University Notes - Senior Year, 2nd Semester

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Table of Contents Keith Parker’s Notes from USC Volume 5 of 5

Senior Year, Second Semester Page Content BUAD-497: Strategic Management 1 Syllabus 11 Course Documents 25 Assignments 37 Class Notes 63 Group Project 89 Powerpoint Slides 179 190 214 228 243

FBE-440: Trading and Exchanges Syllabus Course Documents Assignments Class Notes Exam Things

272 277 282 286 300 315 356

FBE-462: International Trade and Commercial Trade Syllabus Course Documents Handouts Homework Class Notes Group Project Powerpoint Slides

401 412 413 417 435 493

MOR-492: Global Strategy Syllabus Discussion Help Reading Notes Class Notes Projects Powerpoint Slides

BUAD-497: Syllabus University of Southern California

Page 1

Marshall School of Business

BUAD 497: STRATEGIC MANAGEMENT Spring 2007 Instructor: Office: Phones: Email: Sections:

Office Hours: Prerequisites:

Peer C. Fiss, Ph.D. Bridge Hall 303-B Office: 1-213-821-1471 [email protected] Section 15102R – T/TH 12-1:50pm ACC 201 Section 15107R – T/TH 2-3:50pm HOH 304 Section 15112R – T/TH 6-7:50pm ACC 201 Wed 2:00pm – 4:00pm and by Appointment Successful completion of all core business requirements

COURSE DESCRIPTION This course introduces the concepts, tools, and first principles of strategy formulation and competitive analysis. You will learn about why some firms survive and prosper while others do not, and develop the critical analysis and communication skills necessary to create and implement firm strategy. The course focuses on the information, analyses, organizational processes, and skills and business judgment managers must use to design strategies, position their businesses and assets, and define firm boundaries, to maximize long-term profits in the face of uncertainty and competition. Strategic Management (BUAD 497) is an integrative and interdisciplinary course in two important respects: 1.

The course assumes a broad view of the environment that includes buyers/consumers, suppliers, technology, economics, capital markets, competitors, government, and global forces and it assumes that the external environment is dynamic and characterized by uncertain changes. In studying strategy, this course draws together and builds on all the ideas, concepts, and theories from your functional courses such as Accounting, Economics, Finance, Marketing, Organizational Behavior, and Statistics. However, it is much more than a mere integration of the functional specialties within a firm.

2.

The course takes a general management perspective. It views the firm as a whole, and examines how policies in each functional area are integrated into an overall competitive strategy. We designed this course to develop the “general management point of view” among participants. This point of view is the best vantage point for making decisions that lead to sustainable business performance. The key strategic business decisions of concern in this course involve determining and shaping organizational purpose to evolving opportunities, creating competitive advantages, choosing competitive strategies, securing and defending sustainable market positions, and allocating critical resources over long periods. Decisions such as these can only be made effectively by viewing a firm holistically, and over the long term.

This course is intended to help you develop skills for formulating strategy. These skills will help you in whatever job you take after graduation as well as in your personal investing and choice of employment. The strategy formulation process demands the mastery of a body of analytical tools and the ability to take an integrative point of view. You will develop these skills through: • • •

In-depth analysis of industries and competitors Prediction of competitive behavior Techniques for analyzing how firms can develop and sustain competitive advantages over time

NOTE: BUAD 497 is a core course taught by several instructors. Policies regarding assignments and grading may be different for each instructor. Be sure to refer ONLY to this syllabus.

Keith Parker, University of Southern California

BUAD-497: Syllabus EDUCATIONAL OBJECTIVES Theory and Concepts. The central concept of this course is that of competitive strategy. Definitions abound, but they all share some sense of the allocation of critical resources over relatively long periods in pursuit of specific goals and objectives. Successful strategies exploit external conditions, entrepreneurial insights, and internal resources, seeking configurations of prices, preferences, technologies, and information that offer opportunities for sustainable competitive advantage. Strategy can be usefully thought of as the comprehensive alignment of an organization with its future environment. Success, however, depends not only on the soundness of the strategy, but also on its effective implementation through appropriate organizational and administrative choices. In the end, unforeseen external factors may cause a well-conceived and executed strategy to fail, in spite of its initial wisdom -- but a poor strategy badly executed increases the chances of failure. Opportunities to act strategically often do not come labeled as “strategic” and occur infrequently. If missed, or mismanaged, they can prove disastrous for any firm. Understanding the concept of competitive strategy formulation is a primary educational objective of this course. This will involve mastering an array of economic, strategic, and organizational concepts and theories, and acquiring an integrative general manager’s point of view. The course will cover theories for in-depth industry and competitor analysis, for anticipating and predicting future industry developments, and for examining the impact of change (in technologies, tastes, government regulations, global competition, and other important environmental forces) on competition and industry evolution. The course will also examine the economic underpinnings of competitive advantages, and the fundamental conditions that allow firms to conceive, develop, and sustain, advantageous strategic positions. While our primary focus will be on mastering strategy formulation at the business unit or competitive level, the course will also examine corporate and global strategy issues such as diversification, vertical integration, economies of scope across related businesses, the transfer of technology and core competencies, and international expansion and growth. Analytical Skills. Theoretical concepts are a great aid to understanding, but by themselves, they do not help resolve real business problems or challenges. Also needed are analytical skills and techniques that can be applied to the data to "fill in" the facts and premises assumed in the theories. A second educational objective is further to increase each student’s inventory of useful analytical skills and tools. Some of the tools are quantitative -analyzing financial statements, computing comparative buyer costs, and calculating the effects of scale and learning on production costs, for example -- while others are qualitative. Learning how to apply these techniques, and, more importantly, when to apply them is a key objective of the course. In learning to size-up a business and its problems or opportunities, this course will require you to conduct "full blown" strategic analyses. That is, identifying firms’ strategies and testing them for consistency, recognizing potential entrepreneurial opportunities and strategic challenges/problems, selecting and establishing competitively protected market niches, identifying competitive advantages and shaping defenses to circumvent the advantages of rivals, formulating and implementing internally consistent business strategies, and designing efficient and effective organizations. Rhetorical Skills. The best analysis in the world will have little effect if it cannot be communicated to others. Managers must be able to articulate their views coherently and persuasively, and they must be skilled at understanding and analyzing other points of view. Management is a "verbal sport;" perhaps 90% of a typical manager's day is consumed by oral communication. Time is often scarce. You must learn to make convincing arguments and to make them quickly, or the merits of their ideas are likely to become simply irrelevant. This skill takes practice, and we will place a great deal of emphasis on it in class. Wisdom. Much of the knowledge that successful managers and consultants employ consists of "rules of thumb" about what issues are likely to be important in certain kinds of business situations. These rules of thumb, or heuristics, are often implicit in the thinking of people who have never bothered to articulate them explicitly. A fourth goal of this course is to help you build up your set of useful "stories" and heuristics for your future managerial careers. In this course, we are as much interested in developing an appreciation for the art of management as we are in understanding the science of management. Tools alone will not a strategist make. While the ability to master

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Keith Parker, University of Southern California

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BUAD-497: Syllabus analytical models, frameworks, and tools is essential, ultimate success is more strongly predicated on prescient judgment, entrepreneurial insight, iconoclastic vision, and a willingness to act forcefully with conviction.

COURSE FORMAT AND THE CASE DISCUSSION METHOD In order to achieve the objectives of the course, we will devote the majority of our class time to the analysis and discussion of selected management, competitive strategy, and business policy cases. I will use lectures to elaborate on key theoretical models and frameworks or to reinforce crucial concepts. These lectures, however, will be subordinate to the case analysis. Cases provide a natural "test-bed" for theory and provide vivid examples that aid memory of concepts. While nothing can surpass first hand personal industry and managerial experience as a basis for analysis and decision-making, case analysis is an indispensable proxy for the kind of knowledge that can only be gained through years of experience and research. I have selected a mix of old and new business cases on a range of companies from a variety of industry settings. Each case is intended to teach us something specific, yet each can teach many things. We will not attempt to exhaust each case of all its learning experiences, but rather build up a "tool kit" of analytical tools, skills and insights, progressively over all the selected cases. There are other reasons for employing the case discussion method of instruction. First, it allows you to develop skills at problem definition in addition to problem solving. Cases typically do not have an obvious set of tasks whose performance will lead to mastery. Rather, they force you to sift through a mass of information, some of it irrelevant or contradictory, in order to identify the important or strategic issues. Second, the case method gives you a chance to deal with ambiguity. Most cases do not have obvious "right" answers. Managers must be able to function in situations where the right answer is not known, without falling into the trap of assuming that any answer is as good as another. Some analyses and proposed strategies are clearly wrong, and some are clearly better than others are. A popular phrase in case analysis classes is "There are no right answers, but there are wrong answers." Case discussion techniques provide a chance to learn the meaning of analytical rigor in situations other than open-and-shut problems. These rationales are offered because the case method is unfamiliar to most of you and frequently causes initial confusion. There will be many times when I will not reveal my own opinions about a particular issue, and there will be many cases that do not end up neatly packaged with an "answer." You may discover that your preparation "misses" key points of a case, especially at first. This is a normal part of the learning experience. While we will direct class discussions, the quality of your learning experience will be directly determined by: (1) your degree of preparation, active listening, and participation, and (2) your classmates' preparation, listening, and participation. Some will not agree with you, and you may be asked to defend your argument or change your mind. So long as criticism is directed at arguments and not at individuals, is relevant to the issues at hand and coherently argued, it is very much welcomed. Case Preparation Because this course relies heavily on case material, extensive before class preparation and in class participation are required to ensure the class' success. (1) Preparation for a case discussion should begin with a rapid reading of the assigned case and other materials. (2) Then, it is worthwhile to review the discussion questions provided for clues as to what issues require special attention. (3) The next step is normally to re-read the case carefully, taking notes which sort information, facts, and observations under a number of relevant headings. Try to formulate theories or hypotheses about what is going on as you read ("the company loses money on small orders"), modifying or rejecting them as new information surfaces ("Table 2 shows that shipping costs per unit are higher for small orders, but only for long-distance shipments"). Push yourself to reach definitive conclusions before you come to class. (4) You should perform quantitative analyses, “crunching” whatever numbers are available. It is also very important to provide quantitative support wherever possible, particularly when exploring various hypotheses as to the nature and importance of certain phenomena. (If the requisite data are not available in the case, a precise description of what data are missing often triggers ideas for making creative use of the information that is available.) It is usually worthwhile to identify trends in the firm or industry, preferably with a quantitative measurement. Some of these trends, often very important ones, will not be flagged in the text of the case. (5) Finally, preparation will include notes that can be used to guide your interventions in class discussions. You will probably want to, and I strongly encourage you to form study groups that regularly meet to share insights and ideas about the assigned cases. While this is voluntary, experience shows that satisfactory performance in this course, and a good grade, depend on it.

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Keith Parker, University of Southern California

BUAD-497: Syllabus WARNING! There is a good chance that you will feel a bit confused or overwhelmed during the first module, or two, of the course. This is a byproduct of the peculiar structure of the strategy course that does not build up linearly by successively adding components of knowledge week by week. Rather, every case in a sense contains all the material in the entire course. Furthermore, the early theoretical concepts will gain in meaning to you once you have worked through a few cases. As a result, there is no logical way to begin except by immersion. So remember: SOME CONFUSION IS NORMAL AT FIRST. You will gain experience as we progress through the course.

COURSE EVALUATION Course grades will be determined by individual and group activities: Course contribution and participation Individual mini case analysis Individual midterm exam Group project presentation Group project writeup Individual final exam

15% 10 20 10 20 25 100%

In order to pass this course successfully, a passing grade (> 50%) must be achieved in the group and in the combined average of the individual components. Please note that if your individual performance in the course is unsatisfactory, it will not be brought up by a good group grade. The distribution of grades will closely follow the guidelines of the Marshall School of Business (an average class GPA of 3.0 for required courses). Course Contribution and Participation. Managers must often “sell” their ideas to others in order to get their acceptance and support. In this course, the classroom provides a laboratory in which you can test your ability to convince your peers of the appropriateness of your approach to complex management problems. Furthermore, it tests your ability to carefully listen to others’ perspectives and understand why they may reach a different conclusion. Before you can effectively sell your ideas to others, you must understand what is motivating them, what issues they feel are important, and what assumptions they are making that may be different from your own. When evaluating your contribution to the class discussion, then, I will consider how effectively you put forth your own arguments, as well as how well you listen to, understand, and build upon (or refute) the arguments of others. In all cases, I will look for high quality (which is frequently not the same as high quantity) arguments, analyses and questions that improve the class’ collective understanding of the case issues. While I encourage you to speak up at any time, keep in mind that comments that are redundant, tangential or seemingly irrelevant to the case discussion at hand or attempts to dominate class discussion will have a negative impact on your participation grade. I will use the following criteria when determining class contribution grades: • • • • • •



Has the student attended and made significant contributions to each class discussion? Does the student show evidence of careful case analysis by using facts and evidence from the case? Does the student draw valid conclusions from the facts presented in the case? Does the student contribute interesting examples? Does the student make effective comparisons among different cases situations, as well as between case situations and real life cases? Do the ideas suggested by the student push us to consider an aspect of the case that is not necessarily obvious at the outset? Do they go beyond the surface and get into core issues? Is the student is an active listener? Do his/her comments fit in with the flow of the class discussion? Do his/her comments demonstrate listening to and reflection on points suggested by others? Does the student interact with, challenge, question, and extend comments of other participants, or are all comments directed towards the instructor? Does the student engage in constructive debate that challenges the opinions expressed by others without diminishing the value of their contribution?

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Keith Parker, University of Southern California

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BUAD-497: Syllabus

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I realize that some of you may be shy about speaking up in a large class like this. Therefore, I offer you the opportunity to somewhat compensate by participating in the class’s online discussion group. The same evaluation criteria apply here as for in-class discussion. However, keep in mind that this can never fully substitute for in-class discussion. Please remember that your classmates and I expect you to attend and be well prepared for each class, having read the required conceptual material and analyzed the assigned case study ahead of time. We also expect you to play an active role in class discussion. If all class members prepare for and actively participate in each class discussion, your experience will be all the better for it. I will ask you to speak even if you have not volunteered, so please be ready for discussion every class. Individual Mini Case Analysis. For this assignment, I will ask you to analyze a recent event in the business press using the tools we have discussed in class. The analysis should not exceed four (4) double-spaced pages with 1" margins and 12 point font. I will post more information on this assignment on the course website. This assignment will be due on Tuesday, February 6. Individual Midterm Exam. For this assignment, I will provide you with specific questions regarding a company case, and your answers should be confined primarily to the facts as presented in the case. You are expected to use both the concepts and the terminology presented in this course in your write-ups. For the mid-term analysis, the analysis should not exceed six (6) double-spaced typewritten pages, with 1" margins and 12 point font). Your analysis will be evaluated equally on the following criteria: • • • • • • •

How well (i.e., thoroughly and concisely) do you describe the environmental context and internal factors that are important to the problem? Accurate and thorough use of course concepts Integration of course concepts with information about the company and problem How well do you integrate course concepts with information about the problem to illuminate the problem in a way that leads to solutions? Extent to which recommendations are consistent with analysis Feasibility and specificity of recommendations Quality of written analysis

The individual midterm exam will be a take-home exam. It will be due on Tuesday, March 6, at the beginning of class. Please put your name and student number ON THE BACK OF YOUR EXAM ONLY, NOT ON THE FRONT. I don’t want to see your name while I grade these assignments. As always, you should not discuss the case itself with any other student.

Group Project Presentation and Writeup. For this group project, you will self-select into groups of 4-6 members. It is your responsibility to form teams. All team members must be from the same section. The project requires you to examine strategic challenges or an issue of concern at real organizations. The purpose of the project is to give your team an opportunity to apply what has been learned in the course to strategic problems faced by realworld organizations. In terms of the topics for your analysis, groups can choose from a menu of topics including the organizational development of a firm over its entire history, an analysis of a firms’ responses to the internet, an analysis of the growth pattern of a successful and an unsuccessful firm, or a successful and unsuccessful radical repositioning of two companies. Your team should identify one or more public, private, or not-for-profit organizations to study. You may select an organization in which one or more of the team members has worked or been a member. I would suggest that you be selective in choosing an issue or problem to analyze, as a lack of background on the issue itself will not be an acceptable excuse for a lack of depth in the analysis. 1.

an e-mail with the names an addresses of your group members, a team name, and a brief statement that outlines your proposed project (see below)

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Keith Parker, University of Southern California

BUAD-497: Syllabus 2. 3. 4.

a written analysis and data appendix (20% of course grade) and an oral presentation to the class (10% of course grade) completing a peer evaluation form within 24 hours of the presentation

You will conduct original research on your organization(s) and will supplement this information with data from the media, the organization(s)’ own literature, and other secondary sources. You should focus your analysis on applying concepts from the course. Although it is acceptable to incorporate several concepts from the course, please aim for depth rather than breadth regarding the use of course concepts. In my experience, papers that aim to apply a bunch of concepts end up being shallow in their analysis and don’t do well. The project proposal e-mail will be due by midnight on Wednesday, January 31. This e-mail should include: 1. 2.

The team name and names of all team members A brief description (roughly 400 words) of your topic.

The written analysis should not exceed fifteen (15) double-spaced typewritten pages, with 1" margins and 12 point font. I will only read the first 15 pages of text, so please stay within the page limit. The limit does not include appendices, which you can use to provide charts, figures, or other background material, but should be no longer than five (5) pages. Appendices which are not directly referenced in the text will not be read. The appendix is not a catch-all for anything that might be relevant, but is to be used carefully to support your points. Always include page numbers. Staple papers only, (no binding, folders, clips, or anything other than plain paper). This written document is due at noon on Friday, April 6 for all teams. Oral presentations will be given during the final 4 class sessions. Each presentation should be 25-30 minutes in length, and additional time will be set aside for questions from other teams after the presentation. Both the oral presentation and written document should cover all of the key elements of your analysis. For grading purposes, it will not be sufficient to orally present an aspect of your analysis that does not appear in the written document. The in-class presentation of your paper is worth 10% of the course grade. Half of these 10% will come from your peers, who will attend your presentation and afterwards score it, while the other half will come from my evaluation. It is therefore imperative that you both do well on these presentations and also attend the presentations of your peers, as you will have to post grades for them online. Also, I do not expect but welcome non-traditional forms of presentation. I expect that at this time of your USC career, you know how to give a professional presentation, so this may be a good opportunity to play around with the format. However, please remember that presentations that neglect content in favor of form are not likely to score well. Finally, each team is free to structure itself as it wishes. However, at the conclusion of the project, each member of the group will be asked to evaluate every other group member anonymously on the last day of class using a peer evaluation form that will be available on the course website. All team members must complete the form within 24 hours of their presentation. The goal of this evaluation is to discourage free-riding. If any students receives unsatisfactory ratings from their group, their grade will be marked down accordingly. Individual Final Exam. A final exam will be given during the exam time specified by the University. The exam will consist of questions on an exam case passed out to you one week prior to the exam. The format is similar to case presentations and discussions (e.g., you will be asked to diagnose the problem and make recommendations for action based on all the materials covered in this course). The anticipated times are listed in the course schedule attached at the back of the syllabus. However, you are responsible for confirming this date and time in the university schedule of classes.

COURSE POLICIES Attendance. Attendance at all class sessions is expected. Because learning in this course occurs primarily through interactions with other participants during class, every effort should be made to attend each class. There is no substitute for being present, prepared, and participating in the class discussion. While I recognize that from time to time absences may be unavoidable, absences necessarily limit your class contribution (you can’t gain participation points if you are not there…) and hence can influence your grade. Please notify me by email at least a day in

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Keith Parker, University of Southern California

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BUAD-497: Syllabus advance if you must miss a class. If you do miss class, it will be your responsibility to get notes, find out what was discussed, etc. from one of your classmates. Participation Cards. At the end of each case discussion, students who actively participated in the discussion should turn in a Participation Card. These cards should list your name, the date, the case discussed that day, and a synopsis of your contributions during that day’s discussion. The Participation Cards will be used in combination with my own daily evaluations to determine your participation grade for the day. For this purpose, please purchase a package of 3x5 index cards and bring them to each class. Please turn off all Communication and Entertainment Devices. Your classmates and I expect your full attention, so please keep your laptops closed unless we use them for an assignment. Also, please be sure your cell phones, pagers, Blueberries, phasers, tricorders, or other devices are turned off during class. Other Stuff: • • • •

Do not wait until the end of the semester to see me regarding problems with your performance. Your performance in this class is important to me, so please see me early. Written assignments must be submitted on time. As managers, you will not be afforded the luxury of missing deadlines (think of deadlines as “windows of opportunity”). The discount rate for late assignments is steep. If you can convey your thoughts more succinctly in your written assignments, please do so! Suggested paper lengths are only upper limits. Like managers executing actual strategies, we may find that the course syllabus must be amended slightly as the semester progresses. Please be sure to check the course webpage before class for study questions and further information on the readings and cases!

COURSE MATERIAL Case Package:

The assigned cases for this course are available from the University Book Store. When necessary, I will place additional materials on the course website for you.

Text:

There is no required textbook for this course. However, if you would like to use a textbook to extend your understanding, you are welcome to come by my office and browse my collection and pick my brain about them (i.e. which ones to buy, which ones to avoid…)

3x5 Cards:

Please bring a deck of 3x5 cards to every class to record your participation (see above description).

COURSE COMMUNICATION: BLACKBOARD SYSTEM I have posted the course syllabus to the 497 folder for your section in Blackboard. I will also post additional course lecture notes/materials, further details on assignments, and general course announcements to this folder throughout the semester. You should develop the habit of checking the course folder on a daily basis. You can access Blackboard either by going to http://totale.usc.edu/webapps/portal/frameset.jsp or by going through the “My Marshall” portal http://mymarshall.usc.edu. You will need your UNIX password for either site. IMPORTANT: (1) Since e-mails sent to the class originate from the Blackboard system, it is your responsibility to make sure your e-mail is set up to forward your messages to your preferred internet provider (IP) account such as EarthLink, AOL, Hotlink, etc. (2) Be certain that you include a recent digital color photograph of yourself within the personal information section, as I will use these to learn your names (important for your participation grade).

ACADEMIC INTEGRITY The following information on academic integrity, dishonesty, and the grading standard are placed here at the recommendation of the School of Business Administration Faculty and are taken from the Faculty Handbook.

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Keith Parker, University of Southern California

BUAD-497: Syllabus Additional statements about academic integrity may be found in SCampus handbook available at the Topping Student Center and online at http://www.usc.edu/go/scampus. Further information may be obtained from the Office of Student Judicial Affairs and Community Standards at http://www.usc.edu/student-affairs/SJACS/index. “The University, as an instrument of learning, is predicated on the existence of an environment of integrity. As members of the academic community, faculty, students, and administrative officials share the responsibility for maintaining this environment. Faculty has the primary responsibility for establishing and maintaining an atmosphere and attitude of academic integrity such that the enterprise may flourish in an open and honest way. Students share this responsibility for maintaining standards of academic performance and classroom behavior conducive to the learning process. Administrative officials are responsible for the establishment and maintenance of procedures to support and enforce those academic standards. Thus, the entire University community bears the responsibility for maintaining an environment of integrity and for taking appropriate action to sanction individuals involved in any violation. When there is a clear indication that such individuals are unwilling or unable to support these standards, they should not be allowed to remain in the University.” (Faculty Handbook, 1994: 20) Academic dishonesty includes: (Faculty Handbook, 1994: 21-22) 1. 2. 3.

4.

Examination behavior - any use of external assistance during an examination shall be considered academically dishonest unless expressly permitted by the teacher. Fabrication - any intentional falsification or invention of data or citation in an academic exercise will be considered a violation of academic integrity. Plagiarism - the appropriation and subsequent passing off another’s ideas or words as one’s own. If the words or ideas of another are used, acknowledgment of the original source must be made through recognized referencing practices. Other Types of Academic Dishonesty - submitting a paper written by or obtained from another, using a paper or essay in more than one class without the teacher’s express permission, obtaining a copy of an examination in advance without the knowledge and consent of the teacher, changing academic records outside of normal procedures and/or petitions, using another person to complete homework assignments or take-home exams without the knowledge or consent of the teacher.

The use of unauthorized material, communication with fellow students during an examination, attempting to benefit from the work of another student, and similar behavior that defeats the intent of an examination or other class work is unacceptable to the University. It is often difficult to distinguish between a culpable act and inadvertent behavior resulting from the nervous tensions accompanying examinations. Where a clear violation has occurred, however, the instructor may disqualify the student’s work as unacceptable and assign a failing mark on the paper.

STUDENTS WITH DISABILITIES Any student requesting academic accommodations based on a disability is required to register with Disability Services and Programs (DSP) each semester. A letter of verification for approved accommodations can be obtained from DSP. Please be sure the letter is delivered to me as early in the semester as possible. DSP is located in STU 301 and is open 8:30 a.m. – 5:00 p.m., Monday through Friday. The phone number for DSP is (213) 740-0776.

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Keith Parker, University of Southern California

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Dates

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Thursda y Tuesday

Thursda y Tuesday

2/01 2/06

2/08 2/13

3/01

2/22 2/27

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1/25 1/30

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Tuesday Thursda y Tuesday Thursda y Tuesday

Preview Case: Intel Corporation

Introduction

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Sustaining Competitive Advantage: Saturn

Competitor Analysis Applied: Leadership Online (A): Barnes and Noble versus Amazon.com Creating Competitive Advantage: Harnischfeger Industries

Competitor Analysis Competitor Analysis Applied: Ryanair

Competitive Dynamics and Positioning

Fit Applied I: Progressive Corporation Fit Applied II: Airborne Express

Firm Competencies III: WalMart Complementarities and Fit Individual mini case analysis due at the beginning of class

Firm Competencies I Firm Competencies II: Pepsico Restaurants Team project proposal e-mail due by midnight on Wednesday, January 31

Industry Analysis II: CF Motorfreight Industry Analysis III: Apple Inc.: iPods and iTunes

Industry and Firm Analysis Industry Analysis I

Introduction

Topic

BUAD-497: Syllabus

Keith Parker, University of Southern California

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1/16

1/11

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Tuesday Thursda y

Session

1/09

Days of the Week

Tu – Th Schedule for Fall, 2006

COURSE SCHEDULE

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Tuesday Thursda y Tuesday Thursda y Tuesday Thursda y

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3/06

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Team presentations and wrap up

Team presentations Team presentations

Group Project Presentations Team presentations

Performance and Governance II: Bausch and Lomb

Managing with Networks and Power II: Abelli and Savotti Team written projects due by noon on Friday, April 6 Performance and Governance I

Implementation and Change II: Lehman Brothers B Managing with Networks and Power I

Strategy Formulation and Implementation II: Honda B Implementation and Change I: Lehman Brothers A

Strategy Implementation Strategy Formulation and Implementation I: Honda A

Spring Break

Standards and Network Externalities II: The Browser Wars Spring Break

Standards and Network Externalities I Individual midterm exam due at the beginning of class

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Keith Parker, University of Southern California

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BUAD-497: Syllabus

BUAD-497: Course Documents Porter’s 5-force framework: Page 11 • Assesses competitive position of a firm within an industry • 5 variables measure competitive advantage • Assumes continuous downward pressure of competition • Points to interdependencies between factors (i.e. interaction, substitution) Competition… Threat of entry: ease of ability to enter new markets Impacted by: absolute cost advantages, government policy, economies of scale, and brand identity (minimum efficient scale) Patents, tariffs, quotas, licensing, geographical locations, language/cultural Buyer power: size and concentration of customers Impacted by: concentration, switching costs, backwards integration Powerful…large and concentrated, backwards integration Weak…fragmented, producer’s supply critical parts Supplier power: differentiation and switching costs Impacted by: # of suppliers, switching costs and presence of substitute inputs Powerful…concentrated and significant switching costs Weak…standard product and concentrated purchasers Rivalry: intense rivalry reduces average profitability Impacted by: growth, differentiation, # of competitors, diversity and exit barriers Concentration ratio, Herfindahl Index (monopoly, perfect competition) Threat of substitutes: price/performance ratios, switching costs and sub. improvement Impacted by: products in other industries ability to constrain the raising of prices *Great framework for industry dynamics…but complimentors and government influence missing! PEST: Political: tax policy, employment laws, environmental regulations, trade restrictions, tariffs and political stability. Economic: growth, interest rates, exchange rates and inflation. Socio-cultural: health consciousness, population growth rate, age distribution, career attitudes and safety. Technological: barriers to entry, MES and outsourcing decisions (R&D, automation). *Useful for understanding market growth/decline, business positions, potential direction for operations. Overview of various macroenvironmental factors in firm’s particular environment. These factors = external opportunities and threats in SWOT!!! SWOT: Strengths: internal asset Weaknesses: internal liability Opportunities: external asset Threats: external liability *Unfortunately, most strengths have corresponding weaknesses and all future events are both opportunities and threats…thus, SWOT = introspective analysis of company, not the industry or competitive environment Porter’s Generic Strategies: Strategy: unique position for a firm not doing the same activities better, rather doing them differently or doing different activities. Strategy involves trade-offs Due to incompatible product features, inconsistencies in image, limits of coordination, motivation, management, etc. Strategy = achieving high degree of fit between internal activities and external environ. Operational effectiveness is not strategy *Strategy key tension…control and flexibility!!!

Keith Parker, University of Southern California

BUAD-497: Course Documents Hambrick and Fredrickson: Page 12 Strategy: central, integrated, externally oriented concept of how to achieve objectives. Arenas: where will we be active? (geographically, industry, markets, segments/positions) Vehicles: how will we get there? (joint ventures, subsidiaries, LLP, corporations) Differentiators: how will we compete? (quality, quantity, cost, service, efficiency, safety) Staging: what speed and sequence of moves? (monthly, quarterly, annually, saturate markets, slow introduction, across entire continents, select countries) Economic Logic: where will profits come from? (premium prices, superior product, etc.) *does strategy…fit environment? Exploit key resources? Sustain differentiators? Internally consistent? Enough resources to pursue in long term? *Elements of firm must reinforce strategy!!! Boston Consulting Group Matrix: Stars: (high Market share, high Growth) Aggressive investment to support continued growth and consolidate competitive position of firm Question Marks: (low Market Share, high Growth) Selective investments: divestitures for weak firms or those with uncertain prospect for strategic fit. Cash Cows: (high Market Share, low Growth) Investments sufficient to maintain competitive position: excess cash used to nurture stars and select question marks. Dogs: (low Market Share, low Growth) Divestiture, harvesting or liquidation and exit. *Measures market share against growth McKinsey Matrix: Industry Attractiveness (comp. position-good, medium, poor): Low: profit producer, loser, loser Medium: winner, average business, loser High: winner, winner, question mark Core Competencies: Core competencies combine resources and capabilities to create a competitive advantage. Resources: tangible (factories, products) and intangible (reputation, loyalty) assets to firm in the form of: financial, physical, human, org. Capabilities: proficiencies enabling firm to take full advantage of resources (marketing and cooperative relationships). Portfolio of Competencies: existing and new Existing: opportunity to improve existing position in markets by leveraging current core competencies…new products to be created from a different configuration of existing resources. New: new products required to protect and expand brand in current markets…the markets of the future. Resource Based View (RBV) of Corporation: 2 critical assumptions: Resource Heterogeneity (differences in resources among existing firms) and Resource Immobility (costly for firms to acquire)…have something someone doesn’t and can’t get, then a sustainable competitive advantage is created. *Internal focus on idiosyncratic strategies (not external with identical)…resources not highly mobile, therefore possession directly correlated to competitive advantage. VRIO: Value: resource enables firm to exploit opportunity (increase revenue) or neutralize threat (decrease costs). Rare: if not rare, perfect competition observed: no competitive advantage…must have scarcity among firms to enjoy rarity and competitive advantage. *Valuable and rare…competitive advantage *Valuable and not rare…competitive parity

Keith Parker, University of Southern California

BUAD-497: Course Documents *not Valuable…competitive disadvantage PageImitability: 13 cost disadvantage in imitating valuable and rare resources = sustainable competitive advantage: intangible and bundles of resources more costly to imitate. • Unique historical conditions: first mover advantage, path dependence • Casual ambiguity: bundling fogs actual casual links • Social complexity: unable to duplicate relationships exactly • Patents: periods of legal protection Organization: align structure and control mechanisms to exploit resources and compliment other resources within firm (3M rewards innovation and risk taking). * Valuable, Rare, Imitate, Organized resources = sustainable competitive advantage. Greiner’s model of Org. Growth: Phase 1: growth by creativity…crisis by style of management Phase 2: growth by tight management…crisis by autonomy Phase 3: growth by delegation…crisis by control Phase 4: growth by coordination…crisis by bureaucracy Phase 5: growth by team spirit…crisis by unknown factors *Firm grows as organization evolves…each new phase sparked by revolutionary infusion Organizational Structures: Simple: low revenue base, simple product-market scope. Functional: increase in revenues, engage in vertical integration. Cost Leadership: operations = main function. Process engineering > R&D. Large centralized staff, formal procedures, and highly structured job roles. Differentiation: marketing = main function. R&D, decentralization emphasized. Foster change and promote new ideas with organic, less structured job roles. Divisional: expand into new/related product markets and/or geographic areas. More autonomy for divisions: corporate staff relegated to logistical and general strategic oversight. Divisions are solely responsible for functionality. *Decentralized structure (i.e. Nucor). Matrix: expand internationally: extension of divisional concept to project level. Mintzberg’s Organizational Theory: 5 Basic Elements Operating Core: employees perform basic work related to organization’s product. Strategic Apex: corporate executives responsible for running entire organization. Middle Line: managers transfer information between higher and lower levels of organizational hierarchy. Technostructure: organizational specialists responsible for standardizing various aspects of organization’s activities. Support Staff: individuals provide indirect support services to organization. 5 Organizational Structures: The Simple Structure: young, small; nonsophisticated technical system; simple, dynamic environment. (Key: strategic apex) Machine Bureaucracy: old, larger; regulating, nonautomated technical system; simple, stable envir. (Key: technostructure) The Divisionalized Form: diversified markets (esp. products & services); old, large. (Key: Market grouping, performance control, limited vertical decentralization) The Professional Bureaucracy: complex, stable envir. Nonregulating, nonsophisticated technical system: (Key: Operating Core). The Adhocracy: complex, dynamic envir.; sophisticated and often automated technical system (Key: Support Staff) *The Idea Organization: Value-based organizations, public/religious organizations…Jehovas Witnesses, Greenpeace, Al-Qaeda, IRA Activity Systems:

Keith Parker, University of Southern California

BUAD-497: Configurations exhibit high degrees of internalCourse fit. InterplayDocuments of complementarities and trade-offs across Pageand 14 multiple activities is critical to success...equifinal (different, yet equally effective methods). Must extend strengthen fit among activities according to strategic position. What is strategy? Unique position, tailored activities, clear tradeoffs, continuity of position with consistent improvement and integrated system of activities with fit. What is not strategy? Best practices, learning, agility, flexibility, restructuring, mergers/consolidation, alliances or the Internet. Game Theory: 1. Structure of games: • Players – any number of persons • Rules – determined by the number of options/alternatives in the play of the game. Structure of play off matrix is a function of the rules of the game. • Payoff Structure 1. Zero sum: one side must get less if the other gets more 2. Non-zero sum: not an equal trade off of +/• Strategies 1. Minimax – to minimize the maximum loss; defensive strategy 2. Maximin – to maximize the minimum gain; offensive strategy 3. Tit-for-Tat – always respond in kind 4. Tat-for-Tit – always respond conflictually to cooperation and cooperatively towards conflict 2. Moves to change the game played: • Players: can bring in customers, bring in suppliers, bring in complementors, or bring in competitors. • Added Value: can limit the supply, raise amount of consumers are willing to pay, or lower competitors’ value. • Rules of the Game: can change the rules to benefit you • Tactics employed: can make the game more transparent or opaque, depending on which benefits you • Scope of the Game: you can link games to other games or de-couple the game from other games. 3. Basic games: Prisoners’ Dilemma – The result of using a minimax strategy. It assumes no communication. Strategies can be altered if there is sufficient trust between the players. Both confess at the saddle point. Characterized by T > R > P > S • Temptation: desire to double- cross other player • Reward: cooperate with the other player • Punishment: from playing it safe • Sucker’s pay off: for the player who is double-crossed Chicken – there is no saddle point. No matter what one player choose, the other player can change for some advantage. It is unstable and the outcome cannot be predicted, but credible commitment can persuade the other player to back down Dilemma of the Commons – the problem of the unregulated use of a public good. Someone takes advantage of a shared good and profits himself but reduces the overall capacity of the market, hurting the rest of the group.

Competitor profiling

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BUAD-497: Course Documents

PageComplements 15 game theory w/ competitor profiling to work around restrictive assumptions on which game theory is built Behavioral perspective • Focus on competitors’ predispositions • What competitors really want given beliefs, blind spots, and historical gathering Why Competitor Profiling Matters • Goals may not be fully rational • Differences in an organizations’ charter (public, non-profit, family-owned) • Beliefs—see the world differently • Mental models may differ (diff. in functional backgrounds) • Agency problems (top-management’s interests may be different) • Irrationality (pride, jealousy, fairness) •

Routines may constrain opportunities for action • inertia due to size/family/maturity/complexity/strong culture/bureaucratization

Integrating game theory and competitor profiling • Think Broadly about the set of strategic options • Variables (organization, customers, pricing) • Asymmetric • Commitment postures • Information • Augment your toolkit for dynamic Analysis • Scenario analysis (role-playing/devils advocate) • Market testing • Sequenced rollout • Match analytics and industry/company context • Do general assumptions hold in the industry/company? • But: question industry logics/orthodoxies Value chain analysis, including value creation, value division, value added, the value net Value added chain analysis (Harnishfeger Case) •

Why Value Creation? • Before who gets what, determine what there is to get



Assessing= • Who are the players? • Customers willing to pay? • Suppliers’ opportunity costs?

Value Chain • Production Flow SUPPLIER resource or input

BUSINESS

product/output

CUSTOMER

Monetary flow ($) CUSTOMER BUSINESS SUPPLIER •

Value Creation SELLER (indifferent) Opportunity cost

Keith Parker, University of Southern California

BUAD-497: Course Documents

Cost (profit) Price Willingness to pay BUYERS

Value Created = buyer’s willingness to pay – supplier’s opportunity costs • •

Price measures the division between business and the customer Cost measures the division of value between business and supplier

Value Added = total value with you – total value w/o you • What you bring to others | Cost | Price | (positive bargaining zone) | Willingness to pay Size of the pie = willingness to pay – opportunity cost Division of the pie = value added Value net Customers

/

Competitors

|

\

Company

\

|

Complement

/

Suppliers

Standards/network externalities and their role in strategy (open/closed, tactics etc..) Standards matter whenever products depend on compatibility

• • • •

Strategies Hold back product launch Adopt a simple, undifferentiated, standard design Encourage imitation by other manufactures Lower prices to maximize early sales •

Sony vs. JVC

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BUAD-497: Course Documents



Standards introduce network effects



Classic examples are literal networks • Telephone • Fax • Internet Number of possible connections grow rapidly w/ number of users – “network externalities” System w/ one user is of little users System w/ all customers on is very valuable

Page 17 • Benefits that come from having a large installed base of users

• • •







• •



Windows vs. Mac

Wins and looses Consumers • Better off • Reduced uncertainty • More users, more value • Decrease in variety Complementars • Generally better off • Brokering role Key Points Understand the positions and interests of all pates involved in the standards competition Strength of position – 7 key assets 1. Control over an installed based 2. Intellectual property rights 3. Ability to innovate 4. First-mover advantages 5. Manufacturing 6. Strength in complements 7. Reputation and brand name Preemption • New technologies require champions to invest early to build • Being first can back fire if there are better technologies arriving soon



Expectations Management Engage in aggressive marketing, make early announcements of new products, assemble allies, make visible commitments to your technology Self-fulfilling prophecies can overrule technical advantage



Leapfrogging

• • • •

Open No one firm controls Specs are public – anyone can build compatible products May require license fee May not help firm that invented



• • • •

Closed One firm Systems can be controlled, so benefits don’t flow to a competitor Leapfrogging may occur

Keith Parker, University of Southern California

BUAD-497: Course Documents Dynamic industries and their effect on strategy • • • • •

Page 18

Competitive advantages erode quickly Established rules are broken Industry boundaries are breached Customer loyalty is fickle Sustainable competitive advantages becomes a series of shorter unsustainable competitive advantages • •

Internet Explorer vs. Netscape Internet Explorer vs. Mozilla

Judo and Hardball strategies Judo Strategy Target your opponents weakness and use it as leverage Hardball Strategy Use “unfair” advantage

Design vs. Learning schools in strategy (fallacies, deliberate vs. emergent etc..) Design School • Ex-ante analysis, thinking and reasoning • Assumes all relevant factors can be objectively analyzed • Assumes that this analysis precedes and dominates action – implementation follows as a separate stage • Separates thinking from doing and often implies a hierarchy – senior managements thinks – others implement • Option appraisal is conducted logically on the basis of analysis Learning School • Strategy making takes place w/in an unpredictable world • Creates the necessity for the flexible strategic approaches • Serendipity (accidental discoveries, luck, etc) is required for effective performance • Strategy is often made by lower-level managers – strategy evolves through autonomous action • Strategy has both intended and emergent components Mintzberg’s 3 fallacies of strategic planning 1. fallacy of predetermination – future is unknown 2. fallacy of detachment – impossible to detach formulation from implementation 3. fallacy of formation – inhibits flexibility, spontaneity, intuition, and learning = GRAND FALLACY – “because analysis is not synthesis, strategic planning is not strategy formulation” Deliberate vs. Emergent Strategies Intended Strategy + unrealized strategy strategy

Deliberate

realized strategy + emergent strategy = sustained superior

Robust action Allows a company to rapidly take advantage of opportunities as they occur Enables various levels and functions w/in the organization to contribute to the emerging strategies

Keith Parker, University of Southern California

BUAD-497: Course Documents

PageThe 19 public company and its strengths/weaknesses

The public company faces pressure from various angles including: Wall Street – investor expectations, earnings growth, and quarterly pressures Executive Compensation – increase in overall level, use of stock options Economic Cycles Cyclical Industry The above pressures are offset by the following methods of control: Compliance Department Disclosure Governance Ethics and integrit of participants Strengths/Weaknesses of the Public Company Strengths Ability to raise enourmous amounts of capital and spread risk Transparency – financing acitivites are visible and information readily available. Poor performance results in lower share values Corporation are disciplined both by their internal governance systems and by competition in product and factor markets. Weaknesses Separation of ownership and control results in an agency problem Lack of powerful and informed monitors results when the shareholders are widely dispersed Entrenchment incentives – management may invest in protecting their jobs rather than creating value Excessive mandated information disclosure lowers value of proprietary product and strategic information. Agency Theory Risk bearking specialist (principal) pays compensation to a managerial decision-making specialist (agent) “The essence of the Agency Theory is that the Principal has inferior information to the Agent. Moral Hazzard: the principal and agent share the same information up to the point at which the agent takes an action, but thereafter the principal is only able to observe the outcomes. Adverse Selection: the principle does not know some information which is relevant to the action (such as the ability of the agent to perform the task), whereas the agent can make use of this information to his own advantage. Example: any time someone hires an outside consultant or contractor to perform a service for which the principal has no real input/influence that can alter the outcome aside from the directions given to the Agent. Financial Advisor or contractor (construction), Diversification and differences in risk preferences …. The role of the board of directors (formally and actually) The Board of Directors is responsible for hiring, firing, monitoring, and setting compensation of the firm’s managers. They have broad discretion to direct the company’s affairs and is supposed to ensure that the firm in managed in the best interest of shareholders.

Keith Parker, University of Southern California

Documents Shareholder votes are alsoBUAD-497: required to approveCourse corporate mergers, to authorize the sale of major assets, to Page 20 amend the firm’s bylaws, and to authorize the issuance of new equity issues. Directors are frequently selected by management and are beholden to them for their jobs CEO’s are often on the Board which can create accountability problems. Boards too often have poor procedures of evaluation in place, both regarding management and their won performance. As a result, Board’s of Directors often exercise rather little control. Disclosure and shareholder control (formally and actually) Publicly-traded companies are required annually to disclose a great deal of information about corporate earnings, executive compensation, and the ownership of the company’s voting shares. Firms are also required to hold annual shareholders’ meetings that are open to all owners of common stock Prior to these meetings, corporations send out proxy statements to shareholders that describes: The meeting agenda Spells out precisely which issues are to be voted on by shareholders Provides a form for shareholders to use either to vote personally at the meeting or to assign their right to vote to someone else. How corporate control is really exercised… Most corporate elections are usually staid affairs where shareholders are asked to vote for or withhold their vote for single slate of company directors Proxy fights occur when a rival group of shareholders nominate a slate of alternative directors who do not support the current management team. -This is relatively rare due to the expense to shareholders As a result, shareholders often have little opportunity or incentive to actively engage in corporate control. Compensation and stock options (formal and actually) In 2006, avg total compensation of chief executives of S&P 500 companies was $14.78 million. This represented a 9.4% increase in CEO pay over 2005 Performance and compensation have a cloudy connection when it comes to CEO’s Compensation on average was comprised of: Salary (cash): 20% Short term incentive plans (bonus): 20%....usually tied to specific performance measures such as ROI or net profits Long term incentive plans (stock options): 60% Other benefits (insurance, legal, pension…) Underwater options and indexed options Underwater option: an option in which the strike price (price you can purchase stock at) is higher than the current stock price. No reason to exercise option until this situation is reversed. Indexed Options: Indexed options balance a company's relative stock market performance against its absolute gains. Because indexed stock options pay primarily for out performance, they are highly leveraged. This means they require more shares to deliver the same value as traditional stock options Indexed Options strip out market effects. They link an option's strike price to a benchmark such as the S&P 500 or an industry index. Executives are rewarded only for beating the benchmark

Keith Parker, University of Southern California

Course The Market for CorporateBUAD-497: Control and Takeover Defense Documents Page 21 • Board of directors is supposed to act in the interest of shareholders; they decide things such as the hiring and firing of upper-level management. Shareholders must vote on things such as major sales of assets, mergers et cetera • How the corporation controls this: Directors are selected by management, and owe them for their jobs; CEO are very often the head of the boards of directors, causing accountability problems • Boards of directors therefore usually have very little power over companies • Stockholder meeting are usually set up by companies to be intimidating, hard for stockholders to ask questions or make any comments • Voting for directors is usually ‘yes or no’ for a proposed slate of new directors • Shareholders are too fragmented to really put up any fight against current management • The market thus operates when firms face the risk of takeover when they are operated inefficiently. Many firms begin to operate more efficiently as a result of the “threat” of takeover. Hence, the market allegedly acts as an important source of discipline over managerial incompetence and waste • However, it’s an expensive last resort...and often doesn’t work! Predictable Surprise • The learning school theory: remember that you can’t just depend on one core competency and ignore changes in the environment, things change • Externalities will have many effects on business operations, predicting these surprises is an important part of strategic thinking Corporate Crime and Strategic Control Systems, Warning Signs, and how to control it (KPMG guidelines) • White collar crime is a very big problem, yet it is seldom investigated • Most companies aren’t doing very much about the threat of fraud in the business world • Managers often feel enormous pressure to meet financial expectations, and will do a lot to try to meet these numbers, even if some of it is unethical • Company culture has a large effect on the amount of white-collar crime going on • Some warning signs: Kill the messenger attitude in the company; low confidence in accounting statements; employees seldom refer to ethical conduct codes when making decisions; top management ethical statements seem to be just for the public; people who ignore ethics but produce good numbers are promoted • How to control crime: find out what the risks are in your company, address these specifically; make views on fraud known; create a culture that looks down on corporate crime; ensure that internal controls are effective; develop a response plan when fraud comes up; be strict on fraud when it is found • Good news: The majority of consumers will switch to brands/ stores when they are found to be ethical

BUAD 497 Final Study Guide- Scott Exner I. 7-S Framework The 7-S framework is a management model used for internal analysis describing the 7 interconnected factors to: • Organize a company in a holistic and effective way (create alignment among depts.) • Determine “doablility” of strategies • Examine the effects of change on the Org. • Examine functional/dysfunctional aspects of the Org. • • • • •

Strategy – a plan of action to maintain competitive advantage over the competition Systems – measures and actions which accommodate the execution of daily activities Structure – the way the organization is structured, who reports to whom Style – how do you lead? Personal style? Shared Values – company culture, work ethics etc

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• •

BUAD-497: Course Documents Staff – company employees and their capabilities Skills – core competencies of the company as well as that of its staff •

Page 22

Successful strategy implementation requires the alignment of all the seven S’s—fit is just as important inside as outside!

II. Beer’s formula for organizational change and… Δ = f(D•M•P) – C Δ is the effectiveness of change, a positive function of D (dissatisfaction), M (model, or vision), and P (change process) that need to be greater than C (cost of change). III.…Leading organizational transformations

When implementing a new strategy, start with the hard part of operational improvement! Only then make the transition to improving the work environment. IV.Five forces of management and strategy execution

I couldn’t find any info relevant to the graphic provided by Peaches in slides of online. • • •

Many excellent strategies fail because of poor execution Good execution accepts the role of communication and politics Good execution is flexible enough to roll with the punches and builds options into the process è robust action

V. Small world effects, direct/indirect ties, strong/weak ties, and the strength of weak ties •

• • • •

Small World Effects: People know neighbors, distant people, and people at random Small World of Connections (i.e. 6 degrees of Kevin Bacon). The first five random links reduce the path length of the network by half!--> Small World Networks should be everywhere!!! Can be seen in Al Qaeda, Marketing, Connections amongst industry leaders We tend to use “weak ties” (Granovetter) and also friends-of-friends, because they are more likely to have non-redundant information Direct and indirect ties are positively related to innovation Alliance Networks: Access to know-how, contacts, resources expands the size of radar screen and make you detect technological discontinuities, emergent markets, new designs. The position of the firm in the alliance network also determines the propensity to collaborate.

VI.Network foundations of social capital Social capital is a “useful metaphor,” explaining “how people do better because they are somehow better connected with other people- What mechanisms form foundations of? • When focused on a single person, the network is fragile! • As structural cohesion increases, fewer nodes are able to control resource flow within the network. • Power, Information, Norms and Values, Informal Social Control is more uniform for better foundation, less freeriding (Community Character)

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BUAD-497: Course Documents

VII.Structural holes, brokerage and closure, strategic network expansion Structural Holes are contact disconnects- create social capital via brokerage opportunities. Structural holes provide important benefits. • Brokers occupying structural holes earn bigger bonuses • Managers located in structural holes are promoted earlier in their careers • People located in structural holes often have “better ideas” than others Combine Brokerage and Closure:

Strategic Network Expansion was just this lame graphic, basically means build contacts from contacts in different industries I think…

Takeaways: • It is the diversity of contacts that generates social capital—strength in weak ties • Network centrality and structural holes are important for determining power and knowledge flows— both for firms and for your personal experience. Brokers do better! • Social capital and power come from bridges that person can build between others!

