurs and established companies in taking advantage of new opportunities.
While a few twenty dollar bills will always be found by chance, they should not be found in a
fixed location. If this is true, what is the point of studying strategy?
One resolution of the conflict between economics and strategy lies in an observation by
economist Friedrich Hayek in his 1945 paper, The Use of Knowledge in Society. He pointed
out that the fundamental problem in a market economy is the acquisition of information by the
right person at the right time and place. Such information is valuable because it can be used to
allocate resources efficiently, and allows the user to keep part of those gains as profit. A
simple example of this is the entrepreneur who realises there is unmet demand for a particular
product in a particular time and place. Another way to state the idea is that there are a lot of
twenty dollar bills (and some even larger) - not on the sidewalk – but available to a person
with the right knowledge. For an economist, strategy is the knowledge allowing a person to
find and recognize profitable information, and then make the best use of it for it (or sell it to
someone who will). Economists in the strategy area attempt to increase our knowledge of the
principles underlying the success of companies because that is the fundamental source of
profit.