Keith Parker, University of Southern California

BUAD-497: Course Documents BUAD 497: Strategic Management Informal Cheat Sheet for the Final Exam Spring 2007 Listed in chronological order: Porter’s 5-Force framework, PEST and SWOT frameworks Porter’s Generic Strategies Hambrick & Fredrickson framework (from “Are you sure you have a strategy?”) BCG and McKinsey matrices Core competency and resource-based view of the corporation VRIO framework Greiner’s model of org. growth and classic growth patterns of firms Organizational structures (simple, functional, divisional etc.) and their relation to strategy Mintzberg’s approach to org. structure Activity Systems and strategy as positioning/configuration/fit Complementarities, tradeoffs, equifinality, fit Game theory, the structure of games, moves to change the game played Basic games such as PD, Chicken, the Dilemma of the Commons Competitor profiling Value chain analysis, including value creation, value division, value added, the value net Standards/network externalities and their role in strategy (open/closed, tactics etc..) Dynamic industries and their effect on strategy Judo and Hardball strategies Design vs. Learning schools in strategy (fallacies, deliberate vs. emergent etc..) Robust action 7-S Framework Beer’s formula for organizational change and leading organizational transformations Five forces of management and strategy execution Small world effects, direct/indirect ties, strong/weak ties, and the strength of weak ties Network foundations of social capital Structural holes, brokerage and closure, strategic network expansion The public company and its strengths/weaknesses Agency theory, moral hazard, adverse selection (think of examples!) Diversification and differences in risk preferences The role of the board of directors (formally and actually) Disclosure and shareholder control (formally and actually) Compensation and stock options (formal actually) Underwater options and indexed options The market for corporate control and takeover defenses Predictable surprise Corporate crime and Strategic control systems Warning signs of deviant org. cultures KPMG’s recommendations on deterring employee fraud

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BUAD-497: Assignments

Professor Fiss Individual Mini Case Analysis BUAD-497: Tuesday-Thursday 12-1:50 PM ID#6390.4899.77

Keith Parker, University of Southern California

BUAD-497: Assignments 1)

The sales growth in McDonalds Coffee of thirty percent over the past year since the

introduction of McCafe has reinforced Sgro’s belief that a bold move into a more dedicated retail coffee offering in McDonalds’ restaurants provides value. Nonetheless, this is not to say that the current success of McCafe has completely solved the problem of McDonald’s lackluster breakfast offering. First, to tackle the issues facing McDonald’s breakfast sales, one must look at the value that these breakfast items bring to the quick-serve breakfast industry. Clearly, McDonalds is an industry leader in providing good-quality products quickly at a low price. The restaurant had continued to offer this value in their breakfast menu, but hadn’t vigorously sought innovative new breakfast items or changes in the menu to match changes occurring in the industry. As a result of this oversight in McDonald’s product management, the fast-food leader was quickly losing ground in breakfast sales to its competitors, namely Tim Hortons. As McCafe brings value to McDonald’s breakfast menu by turning McDonalds into a one-stop-shop for breakfast and coffee, something valued in the industry as seen by the melding of Wendy’s and Tim Hortons as well as others, McCafe does not solve the McDonalds’ breakfast menu’s lack of dynamism. 2)

If McCafe were to be introduced years before the case date, it may have been much

more rare than it actually was at its introduction. The ‘McCafe’ concept had become more of an industry trend than an exception, with many major quick-service retailers offering similar value to McDonald’s McCafe integration. At the time, Tim Hortons had already begun to broaden its breakfast offerings, essentially offering similar value to that provided by a McDonald’s with a McCafe. The advantage McDonalds would have over Tim Hortons in this arena would have been its historically efficient operations; Tim Hortons, though, has challenged this advantage after being purchased by Wendy’s, another quick-service chain that

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BUAD-497: Assignments

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has brought its operating efficiency to Tim Hortons coffee houses. Furthermore, Tricon Global Restaurants, which includes KFC, Pizza Hut, and Taco Bell, had already begun to offer menus from these three restaurants in different combinations under one roof, the success of which has further strengthened the idea that combination restaurants are appealing to consumers. Concurrently, there is strong evidence that multiple offerings under one roof, such as McDonalds and McCafe, are more attractive to consumers than a restaurant that serves only a menu similar to McCafe’s. Nonetheless, McDonalds is not a first mover in implementing this idea, as the industry has already been busy making a trend out of this concept. 3)

McCafe is imitable, to an extent. For the most part, as mentioned in the above

paragraph, Tim Hortons in collaboration with Wendy’s has largely already implemented this concept in their international operations. Other restaurants in the quick-serve industry cannot imitate McDonald’s strategy in a very important way, though. McDonald’s brand image is arguably stronger than any other restaurant, especially the “Mc” branding. Further, McCafe has attempted to differentiate itself with its coffee delivery. While its competitors take a few minutes to make each cup of specialty coffee, McCafe’s machines take only seconds to brew up the same coffee. While this speedy delivery may prove to differentiate McCafe enough for some gain in market share, its competitors are sure to react quickly to this strategy. Other coffee and breakfast providers, such as Tim Hortons, are likely to either switch to these faster machines or advertise that their coffee is made the ‘right’ or ‘original’ way, and that it is somehow more genuine than the mass-produced McCafe coffee. Further, Wendy’s may further promote the strategy they have been using largely in their international restaurants, melding Tim Hortons and Wendy’s together in one restaurant, by bringing this strategy to the Canadian market. While McDonalds’ McCafes may help the restaurant chain to regain some

Keith Parker, University of Southern California

BUAD-497: Assignments market share in the quick-serve breakfast market, competitors are likely to respond with similar offerings or strong product differentiation. 4)

The McCafe concept falls directly in line with McDonald’s organizational structure.

McDonalds has been organized to depend on low-cost largely unskilled labor, quick service, a strong brand image, and overall low product cost to consumers. Further, McDonalds allows consumers to enjoy their orders in a variety of ways: take-out, eat-in, and drive-through. The new McCafes took advantage of these operating efficiencies by utilizing new coffee technology that allows for unskilled workers to quickly brew premium coffee at a low cost to the consumer as per McDonalds’ trademark efficiency. In tandem, customers can order their premium coffee with take-out, drink-in, and drive through, all on the same receipt as their McDonalds breakfast order. As McCafe so closely follows McDonalds organizational structure, the restaurant will have the knowledge in operating efficiency to be a cost leader in the premium coffee industry in Canada. While others, such as Tim Hortons and Wendys, may have similar restaurant structures with menus similar to McDonalds and McCafe, they may not be able to achieve the operating efficiency of McDonalds that allows for such low prices. Therefore, McDonalds will be able to achieve a sustainable competitive advantage in the lowcost quick-serve premium-coffee market that also serves a breakfast menu as a result of its historically strong operating efficiency and strong brand image. Nonetheless, competitors may be able to capture market share by differentiating themselves as more genuine premium coffee servers that don’t use mass-produced machine-made coffee. Further, if Wendy’s were to further integrate Tim Hortons into its operations, it may be able to achieve the operating efficiency of McDonalds and McCafe, therefore diminishing the McCafe competitive advantage.

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An analysis of the steel industry based on Porter’s five forces model reveals that

rivalry is high, due not only to the basic five forces in the industry but also to powerful changes in the global steel market. To begin, the threat of entrants into the steel industry is low. The primary reason for this threat level is due to the high costs of entry. Steel manufacturing mills are extremely expensive to build and maintain, leading to a low level of new entrants into the market, especially given the state of the industry today. Namely, the industry has been blanketed with over-capacity in the United States while it has been experiencing little growth. Therefore, there is little incentive for new players to enter the market, as providing more capacity in the industry would be of little value to buyers. Buyer power, alternatively, is relatively high in some respects but low in others. Overall, buyer power is rated to be medium. On one hand, there are few possibilities for differentiation in the steel industry, lending buyers the power to bid competing steel manufacturers against each other for the lowest possible price. Further, buyers arrive one at a time for purchases, in a sense. In other words, when a buyer is interested in placing an order for steel, steel manufacturers line up all at the same time to bid on supplying the product to the buyer. Therefore, buyers can easily force these undifferentiated steel manufacturers into a bidding war that drives margins down for manufacturers. As H. Aycock, former Nucor chairman and CEO, said, “The key to making a profit when selling a product with no aesthetic value, or a product that you really can’t differentiate from your competitors, is cost.” On the other hand, some companies in the industry have shown an ability to differentiate their steel product in some ways. Although this has been limited, manufacturers such as Nucor have offered services along with their product such as in-house engineering that provides the buyer with a product that is uniquely designed 2

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BUAD-497: Assignments for their use of the product. Conversely, the high transportation costs of steel products lowers buyers ability to bid manufacturers against each other, as the number of manufacturers that can be bid against each other is limited to those within a reasonable proximity of the buyer. Finally, the ability of buyers to backward integrate is limited due to the high barriers to entry into the steel manufacturing industry mentioned earlier. The threat of substitutes in this industry is relatively high. The largest threats are lighter metals and stronger alloys as well as plastics and synthetics. As technology develops, these types of products have been used more and more in applications typically reserved solely for steel, such as the side paneling of new cars. Further, many other consumer products, such as bicycles, are being made from these new materials. While the steel industry clearly has a future with stable purchasers, such as the construction industry, technology has allowed substitute products to become more of a threat to the steel industry than what the industry has seen in past decades. The power of suppliers, like buyers, is rated at a medium level. First, suppliers of the minerals and scrap steel required for steel production aren’t able to demand a very high margin on their products. While the steel itself makes up a significant portion of costs in this industry (sixty percent in the case of Nucor), the mini-mill developed by Nucor has allowed backward integration to eliminate suppliers in some cases and cause low supplier margins in other cases due to the threat of backward integration. The industry’s other primary supplier, employees, have high bargaining power. Many of those employed in this industry are members of unions that demand high wages and benefits, while others who aren’t unionized are paid high wages and given steep benefits in order to compensate for harsh working conditions. The power of employees in this

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industry becomes clear after reviewing their incredibly high wages, which is usually double the average wage in the manufacturing industry in the United States. Rivalry among firms is very high. There are a variety of reasons for this. First, foreign competition made a strong entrance onto the US steel-manufacturing scene and had more of an impact on domestic competitors than it should have. It was found that many of these new entrants were being unfairly subsidized by foreign governments or were ‘dumping’ into the United States. Secondly, the industry has been burdened with overcapacity, leading to intense rivalry among firms. Further compiling on top of this overcapacity are barriers to exiting the industry. These barriers of exit keep firms in the industry that are under bankruptcy protection or that aren’t making a profit on their goods sold. Third, the industry growth rate has been slow in many of the developed nations of the world that are home to competitive multi-national steel manufacturers, leading to intense global competition. All of these factors contribute to the intense rivalry seen in this industry. Overall, the industry is not very attractive in the state that it is currently in. To compete in this type of industry, a firm will do best to challenge the tough powers working against it. Namely, in order to combat supplier power a firm can backwards integrate and automate the production process to reduce necessary manpower. In order to combat threat of substitutes and buyer power, a firm might find a way to differentiate its product by bundling other services with it. To combat intense rivalry, a firm could take advantage of its excess capacity by expanding into developing markets with a higher industry growth rate. 2)

Central to Nucor’s activity system is low cost. As mentioned in the previous

pages, H. Aycock can be directly quoted in saying that cost leadership is essential to the Nucor activity system. Leading to this low cost advantage first is Nucor’s lean 4

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BUAD-497: Assignments organizational structure. Nucor puts a very strong emphasis on keeping executive management limited, with a total corporate staff of less than twenty-five when 1999 began. This is achieved by having a decentralized management system, where very little corporate oversight is present. Managers of individual mills and manufacturing plants are given nearly full autonomy of operations, and operations such as engineering and software development are operated independently in each facility. Further, executives within the company don’t receive the traditional perks usually associated with their position, such as private jets and plush corporate offices. This lends to employee loyalty, lower costs, and a lean company culture. Also important to Nucor’s activity system is their unique incentive-based employee compensation system. With this system, employees are given bonuses based on the amount of production that is reached in a week that is above a standardized production rate. This system leads to increased employee loyalty, decreased employee turnover rates, and more satisfied employees who don’t demand unionization. Although they pay their employees more per hour than the industry average, Nucor’s incentive system leads to a more productive employee base and a strong company culture. This productivity leads to lower product costs, and their more self-reliant employees are able to self-manage in Nucor’s decentralized management structure. Further strengthening Nucor’s activity system, technological innovation adds value to the entire organization. Nucor’s emphasis on technological innovation is strengthened by in-house engineering in each individual facility that caters to the different demands of customers in different regions and industries, which is supported by the decentralized management structure explained earlier. Further, innovation in the firm led to the development of he mini-mill system of manufacturing, which allowed for 5

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backwards integration and lower costs. Other technological innovations included the placement of electric arc furnaces in their mini-mills to increase efficiency and, again, lower costs. In an industry where low costs and local innovations are key to success, Nucor’s activity system has provided these values enough to become a major competitor in the steel manufacturing industry. The four core elements of Nucor’s activity system, an incentive-based employee structure, technological innovation, a lean organizational structure, and low costs, lend to a product that provides a great value to buyers. (See Appendix #1: Nucor Activity System) 3)

One change in Nucor’s organizational structure involved the overcapacity of the

steel manufacturing industry in the United States. As capacity utilization was about seventy-five percent, opening new plants and adding to this over-capacity would not be beneficial. Although Nucor had traditionally opened Greenfield plants, this structure had lost its effectiveness in the current state of the industry. Thus, the firm’s executives decided that they would move towards mergers and acquisitions. The other relevant move by the management of Nucor was the decision to add a level of management to the corporate office staff: four new Executive Vice Presidents and two specialist jobs in strategic and steel technology. The reasoning for this change, as stated by Aycock, was to enable corporate headquarters to get back in touch with independent facilities. Although this move appears to be a clear departure from the companies tried-and-true activity system, it actually falls neatly into their strategy. Specifically, as competition increased and Nucor grew in size, the small corporate office staff began to lose touch with independent facilities. Thus, the entire organizational structure was deteriorating, which led the organizational structure to be not lean but, 6

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more accurately, non-existent. In order to keep the ‘lean organizational structure’ element of their activity system intact, it was necessary for Nucor to keep communication intact and expand the number of employees in corporate operations. 4)

Nucor’s options for future strategies include the option of doing more of the same.

That is, keeping their newly altered organizational structure with a slightly larger corporate staff. Further, mergers and acquisitions would lead their development in the United States. Yet another option for Nucor would be to focus more on expansion overseas, in markets where the steel industry is growing much quicker than in developed markets. This option would allow for Nucor to utilize some of its excess capacity without trying competing in the over-saturated US market. A third option would be to focus on technological innovations that would lower costs and allow for a lower cost to the buyer. I would recommend a combination of two of these strategies. The best option for Nucor is to continue with mergers and acquisitions of other steel-manufacturing firms in the United States, but place more of an emphasis on technological development that would reduce their costs of steel manufacturing. This is best because it allows Nucor to sustain one of its primary and more important competitive advantages as a company: a very productive self-reliant workforce that is able to manage itself. This advantage might not travel internationally, thus Nucor must focus on the domestic market. In order to compete in the domestic market, price must be lowered by technological innovation. Further, in order to grow as a company, mergers and acquisitions must continue in order to develop the company but not add to the over capacity of the US market.

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Non-Unionized Workers

Customized Products

Allows for Backwards Integration

Mini-Mill System

Electric Arc Furnaces

Technological Innovation

No Traditional Perks for Executives

Lean Organizational Structure

Decentralized Management

In-House Engineering Custom to Market

Company Culture Develops Employee Loyalty

Incentive-Based Employee Compensation

More productive and Self Reliant Employees

Low Cost

Appendix 1: Nucor Activity System

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BUAD-497: Group Project 1: Extremist Religious Ideology Al-Qaeda Defined Al-Qaeda is a radical political group driven by an interpretive religious ideology. Literally meaning “the base,” al-Qaeda is the core of an international network of Islamic terrorist organizations. Its goals include eliminating foreign influence in the Muslim world, especially American forces in Saudi Arabia, eradicating those deemed to be infidels, recapturing Jerusalem, and establishing a new Islamic caliphate. Ultimately, it hopes to create Islamic states and build a formidable army with nuclear capabilities to wage war on the Western world.1 Led by Osama bin Laden and Ayman al-Zawahiri, the evolution from a brick and mortar organization to a decentralized global network is transforming terrorism. Appendix ‘A’ provides a timeline of al-Qaeda’s significant events. Their popular ideology makes them a performance and networking leader. Technology is the vehicle inspiring believers to become recruits, willing to sacrifice everything because of a steadfast dedication to the message of al-Qaeda’s ideology. Radical Influence Al-Qaeda’s ideology is a Sunni Islamist movement using the mujahadeen to pursue jihad against the influence of the West. Although the literal meaning of jihad is not directly correlated with the popularized definition as a holy war, the influence of radical religious factions removes all but this military context from the word. The six rules of jihad and the Koran clearly state that deliberate killing of noncombatants is forbidden unless they are conspirators.2 However, modern Islamists, including bin Laden and al-Qaeda’s ideological leader, al-Zawahiri, extend the religious boundaries of interpretation to generate support for their political agenda. They select elements of tradition and modernity to create a unique religious perspective. Al-Qaeda’s leadership

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understands the significance of its ideology as the fundamental core of its global strategy. Implementing a broad platform that appeals to the greater cause of martyrdom rather than targeting specific rules is instrumental to understanding why al-Qaeda is the world’s leader in terrorism. It is important to note that al-Qaeda was conceptualized by Abdullah Azzam, not bin Laden. Azzam was not a proponent of resorting to terrorist tactics because of the grave implications on future negotiations and hopes of peace.3 After his assassination, an act some believe to have been ordered by bin Laden himself, al-Qaeda was free to broaden the appeal of their ideology to attract the widest possible support base. With alZawahiri and other religious scholars at his side, bin Laden used Qutbism and takfir to create an indiscriminate brand of Islam closely resembling the unifying philosophy of Salafism.4 Strong anti-US and anti-Israeli rhetoric engenders a vast support structure across all spectrums of radical Islam, including the second largest Islamist group Hezbollah, a Shia organization. While many terrorist organizations have short life spans due to their specific convictions and confinement to territorial campaigns, al-Qaeda’s underlying goal to bridge the ethnic, cultural and secular divides between Shia and Sunni Muslims for the greater good applies to every Islamist struggle.5 Uniting Muslims as one coherent force fighting the tyranny of the West, al-Qaeda is instilling a locally rooted, yet globally inspired attitude to develop its global influence. Religious Justification Al-Qaeda engenders support from non-radical Muslims because it establishes religious justification for its actions. Bin Laden constantly refers to the will of Allah in both his writings and speeches, leading many to believe that he is carrying out His divine

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BUAD-497: Group Project requests. As the loudest voice in many areas of the Muslim world, he maximizes effectiveness through expansive awareness of al-Qaeda’s mission. Bin Laden released two fatwa’s, one in 1996 and another in 1998 that clearly describe his disgust of American occupation in several Muslim countries and their unilateral support of Israel. More importantly, he provides religious authorization for the indiscriminate killing of Americans and Jews everywhere. 6 Although bin Laden is not a religious scholar worthy of issuing such official Islamic decrees, he rejects the authority of contemporary Islamic leaders and assumes responsibility for directing the jihad against the West. The strength of this ideology lies in its overwhelming acceptance by Muslims of all social classes. Al-Qaeda is the best at reinforcing the glory of martyrdom because of the time and effort spent on training and preparing its operators for the reward of sacrifice. Believing that sacrifice is the ultimate act of allegiance, suicide operators view death as an appealing opportunity to drive fear into the enemy.7 The robust capacity for regeneration is directly attributable to the widespread sympathy and belief in their ideology. However, the most compelling aspect of their religious legitimization is the danger it poses to civilization at large. Widespread politicization of radical ideas allows al-Qaeda to dramatically influence both non-radical Muslims and the West. Spectrum of Islamist Groups The Spectrum of Islamist Groups is a framework separating terrorist organizations by their goals and methods. It highlights the role al-Qaeda’s ideology plays in making it the most feared and powerful terror network in Islamism.8 Unlike other terrorist organizations, al-Qaeda is evolving from segment to segment as it increases its global capabilities and presence. While their core values are revolutionary and ideological, its

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progression from a utopian to an apocalyptic group following the attacks on 9/11 leaves it the world’s foremost authority of terror. The only other group exhibiting such force is the Armed Islamic Group of Algeria (GIA), an organization even bin Laden denounces for its extreme methods. But al-Qaeda’s leveraging its ideology to validate the dramatic escalation of violence opposed to the sheer terror the GIA is inflicting intentionally.9 Just as Hezbollah politicized its popular national movement in Lebanon, al-Qaeda is doing so on the global stage through its complex organization and operations. This carefully crafted ideology threatens both Western and Islamic societies on a scale that reaches far beyond that of traditional terrorism. 2: Decentralized Organizational Structure Vertical Leadership Al-Qaeda’s decentralized organizational structure is guided by strong leadership, the only vertically integrated segment. Bin Laden is al-Qaeda’s emir-general, or head of operations. He provides spiritual council, financial governance and oversees all strategic objectives. Next is the shura majlis who act as the organization’s board of directors. With twenty to thirty members, including the chief lieutenant al-Zawahiri, they monitor strategic, operational and religious issues.10 Al-Qaeda’s leadership are the lines of authority responsible for coordination and guidance. Their insight keeps the organization on a goal-oriented, big picture approach focusing on furthering their ideology. Compartmentalized Operational Committees Below the council are the four operational committees, each led by an emir who reports directly to the shura majlis. These groups include: military, finance and business, Islamic study and fatwa, and media and publicity. It is the duty of the committees and

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regional networks to oversee day-to-day operations and implement al-Qaeda’s specific operations Military The military committee trains, recruits and acquires military resources without disrupting their decentralized structure. Current estimates indicate Al Qaeda camps have trained more than 100,000 Islamist militants, with over 120 camps operating in Afghanistan at the time of 9/11, although they retain only “a small number of militants under direct orders.”11 Organizational success requires constant attention to internal and external changes within an organization’s environment. As Al Qaeda grows, its leadership has reconciled the challenges faced by expansion through self-sufficient and independent terrorist cells. Al-Qaeda created precise training resources, namely the Al Qaeda Field Manual, Encyclopedia of Afghanistan Jihad and the Declaration of Jihad Against the Country Tyrant’s.12 These comprehensive training manuals cover everything from doctrinal values, military principles, recruiting and the importance of teamwork. Discussing issues ranging from assassinating enemy personnel to qualifications for becoming members, these manuals lay out exact directions for how to live a life free from conceptual problems and full of religious principle. Finance/Business Although al-Qaeda is popularly seen as an illegitimate organization, much of its financing is quite legitimate. With many terrorist organizations resorting to illegal activities, including kidnapping and drug trafficking, al-Qaeda focuses on genuine businesses like diamond trading, import/export, construction, manufacturing, transport and financial services. Nonetheless, some funding has been tracked to fraud, currency

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counterfeiting, document forging and wealthy individual supporters through infiltration of various charities and non-governmental organizations (NGO’s). Al Qaeda's financial network is valued at approximately three-hundred million dollars, with annual dispersion between thirty and forty million a year. Organizing collection and distribution are members of al-Qaeda’s finance committee. Professional bankers, accountants, and financiers control the large and diverse supply of funding. An operational doctrine teaches operatives frugal financial behavior, self-sustaining financial tools, deception and denial.13 The entire financial network is built on a base of operationally strong terrorists and networked financiers, allowing it to be extremely adaptive and flexible. Its means of sourcing, hiding, and distributing funds are numerous and complex. Although the US has had some success in freezing funds, the complexity of the organization minimizes the pervasive effect on al-Qaeda as a whole. As of 2004, every Al Qaeda cell carrying out a successful terrorist attack has received its funding from a different source.14 Al-Qaeda’s primary objective is to carry out financial activities that limit record keeping and potential tracking. Focusing on discretion and decentralization, operatives are trained to manage finances, forge documents, participate in credit card scams and hack into accounts. Many cells are expected to be almost fully self-reliant in terms of funding, a slight change in structure that followed the World Trade Center bombing of 1993.15 Al Qaeda cells were required to be too self-sufficient; the operative involved in this attack didn't have sufficient funds for buying enough explosives to do substantial damage to the trade center, nor did they have the funding needed to fly out of America (leading one of the operatives to foolishly return to the dealership for a deposit refund on the van carrying the explosives). Thereafter, a portion of funds raised by individual sects

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BUAD-497: Group Project is pooled for redistribution to groups planning major attacks. As described in Al Qaeda's military training manual Declaration of Jihad Against the Country's Tyrants, the commander of each cell also divides remaining funds into those needed for operational activity and those to be invested for financial return. Through international banking, the Islamic banking system and the underground hawala network, al-Qaeda easily hides funding sources and distribution channels. International banking does not have heavy regulations or authorities to pursue potential terrorist activity. The Islamic banking system suffers from even weaker oversight due to the poor economic state of most developing countries using this construct. Finally, the hawala network is widespread, even in the US, and has no records of transactions or financial systems. The business environment in which Al Qaeda operates contributes greatly to their ability to conceal their methods. 16 Through these frameworks, al-Qaeda raises substantial amounts of funding and redistributes them across the globe, all under the watchful eye of seemingly powerless anti-terrorist organizations and governments. Islamic Law The Islamic Law committee serves as the lightning rod for growth and creating cohesion between its decentralized units. Combining their intangible ideology with various resources, especially human capital, has far reaching effects on expansion. The many “loosely-organized and widely-disbursed movement or ideology comprised of many small and localized "self-generating" terrorist cells and individuals”17 responsible for the bulk of al-Qaeda activities are linked by religious foundations in Islamic Law. AlQaeda roots its battle on the West in the Sharia, or Islamic Divine Law, illustrated by the fatwas placed upon the West. Maintaining a low profile in its role in global terrorism

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without wavering its ideology allows al-Qaeda to maximize its effectiveness. 18 Legitimizing their actions as a struggle for social justice in combination with the power of religious indoctrination is providing al-Qaeda with both rapid growth and continued success. Media and PR This committee molds al-Qaeda’s public image, aiming to garner support throughout the Muslim world and further insight ill-will against the West. Their strategy and methods are discussed in detail in Part 3: Strategic Use of Digital Technologies. Expansive Global Network The remainder of al-Qaeda exists in an intricate global network of independent cells and affiliates. Al-Qaeda’s strong leadership provides financial, logistical, and strategic guidance to an estimated six to seven million radical Muslims worldwide, roughly 120,000 of them willing to resort to violence.19 The ability to draw on countless independent operators at any time makes their options limitless. Using an arms-length network with some strong ties, al-Qaeda’s decentralized structure acts like that of a consulting firm or holding company facilitating communications with its subsidiaries. Most members of al-Qaeda are actually associates without inside access to the organization. Only a special few whose devotion is constantly tested make up the strong ties within the network. Maintaining maximum security and integrity within the organization is the driving force behind this specialized arms-length approach. Much like the compartmentalized committees, cells are designed to be completely self-sustaining and independent of one another. The “family” idea developed in their training camps is the basic construct for members. Each family represents a separate

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BUAD-497: Group Project nationality. From these families, cells ranging from two to twenty people are organized for specific missions. Whether its surveillance, active reconnaissance or a suicide bombing, these teams are well prepared and fully aware of their objectives. The level of trust remains high even among members from different families because of their common bond of being strict believers in the brotherhood of Islam above all else.20 With a horizontally integrated global network, dissemination of information through different groups is done only on a need to know basis, making it very difficult for intelligence agencies to procure tangible amounts of reliable information. As globalization diversifies the world, al-Qaeda understands the need for interconnectivity, but does so only when necessary to maximize efficiency and effectiveness without sacrificing protection. Appendix ‘B’ illustrates al-Qaeda’s organizational structure in a flow chart. 3: Strategic Use of Digital Technologies Technological Web of al-Qaeda Al-Qaeda’s strategy is continuous reinforcement of their ideology while remaining decentralized and anonymous. Utilizing advances in modern technology, alQaeda delivers an unweaving devotion to a universal brand strategy: communicating a single message to all myriad units. They are ahead of the curve in using digital media, namely the internet and satellite broadcasting. Computer technologies and the internet allow the jihadist networks to communicate, spread their ideology, and recruit new members.21 “Terrorist websites have exploded in numbers from a dozen in 1998 to more than 4,800 today. Modern terrorist organizations exploit the internet to raise funds, recruit members, and execute attacks.”22 Because al-Qaeda is so decentralized with vast networks, the use of the internet explains their superior functionality. They stay connected in complicated webs of networks with minimal risk. Many encrypted internet

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sites facilitate communication and interaction with security and privacy, leaving little to no paper trail. As the internet and digital media are developing a 360º approach, making it available everywhere, on every device, at anytime, it is becoming the cornerstone of modern strategic implementation. Such versatile vehicles, al-Qaeda is constantly pushing their ideology on users at every level. Only a computer with internet access is needed to watch and listen to bin Laden himself. The ease and speed of communication is remarkable, especially when considering they are able to raise funds, spread propaganda, recruit members, and execute attacks online. Be it financing, active involvement or mere sympathy, al-Qaeda’s militaristic strategy is deeply impeded in an ideology successfully communicated through digital media. Adoption of these digital communication networks and methods greatly enhance al-Qaeda’s capabilities. Trying to connect an organization’s strategy and structure through a virtual system is an abstract concept. Al-Qaeda is currently deeply rooted in social networking sites, portable programs, and Massively Multiplayer Online Role-Playing Games (MMORPGs). Social Networking Social networking sites enable al-Qaeda to recruit through propaganda of their ideology. Children growing up with computers and the internet are exposed to jihadist sites dedicated to rearing them on violence and hatred towards the US. They also show graphic images of war casualties, video executions, and leader statements. This generation of internet users is more likely to believe in conspiracies and the ideologies of al-Qaeda because of the psychosomatic interaction between the internet and the jihad

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BUAD-497: Group Project ideology.23 Furthermore, user accessibility is increased through free communication services on the internet like Skype and Voice-Over-Internet Protocol (VoIP). Portable Programs Al-Qaeda’s use of technology is nothing short of staggering, especially with the recent discovery of Mujahadeen Secrets by iDefense/VeriSign. Mujahadeen Secrets is a portable program utilizing USB and pen drive technology that does not require installation of applications, allowing them to operate at internet or computer cafés. 24 It is nearly impossible to trace usage of such programs beyond the café itself. The programs are very popular because they are written in native languages, rather than English based sites like YouTube.com. This language system increases user comfort, trust, and understanding, ultimately allowing for easier acceptance of al-Qaeda’s ideology. MMORPGs Extensive research is developing the functionality of MMORPGs in business and military arenas. MMORPGs are a virtual world where users can live in the game almost as realistically as in real life: design their own characters, team with groups, purchase land and other goods, and socialize through VoIPs. Popular MMORPGs are World of War Craft and Second Life. Second Life is more “realistic” than the fantasy-warrior planet of War Craft. “Second Life is a 3-D virtual world entirely built and owned by its residents. Since opening to the public in 2003, it has grown explosively and today is inhabited by a total of 5,231,598 people from around the globe.”25 The threat comes from virtual terrorism. Extreme activists can connect online and implement 3D plans of attacks, gather intelligence, recruit more members, and perform other aspects of communication and networking. Essentially, Second Life allows for an entire world

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without law or prosecution. Extremist groups “activity has included attempts to infiltrate [other] groups, use of virtual weapons, and mass protest rallies.”26 Al-Qaeda seeks to gain the advantage of this technology’s massive global networking capabilities and virtual scenario executions. Al-Zawraa TV On November 14, 2006, al-Zawraa, a 24-hour insurgent station began broadcasting throughout the Middle East.27 This strategically important information outlet is overloaded with propaganda, audio messages from leaders, violence against the Iraq government, and military footage. It is broadcast on a satellite owned by Egypt as a “purely commercial arrangement.”28 On January 26, the signal started broadcasting from a satellite somewhere in Saudi-Arabia. With these types of satellite collaborations, shutting down this station is highly unlikely making the jihad ideology difficult to tune out. The stations long term effects have yet to be measured however its content is viewed as highly credible.29 Importantly, this is another strong communication of al-Qaeda’s ideology and unifying strategy. Craigslist and Decentralization An interesting parallel is the United States concentration on Craigslist as a model for al-Qaeda. Craigslist is merely an online bulletin board that astonishingly receives over five billion hits a month with only 24 employees.30 This is an exemplary model of a decentralized agency whose unifying-internal-message statement has led to vast success. Founder Craig Newmark states: “Decentralized organizations can be more effective and resilient. People who are passionate and can work independently can get more done than a centralized organization.” Key to al-Qaeda’s operations, the leadership does not require

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BUAD-497: Group Project sub cells to report back, rather they are given a strong up front mission (ideology) and are expected to perform independently. The combination of ideology and devotion is so strong that each sub cell functions extraordinarily well. Bin Laden’s message to followers: “I want to kill people and wreak havoc. Don’t check with me, or they will find me. We’ll send money.” Not reporting back also ensures more secrecy and confidentiality of the leaders.31 Like Craigslist, other user-generated sites provide interesting leverage for communication between strangers. Groups sharing an ideology can develop wikis, post videos, and join blogs. There is almost no limit to the ability of a small group to communicate. With the extensive decentralization of Al-Qaeda, they have truly advanced the art of military communication borrowed from innovative business models. 4: Countering al-Qaeda’s Strategy Western Response Following 9/11, the West intensified efforts to capture and destroy al-Qaeda. The invasion of Afghanistan left the Taliban and al-Qaeda’s infrastructure destroyed. Although nearly two-thirds of al-Qaeda’s leadership has been neutralized, failure to capture bin Laden or al-Zawahiri combined with al-Qaeda’s technological prowess leaves them a major threat. The West’s inability to secure quality counterintelligence through state-of-the-art technology underscores the need for a more inclusive strategy. A military campaign alone will not destroy al-Qaeda. The use of satellite imagery, intercepting communications and direct countermeasures to the digital media devices being employed by al-Qaeda is inadequate because of their decentralization, popular ideology and technical abilities. Focusing on these core elements rather than the peripherals of how they spread their ideology is the only way to defeat them. A successful strategy must be a

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fluid and dynamic approach that challenges their ideology and attacks their financial supporters directly. Challenge the Ideology Discrediting their ideology is the most essential element to destroying al-Qaeda. Undercutting their religious legitimacy by revealing their political motivations and hypocritical actions will tarnish their movement. Damaging their reputations as religious figures fighting for Islam will weaken their massive global support structure and create widespread dissension. By working with legitimate leaders of Islam to inform the Muslim world of the true extent of al-Qaeda’s actions, the West will be able to use Islam against them. Unable to undermine their technology, al-Qaeda’s ideology is becoming deeply engrained into the Muslim world. Western forces must challenge this key differentiator in the global arena in order to halt this rapid progression. Until their fundamental ideology is attacked, their cause will always have believers carrying on the fight. Attack Financial Supporters Attacking those that sponsor terrorism through financing or protection is the next phase of reducing al-Qaeda’s global strength. As Colonel Gadaffi told the American’s post 9/11, “If you want to combat terrorism, bomb London and Riyadh.”32 With various individuals donating over $1.6 million a day to Islamic causes via charities and investments in Saudi Arabia, the time to go after those behind terrorism is now. London is the home to many Islamist offices and anonymous financial contributors. Moreover, support from the governments of Iran, Syria and the Sudan to name a few, must be stopped in order to achieve substantial military success. Al-Qaeda must be destroyed from within by attacking their core strengths. Challenging al-Qaeda’s ideology and

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eliminating their major financing and protection sponsors will erode their global network, not to mention helping locate bin Laden and al-Zawahiri. With technology helping to further their decentralization and spread their ideology, a cohesive strategy confronting these crucial aspects simultaneously is the path leading to the ultimate destruction of alQaeda in its entirety.

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Appendix ‘A’: Timeline of Significant Events  ‘80s: Maktab al Khadamat (MAK), led by Abdullah Azzam and Osama bin Laden, is a mujahadeen financing organization used during the anti-Soviet revolt in Afghanistan begins evolving into the organization al-Qaeda.  ’88: al-Qaeda is officially formed under Azzam and bin Laden in response to an outcry for expanding assistance to Islamist struggles throughout the world.  ’89: Azzam is assassinated and al-Qaeda consolidates remaining MAK members that share bin Laden’s point of view.  ’90: bin Laden returns to Saudi Arabia to find the country’s wealthy oil fields vulnerable to Saddam Hussein’s military, who recently invaded Kuwait. Bin Laden offers his mujahadeen army to protect these natural resources, but the Saudi royal family instead allows American forces to deploy from Saudi Arabia.  ’91: bin Laden’s public outcry against the Saudi royal family for allowing them to profane the sacred soil in the land of the two mosques forces him into exile to the Sudan.  ’92: al-Qaeda builds a solid financial infrastructure through legitimate business (construction firms, import/export companies, and farms) and through banking operations to facilitate unfettered growth for several years.  ’93: World Trade Center (WTC) bombing kills six and injures over one thousand.  ’96: bin Laden returns to Afghanistan amidst heavy foreign pressure on the Sudanese government to extradite him. This is when al-Qaeda establishes alliance with Taliban, whose similar outlook on world relations and isolation from the Western world provides them safe haven for training recruits and solidifying the organization’s operations. Issues first fatwa denouncing the American occupation of Saudi Arabia and their support of Israel.  ’98: bin Laden creates World Islamic Front Against the Jews and Crusaders to issue a fatwa authorizing the indiscriminate killing of Americans and Jews across the globe. US embassy bombings in Tanzania and Kenya kill over three hundred.  ’00: suicide attack on the USS Cole stationed in Yemen kills seventeen.  ’01: suicide attack on WTC and the Pentagon on 9/11 kill three thousand people. US led coalition enters Afghanistan and begins attacking Taliban and al-Qaeda.  ’04: over two-thirds of al-Qaeda leadership has been either captured or killed and much of their physical infrastructure is destroyed, but bin Laden and al-Zawahiri remain at large.

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Appendix ‘B’: Organizational Structure Flow Chart

Osama bin Laden Emir-General/Senior Operations Chief

Shura-Majlis Advisory Council

Finance and Business Committee

Fatwa and Islamic Study Committee

Military Committee

Training Subcommittee

Media and Publicity Committee

Camp Administration Subcommittee

Islamic Army (Affiliate Organizations)

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Appendix ‘C’: Glossary Terms: Caliphate: the only form of government fully approved by Islamic theology. It represents the political unity and leadership of the Muslim world. Emir-general: high title of nobility traditionally used in Islamic nations; literally meaning commander or general. Fatwa: a legal pronouncement made by a mufti, a scholar capable of making judgments on Islamic law. Usually made when fiqh (Islamic jurisprudence) is unclear. Families: each family denotes a different country. At the basic level, cells are organized by nationality. Recruitment is made through family, friends or trusted acquaintances. However, for specific operations, families sometimes merge or recruit outside their nationality (i.e. the 9/11 attacks predominantly used the Saudi family, but were led by Muhammad Atta of the Egyptian family). Hawala: informal value transfer system based on performance and honor of a huge network of money brokers. Via a network of hawaladars, or money brokers, customers transfer a sum of money to recipients is other cities under a promise to repay the debt at a later date. There is no legal interference (or protection) and no records of individual transactions. Infidel: one who denies Allah or the Islamic prophet Muhammad; literally meaning “unbeliever” or “one without faith.” Islamism: the idea that Islam is also a political system, as well as a religion. It also refers to groups violently opposed to Western encroachment on their way of life. Jihad: the exertion of one’s utmost effort in order to attain a goal or to repel something detestable in a variety of contexts, ranging from personal to military conflicts. Mujahadeen: term for Muslim fighting in a war or involved in any other struggle; literally meaning “struggler.” Qutbism: radical strain of Islamic ideology and activism inspired by Sayyid Qubt, a leading Egyptian ideologue who believed only followers of his strain of Islam were true Muslims and that furthering the Middle East required the removal of Israel and the Jews. Salafism: a universalistic vision of classic Islam. Viewing Islam in totality, it has no bias against conflicting sects. Its goal is to return Islam to the sublime nature described in the Koran. Sharia: body of Islamic law, it’s the legal framework within the public and some private aspects of life are regulated for those living in a legal system based on Muslim principles of jurisprudence. Shura majlis: a term used by many Sunni terrorist organizations for their top leadership; literally meaning consultative council. Six rules of jihad: 1. jihad is for the sake of Allah, not for the sake of wealth, goods, fame, glory or power 2. obedience to the imam (Arabic for “leader”) 3. avoid misappropriating booty 4. respect pledges of protection 5. manifest endurance under attack 6. avoid corruption

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Spectrum of Islamist Groups: 4 segments of radical Islamic factions: 1. Revolutionary – seek to legitimize violence by advocating and practicing collective decision making, drawing selectively on the Qutbist ideology. (i.e. Egyptian Islamic Jihad, Hamas) 2. Ideological – have a coherent discourse of political violence. (i.e. Hezbollah) 3. Utopian – seek to destroy existing order. (i.e. Abu Sayyaf Group, Libyan Islamic Fighting Group) 4. Apocalyptic – use collective violence but are indiscriminate. (i.e. GIA) Takfir: in Islamic law, the practice of declaring those previously known as Muslims as actual kafirs, or nonbelievers.

People/Organizations: Abdullah Azzam: Palestinian by birth, he was a central figure in the global development of the Islamist militant movement. As a religious scholar, he created an ideology and paramilitary operation to further the cause of oppressed Muslims. His practical approach to recruitment and training combined with his ideology left a lasting impression of bin Laden and was instrumental in establishing al-Qaeda. Armed Islamic Group of Algeria (GIA): Islamic terrorist organization that seeks to replace the existing Algerian government with an Islamic state. Notorious for extreme violence, their methods during the ‘90s resulted in many fellow terrorist organizations, including the Libyan Islamic Fighting Group, Egyptian Islamic Jihad and bin Laden to denounce their overly aggressive actions. However, they stop short of denouncing their ambitions for an Islamic Algerian state. Ayman al-Zawahiri: Egyptian by birth, he is a poet, physician, author and former head of the militant group Egyptian Islamic Jihad. Fluent in English, French and Arabic, he merged his organization with al-Qaeda in ’98 and is a high ranking member of the shura council. It is believed he is the chief lieutenant to bin Laden and also his physician. Al-Zawahiri is credited with much of al-Qaeda’s ideological ideas and military operations. Colonel Gadaffi: although he holds no public office, he is the de facto leader of Libya. Government officials refer to him as the “Brother Leader and Guide to the Revolution.” Hezbollah: a Shia Islamic political and paramilitary group based in Lebanon. It shares similar goals with alQaeda, including the eradication of Western influence and the establishment of an Islamic government in Lebanon. As the second largest recognized terrorist organization, their expertise in bombing buildings has been tapped by al-Qaeda through their unique and truly rare tactical alliance. Osama bin Laden: Saudi Arabian by birth, he is the leader of al-Qaeda. As a member of the prestigious and wealthy bin Laden family, he inherited between $25-30 million following his father’s death. A careful financial planner and shrewd businessman, bin Laden’s skills have guided al-Qaeda to become a powerful multinational organization. His methods are revolutionary, changing the Islamist movement to pursue a global strategy against the West that is justified by two fatwa’s he issued in ’96 and in ’98. One of the FBI’s Ten Most Wanted, bin Laden remains the most renowned terrorist in the world.

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Notes 1

"Al Qaeda." wikipedia Encyclopedia. Jan 2007. 29 Mar 2007 .

2

Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.120-122

3

Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p. 134

4

Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.124

5

Hayes , Laura. "Al Qaeda: Bin Laden's Network of Terror." infoPlease. 29 Mar 2007 .

6

"fatwa." wikipedia Encyclopedia. Jan 2007. 29 Mar 2007 .

7

Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.112-126

8

Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.112-126

9

Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.72

10

Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.55

11

"Al Qaeda." wikipedia Encyclopedia. Jan 2007. 29 Mar 2007 .

12

Sympathy for al-Qaeda Soars in Pakistan, Frontier Star, January 23, 2006. Monday, 350 words

13

Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.60-69 14

Basile, Mark, ‘Going to the Source: Why Al Daeda’s Financial Network is Likely to Withstand the Current War on Terrorist Financing’, Studies in Conflict & Terrorism, 27:3, 169-185 15

Committee on Banking, Housing, and Urban Affairs, Subcommittee on International Trade and Finance, Hawala and Underground Terrorist Financiang Mechanisms: Hearing before the Subcommittee on International Trade and Finance. 107th Congress., 1st sess., 14 November 2001 16

Schramm, Matthias and Markus Taube, Evolution and institutional foundation of the hawala financial system, International Review of Finincial Analysis, Vol. 12 Issue 4, Pages 405-420 17

Signs Point To a Surviving Terror Network, The Washington Post, August 11, 2006 Friday, Final Edition, A Section; A01, 1214 words, Karen DeYoung, Washington Post Staff Writer

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18

"Al Qaeda." wikipedia Encyclopedia. Jan 2007. 29 Mar 2007 .

19

Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.13-14

20

Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.21-71

21

Bernard, Jerome. "Weakened Military, al-Qaeda Fights On-line." Agence France Presse 19 Feb 2007

22

McKenna, Brian. "Sinister Links to a Deadly Network." Times Higher Education Supplement 06 Oct 2006: 25.

23

McKenna, Brian. "Sinister Links to a Deadly Network." Times Higher Education Supplement 06 Oct 2006: 25.

24

Cochran, Andrew. "Internet Security Company Cracks Special Jihadist Software." Internet Blog 26 Jan 2007 02 Apr 2007 .

25

"What is Second Life?." Second Life. 2 Apr 2007 .

26

Cochran, Andrew. "Part II of ‘MetaTerror: The Potential Use of MMORPGs by Terrorists”." Internet Blog 12 Mar 2007 02 Apr 2007 .

27

Grace, Nick. "Al Qaeda TV." Daily Standard 03 Jan 2007:

28

Cochran, Andrew. "Arabsat Begins to Broadcast Insurgent Propaganda Station." Internet Blog 12 Mar 2007 02 Apr 2007 .

29

Cochran, Andrew. "Arabsat Begins to Broadcast Insurgent Propaganda Station." Internet Blog 12 Mar 2007 02 Apr 2007 .

30

Jones, Del. "Can Small Businesses Help Win the War?." USA Today - Final Edition 3 Jan 2007: 1B.

31

Jones, Del. "Can Small Businesses Help Win the War?." USA Today - Final Edition 3 Jan 2007: 1B.

32

Rohan Gunartna, Inside Al Qaeda: Global Network of Terror (New York: Columbia University Press, 2002), p.192

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AL QAEDA Decentralization and the Technological Evolution of Global Terrorism

5: PEACHES Scott Exner · Lizzy Friedman · Keith Parker Mark Kimbrough · Bryan Neff · Matt Zimmerman

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AGENDA 1: Extremist Religious Ideology Al-Qaeda Defined Radical Influence Religious Justification Spectrum of Islamist Groups 2: Decentralized Organizational Structure Vertical Leadership Expansive Global Network Compartmentalized Operational Committees

3: Strategic Use of Digital Technologies Technological Web of alQaeda Social Networking Portable Programs MMORPGs Al-Zawraa TV Craigslist and Decentralization 4: Countering al-Qaeda’s Strategy

1: EXTREMIST RELIGIOUS IDEOLOGY Al-Qaeda: a radical political group driven by an interpretive religious ideology. Goals:  eliminate foreign influence in the Muslim world  eradicate

those deemed to be infidels

 establish

a new Islamic caliphate

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1: EXTREMIST RELIGIOUS IDEOLOGY Extremist Ideology: Sunni Islamist movement pursuing jihad against the West.

1: EXTREMIST RELIGIOUS IDEOLOGY Maximize effectiveness through expansive awareness  Fatwas,

Core of Ideology  Locally rooted…globally inspired  Fundamental  Extend

rhetoric

religious boundaries

2: DECENTRALIZED ORGANIZATIONAL STRUCTURE

video messages, etc.

Robust capacity for regeneration  glory of martyrdom  Spectrum

of Islamist Groups

2: DECENTRALIZED ORGANIZATIONAL STRUCTURE

Vertical Leadership  Emir-General = Osama bin Laden

Compartmentalized Operational Committees

 Shura

 Finance/Business

Majlis (20-30 members)

– Includes: Ayman al-Zawahiri

 Military

– Oversees strategic, operational, and religious issues

 Islamic

 Lines

of authority = goal-oriented

2: DECENTRALIZED ORGANIZATIONAL STRUCTURE Expansive Global Network  Intricate global network of independent cells and affiliates  Arms-length

network with some strong ties

– “family” construct

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 Media

Law

and PR

2: DECENTRALIZED ORGANIZATIONAL STRUCTURE Finance and Business  Sophisticated financial network – Professional Finance Committee – Strict operational doctrine; self-reliant – Adaptive and flexible 

Limit record keeping and potential tracking – – – – –

Frugal financial behavior Self-sustaining financial tools Deception and denial Limited upward communication/ financing Difficulties with this structure

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2: DECENTRALIZED ORGANIZATIONAL STRUCTURE Finance and Business  Redistribution Channels – International banking: fewer regulations & policing authorities – Islamic banking system: weaker than international banking – Hawala network: no records!

2: DECENTRALIZED ORGANIZATIONAL STRUCTURE Military  Military

Committee

 Trains,

recruits and acquires military resources  Decentralized management through Literature and Ideology  Self-sufficient

and independent terrorist cells

 Purposefully

make unnecessarily high number of money transfers

2: DECENTRALIZED ORGANIZATIONAL STRUCTURE Islamic Law  Rooted in “Sharia”- Islamic Divine Law  Lightning

rod for growth

 Cohesion

between decentralized units

STRATEGIC USE OF DIGITAL TECHNOLOGIES Social Networking

Ideology

 Molds

public image of itself and the West  Garner support in Muslim populations

SOCIAL NETWORKING Propaganda of Ideology

Graphic images, videos, and leader statements

Skype & Voice-Over-Internet Protocol (VoIP)

Alignment

Unified Brand Strategy

Al-Zawraa TV

Autonomy

Media and PR

Portable Programs

MMORPG’s

Networks

Craigslist & Decentralization

Technological Web of al-Qaeda

PORTABLE PROGRAMS “Mujahadeen Secrets”

Program on USB – No installation required

Internet cafés

Impossible to trace Children target sites

Native language

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MMORPG’S

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AL-ZAWRAA TV November 14, 2006, al-Zawraa, a 24-hour insurgent station

5,231,598+ global users

Virtual Terrorism

Violence against the Iraq government & military footage

Scenario Executions January 26, 2007 – satellite somewhere in Saudi-Arabia Recruiting Long term effects have yet to be measured however its content is viewed as highly credible

World without laws

CRAIGSLIST & DECENTRALIZATION Online bulletin board - five billion hits a month with 24 Employees

Decentralized internet organization with a strong internal message

4: COUNTERING AL-QAEDA’S STRATEGY  Western  Strategy

Response thus far for Future Success

– Challenge the Ideology – Attack Financial Supporters

Autonomy – no reporting back

User-generation: build wikis and blog

QUESTIONS?

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BUAD 497: Strategic Management

 Prof. Peer C. Fiss  Office: Bridge Hall 303-B  Telephone: (213) 821-1471  Email: [email protected]  Office Hours: Wednesdays 2-4 pm, or by appointment  Sections 15102, 15107, 15112

Class 1: Introduction to Strategy

 Class Introductions  Who am I 

Why this class What will you learn



How will we operate



 What is Strategy?

My Own Background German citizen Where I grewof up…companies, including Worked for a number Mannesmann and DPD Ph.D. in Management and Sociology from Northwestern University (Kellogg School of Management) Appointments at Queen’s University and USC Published in a variety of top academic journals Taught courses on strategy and corporate governance at the undergraduate, MBA, and executive level Some of my research interests  Corporate governance  Executive compensation  Strategic change

Why this class? Strategic Management is intended to be a challenging and exciting capstone The primary objective of this course is to introduce you to the analysis and formulation of strategic problems and decisions facing managers and leaders. The material in this course is designed to be as “real world,” relevant, and interesting as possible. I hope this course will be one of the most useful you have ever had and that it will be instrumental in helping to make you more successful in your career

What will I teach?

This class will focus both on the making and implementation of business strategy

How will we operate?  Mix of theory and cases  Current events  Performance evaluation      

Contribution to class discussion (15 %) Individual mini case analysis (10%) Individual midterm case analysis (20 %) Group project presentation (10%) Group project writeup (20%) Individual final exam (25%)

 Course packet available from Campus Bookstore – there is no textbook  Come prepared

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Other Administrative Stuff…

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What is Strategy…?  A preliminary definition:  A company‘s strategy is the ‚game plan‘ management has for positioning the company in its chosen market arena, competing successfully, pleasing customers, and achieving good business performance. (Thompson/Strickland 1998)  Strategy-making efforts must aim at producing a good fit between a company‘s resource capability and its external situation

Basics of Strategic Management  Four aspects that set strategic management apart

Why is strategic management important?

Makes a difference in performance levels

 Interdisciplinary  capstone course

 External focus  Competition and the nature of the business landscape

Provides systematic approach to uncertainties and business challenges

 Internal focus  Firm competencies, strengths and weaknesses

 Future direction

Coordinates and focuses employees

 Where are we going and how is the marketplace developing?

Who does strategy?  The Role of the Board of Directors

 Elected representatives of the company’s stockholders  Legally obligated to represent and protect stockholder’s

 The Role of Top Management

 Responsible for decisions and action of every employee  Providing effective leadership

 Other Organizational Employees

 Implement—put the strategies into action and monitor performance  Evaluate—do the actual evaluations and take necessary actions

A Short History of Strategy HBS requires a class in Business Policy in 1912 Adam Smith’s “invisible hand” (the market) gives way to Alfred Sloan (GM CEO from 1923-1946) concept of the “visible hand”—middle manager Chester Bernard influential book “The Executive” argues that managers should pay attention to “strategic factors” Ronald Coase’s 1937 article “why firms exist” (Nobel Prize in economics) and Joseph Schumpter’s concept of “disruptive technologies” written in 1942 bring in organizational economics

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Historical Overview: From Planning to SM

Historical Overview: From Planning to SM

  Phase: Planning (1945-1960)

 2. Phase: Long-Range Planning (1960-1973)

 Only budgeting. If you focus on financial aspects and controlling, you will be able to plan and forecast.  Order optimization  Operations research

 Operations researchers aim to integrate the firm into one single model  But then…main external shock: Oil crisis of 1973, increases demand for forecasts

Historical Overview: From Planning to SM  3. Phase: Strategic Planning (1973-1980)  Before: Main focus on past and extrapolation to the future.  Now: What can we learn from the oil crisis? Do we have to accept such external shocks? Are we able to predict them?  Change of perspective: How can we analyze future chances and risks?  Oil shock was located outside the company, therefore main focus changed to the environment. What is the environment asking for?  Are we able to handle and to meet these requirements?  Important Research: Strategic Issue Management, Strategic Surprise Management (Early Warning Systems by Krystek/MüllerStewens / Weak Signals by Ansoff)

Historical Overview: From Planning to SM

 5. Phase: New Organizational Types…?       

“Knowledge workers” “Complexity science” “Virtual organizations” “Network forms of organizing” “Adaptive teams” “Virtual markets” “Boundariless organizations”

Historical Overview: From Planning to SM  4. Phase: Strategic Management (1980- about now)

 Globalization strengthens the customer‘s position.  Interconnections between firm and environment are getting more and more intensive. In many industries, there is a necessity for permanent change and innovation.  Focus on social sciences and “human factor”: A company can only implement a strategy if it is accepted by all members.  So called “soft factors” are more Important: personnel, organization, culture.  The organization has to be more open for cooperation and integration. Congruence model becomes dominant. 

(1980: Strategic Management Journal and Journal of Business Strategy)

Historical Overview: From Planning to SM  A Central Idea of Strategic Management:  “Fit” between the elements of the system (Intra-System-Fit), focus on structure, culture, and behavior.  Chandler (1962): Strategy and Structure > „Structure follows strategy“  Ansoff (1965): Corporate Strategy > “SystemEnvironment-Fit“  Basic hypothesis: environment, external strategic behavior, and the internal ‚structure‘ are interrelated

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Strategic Management Process

Analyzing Current Situation

Deciding on Strategies

Putting Strategies in Action

Evaluating and Changing Strategies

Situation Analysis

Strategy Formulation

Strategy Implementation

Strategy Evaluation

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Key Takeaways

Fast Paced Class…come prepared! Where strategy came from What strategy is Know the basic strategic management process

Preview for Class 2

Preview Case of interaction between firm actions and industry landscape Prepare the assigned readings (Porter, Intel case; see syllabus and course website)

Fill out the personal information sheet on the course website

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BUAD-497: Powerpoints

BUAD 497: Session 2

Preview Case

Agenda for today

• Administrative items • Case Discussion: Intel Corporation

Learning goals for this session

• Understand how the industry landscape influences a firm’s opportunities for growth • See how strategic choices at the firm level matter • Examine the nature of the competitive landscape and how it can be shaped • Connect strategy and the creation of value for firms

Intel Corporation: 1968-1997

Intel Corporation: 1968-1997

• What was Intel’s strategy in DRAMs? • What accounts for Intel’s dramatic decline in market share in DRAMs between 1974- 1984?

Up Through 286

386 and Later

Licensee

PC Manufacturer

Licensee

• What strategy did Intel use to gain a competitive advantage in microprocessors?

PC Manufacturer

Intel

IBM

Intel

PC Manufacturer

Licensee PC Manufacturer

Licensee PC Manufacturer

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Intel Corporation: 1968-1997

• What threats has Intel faced in sustaining this competitive advantage? • How did Intel deal with each threat?

Intel Corporation: 1968-1997

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Intel Corporation: 1968-1997

• Why has Intel been able to sustain its advantage in microprocessors, but not in DRAMs?

Key Takeaways • Industry landscape strongly influences a firm’s opportunities for profit—microprocessors are a more fertile landscape to achieve high profits

• Intel and Internet: New Challenges

• Strategic choices at the firm level matter—Intel exploited that landscape to its benefit • Firms can shape the landscape—Intel shows how firms can affect the competitive landscape • Strategy is about value appropriation as well as value generation—you have to capture value or someone else will • Capabilities as a source of sustainable competitive advantage

Next session: Industry Analysis I

• Prepare Porter “The structural analysis of industries” • Prepare Hambrick and Fredrickson “Are you sure you have a strategy?”

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BUAD 497: Session3

Industry Analysis: Issues and Tools

 Learning goals for this session

 Industry Analysis I

Industry and competitive analysis

 Know how industry analysis fits into strategy formulation  Know the general tools for industry analysis— be an informed consumer  Know Porter’s model for industry analysis and be able to apply it on your own  Understand Hambrick & Fredrickson’s model of strategy and be able to apply it on your own

Profitability Differences Across Selected Industries (Ghemawat, Rivkin, 1999)

 “When an industry with a reputation for difficult economics meets a manager with a reputation for excellence, it is usually the industry that keeps its reputation intact.” (Warren Buffet)

Profitability Differences Within the Pharmaceutical Industry (Ghemawat & Rivkin, 1998)

Profitability Differences Within the Airline Industry (Ghemawat & Rivkin, 1998)

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A Three-Dimensional Business Landscape (Ghemawat, 2001)

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What is causing the industry to change? An Example

 "An Update on Moore’s Law“ 

Industry Importance: Empirical Evidence

Moore’s Law 

Rumelt, R. (1991). How much does industry matter? Strategic Management Journal, 12: 167185.



"To the extent that accounting returns measure the presence of economic rents, the results obtained here imply that by far the most important sources of rents in … manufacturing businesses are due to resources or market positions that are specific to particular businessunits rather than to corporate resources or to membership in an industry. Put simply, business units within industries differ from one another a great deal more than industries differ from one another.”

Industry Importance: Empirical Evidence

How much does industry matter? Rumelt (1991)



McGahan, A., Porter, M. (1997). How much does industry matter, really? Strategic Management Journal, v18, pp. 15-30.



“We also find that the importance of the effects differ substantially across broad economic sectors. Industry effects account for a smaller portion of profit variance in manufacturing but a larger portion in lodging/ entertainment, services, wholesale/retail trade, and transportation.”

Approximate Effects on Variance in Return on Capital: Variable

% of Variance Explained

Corporate Effects

0.8%

Stable Business Effects

8.3%

Stable Business-Unit Effects

46.4%

The observation made in 1965 by Gordon Moore, co-founder of Intel, that the number of transistors per square inch on integrated circuits had doubled every year since the integrated circuit was invented. This is the current definition of Moore's Law, which Moore himself has blessed. Most experts, including Moore himself, expect Moore's Law to hold for at least another two decades.

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How much does industry matter?

Industry Analysis: Basic Issues

Porter & McGahan (1997)

Approximate Effects on Variance in Return on Capital: Variable

% of Variance Explained

Year

2%

Industry

19%

Corporate Parent

4%

Business Specific Effects

32%

 What does this industry look like?  What are the major competitive forces?  What are the trends?

 What does it take to do better than average in this industry?  What are the sources of sustainable competitive advantage?

Porter’s Five Forces 

 

Michael E. Porter is the Bishop William Lawrence Professor Professor, based at Harvard Business School where he leads the Institute for Strategy and Competitiveness

(1980): Competitive Strategy, Free Press, New York (1990): What is Strategy?, Harvard Business Review

 Framework used to assess the competitive position of a firm within an industry  Uses five forces or variables to measure competitive advantage  Assumes continuous downward pressure of competition  Points to interdependencies between factors  Interaction  Substitution

Industry Rivalry Porter’s Five Forces Model

 Intense rivalry among firms in an industry reduces average profitability.  Rivalry is impacted by

Threat of Entry

Supplier Power

Rivalry

Buyer Power

    

industry growth product differentiation number of competitors competitor diversity exit barriers

Threat of Substitutes

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What causes rivalry to be strong or weak?  Number and relative size of competitors  Concentration ratio = % of total industry sales accounted by the 4 largest firms  Logging = 18%  Cigarettes = 85%

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What causes rivalry to be strong or weak?  Herfindahl Index - a measure of the balance in an industry

 Example: 3 firms with market shares of 0.50, 0.25, 0.25  H = ((0.50)2+(0.25)2+(0.25)2) = 0.25 + 0.0625 + 0.0625 = 0.375  H of 0 ➔ Perfectly Competitive  H of 1 ➔ Monopoly  H > 0.18 ➔ Relatively high concentration, i.e. industries with reduced rivalry

2. Buyer Power  Size and concentration of customers

Buyer Power  The power of buyers is determined by factors such as buyer concentration, switching costs, and backward integration  Buyers are powerful if  Buyers are large and concentrated (government purchases from defense contractors)  Credible threat of backward integration (large auto manufacturers and small parts suppliers—classic Fisher auto body case)

 Buyers are weak if  Buyers are fragmented (most consumer products)  Producers supply critical parts (Intel’s relationship w/ PC manufacturers)

3. Supplier Power  Differentiation  Switching Costs

Supplier Power  Bargaining power is based on factors such as number of suppliers, switching costs, and presence of substitute inputs  Suppliers are powerful if  Suppliers are concentrated (drug industry’s relationship with hospitals)  Significant cost to switch suppliers (Microsoft’s relationship with PC manufacturers)

 Suppliers are weak if  Standardized product with many competitive suppliers (tire industry’s relationship with auto manufacturers)  Concentrated purchasers (garment industry’s relationship to major department stores)

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4. Threat of Substitutes

Threat of Substitutes  In Porter’s model, substitute products refer to products in other industries (Pepsi is not a substitute for Coke!)  A close substitute constrains the ability of firms to raise prices (e.g. aluminum can maker is constrained by price of glass bottles, steel cans, and plastic containers)

 Price to Performance Ratios  Switching Costs

 Factors that affect substitutes:  Price/Performance tradeoff  Switching costs  Substitute improvement

5. Threat of Entry

Threat of New Entrants  Ability of new firms to enter market is determined by factors such as:    

Minimum Efficient Scale

Unit Costs

Entry Point

MES

Volume

absolute cost advantages government policy economies of scale brand identity

Entry Barriers  Patents - pharmaceuticals  Licensing - physicians, lawyers physicians, lawyers  Laws - product standards, corporate crime  Tariffs  Geographic advantages - Panama or Suez canal  Language or culture - publishing in many countries

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A Toolkit fir Industry Analysis

So, what’s missing from Porter’s model…?

(from Macro to Micro)

PEST (or STEP)  Political/Economic/Socio-cultural/Technological

Threat of Entry

Porter’s Five Forces SWOT Supplier Power

Buyer Power

Rivalry

 Strengths/Weaknesses/Opportunities/Threats

Value Chain Analysis Threat of Substitutes

SWOT

But how well does SWOT work?

 SWOT stands for Strengths, Weaknesses, Opportunities, and Threats Now/Internal

Future/External

Assets

Strength

Opportunity

Liabilities

Weakness

Threat

 Research has shown that managers view opportunities and threats differently  But almost any future event can be framed as either an opportunity or a threat.  Likewise, most strengths entail corresponding weaknesses, and vice versa.  Thus, SWOT mostly tells you about yourself, not your environment…

Hambrick & Fredrickson: Do you have a strategy?  Strategy: “central, integrated, externally oriented concept of how we will achieve our objectives”  Five elements:     

Where will we be active? (arenas) How will we get there? (vehicles) How will we compete? (distinctive properties) What speed and sequence of moves? (staging) Where will profits come from? (economic logic)

An Example: GE Transportation Systems -Locomotives Staging

Arenas

1: • New Model X by Year 2 • Push very aggressively in Latin America and Asia • Sign Eastern Europe JVs 2: • New Model XX by Year 4 • Push aggressively in Africa Throughout: • 5% annual productivity gains • Wait-and-see in Western Europe

Arenas

Staging

Economic Logic

• Diesel • Emphasize long and heavy hauls (including industrial and mining) · Americas, Asia, Middle East, Africa Vehicles · Limited defensive position in Europe

Differentiators

Differentiators

Vehicles • Wholly-owned subs with extensive service sites • Selective JVs in Europe (including Eastern/Central)

• Service • Mileage/operating efficiency • Safety • Operator comfort/ergonomics

Economic Logic • Premium prices for superior product and service • Lowest diesel manufacturing costs (Erie factory) 9

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Hambrick & Fredrickson: Key Evaluation Criteria 1. Does your strategy fit with what’s going on in the environment? 2. Does your strategy exploit your key resources? 3. Will your envisioned differentiators be sustainable? 4. Are the elements of your strategy internally consistent? 5. Do you have enough resources to pursue this strategy?

Key takeaways – Industry analysis  Industry matters; know your toolkit for understanding the constraints it poses upon you  Porter’s model is useful for making sense of industry dynamics, but it has important shortcomings; know the blind spots  Don’t take your industry for granted—the definition matters!  Make sure you have a strategy and that its elements reinforce each other

Next class

 Prepare CF Motorfreight Case  Be sure to have handed in the complete personal information sheet (w/ your picture…)

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BUAD 497: Session 4

Industry Analysis II

Learning goals for this session

Administrative Stuff

 Group projects  Other stuff…

CF MotorFreight in 1992

 Apply the tools for industry analysis to a classic industry  Build a deeper understanding of industry dynamics  Connect this to strategy formulation

 Why is it so difficult to make money in the LTL trucking business?

CF MotorFreight in 1992

CF MotorFreight in 1992

 How well positioned is CFMF in the LTL business? How should we evaluate their strategy for this industry?

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 As Bob Lawrence and Don Moffitt, what are your options for solving these competitive problems?

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CF MotorFreight: Update  CF spun off its unionized trucking business and called it CFC  Performance continued to deteriorate  CFC’s competitors such as Roadway Express, Yellow, and Arkansas Best remained profitable  The regional trucking units kept cannibalizing CFC’s business  In May 2002, the board replaced the CEO with a turnaround specialist  CFC filed for bankruptcy September 3, 2002

Your Essential Choice of Strategies

Product Innovation

Price Strategies

What matters most…!

Price Unit Margins

Net Income Return On Investment

Divided By

Assets Managed

Cost

Times

Market Share Unit Volumes

Market Size

Key Takeaways

Product Quality Marketing Effort

Margin

Process Innovation

Cost Strategies

Functional Efficiency Integration

Net Income

Marketing Effort Market Share Strategies

Customer Value

 Industry analysis is a powerful tool for analyzing strategy; it can show what opportunities exist in the environment  A deeper understanding of industry dynamics protects you from simplistic strategies that often get you into trouble

Barriers to Entry

Volume

New Products Market Size Strategies

New Markets More Useage

Next session: Industry Analysis III

 Prepare Apple Inc.: iPods and iTunes case  Begin planning for your group projects

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BUAD 497: Session 5

Industry Analysis III

Apple Computer Inc: iPods and iTunes

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Learning goals for this session

 Use several tools for industry analysis in a dynamic industry  Examine factors that contribute to dynamic industry change  Begin to think about strategy formulation under uncertainty

Apple Computer Inc: iPods and iTunes

 How attractive was the music industry traditionally for the recording companies?

Apple Computer Inc: iPods and iTunes

 How has the attractiveness of the industry changed with the entry of Napster?

Apple Computer Inc: iPods and iTunes

 What was Napster’s strategy and how did it evolve over time?

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Apple Computer Inc: iPods and iTunes

 What was Apple’s strategy as it relates to the music industry?

Four Levels of Uncertainty in Strategic Planning Clear-Enough Future

Alternate Futures

A Range of Futures

True Ambiguity

What can be known?

A single, forecast precise enough for strategy

A few discrete solutions that define the future

A range of possible outcomes, but no natural scenario

No basis to forecast the future

Analytic Tools

Classic industry and strategy analysis tools

Decision analysis; Game Theory; Option valuation models

Latentdemand search; Scenario planning

Analogies and pattern recognition; Nonlinear dynamic models

Examples

Strategy against entrant in the mining industry

Entry into deregulated local phone market

Entry into emerging markets such as India

Entry into the Russian market in 1992

Apple Computer Inc: iPods and iTunes

 As Apple, what should be your strategy going forward?

Key Takeaways

 Companies must look broadly at the economics and forces of the industry. Think about the power constellations and how they are likely to change  Good strategies are coherent, build on existing advantages, and exploit industry landscape. That’s what Apple did  There is a big difference between having a product advantage and having a competitive advantage. Product advantages alone are difficult to sustain  Uncertainty is critical to strategy making, and there are tools to deal with different levels of uncertainty

Source: Courtney et al, Strategy under Uncertainty, HBR 1997

Next session: Firm Competencies I

 Prepare Hill and Jones chapter “Internal Analysis”  Go to the USC and Marshall homepages and study the strategic framework for USC and the Dean’s message for Marshall

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BUAD 497: Session 6

 Firm Competencies I

Learning goals for this session

 Examine the RBV and role of core competencies in building competitive advantage  Understand how a Resource-based View (RBV) of the firm works and how it differs from the IO view  Apply both frameworks to conduct a strategic analysis of USC and Marshall

A Comparison: GTE vs. NEC in 1980

 GTE  Sales 9.98B  Active in telecommunications  Positioned in display technologies  Net cash flow 1.73B

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And eight years later… GTE vs. NEC in 1988

 NEC

 GTE

 NEC

 Sales 3.8B  No telecom experience  Comparable technological base

 Sales – 16.46B  Closed down semiconductors  Divested much of their display business  Telephone operating company  Moved other areas into joint ventures

 Sales – 21.89B  World leader in semiconductors  First tier player in telecommunications  Included lifestyle products – mobile phones, fax, notebooks

GTE’s Strategy: A Portfolio of Businesses  No clear strategic intent or commitment  Significant work to identify key technologies, but little coordination among business units  Decentralization and outsourcing made GTE increasingly dependent on outsiders for critical skills

NEC’s view of changes in the 1980s  NEC identified three interrelated streams of technological and market evolution  Computing would evolve from Main Frame to distributed processing  Components from ICs to VLSI  Communications from mechanical to digital

 → Semi-conductors would become the ‘Core Product’

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NEC’s Strategy: A Portfolio of Competencies  Exploit the convergence of computing and communications – C&C  Communicated its intent to the whole organization  Shifted resources between units to support components and processors

GTE vs. NEC

Portfolio of Businesses

vs.

Portfolio of Competencies

The Strategic Implications of the BCG Matrix

The BCG Portfolio Matrix  Stars

 Aggressive investments to support continued growth and consolidate competitive position of firms

 Question marks  Selective investments; divestiture for weak firms or those with uncertain prospects and lack of strategic fit

 Cash cows  Investments sufficient to maintain competitive position. Cash surpluses used in developing and nurturing stars and selected question mark firms

 Dogs  Divestiture, harvesting, or liquidation and industry exit

The McKinsey/GE Matrix

The Corporation as a Portfolio of Core Competencies

Source: G. Hamel and C. K. Prahalad, Competing for the Future (Cambridge, Mass.: Harvard Business Sc hool Press, 1994), p. 227.

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Core Competencies and the RBV: What is the company good at?

Two Concepts of the Corporation

Basis for competition

Portfolio of Businesses

Portfolio of Competencies

Product competition based on today’s products

Interfirm competition to build competencies

Corporate structure

Portfolio of businesses related in product-market terms

Portfolio of competencies, core products and businesses

Status of the business unit

Autonomy is central; the SBU “owns” all resources other than cash

SBU is a potential reservoir of core competencies

Resource allocation

Discrete businesses are the unit of analysis; capital is allocated business by business

Businesses and competencies are the unit of analysis; top management allocates capital and talent

Value added of top management

Optimizing corporate returns through capital allocation tradeoffs among businesses

Building strategic architecture and competencies to secure the future

 Core competencies are a source of competitive advantage  They make a company distinctive

 Competencies = Resources and Capabilities  Resources  tangible and intangible assets of a firm » tangible: factories, products intangible: reputation  four general categories: financial, physical, human, organization

 Capabilities  proficiencies that that enable a firm to take full advantage of other resources » marketing skills, cooperative relationships

Examples: Distinctive Competencies



Low-cost, high-quality manufacturing capability and short design-to-market cycles

Intel 



Competencies At Marks & Spencer

Toyota, Honda, Nissan 



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Marks & Spencer

Ability to design and manufacture ever more powerful microprocessors for PCs

Motorola 

Defect-free manufacture (six-sigma quality) of cell phones Adapted from Exhibit 3.5 M arks & Spencer: How Resources and Capabilities Lead to Advantages, with permission of Harvard Business Review: Exhibit from “Competing on Resources: Strategy in the 1990’s” by D. J. Collis and C. M ontgomery, 73, no. 4 (1995).

The Resource Based View (RBV)

IO vs. RBV

Some Authors:

Porter, Rumelt

Industrial Organization (IO)

Resource Based View (RBV) Barney, Wernerfelt

Focus:

External—describes environmental conditions favoring high levels of firm performance

Internal—describes firm’s internal characteristics and performance

 Two critical assumptions of RBV:  Resource Heterogeneity  differences in resources among similar firms

 Resource Immobility  costly for firms to acquire

 What do these assumptions mean?  If one firm has resources that are valuable and other firms don’t AND if other firms can’t imitate these resources without incurring high costs, THEN the firm possessing the valuable resources will likely gain a sustained competitive advantage

Assumptions: Firms within an industry have identical strategic resources Resources are highly mobile (easily bought and sold) and therefore homogeneous

Firms have idiosyncratic, not identical strategic resources Resources are not perfectly mobile and therefore heterogeneous

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The VRIO Framework

Applying the VRIO Framework The Question of Value

If a firm has resources that are… • valuable, • rare, and • costly to imitate, and… • the firm is organized to exploit these resources,

…then the firm can expect to enjoy a sustained competitive advantage

Applying the VRIO Framework

 In theory: Does the resource enable the firm to exploit an external opportunity or neutralize an external threat?  The practical: Does the resource result in an increase in revenues, a decrease in costs, or some combination of the two? Levi’s reputation allows it to charge a premium for its Docker’s pants

Applying the VRIO Framework

The Question of Rarity  If a resource is not rare, then perfect competition dynamics are likely to be observed (i.e., no competitive advantage, no above normal profits)  A resource must be rare enough that perfect competition has not set in  Thus, there may be other firms that possess the resource, but still few enough that there is scarcity Several pharmaceuticals sell cholesterol-lowering drugs, but the drugs are still scarce—look at prices

Applying the VRIO Framework The Question of Imitability

Valuable and Rare If a firm’s resources are… Not Valuable

Competitive Disadvantage

Valuable, but Not Rare

Competitive Parity

Valuable and Rare

Competitive Advantage (at least temporarily)

Costs of Imitation  Unique Historical Conditions  First mover advantages  Path dependence

 The temporary competitive advantage of valuable and rare resources can be sustained only if competitors face a cost disadvantage in imitating the resource

 Causal Ambiguity

 intangible resources are usually more costly to imitate than tangible resources and bundles of resources are more costly than single resources

 Social Complexity

Harley-Davidson’s styles may be easily imitated, but its reputation cannot

…the firm can expect:

 Causal links between resources and competitive advantage may not be understood  Bundles of resources fog these causal links

 The social relationships entailed in resources may be so complex that managers cannot really manage or replicate them

 Patents

 Offer a period of protection if the firms is able to defend its patent rights  Can be a two-edged sword as firms disclosure may decrease costs of imitation by other firms

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Applying the VRIO Framework The Question of Organization  A firm’s structure and control mechanisms must be aligned so as to give people ability and incentive to exploit the firm’s resources  Examples: formal and informal reporting structures, management controls, compensation policies, relationships, etc.  These structure and control mechanisms complement other firm resources—taken together, they can help a firm achieve sustained competitive advantage 3M Company – rewards innovation and risk-taking

Competitive Dynamics of Resource Imitation

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The VRIO Framework Costly to Exploited by Competitive Valuable? Rare? Imitate? Organization? Implications No

No

Yes

No

Yes

Yes

No

Yes

Yes

Yes

Yes

Economic Implications

Disadvantage

Below Normal

Parity

Normal

Temporary Advantage

Above Normal

Sustained Advantage

Above Normal

Source; Adapted from J. Barney, “Firm Resources a Sustained Competitive Advantage, ‘ Journal of Management 17 (1991), pp. 99-120.

Case Study: USC/Marshall

Competitive Dynamics  The strategic decisions and actions of firms in response to the strategic decisions and actions of other firms Firm B’s Possible Responses Firm A (strategy decisions lead to competitive advantage)

No Response Change Tactics Change Strategy

Key Takeaways

 While traditional factors used to be important, knowledge-based core competencies are increasingly important in the new business landscape  Internal strategic analysis aims to integrate the firm’s specific strengths to maximize advantage  Know the VRIO framework for understanding how to achieve and sustain competitive advantage  Core competencies can become core rigidities

Next class: Firm Competencies II

 Examine the role of corporate headquarters in acquiring and developing competencies  Prepare PepsiCo case

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BUAD 497: Session 7

Firm Competencies II

PepsiCo’s Restaurants

Learning goals for this case

 Use the RBV to understand what PepsiCo should do  Examine how we can achieve coordination among businesses to exploit competencies  Examine the relationship between corporate vs. business unit strategy and trade-offs between autonomy and coordination

PepsiCo’s Restaurants

 Should PepsiCo acquire CoC and CPK?

PepsiCo’s Restaurants

PepsiCo’s Restaurants

 Given PepsiCo’s strategic goals, where should CoC and CPK be placed in the PepsiCo structure?

 How could PepsiCo be re-structured to improve coordination and synergy?

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PepsiCo Restaurants: Update  Pepscio made both acquisitions. They took a 51% ownership with agreements to buy out the rest over time, conditional on performance.  CPK and CoC were left as independent companies reporting to VP Strategic Planning (Ken Stevens) and one or two restaurant presidents  CoC was reconceived as a design and marketing company, with production outsourced  CPK has rolled out more stores nationwide, using the funding from PepsiCo

Key Takeaways  Be able to analyze what actions create competencies and how they affect corporate strategy  PepsiCo: clear example of benefits of sharing and coordination at the corporate level (you can’t get much more related than three fast food restaurants…!)  But even here: tradeoff between autonomy and growth!  You can create value through fairly independent divisions—the question is, can coordination create even more?

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PepsiCo Restaurants: Update (Cont’d)  

 



However, 1994 operating profits from restaurants fell 6% Pepsico Vice-Chairman Roger Enrico’s goals are to return to profitable growth by tying together business functions across the chains, including accounting, billing, and purchasing to cut costs, and reducing the number of company owned stores. In 1997, PepsiCo spun off its restaurants as Tricon, renamed Yum! in 2002. Yum! focused on generating concentrated efficiencies under a single brand, sometimes placing two or three brands into a single restaurant; sales have increased considerably, though still less than at McDonalds Growth has been impressive in China, with operating profits rising from $20m to $200m from 1998 to 2005

Next class: Firm Competencies III

 Prepare Wal-Mart Case and skim the business press on current developments around WalMart  Remember that group emails are due by midnight on Wednesday, the 31st

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BUAD 497: Session 8

Firm Competencies III

Wal-Mart Stores Inc.

Learning goals for this session

 Continue analyzing the sources of a firm’s competitive advantage and how they relate to competency  Examine the sustainability of this competitive advantage  Analyze the transferability of competitive advantage and what factors matter when moving into different environments

Wal-Mart Stores Inc.

 What are Wal-Mart’s sources of competitive advantage?

Wal-Mart Stores Inc.

 How sustainable is Wal-Mart’s position?

Wal-Mart Stores Inc.

 What are the issues involved with WalMart diversifying into foreign countries?

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Next class: Complementarities and Fit

 Prepare readings  Milgrom and Roberts, “Complementarities and Design Decisions”  Grant, “Alternative Structural Forms”

 Mini case analysis due at beginning of class

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BUAD 497: Session 9

Fit and Complementarities

Learning Goals

 Understand the importance of organizational structure and configurations for designing and in implementing strategies  Understand the tension between differentiation and integration in organizing  Know the relative advantages and disadvantages of the most common organizational structures (functional, divisional, matrix)  Examine different views of organizations, such as Mintzberg’s approach and a view of firms as activity systems

Why Understand Organizational Configurations and Structure?

Organizational Structure and Design  Organizational Structure

 Internal fit of organizational configurations is essential for achieving sustainable competitive advantage  Understanding configurations and structures is important for your career. What activities are core? Where do you fit in? What organization do you want to be in? Formal vs. informal? Centralized vs. decentralized? Entrepreneurial vs. rule-guided?

 The formal configuration between individuals and groups with respect to the allocation of tasks, responsibilities, and authorities within organizations

 Organizational Design  The process of coordinating the structural elements of an organization in the most appropriate manner

 Three approaches:  Classical Organization Design  Mintzberg’s Framework  Activity Systems

The history of a hostel that grew too fast…

Part I: The Classical Approach

Husband Children Midlevel manager

It-technician

Cleaning aid

Wife

Midlevel manager

Midlevel manager

Chef

Caretaker

Receptionist

Dishwashers

Waiter

Guests

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Graphic Description Greiner’s Model of Organizational Growth Phase 1

Phase 2

Phase 3

Size of Organisation

= Evolution = Revolution Growth by Creativity

Growth by Tight Management

Growth by Delegation

Phase 4 Growth by Coordination

The of formalisation The circularity Basic Problem of Organizing

Phase 5 Growth by Team Spirit The problem is how to find

Controlthe right balance and not let the Flexibility

Crisis by what?

organisation drown in complexity

Crisis by Bureaucracy Crisis by Control

Crisis by Style of Management

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Crisis by Autonomy



”After the task has been divided into specialist subtasks, the problem is to integrate the subtasks around the completion of the global task. This is the problem of organisation design.” Jay Galbraith (1974), Organization Design – An Information Processing View

Age of Organisation

Growth Patterns of Firms

Functional Structure

Phase 1 Strategy: Low revenue base; simple product-market scope Structure: Simple

Chief Executive Officer or President

Phase 2 Strategy: Increase in revenues; engage in vertical integration Structure: Functional Phase 3 Strategy: Expand into new, related product-markets and/or geographical areas Structure: Divisional Phase 4 Strategy: Expand into international markets Structure: International Division, Geographic Area, Worldwide Product Division, Worldwide Functional, or Worldwide Matrix

Functional Structure Advantages  Pooling of specialists enhances coordination and control  Centralized decision making enhances an organizational perspective across functions  Efficient use of talent  Career paths and professional development in specialized areas are facilitated

Disadvantages

 Differences in functional orientations impede communication and coordination  Tendency for specialists to develop a short-term perspective and a narrow functional orientation  Functional area conflicts may overburden top level decision makers  Difficult to establish uniform performance standards

Manager Manager Manager Production Engineering Marketing

Manager R&D

Manager Personnel

Manager Accounting

Lower-level managers, specialists, and operating personnel

Structure for Cost Leadership Strategy • Operations is main function • Process engineering is

Office of the President

emphasized over R&D

• Large centralized staff • Formalized procedures • Structure is mechanical, job

Centralized Staff

roles highly structured

Engineering

Operations Marketing

Accounting Personnel

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Divisional Structure

Structure for a Differentiation Strategy

President and Limited Staff R&D New Product R&D

Chief Executive Officer or President

Marketing Marketing

Operations

Corporate S taff

Finance Human Resources

• Marketing is the main function for tracking new product ideas • New product R&D is emphasized • Most functions are decentralized • Formalization is limited to foster change and promote new ideas • Overall structure is organic; job roles are less structured

Manager Production

Manager Engineering

Division A

Division B

Division C

General Manager

General Manager

General Manager

Manager Marketing

Manager R&D

Manager Personnel

Manager Accounting

Lower-level managers, specialists, and operating personnel Organized similarly to Division 1

Divisional Structure

Organized similarly to Division 1

Multi-Divisional Structure (A)

Advantages

Disadvantages

 Increases strategic and operational control, permits executives to address strategic issues  Quick response to environmental changes  Increased focus on products and markets  Minimizes problems associated with sharing resources across functions  Facilitates development of general managers

 Increased costs incurred through duplication of personnel, operations, and investment  Dysfunctional competition among divisions may detract from corporate performance  Difficulty in maintaining uniform corporate image  Overemphasis on shortterm performance

Chief Executive Officer Corporate Office (Staff)

North America

Europe

Asia

Latin America

Product A

Product B

Product C

Product D

Africa

Australi a

A structure based on geographic lines usually implies a multi-domestic international strategy

Matrix Structure

Multi-Divisional Structure (B) Chief Executive Officer

Chief Executive Officer or President

Corporate Office (Staff)

Product A

Product B

Product C

Product D

Manager Administration and Human Resources

Manager Projects

Manager Manufacturing

Manager Engineering

Corporate Staff

Manager Marketing

Manager Public Relations

Project A

A structure based on product lines usually implies a global international strategy

Project B Project C Project D

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Matrix Structure Advantages

Disadvantages

 Increases market responsiveness through collaboration and synergies  Allows more efficient utilization of resources  Improves flexibility, coordination, and communication  Increases professional development through broader responsibilities

 Dual reporting relationships can result in uncertainty regarding accountability  Intense power struggles may lead to increased levels of conflict  Working relationships may be more complicated and resources duplicated  Excessive reliance on teamwork may impede timely decision making

Part II: Mintzberg’s Approach

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Restructuring Leo Burnett

Henry Mintzberg: Five Basic Elements  Operating Core: Employees who perform the basic work related to an organization’s product or service.  Strategic Apex: Top-level executives responsible for running an entire organization.  Middle Line: Managers who transfer information between higher and lower levels of the organizational hierarchy.  Technostructure: Organizational specialists responsible for standardizing various aspects of an organization’s activities.  Support Staff: Individuals who provide indirect support services to an organization.

Mintzberg’s Five Organizational Forms

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Five Organizational Forms (1)

Five Organizational Forms (2)

The Simple Structure: young, small; nonsophisticated technical system; simple, dynamic environment. Key: strategic apex

The Professional Bureaucracy: complex, stable envir. Nonregulating, nonsophisticated technical system: Key: Operating Core.

Machine Bureaucracy: old, larger; regulating, nonautomated technical system; simple, stable envir. Key: technostructure

The Adhocracy: complex, dynamic envir.; sophisticated and often automated technical system Key: Support Staff

The Divisionalized Form: diversified markets (esp. products & services); old, large. Key: Market grouping, performance control, limited vertical decentralization

The Idea Organization: Value-based organizations, public/religious organizations…Jehovas Witnesses, Greenpeace, Al Quada, IRA

Summary of Mintzberg

Part III: Organizations as Activity Systems

The Underlying View: Strategy as Positioning (Porter, 1996)

A Different View: Firms as Activity Systems

 Operational effectiveness is not strategy  Operational effectiveness is a given

 Strategy is a unique position for the firm  Strategy is not doing the same activities better, rather doing them differently or doing different activities

 Strategy involves trade-offs  Due to incompatible product features, inconsistencies in image, limits of coordination, motivation, management, etc.

 Strategy means achieving a high degree of fit between internal activities/resources and the external environment

 Activity Systems form configurations that need to exhibit a high degree of internal fit  Interplay of complementarities and tradeoffs across multiple activities is critical to success  Different configurations can be equifinal, i.e. equally effective (“many best ways to organize”)

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IKEA’s Activity System

Explanatory Catalogues, Informative Displays and labels

Ease of T ransport and assembly

SelfT ransport by customers

Suburban Location With ample parking

Limited Customer S ervice

High-traffic Store layout More Impulse buying

S elf-selection by Customers

Most Items in inventory

Limited Sales staffing Self-assembly By customers Increased Likelihood of Future purchase

“ knock-down” Kit packaging

Modular Furniture Design

Ample Inventory On site Year-round stocking

Low Manufacturing Cost In-house Design focused On cost of manufacturing

Wide variety With ease of manufacturing

100% Sourcing from Long-term suppliers

Equifinal Activity Systems with Internal Fit: Wine Industry Robert Mondavi  Premium wine producer  Long-term contracts with outside growers, also owns vineyards  Established relationships, extensive knowledge-sharing  Extensive use of handmethods to ensure highest quality  Aging in small oak barrels  Heavy use of tastings, PR, wine tours

Equifinal Activity Systems with Internal Fit: Home Improvement Retailing

Home Depot

Lowe’s

 Huge stores with no-frills design  Widest selection of items  High ceilings allow large inventories on store shelves  No warehouses or distribution centres; direct deliveries from limited number of vendors  Goods delivered go directly on selling floor on palettes  Well-trained employees to advise mostly DIYs and small contractors  Low prices

 Slightly smaller, more attractive stores  Greater emphasis on fashion, kitchen, decorating  Lower ceilings with more attractive shelving  Regional distribution centres with hub-andspoke system  Contractors are served by separate corporate divisions  Higher proportion of unique and fashion items w/ higher prices

E.&J. Gallo  Large-volume, low-price producer  Grapes purchased at armslength from outside growers, often also imported  Highly automated production methods  Aging in stainless steel tank farms  Heavy use of advertising (leading advertiser among California wineries)

Implications: Strategy and Fit  Taylor many activities to the strategic position  Strengthen the fit among activities  The strategic value of outsourcing depends on fit  Outsourcing tends to make activities generic  Tailor suppliers to strategy

 Improve the strategy (and counter your rivals’ moves) in ways that extend and strengthen fit

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Summary: Strategy as Configuration

What is a Strategy?

What is not a Strategy?

 Unique position  Tailored activities  Activities fit together in an integrated system  Clear tradeoffs  Continuity of position but consistent improvement

       

Best practice improvement Learning Agility Flexibility Restructuring Mergers/Consolidation Alliances/Partnering The Internet

Key Takeaways  Structure and configuration need to follow strategy  There is a key tension in organizational structures between control and flexibility; know which one is more important for your situation  Organizations go through growth cycles; know which one you are in and recognize the symptoms  Know the main organizational structures and their advantages and disadvantages  Formal structures are only half the story—know how a firm’s activity systems are configured and how this supports/hinders the firm’s strategy

Next Session: Fit Applied

 Prepare Progressive Case

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BUAD 497: Session 10

 Fit Applied I

Learning Goals

 Get experience applying the activity system framework  Examine trade-offs of strategic positions  Understand the model of strategy that underlies the configurations approach

Progressive Corporation

Average Industry Ratios 19951998

Alternative Views of Strategy

Key Takeaways

 Strategy as “One Best Way”  One ideal competitive position in the industry  Benchmarking of all activities and achieving best practices  Aggressive outsourcing and partnering to gain efficiencies  Advantages rest on a few key success factors, critical resources, core competencies  Flexibility and rapid responses to competitive and market changes

 Strategy as Fit  Unique competitive position for the company  Activities tailored to the firm’s strategy  Clear trade-offs and choices vis-à-vis competitors  Advantages arise from fit across activities  Sustainability comes from the activity system, not the parts

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 Competitive advantage emerges out of the entire system of a firm’s activities  Fit among activities reduces cost or increases differentiation  Relying on complex activity systems decreases the threat of imitation by competitors  The most viable strategic positions are those whose activity systems are incompatible because of tradeoffs

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Next Session: Fit Applied II

 Continue with analysis of activity systems  Prepare Airborne Express case

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Fit Applied II

Learning Goals

 Compare different positions within an industry and understand the strategies that go with them  Examine the effect of cost position on strategy  Be able to identify priorities based on total and marginal relative costs

Airborne Express

Airborne Freight Stock Price

Update

Update (cont’d)

 Airborne continued to prosper in 1997 and 1998 (net income 1996: $28m, 1997: $120m, 1998: 137m).  However, in 1999 Airborne began to falter. FedEx moved further into ground operations. Both FedEx and UPS exploited the online shopping boom of the late 1990s, but Airborne struggled.  After 1999, Airborne’s profits were meager with losses in some quarters

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 In March 2003, DHL announced it would acquire Airborne for about $1.2 billion.  Since 2003, DHL has committed extensive funds to catch up with FedEx and UPS in the US. DHL’s brand has replaced Airborne’s and is trying to establish itself as a “third force” in the express mail industry

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Key Takeaways  Greater interactions between decisions tend to lead to internally consistent but mutually exclusive positions  Even a small firm can carve out a long-viable position in an inhospitable environment by exploiting a distinct position  Successful strategies tailor a large number of activities in mutually reinforcing ways to create this position  However, even the best fit is not invulnerable to competitive moves that take away positional advantages

Next Session: Fit Applied II

 Continue with analysis of activity systems  Prepare Airborne Express case

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BUAD 497: Session 12

Competitor Analysis

What is Game Theory?

“No man is an island” Analysis of rational behavior in interactive or interdependent situations The bad news… …knowing game theory does not guarantee winning The good news… …very useful framework for thinking about strategic interaction

Decision Theory vs. Game Theory

Ten of you go to a restaurant If each of you pays for your own meal… …this is a decision problem If you all agree to split the bill... …now, this is a game

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Learning Goals

Understand how game theory applies to business and helps us to analyze strategic moves by our competitors Know the main elements of games and their basic forms Examine how firms can change the rules of a game to capture more value for themselves See how competitor profiling can complement game theory

Games We Play

Group projects Poker Traffic Dating Dining out

Free riding and reputation Credibility Congestion Information manipulation Coordination

Restaurant Decision-Making May I recommend that with the Bleu Cheese for ten dollars more? Sure! It is only a dollar more for me!

A check splitting policy changes incentives: they depend now on the moves of other players…

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Games Businesses Play Market entry Supply chains Corporate takeovers Fishing Patent races OPEC output

Commitment Auctions Winner’s curse Congestion Game of chicken Collusion & enforcement

Games as Defined by the Number of Players

1-person (or game against nature) 2-person n-person (3-person & up)

Games as Defined by the Payoff Structure Zero-sum  Classic games: Chess, checkers, tennis, poker.  Business games: Sales negotiations (often)

Non-zero sum  Classic games: Monopoly  Business games: Market entry, research investment

Components of a Game

Games have the following characteristics:  Players  Rules  Payoffs  Strategies

Games as Defined by the Rules

Rules determine the number of options/alternatives in the play of the game. The payoff matrix has a structure (independent of value) that is a function of the rules of the game Thus many games have a 2x2 structure due to 2 alternatives for each player

Generic Strategies In simple games, it is natural to suppose that one player will attempt to anticipate what the other player will do  Minimax: to minimize the maximum loss; a defensive strategy  Maximin: to maximize the minimum gain; an offensive strategy

Games can also have sequential play, which leads to more complex strategies  Tit-for-tat: always respond in kind  Tat-for-tit: always respond conflictually to cooperation and cooperatively towards conflict

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(1) The Prisoner’s Dilemma

Game or Nash Equilibria Games also often have solutions or equilibrium points These games, owing to the selection of particular reasonable strategies, will result in a determined outcome A Nash Equilibrium is that point where it is not to either player’s advantage to unilaterally change his or her mind

Prisoner A

Should you confess?

~ Confess

~ Confess

Six months Six months

Prisoner B

Confess

Confess

Ten years Free

Free Ten years Two years Two years

John F. Nash (1928-)

What makes a Game a Prisoner’s Dilemma? We can characterize the set of choices in a PD as:  Temptation (desire to double-cross other player)  Reward (cooperate with other player)  Punishment (play it safe)  Sucker’ pay off (for the player who is double-crossed)

Free > Six months > Two years > Ten years

(2) The Game of Chicken

Driver B

Swerve

-20 -20

Swerve

-1 +1

+1 -1

0 0

 The game assumes no communication  The strategies can be altered if there is sufficient trust between the players

Chicken is an Unstable game

Driver A

~ Swerve

The saddle point is where both confess This is the result of using a minimax strategy. Two aspects of the game can make a difference.

Examples in Business: two companies deciding on whether to start an advertising campaign; Boeing vs. Airbus in VLAs; research investments, …

A game is a Prisoner’s Dilemma whenever: T>R>P>S

~ Swerve

What is the Outcome of a PD?

There is no saddle point in the game. No matter what one player chooses, the other player can unilaterally change for some advantage Chicken is therefore unstable We cannot predict the outcome BUT: Credible commitment can persuade the other player to back down Examples in Business: Patent races, Microsoft vs. Linux, etc.

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(3) Tragedy of the Commons Describes the problem of the unregulated use of a public good Take a village with 10 families Each family has 10 cows which just exactly provide the food they need The village commons has a carrying capacity of 100 cows

One more cow… So Farmer Smythe decides he really needs one more cow And there is no one to tell him “No!” because the commons is an unregulated public good  Some modern commons are forests, oceans, public roadways, air quality, Internet (no spamming), markets with limited carrying capacity, etc..

Looks familiar…? Look at the situation:    

N players Equilibrium solution is to ~cooperate Joint optimal outcome is to cooperate This is an n-person, collective Prisoner’s dilemma

Cow Carrying Capacity Each cow produces 500 lbs of meat & dairy per year up to or at carrying capacity of the pasture. 10 families X 10 Cows X 500 lbs = 50,000 lbs of food at carrying capacity …and then Farmer Symthe’s wife has triplets…

Reduced Capacity With the overgrazing, each cow will now produce only 490 lbs of food. 101 Cows X 490 lbs = 49,490 lbs of food at carrying capacity Each family gets 4900 lbs of meat & dairy, instead of 5000 Except Farmer Smythe, who gets 5390 lbs Even with the reduced carrying capacity, it is still to his advantage to add the extra cow

Applying Game Theory to Business: Toys “R” Us Competitive Landscape  Toy & department stores

 Do not compete with TRU on price (50% markups)

 General discounters (Wal-Mart, Target)

 Cannot compete with TRU on selection (9% markups)  Toys exhibit high product differentiation

 Specialized discounters (only TRU)  Enjoyed 20% market share nationally

 Warehouse clubs (Costco, Pace)

 Introduced in the 1980s  By 1989, about 200 items in competition

 Cause of concern for Toys “R” Us!

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Toys “R” Us (continued) Market research into the future of warehouse clubs  Manufacturers estimated 3-5% annual growth rate  Toys “R” Us conducted comprehensive but proprietary study  Manufacturers were aware of the study, but not its results  Toys “R” Us expected warehouse clubs to grow quite fast…

Idea! Issue statement to manufacturers:

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Toys “R” Us (continued) Manufacturers agreed to TRU deal  Really they had little choice given the uncertainty about the future

Warehouse club toy sales decreased

 Pre-agreement growth of 51% per year  Overall growth of clubs of over 10% per year

Toys “R” Us kept its market

 “You may not sell to warehouse clubs without losing Toys “R” Us as a customer.”

 Effectively, choose between a $5 billion market (TRU) and a less than $500M market (warehouse clubs)

The Toys “R” Us Example

Changing the Game…

Sequential timing  Threat of Manufacturer’s decisions How will my opponents react?

Simultaneous timing  Manufacturer’s decisions What is my opponent doing right now?

Information  Future profitability of warehouse clubs What can I infer from the actions of others?

Agreements  Enforceability of contracts & agreements What happens if someone breaks the agreement?

What game is being played?

How can the game be changed?

Who are the key players?  duopoly game; oligopoly game; etc…

The game can be changed by changing…

What options are open to the players?  pricing game; advertising game; etc.

What goals are the players pursuing  market share? profits?..

Are goals complementary or conflicting?  issues the players agree on, sources of conflict, etc..

What is the time structure of the game?

 Players  Added value  Rules of the game  Tactics employed  Scope of the game

 one shot, repeated, simultaneous, sequential…

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Changing the players Bring in customers  Pay customers (esp. early adopters) to play (Samples, Netscape)  Subsidize some customers, other full paying customers will follow (Initial discount to lower risk)

Bring in suppliers  Holland Sweetener Co./NutraSweet and Coca-Cola

Bring in complementors  Do it yourself. Nintendo - both h/w & s/w  Pay complementors to play (at least initially)

Change the added value Limit your supply  DeBeers and diamonds; Nintendo & video games  Downside: Shrinks the pie today; leaves entry opportunity open

Raise amount consumers are willing to pay  Policies that build loyalty (frequent flier miles) increase willingness to pay - GM / Ford credit cards

Lower competitors’ value  Softsoap - by cornering the supply of pumps

Bring in competitors  Create a second source to encourage buyers to adopt technology

Changing tactics Make the game more transparent or opaque  depending on which benefits you

To establish credibility (clear the fog)  Absorb uncertainty (e.g. accept a pay-for-performance contract)  Offer guarantees or advertise  Ask others to demonstrate their credibility to you

To establish uncertainty (preserve the fog)  Create complexity (long distance calling rates)  Bluff: Ask yourself whether you will be believed and under what circumstances  Ask what others stand to gain by preserving the fog, and what they could be bluffing about

Beyond Game Theory: Competitor Profiling

Changing the scope What is the current scope of the game?  Games are often linked across geographic and product markets

Do you want to link the game to other games?  Would a multi-market contract be beneficial to you?

Do you want to de-couple the game from other games?  Leave a market to stop competing head-on with another firm

Why Competitor Profiling? Game Theory takes an economic perspective  Focus on incentives and interactions among moves  Assumption of rationality; what competitors should do if they behaved rationally

Competitor Profiling takes a behavioral perspective  Focus on competitors’ predispositions  What do competitors really want given their beliefs, blind spots, and historical tendencies

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How to Integrate Both Game Theory and Competitor Profiling

Why Competitor Profiling Matters Goals may not be fully rational due to - Difference in an organizations’ charter (public, nonprofit, family-owned…) - Agency problems (top management’s interest may be different) - Irrationality (pride, jealousy, fairness…)

Beliefs may lead them to see the world differently - Mental models may differ (e.g. due to differences in functional backgrounds)

Routines may constrain opportunities for action -

Inertia due to size/maturity/complexity/strong culture/bureaucratization etc.

Key Takeaways Game theory is a powerful tool for analyzing competitive moves—know the typical games and be able to anticipate your rival’s response Logics can often be changed so a new game is played—use this to your advantage Never assume your opponent’s behavior is fixed! Predict their reaction to your behavior Complement game theory with competitor profiling to work around the restrictive assumptions on which game theory is built

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Think broadly about the set of strategic options    

Variables (organization, customers, pricing…) Asymmetries Commitment postures Information

Augment you toolkit for dynamic analysis  Scenario analysis (role-playing/devil’s advocate)  Market testing  Sequenced rollout

Match analytics and industry/company context  Do general assumptions hold in this industry/company?  But: question industry logics/orthodoxies

Next Session

 Get experience applying game theory and competitor analysis  Prepare Ryanair case

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BUAD 497: Session 13

Competitor Analysis Applied I

Learning Objectives

 Get experience applying competitor analysis  Examine market entry and the threat of retaliation

Ryanair

Ryanair: What Happened…

 Even before Ryanair initiated service in May 1986, Air Lingus and BA reduced their lowest, restricted round-trip fare to £95!  Ryanair countered with an unrestricted fair of £94.99  By 1989, customers could find fares as low as £70  Ryanair’s initial performance was promising  almost 100% seats sold  great PR for “taking on the big guys”

Ryanair: What Happened… (Con’d)

Ryanair reborn!  The airline cut costs radically

 Ryanair soon grew to serve 27 routes (Dublin, Manchester, Liverpool, Glasgow etc.)  Passenger volume grew rapidly  But…the company began to accumulate large losses  I£6 Million in 1988, I£4.5 Million in 1989

 Expansion strained the firm’s management system  January 1991, Ryanair was hours away from bankruptcy…

   

dropped all loss-making routes removed all in-flight amenities (coffee, snacks, etc.) promoted duty-free sales renegotiated labor contracts

 Ryanair remodeled itself completely on Southwest Airlines  2002-2003: 30% operating profit margin vs. British Airway’s 3.8%  2003: market capitalization of $5b – compared to $3b for BA and $2.7b for Air France

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Key Takeaways

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Mini Case Analysis Notes and Comments

 Combining game theory analysis with competitor profiling is essential; you need to examine both sides of the story  Retaliation is extremely unattractive when the entrant is small, the incumbent large, and acrossthe-board price cuts necessary to retain customers  But: the ability to retaliate in a targeted way makes retaliation more attractive and likely  Credible commitment is often difficult

Next Session

 Continue with applying competitor analysis  Case: Leadership Online—Barnes and Nobles vs. Amazon

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BUAD 497: Session 14

Competitor Analysis Applied II

Leadership Online

Learning Objectives

 Examine competitive moves in the new economy of online selling  Understand how positioning analysis—the analysis of willingness to pay and of cost—matters in the context of online selling  Explore the substitution threat to competitive advantages in this new business landscape

Cost Comparison of Online vs. Offline Business Models

vs.

What B&N brings to the table…



The B&N annual report of 1996 read as follows:



“The competitive advantages we bring to this

Amazon vs. Barnes & Noble

business are enormous, as is our ability to leverage pre-existing assets. They include [the] distribution center, [the] 2.5 million title data base, special order processing, direct marketing expertise, name recognition and franchise value, international reputation, excellent partnerships (Firefly, AOL, etc), [and] bookselling expertise.”

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Update on the Online Battle  Amazon in 2004:  $588m net income on revenues of $6,921m  about 70% of the online book market  market cap of $18 billion  Barnes & Noble in 2004:  $143m net income on revenues of $4,874  about 15% of the online book market  market cap of $2.3 billion  By 2005, Amazon had become the world’s largest online retailer with 47 million accounts. It had moved from books into other media (CDs, DVDs…) and then into electronics and a dozen other categories  Amazon added operations in the UK (1998), Germany (1998), France (2000), Japan (2000), Canada (2000), and China (2004)

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Key Takeaways  Competitor analysis is valuable across various business landscapes and can show the differences resulting from differing ability to digitize products  There is usually a continuum of competitive responses—consider all and select the one that best works with your capabilities and is hardest to imitate  The sustainability of competitive advantage is often complicated in virtual contexts. Online and offline competition can coexist and interact  The threat of imitation for online business models is frequently overblown, but such business likely have to deal with new threats to sustainability

Next Session

 Focus on creating value and competitive advantage  Case: Harnischfeger Industries

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BUAD 497: Session 15

Creating Competitive Advantage

Why Care About Value Creation?

 In any market, before considering who gets what it is important to understand what there is to get  What determines total value created?

The Value Chain

Learning Objectives

 Enhance our understanding of value creation, value appropriation, and value added  See how value creation and appropriation relate to competitive moves  Apply these concepts to the Harnischfeger case

Assessing Value Creation

 Who are the players?  What are customers willing to pay for the good or service?  What are suppliers’ opportunity costs of providing the good or service?

Value Creation

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Value Creation

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Value Division

Value created = Buyer’s willingness-to-pay minus Supplier’s opportunity cost This is the value that can be appropriated

Value Added

 Price measures the division of value between business and customer  Cost measures the division of value between business and supplier  What determines these divisions of value?  Added Value

Added Value - A Simple Game Imagine the instructor holds 30 red cards.

Value Added - A Simple Game Imagine there are 30 students in this class. A black card is passed out to each student.

Added Value - A Simple Game The Dean has agreed to pay $100 for each pair (1 black + 1 red) of cards.

$100

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Added Value - A Simple Game How much would you be willing to accept for your black card? Imagine the instructor offered you $20. Would you accept this offer?

Added Value in the card game =

When the instructor is in the game, the value of the game is $3,000. When the instructor is not in the game the value of the game is $0. When there are 30 black and 30 red cards, each student has an added value of $100 because without each student a match cannot be made and $100 is lost.

What you get is based on your added value

Added value = total value with you minus total value without you

Added Value – A Slight Modification Imagine the same game except now the instructor only has 27 red cards. There are still 30 black cards for 30 students. How much would you accept for your black card?

Added Value in the card game =

When there are 30 black and 27 red cards, the instructor has an added value of $2,700 and an individual student has an added value of $0. Since 3 students will end up without a match, no one student is essential to the game. The total value of the game with 30 students is $2,700. The total value of the game with 27 students is also $2,700.

What is your added value?

Ask yourself the following question: If I enter this game, what do I add? That is how much you can bargain for…

It’s what you bring to others (Brandenburger and Nalebuff, Coopetition, 1996)

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Summary

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Harnischfeger Industries

 The size of the pie  Willingness-to-Pay minus Opportunity Cost

 The division of the pie:  Added Value

 The next step: what happens if you cannot cooperate to maximize value created?

Update on Harnischfeger…

The Value Net

 Bob Hale of Harnischfeger chose to do battle with Kranco  In July 1992, Kranco filed for Chapter 11 bankruptcy after its biggest lender cut off the funds  In January 1993, Kone announced that it had acquired Kranco’s operating assets, including the rights to designs and trade names, for $3.5 million  This was about the worst possible outcome from Harnischfeger’s perspective  In January 1998, Harnischfeger sold its crane unit to an investment firm and left the market for overhead cranes

Key Takeaways  Value creation and value division are both important aspects of strategy  If you only consider the competitive battle, you may miss the larger opportunities that come from creating value!  Added value largely determines the division of the pie  Expanding the game by bringing in new players may frequently be your best bet at capturing more value (i.e. more of the pie)

Next Session

 Move from creating to sustaining competitive advantage  Case: Saturn—A Different Kind of Car Company

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BUAD 497: Session 16

Sustaining Competitive Advantage

Saturn: A Different Kind of Car Company

Learning Objectives

 Examine how to create competitive advantage as a de novo entrant in a mature industry  Understand the challenges of sustaining competitive advantage  See how Saturn has used the configuration of its value chain to secure its competitive position

Key Takeaways  As a de novo entrant in a mature industry, you can only achieve competitive advantage by creating value in a new way  The likely way of creating new value is through reconfiguring the value chain to achieve novel product attributes  Sustaining competitive advantage may rest on a narrow set of interlinked activities  Taking actions to secure and protect competitive advantage can be a two-edged sword: it can prevent imitation but may also make knowledge transfer to the corporate parent more difficult

Next Session

 Strategy in a world of standards and network externalities  Reading: Shapiro and Varian, “The Art of Standard Wars”  Also: Check out the Blue-Ray/HD-DVD battle going on right now

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BUAD 497: Session 17

Standards and Network Externalities I

Learning Goals

 Understand the role of standards in strategy and implementation  Know the rules of standards strategy and the politics of standard setting  Apply these concepts to a current reallife example

Standards Require Different Strategies

Winning with Standards

 Standards are central to business strategy, yet are often not well understood  Standards matter wherever products depend on compatibility (software, CDs, video

tapes, lamp batteries, razor blades, typewriter keyboards, ski bindings, credit card systems…)

 Standards change the game and the required different strategies

An Example…

versus

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 The elements of the generic “Porter Style” strategy:    

get in the market early differentiate the product protect it from imitation charge premium prices

 With standards, successful strategies often work differently. It may be smarter to…    

hold back the product launch adopt a simple, undifferentiated, standard design encourage imitation by other manufacturers lower prices to maximize early sales

Sony vs. JVC  Sony launches its Betamax videotape recording system in 1974  Two years later, JVC introduces its Video Home System (VHS), an incompatible alternative to Betamax  By that time, more than 100,000 Betamax machines had already been sold  BUT: JVC adopts a more “open” policy for partners, sharing information about the technology…  By 1984, the JVC “family” has 40 companies, including Grundig, Hitachi, Matsushita, Philips, RCA, and Sharp, some of the biggest manufacturers in Japan, Europe, and North America. The Betamax group has only about a dozen members

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Sony vs. JVC: Number of Units Sold

Sony vs. JVC: Share of VCR Market

Sony vs. JVC

Understanding Standards and Network Externalities

 Sources of JVC’s success:  “Bandwagon” of supporting firms  Consumer confidence  Faster pace of product improvement at moment of choice

 Larger scale lowers costs  Network externalities for consumers  The Result: by 1988, Sony conceded and began production of VHS recorders; the war was officially over

How Standards Change the Game  Standards introduce network effects “Demand side Economies of Scale”

 Benefits that come from having a large installed base of users  Classic examples are literal networks   

telephone network (“natural monopoly”) fax machines Internet

 Number of possible connections grows rapidly with number of users – “network externalities”  

system with one user is of little use system with all customers on is very valuable

How Standards Change the Game  Positive feedback strengthens widely used platforms  Example: Windows vs. Mac  Windows    

has more users, therefore

More retailers sell Windows PCs More software producers write for Windows Windows documents can easily be exchanged with others More IT staff specialize in Windows

 Therefore,

still more people switch to Windows

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Network effects are not based on efficient production

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The Evolution of a Standard War

 Microsoft products are not necessarily better  Some quality benefits from huge sales, but not crucial  “Popularity adds value”

 Switching costs can be considerable  Legacy systems can create path dependencies

 Where no clear winner exists yet  Customer expectations for future will decide winner  Need to lure developers and users in early stages (win “mindshare”)

Who Wins and Who Loses From Standard Adoption?  Consumers    

Generally better off Reduced uncertainty; no need to wait More users, more value But variety may decrease

 Complementors

 Generally better off  May serve in a brokering role (DVD)

 Incumbents

 May be a threat  Strategies  Deny backward compatibility  Introduce its own standard  Ally itself with new standard

Strategies for New Standards: Open vs. Closed Control

Open

Controlled Migration

Open Migration

Open versus Closed Standards  Some technological standards are open (WiFi networks, Ethernet, TCP/IP)  no one firm controls them  specifications are public, anyone can build compatible products  may require license fee

 Some standards are closed, controlled by one firm (e.g. most of Windows)  Important tradeoffs here:  Openness helps technology become dominant  But success of a technology may not help the firm that devised it (e.g. IBM and desktops)  Closed systems can be controlled, so benefits don’t flow to a competitor  But development may be stifled and leapfrogging may occur

Part One: Tactics in Formal Standard Setting  Don’t automatically participate  If you do you have to license

Compatible

Windows 98, Pentium, Software upgrades

Incompatible

Performance Play Palm Pilot, Iomega Zip

(Many vendors) Fax machines, some modems

 Keep up momentum  Continue R&D while negotiating

 Look for logrolling  Trading technologies and votes

Discontinuity (Many vendors) CD audio, 3.5” disks

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Part One: Tactics in Formal Standard Setting

Part Two: Tactics in Standard Wars

 Be creative about deals  Second sourcing, licensing, hybrids, etc.

 Beware of vague promises  Definition of “reasonable royalties”

 Search carefully for blocking patents  Also patents held by non-participants

 Preemptively build an installed base

Key Assets for Standard Wars       

Control over an installed base Intellectual property rights Ability to innovate First-mover advantages Manufacturing Strength in complements Reputation and brand name

Blu-ray vs. HD-DVD

 Standard wars emerge when two incompatible technologies struggle to become a de facto standard  These wars usually end in  truce (56 k modems)  duopoly (video games)  fight to death (VCRs)

Two Basic Tactics for Standard Wars  Preemption  New technologies require champions willing to invest early to build an installed base  Being first to market can backfire if superior technology will soon arrive

 Expectations management  Engage in aggressive marketing, make early announcements of new products, assemble allies, make visible commitments to your technology

Strategies after you win a war

 Staying on your guard  Offer your customers a migration path to fend off challenges from upstarts

vs.

 Leverage your installed base and commoditize complementary products  But enter adjacent markets only if integration adds value for consumers

 Competing with your own installed base  You need improvements to drive upgrade sales

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Strategies after you win a war  Protecting your position  Offer ongoing attractive terms to important complementors

 Stay ahead  Develop proprietary extensions to improve your technology

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Strategies if you fall behind  Adapters and interconnection  Target a market niche or interconnect with the larger network (American Express with Visa)

 Survival pricing  It doesn’t work

 Legal approaches  If all else fails, sue!

Key Takeaways  Understand the positions and interests of all parties involved in a standards competition  The strength of your position in standards competitions depends on seven key assets  Preemption is a critical tactic, but there are ways around it  Expectations management is critical; self-fulfilling prophecies can overrule technical advantage  Once you’ve won the war, don’t rest; beware of leapfrogging

Next Class

 Apply standard strategy to the marketplace  Prepare Browser Wars Case

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BUAD 497: Session 18

Standards and Network Externalities II

Competition in Dynamic Industry Environments

    

Competitive advantages erode quickly Established rules are broken Industry boundaries are breached Customer loyalty is fickle Sustainable competitive advantages becomes a series of shorter unsustainable competitive advantages

Learning goals for this session

 Analyze fast-moving competition in an industry with network externalities  Understand the dynamics of a small firm taking on a much larger rival

New Rules of Competitive Engagement  Don’t cling to competitive advantages—create new ones  Entry barriers are easily overcome  Consistency and logical thinking make your firm predictable, so think outside the box  Long term planning only prepares you to sustain and exploit existing advantages, so work to create new competencies and advantages  Consistently attacking your competitor’s main weakness forces them to become stronger, so attack a range of weaknesses

(D’A veni--Hypercompetition )

The Browser Wars

vs.

Mike Homer—Netscape

 Held Senior Positions at Netscape as well as other firms such as Apple and AOL  Graduate of University of California at Berkeley

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Usage Share of Major Web Browsers

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The Next Challenger: Firefox

vs.

Source: Wikipedia.org

Current Market Share

Key Takeaways  The winning strategy in the Browser War  Get market share (give the product away)  Innovate constantly  Adopt open standards; but not too open

 “Judo Strategy”: target your opponents weakness and use it as leverage  Netscape exploiting its competitors’ retail sales and revenue streams  Microsoft doing the same to Netscape

 “Hardball Strategy”: use “unfair” advantage  Microsoft exploiting its Windows advantage

End of the course’s first part

 Move on to strategy implementation  Prepare Honda (A) case

Have a great break!

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BUAD 497: Session 19

Strategy Formulation and Implementation I

The Honda Case (A)

Second Part of the Course

 How do good strategies get implemented?  What can managers do to foster good strategies?

Next Class

 Prepare Honda (B) case  Read Eccles and Nohria: “Strategy as a Language Game”

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BUAD 497: Session 20

Strategy Formulation and Implementation II

Where we left off…

Understanding Strategy

 Honda (A) and (B):  Two versions of a story that emphasize the differences between planned and emergent strategies

Where we left off… …and what Honda did with it!  Changed market perception of the definition of a motorcycle  Drove rapid increase in overall U.S. market for motorcycles  Grew from ~ 0% in 1959 to 43% of total market in 1974

What motorcycles used to be about in the 1950s…

July 21st, 1947 Life Magazine Photo

BCG’s View of Honda’s Entrance into the US Motorcycle Market Honda (A) Made strong investments in R&D Used extensive vertical integration Aggressive low price strategy for entry into USA. Market strategies expanded and redefined the market segment – “You meet the Nicest People on a Honda”, through pricing, distribution and advertising.  Progressive expansion of market from region to region (West to East) over a six year period  Construction of plant with a capacity 10x demand  Low cost producer with high volumes and high productivity based on capital intensive automated techniques to exploit economies of scale; focus on longterm profitability & share    

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The Inside View of Honda’s Entrance Honda (B)

Soichiro Honda on the assembly line (circa 1950s)

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Two Views of Strategy

The Design School in Strategy  Ex-ante analysis, thinking and reasoning.  Assumes all relevant factors can be objectively analysed  Assumes that this analysis precedes and dominates action – implementation follows as a separate stage.  Separates thinking from doing and often implies a hierarchy – senior management thinks – others implement.  Option appraisal is conducted logically on the basis of analysis

The Classic Planning Process Identify Mission, Goals, & Strategies Analyze the Environment

Opportunities and Threats

Analyze Resources

Strengths and Weaknesses

Evaluate Results

Reassess Objectives

Formulate Strategies Implement Strategies

The Learning School in Strategy  Strategy making takes place within an unpredictable world  Creates the necessity for flexible strategic approaches

 Serendipity (accidental discoveries, luck, etc.) is required for effective performance  Strategy is often made by lower-level managers  Strategy evolves through autonomous action

 Strategy has both intended and emergent components  Realized strategies are combinations of intended and emergent strategies

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Mintzberg’s Three Fallacies of Strategic Planning

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Deliberate versus Emergent Strategies

In S t te n d ra e d te gy

 Fallacy of predetermination The future is unknown

 Fallacy of detachment

Deli

Impossible to detach formulation from implementation

 Fallacy of formalization

ber

a te

S tra

te g

y

Inhibits flexibility, spontaneity, intuition, and learning

All three contribute to the “Grand Fallacy”:

"Because analysis is not synthesis, strategic planning is not strategy formation" (Mintzberg 1994, “The Rise and Fall…”, p. 321)

Sustained Superior Performance

Emergent Strategy Adapted from: Mintzberg, H. “The Strategy Concept I: Five Ps for Strategy” California Management Review. Volume 30 Number1, Fall 1987.

Eccles and Nohria

 Strategy as Robust Action

Realized Strategy

Unrealized Strategy

Robust Action is…

      

Acting without certitude Constantly preserving flexibility Being politically savvy Having a keen sense of timing Judging the situation at hand Using rhetoric effectively Working multiple agendas Eccles & Nohria, Beyond the Hype

What, then, is the role of strategic planning? 1. Provide a structured mechanism for analysis and thinking about complex strategic problems 2. It involves people in strategy process giving them ownership 3. Planning helps communicate the strategy 4. Planning assists control by requiring regular review of performance 5. Assist in presentation of alternative and possible radical ways of considering strategic issues –“thinking outside the box”

Key Takeaways  Effective strategies combine both deliberate and emergent elements; both are important  Strategic planning processes should really be viewed as strategic learning processes  Use strategy language to build consensus on mission, objectives, and strategic alternatives

 Plans and processes must be robust enough to…  …allow a company to rapidly take advantage of opportunities as they occur  …enable various levels and functions within the organization to contribute to the emerging strategies

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Next Session

 Continue with implementation and change inside the firm  Prepare Lehman Brothers (A) case

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BUAD 497: Session 21

Implementation and Change I

Lehman Brothers (A)

The 7-S Framework

Page 154

Session Objectives

 Examine strategy implementation up close and personal  Understand the key ingredients in successful strategy implementation  Understand what it takes to successfully manage change

The Rise of Lehman Brothers’ Equity Research Department, 1987-1990

The 7-S Framework  A tool for determining the “doability” of strategies  Used for internal analysis of a company  Analyze strategic characteristics of a company  Aims to create alignment among various departments of an organization  Allows to examine the effect of change on a company  Analyze the successful and dysfunctional aspects of an organization

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The 7-S Framework: “Hard S”  Strategy – a plan of action to maintain competitive advantage over the competition  Systems – measures and actions which accommodate the execution of daily activities  Structure – the way the organization is structured, who reports to whom

The 7-S Framework: “Soft S”  Style – how do you lead? Personal style?  Shared Values – company culture, work ethics etc  Staff – company employees and their capabilities  Skills – core competencies of the company as well as that of its staff

Beer’s Formula of Organizational Change

Leading Organizational Transformation Desired State

Ineffective transformation path

Δ is the effectiveness of change, which is a positive function of D (dissatisfaction), M (model, or vision), and P (change process) that need to be greater than C (cost of change).

Work environment

Δ = f(D•M•P) - C

Effective transformation path

Existing State Operational efficiency

(Michael Beer, “Leading Change,” HBS Press, 1988)

The Five Forces of Management

Key Takeaways  Successful strategy implementation requires the alignment of all the seven S’s—fit is just as important inside as outside!

Up

 Know Beer’s formula of organizational change: it’s a function of Dissatisfaction, Model, and Process Across

Self

Down Down

Out

 When implementing a new strategy, start with the hard part of operational improvement! Only then make the transition to improving the work environment. But do make it!  Success in playing a game changes the game. Failure to appreciate the consequences of one’s success and tenacity in playing the old game are what tragedies are made of!

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Next Session

 Continue with implementation and change  Prepare Lehman Brothers (B) case

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BUAD 497: Session 22

Implementation and Change II

Session Objectives

 Examine the factors that lead to the decline of Lehman Brothers  Understand the challenges of strategy implementation and staying on top  The role of leadership in strategy execution

Lehman Brothers (B): The Story Continues…

The Rise and Fall of Lehman Brothers’ Equity Research Department, 19871995

The 7-S Framework: What’s not aligned now…?

Leading Organizational Transformation

Global Coordination

Ineffective

Effective

Ineffective Local Autonomy

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How Much Do You Want to Rely on People?

“More than anything else, management cut the analysts’ emotional ties by ejecting the nucleus of the department, Jack and Fred” (Dean Eberling, 1993)

What Happened Next…

Back on top…but at what price?

 Firm-wide change, 1997-2001: Employees up more than 44% since 1997, as Lehman bulks up in banking, equity research, and sales & trading − 2001: 2/3 of Lehman’s revenues from trading and underwriting, with the balance from bonds; in 1997, it was opposite − 2001: Lehman’s 150th anniversary; average tenure of upper ranks: 22 years; “no splashy acquisitions, no managerial coups, no lay-offs; employees own 35% of the firm

 “2001 was Lehman’s year…” Posted the best ROE of any securities firm; top tier of corporate debt underwriting; almost doubled its equity underwriting market  

“It wasn’t what happened in 2001. It takes years to create change” (Fuld) No plans to downsize; “Now is the time to build market share” (Fuld, 2002)

How They Did It Again

Back on top…but at what price?

 In 1999, analyst Steve Hash is Lehman’s new equity research head  Hash gets senior leadership’s mandate to rebuild the equity research department  He consults with Fraenkel and reintroduces several of Rivkin & Fraenkel’s processes to the department  

Training sessions Weekly meetings

 Hash later reflects that he had taken “all that Jack and Fred had done” and did it again—and the formula had again succeeded

An industry expert estimated it cost Lehman close to $100 million in additional expenses to get back to #1

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Why Many Strategies fail…the Importance of Execution

Leadership John Chambers Styles and Jack Welch

 “We had a failure in communication and execution, not in planning…” (Chris Pettit, August 1995)  Common mistakes in execution:   

The strategy is not made by those responsible for its execution Pursuing too many initiatives concurrently Failure to appreciate the weaknesses of the assumptions and develop contingency plans

 Successful execution involves both communication and politics. It entails…   

Jointly setting goals Following through and holding people accountable Learning from how reality deviates from the plan.

 “Execution…it’s the leader’s most important job.” (Bossidy and Charan, 2002)  Effective leadership is key to execution

Seven Critical Aspects of Successful Execution

Seven Critical Leadership Attributes

1. Know your people and your business Can you trust the information you get or has it been extensively filtered? 2. Insist on realism Can you clearly articulate the organization’s problems and weaknesses? 3. Set clear goals and priorities Are the business priorities few in number and focused in a constructive way? 4. Follow through How many meetings have you attended in which a good idea surfaced, but never got done?

5. Reward the doers Do you have a process in place that rewards highperformers objectively, fairly, and openly? 6. Expand people’s capabilities Do you spend enough time directly coaching, providing feedback, and cultivating people? 7. Know yourself Can you be honest with yourself, deal objectively with business and organization realities, and give people direct and forthright assessments?

Key Takeaways  Many excellent strategies fail because of poor execution  Good execution keeps the 7 S’s aligned—fit rules!  Good execution accepts the role of communication and politics

Next Session

 Managing with networks and power  Burt, “Structural Holes: Introduction”  Reading: Cross, Borgatti, and Parker, “Making Invisible Work Visible”

 Good execution is flexible enough to roll with the punches and builds options into the process  robust action

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BUAD 497: Session 23

Managing with Networks and Power I

Learning Goals

 Understand how and why networks matter  Know the different characteristics of networks and network positions  Know the basic concepts tools for analyzing your firm’s and your own position in a network

What is “Six Degrees”?

The Kevin Bacon Game  Invented by Albright College students in 1994  Goal: Connect any actor to Kevin Bacon, by linking actors who have acted in the same movie.  Oracle of Bacon website uses Internet Movie Database (IMDB.com) to find shortest link between any two actors http://oracleofbacon.org/

“Six degrees of separation between us and everyone else on this planet” John Guare (1990)

Not Quite the Kevin Bacon Game…

The Kevin Bacon Game: An Example

Kevin Bacon Tim Robbins

Kevin Bacon

Mystic River (2003)

Teri Hatcher

Code 46 (2003)

Om Puri

Larry Shaw

Yuva (2004)

Rani Mukherjee

Page 160

The Big Picture (1989)

Desperate Housewives (2004)

Is the brother of…

Lynda Mansson Is the aunt-in-law of…

Black (2005)

Amitabh Bachchan

Peer Fiss Source: Kentaro Toyama, Microsoft Research India

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Another Fun Example: The Erdős Number  Number of links required to connect scholars to Paul Erdős, via co-authorship of papers  Erdős wrote 1500+ papers with 507 co-authors.  Jerry Grossman’s (Oakland Univ.) website allows mathematicians to compute their Erdos numbers: http://www.oakland.edu/enp/ Paul Erdős (1913-1996)

The Science Behind “Six Degrees”

The Small World Experiment (Milgram, 1967)

Stanley Milgram (1933-1984)

 Connecting path lengths, among mathematicians only:  average is 4.65  maximum is 13

Society as a Graph

 A single “target” (stock broker in Boston)  Random ”senders” chosen in Nebraska  Each sender asked to forward a packet to a friend who was “closer” to the target  All friends got the same instructions  64 packets reached the target via different “chains”  Six…  Typical length of chain?

Society as a Graph

People are represented as nodes

People are represented as nodes Relationships are represented as edges (lines) (Relationships may be friendship, colleagues, business contacts etc.)

The Small World Effect Watts and Strogatz (1998)

Fully Connected graph Ring graph

Random graph

Power Law Graph

b=0

b = 0.125

b=1

People know their neighbors.

People know their neighbors, and a few distant people.

People know others at random.

Clustered, but not a “small world”

Clustered and “small world”

Not clustered, but “small world”

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The Small World Effect

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But Who Cares…?

Watts and Strogatz (1998)

So what would it take for any world at all to be small? It turns out: not much… Some source of “order” The tiniest amount of randomness

So: Small World Networks should be everywhere!

Why do networks matter? Clustering coefficient / Normalized path length

First five random links reduce the average path length of the network by half, regardless of N!

Clustering coefficient (C) and average path length (L) plotted against b

The 9/11 Hijackers and Their Associates

Why is Six Degrees interesting?

Business ties in US BiotechIndustry: 1988 Nodes: investment pharma research labs public biotechnology

Links: financial R&D collab.

Source: http://ecclectic.ss.uci.edu/~drwhite/Movie

Business ties in US BiotechIndustry: 1991

Viral and Buzz Marketing

Nodes: investment pharma research labs public

black: purple: green: grey:

biotechnology

opinion leaders influenced uninfluenced undecided

Links: financial R&D collab.

Source: http://ecclectic.ss.uci.edu/~drwhite/Movie

Source: http://www.orgnet.com

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Typical Small Interfirm Production Network in NYC Garment Industry

Example 1: Finding a Job  Contrary to economic theory, many labor markets rely on personal contacts  We ask family, friends, colleagues for help  In particular, we tend to use “weak ties” (Granovetter) and also friends-of-friends, because they are more likely to have nonredundant information  Hence, the “Strength of Weak Ties”

Source: Uzzi, ASQ 1997

Example 2: Making Business Contacts

Sarah Ralph Jane

Peter

Example 3: Mapping Email Flow to Find „Hidden“ Communities of Experts

colors refer to department affiliation

Example 4: Alliance Networks  Access to know-how, contacts, resources expands the size of radar screen and make you detect technological discontinuities, emergent markets, new designs  Direct and indirect ties are positively related to innovation (Ahuja 2000)  Experience and centrality in the network are related to success—the relevant knowledge is widely distributed outside the firm (Powell et al. 1996)  The position of the firm in the alliance network also determines the propensity to collaborate (Stuart 1998)

sourc e : http://www.orgnet.c om

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Networks and Social Capital Ron Burt argues that social capital is a “useful metaphor,” explaining “how people do better because they are somehow better connected with other people,” and that we need to “cut beneath the metaphor to reason from concrete network mechanisms responsible for social capital” (Burt 2005)

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Network Foundations of Social Capital A collectivity is structurally cohesive to the extent that the social relations of its members hold it together

 What are the “concrete network mechanisms” that create advantage for communities & organizations?  How do individual membership patterns shape community cohesion? LOW Cohesiveness

Network Foundations of Social Capital

Network Foundations of Social Capital

Add more ties ….

But when focused on a single person, the network is fragile!

Network Foundations of Social Capital

Remove that one person and the whole network disintegrates… Problem!

Network Foundations of Social Capital

Solution: Spreading relations around the structure makes it robust to node removal

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A Key Feature: Structural Holes

Network Foundations of Social Capital As structural cohesion increases, fewer nodes are able to control resource flow within the network  Power is more evenly distributed because nobody controls access to network resources  Information flows more uniformly across the network  Norms & values tend to be more uniform  Informal Social Control is uniform as there are fewer opportunities to free ride The collectivity should take on a community character

(Burt 1992)

 Structural Holes are disconnects between contacts that create social capital via brokerage opportunities  Ego actor gains earlier access to flows of valuable information  Ego fills structural holes by forging new ties linking its unconnected alters, extract “commission” or “fee” for providing brokerage services  Information and control benefits mean better performance, which mean higher return on human capital  Ego maximizes its self-interests by controlling & exploiting information, playing one actor against another (“tertius gaudens”)

Structural Holes and the Social Structure of Competition Redundant contact

?

A

Non-redundant contact D

YOU

Structural Holes Filled by “You” B

How Network Position Matters Structural holes provide important benefits. For example…  Brokers occupying structural holes earn bigger bonuses  Managers located in structural holes are promoted earlier in their careers  People located in structural holes often have “better ideas” than others

C (Burt 1992; 2003)

How Network Position Matters

Strategic Network Expansion

You

Network A’

You

Network B’

You

Network C’

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Exercise: Assessing YOUR Network

Combining Brokerage and Closure

Ask yourself the following questions…  Academic matters  Who are the people with whom you have discussed important projects and assignments?

 Job Search  What people have been most helpful in your job search so far?

 Friends  Who are your closest friends?

 Professional development during your time at USC  What people have contributed most significantly to your professional development during the last year? © 2004 Ronald Burt. Brokerage and Closure, Cambridge University Press 2005.

Key Takeaways  Network centrality and structural holes are important for determining power and knowledge flows—both for firms and for your personal experience. Brokers do better!  Social capital and power come from the bridges that a person can build between others  It is the diversity of contacts that generates social capital—strength lies in weak ties  Network effectively; what does a new contact add to your network? What do YOU contribute to their network?

Next Session

 Prepare case: Abelli and Savotti at Banca Commerciale Italiana (A)

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BUAD 497: Session 24

Learning Objectives

Managing with Networks and Power II

 Get experience applying tools of network analysis  Examine the role of power and influence in interorganizational and interpersonal networks

Another Example: The German Network of Crossholdings

Abelli & Saviotti at BCI

Cross-shareholdings—March 1999 3.3% 3.2%

13.2%

0.4% SAI

9.4%

Burgo

0.4%

14.2%

10%

5%

2.2% 0.7% Pirelli

1.4% 2.2% 0.6%

5% 1.2%

4.9%

4.5%

2.2% 0.7% Pirelli

3.3%

4.5%

2.9%

0.8%

Lazard 10%

1.4% 2.2% 0.6%

5% 1.2%

4.9%

Commerzbank 1%

Banc a Commerc iale Italiana

2%

4.9% 1%

6%

3.1%

3.4%

4.8%

Generali 5%

11.7%

4.9% 0.4%

9.2%

2%

21%

Commerzbank

1% 5.7%

6.2%

2.7%

1%

Banc a Commerc iale Italiana

2%

Banc a Intesa

12.5%

2.1%

Burgo

11.7%

9.4%

4.7%

SAI Lazard

21%

2.7%

6%

1.9%

8.2%

2%

Mediobanc a

3.4%

4.8%

Generali

2% 2%

Banc a d’Italia

7.6%

2%

13.1%

3.1%

13.2%

9.2%

6.2%

4.5%

4.5%

Banc a Intesa

Banc a di Roma

14.5%

HdP

12.5% 4.7%

2.1%

14.2%

2%

8.2%

1.7%

Compart

8.1%

Italmobiliare

2%

Mediobanc a

2% 1.9%

3.2%

7.6%

2%

HdP

Banc a d’Italia

3%

2%

13.1%

3.1%

Banc a di Roma

14.5%

3% 4.5%

3.3%

1.7%

Compart

8.1%

Italmobiliare

Cross-shareholdings—March 1999

0.4%

5.7%

Unic redito Italiano

3.3%

4.5%

2.9%

0.8%

Unic redito Italiano

3.1% FIAT

Paribas

Deutsc he Bank

FIAT

Paribas

Deutsc he Bank

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Director Interlocks—March 1999 Compart

Banca di Roma

Italmobiliare

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Influence Matrix for BCI Case

Banca d’I talia

Lucchini Banca Intesa HdP

Mediobanca Gutty

Lucchini

Desiata

Sav iotti Sav iotti

SAI

Lazard

Gutty

Generali

Rondelli

Burgo Gutty Sozzani

Lucchini v Ruedorf err

Commerzbank

Banca Commerciale Italiana

Pirelli

Rondelli Gutty

FIAT

F.-Poncet

Paribas

Unicredito Italiano

Deutsche Bank

BCI: What Happened Next…

 May 12, 1999: BCI chairman Luccini calls a general shareholders meeting for June 21  May 15, 1999: Under pressure from the Mediobanca coalition, the BCI board rejects the Unicredito proposal  June 17, 1999: The BCI board convenes to asses Banca Intesa’s offer (70% stake, BCI to remain a separate entity within Banca’s group)  June 20, 1999: Abelli and Saviotti resign with the entire BCI board except for Luccini and one other board member

A Comparison of the Banca Intesa and Unicredito Italiano Offers

What Happened Next… (Cont’d)

• June 21, 1999: The general assembly the next day appoints a new board that duly reflects Mediobanca’s control over BCI. Fausti is appointed honorary chairman • June 23, 1999: The governor of Banca d’Italia (the central bank) publicly states his approval of the Banca Intesa deal • End of June, 1999: BCI and Banca Intesa seal a takeover deal; by September, Banca Intesa has complete control of BCI

What Happened Next… (Cont’d) So Mediobanca seems to have prevailed…?  April 2000: Banca Intesa severs its ties with Mediobanca! Moreover, the reorganization of IntesaBCI turns BCI into a direct competitor of Mediobanca  June 2000: Mediobanca Honorary Chairman, Enrico Cuccia, dies  2001 and after: Mediobanca’s influence over Italy’s corporate world continues to decline. By 2003, its shareholders agree to restrain the banks management from using its holdings as a means of control over corporate Italy

Source: Morgan Stanley Dean Witter Research estimates, MSDW Equity Research, 09/01/1999

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(Some) Key Takeaways  Understanding power and influence in complex networks is an important advantage; as both A&S and Cuccia found out, you have to know the territory  There is a lot more to power than authority and competence; often power is best exercised indirectly through intermediaries  There is considerable value in building interdependent relationships with key players over time that can be leveraged when needed in the future

Next Week

 Last topic relating to strategy implementation: Performance and Governance  Sharon Oster “Organizational Goals: Politics and Power in Organizations”  Prepare Monks and Minow on “Arthur Andersen”

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BUAD 497: Session 25

Performance and Governance I

Strategy, Performance, and Integrity

Page 170

Goals for this Session

 Examine challenges to implementing strategy and the essential problem of the public company  Know the various mechanisms for exercising corporate governance  Examine problems at Arthur Anderson

Arthur Andersen’s Houston Branch Office

 A critical function of managers is to create strong competitive strategies that enable the company to meet financial goals without compromising integrity  BUT: Today’s business environment is extraordinarily complex  Less staff forces organizations to do more with less  Expense reductions continue to be major way companies increase EPS  Earnings growth continues to be core focus  Unrealistic performance goals can pressure those who must make them work  Reward and compensation systems can expose employees to ethical compromises

The Paradox of Operating as a Public Company Pressures

Offsetting Controls

 Wall Street Influence  Investor expectations  Earnings growth  Quarterly pressures

 Exec. Compensation  Increase in overall level, stock options

 Economic Cycle  Cyclical Industry

 Compliance (Enron)  Disclosure (Worldcom)  Governance (Tyco)  Ethics and integrity of participants (Arthur Andersen)

“…perhaps nothing can bring a company down with such amazing speed as misconduct.” M. Ingebretsen, Why Companies Fail: The 10 Big Reasons Businesses Crumble, and How to Keep Yours Strong and Solid. (2003)

An Example: The “Walk-down to Earnings Game”  Analysts are “systematically optimistic” regarding earnings forecasts at the beginning of the fiscal reporting period  Aware of these tendencies, company financial officers give “guidance” to analysts (usually in the form of discretionary information disclosures” suggesting the analysts lower their estimates)  As analysts lower their estimates towards the end of the period  The company releases its official reported earnings at a level that “beats” the analyst estimates  The analysts issue “strong buy” recommendations  If the game is played right, the company’s stock will rise sharply on the day it announces its earnings

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The Public Company Conundrum Strengths  Ability to raise enormous amounts of capital and spread risk  Transparency - financing activities are visible and information readily available / Poor performance results in lower share values  Corporations are disciplined both by their internal governance systems and by competition in product and factor markets

Weaknesses  Separation of ownership and control results in an agency problem  Lack of powerful, informed monitors results when the shareholdings are widely dispersed  Entrenchment incentives - management may invest in protecting their jobs rather than creating value  Excessive mandated information disclosure lowers value of proprietary product and strategic information

A historical example… On a boat trip up China’s Yangtze River in the 19th Century, a titled English woman complained to her host of the cruelty to the oarsmen. One burly coolie stood over the rowers with a whip, making sure there were no laggards. Her host explained that the boat was jointly owned by the oarsmen, and that they hired the man responsible for flogging! Why would such an organizational arrangement arise voluntarily?

Basic Problems of Information Asymmetry

Agency Relationship: Owners and Managers

The essence of the Agency Theory is that the Principal has inferior information to the Agent.

Shareholders (Principals)

 Moral Hazard: the principal and agent share the same information up to the point at which the agent takes an action, but thereafter the principal is only able to observe the outcomes

• Firm owners • Decision makers

Managers (Agents)

• Risk bearing specialist (principal) pays compensation to • A managerial decision-making specialist (agent)

An Agency Relationships

 Adverse Selection: the principal does not know some information which is relevant to the action (such as the ability of the agent to perform the task), whereas the agent can make use of this information to his own advantage

The Tradeoff Between Profitability and Revenue Growth Rates

Risk

Manager and Shareholder Risk and Diversification

Shareholder (business) risk profile

Managerial (employment) risk profile

A B Dominant Related Related Unrelated Business Constrained Linked Businesses

Diversification

Keith Parker, University of Southern California

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How is Corporate Control Exercised The Board of Directors  The elected B of D is responsible for hiring, firing, monitoring, and setting the compensation of the firm’s managers  The B of D has broad discretion to direct the company’s affairs and is supposed to ensure that the firm is managed in the best interest of shareholders  Shareholder votes are also required to approve corporate mergers, to authorize the sale of major assets, to amend the firm’s bylaws, and to authorize the issuance of new equity issues

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How is Corporate Control Exercised (really…)  Directors are frequently selected by management and are beholden to them for their jobs  CEOs are all to often also the chairs of the boards, which creates all kinds of accountability problems  This is the case in about 75% of S&P 500 firms in the US (McKinsey & Company US Directors Survey,2002)

 Boards too often have poor procedures of evaluation in place, both regarding management and their own performance As a result, BoDs often exercise rather little control…

How is Corporate Control Exercised Disclosure and Shareholder Meetings  Publicly-traded companies are required to annually disclose a great deal of information about corporate earnings, executive compensation, and the ownership of the company’s voting shares  Further, these firms are also required to hold annual shareholders’ meetings, which is open to all owners of even a single share of common stock  In announcing these meetings, corporations send every shareholder a proxy statement that describes:  the meeting agenda,  spells out precisely which issues are to be voted on by shareholders,  and provides a form for shareholders to use either to vote personally at the meeting, via www, via telephone or to assign the right to vote the shares they own to someone else

How is Corporate Control Exercised (really…)

Flow of Authority in Corporate Governance

 Most corporate elections are usually staid affairs where shareholders are asked to vote for or withhold their vote for single slate of company directors  “Proxy fights” occur when a rival group of shareholders nominate a slate of alternative directors who do not support the current management team.  However, these are relatively rare due to expense to shareholders  As a result, shareholders often have little opportunity or incentive to actively engage in corporate control © 2006 The McGraw-Hill Companies

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How is Corporate Control Exercised

Compensation and Corporate Earnings (Bebchuck & Grinstein, 2006)

Compensation and Incentives  In 2006, the average total compensation of chief executives of S&P 500 corporations was $14.78 million, including salaries, bonuses, and incentive plans  That’s a 9.4% increase in CEO pay over 2005  The connection between superior performance and pay is rather tenuous

 CEOs Henry McKinnell of Pfizer and Robert Nardelli of Home Depot both received exit packages of more than $200 million. Both firms underperformed during their tenures

 Compensation on average consisted of

 Salary (cash): ~20%  Short term incentive plans (bonus): ~20%, usually tied so specific measures (ROI, net profits…)  Long term incentive plans (stock option plans etc): ~60%  Other benefits (insurance, legal, pension etc.) Source: Bebchuck & Grinstein, The Growth of Executive Compensation (2005)

Market Downturn and the Dilemma with Stock Options The problem of “underwater” options…

Why take action? Why NOT take action?

Impediments to the Market for Corporate Control  Entrenched insider groups frequently fight these bids using:        

Various court actions Staggered boards Poison pills Amendments to the corporate charter Greenmail Selling off “crown jewels” (aka “scorched earth”) Searching for white knights Any other strategy designed to discourage the bidder from pursuing the target further

 Firms frequently succeed in fending off takeover bids even when they would yield the target firm shareholders very large share premiums

An External Mechanism: The Market for Corporate Control  To the extent that managers do not act in the best interest of shareholders, the stock price of the firm will be less than what it would have been if the managers focused on maximizing shareholder wealth.  The market thus operates when firms face the risk of takeover when they are operated inefficiently. Many firms begin to operate more efficiently as a result of the “threat” of takeover.  Hence, the market allegedly acts as an important source of discipline over managerial incompetence and waste  However, it’s an expensive last resort…and often doesn’t work!

The Full Picture on Corporate Control…  Boards of Directors have a fiduciary duty to shareholders to monitor management, but…  Principals (i.e. shareholders) may engage in monitoring behavior to assess the activities and decisions of managers, but…  Executive Compensation can be used to align the incentives of managers and owners, but…  The Market for Corporate Control can discipline ineffective management, but…

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Arthur Andersen

Page 174

Arthur Andersen Background Info

 Arthur Andersen was an accounting and consulting service that operated businesses throughout the US & world.  The 89 year old company was part of the “Big 5” accounting firms.  Main headquarters in Chicago, Illinois and Houston, Texas.  Enron, the large energy corporation, was a client of Andersen’s for 16 years up until Enron’s 2001 bankruptcy.

Timeline of the Scandal

 In the summer and fall of 2001, Arthur Andersen foresaw government litigations and investigations against Andersen and Enron.  October 16th,2001- Enron issued a press release announcing the company’s $618m net loss for the 3rd quarter of 2001.  On the same day, Enron reduced shareholder’s equity in the stock and the stock price plummeted.

Key Takeaways

Timeline (cont’d)  October, 2001- Enron informs Andersen to destroy all paper documents and emails concerning Enron.  Shortly after, the SEC starts an investigation of the two companies.  Lawyers defending Arthur Andersen argued that shredding documents was a routine practice.  Eventually, Andersen was charged with obstruction of justice for destroying the documents before the collapse of the energy giant.  August 31, 2002- Arthur Andersen dissolves

Next Session

 Know (and be able to “speak”) Agency Theory;

it is the most dominant theory today in corporate governance and likely to remain so in the future  Also know the limits of Agency Theory; it has little to say about trust, dominant social, political, or organizational culture. These matter! (and may differ considerably…)  All the different mechanisms of internal and external governance as currently on the books have their weaknesses—know and avoid them!

 Prepare Bausch & Lomb Case

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Page 175

BUAD 497: Session 26

Performance and Governance II

Corporate or “White Collar” Crime  “…crime committed by a person of respectability and high social status in the course of his occupation” (Sutherland 1939)  Encompasses a variety of non-violent crimes usually committed in commercial situations for financial gain, including antitrust violations, computer/internet fraud, credit card fraud, phone/telemarketing fraud, bankruptcy fraud, healthcare fraud, environmental law violations, insurance fraud, mail fraud, government fraud, tax evasion, financial fraud, securities fraud, insider trading, bribery, kickbacks, counterfeiting, public corruption, money laundering, embezzlement, economic espionage, trade secret theft etc…

Companies reporting fraud by industry sector (Global)

Session Goals

 Examine what factors contribute to unethical conduct in organizations  Understand what went wrong at Bausch & Lomb

Corporate or “White Collar” Crime  In the U.S., the cost of corporate crime such as pricefixing and unsafe or illegal practices is estimated at up to $200 billion annually  Employee theft is 10 times as big a problem as street theft, white collar crime is 2-10 times as big a problem as employee theft  White collar criminals are far less likely to be investigated, arrested or prosecuted than other types of offenders  White-collar crime is especially dangerous because of opportunities for large-scale thefts; large enough to sink even a large company

Fraudster’s relation to the company

45% of companies worldwide reported being victims of economic crime in the last 2 years

Typical profile male (80%), between 31 and 41 years (34%), educated with degree or higher (48%)

Source: PWC Global Economic Crime Survey 2005

Source: PWC Global Economic Crime Survey 2005

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Reasons for committing fraud

Page 176

How are companies responding to the threat of fraud…? KPMG’s survey of large companies in 2002 found that

Almost a quarter of acts committed by senior management

 10% admitted fraud is “something we have not really thought about”  17% said fraud risk management is not adequately addressed  55% said they needed to improve channels for reporting suspicion of fraud  More than 80% said the person with overall responsibility for fraud prevention and detection is either the CEO or CFO

KPMG Fraud and Misconduct Diagnostic Survey 2002 Source: PWC Global Economic Crime Survey 2005

Bausch & Lomb: Pressure to Perform

Essential Elements of Strategic Control Systems

Bausch & Lomb: Missing the Mark

Update: Bausch & Lomb  Between 1994 and 1995, the value of the company’s shares sank by about a third

Boundaries

Culture

Rewards

 Daniel Gill retired in late 1995 in response to increasingly angry shareholders  A later SEC inquiry cleared Gill personally but stated that “Bausch & Lomb violated the anti-fraud, reporting and record keeping, and internal control provisions of the Exchange Act.”  Bausch & Lomb struggled to develop a viable long-term strategy, resulting in the restructuring of the company in late 2001 and early 2002, which included the loss of some 700 jobs.

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Update: Bausch & Lomb Again in Trouble (cont’d)  In October, 2005, Bausch & Lomb disclosed that an accounting fraud problem in its Brazilian subsidiary may require the company to postpone filing its quarterly financial report due to problems with its books and records  On March 17, 2006, B&L announced it would delay its 2005 annual report by about 6 weeks to make adjustments following internal investigations  Bausch & Lomb also said its ongoing investigation into South Korean vision joint venture BL Korea has found evidence of improper sales practices from 2002 to 2005.  On March 23, 2006, Moody's Investors Service announced it considering lowering its "Baa3" rating on B&L’s $544 million of unsecured debt (that’s just one notch above junk)  Bausch & Lomb is currently still working on its 2006 financial statements and plans to file them by April 30

Warning Signs of a Deviant Organizational Culture 1. There is a "kill the messenger" ethos in the organisation -- justifies distortion and concealment of information 2. There is a low degree of confidence in the accuracy of internal reports 3. Despite claims to doing the right thing, in the last analysis, top management does the most expedient thing 4. Employees do not know of or refer to written ethics policies 5. The operative value of the organisation is: if it's legal it's ethical

KPMG: How to Deter Employee Fraud  Know the risks in your business  What areas are most at risk? Where do you need to concentrate your efforts?

 Make your views on fraud known  Set the tone, establish clear guidelines, make clear your intention to investigate vigorously. Nothing is a better deterrent than a history of investigation

 Create a culture that frustrates fraud  Lead by example and avoid gray areas in rules, including receiving or giving gifts, entertainment, commissions, conflict of interest

 Ensure that your internal controls are effective

Bausch & Lomb: Not the Exception…  Managers often feel enormous pressure to do whatever it takes to deliver good financial performance  Actions often taken by managers Cut costs wherever savings show up immediately Squeeze extra sales out of early deliveries Engage in short-term maneuvers to make the numbers Stretch the rules further and further, until limits of ethical conduct are overlooked

 Executives feel pressure to hit performance targets since their compensation depends heavily on company performance  Fundamental problem with a “make the numbers” syndrome: The company does not serve its customers or shareholders well by placing top priority on the bottom line!

Warning Signs of a Deviant Organizational Culture (con’d) 6. Top management's stated concern for ethics appears to be mainly for public relations 7. Managers (while basically truthful) are willing to deceive in order to accomplish organizational or personal goals 8. Managers do not believe there is an obligation to be candid where it could harm personal or organizational goals 9. People who ignore ethics but produce bottom line results get promoted

KPMG: How to Deter Employee Fraud  Make certain that personnel policies are effective  Check applicant’s information and references thoroughly, particularly for risk areas. Establish an employee hotline for reporting fraud.

 Review disciplinary policy  Be tough on fraud; it can put your entire business at risk and damage its reputation as well as yours. A firm response to fraud will be your best protection against future fraud.

 Be alert for indicators of fraud. Develop a fraud response plan so you know what to do. Set up an audit committee or expand the role of the BoD’s audit committee

Keith Parker, University of Southern California

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But there’s also good news..!

Page 178

Next Class

 76% of customers will switch to brands or stores based on ethics & societal issues (Cone/Roper, 1997)  88% of consumers are more likely to buy from a socially responsible firm (Walker Research, 1998)

Next….YOUR Turn Presenting!

 Sales growth, profits, and ROI are correlated with corporate citizenship (Maignan, 1997)

Ethical strategy and business = profits!

Keith Parker, University of Southern California

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Professor Larry Harris Marshall School of Business University of Southern California

FBE 440 Courses 15355R (MW) & 15356R (TTh) Spring 2007

TRADING AND EXCHANGES Course Syllabus

Course Objectives This course will introduce you to the theory and practice of securities and contract trading at exchanges and in dealer networks. We will examine • • • • • •

why and how people trade, the principals of proprietary trading, why market institutions are organized as they are, how markets are changing in response to innovations in information technologies, the origins of liquidity, volatility, price efficiency, and trading profits, and the role of public policy in the markets.

To address these questions, we must understand why and how institutions, dealers, and individuals trade. Understanding trader behavior thus is a primary course objective. At the end of this course, you should be able to • • • • • •

solve various trading problems, recognize various trading styles, judge whether you would be a successful trader, evaluate and motivate brokers, design markets, and effectively lobby policy-makers on market issues.

Target Audience I designed this course for anyone who wants to understand how markets work and how traders trade. The reading assignments and the class lectures are appropriate for students who have no market experience. Experienced traders will also find this course to be valuable. Although you may already know much about market institutions, the economic perspectives that you will learn in this course will greatly improve your understanding of why some people make money while others lose money. Many brokers and dealers have greatly appreciated taking this course. Students with substantial market experience have little advantage over other students other than initial familiarity with the jargon and institutions.

Prerequisites This course has no prerequisites. Familiarity with Investments, Microeconomics, Corporate Finance, Information Technologies, and Statistics is helpful but not necessary.

Keith Parker, University of Southern California

FBE-440: Syllabus You will not be lost if you have not yet studied these subjects, but you may have to work harder than students who are already familiar with their principle concepts.

Addresses and Telephone Numbers Professor Larry Harris Fred V. Keenan Chair in Finance USC Marshall School of Business Hoffman Hall 600G Los Angeles, CA 90089-1427

(213) 740-6496 office (323) 933-0888 home (323) 244-1154 mobile You may call me at home or on my cell, but not before 7:00 AM, after 9:30 PM, on Friday night, or on Saturday.

[email protected] LarryHarris.com

How to Reach Me 1. Drop in during office hours—no appointment is necessary. My office is in Hoffman 600G. My office hours this semester are: Mondays Thursdays

1:00-2:00 PM 9:45-10:45 AM

2. Arrange to meet me by appointment. 3. Just drop in. I am in my office most days. It is best (but not necessary) to call ahead to make sure I am available and not occupied. I am obviously unavailable when I am teaching. I teach MW 10-12, TTh 8-10, and TTh 11-12:30. 4. Call me on the telephone. If you leave a message, please speak slowly and clearly when you give your phone number. You may call me at home or on my cell phone, but please not before 7:00 AM, after 9:30 PM, on Friday night, or on Saturday. 5. Arrange to dine with me before or after class. Consider inviting your classmates too. 6. Send me e-mail at [email protected]. While I am always happy to take questions about course topics, I prefer to respond orally rather than by e-mail. The opportunity to listen and respond generally produces more effective learning.

Electronic Notices I post assignments and information of interest to this class on Blackboard. The web address for BlackBoard is http://blackboard.usc.edu. I may use a password to protect some documents. If so, the password will be TradeOn. The password is case sensitive.

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FBE-440: Syllabus

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Grades and Examinations I will base the course grade on two midterm examinations, many small homework projects (see below) and on a final examination. Their relative weights in the course grade are as follows: 2 midterm examinations at 20 percent per midterm Homework projects / class participation Final examination Total

40% 25% 35% 100%

The examinations are scheduled as follows: Midterm 1 Midterm 2 Final Exam

MW Class Wednesday, February 14 Wednesday, April 4 Monday, May 7, 8:00 - 10:00 AM

TTh Class Thursday, February 15 Tuesday, April 3 Wednesday, May 9, 8:00 - 10:00 AM

The midterm and final examination dates will not change. Please check now to see that you do not have any conflicts. The second midterm will cover primarily topics covered since the first midterm. Since you cannot fully understand some topics without understanding earlier topics, you may wish to review earlier topics before the second midterm. The final examination will be a cumulative examination. Topics covered after the second midterm, however, may be somewhat over-represented. When assigning grades, I compute the weighted sum of examination and homework numeric scores using the weights above. Since the in-class variance of scores typically varies across exams and homework, the influence of a given score may be different from the weights presented above. In the past, the greatest in-class variation has been in homework scores and in essay exam scores. These exercises therefore have had a greater influence on the final grade than the above weights would suggest.

Grading Standards The Marshall School uses (and I adhere to) the following standards for undergraduate grading: A B C D F

Excellent quality work Good quality work Fair quality work Work of minimum passing quality This grade is awarded to any undergraduate student failing to meet the minimum standards for passing the course. The grade of F indicates that the student failed at the end of the semester or was doing failing work and stopped attending the course after the twelfth week of the semester.

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Plus/minus grading (A, A-, B+, B, B-, C+, C, C-, D+, D, D-, F) increases the basic five grades to a total of twelve possible levels of performance. I interpret these standards as follows: A

Mastery of course concepts, tools, and techniques, plus a solid understanding of implications, applications, and interrelationships. Ability to apply and express that understanding with meaningful oral and written language.

B

Solid understanding of course concepts, tools, and techniques, plus knowledge of or awareness of implications, applications, and interrelationships. Capability to converse effectively in the terminology of the course.

C

Knowledge of course fundamentals. Basic understanding or awareness of finer points of course and discipline. Meets normal expectations of course input criteria.

D

Barely grasps the essentials of the course with little or no understanding of the finer points.

F

Unable to communicate an understanding of the basic concepts, tools, or techniques of the course. A failure to measure up to the basic course output goals.

Class Participation and Homework Projects Class participation is an important part of the learning experience of this course. The richness of the learning experience depends upon the degree of preparation by all students before each class session. Your classmates and I expect you to prepare for all classes and to actively participate in class discussions. I may call upon you at any time during class discussions to summarize insights from readings and class discussions, to analyze problems, or to opine on the value of what you are learning. Many concepts that we will discuss in the class sessions do not appear in the textbook. We also will discuss many topics more thoroughly and from different perspectives than does the textbook. Accordingly, class attendance also is an important component of the learning experience for this course. I generally will assign a short homework project for you to do before each class session. The homework usually will challenge you to think deeply about topics of interest to this course. It often will provide a foundation for an in-class discussion. The project will be due at the beginning of the class session. To encourage on-time attendance, I do not accept late projects. You must personally turn-in your homework projects. On days when no homework is due, I may pass an attendance signup sheet which will serve as a substitute for the homework.

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To encourage you to attend the entire class session, I may call upon you at anytime until I dismiss the class. If you do not respond when I call your name, you will not receive credit for the homework assignment, even if you turned it in. I designed these homework collection procedures to encourage you to attend class. I have taught this course without these procedures and have observed that students who did not attend class typically learned much less than those who did. Since I adopted these procedures, I have observed that students come to class better prepared and that they learn more. Take the homework assignments seriously. You may fail the course if you do not receive credit for enough assignments. Regrettably, I have failed students who did not obtain credit for enough homework assignments. To ensure that these policies are not too burdensome to you, you may miss three homework assignments during the semester with no negative effect on your grade. For example, if I assign 25 homework projects during the course, you will have a perfect homework/participation score if I accept at least 22 adequately prepared assignments from you. Although I will not award extra credit if you complete all the assignments, I strongly encourage you to do so. After you have missed three assignments, you may request permission to be absent. I will grant permission entirely at my discretion and only under the most severe circumstances. You should avoid missing homework assignments early in the semester because you may need to miss them later if you get sick or need to attend an interview or a funeral. Since I expect that missing homework will be a rare occurrence, and since you will always know when you have missed an assignment or have left class early, I will not post my records of completed assignments. I will notify you if your work has not been acceptable. To obtain complete credit for a homework project, • it must be turned in on time, as noted above, • you must be present if I call your name, as noted above, • your paper must represent your sincere effort to address the assignment, • the paper should be properly formatted, and • your name and social security number must be legibly written in the upper right hand corner of the paper. I will judge the sincerity of your effort by whether your written presentations are thoughtfully prepared and/or by your ability to discuss your work in class. If I have accepted your homework and I have not contacted you to tell you that your assignment was not adequately prepared, you may assume that you obtained full credit for the assignment. Given the very large number of homework papers that I will receive, our time would be poorly spent returning your homework papers to you in class. I therefore will not return your homework papers to you unless I have specific comments to give you. You therefore may want to keep a copy for yourself. Adequately completing the homework assignments will primarily require that you be disciplined and that you make an honest effort to complete the assignment. To trade

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effectively requires good personal discipline. In a course about trading, asking you to exercise personal discipline is very reasonable.

The Fine Print on Grades These rules protect you and me should unexpected events occur. You generally will receive no credit for tests that you miss. If you secure prior permission from me to miss a test, or if you have a valid medical excuse, I will make a special arrangement for you. At my sole discretion, I will allow you take the test (or a similar test) at another time, or I will arrange to give more weight to your other test results. To prove illness, you must submit your doctor’s note stating the nature of the illness and your doctor’s name, address, and telephone number. To prove that you were sent out of town on business, you must submit a copy of your airline and motel receipts, plus the name, address, and telephone number of your superior. I will not excuse you unless I receive all documentation listed above. I reserve the right to contact your doctor, superior, etc. USC strongly discourages incomplete grades, except in dire circumstances. Consequently, I will not give a grade of “Incomplete.” I will only make an exception to this rule if you have taken the examinations when scheduled, but missed the final examination due to illness or to a required out-oftown business trip for which you give prior written notice. You cannot pass the course without taking the final examination. Students who do not complete all required work, and do not receive a grade of “incomplete” will fail. To receive a final grade in the unlikely event of an “Incomplete,” you may either take the final exam that I administer to my next “Trading and Exchanges” class (which could be years from now) or take the final of another professor teaching an equivalent class (which is not likely as I have been the only professor teaching this class).

Register in this class only if you are willing to abide by these rules. Your registration will be your confirmation that you agree to abide by these rules.

Academic Integrity Academic integrity is an important component of the optimal learning environment that USC seeks to maintain. General principles of academic integrity include the concept of respect for the intellectual property of others, the expectation that individual work will be submitted unless otherwise allowed by an instructor, and the obligations both to protect one’s own academic work from misuse by others as well as to avoid using another’s work as one’s own. All students are expected to understand and abide by these principles. SCAMPUS, the Student Guidebook, contains the Student Conduct Code in Section 11.00; recommended sanctions appear in Appendix A. http://www.usc.edu/dept/publications/SCAMPUS/gov/ I do not expect academic dishonesty to be a problem in this course. However, should any suspicion of academic dishonesty arise, students will be referred to the Office of Student Judicial Affairs and Community Standards for further review. The review process appears at: http://www.usc.edu/student-affairs/SJACS/.

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Disability Services Any student requesting academic accommodations based on a disability must register with Disability Services and Programs (DSP) each semester. You can obtain a letter of verification for approved accommodations from DSP. Deliver the letter to me as early in the semester as possible. DSP is located in STU 301 and is open 8:30 AM - 5:00 PM, Monday through Friday. The phone number for DSP is (213) 740-0776.

Returned Papers To protect the confidentiality of your work, you must pick up your own graded paperwork. I will not give your papers to anyone else. Students who miss class sessions when paperwork is returned must arrange for an appointment to retrieve the material. I will discard graded paperwork unclaimed by a student after four weeks. Disputes over graded material must be brought to my attention as soon as possible.

Technology Use in Class Sessions Communication devices such as cell phones, Blackberries, etc. capable of sending or receiving electronic communication and all entertainment devices such as iPods or other MP3 players must be turned off and kept off throughout the class session. Receiving or sending communication or entertainment during class disrupts the learning environment and is rude to those around you. You may use laptops for taking notes, but I may revoke this privilege on an individual or global basis if I find that it is disruptive. You may use laptops for other purposes only with my expressed permission. In all events, you may not connect to the Internet unless I specifically permit it. You may not use laptops during examinations.

Your Responsibilities •

Read assigned readings before coming to class and come prepared to discuss them. If you are uncertain of the assignment, consult the course web pages at http://blackboard.usc.edu. The readings and our discussions are an integral part of the course.



Read the financial press every day. Come to class prepared to discuss current events in the markets. At a minimum, read the front page of the Money & Investing section of The Wall Street Journal. You also should read the Los Angeles Times business section. The business sections of the New York Times, The Financial Times and Investor’s Daily are even better. Try reading the finance section of The Economist and any relevant special reports. Best of all, read Traders Magazine or Securities Week, if you can get a copy. Serious professionals follow current events in their industry. Be a securities industry professional, if only for the next seventeen weeks. Reading the news will help you get more out of this class.

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Come to class on time. If you are late, enter quietly. If it is raining, remember that you will need more travel time. If you are habitually late, think about why you are not excited about coming to class. If I can improve things, please tell me. If you are simply not interested, drop the class for your sake—you must have better things to do than to attend a class that does not interest you.



Help your classmates study and prepare for class. The best way to learn is to teach. Teach each other, and you will learn quickly and thoroughly. Also, your classmates may become your professional colleagues. Start forming your professional networks by getting to know them now.



Express yourself. This is your class. Express your opinions, your problems, your reservations, your suggestions, and your interests. Make this class work for you. Help me improve the course. There are no dumb questions. If you do not understand something, many of your classmates also probably do not understand it either. Please ask the question.



Initiate. Do not limit yourself only to the resources I assemble for the course. If you want to learn something we do not cover, find a source (I can help) and study.

Required Text Larry Harris, Trading and Exchanges: Market Microstructure for Practitioners, Oxford University Press, 2003. I am offering a one-dollar bounty for each new error in the book that you bring to my attention. To earn this reward, you must be the first to identify the error. I am interested in typos, grammatical problems, factual inaccuracies, and any other objective issues that are the responsibility of the author. I will be the sole arbiter of what qualifies and I reserve the right to cancel this offer at anytime. An errata sheet appears at http://www.tradingandexchanges.com.

A Very Useful Book John Downes and Jordan Elliot Goodman, editors, Dictionary of Finance and Investment Terms, 7th Edition (New York: Barron’s Educational Series, 2006, ISBN 9780764134166) This inexpensive dictionary is very useful for quickly defining financial jargon and concepts.

A Strong Recommendation Edwin Lefèvre, Reminiscences of a Stock Operator, (New York: John Wiley and Sons, Inc., Reprinted 1993, ISBN 0-47105970-6, first published in 1923) Reminiscences is a ghostwritten autobiography of Jesse Livermore. Livermore was a very successful stock and commodity speculator who traded in the late 19th and early 20th centuries. The author, Edwin Lefèvre, was a financial reporter who spent two months interviewing Livermore for this project. The result is presented as a first-person narrative by a character called Larry Livingston, who clearly represents Jesse Livermore. The book is full of market wisdom and human wisdom. It is easy to read, engaging, and covers many of the topics of this course.

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FBE-440: Syllabus Rev: 1/4/07

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Professor Larry Harris

USC Spring 2007

FBE 440 TTh Class Schedule The examinations indicated on this schedule will take place as scheduled. Otherwise, this is a tentative schedule that I may modify in response to the needs and interests of the class. As the course evolves, I will post the topics to be covered in the next lecture (and associated reading assignments) on BlackBoard. The topics below correspond to chapters in the textbook. Please read them before coming to class. I will not attend class on March 27 (Q Group Conference) and April 10 (Passover holiday). I hope to arrange for outside speakers on those days. Date

Topic

Jan 9

Tu

1 Introduction

Jan 10

Th

2 Trading Stories 3 The Trading Industry 4 Orders and Order Properties

Jan 16

Tu

5 Market Structures

Jan 18

Th

6 Order Driven Markets

Jan 23

Tu

6 Order Driven Markets (continued)

Jan 25

Th

7 Brokers

Jan 30

Tu

8 Why Do People Trade?

Feb 1

Th

9 Good Markets

Feb 6

Tu

10 Informed Traders and Market Efficiency

Feb 8

Th

11 Order Anticipators

Feb 13

Tu

12 Bluffing and Price Manipulation

Feb 15

Th

Midterm Examination

Feb 20

Tu

13 Dealers

Feb 22

Th

14 Bid/Ask Spreads

Feb 27

Tu

15 Block Trading

Mar 1

Th

16 Value-motivated Traders

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Professor Larry Harris Page 189 Date

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USC Spring 2007

Topic

Mar 6

Tu

17 Arbitrageurs

Mar 7

Th

18 Buy-side Traders

Mar 13

Tu

Spring Recess Holiday

Mar 15

Th

Spring Recess Holiday

Mar 20

Tu

19 Liquidity 20 Volatility

Mar 22

Th

21 Liquidity and Transaction Cost Measurement

Mar 27

Tu

No Class

Mar 29

Th

22 Performance Evaluation and Prediction

Apr 3

Tu

Midterm Examination

Apr 5

Th

23 Index and Portfolio Markets

Apr 10

Tu

No Class

Apr 12

Th

24 Specialists

Apr 17

Tu

25 Internalization, Preferencing, and Crossing

Apr 19

Th

26 Competition within and among Markets

Apr 24

Tu

27 Bubbles, Crashes, and Circuit Breakers

Apr 26

Th

28 Floor versus Automated Trading Systems 29 Insider Trading

May 9

W

Final Examination, 8:00 AM - 10:00 AM

May 11

F

University Commencement

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Techniques for Learning Efficiently You will learn more in less time if you learn efficiently. You then will have more time for other activities. Consider the following suggestions to make your learning quicker and more effective.

The General Principle You learn most effectively when you force yourself to use what you must learn. You must put new information and concepts into your own words. Then you must organize, manipulate and use them.

Specific Suggestions When studying, imagine that you will have to teach others what you have learned. Think carefully about how you would do this. This objective is more real than you might imagine. When people hire you for what you know, they expect you to share your knowledge. You soon will be educating your supervisors, colleagues and employees. Practice teaching the course material to your classmates in study sessions. If you have a copy of a speaker’s lecture notes, do not use them when you attend the lecture. You will learn most effectively if you take notes yourself and then later compare your notes to the speaker’s notes. If no speaker’s notes are available, trade lecture notes with your classmates and discuss the differences among them. Do this even if the speaker’s notes are available. Highlighting and underlining may help you identify what you need to learn, but they are not efficient learning techniques. At best, they help you understand what other people have written. To remember your studies, you must put them into your own words. People like to highlight and underline because these tangible activities make them feel productive. Do not mistake activity for productivity. If you ever catch yourself highlighting and underlining on autopilot, you know what I am talking about. You learn most effectively by taking notes. If you do not feel like writing, consider dictating your notes into a tape recorder. Both methods work well. In either event, do it in your words. Do not copy what others have written. You learn more from composing your notes than from studying them. Spend more time composing. Compose notes after you finish reading a section or a chapter. It is best to wait a few hours. Recompose your lecture notes after a lecture, preferably without looking at your original notes. To remember something, you have to practice remembering. If you know that you will later compose and recompose, you will remember more. When you review your studies, start by trying to remember what you want to review. Then go back to your notes, see what you forgot, and study just that. It is inefficient to study what you already know. If necessary, return to the original sources.

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To prepare for tests, practice taking old tests if they are available. Take the tests before you read the answers. Being able to recognize a correct answer is not the same thing as being able to provide the correct answer. Practice providing, not recognizing. If you cannot understand an important passage in your readings, go back and review. Good texts are organized so that you should not have to read forward to understand an earlier passage. You accomplish little by plowing through confusion. Unlike snow, confusion usually piles up in front instead of being pushed to the side. Not all texts are well written, however, and even the best texts may have some weak sections. Sometimes it is best to do a quick first pass over the material so you can see where it is going. Then go back and read it carefully. If you are lost in a lecture, tell your instructor. Many others may be lost too. The true object of a lecture is to transmit knowledge, not to finish a set of topics. Instructors that finish their lectures without conveying information have wasted your time and their time. Come to class prepared to minimize the chance that you will get lost. Everyone gets frustrated when they are confused about something that they believe they must know. Frustration is an emotion that makes learning less effective. It can cause you to overestimate the time necessary to accomplish your objectives and lead to feelings of failure that would become self-reinforcing if you quit. Managing frustration therefore is essential to effective learning. You can prevent frustration by not allowing yourself to get confused. When you do not understand what you are reading, go back and review. When you do not understand a point made in lecture, ask the instructor to explain it again differently. When you do become frustrated (everyone does at some point), deal with it immediately by taking action to control this emotion instead of letting it control you. If you are studying, stop and do something else for a while. If you are in a lecture or a meeting, ask a question. Do not waste time in an emotional state that is not productive. Instead, recognize your emotion and deal with it. Do not eat a heavy meal before you attend class or plan to study. It is easier to learn when you do not have to fight the natural inclination of your body to doze on a full stomach. Most peoples’ minds slow down in the early afternoon (if they keep normal sleeping hours). Try to avoid studying and taking classes when your mind is not active. If you are too tired to learn effectively, get some sleep and return to your studies when you are more rested. Otherwise you will waste your time and be even more tired. Study somewhere where you will have few distractions. You only have one CPU in your head. Multitasking is inefficient because keeping track of tasks and switching among them consumes energy and time. You can accomplish more in less time by devoting your full attention to one task at a time than if you try to do several at the same time. If you review a little bit every now and then, you will learn more than if you spend the same amount of time cramming before an exam.

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A Final Note of Encouragement Although these suggestions may seem as though they are difficult, they will allow you to learn more in less time. Learning effectively will give you more time to do other things. Time is our most scarce resource. Use it wisely.

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FBE-440: Course Name _____________________________ Page 193 Last, First Professor Larry Harris

Documents

Trading and Exchanges

USC Spring 2005

FBE 440 MW Midterm 1 Write your name on the exam now. Each question can be answered with a short answer. Please use a pen and write legibly. If most fourth grade students could not read your cursive script, please write in block print. Take your time and do well. Please ask me if you have trouble with spelling or grammar. Since knowing that you do not know something is a valuable form of knowledge, I give half credit for blank answers. A completely wrong answer, of course, will receive no credit. Good luck! Very Short Answers (five points each) 1. What kind of option does a buy limit order represent?

__________________________

2. What common order type has the greatest market impact?

__________________________

3. What benefit do commodity hedgers expect to obtain from trading?

__________________________

Simple One Sentence Answers (5 points each) 4. In what sense are exchanges and brokers the same?

5. What is the primary conflict of interest within an SRO?

Keith Parker, University of Southern California

FBE-440: Course Documents 6. What is the main advantage of a call market over a continuous trading market?

7. Why is price priority self-enforcing?

8. The pricing rule used in the bucket and bucketering shops that Jesse Livermore traded in is a derivative pricing rule. Why have I classified it as such?

Slightly Harder One Sentence Answers (10 points each) 9. Why do mutual fund management companies like soft dollars commissions?

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FBE-440: Course Name _____________________________ Page 195 Last, First

Documents

10. Of what benefit is orthogonality to a well-informed trader?

11. Consider a sealed bid auction in which the highest bidder wins and pays the average of the highest and second highest bid prices. Explain why bidders should or should not bid their reservation prices in this auction.

12. Provide one example of how informative prices in the secondary capital markets (trading of seasoned securities) help make production in our economy more efficient.

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FBE-440: Course Documents

Computation Questions (10 points each) 13. Suppose that the following orders are submitted to a call market that conducts a single price auction using price-time precedence rule at 10:15. What will be the market clearing price and the total volume of trade? (Please do not double-count the volume.) Trader A B C D E

Arrival time 9:30 9:40 9:45 9:50 10:00

Side Buy Sell Buy Sell Buy

Price _____________

Price 11 11 9 9 12

Size 10 10 20 10 5

Volume _____________

14. Mark submits a market order to sell 9 to a continuous market with the following order book: Trader Ann Jack Steve Beth

Bid Size 15 3

Price 80.0 80.3 80.4 80.6

Offer Size

5 10

At what average price will Mark’s order be filled?

__________________________

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FBE-440: Course Name _____________________________ Page 197 Last, First Professor Larry Harris

Documents

Trading and Exchanges

USC Spring 2005

FBE 440 TTH Midterm 1 Write your name on the exam now. Each question can be answered with a short answer. Please use a pen and write legibly. If most fourth grade students could not read your cursive script, please write in block print. Take your time and do well. Please ask me if you have trouble with spelling or grammar. Since knowing that you do not know something is a valuable form of knowledge, I give half credit for blank answers. A completely wrong answer, of course, will receive no credit. Good luck! Very Short Answers (5 points each) 1. Price is currently at 50. What order should a trader use if she wants to sell if the price falls to 30? __________________________

2. What limits the trading profits of informed traders?

__________________________

Simple One Sentence Answers (5 points each) 3. Who or what is on the “buy-side?”

4. What is the difference between a broker and a dealer?

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5. What benefit do members of an SRO obtain by subjecting themselves to its regulation?

6. Ignoring labor costs, what is the most important argument against opening the NYSE an hour earlier to accommodate European traders?

7. The pricing rule used in the bucket and bucketering shops that Jesse Livermore traded in is a derivative pricing rule. Why have I classified it as such?

8. Rational investors expect to lose on average to well-informed traders. Why are they still willing to trade?

Keith Parker, University of Southern California

FBE-440: Course Name _____________________________ Page 199 Last, First

Documents

Slightly Harder One Sentence Answers (10 points each) 9. Consider a sealed bid auction in which the highest bidder wins and pays the average of the highest and second highest bid prices. Explain why bidders should or should not bid their reservation prices in this auction.

10. Why is a large tick (minimum price variation) necessary to make secondary precedence rule such as time precedence economically meaningful?

11. How do informative prices in the primary (new issue) capital markets help make production in our economy more efficient?

12. How might gamblers in the financial markets benefit the economy as a whole?

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Computation Questions (10 points each) 13. An ECN that organizes a continuous pure price-time auction opens with an empty limit order book. It then receives the following orders: Trader A B C D E

Arrival time

Side

9:30 9:40 9:45 9:50 10:00

Buy Sell Buy Sell Buy

Pric Size e 10 10 11 10 9 20 8 15 10 5

List the trades, if any, that the ECN arranges: Trade #

Time

Buyer

Seller

Price

Size

1 2 3 4 5

14. Consider the following order book for a single price auction: Aggregate Bid Sizes 15 35 15 5 5

Price 12.0 12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8 12.9 13.0

Aggregate Offer Sizes

5 10

10 15 15 10

What will be the market clearing price and the total volume of trade? (Please do not double-count the volume.)

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FBE-440: Course Name _____________________________ Page 201 Last, First Price _____________

Documents

Volume _____________

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FBE-440: Course Documents Professor Larry Harris

Trading and Exchanges

Page 202 USC Spring 2005

FBE 440 MW Midterm 1 Answers Very Short Answers (five points each) 1. What kind of option does a buy limit order represent? A put option. 2. What common order type has the greatest market impact? Large market orders 3. What benefit do commodity hedgers expect to obtain from trading? Risk reduction Simple One Sentence Answers (5 points each) 4. In what sense are exchanges and brokers the same? They both arrange trades for their clients. 5. What is the primary conflict of interest within an SRO? An SRO is managed by the members that it regulates. The SRO thus may place the members’ interests before the public’s interests. 6. What is the main advantage of a call market over a continuous trading market? The call market reduces search costs by concentrating liquidity at a single point in time and space. 7. Why is price priority self-enforcing? Traders always seek the best prices. 8. The pricing rule used in the bucket and bucketering shops that Jesse Livermore traded in is a derivative pricing rule. Why have I classified it as such? Bucket and bucketering shops obtain (derive) their contract prices from prices printed at other venues. Slightly Harder One Sentence Answers (10 points each) 9. Why do mutual fund management companies like soft dollars commissions? Soft dollar commissions allow fund management companies to pay for goods and services with their customers’ assets.

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10. Of what benefit is orthogonality to a well-informed trader? Orthogonality increases the liquidity available to wellinformed traders by decreasing the probability that they will compete with other informed traders for the same liquidity. 11. Consider a sealed bid auction in which the highest bidder wins and pays the average of the highest and second highest bid prices. Explain why bidders should or should not bid their reservation prices in this auction. Bidders should bid slightly less than their reservation prices because their bids determine to some extent the prices that they will pay if they win. 12. Provide one example of how informative prices in the secondary capital markets (trading of seasoned securities) help make production in our economy more efficient. Informative secondary prices help allocate managers to existing capital by pricing how well they use the resources available to them. Informative secondary prices also allow shareholder to motivate their managers with stock options.

Keith Parker, University of Southern California

FBE-440: Course Documents

Computation Questions (10 points each) 13. Suppose that the following orders are submitted to a call market that conducts a single price auction using price-time precedence rule at 10:15. What will be the market clearing price and the total volume of trade? (Please do not double-count the volume.) Trader A B C D E

Arrival time 9:30 9:40 9:45 9:50 10:00

Side Buy Sell Buy Sell Buy

Price 11 11 9 9 12

Size 10 10 20 10 5

The sorted order book is Bid Size 20 10 5

Price 9 11 12

Offer Size 10 10

The 5 to buy at 12 are matched with 5 of the 10 to sell at 9 leaving 5 to sell at 9. The remaining 5 to sell at 9 are matched with the 10 to buy at 11 leaving 5 to buy at 11. The remaining 5 to buy at 11 are matched with 5 of the 10 to sell at 11. No further trades can be arranged because the next best buyer is only willing to pay 9. The single price is 11 and the volume is 15. 14. Mark submits a market order to sell 9 to a continuous market with the following order book: Trader Ann Jack Steve Beth

Bid Size 15 3

Price 80.0 80.3 80.4 80.6

Offer Size

5 10

At what average price will Mark’s order be filled? 3 trade at 80.3 and 6 trade at 80.0 so that the average price is 80.1.

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FBE-440: Course Documents

Professor Larry Harris

Trading and Exchanges

USC Spring 2005

FBE 440 TTH Midterm 1 Answers Very Short Answers (5 points each) 1. Price is currently at 50. What order should a trader use if she wants to sell if the price falls to 30? A stop order at 30. 2. What limits the trading profits of informed traders? Liquidity Simple One Sentence Answers (5 points each) 3. Who or what is on the “buy-side?” Institutions and individuals that manage money. 4. What is the difference between a broker and a dealer? A dealer trades for his own account whereas a broker trades as agent for other accounts. A dealer fills orders from his own account whereas a broker fills orders by finding a trader to take the other side. 5. What benefit do members of an SRO obtain by subjecting themselves to its regulation? SROs regulate their members to decrease the costs that members may impose upon each other. The costs may result from bad business practices or from the loss of reputation suffered by all when some members cheat the public. 6. Ignoring labor costs, what is the most important argument against opening the NYSE an hour earlier to accommodate European traders? It will dilute liquidity by further spreading it through time. 7. The pricing rule used in the bucket and bucketering shops that Jesse Livermore traded in is a derivative pricing rule. Why have I classified it as such? Bucket and bucketering shops obtain (derive) their contract prices from prices printed at other venues. 8. Rational investors expect to lose on average to well-informed traders. Why are they still willing to trade? They benefit by using the markets to move money from the present to the future.

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Slightly Harder One Sentence Answers (10 points each) 9. Consider a sealed bid auction in which the highest bidder wins and pays the average of the highest and second highest bid prices. Explain why bidders should or should not bid their reservation prices in this auction. Bidders should bid slightly less than their reservation prices because their bids determine to some extent the prices that they will pay if they win. 10. Why is a large tick (minimum price variation) necessary to make secondary precedence rules such as time precedence economically meaningful? A small tick allows traders to cheaply obtain precedence through price priority. 11. How do informative prices in the primary (new issue) capital markets help make production in our economy more efficient? They make it impossible or expensive for entrepreneurs to obtain capital for bad investment projects and make it easy for entrepreneurs to obtain capital for good projects. 12. How might gamblers in the financial markets benefit the economy as a whole? They make prices more efficient in the long run by making markets more liquid for informed traders. Computation Questions (10 points each) 13. An ECN that organizes a continuous pure price-time auction opens with an empty limit order book. It then receives the following orders: Trader A B C D E

Arrival time 9:30 9:40 9:45 9:50 10:00

Side Buy Sell Buy Sell Buy

Price Size 10 10 11 10 9 20 8 15 10 5

List the trades, if any, that the ECN arranges: Trade #

Time

Buyer

Seller

Price

Size

1

9:50

A

D

10

10

2

9:50

C

D

9

5

3 4 5

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14. Consider the following order book for a single price auction: Aggregate Bid Sizes 15 35 15 5 5

Price 12.0 12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8 12.9 13.0

Aggregate Offer Sizes

5 10

10 15 15 10

What will be the market clearing price and the total volume of trade? (Please do not double-count the volume.) Match 5 bid at 12.4 with 5 offered at 12.2. Match the 5 bid at 12.3 with 5 of the 10 offered at 12.3. No more trades are possible. The only price that works for all is 12.3. The total volume is 10.

Keith Parker, University of Southern California

Course Documents Professor Larry HarrisFBE-440: Trading and Exchanges

USC Spring 2007 Page 208

Homework Assignment 7 - Answers Using the following orders, please complete the following tables taken from Chapter 6. Table 6-1-New. Example Orders Time

Trader

10:01 10:05 10:08 10:09 10:10 10:15 10:18 10:20 10.27 10:29

Bea Sam Ben Sol Stu Bif Bob Sue Sun Bud

Order side

Size

Buy Sell Buy Sell Sell Buy Buy Sell Sell Buy

3 2 4 2 5 4 3 4 3 3

Price 30.0 30.1 30.2 30.3 30.3 market 30.2 30.0 30.2 30.3

Assume that Bif’s true reservation price is 30.5. Table 6-2. Example Order Book Sellers Trader Sue Sam Sun

Sol Stu

Buyers

Size Order price 4 2 3

2 5

30.0 30.0 30.1 30.2 30.2 30.2 30.3 30.3 30.3 Market

Size

Trader

3

Bea

3 4 3

Bob Ben Bud

4

Bif

Keith Parker, University of Southern California

FBE-440: Course Documents

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Please conduct a single price call market auction and present the re sults: Table 6-3. Call Market Trades Match 1 2 3 4

Seller

Buyer

Sue Sam Sun Sun

Bif Bud Bud Ben Total:

Quantity 4 2 1 2 9

What is the single uniform price? 30.2 Table 6-7. Trader Surpluses in the Single Price Auction Example Trader

Order

Sue Sam Sun Bif Bud Ben

Sell 5 limit 30.0 Sell 2 limit 30.1 Sell 3 limit 30.2 Buy 4 at market Buy 3 limit 30.3 Buy 4 limit 30.2

Totals

Filled sales

Filled buys

Trade price

4 3 2

30.2 30.2 30.2 30.2 30.2 30.2

4 2 3

9

9

Assumed value Trader surpluses 30.0 30.1 30.2 30.5 30.3 30.2

(30.2 − 30.0) × 4 = (30.2 − 30.1) × 2 = (30.2 − 30.2) × 3 = (30.5 − 30.2) × 4 = (30.3 − 30.2) × 3 = (30.2 − 30.2) × 2 =

0.8 0.2 0.0 1.2 0.3 0.0 2.6

2

Keith Parker, University of Southern California

FBE-440: Course Documents Please conduct a continuous market auction using the same orders from Table 6-1-New above and present the results: Order Book after First Order Arrives Sellers

Buyers

Trader Size Order price 30.0

Size Trader 3

Bea

The market is 30.0 bid for 3

Order Book after Two Orders Sellers

Buyers

Trader Size Order price Sam

2

30.0 30.1

Size Trader 3

Bea

The market is 30.0–30.1 3 x 2.

Order Book after Three Orders Sellers

Buyers

Trader Size Order price 30.0 30.2

Size Trader 3 2

Bea Ben

The market is 30.2 bid for 2

3

Keith Parker, University of Southern California

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Order Book after Four Orders Sellers

Buyers

Trader Size Order price

Sol

2

30.0 30.2 30.3

Size Trader 3 2

Bea Ben

The market is 30.2–30.3 2 x 2.

Order Book after Five Orders Sellers

Buyers

Trader Size Order price

Sol Stu

2 5

30.0 30.2 30.3 30.3

Size Trader 3 2

Bea Ben

The market is 30.2–30.3 2 x 7.

Order Book after Six Orders Sellers

Buyers

Trader Size Order price

Stu

3

30.0 30.2 30.3

Size Trader 3 2

Bea Ben

The market is 30.2–30.3 2 x 3.

4

Keith Parker, University of Southern California

FBE-440: Course Documents Order Book after Seven Orders Sellers

Buyers

Trader Size Order price

Stu

3

30.0 30.2 30.2 30.3

Size Trader 3 3 2

Bea Bob Ben

The market is 30.2–30.3 5 x 3.

Order Book after Eight Orders Sellers

Buyers

Trader Size Order price

Stu

3

30.0 30.2 30.3

Size Trader 3 1

Bea Bob

The market is 30.2–30.3 1 x 3.

Order Book after Nine Orders Sellers

Buyers

Trader Size Order price Sun Stu

2 3

30.0 30.2 30.3

Size Trader 3

Bea

The market is 30.0–30.2 3 x 5.

5

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Order Book after Ten Orders Sellers

Buyers

Trader Size Order price Stu

Size Trader

30.0 30.3

2

3

Bea

The market is 30.0–30.3 3 x 2.

Table 6-8. Trades in the Continuous Auction Example Time

Seller

Buyer

Price

Quantity

10:08 10:15 10:15 10:20 10:20 10:27 10:29 10:29

Sam Sol Stu Sue Sue Sun Sun Stu

Ben Bif Bif Ben Bob Bob Bud Bud

30.1 30.3 30.3 30.2 30.2 30.2 30.2 30.3 Total:

2 2 2 2 2 1 2 1 14

Table 6-9. Trader Surpluses in the Continuous Auction Example Trader Order Sam Sol Sue Sun Stu Ben Bif Bob Bud Totals

Sell 2 limit 30.1 Sell 2 limit 30.3 Sell 4 limit 30.0 Sell 3 limit 30.2 Sell 5 limit 30.3 Buy 4 limit 30.2 Buy 4 at market Buy 3 limit 30.2 Buy 3 limit 30.3

Filled sales

Filled buys

Average trade price

Assumed value

4 4 3 3

30.1 30.3 30.2 30.2 30.3 30.15 30.3 30.2 30.233

30.1 30.3 30.0 30.2 30.3 30.2 30.5 30.2 30.3

2 2 4 3 3

14

14

Trader surplus (30.1 − 30.1) × 2 = (30.3 − 30.3) × 2 = (30.2 − 30.0) × 4 = (30.2 − 30.2) × 3 = (30.3 − 30.3) × 3 = (30.2 − 30.15) × 4 = (30.5 − 30.3) × 4 = (30.2 − 30.2) × 3 = (30.3 − 30.233) × 3 =

0.0 0.0 0.8 0.0 0.0 0.2 0.8 0.0 0.2 2.0

6

Keith Parker, University of Southern California

FBE-440: Assignments Keith Parker ID#6390.4899.77 [email protected] WSJ Article Summary From Tuesday, January 9th, Print edition of the WSJ “Same Crowd Behind Oil Rise Now Sells Out” Many people expected investors to continue to put more money into crude oil and to continue to buy futures in the commodities market. Many analysts don’t believe this to be completely true, as returns have slowed and the costs of holding investments in this market have increased significantly. If the large cost of holding onto an investment in the crude oil market continues, investors may not be willing to buy. Further, oil futures have fallen 27 percent since their peak in July of last year. This article is important to the class largely because it demonstrates that an investment that provides a return may not be attractive to investors if the cost of holding onto said investment is too high.

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Page 215 Keith Parker ID#6390.4899.77 [email protected]

Discussion on SRO’s self-regulation and its implications For Thursday, January 18th While there are clearly ways in which for-profit stock exchanges that list themselves on their own exchange could manipulate the regulations applicable to buying and selling stock, I do not believe that this would happen in today’s market. The most prominent reason for this is the industry’s focus on such a thing happening. Further, because the idea that a for-profit organization regulating itself seems to many to be illfated, there follows the idea that there will be intense scrutiny of discrepancies and manipulations of self-imposed regulations that might be aimed at the increase of profits for said exchange. As a result of this scrutiny that is likely to occur over these organizations’ self-regulations, it would be too risky for such exchanges with longstanding reputations (such as the NYSE or NASDAQ) to take part in self-regulation manipulations for fear of being caught. As far as regulatory problems that could occur go, there are a few possibilities. First, an exchange such as the NYSE or NASDAQ could manipulate the time it takes for their own stock to update in electronic trading systems to work in their advantage when trading of their stock is taking place. Further, when buyers purchase their own stock at low prices, these exchanges could artificially make it appear that prices are low for a period of time; this would result in more stocks being sold than if the price were allowed to rise, as regulations require.

Keith Parker, University of Southern California

FBE-440: Assignments Keith Parker ID#6390.4899.77 [email protected] WSJ Article Brief The Most Important Traders in the Stock Market For Tuesday, January 30th In the stock market the most important traders are speculators, particularly the informed traders within this group. This is true because the price of stock for a certain company in the stock market should represent as best it can the true value of that firm. Informed traders act on information about the fundamental values of a firm, thus their trades balance out to an equilibrium price that is the nearly true value of the firm, according to what is known in the market. This ‘close-to-true’ value is based on trades from value traders who extensively research the worth of the company, as well as news traders who keep the stock price up-to-date by acting on the most recent news relevant to the organization. Nonetheless, the price of a stock usually doesn’t represent the true worth of a firm, as noise traders whose trade is based on factors outside of standard information and news cause the price of a stock to vary widely from its real value. Essentially, informed traders are important to the stock market because they act as a counter-balance to the noise created by ‘noise traders’ (essentially all traders who are not ‘informed traders’).

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Page 217 Keith Parker ID#6390.4899.77 [email protected]

What Is The Optimal eBay Bidding Strategy? For Thursday, January 25th In order to receive an item for the lowest possible price through the online bidding site eBay, a user is best served by not bidding at all until as close to the auction end as they can get, then entering their bid limit. EBay is essentially an English auction. Further, the eBay system automatically enters a bid for one’s item at a set bidding increment above the previous bidder’s bid limit, up to the price of one’s bid limit. As a result of this, a user needs not constantly sit at his or her computer outbidding somebody else up to their bid limit, they can merely enter their bid limit and let the eBay system do the rest. Secondly, it is best to enter one’s bid limit as close to the end of the auction as possible. The reason for this is as follows. If users enter their bid limits early in the auction, the current bid price will rise and other users may reconsider their bid limit, raising their limit to a higher amount than it would have previously been. This will result in a higher cost of the item. The exception here is an item with many substitutes or listed by many sellers. In this case, bidding early will raise the bid price enough to cause other users to look elsewhere and not bid on the item at all.

Keith Parker, University of Southern California

FBE-440: Assignments Keith Parker ID#6390.4899.77 [email protected] WSJ Article Brief The Most Important Traders in the Stock Market For Tuesday, January 30th In the stock market the most important traders are speculators, particularly the informed traders within this group. This is true because the price of stock for a certain company in the stock market should represent as best it can the true value of that firm. Informed traders act on information about the fundamental values of a firm, thus their trades balance out to an equilibrium price that is the nearly true value of the firm, according to what is known in the market. This ‘close-to-true’ value is based on trades from value traders who extensively research the worth of the company, as well as news traders who keep the stock price up-to-date by acting on the most recent news relevant to the organization. Nonetheless, the price of a stock usually doesn’t represent the true worth of a firm, as noise traders whose trade is based on factors outside of standard information and news cause the price of a stock to vary widely from its real value. Essentially, informed traders are important to the stock market because they act as a counter-balance to the noise created by ‘noise traders’ (essentially all traders who are not ‘informed traders’).

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Page 225 Keith Parker ID#6390.4899.77 [email protected]

New York Times Article Brief S.E.C. is Looking at Stock Trading For Thursday, February 8th The SEC has begun an investigation that will attempt to reveal which banks on Wall Street, if any, have been engaging in front running. Front running is when a bank tells valuable clients about a major trade before the trade actually happens. This allows the client to make a risk-free trade on said stock. Some banks may have been allowing front running a little differently than it has happened in the past; banks may be giving their valuable clients information about trades in advance of large trades, after which these clients would go to a different bank to make the trade. The SEC has demanded all stock and option trading data for the last two weeks of September from Major Wall Street Banks. Concerns have arisen from studies that show unusual amounts of trading occurring before major deals are carried out. Further, the growing dominance of Hedge funds on Wall Street, which now account for 30 to 50 percent of trading on most major markets, has fed concerns of insider trading. The SEC has reported that any information regarding insider trading will be immediately investigated as usual.

Keith Parker, University of Southern California

FBE-440: Assignments Keith Parker ID#6390.4899.77 [email protected] Bidding for CBOT For Thursday, March 23rd Although ICE may be offering a higher bid price for CBOT (over one billion dollars higher), the shareholders will benefit more from the acceptance of the CME bid. The underlying reason for this is compatibility. The nature of the futures trading markets, that futures can only be traded within their exchanges (unlike stocks which can be moved from exchange to exchange), it is important to build market share. Most importantly, a merger between CBOT and CME will provide customers with more liquidity. CBOT should accept the lower bid offer and through this provide a better service with more liquidity, thus providing more value to their shareholders.

Keith Parker, University of Southern California

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Page 227 Keith Parker ID#6390.4899.77 [email protected]

Jim Cramer on Market Manipulation For Thursday, March 29th It seemed to me that Jim Cramer, when speaking of things that would manipulate the market illegally, wasn’t as concerned as much about the legality of such moves as he was whether or not such actions were commonplace and accepted as standard in the market. His insights into the way in which markets could be manipulated were interesting though. His comments in regards to short-selling companies such as Apple and RIM (Research in Motion), then leaking rumors that the near futures of those companies weren’t looking very good in order to lower stock price in order to make a profit were also a clear indication that market manipulation and corruption were more routine than many people might think. Some comments in the video, such as it ‘only’ costing 10 or 15 million dollars to manipulate the market in some ways, made it clear that market manipulation is often a very expensive game to play.

Keith Parker, University of Southern California

FBE-440: Class Notes

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FBE-440 Review

FBE-440: Exam Things 2/9/07 2:13 PM

Traders often use whole numbers more often than fractions, et cetera Some questions will come from boxes in the book What are the benefits of a call market? • Bring people together at the same place and time, creating and offering more liquidity • What’s the role of time and place when we think about Call markets? Liquidity How do order-driven markets arrange trades • Market uses a set of rules, order precedence rules, to match buyers to sellers, and use pricing rules to determine price Do brokers work for their clients or for themselves? Obviously, they work for themselves, though the nature of their work is that they are working for other people Of what value is a large entertainment budget to a broker? • Brokers are most valuable when they have many clients Soft dollars, what are they? Soft dollars paid towards research from one account might benefit another account, this could be a problem here What agency regulates options trading? The SEC Find out what a deep-discount broker is Activities that may appear in the back office of a brokerage firm? Why is it important to have a poker face in a physically convened market? This is negotiating prices face-to-face Why do traders care about trustworthiness? Don’t ramble on when answering questions like these, just answer it very straightforward

Keith Parker, University of Southern California

FBE-440: Exam Things Things from the book that weren’t in class? • Does it appear in the list of important points in the chapter? • Was it highlighted in some way in the book? • Was an example provided to make it more clear? • Were there questions on it at the end of the book? Will get more credit for not writing something on the exam that you know you don’t know, rather than making something up What do brokers do? • Help their clients arrange trades, provide more value when they have more clients Figure out what payment for order flow is • What is payment for order flow, why are regulators concerned about it, and what affect does it have on commissions? What markets would you expect to see the greatest market efficiency? What makes prices informative? In what way is market structure like the rules of the game? It determines who has power, et cetera Lecture notes on blackboard represent at least one outline for going through the course; basically an abbreviated form of the book with the important stuff; often professor looks at lecture notes when writing exam A couple of questions might be on current events in the trading arena

Keith Parker, University of Southern California

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Page 245 Continuous Auction Time Trader 10:01 Bea Sam Ben Sol Stu Bif Bob Sue Sun 10:29 Bud Trades Buyer Ben Bip Bif Ben Bob Bob Bud Bud

Order Book Buyer side Buyer Ben Bob Bea

Order Side Buy Sell Buy Sell Sell Buy Buy Sell Sell Buy

Size

Seller Sam Sol Stu Sue Sue Sun Sun Stu

Price

Quantity

Price

Quantity

30.1 30.3 30.3 30.2 30.2 30.2 30.2 30.3

30.2 30.2 30

Buyers' Surplus Surplus Reservation (30.2-30.1)2 30.2 Ben List goes on

Price 3 2 4 2 5 4 3 4 3 3

30 30.1 30.2 30.3 30.3 Market 30.2 30 30.2 30.3

2 2 2 2 2 1 2 1

Sellers side Seller Price 2 Sam 3 1 Sun 3 Sol Stu

Quantity 30.1 30.2 30.3 30.3

2 2 2 532

Seller Surplus Surplus Reservation (30.1-30.1)2 30.1 Sue List goes on

When calculating suplus for Bud, who traded at two prices, you have to calculated his weighted average trading price

Keith Parker, University of Southern California

FBE-440: Exam Things Professor Larry Harris

Trading and Exchanges

Page 246 USC Spring 2007

FBE 440 MW Midterm 1 Answers Very Short Answers (five points each) 1. Suppose the market is 100 bid, offered at 101. What would be the limit price of a limit buy order if it were placed at the market? 100 2. The following orders are in a market: Order A: Buy 10 for 18 Order B: Buy 15 for 19 Order C: Buy 5 for 20 Order D: Sell 5 at 21 Order E: Sell 25 at 22 Order F: Sell 20 at 23 What is the best bid? Order C: Buy 5 for 20 (The highest priced buy order.) 3. An order book in a continuous auction contains only one limit order. It is a buy order with a limit price of 5. A limit sell order with a limit price of 4 arrives. At what price will a trade be arranged, if any? 5 4. In the extreme, a market sell order is like what kind of limit order? A limit order with a zero price. 5. In what direction is price moving when a limit sell order placed at the market fails to execute? Down 6. What do you expect will happen to bid/ask spreads if volatility increases? Spreads will increase. 7. Suppose a buyer buys 5 contracts for 40 using a limit order priced at 42. Given this information only, what is a reasonable lower bound for his trader’s surplus? (42-40)*5=10 8. Who makes payments for order flow? Dealers

Keith Parker, University of Southern California

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FBE-440: Exam Things

Simple One Sentence Answers (5 points each) 9. How can a buyer who does not have time-precedence at $25 acquire order precedence? Raise her bid. 10. The market in a continuous trading auction is 100 bid, offered at 101. An IOC order to buy, limit 100.5 arrives. What happens? Nothing. The order does not fill and it cancels automatically. Simple One Sentence Answers (10 points each) 11. Why do traders only want to trade with creditworthy counterparts? They want to be sure that their counterparts are able to settle their trades. 12. Why would it be difficult to enforce the uniform pricing rule in a continuous trading market? Traders will break their orders into pieces to price discriminate. 13. In this course, what is the difference between an investor and a speculator? An investor trades to move money from one point in time to another. A speculator trades to profit from unique information.

Keith Parker, University of Southern California

FBE-440: Exam Things

Computation Questions (10 points each) 14. Consider the following summary order book for a single price auction. Aggregate Bid Sizes 15 20 15 10 7 5 1 1

4

Price Market Sell 12 12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8 12.9 13 Market Buy

Aggregate Offer Sizes 2 2 7 4 4 10 15 30 15 10

At what price should the single price auction be conducted? What total quantity will trade? The single price auction price will be 12.4. The market buy orders are matched with the market sell orders leaving 2 unmatched on the buy side. These are matched with the sell orders placed at 12.1. The sell orders placed at 12.3 are matched with the buy orders placed at 12.7, 12.6 and 12.5. The sell orders place at 12.4 are matched with 4 of the buy orders placed at 12.4, leaving 3 unfilled on the buy side. No further trade is possible. The clearing price of 12.4 maximizes the total volume. The volume, counted on the buy side is 4 + 1 + 1+ 5 + 4 = 15. Counted on the sell side it is 2 + 2 + 7 + 4 = 15. 15. Mark submits a market order to buy 9 to a continuous market with the following order book: Trader Ann Jack Steve Beth

Bid Size 15 3

Price 80.0 80.3 80.4 80.7

Offer Size

6 10

Keith Parker, University of Southern California

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FBE-440: Exam Things

At what average price will Mark’s order be filled? 6 trade at 80.4 and 3 trade at 80.7 so that the average price is 80.5.

Keith Parker, University of Southern California

FBE-440: Exam Things Professor Larry Harris

Trading and Exchanges

Page 250 USC Spring 2007

FBE 440 TTH Midterm 1 Answers Very Short Answers (5 points each) 1. In what direction is price moving when a limit buy order placed at the market fails to execute? Up 2. Whose trading would a public order precedence rule restrict? The members of an exchange 3. The following orders are standing in a market: Order A: Buy 10 for 18 Order B: Buy 15 for 19 Order C: Buy 5 for 20 Order D: Sell 5 at 21 Order E: Sell 25 at 22 Order F: Sell 20 at 23 What is the best offer? Order D: Sell 5 at 21

(The lowest priced sell order).

4. Suppose a seller sells 8 bonds for 95 using a limit order priced at 93. Given this information only, what is a good lower bound for her trader’s surplus? (95-93)*8=16 or 1600 if you remember the bond pricing convention. 5. An order book in a continuous auction contains only one limit order. It is a buy order with a limit price of 5. A limit sell order with a limit price of 4 arrives. At what price will a trade be arranged, if any? 5 6. Which type of informed trader typically profits when values change but prices do not change? News trader Simple One Sentence Answers (5 points each) 7. The market at a continuous trading auction is 100 bid, offered at 101. A day order to buy, limit 100.5 arrives. What happens? The order is placed into the book on the buy side at 100.5 to await execution.

Keith Parker, University of Southern California

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FBE-440: Exam Things

8. What makes a market transparent? A transparent market publishes its quotes, orders and trades in a timely fashion. Simple One Sentence Answers (10 points each) 9. Why is a large tick (minimum price variation) necessary to make secondary precedence rules such as time precedence economically meaningful? A small tick allows traders to cheaply obtain precedence through price priority. 10. Why would it be difficult to enforce the uniform pricing rule in a continuous trading market? Traders will break their orders into pieces to price discriminate. 11. What effect does liquidity have on price efficiency? Prices should be more efficient in liquid markets because informed traders need liquidity to profit. 12. Why are uninformed traders willing to lose to informed traders? Uninformed traders are willing to lose to informed traders because they obtain some other benefit from trading besides trading profits. These benefits may come from investing, hedging, gambling or asset exchanging.

Keith Parker, University of Southern California

FBE-440: Exam Things

Computation Questions (10 points each) 13. Suppose that the following orders are submitted to a call market that conducts a single price auction using price-time precedence rule at 11:00. What will be the market clearing price and the total volume of trade? (Please do not double-count the volume.) Order A B C D E F

Arrival Time 9:30 10:00 10:15 10:31 10:35 10:38

Side Sell Buy Buy Sell Buy Sell

Limit Price 50 Market 51 50 49 51

Size 25 25 10 5 10 20

What is the market clearing price? First sort the orders into an order book as follows: Order A D F

Arrival Time 9:30 10:31 10:38

Side Sell Sell Sell

Limit Price 50 50 51

Size 25 5 20

B C E

10:00 10:15 10:35

Buy Buy Buy

Market 51 49

25 10 10

In a single price auction, all of Order A (25) is first matched with Order B and both are completely filled. All of Order D is then matched with 5 of Order C. The remaining 5 of Order C are matched with part of Order F. No further trades are possible because Order E is only willing to pay 49 but Order F wants 51. The uniform price for this auction is 51 since 51 is the only price at which a trade can be arranged between Order C and Order F. What total quantity will trade? The total volume is 25 + 5 + 5 = 35.

Keith Parker, University of Southern California

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14. Mark submits a market order to buy 9 to a continuous market with the following order book: Trader Ann Jack Steve Beth

Bid Size 15 3

Price 80.0 80.3 80.4 80.7

Offer Size

6 10

At what average price will Mark’s order be filled? 6 trade at 80.4 and 3 trade at 80.7 so that the average price is 80.5.

Keith Parker, University of Southern California

FBE-440: Exam Things

Midterm #2 Review FBE-440

Page 254 3/30/07 2:17 PM

Arbitragers provide liquidity – connects people who arrive in different places and time, provide an example of a speculative arbitrage Recognize pure and speculative arbitrages It is speculative for sure if you can image some factor that would cause the arbitrage spread to forever move apart All arbitragers are risky Discuss the risks of doing an arbitrage, implementation risks, risks of engaging in a speculative arbitrage Market manipulation • Potential for bluffing imposes a discipline • The price impact per share, when your buying you typically raise prices • If the price impact per share of buying is higher, than you could just buy a bunch to push prices up and then sell them Understand that brokers end up staking their reputation on the quality of information that they produce Order anticipation chapter, if you go around telling everybody that you’re going to trade, people will front run you- control the exposure of your order Dark liquidity pool: a trading system where people can’t see who is willing to trade Explain why firms with crummy ideas have a hard time selling capital • If you have a bad idea, you have to sell a lot of shares and this dilutes the values of the shares, which is just transferring the cost of the new venture to the shareholders, which isn’t good Know a lot about adverse selection, and where it arises in trading markets • Bid-Ask spreads, et cetera

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What determines a bid-ask spread? Why is it unlikely that a liquid market would ever develop around somebody’s pizza parlor? There would be too much asymmetric information Two models of the bid-ask spread: the equilibrium spread model talked about in class should be known • The implications of free entry and exit • People are deciding whether to, if you are selling, to take a bid or make an offer, and, if you are buying, whether to take a bid or make an offer Who is going to be doing the best with arbitrage? The arbitrage portfolio, the high frequency arbitrage is going to tend to be done with high something Fundamental volatility is due to changes in actual value; transitory volatility is the volatility due to everything else (effects of uninformed traders, et cetera) Transitory volatility has a strong link with transaction costs When is a value motivated trader able to trade? • If price is below (or above) fundamental value o This can happen for two reasons: prices changed and values didn’t (uninformed traders), or vice versa (news trader) o Value motivated trader is a supplier of liquidity Winner’s curse • Why it arises (valuation errors) • When bidding in an auction, must be careful because, as a buyer, the highest bidder is the one who wins. It is likely that the highest bidder is the guy who probably overvalued the thing being bid on

Keith Parker, University of Southern California

FBE-440: Exam Things Professor Larry Harris

Trading and Exchanges

Page 256 USC Spring 2005

FBE 440 MW Midterm 2 Write your name on the exam now. Each question can be answered with a short answer. Please use a pen and write legibly. If most fourth grade students could not read your cursive script, please write in block print. Take your time and do well. Please ask me if you have trouble with spelling or grammar. Since knowing that you do not know something is a valuable form of knowledge, I will give 40 percent credit for blank answers. A completely wrong answer, of course, will receive no credit. Good luck! Short Answers: These questions can be answered with one or two sentences. (10 points each) 1. Order anticipators, informed traders, and dealers all profit from other traders. Which of these traders are parasitic traders and why?

2. Why are momentum traders especially vulnerable to bluffers?

3. How do dealers learn about value from their order flow?

Keith Parker, University of Southern California

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FBE-440: Exam Things 4. Under what conditions would you expect adverse selection spreads to be large?

5. Why do block brokers prefer to serve uninformed traders rather than informed traders?

6. How do we know that value traders are the ultimate suppliers of liquidity?

7. Arbitrageurs and dealers both match buyers to sellers. How do their methods differ?

Keith Parker, University2 of Southern California

FBE-440: Exam Name _____________________________

Things

Last, First

8. How do exchanges simplify bilateral searches?

9. What distinguishing characteristics of fundamental volatility and transitory volatility allow us to discriminate between them?

10. Suppose that transaction costs for a trader are evaluated relative to an opening price benchmark. The trader fills orders for a portfolio manager who trades on momentum. Will the trader’s estimated transaction costs be unbiased?

Keith Parker, University3 of Southern California

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FBE-440: Exam Things

Keith Parker, University4 of Southern California

FBE-440: Exam Things Professor Larry Harris

Trading and Exchanges

Page 260 USC Spring 2005

FBE 440 TTH Midterm 2 Write your name on the exam now. Each question can be answered with a short answer. Please use a pen and write legibly. If most fourth grade students could not read your cursive script, please write in block print. Take your time and do well. Please ask me if you have trouble with spelling or grammar. Since knowing that you do not know something is a valuable form of knowledge, I will give 40 percent credit for blank answers. A completely wrong answer, of course, will receive no credit. Good luck! Short Answers: These questions can be answered with one or two sentences. (10 points each) 1. How do the strategies used to front-run a market order and a standing limit order differ? (Assume the orders are buy orders.)

2. Why do bluffers fear value traders?

3. Suppose that an uninformed trader trades only with dealers who only know about market values but nothing about fundamental values. Do the uninformed trader’s trading profits depend on the number of informed traders in the market? Why or why not?

Keith Parker, University of Southern California

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FBE-440: Exam Things 4. If the value of all traders’ time increased, what would you expect would happen to bid/ask spreads? Why?

5. Why do large liquidity suppliers want to know whether the traders who seek to trade with them will want to trade more of the same security in the future?

6. You plan to bid in an auction for an item for which the value is uncertain. You set your bid assuming that there will only be ten bidders. Before submitting your bid, you learn that 100 people will bid on the item. Should you change your bid? Why?

7. Do arbitrageurs and dealers compete with each other for trading profits? Why or why not?

Keith Parker, University2 of Southern California

FBE-440: Exam Name _____________________________

Things

Last, First

8. What is liquidity?

9. How is transitory volatility related to transaction costs?

10. Suppose that transaction costs for a trader are evaluated relative to a closing price benchmark. The trader fills orders for a portfolio manager who tends to be well informed. Will the trader’s estimated transaction costs be unbiased?

Keith Parker, University3 of Southern California

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FBE-440: Exam Things

Keith Parker, University of Southern California

FBE-440: Exam Things Professor Larry Harris

Trading and Exchanges

Page 264 USC Spring 2005

FBE 440 MW Midterm 2 Answers Short Answers (10 points each) 1. Order anticipators, informed traders, and dealers all profit from other traders. Which of these traders are parasitic traders and why? The order anticipators are parasitic traders because their trading neither makes markets more liquid nor prices more informative. 2. Why are momentum traders especially vulnerable to bluffers? Since momentum traders follow trends, bluffers can cause them to trade unwisely by manipulating prices. 3. How do dealers learn about value from their order flow? A surplus of buy order volume over sell order volume suggests to them that informed traders may be present so that values are probably higher then current prices, and vice versa for a surplus of sell order volume. 4. Under what conditions would you expect adverse selection spreads to be large? When many informed traders are in the order flow or when the information that informed traders tend to have is highly material (i.e. price is very different from value). 5. Why do block brokers prefer to serve uninformed traders rather than informed traders? The clients with whom the block brokers match block initiators do not want to lose to informed traders. If they burn these clients, they won’t be able to do more business with them. 6. How do we know that value traders are the ultimate suppliers of liquidity? Value traders trade when price departs from value, which usually happens when uninformed traders are moving prices away from values. They thus supply liquidity in response to the demands from these uninformed traders.

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7. Arbitrageurs and dealers both match buyers to sellers. How do their methods differ? Arbitrageurs use their hedge portfolios to match buyers to sellers at the same time but in different places. Dealers use their inventories to match buyers to sellers in the same market buy who arrive at different times. 8. How do exchanges simplify bilateral searches? They reduce the costs of searching by creating systems that allow buyers and sellers to quickly find the best trading opportunities. 9. What distinguishing characteristics of fundamental volatility and transitory volatility allow us to discriminate between them? Price changes due to fundamental volatility are unpredictable whereas those due to transitory volatility tend to reverse (are mean-reverting). 10. Suppose that transaction costs for a trader are evaluated relative to an opening price benchmark. The trader fills orders for a portfolio manager who trades on momentum. Will the trader’s estimated transaction costs be unbiased? The estimated transaction costs will be upward biased because momentum managers buy when prices are rising and sell when prices are following so that the trader will tend to buy when price is above the open and sell when price is below the open.

Keith Parker, University2 of Southern California

FBE-440: Exam Things Professor Larry Harris

Trading and Exchanges

Page 266 USC Spring 2005

FBE 440 TTH Midterm 2 Answers Short Answers (10 points each) 1. How do the strategies used to front-run a market order and a standing limit order differ? (Assume the orders are buy orders.) To front run the market order, you buy first and then sell when the price impact of the market order moves prices up. To front run a standing limit order, you buy first. You then sell to the standing limit order if you believe that prices will fall. 2. Why do bluffers fear value traders? Value traders can stop a bluff by supplying all the liquidity that the bluffer is demanding when the bluffer is trying to move prices. 3. Suppose that an uninformed trader trades only with dealers who only know about market values but nothing about fundamental values. Do the uninformed trader’s trading profits depend on the number of informed traders in the market? Why or why not? The uninformed trader’s profits are reduced by adverse selection spreads that the dealers must charge to recover from them what the dealers lose to the well informed traders. 4. If the value of all traders’ time increased, what would you expect would happen to bid/ask spreads? Why? Bid/ask spreads would widen to compensate traders who offer liquidity for the additional value of their time committed to do so. 5. Why do large liquidity suppliers want to know whether the traders who seek to trade with them will want to trade more of the same security in the future? They do not want to offer liquidity to price discriminators. 6. You plan to bid in an auction for an item for which the value is uncertain. You set your bid assuming that there will only be ten bidders. Before submitting your bid, you learn that 100 people will bid on the item. Should you change your bid? Why? You should lower your bid because if you win the auction, you will learn that your estimate was higher than 100 people rather than just 10—you probably over estimated value.

Keith Parker, University of Southern California

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7. Do arbitrageurs and dealers compete with each other for trading profits? Why or why not? Arbitrageurs and dealers compete to match buyers to sellers. If either were not in the market, the other would be more profitable. 8. What is liquidity? 1. The ability to trade quickly when you want at low cost. 2. The successful outcome of a bilateral search in which buyers look for sellers and vice versa. 9. How is transitory volatility related to transaction costs? The price impacts of trades are both transaction costs and contributors to transitory volatility. 10. Suppose that transaction costs for a trader are evaluated relative to a closing price benchmark. The trader fills orders for a portfolio manager who tends to be well informed. Will the trader’s estimated transaction costs be unbiased? The estimated transaction costs will tend to underestimate the actual transaction costs because the trader will tend to buy at a price below the close because his manager is well informed.

Keith Parker, University2 of Southern California

FBE-440: Exam Things Professor Larry Harris

Trading and Exchanges

Page 268 USC Spring 2007

FBE 440 MW Midterm 2 Answers Very Short Answers (five points each) 1. Which type of informed trader typically profits when prices change but values do not change? Value-motivated trader 2. When deliberately moving prices, bluffers hope that other traders will identify them as what kind of trader? Informed trader 3. When selling has more price impact than buying, should a bluffer buy first or sell first? Sell first. 4. Name an important way that dealers attract order flow. Quote aggressive prices Quote substantial sizes Purchase order flow Advertise 5. Dealer Jack quotes a market of 20 bid, 21 offered. Dealer Jill quotes 20.5 bid, 21 offered. Dealer Julia quotes 20 bid, 20.75 offered. What is the inside market quote? 20.5 bid, offered at 20.75 6. Name the two most important risks that concern traders who offer liquidity to large traders. Risk of trading with an informed trader (Adverse selection risk) Risk that the large trader will trade more size 7. Name an important risk that an arbitrager faces when he engages in a pure arbitrage. Poor implementation (poor trading) Model risk (winner’s curse)- Failure to properly understand the relative value relation. 8. Is the outside spread generally wider or narrower than a typical dealer’s spread? Wider

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Very Short Essays (20 points each) 9. In what sense can we identify arbitrageurs as producers and recyclers of financial instruments? Many arbitrages involve trading of nearly identical risks that appear in different forms. When an arbitrageur buys one instrument and sells the others, he or she in effect transforms the risk from one from to another. The process can be viewed as producing or recycling financial instruments. For example, when an arbitrageur buys the 500 S&P 500 stocks and sells the S&P 500 futures contract, the arbitrageur effectively creates the futures contract. The arbitrageur would do this when the futures contract gets expensive relative to the cash index, which typically will happen when demand for the futures form of the S&P 500 equity risk rises relative to demand for the cash form of the risk. 10. What causes the winner’s curse and how do traders avoid it when bidding for an item? The winner’s curse arises because traders cannot perfectly value the instruments that they trade. When they overvalue them, they tend to bid too high and win the auctions at prices above values. Traders avoid the winner’s curse by considering what they learn when they are the highest bidder. In particular, if they are the highest bidder, they likely overvalued the item. They avoid the winner’s curse by lowering their bids to reflect the fact that, if they win, they will learn that everyone else likely had a lower valuation. The amount that they lower their bid increases with the number of other bidders and with the uncertainty in their estimates of value. 11. Describe how a sentiment-oriented technical trader might identify profitable trading strategies. A sentiment-oriented technical trader tries to anticipate the trades that uninformed traders will do. He or she would do this by considering why uninformed traders trade. If the reasons can be predicted, the technical trader can front-run the uninformed traders. For example, suppose that uninformed traders tend to buy whatever stocks are featured on CNBC. A sentiment-oriented technical trader would watch CNBC and immediately buy on the first indication that a stock will be featured on the show.

Keith Parker, University2 of Southern California

FBE-440: Exam Things Professor Larry Harris

Trading and Exchanges

Page 270 USC Spring 2007

FBE 440 TTH Midterm 2 Answers Short Answers (10 points each) 1. When buying has more price impact per contract than selling, should a bluffer buy first or sell first? Buy first. 2. To which type of trader do bluffers most commonly lose? Value-motivated traders 3. Name an important way that dealers attract order flow. Quote aggressive prices Quote substantial size Purchase order flow Advertise 4. What do you expect would happen to bid/ask spreads if gamblers traded more often in the instruments in which dealers make markets? Spread would narrow because gamblers are uninformed traders. 5. How does large trade size affect the adverse selection spread component? It increases it because people fear that large traders are well informed. 6. Name the two most important risks that concern traders who offer liquidity to large traders. Risk of trading with an informed trader (Adverse selection risk) Risk that the large trader will trade more size 7. What trader type can ultimately supply the most liquidity to a market? Value-motivated traders 8. In a pure order-driven market, how would an increase in the value of all traders’ time affect bid/ask spreads? Bid/ask spreads would increase.

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Very Short Essays (20 points each) 9. Why do we expect a liquid market to have more informative prices? The liquidity would make informed trading more profitable since the informed traders would have less impact on price when trading. They then would acquire more costly information and put it into the price. 10. A slow trader has issued a large standing buy limit order at the market. How could a clever fast trader profit from this situation? Place a buy order at a slightly better price and hope that it executes. If values subsequently rise, the clever trader profits without bound. If values fall, the clever trader will sell to the large buyer for a small loss. This strategy is profitable if the slow trader is not likely to cancel his order after the clever trader’s order is filled. This strategy effectively extracts the option value of the put that the buyer granted to the market. 11. How do arbitrageurs and dealers compete with each other? Dealers use their inventories to move liquidity through time by connecting a buyer who arrives at one point in time with a seller who arrives at a different point in time, both in the same market. Arbitrageurs use their hedge portfolios to move liquidity from one market to another by connecting a buyer who arrives at one market to a seller who arrives at a different market, both at the same time. Since dealers and arbitrageurs both can satisfy demands for liquidity, they are competitors.

Keith Parker, University2 of Southern California

FBE-462: Syllabus

Page 272

International Trade and Commercial Trade (FBE 462) Department of Finance Marshall School of Business University of Southern California

Fall 2007 740-7558 email: [email protected] http://www-rcf.usc.edu/~baizhu/ Office Hours: M 4:00 – 6:00pm TTH 2:00 – 3:00pm or by appointment

Professor Baizhu Chen HOH701C

The post-war period has been a remarkable era of growth in trade. As a result economies in general have become more open. Countries are more interconnected through international trade. Firms are now more and more facing competitions from other countries. Many aspects of trade relations are now headline news - for example the bilateral trade conflict between U.S. and Japan; alleged unfair trading practices of Japan, Korea, Taiwan, and now increasingly China and others; the Super 301 provisions; restrictions on U.S. multinationals; newly negotiated voluntary restraint agreements; liberalization in Eastern Europe and other formal socialist countries; Human rights and trade; the Uruguay Round of GATT negations; NAFTA,WTO and so on. U.S. policy on these and other issues is of crucial importance to global prosperity in the 1990s. Firms' competitive strategies are increasingly influenced by the trade policies of U.S. and other countries. A firm without a global view will not be competitive in a global economy in which competitions come not only from domestic competitors but also from competitors located in different countries. COURSE OBJECTIVES: This course surveys the major topics in the theory of international trade. Like all branches of economics, this course is concerned with decision making with respect to the use of scarce resources to meet desired economic objectives. It is consequently concerned with how international transactions influence such things as social welfare, income distribution, employment, growth, and the possible ways public policy can affect the outcomes. We will focus on such questions as: (1). What determines the basis for trade? (2). What are the effects of trade? (3). What determines the value and the volume of trade? (4). What factors impede trade flows? (5). What is the impact of public policy that attempts to alter the pattern of trade? We will cover most basic trade theories and their policy implications. In this course, we will analyze various trade and industrial policies, for instance, tariff, quota, VER, anti-dumping, customs union. We will also discuss the U.S. trade law, institutional framework of WTO/GATT, the Uruguay Round negotiations, the Multi-Fiber Agreement, and NAFTA. This course is concerned mainly with the nonmonetary aspect of international economics. The monetary and balance of payments issues are only marginally discussed. COURSE REQUIREMENTS:

Keith Parker, University of Southern California

FBE-462: Syllabus

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Thomas A. Pugel, International Economics, 12th edition, Irwin McGraw-Hill, 2004 Reading Packet Wall Street Journal is required Lecture notes will be posted in the BLACKBOARD system under the course number for downloading. You should be able to access the BLACKBOARD by typing your userid and password of your UNIX account. For more information of the BLACKBOARD, please contact the Keck Center. COURSE EVALUATION: Requirements for the course include one project (25%), three examinations (45%), three homework assignments (each 5%) and class participation (15%). Class participation may alter your grade by as much as one level. The final grade is based on a “curve.” I adhere roughly to the school guidelines: An average grade of 3.30 out of 4.00 for undergraduate elective courses. This translates loosely into something like 3035% A, 45-50% B, 15-20% C, and 0-10% D&E. I do not assign letter grades to individual exams and homework assignments. However, I will give you complete distributions for each grade and you can apply the scale indicated above. Project Examinations Homework Class Participation

25% 45% 15% 15%

Examinations will consist of multiple choice questions, numerical problems, and in some cases short essays. All exams are closed-book, closed-notes. Each exam will cover the required readings from the text and all the material covered in class. Students should turn in their homework assignments before the due dates. Generally the homework assignment should be turned in at the beginning of the lecture on the due date. Should he or she for any reasons turn in the homework assignment after the due dates, his or her scores will be discounted 10% for every hour the homework is overdue up to a maximum of 50% discount. Violations of academic integrity standards will be treated seriously. "The use of unauthorized materials, communication with fellow students during an examination, attempting to benefit from the work of another student, and similar behavior that defeats the intent of an examination or other class work is unacceptable to the University. It is often difficult to distinguish between a culpable act and inadvertent behavior resulting from the nervous tensions that accompany examinations. Where a clear violation has occurred, however, the instructor may disqualify the student's work as unacceptable and assign a failing mark on the paper." Make-up Exams: Current department policy to which I adhere is “No makeup midterm and final exams will be allowed.” If you have an extenuating circumstance that prevents you from taking the exams, discuss your reasons with me BEFORE the time of the exam. Current department policy is that a student may not be given a make-up exam unless he or she has obtained written permission from the course instructor in advance. In addition, you must be able to document your extenuating circumstance. Any student requesting academic accommodations based on a disability is required to register with Disability Services and Programs (DSP) each semester. A letter of verification for approved accommodations can be obtained from DSP. Please be sure the letter is delivered to me (or my TA) as

Keith Parker, University of Southern California

FBE-462: Syllabus early in the semester as possible. DSP is located in STU 301 and is open 8:30 a.m. - 5:00 p.m. Monday through Friday. The phone number for DSP is (213) 740-0776 Team Project: We will arrange a field trip to Maquiladoras of Mexico. The trip date is tentatively scheduled on March 1-4, 2005. We will leave in the evening of March 1, Thursday, and return on March 4, Sunday. We will visit several Maquiladoras in Tijuana and other places in Mexico. Students are asked to conduct preliminary research on these Maquiladoras before the trip. After the field trip, students are required to complete a team research paper, which is to be presented at the end of the semester.

Disclaimer This syllabus is an invitation to you to engage in an exciting and interactive study international trade. It is my goal to provide a collaborative and supportive learning environment where students will learn from one another both inside and outside of the classroom. To that end, modifications to this syllabus may be warranted as I assess the learning needs of this particular class. This is a contract for this course between you and me. If you want a grade from this class, implicitly you have to follow this contract. COURSE OUTLINE: 1/9

Introduction

1/11

Global Trade Overview

International Economics (TP), ch. 1, p1-11, p33

1/16

Is Trade A Zero-Sum Game?

International Economics (TP), ch. 2, p15-28

1/16/18

Why Nations Trade (I)?

International Economics (TP), ch. 3, p31-43 “The Halo Effect”, The Economist, Sept. 30, 2004 “Trade Disputes,” The Economist, Sept. 16, 2004 Case Discussion: Free Trade vs. Protectionism: the Great Corn Laws Debate, HBR Case 9-701-080, Feb. 20, 2001

1/23 1/25

Why Nations Trade (II)?

International Economics (TP), ch.3, p48-57, ch.4, p68-72 “A forbidden fruit in Europe: Latin bananas face hurdles”, The New York Times, April 5, 1993 “Working Man’s Dread”, The Economist, October 1, 1994. “The Sucking Sound from the East”, the Economist, July 26, 2003

1/25 1/30

Why Nations Trade (III) ?

International Economics (TP), 5

2/1

Growth and Trade

International Economics (TP), ch.5 “Korea is overthrown as sneaker champ”,

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the Wall Street Journal, October 7, 1993

2/6

Examination 1

2/8

Tariff

International Economics (TP), ch. 7

2/13

Tariff

Case Discussion: Can Florida Orange Growers Survive Globalization?, HBR Case 9-904-415, March 8, 2004

2/15

Non-tariff Barriers

International Economics (TP), ch. 8 “U.S. import rights: going once, going twice...” Business Week, March 9, 1997 “China Trade Policy’s Ripple Effect,” the Washington Post, November 11, 2003

2/202/22

Protect or Not To Protect

International Economics (TP), ch. 9 “Argument against free trade when market fails,” Notes (to be provided in class) “How Countries Go High-tech,” the Economist, November 8, 2001 Case Discussion: Brazil on Wheel, HBR Case 9-804-080, May 25, 2004

2/27-

Pushing Exports

International Economics (TP), ch. 10 “How to beggar your neighbor” the Economist, February 3, 1996

3/1

No Class (Preparation for Mexico trip)

3/1-4

Trip to Mexico

3/6

Pushing Exports

International Economics (TP), ch. 10 “How to beggar your neighbor” the Economist, February 3, 1996

3/8

Examination 2

3/123/16

No Classes (Spring Break)

Keith Parker, University of Southern California

FBE-462: Syllabus

3/203/22

Trade Blocs and Trade Blocks

International Economics (TP), ch. 11 “Regionalism and trade, the right direction?” the Economist, September 16, 1995 “Building blocks or stumbling blocks”, the Economist, October 31, 1992 “Everybody’s Doing It,” the Economist, February 26, 2004

3/273/29

GATT/WTO, US Trade Laws

Case Discussion: Creating the International Trade Organization, HBS, Case, 9798-057, Feb. 1998 David Moss and Nick Barlett, The World Trade Organization, Sept. 2002, HBR Case, 9-703-015

4/34/5

Trade and Environment

International Economics (TP), ch. 12 “Trading Hot Air”, the Economist, October 17, 2002 “Tax or Trade”, the Economist, February 14, 2002 Case Discussion: the Sweat Serpent of the South-East Asia, the Economist, Dec. 30, 2003

4/10

Trade in Factors

4/12

Review/Catch up

4/17

No Class (Preparation for Project)

4/19

Project Due Project Presentation

4/24

Project Presentation

4/26

Examination 3

International Economics (TP), ch. 14

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FBE-462: Course Documents

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Midterm Examination International Trade and Commercial Policies (FBE 462) Spring 2007 740-7558

Professor Baizhu Chen HOH701C

II. Please answer each question in the space provided. Do not feel compelled to fill the entire space. Complete but concise answers are appreciated.

1. (8 points) The following table shows the labor costs of producing cloth and wheat in England and Poland Poland 4 2

Wheat Cloth

England 1 1.5

Both countries use only labor to produce each product. Labor can move between the two industries. Each country is endowed with 100 units of labor. a.

Which country is more productive in producing wheat? What is its labor productivity in wheat? Which country is more productive in producing cloth? What is its labor productivity in cloth?

Answer: England more productive in both wheat (productivity: 1) and cloth (productivity: 2/3)

b.

Write out the full employment condition for each nation. Draw it in the following diagram. What is the autarky relative price of cloth in Poland? W

W 100

25

Poland

50 C

66.7 England

C

Keith Parker, University of Southern California

FBE-462: Course Documents 4W+2C=100

W+1.5C=100

c. Which country has a higher wage? Why? 1*WE = Pw 2*WP=Pc Pw = Pc => W E =2*WP

Keith Parker, University of Southern California

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FBE-462: Course Documents

Page 279 2.

(5 points) The following table shows the factor endowments of several countries.

3. (4 points) In article "Working Man's Dread" published in The Economist, October 1, 1994, in the reading packet, it says: -

Trade => price of skilled labor intensive goods goes up and price of unskilled labor intensive goods goes down => unskilled labor wage goes down while skilled labor wage goes up => gap increases

-

technological change => demand for skilled labor increases while demand for unskilled labor decrease

4. (11 points) In the great Corn-Laws debate, many arguments have been made to support or against the repeal of Corn Laws in Britain in the mid-19 century. These arguments are listed in the following table. In the column “Effect”, enter R if you believe that the argument is for repealing the Corn Laws. Enter N if the argument is not for repealing.

5. (4 points) BANANA question (a). Answer: these factors are possibly the reasons – weather, cheaper land and cheaper labor (b). Answer: benefiting American consumers

Keith Parker, University of Southern California

FBE-462: Course Documents

International Trade and Commercial Policies, FBE 462 Group Project This group project is to be completed by a group of no more than 5 students. It is due on April 19, 2007. The project needs to be typed with double space. Total pages should not exceed 20, including tables, reference, footnotes, executive summary and title page. You will present your findings at the end of this term. Any report exceeding the page upper limit will be penalized. There is no minimum page requirement. Each group will choose one of the companies visited as your target company. One company can be selected by multiple groups. Discussions between different groups are not allowed. Your project write-up should contain an executive summary, a body of analysis, and a conclusion. You should also include references and footnotes, if necessary. You should collect as much data/evidence as possible to support your statements in your project. Ideally, you should utilize as much as possible in your report the knowledge, terms, models/frameworks, and techniques that you have learnt in this class. You should use your target company as a sample to study the industry. You should address the broad question if the industry in Mexico has a comparative advantage. The overall aim of your report is to develop a detailed industry report, focusing on the strategic challenges and opportunities in your industry in Mexico today and in the next five or so years. It should emphasize analyses instead of description. Descriptive information should be discussed to set the stage and context for the situation facing your industry but the analyses of the situation should receive much greater emphasis. Your team should think critically about the industry and should develop your own perspective on the situation facing the industry now and in the future. The intended audience should be managers in the industry who are interested in Mexico, both local and foreign managers. Thus, it should read like a report prepared for an industry association or set of players in the industry. Any company in the industry, foreign or local, should be interested in the report as it should discuss the basic structural information of this industry. In analyzing your industry, think back to frameworks, concepts, tools, theories, models, and other material learned in this class, as well as in other classes of your undergraduate curriculum. Use appropriate frameworks, concepts, tools, theories, and models you learned earlier in the undergraduate program for analyzing and drawing conclusions about your industry. A well developed industry analysis is interdisciplinary in nature, drawing upon strategic, marketing, operational, financial, economic, and management perspectives. Therefore, you should apply and integrate appropriate material from earlier courses in preparing your industry report. Issues to Address 1) Conclusions and recommendations about opportunities for foreign companies to compete in the industry in Mexico over the next five years 2) Conclusions and recommendations about opportunities for local Mexican companies to compete domestically and globally over the next five years

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FBE-462: Course Documents In analyzing your industry, the following are some possible areas you may wish to consider. However, the following list is NOT meant to be a template of areas that you must cover for the report. You should think about what kinds of analyses are appropriate to analyzing the situation facing your industry in your target country and include those relevant analyses in your report. You should define the areas of analyses that are relevant to your report. 1) Evolution of the industry over time – forecasts of growth, future trends, upcoming opportunities and challenges, etc. 2) Competitive analysis of local players in the industry in Mexico – strengths and weaknesses of domestic participants in the industry, the strategies pursued by various players, the relative levels of success and profitability of various players, the likelihood of new domestic entrants into the industry over the next five years, etc. 3) Competitive analysis of foreign players in the industry in Mexico – strengths and weaknesses of foreign participants in the industry, the strategies they are pursuing, the relative levels of success and profitability of these players, the likelihood of new foreign entrants into the industry over the next five years, the relative comparative advantages of foreign vs. local players in this industry, etc. 4) Strategic marketing analysis – assessment of the dynamics of customers, viable target segments, market potential in the target country, marketing opportunities and challenges, etc. 5) Cost structures of the industry – what are the major components of the cost? Is it mainly the labor cost, or capital cost? How does regulations affect the cost structure? 6) Strategic operational analysis – assessment of the challenges, opportunities, and critical success factors for carrying out effective operations in the country, advantages and disadvantages of local production, etc. 7) Environmental analysis of Mexico – assessment of the impact of the economic, political, cultural, and technological environment of Mexico on the industry, the implications of these environment factors for being successful in the industry, etc. 8) Policy analysis – assess the impact of various government policies on your industry. You may want to address how NAFTA or China’s entry of WTO influences the competitive structure of this industry. 9) Ethical issues confronting companies in your industry in Mexico – assessment of the ethical challenges faced by managers in your industry doing business in Mexico, the implications of these ethical challenges for competition and for being successful in the industry, etc. 10) Comparison of the characteristics and strategic challenges of the industry in Mexico with that of the industry in other countries, particularly the U.S. or China – assessment of the similarities and differences in your industry Mexico and other countries in areas such as competitive environment, customer environment, opportunities and challenges, key success factors, etc. 11) Strategic importance of the country in regard to global competition in the industry – importance of the country in the global context of the industry in terms of market opportunities, access to factors of production, access to new innovations, competitive positioning, as a base for exporting to other countries, etc. 12) Conclusions and recommendations about opportunities for foreign companies to compete in the industry in Mexico – motivations for foreign companies to participate in the industry in Mexico, likelihood of new foreign entry into the industry, etc. 13) Conclusions and recommendations about opportunities for local companies domestically and globally

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Globalization and global trade overview • People same • Communicate (transaction cost goes down) • Trade freer o Goods and services o Capitals and labors • Interdependence o Factors of production • Technology • Conflict • Trade is more regional o 49% of Asian exports go to Asia, if you add 20% to that (the amount that goes to North America), you see that over 70% of Asian trade is within Asia

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Basic mercantilist idea assumes that the more precious metals a country has, the wealthier it is • This promotes exports, and dissuades from high imports • Agriculture was always the heavily protected industry protected back then, during this period Is trade • • •

a zero-sum game? Barriers still exist in trade among countries As long as there are barriers, there is arbitrage Globalization process creates winners and losers, more social stratification, some countries are becoming worse off than they were before

Wealth of a nation should be measured by the amount of goods and services that can be produced, not by the amount of gold • This is less convenient than gold, but better • Today, we see gold as just another good, like anything else • Many people still think that export is better than import, without any preconditions • Section 301 is a trade law that says that any foreign country that has an excessive trade imbalance with the US, the US will enter into trade negotiations with that state to attempt to eliminate this imbalance o This was targeted at Japan when it was first introduced • Consumer surplus • Utility curve for consumers, indifference curve, the shit learned last semester in Econ for business – the more of a good one has, the less it is worth to them • Marginal willingness to pay for a good or service • Consumer surplus is $2 if the consumer is willing to pay $8 for a service, but only has to pay $6 • Selling Apples, market price is $10 but you are willing to sell them for $8, producer surplus is thus $2 Autarky to open economy • Supply equals demand

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What is the total wealth of this country? Total welfare of a nation is consumer surplus plus producer surplus (CS+PS=Total Welfare) North Korea is a close example of this, China before 1978 In the slide, the difference (e) is exports, when price is above the market equilibrium of demand and supply CS=c, PS=d Total welfare in this case is c=d=e, so by engaging in trade, a small country will benefit (the total welfare of that country is higher with trade) Consider two countries, one is the home country the other is foreign o One is importing the other is exporting o World market price is determined by the equilibrium of the export supply and the import demand o The smaller the country is, the more relative gains you will receive from trade from other countries o We see this, small countries have applied more free trade policies because of the benefits that come to these countries from this free trade o NAFTA set up an emergency fund to compensate those countries that will be negatively affected by the opening of trade o In exporting country, consumers will suffer and producers will gain, while this is vise-versa in importing country

General Equilibrium Approach • Production possibility frontier • There is a line tangent to the production frontier that shows world relative price, this line meets consumer utility curve • Relative price of cloth, versus relative cost of wheat • Suppose in a world market, cloth is more expensive than wheat • The world market price line (in the slide) will be steeper • Price of exports divided by Price of imports = relative price of exports or TOT (terms of trade) • When terms of trade increases, line gets steeper and country can get more of relative product for each product being exported

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China, long history of China Chinese have small bananas, while the US has very big bananas

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Why nations trade? Going over handout given in class “The halo Effect” article from the economist Benefits • Change in relative prices will be good for developed countries Downsides • Hurts developing countries who are competing with China in industries attractive to developing nations For a developed country, TOT (terms of trade) will improve because of this effect in China, with 200 million unskilled workers “One man’s junk is another man’s treasure” article for today • Scrap metals, papers • Trash is the number one export from the US to China • This is based on relative prices, exports of scrap metals, papers, et cetera are cheaper as raw materials in China than getting these products in others ways from within China Another example of how demand affects imports and exports • Chicken breast exported to the US from China, more demand for it here than there • Chicken slaughtering in China Case Analysis • Corn law- protecting agriculture industry within the UK (not just corn, many other agricultural products as well) • Case is about Britain thinking about appealing the corn law and opening free trade of agriculture • Pros of this proposition o Price of agricultural goods in the UK will go down

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o Trade relations with countries supplying these goods might be improved o Better usage of land within the UK, instead of subsidized agriculture o Shifting resources to other industries, reduce strain on government funds to subsidize farmers o Solve certain food shortage problems o More varieties of goods available in the country Cons o Farmers’ wages will decrease o Increase dependence on other countries for agricultural products o Other countries may not reciprocate o Will the economy be able to absorb the shock? o Losing political support from farmers o Loss of revenue and fairness

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Why Nations Trade? • What determines supply and what determines demand? • Substitutes, et cetera • Article brings up concerns of Southeast Asian countries of whether or not they will have a competitive advantage over China in industries that might benefit these nations • Ricardo’s Theory of Competitive Advantage Both productivity and wage are very important • Outsourcing • Starting to outsource white-collar jobs has caused dispute Ricardo model • Requires a high degree of specialization • Competitive advantage o If a country has a lower opportunity cost of producing good A, the country has a comparative advantage in that trade • The line in the graph is usually not straight in the real world, it is curved • Japan is smaller than the US in all respects

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Dogswell presentation Why nations trade Resource-based trade Labor-based trade Chile trade article • Farming products, most notably fruits, made in Chile (their summer is our winter) • Chilean wines are now becoming more competitive in other countries • In their winter, we sell them fruits Brazilian article • Covering the agriculture sector in Brazil o Oranges are very competitive, especially orange juice o Sugar, Coffee, Soy beans  Growth rate of soy bean exports in Brazil is very high • Why do they have a competitive advantage in growing? o Good growing conditions, tropical weather o Vast amounts of land, it’s a land-abundant country • Prices of these commodities have gone up (such as orange juice prices) Who wins and who loses? • Everybody doesn’t always win, creates larger income gaps • For simplicity, assume that production technologies are constant Article “Working Man’s Dread” • What happened to the real wage in America since 1973? o It has gone up at a slower rate than other wages • Wage is price for labor • Demand is determined by labor productivity • Labor for tech jobs has increased, as demand for technology increases

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Article “The Sucking Sound From The East” • Mexico • Low-skilled manufacturing demand has gone down in Mexico • They are less competitive, can’t compete with labor costs in China • Also, Mexico has high energy costs • Energy sector in Mexico is a monopoly, and has reduced the competitiveness of their low-skilled work force • This work force isn’t as productive as China’s work force • Unions of labor forces in Mexico makes them less competitive

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Exam on Tuesday will be similar to class discussions and homework • There will be a couple of questions on the articles read for the class, but these questions will be preceded by an excerpt from the article • Structure of exam will be similar to homework, but a bit longer and with questions from cases and articles Who is most likely to benefit from free trade and who is most likely to be hurt from free trade? Labor C

W

Price of cloth relative to wheat will go up

Land • Exporting cloth o Labor will be better off and land owner will be worse off (as cloth is labor intensive, and price relative to wine will increase as the country exports cloth) • US is capital abundant, US will export capital o Capital owners will likely vote for free trade, and will benefit from it, labor will be worse off from free trade as labor prices relative to capital will go down • Will the two groups always vote against each other on the issue of free trade? o It depends on which industry one is in, those in industries who don’t have a competitive advantage will be protectionist, those in industries with an advantage will be pre-free trade o Boeing all voted for a most-favored nation status for China Section 5: Economies of Scale and Trade • Intra-Industry trade o US imports and exports cars o US sells soybeans, buys shoes from China Economies of scale • External economies of scale (EES) o Prices go down when the entire industry gets bigger

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• • •

Internal economies of scale (IES) o Prices go down as the size of operations within the firm increases C = F + a*X AC = (C/X) = (F/X) + A The more a firm produces, the less the fixed costs per unit are

Perfect Competition Monopolistic Competition •



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Monopoly Oligopoly

Companies often merge if the fixed costs factor is high enough, this way Internal Economies of Scale come into effect o Examples here are car manufacturers and banks Monopolistic competition: Each firm is a monopoly in its own product, but competes with similar products

Scale economies and product differentiation • Two countries that are exactly the same o Instead on each country making some expensive cars and some cheap cars, these nations will benefit from economies of scale if one nation produces cheap cars only and the other country produces expensive cars only

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Dutch disease • Currency appreciation • Direct result of the resource-based trade model • Immiserizing growth: Even though there is a harvest of coffee, because of price drops some coffee producers are worse off than if they had not increased production o In a small country, growth is always good o Balanced growth for a large country is usually good o Growth biased towards export sector of a large country, may be worse off- prices of export drop, country gets less of import product for each unit of export product • Economic growth can also affect the TOT • When export growth occurs in a large country, world price may decrease and effect TOT so much that the country is worse off (with a small country, world price may not be affected as much) • ISI strategies (He calls is Import Substitution Strategy) Product cycle theory • Dynamics of comparative advantage • Comparative advantage changes over time because of economic growth o South Korea and the shoe-making market • Countries will gain competitive advantage, and other will lose it, its all part of a cycle • Difficult to figure out when a country will lose its competitive advantage, took about 20 years for South Korea to lose its competitive advantage in sneakers Tariffs – Section 7

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Tariffs – • • • •

Basics NAFTA- trade should be duty free by 2015 Preferential duties GSP (Generalized System of Preferences) Weighted average of tariff rates- weighted average based on dollar amount of trade of each product/service

Welfare • • • •

of import duty Small nation: its TOT is given Tariff has no effect on its TOT Gain or loss? For large countries, when tariff is imposed the world market price drops and P-star (P*) declines, making the Tariff more than it would be for a small country

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Dumping and Anti-dumping • The product is sold in another country at lower than the fair market value o How does one determine the fair market value? o Compare to other similar products or prices of same or similar products in other countries o If you can’t do this, base it on the cost of production • The case of China and shrimp dumping o There is a 112% import duty on shrimp from China o Even though price is lower in China, this can’t be used for comparison in determining fair market price because Chinese are commies o The US just makes excuses why it can’t use local price for comparing shrimp prices in the US (i.e., in Thailand they eat fresh shrimp so its OK that the price for shrimp there is lower than the price for Thai shrimp in the US) • Conditions for dumping to occur o Imperfect markets o Segmented markets • Types of dumping o Predatory dumping  Very difficult to do this, because after you raise prices back up, more competitors will enter o Cyclical dumping  Dumping Christmas trees at low prices after Christmas is over o Persistent dumping Export subsidy and countervailing duties • China is the largest cotton producer, with US coming in second and India coming in third • US cotton subsidy is $2 billion • Divide that out, you get $120,000 to produce cotton in the United States

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Export subsidies • Consumers lose welfare • Producers gain welfare • Government must pay for subsidy • Results in a deadweight loss • Country will always lose if implementing a export subsidy, whether the country is large or small • European agricultural industry o Agriculture goods are more expensive in Europe o Land for farming is limited in Europe, makes it hard for them to compete in the world market o World price is $10 for farm goods, EU set a price floor at $15, at one point 75% of the EU budget was for buying Europe’s excess supply o EU implemented an export subsidy of $5, so farmers had incentive to export their excess production to foreign countries (this way they wouldn’t have to spend so much buying and storing excess production) o Many reasons for the original protection of the agriculture industry

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Mexican Wine Industry Analysis Prepared by: Eric Chen Cyrus Chini Alex Daly Shelley Goto Keith Parker FBE 462 – International Trade and Commercial Policy April 19, 2007

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Executive Summary This report on the Mexican wine industry is intended to serve as a resource for both domestic wineries and foreign wine companies considering Mexico as a potential investment opportunity. As a truly global industry, we had to center our analysis of Mexico’s wine industry within the context of this international market. What we found on a global level is a $90 billion industry undergoing a serious transition, with New World producers reinventing the way that wine is produced, distributed, and marketed, and challenging the traditional vintners of Europe worldwide. Scale economies and cost efficiency, consistent quality, and aggressive branding campaigns have replaced esteemed terroir as the success factors for wineries. Tariff barriers and regulations are falling, allowing almost any wine-producer to compete worldwide. Turning to Mexico, we will examine the $230 million wine industry in terms of its factor endowment advantages and infrastructural and customer base shortcomings. There is very little foreign investment in the industry, and the largest domestic wineries have done little to break into export markets. An analysis of the environment facing Mexican wineries highlights the favorable political and economic policies in place but also the striking lack of experience with viticulture and interest in wine within the country. Looking ahead to opportunities and challenges, wineries worldwide will continue to compete aggressively for the sole growth segments of premium and super-discount wines. Innovative branding and access to solid distribution channels will continue to be essential. In the end, we offer the following recommendations: o Mexican wineries must place much more emphasis on these marketing concepts and strongly push the export of their premium and super-premium wines. o Due to existing global oversupply and the many challenges impeding successful operations in Mexico, we do not believe that any foreign wine companies should look to invest in the Mexican industry.

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Mexican Wine Industry Analysis A Global Overview The global wine industry is currently undergoing a drastic transition. In the past 30 to 40 years, this $90 billion industry has changed from a European agricultural product based on centuries of tradition to a globally competitive, marketing-centric industry. New World producers in Australia, the United States, and South America have turned the conventions of wine-making upside down, utilizing huge plots of fertile land, implementing advanced agro-industrial techniques, and aggressively pushing the exports of strongly branded wines. Major Players Though their hold over the market is declining, the largest wine exporters are still the traditional countries of France, Italy and Spain, followed by the United States and Australia. However, even though France and Italy produce far more wine than New World countries, the two largest wine companies are from the U.S. and Australia. A 2003 merger between Constellation of the U.S. and BRL hardy from Australia formed the world’s largest wine producer, just passing E&J Gallo of California. These conglomerates have achieved economies of scale in both production and distribution that far exceed any current competitors in Europe. Consumption Patterns Wine consumption is still concentrated in Europe, with France, Italy and Spain being the three largest wine markets in the world, but per capita consumption is rapidly declining in these traditional wine regions – from over 100 liters per capita in 1966 to under 60 liters today.

At

the same time, wine consumption is steadily increasing in North America, Australia, and most rapidly in totally new markets such as Asia and Africa. Across all markets, demand for higher quality wine is actually still growing, leading to an emphasis on quality, not quantity. Trend-

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wise, red wines are on the upswing, and younger consumers especially look for new, more exciting wines than the traditional Chardonnays of the 1980s. With their open acreage for planting and more consistent production, New World wineries are much more capable of adjusting to these changing trends than European competitors.

New World Innovations Australian, American, and South American entrepreneurs have fully taken advantage of their ability to carve a domestic industry out of nothing – to completely reinvent wine-making. Utilizing resource factors such as abundant land, a warmer climate, and capital intensive technology, New World producers are now challenging European wine makers in almost every market and at every price segment. The use of irrigation, trellis growing systems, scientific experimentation, stainless steel fermentation tanks has all but eliminated the annual quality variations that affect the consistency of European wines. New marketing techniques such as half gallon bottles, screw off tops, and boxed wines have also proven very attractive to consumers, in addition to reducing shipping and storage costs. The Rise of Australian Wines “Australia is the driving force in the global wine industry.”1 This quote would have been unheard of just 30 years, but since Australia is now the largest wine exporter to the United Kingdom, it is probably fitting. Due to their relatively small domestic market, Australian wineries had to combine their new production methods with an aggressive marketing campaign to establish themselves on the international stage. Companies such as BRL Hardy and Southcorp vastly improved the accessibility of wine by simplifying their denomination systems and

1

The Economist. “Blended.” http://economist.com 23 June 2003.

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establishing strong brand identities that could carry over from one varietal to the next. Their methods have obviously worked, as Britain, long considered a key import market due to its lack of domestic production, now sells more Australian wine than French wine. Showing how much the industry has changed, a recent study shows that British consumers choose their wines based on previous purchases, price, country and occasion, in that order – nothing to do with the region or variety, which are two areas often focused on by traditional wine-makers. 2 South American Experiences Of particular interest to the Mexican winemakers may be the successes of the wine industry in Chile and Argentina. Argentina is the world’s fifth biggest wine producer, most of which is consumed domestically, and Chile is one of the most competitive wine exporters. Argentina has all the natural endowments necessary for wine production, and its exports have increased dramatically during the past seven years of domestic stability – many of its signature varietals are especially popular with American consumers.3 Chile, on the other hand, has followed Australia’s model of strongly branding its wines and even promotes its exports through the use of overseas wine trade groups. Chile has been further aided by its existing free trade agreements with countries including the United States, Japan, and South Korea.

Cost Structure of the Industry New World wine producers launched their immensely successful growth based on their efficiency and ability to essentially mass produce what was once considered an artisan’s product. While the quality of wine exported by countries such as Australia and Chile has greatly

2 3

Campbell, Gwyn and Nathalie Guibert. “Introduction.” The British Food Journal 108:4 233-39. The Economist. “Vino’s Twin Peaks.” http://economist.com 15 Mar 2007.

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improved, a large part of their competitive advantage still stems from lower production costs, of which there are four major components: •

Grape costs per case



Crush and Capitol costs



Barrel Costs (corks, labels, etc.)



Dry goods costs per case

Grape Costs Depending on the quality of wine produced, this cost sees the most variability. For Basic quality wines, grape costs are usually around 8% the total cost of production. On the other end of the spectrum, for Ultra-Premium quality wines, the cost of grapes range from around 65%-85% of the total cost of production. Of greater importance, however, is the fact that the amount of grapes needed for a 9L case of Ultra-Premium Australian wine can be produced for $45.45 as opposed to $104.55 in France. Crush and Capitol Costs This category includes the cost of the machinery and labor used to produce the wine. These costs are usually fixed and do not see much variability between the different qualities of wine nor between the different wine-producing countries. Costs range from $13-20 for each 9L case produced. Barrel Costs These costs are relatively 0% for lower quality wines and only reach up to about 2% of the total cost of producing higher quality wines.

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Dry Goods Costs The costs remain less than 1% of the production per case regardless of the quality of the wine or the country. But when all of the production costs are added together, New World wineries are able to achieve significantly higher margins than European producers across every market segment and most notably with their Super-Premium and Ultra-Premium wines. In these segments, Australian winery margins of 17% and 50%, respectively, far outshine the 4% and 18% of their French counterparts. Further downstream profits are also available for companies who have vertically integrated enough to own their own marketing and distribution channels.

Regulations The historical status of wine production in Europe plays a major role in the cost structure of the wine industry. Heavy fines may be imposed if guidelines are not properly met, and many countries that produce wine, mostly in Europe, have restrictions placed on grape varieties in particular regions. Other regulations may include the amount of sugar content in the wine, the amount of time spent aging the wine, and the geographic origin of the oak used for barreling. These sorts of limits hurt certain countries when there are shifts in demand. For example, if the market demand shifts to a drier red wine, there may be restrictions holding back wineries in certain German regions from producing what the market demands. With their non-traditional, more market-based approach, New World producers are largely free from these constraints and can quickly adapt to market preferences. Tariffs The tariffs applied to the imports of wine vary greatly from country to country. The United States charged a tariff of $0.063 per liter of wine in 2002, which is one of the lowest in the

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world.4 Other import tariffs range from $0.11 per liter in Europe, to 4% ad valorem in Mexico, to 60% ad valorem in Hong Kong. A 2002 Mutual Acceptance Agreement (MAA) on Oenological Practices signed by the U.S., Canada, Chile, Australia, and New Zealand sought to promote the international wine trade and ease barriers.5

Strategic Market Analysis Wineries have two main customers: Wholesalers Retailers such as grocery stores, liquor stores, etc. obtain the wine they sell from their wholesalers or wine merchants, who have previously purchased cases from the wineries themselves. Wine retailing has undergone a shift in recent years, as large, powerful grocery chains or wholesale stores such as CostCo have exerted more influence on their distributors. These chains are able to demand a large scale and scope from their distributors, meaning the most successful wine producers will often be those who are able to provide their distributor (or retailer if the winery owns their distribution) with enough variety to stock an entire grocery shelf. And of course, the wine conglomerates of Australia, Chile and the United States are in a much better position to do this than the independent vintners of Bordeaux. End Consumers Wine drinkers can also purchase their wine directly from the winery but this method is often inconvenient, and largely relegated to small, local wineries that are unable to gain access to broader distribution channels. End consumers are much more likely to purchase their wine at a local retailer. To reach more consumers, producers strive to create a diverse product line to

4 5

Penn, Cyril. “Wine Gaining Ground in US Trade Outlook.” Wine Business Monthly Penn.

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appeal to all palates. For example, German wineries do their best, with respect to regulations, to respond to the market demand in sweeter wines by producing their own brand of dessert wine. These shifts in ‘fashion’ are one of the biggest challenges wineries are faced with. Strict regulations prohibit many Old World wineries from quickly meeting the new demands.

Competitive Analysis of Mexico’s Wine Industry With this understanding of the global wine industry, we can now turn specifically to Mexico. In 2005 the Mexican wine industry generated revenues of $230.2 million, and growth is expected to accelerate in the coming years, with the market reaching $313.6 million by 2010.6 The industry centers around the city of Ensenada in Baja California, which accounts for 90% of the quality wine produced in the country. Other major winegrowing regions include Guadalupe, Calafia, San Vicente and Santo Tomas Valleys. Although Mexico is not a global leader in the wine industry, one advantage it has over many other countries is its weather. Baja California lies above the 30th parallel on the Pacific Coast and has the perfect climate of hot days and cool nights needed for winegrowing, allowing grapes to develop their sugar without a corresponding drop in acidity. Challenges for the Industry Even though Mexico has this ideal weather for producing high quality grapes, the Mexican wine industry still faces many barriers, one of which is the relative shortage of wine drinkers. Traditionally, wine is not the primary choice of alcoholic beverage for Mexican people, who tend to prefer beer and tequila. Domestic consumption is further discouraged by the fact that the Mexican government put a 40% tax on each bottle of wine, making it harder for wine to compete with the more traditional Mexican beverages. A more complicated challenge for the Mexican 6

Datamonitor Industry Market Research. “Mexico – Wine.”

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wine industry is the water supply, specifically the management of water use in the winegrowing areas. Controlled water stress has worked well for Mexican wineries in the past, but due to the proliferation of new wineries, many Mexican vineyards that require irrigation are not getting enough water supply. On top of that, the fact that the city of Ensenada is growing rapidly results in even less water available for the vines, leading Josef Backhoff to argue that “if the region were to have no problem with water, without a doubt we would be growing 10 times faster." The Market Leader – L.A. Cetto There is very little foreign involvement in the Mexican wine industry, but there are a few domestic companies that have enjoyed some success both domestically and internationally. The largest producer is L.A. Cetto. L.A. Cetto is a family owned company that has a large vineyard in the Guadalupe Valley and Sonora and annual sales of 1.8 million liters. The winery divides its wine into three different levels, commercial blends, the single varietal series, and the "Limited Reserve". In addition to the more common wines, it also sells wines that acknowledge their Italian heritage, such as Nebbiolo and Passito dessert wine, as well as the Californian specialties of Zinfandel and Petite Syrah. Overall, L.A. Cetto enjoys a great deal of success; it has a large market share of 9.9% within Mexico, and exports about 40% of its total wine production. Other Mexican Wineries The second biggest producer in Mexico is Bodegas de Santo Tomas, with an 8.8% market share and sales of 1.6 million liters in 2005. Another winery that is doing fairly well is Monte Xanic. Monte Xanic is smaller than L.A. Cetto, but it is a proud winner of numerous prizes, including the bronze medal at the 2000 Challenge International Du Vin in Blaye-Bourg, France for the 1998 Monte Xanic Chardonnay. Strategically speaking, Monte Xanic chooses to differentiate itself by concentrating on Bordeaux varietals and Chardonnay.

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Environmental Analysis for Mexico’s Wine Industry Economic Environment Despite primary and secondary education being free and mandatory, 47% of the population live below the poverty line.7 This provides an abundance of cheap, disposable labour, which is especially useful in a seasonal, labor-intensive industry as is wine. Since the growing and harvesting season only comprises about a third of the year, the ability to pick up seasonal workers is very important to the industry, and Mexico can provide that. The relative abundance of labor along with the shortage of available jobs for low-skilled employment allows the winery to freely hire and fire as many workers as it needs, allowing them to keep wages down and profit maximized. The second important dimension of the economic environment is overall macroeconomic stability. While the economic and financial crises that Mexico experienced in the 1980s and 1990s may seem to be distant memories, in terms of wine-growing this really is not that long at all. To produce top quality wines, vintners must wait as long as 20 years to really see their investment mature, which helps explain why wine production and exports in the more stable Chile have grown so much more rapidly than in Argentina. Cultural Environment From our first-hand experiences in Mexico, it was apparent that Mexico has a very small domestic market for wine. The alcohol sector is dominated by beer and tequila, because those are the more traditional drinks. This means that if wineries and the industry want to expand, they will have to export a good portion of their product.

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Ed. Starr, Pamela K.. Challenges for a Postelection Mexico: Issues for US Policy. Council on Foreign Relations. Council special report no. 17, November 2006

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Political Environment Mexico is very open to trade; they have free trade agreements with about 40 different countries.8 Also, as the NAFTA transition periods progress, and US-Mexico trade becomes more and more open, whatever tariffs exist on liquors and wines will be dropped along with the rest of the agribusiness sector.9 This will give Mexican wineries a large market in the US that allows low transportation costs, and a favorable market. This would give them a larger target market and allow them to expand beyond the capacity of the domestic market. Technological Environment Mexico, unlike the more traditional wine-producing regions like France and other European states, lacks the rules and regulations regarding the traditions in wine production. Therefore, it can utilize technological advances like steel vats for brewing white wines, as we observed at L.A. Cetto. This gives the Mexican wineries an advantage in the cheaper-grade or boxed wine industries that can be produced en masse.

Policy Analysis NAFTA’s effect on the industry About 90% of all Mexican imports go to either the US or Canada, both of which have an appreciation for imported wine and cheap wine.10 Also, the lower trade barriers allow for the Mexican wineries to take advantage of lower transportation costs to the US and Canada as opposed to overseas. Also, as the NAFTA countries continue to integrate, Mexico will have

8

Ed Starr. Adams, John A., Jr.. Bordering the Future: The Impact of Mexico on the United States. Praeger Publishers: Westport, Connecticut. 2006 10 Starr. 9

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freer and freer access to the North American markets, allowing them to expand their wine exports. Border Control Since there is a 1 liter limit on how much alcohol private citizens can bring across the border from Mexico to the US, Mexican wineries can mark up the prices of wine they import based on supply and demand. Since the US consumers can therefore really only get Mexican wines domestically as opposed to buying in bulk while south of the border and bringing it back, the wineries can up the price that they charge distributors in the states to reflect that exclusivity. In addition to this, the increased security at the border is draining California wineries of their supply of seasonal workers. The migrant workers that used to pick the wineries’ grapes during the relatively short harvesting season can no longer go to the US from Mexico as easily. This restriction on the international mobility of labor gives Mexico a comparative advantage over the US wineries, since the labor is much cheaper and more readily available in Mexico. China’s Effect on the Industry Although China is the world’s sixth largest producer of wine, it consumes most of it domestically, and does not rank among the top ten wine exporting countries.11 In the future, however, China may become a threat to the Mexican wine industry, especially as the country becomes more open to western cultures and consumables. Analytically speaking, China has the climate, the resources and the land for wine production, it just hasn’t taken off because wine in the conventional sense is not traditionally a part of Chinese culture. Right now, in the wine and beer sectors, Mexico exports over 200 times as much as China does to the US.12 Mexico, as well as

11

FAOSTAT. Food and Agriculture Organisation of the United Nations. http://faostat.fao.org. 12 April 2007. USDA Foreign Agricultural Service (FAS). United States Department of Agriculture: Foreign Agricultural Service. http://www.fas.usda.gov. 12 April 2007 12

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any other wine-producing country, will continue to benefit from China staying out of this export market.

Competitive Environment The domestic array of wine producing competitors in Mexico is very limited, due to its status as a relatively under-developed market for wine production. Competition from imports poses a very strong risk to any potential wineries in Mexico, though. Established foreign wine producing markets have years of experience in making high quality wine in bulk at low prices, most notably the California and Australian markets. Further, European wineries have long produced premium wine brands and still hold a large portion of the world wine market, despite the problems they have had in recent decades. In order to develop as an effective world wine-producing competitor, Mexico would first have to develop its own domestic wine market. Currently, Mexico makes up .7 percent of the wine market for the Americas.13 With such a small market, it would be difficult to establish the image of desirability so needed in this competitive industry. Further, wine making has been making a move from a labor-intensive business to a capital intensive business, as evidenced by the emergence of very large mass-producing wine companies such as E&J Gallo, who recently posted a US$4 Billion revenue intake. While California is known for its abundance of Capital, Mexico is not.14 These conditions paint a clear picture of the difficulties Mexico would face in emerging as a competitive force in the world wine industry.

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“Wine Industry Overview.” Business and Company Resource Center, 11 April 2007 “Business: Blended; Wine Industry Mergers.” The Economist, 25 January 2003

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Customer Environment When looking at consumer trends in the wine industry in Mexico, the picture is a little brighter. While US wine sales growth has slowed from its record-breaking numbers in the 90s, Mexican consumers’ demand has seen recent sharp increases. Wine sales in Mexico are expected to have a compound annual growth rate of 6.2 percent, compared with similar markets such as Brazil who have seen growth slide to 1.9 percent.15

Opportunities and Challenges The vast majority of growth in the wine industry has been in the premium wines and superdiscount wines. The market for wines between these two extremes has seen very little growth, and often market shrinkage. As the Mexican wine industry is fairly under-developed, wine producers in this market have little opportunity to achieve the scale needed for the production of super-discount wines, the opportunity in this market lies in premium brands. This actually coincides nicely with the wine-growing conditions in Mexico, as the Mexican climate and soil are said to be very conducive to premium grape growing. Also, when looking at the target market for wine consumption in Mexico, the focus will quickly fall to the upper-middle to higher income population. This segment, and specifically urban professionals with travel experience and greater discretionary spending, will be the people most likely to venture away from the traditional choices of beer and tequila. An opportunity for Super-Premium and Ultra-Premium wines exists here as a status symbol. Furthermore, as mentioned earlier, the lack of domestic competitiveness leads to a lack of pressure for innovation and improvement in quality; conversely, the highly developed wine producing regions around the world are constantly under pressure from competitors to improve 15

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quality and to rapidly innovate. A major boost from foreign investors with agricultural, technological, and most importantly marketing experience would probably be needed to really raise the Mexican wine industry up to the standards of even Chile or Argentina, but the problem lies in attracting these investors.

Conclusions and Recommendations With this understanding of the global wine industry, the economics of wine production, the history of the industry in Mexico, the overall business environment in Mexico, and the ongoing development of the wine market in Mexico, it is possible to make some concluding recommendations for both local wineries and foreign companies considering expanding to Mexico. Domestic Producers For a domestic winery such as LA Cetto to be grow and be successful both domestically and internationally, we strongly believe the emphasis must be placed on quality and branding, due to the fact that the only segments that continue to grow in sales on a global basis are the premium wines. The primary challenge in entering the market as a high quality brand is the development of a strong brand image. In order to compete in the premium wine segment, a Mexican wine producer would need to develop a brand image that could compete with well established and respected brand name labels from Australia, California, France, Italy, and others. Given the fact that Mexico has no history of wine-making, this could prove especially challenging. However, since there have already been a few wineries such as Monte Xanic experiencing success internationally, perhaps the Mexican government could consider export subsidies for the wine

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industry, or at least looking into MAA’s such as the one signed in 2002 to promote their involvement in the international wine trade. Foreign Companies In the final evaluation, we do not believe that the Mexican wine industry is a desirable investment opportunity for foreign wine companies looking to expand. As mentioned above, the infrastructure in Mexico is still lacking, especially in regards to irrigation and water supply, but also concerning financial and economic stability. The domestic market for wine is also very small, meaning a new foreign producer would have to focus almost entirely back on their home market, limiting the advantages to be gained from economies of scale. This need to focus almost entirely on exports would cause problems of its own due to the fact that there is very little recognition of Mexican wines worldwide. With no wine heritage, it would be very hard for a new Mexican wine to compete with the established vintners of Europe, the US, Australia, or even Chile. Furthermore, success in the wine industry is currently being driven by marketing and quality, and while foreign investors could bring their branding experience to Mexico, they would have a very difficult time establishing a competitive image for Mexican wines. Finally, and perhaps most fundamentally, there is currently a huge global oversupply of grapes for every type of wine except specialties such as champagne and port. In the face of declining global consumption and falling prices for grape growers, there is simply no reason for a foreign firm to make the huge investment necessary to jumpstart the Mexican wine industry.

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FBE-462: Group Project Comparison of markets Competitive Environment The domestic array of wine producing competitors in Mexico is very limited, due to its status as a relatively under-developed market for wine production. Competition from imports poses a very strong risk to any potential wineries in Mexico, though. Established foreign wine producing markets have years of experience in making high quality wine in bulk at low prices, most notably the California and Australian markets. Further, European wineries have long produced premium wine brands and still hold a large portion of the world wine market, despite the problems they have had in recent decades. In order to develop as an effective world wine-producing competitor, Mexico would first have to develop its own domestic wine market. Currently, Mexico makes up .7 percent of the wine market for the Americas.1 With such a small market, it would be difficult to establish the image of desirability so needed in this competitive industry. Further, wine making has been making a move from a labor-intensive business to a capital intensive business, as evidenced by the emergence of very large mass-producing wine companies such as E&J Gallo, who recently posted a US$4 Billion revenue intake. While California is known for its abundance of Capital, Mexico is not.2 These conditions paint a clear picture of the difficulties Mexico would face in emerging as a competitive force in the world wine industry. Customer Environment When looking at consumer trends in the wine industry in Mexico, the picture is a little brighter. While US wine sales growth has slowed from its record-breaking numbers 1 2

“Wine Industry Overview.” Business and Company Resource Center, 11 April 2007 “Business: Blended; Wine Industry Mergers.” The Economist, 25 January 2003

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in the 90s, Mexican consumers’ demand has seen recent sharp increases. Wine sales in Mexico are expected to have a compound annual growth rate of 6.2 percent, compared with similar markets such as Brazil who have seen growth slide to 1.9 percent.3 Opportunities and Challenges The far majority of growth in the wine industry has been in the premium wines and super-discount wines. The market for wines between these two extremes has seen very little growth, and often market shrinkage. As the Mexican wine industry is fairly under-developed, wine producers in this market have little opportunity to achieve the scale needed for the production of super-discount wines, the opportunity in this market lies in premium brands. This actually coincides nicely with the wine-growing conditions in Mexico, as the Mexican climate and soil are said to be very conducive to good grape growing. The primary challenge in entering the market as a premium brand is the development of a strong brand image. In order to compete in the premium wine segment, a Mexican wine producer would need to develop a brand image that could compete with well established and respected brand name labels from Australia, California, France, Italy, and others. Further, as mentioned earlier, the lack of domestic competitiveness lends to a lack of pressure for innovation and improvement in quality; conversely, the highly developed wine producing regions of the world are constantly under pressure from competitors to improve quality and to rapidly innovate.

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Entering the Mexican Wine Industry Professor Chen FBE-462 Yu Chen Cyrus Chini Alexander Daly Shelley Goto Keith Parker

Global Wine Industry Overview • $90 billion industry in 2002 • Largest national producers and exporters – France, Italy, Spain, United States, Australia

• Key import markets – Germany, United Kingdom, United States, France

• Major wineries/conglomerates – Constellation, LVMH, E&J Gallo, Southcorp, Seagram

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Agenda • • • • • •

Global Wine Industry Overview Industry Cost Structure Overview of Mexican Wine Market Analysis of market externalities Opportunities and Challenges Conclusion and Recommendations

The Reshaping of the Competitive Environment • The decline in European dominance – Falling consumption rates – New World production methods and innovation – Oversupply of grapes

• The rise of Australian exports • The South American experience

Market Analysis

Cost Structure of the Industry • Production – Grape Costs – Crush and Capitol Costs – Barrel Costs – Dry Goods Costs

Winery

Wholesaler

Retailer

End Consumer

• Non Production – Regulation Fines – Tariffs – Marketing, Shipping, and Distribution

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The Mexican Wine Industry

Advantages and Disadvantages of the Mexican Wine Industry Weather

• Centered in Ensenada

Water Supply • Guadalupe, Calafia, San Vicente and Santo Tomas Valleys

Main Wine Producers in Mexico L.A. Cetto Monte Xanic

Environmental Analysis • Cultural – Small domestic market – Expansion opportunities lie in exports – Marketing necessary to increase domestic consumption

• Technological – Lacks traditional wine-making regulations – Cheap mass production possible

Number of Wine Lovers

Environmental Analysis • Economic – Abundance of cheap, low-skilled labor – Favors the seasonal nature of the wine industry – Possibility of macroeconomic instability

• Political – Free trade agreements – NAFTA

Policy Analysis • Border Control: mobility of goods – Limited amounts may be brought across the border – Can sell for a higher price to reflect exclusivity

• Border Control: mobility of labor – US lack of cheap seasonal labor – Give Mexican producers an advantage

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Competitive Analysis • Domestic Wine Competition

– Take advantage of US markets – Continuing integration promises less profit loss to tariffs

• China – Large producer, but not exporter – Has the resources to take market share away, but less cultural incentive

Opportunities and Challenges • Overall Industry Growth – On the extremes – Mexican entrants should focus on Premium

• Establishing a Premium Brand – Good Terroir in Mexico – Would compete with established name brands – Lack of significant domestic competition • Less innovation • Less pressure for higher quality

– Very Limited

• International Wine Competition – Very large and established – Have reached Economies of Scale and Scope – Competitors have established images • Very hard to develop • Mexico currently doesn’t have the right image

Conclusions and Recommendations • Domestic Firms – Focus on branding – creating a Mexican identity – Expand exports, especially within premium segments

• Foreign Companies – NOT attractive – Infrastructure not in place – Domestic market too small – Lack of a national wine heritage, limited branding possibilities – Global oversupply

Thank You Questions?

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Business & Company Resource Center Datamonitor Industry Market Research, Nov 15, 2006 pNA Mexico - Wine. (L.A. Cett)(Industry overview) Full Text: COPYRIGHT 2006 Datamonitor MarketDefinition The wine market consists of fortified wine, sparkling wine and still wine. The market is valued according to retail selling price (RSP) and includes any applicable taxes. Any currency conversions used in the creation of this report have been calculated using constant 2005 annual average exchange rates. For the purpose of this report, the Americas comprises the US, Canada, Brazil and Mexico. ResearchHighlights *The Mexican wine market generated total revenues of $230.2 million in 2005, this representing a compound annual growth rate (CAGR) of 5.6% for the five-year period spanning 2001-2005. *Market consumption volumes increased with a CAGR of 2.5% between 2001-2005, to reach a total of 18.2 million liters in 2005. *The performance of the market is forecast to accelerate, with an anticipated CAGR of 6.4% for the five-year period 2005-2010 expected to drive the market to a value of $313.6 million by the end of 2010. MarketAnalysis The Mexican wine market has posted steady rates of growth throughout 2001-2005 and is expected to grow at an even faster pace in the forthcoming five year period. Similarly to wine markets in Brazil and Canada, Mexico benefits primarily from the sale of still wines. The Mexican wine market generated total revenues of $230.2 million in 2005, this representing a compound annual growth rate (CAGR) of 5.6% for the five-year period spanning 2001-2005. In comparison, the Canadian and Brazilian markets grew with CAGRs of 4.1% and 1.9% over the same period, to reach respective values of $4257.8 million and $2235.7 million in 2005. Market consumption volumes increased with a CAGR of 2.5% between 2001-2005, to reach a total of 18.2 million liters in 2005. The market's volume is expected to rise to 19.4 million liters by the end of 2010, this

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representing a CAGR of 1.3% for the 2005-2010 period. Still wines sales proved the most lucrative for the Mexican wine market in 2005, generating total revenues of $183.7 million, equivalent to 79.8% of the market's overall value. In comparison, sales of sparkling wines generated revenues of $33.4 million in 2005, equating to 14.5% of the market's aggregate revenues. The performance of the market is forecast to accelerate, with an anticipated CAGR of 6.4% for the five-year period 2005-2010 expected to drive the market to a value of $313.6 million by the end of 2010. Comparatively, the Canadian and Brazilian markets will grow with CAGRs of 3.4% and 3.8% respectively over the same period, to reach respective values of $5026.1 million and $2,697.7 million in 2010. Value The Mexican wine market grew by 5.1% in 2005 to reach a value of $230.2 million. The compound annual growth rate of the market in the period 2001-2005 was 5.6%. Mexico Wine Market Value Unit: USD

Year 2001 2002 2003 2004 2005 CAGR

Value 185300000 197100000 207200000 219000000 230200000 2001-2005

Growth 6.4% 5.1% 5.7% 5.1% 5.6%

Volume The Mexican wine market grew by 2.1% in 2005 to reach a volume of 18.2 million liters. The compound annual growth rate of the market volume in the period 2001-2005 was 2.5%. Mexico Wine Market Volume Unit: Liters

Year 2001 2002 2003 2004 2005 CAGR

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Volume 16500000 17000000 17400000 17800000 18200000 2001-2005

Growth 3.3% 2% 2.5% 2.1% 2.5%

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Sales of still wine accounts for 79.8% of the Mexican wine market's value. In comparison, sparkling wine generates a further 14.5% of the market's revenues. Mexico Wine Market Segmentation Year: 2005 Category Still wine Sparkling wine Fortified wine

Percentage 79.8% 14.5% 5.7%

Segmentation The Mexican wine market accounts for 0.7% of the Americas market value. In comparison, Brazil generates 7.3% of the market's value. Mexico Wine Market Segmentation Year: 2005 Geography United States Canada Brazil Mexico

Percentage 78.1% 13.9% 7.3% 0.7%

Share L.A. Cetto accounts for 9.9% of the Mexican wine market's volume. In comparison, Bodegas de Santo Tomas generates a further 8.8%. Mexico Wine Market Share Year: 2005 Company L.A. Cetto Bodegas de Santo Tomas Pernod Ricard Serena Other

Percentage 9.9% 8.8% 1.1% 0.5% 79.7%

CompetitiveLandscape L.A. Cetto leads the Mexican wine market, with sales in 2005 amounting to 1.8 million liters, this accounting for 9.9% of the markets volume. Other significant players include: Bodegas de Santa Tomas, whose sales of 1.6 million liters comprise 8.8% of the markets volume, and Pernod Ricard, which has sales of 0.2 million liters and a volume share of 1.1% of the market.

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Supermarkets & hypermarkets form the most significant distribution channel for wine sales in Mexico, accounting for 35.7%. On-trade sales account for an additional 28% of the market. This section contains brief overviews of the leading companies in the Mexican wine market. Company L.A. Cett L.A. Cetto is based in Chapultepec, Mexico. It primarily produces Cava and exports to 27 countries. No recent financial data is available. Company Pernod Ricard Pernod Ricard is the second largest manufacturer of spirits and fourth largest manufacturer of wines globally. It manufactures and distributes wines and spirits under more than 65 brand names. The company operates in the Americas, Europe and the Asia Pacific. It is headquartered in Paris, France and employed about 12,250 people as of December 2003. The company recorded revenues of $6.5 billion during the fiscal year ended December 2005, an increase of 46.9% over 2004. The operating profit of the company during fiscal 2005 was $1.3 billion. The net profit was $800.5 million during fiscal year 2004, an increase of 22% over 2004. Supermarkets & hypermarkets are the most important distribution channel, with 35.7% of the market's volume distributed via this channel. On-trade accounts for a further 28%. Mexico Wine Market Distribution Year: 2005 Channel Supermarkets/hypermarkets On-trade Specialist Retailers Other

Percentage 35.7% 28% 24.7% 11.6%

ForecastValue In 2010, the Mexican wine market is forecast to have a value of $313.6 million, an increase of 7.3% since 2005. The compound annual growth rate of the market in the period 2005-2010 is predicted to be 6.4%. Mexico Wine Market Value Forecast

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Year 2005 2006 2007 2008 2009 2010 CAGR

Value 230200000 242100000 255900000 275500000 292200000 313600000 2005-2010

Growth 5.1% 5.2% 5.7% 7.7% 6.1% 7.3% 6.4%

ForecastVolume In 2010, the Mexican wine market is forecast to have a volume of 19.4 million liters, an increase of 6.6% since 2005. The compound annual growth rate of the market volume in the period 2005-2010 is predicted to be 1.3%. Mexico Wine Market Volume Forecast Unit: Liters

Year 2005 2006 2007 2008 2009 2010 CAGR

Volume 18200000 18400000 18600000 18900000 19200000 19400000 2005-2010

Growth 2.1% 1.3% 1.1% 1.4% 1.4% 1.3% 1.3%

MacroeconomicData Population Mexico Size of Population Unit: Population

Year 2001 2002 2003 2004 2005

Value 101200000 102500000 103700000 105000000 106200000

Growth 1.2% 1.2% 1.2% 1.2%

GDP Mexico GDP Unit: Real GDP (1995=100)

Year 2001 2002

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Value 130.2 131.5

Growth 1%

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133.4 137.7 142.6

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1.4% 3.2% 3.5%

Inflation Mexico Inflation Unit: Inflation Rate %

Year Value 2001 0.044 2002 0.057 2003 0.04 2004 0.04 2005 0.033 Exchange Rate Unit: Exchange Rate

Year 2001 2002 2003 2004 2005

Value 0.001 0.001 0.001 0.001 0.001

Article A156814249

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Business & Company Resource Center Wines, Brandy, and Brandy Spirits SIC Code(s) Covered 2084-Wines, Brandy & Brandy Spirits

NAICS Code(s) Covered 312130-Wineries

Industry Snapshot

Although the first commercial wine venture in the United States was in Pennsylvania in 1793, the majority of modern American wineries have been located in California, with Washington and New York coming in a distant second and third, respectively. California and its 1,300 wineries has accounted for more than 90 percent of all U.S. wine production and more than 70 percent of all wine sold in the United States. If viewed as a nation, California would rank fourth in worldwide wine production, following Italy, France, and Spain. In the mid-2000s Gallo was the dominant wine producer in the country, as well as the leading exporter. In the mid-2000s Americans purchased 627 million gallons of wine, with a retail value of approximately $23 billion. Eighty-eight percent of the total was table wine, 7 percent was dessert wine, and 4 percent was sparkling wine or champagne. Table wine has been the most popular kind of wine sold in the United States. Varietals, table wines made predominately of one kind of grape, grew in popularity in the past decade. In 2004, 40.5 percent of wine sold in supermarkets was red, 40.4 percent was white, and 19.1 percent was blush.

Organization and Structure

All winemakers must sell their products through wholesalers and retailers to accommodate various federal, state, and local regulations regarding the sale of alcoholic beverages. The Federal Alcohol Administration Act (FAA) was established after the 13-year Prohibition Era ended in 1933. The Bureau of Alcohol, Tobacco, and Firearms (ATF) is responsible for administering and enforcing the FAA, including qualifying winemakers, collecting producer and wholesaler occupational taxes, and regulating trade practices, advertising, and labeling. Beyond the uniformity of the FAA, regulations vary greatly among the 50 states.

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States can sell wine in one of two ways, either in a controlled environment or using an open, licensed method. "Open" states have licensed retailers and wholesalers that handle the distribution and sale of alcoholic beverages. Thirty-two states and the District of Columbia are open states. The other 18 states operate under the control method, in which each state government buys and sells alcoholic beverages at the wholesale and retail levels. In addition to federal regulations, some states have set up their own independent agencies that are responsible for the administration, licensing, and enforcement of state laws and the collection of state revenues. Some state legislatures even have created their own alcoholic beverage control (ABC) agencies with rule-making power, and 32 states allow their citizens to vote for or against the sale of liquor on a city or county-wide basis.

Background and Development

California winemaking began in 1769 when Father Junipero Serra planted vines at Mission San Diego. In September 1772, the grapes were harvested and pressed, creating California's first vintage. These early wines were produced for sacramental purposes and personal consumption at the missions. The commercial era of wine production began in 1830 with the efforts of Frenchman Jean Louis Vignes from Bordeaux, France. His vineyard was located in what is now downtown Los Angeles. The wine industry boomed as an ancillary result of the discovery of gold in California in 1848. A surge of Europeans came to the state seeking their fortune. Immigrants from Italy, France, and Germany who had no luck finding gold turned to a trade they already knew--winemaking. Between 1860 and 1880, the industry grew rapidly as numerous wineries were established. By 1890, several of the state's famous wine regions already had taken shape and the industry was producing 25 million gallons of wine per year. After suffering losses from a vine pest called phylloxera, the industry virtually disappeared with the passage of Prohibition in 1919. The repeal of Prohibition in 1933, however, prompted the industry to rebuild. Growth was steady between 1949 and 1960, with annual output increasing from 117 million gallons to 129 million gallons. By the 1970s, the demand for California table wines had doubled. As the industry evolved, so did consumer preferences. From 1933 to 1967, dessert wine was the most popular kind of wine in the United States. During the 1970s, generic table wines, like California Chablis and California Burgundy, dominated sales. By the late 1980s, varietal wines, those labeled with the name of the grape, had taken over. After posting a 6.5 percent loss in 1993, wine sales in the United States continued to rise, while per capita consumption remained steady at 1.8 gallons. According to the San Francisco-based Wine Institute, consumer demand for premium varietal wines spurred a 5 percent increase in California table wine sales in 1994--the strongest performance in more than a decade. While most of the largest wine producers reported record sales, and consumer tastes moved upscale to more expensive wines, 1994 was noted as the best year for the wine industry since the late 1980s. "The end of the drought, the waning of phylloxera root

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louse problems and increased consumer demand all have winemakers singing a new tune," reported Clifford Carlsen of The San Francisco Business Times. Total U.S. production again rose in 1995, up 10.3 percent at 437 million gallons. According to wine industry analyst Jon Frederickson of San Francisco-based Gomberg, Fredrickson and Associates, wine sales increased 8 percent in 1995 to a record $4.4 billion. Increased consumer demand and a relatively strong supply of fruit contributed to the industry's continued strong growth. Following record wine sales and all-time high prices for grapes in 1995, the industry experienced another banner year in 1996. In fact, many North Coast wineries, with sales increases of 30 to 40 percent, did not have enough wine to meet the staggering demand. The improved economy and continuing news reports about the health benefits of moderate wine consumption fueled the continued growth of the industry. A 1991 broadcast of 60 Minutes reported a link between moderate wine consumption and a reduced risk of heart attack. Called the French Paradox, two scientists found that despite similar fat intake, France's heart attack rate was one-third that of the United States. A key factor they attributed to this was the French custom of drinking wine with meals. Red wine sales increased more than 75 percent after that 1991 report. Champagne sales continued to drop despite increases of specific brands. From a peak of 18.2 million 9 liter cases of sparkling wine and champagne in the United States in 1986, consumption fell to 12.3 million 9 liter cases in 1995. Causes for the decline were high prices for champagne, high taxes, high cost of shipping, and lack of consistent, high-profile marketing programs. Wine sales were expected to continue their increase as the federal government took an unprecedented step in advocating moderate consumption. When the U.S. government issued new dietary guidelines in 1996, it acknowledged, for the first time, the benefits of moderate wine consumption. Previously, the government had warned that even small amounts of alcohol had "no net health benefit." "Writing that language into the dietary guidelines was an extraordinary statement of public policy change in the United States. It's a foundation we can build on into the next century," said John De Luca, president of the Wine Institute, the trade association for the wine industry. He added that the revised guidelines culminated five years of work to redefine the image of wine, "putting it back on the dining room table where it's been for 2,000 years." Leading the pack in wine sales have been the varietals. Relatively new to the industry, a "fighting" varietal has been defined as a value-priced, cork-finished, 750 ml varietal wine. The leader in fighting varietals has been Glen Ellen, followed by Fetzer's Bel Arbors, Sebastiani's Country Wines and Swan Cellar label, Beringer's Napa Valley, and Robert Mondavi's Woodbridge. Tim Wallace, a Glen Ellen executive, told Beverage Dynamics that "fighting varietals are the foundation for the American wine industry in the future." In the late 1990s, fruit-flavored varietal wines became popular. Canadaigua introduced Arbor Mist in 1998 in flavors such as peach and tropical fruits chardonnay and exotic fruits and sangria zinfandel. Other producers followed suit, including Sutter Home's Portico, Earnest & Julio Gallo's Wild Vines, and the Wine Group's Lyrica.

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The introduction of fruit-flavored varietals caused a minor uproar among wine purists in the industry. Because these wines contain less than 7 percent alcohol, they are regulated for the Federal Drug Administration (FDA), which does not issue designation requirements for varietals. At the end of the twentieth century, U.S. producers of champagne and sparkling wine commanded a 70 percent share of the domestic market. Growth continued to be slow. In 1997, shipments of champagne rose 1 percent for the first time since the 1980s, but they fell by 3 percent the following year. These losses were attributed to consumers' abandonment of the less expensive charmat producers in favor of the higher-end method champenoise varieties. The good news was that the quality of champagne, both domestic and imported, was rising. Those producing champagne began to make a product that was more suited to American tastes. Improvements in champagne production were forged mainly in Carneros, Mendocino County, California, as well as on the central coast. In return, these domestic producers saw consumers move to brands that offered high quality at affordable prices. The sale of wine over the Internet stirred a heated debate between the U.S. Congress and the wine industry. Spurred by a rash of student-led violence in the nation's schools, legislators created a bill on youth crime and gun control. An amendment to the bill gave states the power to use federal courts to enforce local laws governing the interstate alcohol trade. Proponents said that the amendment's purpose was to prevent underage drinking. Many in the wine industry believed that it would restrict their business. A survey of 176 California vintners, conducted by the Wine Institute, found that nine out of ten shipped their products to out-of-state customers and 50 percent used Web sites to sell their products. Production. The making of wine begins with the grape harvest, which generally occurs from August through November, depending on the grape variety and the weather. The grapes are placed in a crusher that separates the stems from the fruit and breaks up the berries. The stems are then discarded, leaving a combination of juice, seeds, pulp, and skins, called "must." Juice from red or white wine grapes is colorless. To make white wine, the skins and seeds usually are removed from the must after a few hours. The remaining juice is called "free-run." The discarded skins also are pressed to extract the "press juice." Both juices then are filtered, placed in storage, and given yeast to facilitate the fermentation process. White wine fermentation can last anywhere from three days to three weeks. Upon completion, the wine is filtered for solids or remaining yeast. The wine then is aged for a period of one week to a year in stainless steel, oak, or redwood containers. It also can be aged in the bottle. After aging, the wine can be blended with other wines to create a desired style or can be sent to be finished, a process that stabilizes and filters the wine before bottling. Production of red wine is slightly different than the process of making white wine. Red wine is fermented at warmer temperatures than white wine. For red wine production, the skins are fermented with the crushed juice to give it color and flavor. The skins float to the top and are moistened regularly with juice to extract color and flavor. Red wine usually is fermented for five to ten days and then is filtered, clarified, and preserved with sulfites. Red wine commonly is aged in oak barrels for one to two years.

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Champagne is made in one of two ways: by method champenoise or the charmat process. In method champenoise, still wine is blended with a mixture (called triage) of still wine, yeast, and a sugar substance. This blend is resealed in bottles where it is fermented for a second time and aged. Carbon dioxide collects in the bottles, which is released in a rush of bubbles when the bottles are uncorked. In the charmat, or bulk, process, the still wine, yeast, and sugar are fermented in a pressurized tank rather than in bottles. Types of Wines. Wines sold in the United States generally are divided into the following categories: champagne, aperitif, dessert wine, table wine, and varietal wine. Also included in this discussion are brandy and other fortified wines. Wines can be named one of four ways: by variety, which tells the predominant type of grape; by a generic name describing the color, such as blush; by the region that originally inspired the wine, such as Chablis; or by a proprietary name, which is a label created by the winery. Champagne and sparkling wines are names used interchangeably in the United States for wines with effervescence. These wines range from very dry (natural), to dry (brut), to slightly sweet (extra dry), to sweet (sec and demi-sec). Aperitifs are appetizer wines usually served prior to a meal and can include champagnes and sherries. Dessert wines are officially classified as those with an alcohol content of 17 percent to 21 percent. They can be sweet or dry and include sherries and ports. Table wine is a term commonly used to describe all red, white, blush, and rose wines that contain 7 to 14 percent alcohol. These wines are still rather effervescent and are served mainly with meals. Table wines can be made from any grape or combination of grapes and in any style that the winemaker chooses. Varietal wines are table wines that are made from a minimum of 75 percent of a particular grape variety; they carry the name of the grape variety from which they are produced, such as Chardonnay or Merlot. The red table wine category has been led by Cabernet Sauvignon, a full-bodied, rich, intense wine with noticeable tannins. A leading prestigious varietal, Cabernet Sauvignon has been one of the most widely available wines from California. Other red varietals include Merlot, Petite Sirah, and Zinfandel. Merlot is a medium- to full-bodied wine that originally was made for the sole purpose of blending with Cabernet Sauvignon. Petite Sirah is a wine with deep color, full body, and a fresh-berry taste. Zinfandel, known as the classic California wine, is known too for its versatility, range of style, and raspberry-spicy aroma and flavor. White table wines have been dominated by Chardonnay, which is the most widely planted variety of grape in California, making up more than 56,000 acres. It is a dry wine that has a balance of fruit, acidity, and texture. Depending on what the winemaker uses for storage, Chardonnay can range from clean and crisp wines to rich, complex, oak-aged wines. Other white varietals include French Columbard, Sauvignon Blanc, Johannisberg Reisling, Gewurztraminer, and Pinot Blanc. French Columbard is generally fresh and fruity, ranging from light to medium in body. Sauvignon Blanc has been one of the fastest growing varietals in California; sometimes called Fume Blanc, it is best known for its grassy, herbal flavors and is often consumed with fish and shellfish. Johannisberg Riesling, from the German Riesling grape, is aromatic, delicate, and slightly sweet. Late Harvest Rieslings are good accompaniments for dessert.

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Gewurztraminer offers spicy aromas and flavors and a slight wisp of residual sweetness. Often this wine goes well with Asian food. Pinot Blanc is a unique, dry white wine, with styles ranging from bold, oak-aged to crisp and medium-bodied. Brandy is "burnt wine" or fruit wine that is boiled and aged in wood. Virtually any type of fruit can be used to make brandy, although grapes have been the most common. Brandy has been produced primarily in Spain, Italy, and France, and most recently in the United States. Cognac has been considered to be the best of all brandies. Cognac's discerning characteristic has been its blending, often created from a number of different cognacs coupled carefully to achieve an appropriate mixture. Fortified wines were the creation of the Spanish and Portuguese and included port, sherry, and Madeira. Sherry is made by blending younger sherries with older sherries in oak casks. It varies in dryness levels and in hues. Harvey's Bristol Cream, imported by Hiram Walker & Sons, has been the top-selling sherry in the United States, with a nearly 41 percent market share. The best-seller is a blend of aged oloroso, a fortified full-bodied sherry, and Pedro Ximines grapes, which sweetens the mixture. Port is red wine fortified with grape brandy. It was created unintentionally in the seventeenth century when Portugal tried to ship its table wine to England. In order to stabilize the wine during its voyage across the Atlantic, the wine needed the addition of grape brandy. England has remained the most popular market for port. Madeira comes from a tropical island of the same name and is a raisiny, sweet wine. Madeira has been closely linked with the history of the United States, according to the New York Times Magazine. It was considered to be the wine of choice for American Revolutionary notables such as Thomas Jefferson, George Washington, and Ben Franklin. Unlike other wines that soured during the long, hot voyage across the Atlantic, Madeira was the only wine known to improve dramatically with the introduction of heat. After a time of record growth throughout the 1990s, U.S. winemakers began seeing wine sales flatten in the early 2000s. With a shaky economy made all the more so by the attacks of September 11, 2001, the wine industry, like many U.S. industries, was affected by the decrease in consumer spending on travel and recreation, which is tied in to wine drinking. Another factor in the state of the wine industry from 2000 to 2003 was the overproduction of grapes and the ensuing drop in grape prices by as much as 75 percent in 2001 and 2002. Wine prices dropped during this time while sales flattened. Retail sales of wine in the United States were $19.8 billion in 2001, a 4 percent increase over 2000's sales of $19.0 billion. By 2002, sales of California wine dropped in all categories for the first time in more than a decade. Finally, the proliferation of high quality, inexpensive imported wine caused further woes for U.S. winemakers. Imports rose 17 percent in 2002, accounting for 25 percent of total wine sales in the United States. White wine continued to be popular, owning 40 percent of the wine market in 2001, with red not far behind, growing from 17 percent in 1991 to a strong 37 percent of market share in 2001. The MKF Wine Trends Report noted that the leading California table wine varietals, Chardonnay, Cabernet Sauvignon, Merlot, and White Zinfandel/Blush, accounted for about 76 percent of all retail sales by value of California wine in 2001. Chardonnay continued its leading spot with a 29 percent dollar market share, followed by Cabernet with 19 percent, Merlot with 15 percent, and White Zinfandel/Blush holding 13 percent of the market by value. Secondary red varietals, including Syrah, Pinot Noir, and Red Zinfandel, all were up more than 30 percent in

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revenues for California wineries. There was a surge in popularity of Pinot Grigio, which the Wine Spectator reported had sales increasing faster that any other white wine in supermarkets. Wine coolers, once popular in the late 1990s, were less so as the new millennium dawned. In a climate of more cautious consumer spending, wines priced at $50 and higher were selling far less than in the robust 1990s, noted Charles Krug Winery co-proprietor Peter Mondavi in a July 2002 interview with Beverage Industry. "The wines that are $35 or so are still going through the roof. So we're having great success in that category," he added. With prices falling to record lows, consumers were indeed enjoying bargains in the early 2000s. Indeed, California chain Trader Joe's seemed to be leading the bargain trend, offering the Charles Shaw line of Merlots, Cabernets, and Chardonnays for $1.99 in late 2002 and early 2003. In those six months, wine industry analysts Jon Fredrikson estimates the company sold about 1 million cases of the generally good quality wine that was dubbed, "Two-Buck Chuck."

Current Conditions

By the mid-2000s the U.S. wine industry was picking up. California wineries shipped a record amount of products, with approximately 428 million gallons shipped domestically, from a total 522 million gallons shipped worldwide. While so-called "extreme value" varieties continued to sell well, the expensive premium wines also were seeing increases, accounting for 64 percent of industry revenues. Following the trend across nearly all American retail industries, the middle variety sales were flat, with the majority of the industry growth occurring at either extreme end of the price spectrum. In 2004 sales of red outpaced white for the first time in years. To ensure that California sustained its fertile winegrowing land, the Wine Institute and the California Association of Winegrape Growers launched the "Code of Sustainable Winegrowing Practices" in 2002, which in 2004 received a $475,000 USDA grant for support of sustainable winegrowing practices. The program for vintners and growers was a voluntary and helpful tool for conserving natural resources, protecting the environment, and enhancing relationships with neighbors, local communities, and employees. A new trend in the mid-2000s was that of bringing winemaking to the masses with make-your-own wineries and classes springing up in Florida, New York, California, and Texas, to name just a few of the locations. While the majority of these operations, which were not affiliated with any particular winery, allowed customers to simply choose grapes, add yeast, and design labels, some of the larger operations, such as the Bacchus School of Wine, were truly teaching the winemaking process in less than a year, starting students from the very beginning. Other relevant trends included more vintners moving to plastic corks. Although considered "tacky" by some, more and more winemakers worldwide were seeing the benefits to the move, as costlier, traditional corks were increasingly blamed for ruining bottles with sediment, mustiness, or leakage. This negative cork performance costs vineyards money, as they absorb the cost of returned bottles. Other winemakers made a move to organics, as Fetzer Vineyards announced that it intended to grow and use 100 percent organic grapes for all of its wine by the 2010 harvest.

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Industry Leaders

As dominant as the state of California is in the wine industry, so too are the wineries of California winemakers Ernest & Julio Gallo (E & J Gallo). Controlling nearly 40 percent of the U.S. wine market, E & J Gallo Wineries led every wine category in which it competed. According to the Wine Spectator, one out of every three bottles of wine made in America is a Gallo product. The world's largest winemaker, E & J Gallo Wineries had annual sales of more than $3 billion in 2004. In 1933 the original Ernest and Julio Gallo brothers winery was founded in Modesto, California. Unable to obtain bank financing, the company bought crushing and fermenting equipment on 90-day terms and rented a warehouse to make its first commercial wine. Using pamphlets on winemaking from the local library and grapes bought on a promise to pay from eventual sales, the two brothers made their first batch of wine. By 1993 Gallo owned five separate vineyards totaling more than 2,000 acres. The company remained a private, family-owned business (two of Julio Gallo's great-grandchildren, Matt and Gina, are actively involved in the company's winemaking operations) and was one of the largest organic farms in the United States. The company's success was due in part to the partnership of the Gallo brothers; Ernest marketed the wine that Julio made. Another part of Gallo's success was its quest for improving the quality of the wine it produced. To this end, Gallo replanted its vineyard in Livingston in 1946 using grape varieties that had not been previously grown in the area. Various viticultural techniques were experimented with, and in 1947 a formal research program was established to evaluate the results. Specific standards were developed for winemaking and were used thereafter. In 1965 Julio Gallo established the first Growers Relations Department and shared research findings with area growers. In 1967 Gallo offered long-term contracts to selected growers, giving economic security and incentive to replant vineyards with the better grape varieties recommended by Gallo. During the 1970s, the winery shifted to producing premium varietal wines, and in 1991 it introduced its first ultra-premium wine, 1991 Sonoma Estate Chardonnay. Leading brands for E & J Gallo Wineries have been Gallo, Andre, Bartles & James, and Carlo Rossi. Constellation Brands, the former Canadaigua Wine Company, became the number-two seller in the U.S. wine market in 1995 with the acquisition of the Almaden and Inglenook wine labels (in 1994) from Heublein for $130.5 million. Although the company name may not be well known, its products such as Almaden, Inglenook, Taylor California Wines, and Paul Masson Wines are household names. Constellation had sales of $3.6 billion in 2004. The company is a father-and-son operation located in upstate New York, started in 1945 by Marvin Sands, who bought a sauerkraut factory and turned it into a winery for $60,000. For ten years, Canandaigua Industries sold fruit wines in bulk to local bottlers who then sold them under their own brand names. In 1954 Sands turned away from bulk wines and created a brand for himself--Richards Wild Irish Rose, a blended red dessert wine. During the 1960s Wild Irish Rose represented nearly all of the company's sales.

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Working from that base, Sands slowly expanded, acquiring 11 small wineries through 1984. Then the company entered the wine cooler market with its Country Wine Coolers. Although the company suffered an operating loss of $20 million in 1987 and 1988 due to expensive advertising, Sands realized the power of the company's distribution network and began looking for established brands. In 1991 Canadaigua made its first major purchase with Cook's Champagne for $60 million. Then came additional purchases in 1993, 1994, 1998, and 1999. By the end of the twentieth century, Canadaigua was posting annual sales of $740 million. In 2004, the company had more than 200 brands of wine, beer, and spirits on the market.

Workforce

In 2003, the beverage manufacturing industry as a whole employed more than 169,000 workers. In total, as of the early 2000s, the winemaking industry employed more than 17,000 workers. The majority of wineries were family-owned, were located in California, and had a tremendous impact on that state's economy. Los Angeles-based Recon Research Corporation reported that the California wine industry contributed nearly $1.5 billion annually to the Sonoma County economy, employing more than 3,600 people and creating secondary industrial employment of an additional 2,500 jobs.

America and the World

U.S. wine companies' efforts to establish joint ventures in Europe were not as successful as they had hoped. Controlled by small producers and cooperatives, experiences there led U.S. companies, in the early 2000s, to the more successful, growing trend of teaming with Australian companies, who were more than willing to establish a greater foothold in the United States. However, overseas planting of premium varietals elsewhere had been growing at a fast pace and was expected to be a significant new source of wine for U.S. consumers. In fact, California wineries bought unprecedented amounts of overseas wine to meet consumer demand for low-priced everyday wine and to expand their existing line of products in the mid-1990s. For example, in 1996 Robert Mondavi began importing a Chilean line of wines, the Caletara brand, priced in the $6 to $9 range. A second brand, Edwardo Chadwick, was introduced in the $12 to $15 range, followed by a brand in an even higher price range. In 1995 the winery also launched a line of Italian varietals. Demand for Australian wine in the United States skyrocketed as American consumers enjoyed the Australian style of wine. Its worldwide trademark of generous flavors, soft tannins, and accessible fruit made this wine easier to like when young, a perfect style of wine for Americans. In 1990 the Australians shipped only 578,000 cases of wine to the United States. By the decade's end, the Australian Wine Bureau reported that more than 4 million cases of Australian wine would be shipped to the United States by 2001, and by 2026 shipments should total more than 10 million cases with an estimated value of

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$440 million. Chilean wine became popular in the late 1990s and early 2000s as well, with Chilean exports up 15.6 percent, but falling prices earned them only 1.4 percent more money. Exports of Chilean wine to the United States fell 1.8 percent in 2001. South African wines, meanwhile, grew faster than projected, growing by 29 percent and increasing 133 percent in value, based on 1999 sales figures. In late 2001, the United States, Canada, Australia, Chile, and New Zealand signed the Mutual Acceptance Agreement on Oenological Practices. The wine trade agreement was a significant development in promoting international wine commerce and would loosen trade restrictions for U.S. wines. John De Luca, president and CEO of the Wine Institute in San Francisco exclaimed, "This agreement is a breakthrough for the world wine trade that recognizes the effectiveness of other country's regulatory and enforcement systems for assuring that producers comply with its country's standards." Argentina and South Africa had the option to sign the agreement prior to March 2002. According to the Department of Commerce, U.S. wine exports totaled $541 million in 2001. The largest market was the United Kingdom, which grew by 32 percent in volume with values of exports rising 20 percent to $170 million in that market. Other leading markets included Canada, with $95 million; the Netherlands, with $69 million; Japan, with $57 million; Belgium, with $28 million; the Federal Republic of Germany, with $14 million; Ireland, with $14 million; France, with $7.1 million; Sweden, with $6.6 million; and Denmark, with $6.2 million. Champagne and sparkling wine exports totaled 25 million gallons valued at $31 million, down from a high of 37 million gallons in 1999 due to consumers stocking up for millennium celebrations. Dessert wine exports were $31 million, and grape must and other fermented beverage exports stood at $22 million in 2001. In total, the United Stats shipped 1 percent less wine in 2001 than the previous year. Mexico was expected to be an important market in the twenty-first century because, according to the North American Free Trade Agreement (NAFTA), the 16 percent tariff on American wine sales to that country would be lifted around the year 2004.

Further Readings Baker, Deborah J., ed. Ward's Business Directory of U.S. Private and Public Companies. Detroit: Thomson Gale, 2003. "Bottled Perfection." Entrepreneur, February 2005. "Business: Blended; Wine Industry Mergers." The Economist, 25 January 2003. "California Vintners Getting Stomped After a Decade of Growth." The San Diego Union-Tribune, 7 January 2003. Carlsen, Clifford. "Full-bodied Sales Make 1994 Vintage Year for Wineries." San Francisco Business Times, 4 August 1995. ------. "Robust Year of Sales Gives Wine Makers a Healthy Glow." San

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Francisco Business Times, 15 November 1996. Ceausu, Joel. "US: Winegrowing Study Results Revealed." Entrepreneur, February 2005. Cioletti, Jeff. "Three Markets in One." Beverage World, 15 February 2005. "Crisp Pinot Grigio at Last Gets Chance to Sparkle as Chardonnay Alternative." Nation's Restaurant News, 10 February 2003. "Fetzer Vineyards." Beverage Industry, 18 November 2002. George, Jason. "An Italian Tradition Moves from the Cellar to the Classroom." The New York Times, 27 September 2004. "GP Life: Drink." GP, 5 July 2004. Hallett, Vicky. "Vintage Me, 2004." U.S. News & World Report, 27 September 2004. "Hoover's Company Capsules." Hoover's Online, 2005. Available from http://www.hoovers.com. Lazich, Robert S., ed. Market Share Reporter. Detroit: Thomson Gale, 2005. "Plastic Corks Coming of Age; Low Cost Appeals to Vintners." South Florida Sun-Sentinel, 6 February 2003. "Seeing Red: Changing Preferences Make U.S. Wineries Happy to be 'In the Red.'" Beverage Industry, July 2002. "Too Many Bottles, Not Enough Buyers; Wine Industry Souring." Seattle Times, 24 January 2003. "Up Close with Peter Mondavi, Jr." Beverage Industry, July 2002. U.S. Department of Labor. Industry-Specific Occupational Employment Statistics, 17 February 2005. Available from http://www.bls.gov.

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Whitley, Robert. "Big Cult Is Swallowing $1.99 Wine." The San Diego Union-Tribune, 25 February 2003. Wine Institute. "California Vintners and Growers Introduce Code of Sustainable Winegrowing Guidelines," October 2001. Available from http://www.wineinstitute.org. ------. "California Wine Industry Statistical Highlights," December 2004. Available from http://www.wineinstitute.org. ------. "Despite Economic Conditions, September 11 and the Strong Dollar 2001 California Wine Shipments Up One Percent," April 2002. Available from http://www.wineinstitute.org. ------. "New Ground-Breaking Report Documents California Sustainable Winegrowing Practices," 6 October 2004. Available from http://www.wineinstitute.org. ------. "Strong Sales Growth in 2004 for California Wine as Shipments Reached New High," 5 April 2004. Available from http://www.wineinstitute.org. ------. "United States, Canada, Australia, Chile and New Zealand Sign Mutual Acceptance Agreement on Oenological Practices," December 2001. Available from http://www.wineinstitute.org. ------. "U.S. House and Senate Approve Limited Direct Wine Shipments for Winery Visitors," October 2002. Available from http://www.wineinstitute.org. ------. "U.S. Wine Exports Up Three Percent in Volume, Strong Dollar Contributes to One Percent Decrease in Revenues," May 2002. Available from http://www.wineinstitute.org.

Source Citation: "Wines, Brandy, and Brandy Spirits." Encyclopedia of American Industries. Online Edition. Thomson Gale, 2006. Reproduced in Business and Company Resource Center. Farmington Hills, Mich.:Gale Group. 2007. http://galenet.galegroup.com/servlet/BCRC Document Number: I2501400038

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© 2007 by The Gale Group, Inc.

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Overview Questions  Discussion of Globalization  List some stylized facts about the world trade  What is Mercantilism?

Section 1. Globalization & Global Trade Overview Professor Baizhu Chen FBE462 Marshall School of Business

1

2

1. Globalization

Globalization International Interdependence, % import of GDP Export of G&S 1970 1998 United States 6% 12% United Kingdom 23 29 Japan 11 10 Netherlands 42 56 Germany 21 27 Singapore 102 170 China 3 22 Belgium 52 73

 Product Market – Trade Flow World Merchandise export as % of GDP 9 8 7 6 5 4 3 2 1 0 1889

1913

1929

1950

1960

1970

1980

1990

2000

Korea

3

Globalization

14

28

4

Globalization Destination of Merchandise Export, 2003 destination origin

5

North America

Latin America

North America

40.5

15.4

Latin America

57.8

15.6

Western Europe

9.5

C.E Europe/CIS

Western Europe

CIS/ CE Europe

Africa

Middle East

Asia

18.1

0.8

1.2

2.1

22.0

13.6

1.2

1.4

1.2

7.6

1.8

67.7

6.8

2.5

2.6

7.9

4.6

1.7

56.8

24.5

1.1

2.3

7.6

Africa

18.9

2.5

48.4

0.6

10.2

1.5

17.7

Middle East

15.5

0.9

16.0

0.8

3.5

7.3

48.6

Asia

22.5

2.2

16.8

1.7

1.7

3.0

49.9

World

19.8

4.4

41.7

4.9

2.2

2.7

22.6

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Globalization

Globalization

Baldwin & Martin NBER 6904

transaction costs are lower but still exist

7

8

Baldwin & Martin NBER 6904

 Product Market – LOOP

Globalization

9

Globalization

Globalization

 Factor Market – FDI

World FDI Stock as a % of World Output

1914

1938

1960

1980

1985

1990

1995

1997

21.1

27.8

6.8

2.7

6

9.2

12

13.6

Germany 11.1

0.8

1.1

5.3

9.7

9.2

11.1

14.4

Japan

0.8

9.9

1.2

1.9

3.3

6.9

4.7

6.5

UK

52.3

38.5

15

15

21.9

23.8

28.3

29.1

US

7.2

8.5

6.2

8.1

6.2

7.9

10

10.6

France

10

Outward FDI Stock as a % of GDP

11

12

Keith Parker, University of Southern California

2

FBE-462: Powerpoints

Globalization

Page 358

Globalization

Correlation between domestic savings and domestic investment

Foreign securities held by Pension, % of total assets

US

Japan

UK

13

Globalization

Overview of World Trade  Factor Market – Labor

Share of U.S. Population That is Foreign-Born 1900-2000 percentage 20

15

10

5

0 1900

1920

1940

1960

14

1980

2000

Source: Department of Commerce Historical Statistics of the US Colonial Times to 1970, US Statistical Abstract 2000

15

Overview of World Trade

16

Overview of World Trade

Country

Export Share

Country

Import Share

Country

Export Share

Country

Import Share

Germany

10.0

US

16.8

US

16.0

US

12.8

US

9.6

Germany

7.7

UK

8.0

Germany

9.6

Japan

6.3

China

5.3

Germany

6.4

UK

6.6

China

5.8

UK

5.0

France

5.5

Japan

6.2

France

5.2

France

5.0

Spain

4.2

France

4.7

UK

4.1

Japan

4.9

Italy

4.0

Italy

4.2

Netherlands

3.9

Italy

3.7

Japan

3.9

Netherlands

3.6

Italy

3.9

Netherlands

3.4

Netherlands

3.5

China

3.1

Canada

3.6

Canada

3.2

China

2.6

Ireland

2.8

Belgium

3.4

Belgium

3.0

HK, China

2.5

Canada

2.8

$7.5T

Total World

$7.7T

World Total

$1.8T

World Total

$1.8T

Total World

2003, leading merchandise exporters and importers

17

2003, leading service exporters and importers

18

Keith Parker, University of Southern California

3

FBE-462: Powerpoints

Page 359

Overview of World Trade

Overview of World Trade

Share of China and other Asian countries in US merchandise imports, 1990-03 (%)

Merchandise/2004

出口比例占全球

进口占全球比例

D eveloped N ations

65.4%

70%

U S & C anada

12.5

19.0

E urope

45.3

44.8

Japan

6.4

4.8

A ustralia/N ew Z ealand

1.2

1.4

D eveloping N ations

34.6%

30%

C hina

6.5

5.9

B razil

1.1

0.7

India

0.8

1.1

6 E conom ies in E .A sia

9.7

8.5 19

20

Overview of World Trade

Overview of World Trade

Intra-regional trade of major RTAs, share in world exports

21

Foods & Beverage

45

Industry Supplies

148

Capital Goods

300

Auto & Parts

69

Consumer Goods

83

Others

32

Total

676

Meat 7 Soybeans 5 Corn 5 Chemicals 26 plastic 13 others 13

semiconductor 42 Computer accessories 34 Telecom equipment 26 Civilian aircraft 25

Pharmaceutical preparations 15 Apparel, textiles7

US Export (Jan – Nov 2001, billion)

22

Overview of World Trade Foods & Beverage

43

Industry Supplies

258

Capital Goods

276

Auto & Parts

174

Consumer Goods

262

Others

44

Total

1057

fish 9 meat 6 wine 4 Crude oil 70 Chemical 18 Natural gas 16

US Trade Deficits (Quarterly)

Computer accessories 57 Semiconductor 29 Telecom equipment 22 Electronic apparatus 22

Apparel 64 Pharmaceutical preparations 30 Toys 20

US Import (Jan – Nov 2001, billion)

23

24

Keith Parker, University of Southern California

4

FBE-462: Powerpoints

Page 360

2. Mercantilism  Assumption: the wealth of the nation is measured by the nation’s stock of precious metals export goods to other nations => receive precious metals from other nations  import goods from other nations => pay precious metals to other nations 

25

26

- Mercantilism

- Mercantilism

 If a nation’s export exceeds its import => its stock of precious metals increase 

 Policy implication based on Mercantilism: a nation’s wealth can be accumulated through export rather than import  trade is a zero-sum game  trade policy should be used to promote export  trade policy should be used to restrict import 

=> wealth increases

 If a nation’s export exceeds its export => its stock of precious metals decrease 

=> wealth decreases

27

28

Keith Parker, University of Southern California

5

FBE-462: Powerpoints

Page 361

1. Overview Questions  What is consumer’s surplus?  What is producer’s surplus?  Will a small nation gain from trade?  Is trade a zero-sum game?

Section 2. Is Trade A ZeroSum Game? Professor Baizhu Chen FBE462 Marshall School of Business

1

2

2. Demand

- Demand

 Consumer decision: max U(q1,q2)  Budget constraint: F(q1,q2, p1, p2, I) = 0  Demand function: qi=qi(p1, p2, I)

 Consumer surplus: 

p

measures the amount a consumer gains from a purchase by the difference between the price he actually pays and the price he would have been willing to pay

q 3

- Demand

4

- Supply

 In the diagram, the consumer surplus of consuming 10 units of apple is given by a

 Producer’s decision: max pq-c(q)  the cost function c(q) depends on factor prices and techniques of production (# of factors required to produce one unit output)  supply function: qs=qs(p, …)

p 12

p

a b

q

q

10 5

6

1

Keith Parker, University of Southern California

FBE-462: Powerpoints

- Supply

- Supply

 Producer surplus: 

Page 362

 In the diagram, the producer surplus of selling 10 units of apple is a

measures the amount a producer gains from a sale by the difference between the price he actually receives and the price he would have been willing to accept

p

a b

p 10

7

3. From Autarky To Open Economy

- From Autarky To Open Economy

 Autarky 

 Small country: price is taken as given  welfare with trade = ?  gains = ?

total welfare of this nation = ? p

8

D

p*

a b

c

e

d

S q 9

- From Autarky To Open Economy

- From Autarky To Open Economy

 Large country: price is endogenous  Two countries: Home and Foreign p

c d

H e

F export supply

H import demand

p* c* d*

e*

10

 world market price: determined by the world demand and supply  ==> gains from trade  In Home country, anyone worse off?  Income distribution: across nations, within the same nation

F

11

12

2

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 363

General Equilibrium Approach

4. General Equilibrium Approach  General equilibrium analysis   

 General equilibrium analysis

Wheat



Two goods Autarky equilibrium – A Relative price of cloth - p

  

A



 P

World relative price – p* Production – B Consumption – C Country gains from trade Gains are not distributed evenly Trade creates winners and losers

Wheat

C A● ●B

P*

Cloth

13

P

Cloth

14

Gains From Trade  Terms of trade (TOT) Relative price of export to import  When TOT improves, the country is better off 

Wheat B

D

A● C● P*

Cloth 15

3

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 364

Overview Questions  Know the determinants of trade pattern  What is comparative advantage?  What is absolute advantage?

Section 3. Why Nations Trade (I)? Professor Baizhu Chen FBE462 Marshall School of Business

1

2

Determinants of Trade

Determinants of Trade

 Countries trade with each other because they are different 



Pc/Pw

Demands are different

Pc/Pw

Supplies are different

(Sc/S w)h= (Sc /S w)f

(Sc/S w)h

(Pc/P w)h

(Sc/S w)f

(Pc/P w)h (Pc/P w)f

(Pc/P w)f (Dc /D w)f

C/W

C/W 3

4

Ricardo’s Theory of Comparative Advantage

Determinants of Trade  Demands are different because tastes differ 

 Consider a simple situation:

it is hard to explain the difference in tastes

two countries, two goods produced by labor, labor fully mobile domestically not internationally, full employment  no trade barrier, perfect competition 

 What cause the difference in supply?  

(Dc /D w)h = (Dc/Dw)f

(Dc /D w)h



labor cost or labor productivity factor endowments

 Will Mexico be able to export? Labor cost to make 1 bushel of Wheat 1 yard of cloth 5

In Mexico 4 hours 2 hours

In the US 1 hours 1.5 hour 6

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 365

Ricardo’s Theory of Comparative Advantage

Ricardo’s Theory of Comparative Advantage

 If no trade between them, the opportunity cost of producing cloth

 Comparative Advantage: 

in Mexico: 0.5 bushel of wheat per yard  in US: 1.5 bushel of wheat per per yard 

One bushel of wheat

Mexico

 A country will export the good in which it has a comparative advantage

US

One yard of cloth



Save 0.5 bushel of wheat

Get 0.5 more bushel of wheat

If a country has a lower opportunity cost of producing good A, the country has a comparative advantage in producing A

In Ricardo’s Theory: opportunity cost of production is determined by the relative labor cost

7

8

Ricardo’s Theory of Comparative Advantage

Ricardo’s Theory of Comparative Advantage

 If each country has 100 labor hour 

wheat

wheat 100 S*1

Mexico

50

80 76

25

20

US



S*0

S1 30

50

Cloth

16

20

Mercantilism: Trade is a zero sum game

 Direct comparison of the absolute labor cost of production is irrelevant for trade  The country that has an absolute advantage in labor cost has a higher wage

C*

C

S0

20 15

 Countries gain from trade if trade is based on comparative advantage  Trade is a positive sum game

still assume the free-trade relative price of wheat is one per yard of cloth (terms of trade)

66.7

Cloth

9

10

Ricardo’s Theory of Comparative Advantage

Extension from Ricardo

 Ricardian model implies extremely high degree of specialization  Ricardian model implies that trade will benefit everyone

wheat

wheat

C C

S0

S1

S0 S1 11

Cloth

Cloth 12

Keith Parker, University of Southern California

FBE-462: Powerpoints

Extension from Ricardo  Gains from trade with increasing cost of production wheat

wheat

S0

C C S1

S0

Cloth

S1

Cloth

13

Keith Parker, University of Southern California

Page 366

FBE-462: Powerpoints

Page 367

Module Objectives  To explain why countries with similar technologies trade  Income distribution effect of trade

Section 4. Why Nations Trade (II)

1

2

Factor Endowments

Factor Endowments

How to explain this trade pattern?

 Consider a simple situation: Two factors of production: labor and capital factors can freely move domestically but not internationally, full employment  technologies of production are the same for all countries (two countries)  no trade barriers, perfect competition  countries differ in their endowments  

3

Will A Less Resource Nation Be Able to Export?

They Have the Same Technology

 US is said to be land abundant and Japan is labor abundant  Cloth is said to be labor intensive, and Wheat is land intensive  Will Japan be able to find anything to export?

 Japan endowments: Land=10, Labor=8  US endowments: Land=20, Labor=10 Japan

3W + C =10 W + 3C = 8

 

US

3W + C = 20 W + 3C = 10

Land 1

3 Wheat

4

Cloth



3

1 Labor

5

6

Keith Parker, University of Southern California

1

FBE-462: Powerpoints

Which Country Relatively Supply More?

Production Possibility Frontier W Japan

3W + C = 10 W + 3C = 8 

 More general, production possibility frontiers in these countries

8

10/3 W 10 US

3W + C = 20 W + 3C = 10



Page 368



C 8/3

10

W

which country relatively supply cloth more at any given relative price? W Japan

US

20/3



C 10/3

20

C

7

Factor Endowments Determine

C

8

Comparison of Factor Endowments

 Countries export the products that use their abundant factors intensively 

Heckscher-Ohlin Theory

 To know your advantage:  

Which factors are abundant? Does your industry use the abundant factor intensively?

9

10

Who Wins and Who Loses?

- Who Wins and Who Loses?

 For simplicity, assume that production technologies are constant  W is land intensive, C is labor intensive  capital-labor ratio: Land W: 1/3  C: 3

3



 Assume the prices are:  

 Perfect competitive conditions:

1



W



C 1

labor

Wheat: Pw = $14 Cloth: Pc = $10 MC of producing cloth = MR of selling cloth MC of producing wheat = MR of selling wheat

3 11

12

Keith Parker, University of Southern California

2

FBE-462: Powerpoints

Page 369

- Who Wins and Who Loses?

- Who Wins and Who Loses?  Suppose Pc increases by 20%  3r + w = $14  r + 3w = $12

 3r + w = $14  r+ 3w = $10  ==> equilibrium factor prices r = $4  w = $2

r = $3.75  w = $2.75 



r

Pc

r

Pc Pw

Pw

w

w 13

- Who Wins and Who Loses?

14

- Who Wins and Who Loses?

 ==> %Δr = -6.25%  ==> %Δw = 37.5%  %Δr < 0 = %ΔP w < %ΔPc =20% < %Δw  those factors intensively used in sectors with prices increase will be better off  those factors not intensively used in sectors with prices increase will be worse off  Stolper-Samuelson Theorem

 Application: Suppose U.S. has export and import sectors. Assume export sector is high-skill labor intensive and import is lowskill labor intensive. U.S. is high-skill labor abundant  who will support freer trade in U.S.?

15

16

Keith Parker, University of Southern California

3

FBE-462: Powerpoints

Page 370

Module Objectives  To explain the scale economies  To explain trade that is not based on the standard assumptions

Section 5 Economies of Scale and Trade

1

2

Patterns of Trade of US

Inter- versus Intra-Industry Trade  How to explain intra-industry trade? 

A country exports and imports goods of the same industry

 Can difference in labor cost and factor endowments explain intra-industry trade?  Inter-industry trade 

a country exports goods in some industries and imports goods in other industries.

3

Economies of Scale

Economies of Scale

 External economies of scale (EES) 



 Examples of EES?  What kinds of market structures are consistent with EES?  If EES is significant, history, luck, coincidence, or government policy play important role in determining the pattern of trade  Policy implications?

average production cost of a firm is lower if the whole industry at a particular location is larger but does not depend on the size of the firm

Internal economies of scale (IES) 

4

average production cost of a firm is lower if the firm size is larger 5

6

Keith Parker, University of Southern California

1

FBE-462: Powerpoints

Page 371

Scale Economies and Monopolistic Competition

Economies of Scale

 Consider

 What can lead to Internal Economies of Scale?  What kinds of market structures are consistent with IES?



 



7

Scale Economies and Product Differentiation cheap car  labor output  10 5  15 10  20 15  25 20  30 25  35 30

 Assume U.S. and UK were identical, and each has 35 labors  Assume in autarky, each produce 10 cheap cars and 5 expensive cars

expensive car labor output 20 5 25 10 30 15 35 20 40 25 45 30 9

10

Gains From Trade

Gains From Trade, Again

 If U.S. and UK can trade with each other, consider the following two situations: 

8

Countries Are Identical

 Two nations: US and UK, two types of car 

differentiated product - products that are seemingly the same good but that are perceived by consumer to have real or imagined difference consumers value varieties monopolistic competition - a producer has a monopolistic power on his brand; but compete with other brands scale economies - size of the firm increases reduces the cost of production (two types of scale economies)



U.S. uses 35 labors produce cheap car and UK uses 35 labors produce expensive car => how many cheap and expensive cars total?

11

U.S. uses 35 labors produce expensive car and UK uses 35 labors produce cheap car => how many cheap and expensive cars total?

12

Keith Parker, University of Southern California

2

FBE-462: Powerpoints

Scale Economies and Monopolistic Competition

Why Trade Benefits?  With economies of scale and product differentiation, nations with similar characteristics will still trade with each other  

 How to describe the pattern of trade? Japan - capital abundant Canada - land abundant  Two goods: manufacturing (capital intensive) and food (land intensive)  differentiated products in manufacturing with increasing returns to scale  

to explore the scale of the market to satisfy the diversified needs of consumer

13

14

Patterns of Trade

What If Market Sizes Differ?  If nations have different sizes of markets and trade has to incur transportation costs, what kind of pattern of trade will it be?

Canada



Food

Page 372

Manufacturing products

=> country with a larger demand for a good will likely to be the export of this good, if scale economies are present

Japan 15

16

Keith Parker, University of Southern California

3

FBE-462: Powerpoints

Page 373

1. Overview Questions  What is the Rybczynski Theorem?  What is the “Dutch Disease”?  Under what circumstances the immiserizing growth will more likely occur?  What is the product cycle theory?

Section 6. Growth and Trade

1

2

2. Rybczynski Theorem

- Rybczynski Theorem

 Two factors of production: labor and capital  factors can freely move domestically but not internationally  all factors are fully employed  technologies of production are the same for all countries  no natural and man-made trade barriers  perfect competition

 Consider only two goods: wheat and cloth

L W

C K

3

4

- Rybczynski Theorem

- Rybczynski Theorem

 For simplicity, first assume that production technologies are constant  W is labor intensive, C is capital intensive  capital-labor ratio: L W: 1/3  C: 3

3



 Home country endowments:  

 full employment condition:

1

3W + C = 10  W + 3C = 14  A: (W,C)=(2,4) 

W

C 1

K

Labor: 10 capital: 14

3

W 14

10/3

K A 14/3

5

L

C 10 6

Keith Parker, University of Southern California

FBE-462: Powerpoints

- Rybczynski Theorem

- Rybczynski Theorem  If one factor endowment increases, the industry uses the factor intensive will grow, the other industry will decline  “Dutch Disease”

 Suppose L increases by 20% A: (W,C) = (2.75, 3.25)  W↑by 37.5%, C↓ by 18.75% 



W 14

Page 374

K

10/3

A

L

14/3

10

C

The deindustrialization of an economy as a result of the discovery of a natural resource. So named because it occurred in Holland after the discovery of North Sea gas; it has also been applied to the UK since the discovery of North Sea oil. The discovery of such a resource lifts the value of the country's currency, making manufactured goods less competitive; exports therefore decline and imports rise. Ÿ Dictionary of Business, Oxford University Press

7

8

3. Immiserizing Growth

- Immiserizing Growth

 For a small country, growth is always good.

 Balanced growth for a large country 

W

The country tends to be better off W

C

C 9

- Immiserizing Growth

10

- Immiserizing Growth

 Growth biased toward to the import sector for a large country => better off

 Growth biased toward to the export sector for a large country => maybe worse off

W

W

C

C 11

12

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 375

- Immiserizing Growth

- Immiserizing Growth

 Two effects when a large country grows

 Conditions that growth causes TOT worsens such that immiserizing growth occurs:

growth effect => tends to make it better off  TOT effect 

growth strongly biased toward to the export sector world demand for the export good is very inelastic  the country is heavily dependent on the export sector (heavily involved in trade) before growth  the country must be a large economy 

 if

growth biased toward to import sector =>TOT improves  if growth biased toward to export sector => TOT worsens 



If TOT worsens so much that dominates the growth effects => growth is immiserizing 13

14

4. Product Cycle Theory

Product Cycle Theory

 Dynamics of Comparative Advantage 

 New Product Stage

comparative advantage changes overtime because of economic growth



high income countries (US) produce and consume new product  firms

need to familiarize the products and to detect consumer response  high R&D cost, high cost in advertising, sales promotion, marketing, etc.  demand is local  almost no international trade 15

16

Product Cycle Theory

Product Cycle Theory

 Maturing Product Stage 

 Standardized Product Stage

standards begin to emerge and large-scale production is adopted

 

of scale begin to realize high income countries (US) exports to medium income nations (Spain)  later medium income nations (Spain) export to high income countries (US)  foreign direct investment occurs, and MNCs emerge

product is familiar to consumers production processes can be easily learnt

 economies

 labor

 first

 developed

costs play an important role countries busy introducing other new products  production shifts to developing counties  developed countries become the importer

17

18

Keith Parker, University of Southern California

FBE-462: Powerpoints

Product Cycle Theory Production, consumption of a product imports

U.S. Consumption

exports

U.S. Production

t0

t1 New product stage

Maturing product stage

t2

Standardized product stage

19

Keith Parker, University of Southern California

Page 376

FBE-462: Powerpoints

Page 377

1. Overview Questions  What are different types of tariffs?  What happens to terms of trade when a small country imposes a tariff? a large country?  What is the effective rate of protection?  What is the optimal tariff rate?

Section 7. Tariff

1

2. Basics of Tariff

2

Basics of Tariff

 tax on import or export  

ad valorem tariff: P = P* (1+t) specific tariff: P = P* + t

Source: http://www.usitc.gov/tata/hts/bychapter/index.htm

3

Basics of Tariff

4

Basics of Tariff

 Tariff structures can be quite complicated 

wristwatches with case of precious metal or of metal clad with precious metal: with mechanical display only, having no jewels or only one jewel in the movement  MFN: 51c each +6.25% on the case & strap, band

Tariff Rates in China, 1995

or bracelet +5.3% on the battery

 Non-MFN: $2.25 each +45% on the case+80% on

strap, band or bracelet +35% on the battery

5

6

Keith Parker, University of Southern California

FBE-462: Powerpoints

- Basics of Tariff

- Basics of Tariff

 Preferential duties

 Measurement of tariff rates

tariff rates applied to an import according to its geographical source; a country that is given preferential treatment pays a lower tariff  e.g., British Commonwealth, EU, NAFTA





unweighted average tariff rate   

 GSP (generalized system of preferences) 

Page 378



overstate the height of the country’s average tariff if the country imports mostly good A

weighted average tariff rate 

developed countries permit duty-free entry of a selected list of products if those products are imported from particular developing countries

10% on Good A, 15% on good B, 20% on good C unweighted average tariff rate = 15%

 

value of A import $500, B $200, C$100 weighted average tariff rate = 12.5% What is the problem of using weighted average tariff rate as a measure of degree of protection?

7

8

3. Welfare of Import Duty  small nation: its TOT is given  tariff has no effect on its TOT D  gain or loss?

- Welfare of Import Duty  large nation: tariff affects its TOT  gain or loss? D

S

P

a

a b

P*+ t c

P*

S

P

d

e

b

P*+ t c

f

P* d P* e Q

f

g

h

i

Q

9

- Welfare of Import Duty

10

- Welfare of Import Duty

 Effects of tariff

 tariff=consumption tax+production subsidy  e.g. $10 shirt, 50% tariff => P = $15, government collects $5

consumption effect  production effect  trade effect  revenue effect  redistribution effect  terms of trade effect 



11

This is equivalent to a 50% consumption tax + 50% production subsidy

12

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 379

- Welfare of Import Duty

- Welfare of Import Duty

 Optimal tariff

 A country has both tariffs on its car imports and auto engine imports. The country produces cars using imported auto engine. As the pressure of trade liberalization rises, the country pledges to move toward freer trade by eliminating the tariff on engine imports. Evaluate the country’s policy.

the tariff rate that maximizes the welfare of the tariff-imposing nation  what is the optimal tariff of a small nation?  what is the optimal tariff of a large nation?  Why U.S. does not impose the optimal tariff? 

13

14

- Welfare of Import Duty

4. Welfare of Export Duty

 effective rate of tariff 



when there are different levels of production, and at each level, there is a tariff imposed, how to measure the degree of protection?

examples of export tax: cocoa (Ghana) coffee (Brazil and Colombia)  jute (Pakistan)  rice (Burma and Thailand)  timber (Ivory Coast and Liberia)  tea (Sri Lanka)  tin (Malaysia)  

15

16

- Welfare of Export Duty  small country: export duty $25 Pw=60 P=35

a

b

c

S

d

20

D

17

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 380

1. Overview Questions  What are the effects of an export tariff?  What are the differences and similarities of a tariff, quota, and VER?  Name some other non-tariff barriers

Section 8. Non-tariff Barriers

1

2

2. Quota and VER

- Quota and VER

 Tariff, Quota and VER  What if it is a large nation?

 Quota versus Tariff With increasing foreign competition, quota offers more protection to domestic industries than tariff  Quotas provide bureaucrats more power  quotas are more likely to create a domestic monopoly than tariff 

P

12 10

a

b

q3 q1

c

d

q2 q4

Q

3

4

- Quota and VER

3. Other Barriers

 MFA: multifiber arrangement (1974)  iron and steel  sugar (quota + tariff) 

 Local content requirement  technical, administrative and other regulations

1989, US sugar price $0.2281/lb, World price $0.1445, equivalent tariff rate of 58%



health and technical regulations

 Government procurement policies

 Japanese car



“Buy America” act  Fed

government agencies must buy from home U.S. firms unless the price is 6% abover foreigners’  for Department of Defense, this figure is 12%

1981, 1.68 million cars (VER) to U.S.  84-85, increased to 1.85 million cars 

5

6

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 381

- Other Barriers

- Other Barriers

 Reclassification  Restrictions on services trade

 Foreign exchange controls exporters are required to sell their foreign exchange earnings to the central bank, which in term parcels out to importers selectively  Advance deposit requirement  license to import is awarded only if the importing firm deposits with the government specific funds 

restrictions on foreign insurance companies foreign ships not allowed from carrying cargo between purely domestic ports (U.S., etc.)  landing rights for foreign aircraft limited (open space? Canada, EU versus US)  

7

8

9

10

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 382

1. Overview Questions  What is market failure?  What is the implication to trade when market fails  What is the Coase Theorem?  What is the industrial policy?

Section 9 Protect or Not to Protect

1

2

2. For and Against Free Trade

-For and Against Free Trade  Arguments against free trade

 Arguments for free trade

optimal tariff theory Revenue  Income Distribution/welfare policy  Political and strategic objectives  market failure 

efficiency  scale economy  transfer of technology  reducing social cost (e.g. rent-seeking cost) 



 free

trade no longer optimal=> policy need to be used to correct market failure

3

4

5

6

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 383

7

3. What if market fails?

8

- What if market fails?

 Market fails if there is monopoly, or increasing returns to scale, or, …  When market fails, the price no longer reflects the opportunity cost of producing this good  When market fails, producer’s surplus or consumer surplus does not fully capture the benefit of producing or consuming a good

 If the market fails to compensate the producer for the extra benefits generated Spr=MCpr

p

Sso =MCso

Q 9

10

- What if market fails?

- What if market fails?

 What is the first-best policy to correct market failure? - a positive externality

 What is the first-best policy to correct market failure? - a negative externality Sso

Spr

p

Spr

p Sso

12 pw=10

a b e q1 q3

c

h a c 8 b d

pw=10

d Q q4 q2

11

q1 q3

e

f

g Q

q4 q2

12

Keith Parker, University of Southern California

FBE-462: Powerpoints

- What if market fails?

- What if market fails?

 The first-best policy is always the one which can directly correct the market failure  The second-best policy is the one which is most closely targeted to the market failure though cannot directly correct it.  A general rule: 

 An alternative to impose policies, specify the property rights 

Coase Theorem  If

costless negotion is possible, rights are wellspecified, and redistribution does not affect marginal values, then Ÿ the allocation of resources will be identical whatever the allocation of legal rights, and Ÿ the allocation will be efficient, so there is no problem of externality, further more Ÿ if additional policy (tax/subsidy) is imposed in such a situation, efficiency will be lost.

The closer a policy is targeted to the problem, the better it is (requires to identify the problem!) 13

- What if market fails?

14

- What if market fails?  The African elephant population was cut in half within a span of 8 yrs in 1980s due to poaching  Public pressure from affluent countries to save the elephants intensified in late 1980s and early 1990s  What is the source of problem?  What are the policy options?

 Purse-seine fishing of tuna fish results in drowning of dolphin (similarly the sea turtles killed trapping in the nets with shrimp)  What is the source of problems?  What are the policy options?

15

16

4. Industrial Policy

- Industrial Policy

 Government policy to channel resources to particular industries, generally those industries that government views as important to future economic growth  Instruments used to channel resources: 

Page 384

 Consider using industrial policy for the followings: industries with high value-added per worker upstream industries  industries with future growth potential  high-tech industries  

tariff, direct production subsidy, government procurement, free R&D, cheap credit, etc...

 Should or should not use industrial policy? 17

18

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 385

1. Overview Questions  What is dumping?  What is countervailing duty?  Explain the strategic trade policy

Section 10. Pushing Export

1

2

2. Dumping and Anti-dumping

- Dumping and Anti-dumping

 The product is sold in another country at a price less than fair value.

 dumping if the good is selling below “fair market value”  how to calculate the “fair market value”  Conditions for dumping to occur:

less than the price of the like product in the exporting country  or (in the absence of such domestic price) less than the highest comparable price of the like product selling in any third country  or less than the cost of production in the country of origin 

 

imperfect market segmented markets

3

4

- Dumping and Anti-dumping

- Dumping and Anti-dumping

 types of dumping

 Persistent Dumping

predatory dumping  cyclical dumping  persistent dumping







perfect competition in foreign market monopoly domestic P MC

Dfor=MRfor MRdom 5

Ddom Q

6

Keith Parker, University of Southern California

FBE-462: Powerpoints

- Dumping and Anti-dumping

- Dumping and Anti-dumping

 antidumping duty can be imposed if 



Negotiate settlemen t

dumping occurred (selling at less than fair value) Petitio n

 ITA

of Commerce Dept. determines if dumping occurs



Page 386

If not below LTFV

dumping causing material injury to plaintiff  ITC

ITC

ITA

ITA If no injury

determines if material injury occurs Case dismissed

Case dismissed

Impose penalty

7

8

- Dumping and Anti-dumping

- Dumping and Anti-dumping

 Numbers of antidumping investigations in U.S. 1980 37 1981 15  1982 65  1983 46  1984 74  Total 1980-1989: 451  

1985 1986 1987 1988 1989

 Target industries of U.S. antidumping investigations

63 71 15 42 23

- Dumping and Anti-dumping

58 29 27 26 25

Brazil France UK China

10

- Dumping and Anti-dumping

 Target countries of U.S. antidumping investigations, 1980-1989 Japan  Germany  Korea  Italy  Canada

58 16 201 8 15 153 451



9



Chemicals Food  Iron and Steel  Machinery  Textiles and apparel  others  Total 1980-1989: 

 U.S. cases  duties  rejected  withdrawn  total cases

24 22 18 17

1980

1982

1985

total(80-85)

10(27%)

13(20%)

25(40%)

82(27%)

9(24%)

21(32%)

20(32%)

104(35%)

18(49%)

31(48%)

18(29%)

114(38%)

37

65

63

300

 U.S. International Trade Commission Annual Report

11

12

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 387

3. Export Subsidy and Countervailing Duty

- Export Subsidy and Countervailing Duty

 welfare cost of export subsidy  what if it is a large nation?

 European Common Agriculture Policy (CAP) 

P ps

a

b

Pw

c

d

EC members: Germany, France, Italy, Belgium, Netherlands, Luxembourg, UK, Ireland, Denmark, Greece, Spain, Portugal.

13

14

- Export Subsidy and Countervailing Duty

Million T

- Export Subsidy and Countervailing Duty  According to GATT/WTO, export subsidy is to be condemned (except farm subsidy)  Countervailing duty is permitted

Million T

 

if export subsidy is found if the subsidized export cause or threaten to cause material injury to domestic firms

15

16

- Export Subsidy and Countervailing Duty

- Export Subsidy and Countervailing Duty

 Numbers of CVD investigations in U.S. 1980 69  1981 17  1982 116  1983 8  1984 26  Total 1980-1989: 301 

1985 1986 1987 1988 1989

 Target countries of U.S. CVD investigations, 1980-1989

63 71 15 42 23

Japan Germany  Korea  Italy  Canada  

17

17 18 17 24 18

Brazil France UK China

36 28 18 --

18

Keith Parker, University of Southern California

FBE-462: Powerpoints

4. Strategic Trade Policy

- Strategic Trade Policy

 Government may encourage exporters to form cartel to extract rents from foreign countries 

Page 388

 Airbus v.s. Boeing  If Boeing starts produce first

OPEC, MITI

P

 An importing country facing a foreign cartel may tax the import to extract back part of the monopoly rents.

Airbus

-5

Boeing

NP 0

-5

P

100 100

NP

0 0

0 19

20

- Strategic Trade Policy

- Strategic Trade Policy

 Airbus v.s. Boeing  If Europe subsidizes Airbus $25

 Airbus v.s. Boeing  If Europe and US both subsidy their firms

Airbus

Airbus

P 20

P -5

Boeing

NP 0

P

100 125

NP

0

120 120

NP

0

0

20

Boeing

NP 0

20

P

0

0 0

21

22

- Strategic Trade Policy

- Strategic Trade Policy

 Suppose the payoff matrix is the following  What if EC $25 subsidy

 What lessons we learn from these? strategic trade policy is a beggar-thy-neighbor policy  strategic trade policy could be used to increase the welfare of the nation imposing the policy  it is not clear that strategic trade policy will always increase the welfare of the nation  if foreign nation retaliates, all nations may be worse off in this non-cooperative game 

Airbus P 5

Boeing

NP 0

-20

P

125 100

NP 0

0 0 23

24

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 389

1. Trade Blocs  Free-trade-area

Section 11. Trade Blocs and Trade Blocks

countries abolish all import duties on their mutual trade in all goods, but each country has its own tariffs for the rest of the world  Andean Group 

Ÿ Bolivia, Colombia, Ecuador, Peru, Venezuela  European

Free Trade Association (EFTA)

Ÿ Austria, Finland, Iceland, Liechtenstein, Norway, Sweden and Switzerland  NAFTA  transshipment

1

- Trade Blocs

 Common Market

a free-trade-area with a common external tariff toward the rest of the world  Benelux



(1947, later absorbed into EC in 1958)

a customs union with mobility of factors of production  EC

Ÿ Belgium, Netherlands, and Luxembourg

(European Community, 1958, Treaties of Rome) (Southern Cone Common Market)

 MERCOSUR

 ASEAN

(loose association-moving toward customs union)

Ÿ Argentina, Brazil, Paraguay, Uruguay  Central

Ÿ Brunei, Indonesia, Malaysia, Philippines, Singapore, Thailand  no

2

- Trade Blocs

 Customs Union 

and rules of origin

American Common Market

Ÿ Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua

transshipment problem 3

- Trade Blocs

- Trade Blocs

 Economic Union 

 Is a FTA always welfare improving?  tariff $4

a common market with unified fiscal, monetary and socioeconomic policies  European

4

Union

Ÿ Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain and UK

15

SUS

14

5

12

SM

10

SK 6

Keith Parker, University of Southern California

FBE-462: Powerpoints

- Trade Blocs

- Trade Blocs

 If U.S. and Korea form a FTA, US better off?  If U.S. and Mexico form a FTA, U.S. better off? 15 15 a 14 b c d e f 12 g h i 10 A

B

 FTA improves welfare if Trade Creation dominates Trade Diversion  What kind of FTA likely improves welfare? 

SM

j C

SK D

7

8

- Discuss:When Can Sanctions Succeed

 NAFTA  Benefits of being in NAFTA for each of the following nations?

 Give some successful examples of economic sanction  Give some unsuccessful examples of economic sanction  Under what conditions economic sanctions will be more successful?

U.S., Mexico, and Canada

 EC 

more trade originally (large trade partner) low tariffs among members before FTA relative to external tariff  member nations complement with each others  more members and larger size of economies  if transportation => closer geographically 

SUS

- Trade Blocs



Page 390

Difference between EC and NAFTA?

 PAFTA? (Pacific-Asia Free Trade Area) 

APEC 9

10

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 391

History of WTO  1944 Bretton Woods

Section 12. WTO

IMF, World Bank and ITO (GATT) GATT suppose to be temporary  GATT function  

 lists

code of conduct settlement  multilateral negotiation  dispute

1

2

Principles of WTO  

GATT/WTO negotiations

non-discrimination (MFN, Article I) trade liberalization  



reciprocity any new tariff or increase in tariff must be offset by cuts in other tariffs no unilateral quotas on imports, except threaten “market disruption”



no unfair encouragement for exports



transparency





  Kennedy Round:  Tokyo Round:  Uruguay Round:

yr nations $ 62-67 48 40b 73-79 99 155b 86-93 108 1,000b

no export subsidy, except agricultural goods protect through tariff

3

4

US Tariff Rates

Exemptions  Exemptions from GATT/WTO rules antidumping and countervailing duties (VI) safeguard arrangements (XIX)  BOP and Economic Development (XII, XVIII)  free trade areas (XXIV)  general exemptions (XX, XXI) 

Smoot-Hawley (1930)

% of of dutiable



Kennedy Round

Tokyo Round

% of total import

5

6

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 392

US Tariff and Non-tariff Barriers

GATT problems  “gray area”: VER  abuse antidumping and CVD exemptions  traditional issues: agriculture, T&C  new issues: service, & IPR  free-trade-area  weak GATT institution

Tariff (% of dutiable)

Equivalent tariff rate of non-tariff barriers

7

8

- GATT negotiations

The Uruguay Round  Accomplishment of Uruguay Round

 GATT Rounds resulted tariff reduction  % of nations’ trade subject to nontariff barriers 1966 1986  US 36% 45%  EU 21% 54%  Japan 31% 43%  All DC 25% 48%

  





 Laird & Yeats, Weltwirtschaftliches Archiv, 1990, 126, 2:299-326

 9

40% reduction in tariffs agreement of all nations to recognize IPR agreement among developed nations on starting to convert nontariff to tariff barriers on Textile & Clothing (over 10 years) and then cut tariff rate Subsidies in agriculture be cut over six years by 20%, non-tariff barriers be converted to tariffs and cut by 36% more formalized institution (WTO) to monitor tariff reductions and resolve disputes No agreements on financial services and telecommunications yet, but talks continue

10

Achievement of WTO  Dispute settlement mechanism is working 

 

104 disputes submitted in less than 2 years (compare with 196 cases to GATT in 50 years) Case of Kodak v.s. Fuji Case of Costa Rica lingerie case v.s. US

 Telecommunications Agreements (Feb. 1997)  

68 nations (account for 90% of the revenue) pledged US, EU, and Japan fully liberalized by Jan 1, 1998

 Financial Service Agreement (Dec. 1997)   11

102 nations (over 95% market) pledged US, EU fully open to foreign banks, insurance and securities with minor exceptions

12

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 393

Unresolved Issues

Some U.S. Trade Policies

 Substantial trade barriers remain in some sectors 

 US Trade Laws

Financial, entertainment, and publishing

 Environmental concerns  Worker’s rights  Foreign Direct Investment 

Local content requirement, local ownership rules, outright prohibition

 Abusive use of antidumping 13

Case: China’s Entry of WTO

14

Case: China’s Entry of WTO

 Agriculture average tariff reduced to 17%, duty on US major agri-export to 14.5%  grace period to 2004  accept USDA certification  tariff once lowered, cannot be increased  tariff-rate quota (TRQ) 



low tariff rate if within quota (1-3%), but high tariff exceeding the quota Ÿ soybean oil: TRQ currently 1.7 million cubic ton, increases to 3.3 million cubic ton in 2005, TRQ to be abolished in 2006

15

Case: China’s Entry of WTO

16

Case: China’s Entry of WTO

Export from US to China

17

18

Keith Parker, University of Southern California

FBE-462: Powerpoints

Case: China’s Entry of WTO

Case: China’s Entry of WTO

 Industrial Products 



 



 

average duty lower from 24.6% to 9.44% after WTO, key products to 7.1% high tech products duty lower from 13.3% to 0, no requirement of technological transfer lowered duty cannot be adjusted 2/3 of products grace period to 2003, majority of others to 2005 no quotas on major US products (fertilizer, fiber optical cable, etc.), grace period 5 years if there is a quota, increase 15% per year car quota 6 million, abolish by 2005

 Services permitting grandfathering the provincial agreement  abolish restrictions on domestic distribution within 3-5 years  restrictions on leasing, warehouse, advertising, packaging, air shipping, inspections abolished within 3-4 years 

19

20

Case: China’s Entry of WTO

Case: China’s Entry of WTO

 Telecommunication 

Page 394

 Insurance

abolish geographical restriction

abolish geographical restriction with 5 years foreign insurance firms can do group insurance, health insurance and pension  life insurance firms can choose their own domestic venture partner, can take 50% share after WTO and increase to 51% after one year  non-life firm can take 51% share after WTO, can be WOFE after 2 years. 

 paging

- within 4 years  mobile - within 5 years



foreign investment after 4 years can be 49% (51% in paging)  adopt CDMA protocol 

21

22

Case: China’s Entry of WTO  Banking and Security retail banking will be opened for WOFE banks by 2005  banking on RMB business allowed by 2005  only joint venture is allowed in security, foreign firms can take up to 33% (???) 

23

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 395

What are the differences? Income (1999)

Section 13. Environmental and Labor Standards

Numbers

Population (b)

Income Range per person ($)

Average Income per person ($)

Low

58

2.4

100-754

410

Lower middle

49

2.1

755-2995

1200

Upper middle

27

0.6

2996-9265

4900

High

27

0.9

9266+

25730

1

What are the differences? Income (1999)

Infant Deaths per 100,000 birth

% children of 10-14y works

CO2 Emissions Metric Tons per person

Setting Standards

Annual deforest. square kilom per 100,000 person

Low

68

19

100-754

1.8

Lower middle

35

7

755-2995

1.2

Upper middle

26

6

2996-9265

7.2

6

<1

9266+

-1.3

High

2

 Harmonization of standards  Mutual recognition of standards  Separate standards

3

Labor Standards

4

Child Labor

 International Labor Organization (ILO)

% of its children

Prohibition of forced labor  Freedom of association  The right to organize and bargain collectively  An end to the exploitation of child labor  Nondiscrimination in employment 

20%

40%

18%

5

US Child Labor 300,000 – 800,000

6

Keith Parker, University of Southern California

FBE-462: Powerpoints

Trade and Environmental Issues

Page 396

How to attack externalities?

 Non Transboundary Environmental Issues

 impose tax to force producer to pay extra social cost P MC of waste  Problems? dumping to Austria  second-best D

Difference in environmental standards  Pollution havens 

 Transboundary Environmental Issues

400

B Germany’s MB of dumping waste

C

- How to attack externalities?

8

Cases

 Coase Theorem 

A 80

7

 CFC’s and Ozone

if costless negotiation is possible, property rights are well-specified, and redistribution does not affect marginal values, then

what is the policy used? is the policy working?  why the policy is (or not) successful?  

 the

allocation of resources will be identical, whatever the allocation of legal rights  the allocation will be efficient, so there is no problem of externality  if a tax is imposed in such a situation, efficiency will be lost 9

10

- Cases

- Cases

 Dolphins and Tuna

 Elephants and Ivory

what is the policy for U.S?  Is the policy working?  why the policy is (or not) successful?

what is the policy? Is the policy working?  why the policy is (or not) successful?



 

11

12

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 397

- Cases  Brazilian Rain Forests what is the policy? Is the policy working?  why the policy is (or not) successful?  

13

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 398

International Capital Flow  foreign portfolio investment

Section 14. Trade in Factors

 

Stocks and bonds No direct management and control

 foreign direct investment

Professor Baizhu Chen FBE462

 

Marshall School of Business

Often involves control and management In the U.S., owns more than 10% shares to be counted as FDI for accounting purpose.

1

2

FDI  Firm factors Inbound FDI



What unique advantage the firm has over local firms?

 Local factors 

What factors in local are attractive? Is it cheaper labor or land? Or is it the market? Or else?

 Policy factors 

Is the local policy encouraging FDI? Legal structures are favorable?

 Competitive factors 

Scale economy? Competitors there already? Can we keep our competitiveness?

3

FDI

4

FDI

5

6

Keith Parker, University of Southern California

FBE-462: Powerpoints

Page 399

FDI – China Case

FDI – China Case

7

8

FDI – China Case

FDI – China Case

2003

Nation

01

HK

Accumulated $B 24.63

02

Cayman Is

3.691

03

Virgin Is

0.533

04

U.S.

0.502

05

Macau

0.446

06

Australia

0.416

07 08

Korea Singapore

0.235 0.165

09

Thailand

0.151

10

Zambia

0.144

55% % of asset overseas 56%

46% 74%

4%

57% 15% 26% 16% 2%

10% 1%

Source: UNCTAD

9

FDI – China Case

10

FDI – Why Go Global?

Company

Target

US$ million

2001

Haier

Menghetti Spa

7

2002

CNOOC

Repsol-YPE

592

2002

SinoPec

Oil fields Algeria

394

2002

CNOOC

5% interests Northwest Shelf Venture

320

2002

CNOOC

BP’s refinery assets

275

2002

Petrol China

Devon’s oil field

262

2002

TCL

Schneider Electronics AG

9.8

2003

BOE

Hynix TFT-LCD unit

650

2004

Minmetals

Noranda

7000*

2005

Lenovo

IBM PC

1750

2005

SAIC

Ssangyong Motors

520

2005

Haier

Maytag

1275*

2005

CNOOC

Unocal

18500*

2006

CIMC

Burg

130

 Domestic competition 

Diversification v.s. globalization

 Technology & know-how  Global brand  Protectionism  Exchange Rate  Government policies 11

12

Keith Parker, University of Southern California

FBE-462: Powerpoints

Immigration

Page 400

Immigration MPLS

DS

DR A

WR E

WR

c

B

WE d

C

WS

0S

13

MPLR

F

LE

L1

a WE b WS

0R

14

Immigration MPLS

MPLR

F

WR

DS

G A

W’R E

c

WE d WS DR 0S

WR

L

W’R

B

M

C

N

a WE b WS

H LE

If L1 L2 in S country is unemployed

L1

L2

0R

15

Keith Parker, University of Southern California

MOR-492: Syllabus

Page 401

University of Southern California Marshall School of Business

MOR 492: GLOBAL STRATEGY Spring 2006 Professor: Office: Phone: Email: Office Hours:

Carl W. Voigt, Ph.D. Bridge Hall 303-E Direct: (213) 740-0764 Department of Management and Organization Office: (213) 740-0728 [email protected] [Note: I do not check email sent to [email protected]!!!] MW 11:00-12:00 noon, 1:30-2:00 pm, immediately after class, and by appointment

COURSE DESCRIPTION Business enterprise in today’s environment increasingly involves crossing national borders and, more generally, engaging in business activities in numerous countries that are often very different from each other. Changes in technology, transportation, communications, and political alliances have significantly internationalized business. Increasingly, firms are required to compete in multiple foreign markets at both the product and supply-chain levels. Understanding the management, marketing, financial, and operational challenges associated with global business activity, and developing skills in these areas, have become essential requirements for success. The Global Strategy course is designed to provide students with the skills, knowledge, and sensitivity required to create, maintain, and renew sustainable competitive advantage within a global environment. Global Strategy will explore international business issues from an integrated firm-level perspective. The course will adopt a strategic perspective and will highlight the following topics from this perspective: the analysis of industry and environmental forces, the competitive context in which companies operate in global industries, creating and sustaining global competitive advantage, the characteristics of global, multi-domestic and transnational strategies, international entry strategies, global strategic alliances, the role of global organizational structures, and the importance of global strategic control. Case studies used in this course will help you develop your analytical and decision-making skills and also highlight the reality of environmental uncertainties influencing decision making in the global context. Cases also seek to develop your capacity to identify issues, to reason carefully through various options and improve your ability to manage the organizational process by which decisions get formed and executed. In addition to case analyses we will also read and discuss additional articles on strategic issues relevant to operating in a global context. Thus, students will develop both, historical and current, and theoretical and practical, perspectives on operating in a global context. This course has two broad objectives and will be taught simultaneously at two levels. First, this course is designed to teach students “about” international business issues. That is, the course intends to help students understand how business practices vary widely across regions and countries. Secondly, this course is designed to teach students “how to” formulate and evaluate winning global strategies. In a very real sense, this course is designed for students who seek to work in, or with, firms that operate in many different countries, or which operate outside the US. By the end of the course, students should be able to: perform country, region, industry and firm analyses in an international setting, evaluate the effectiveness and sustainability of international and global corporate strategies, analyze the benefits and shortcomings of various multinational organizational structures, compare the relative merits of different modes of global market entry, and understand the underlying conditions of the international economy that influence global competitive behavior activity such as economic, legal, political and cultural differences, exchange rates, comparative national advantage, national economic policy, the role of international agreements and customs unions, and balance of trade and payments.

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COURSE EVALUATION Course grades will be determined by students’ relative performance on the following course components: Course Contribution (participation and unannounced quizzes) Individual Case Analysis (one) Group Case Analysis (one) Doing Business with Mexico Group Project and Presentation First Mid-term Exam Second Mid-term Exam

20% 10 10 25 15 20 100%

In order to successfully pass this course, a passing grade (> 50%) must be achieved in each individual course component. Missed mid-terms and/or assignments severely reduce a students grade. Plus and minus shades will be assigned to those immediately above or below grade cutoff points. The distribution of grades will closely follow the guidelines of the Marshall School of Business (an average class GPA of 3.3). ATTENDANCE POLICY Class attendance is absolutely essential. All missed classes will be noted. The policy on missed classes is to allow each student three (3) absences, no questions asked, no penalty. All further absences over the limit will reduce the student's participation grade, no questions asked, no excuses of any kind expected or accepted. Students with an excessive number of absences are at risk of failing the course. Only Official University engagements, such as scheduled debating events, sports events, are excepted from this policy. Job interviews, etc., are not excused, so choose your absences carefully. Habitual lateness (and leaving class early), for whatever reason, will be noted as evidence of low course commitment, and penalized. Simply put, you cannot learn for our class discussions, and your classmates cannot learn from you, if you are not present. COURSE CONTRIBUTION Since this course is principally a case and seminar class, your overall commitment and attitude toward this course, and your daily active verbal participation (speaking and listening) in classroom discussions, will be closely monitored. In grading class participation, we will look at both the quantity and quality of your class contributions/interventions. Class participation is obviously a function of preparation, skills, attitude, and a willingness to actively commit yourself in front of your instructor and colleagues. A classroom is a cost-free environment for experimenting and learning to "play the game." Make use of it. Shyness is no excuse. With regard to quality, the dimensions that we look for include: Relevance -- does the comment bear on the subject at hand? Comments that do not link up with what the discussion is focusing on can actually detract from the learning experience. Causal Linkage -- are the logical antecedents or consequences of a particular argument traced out? Comments that push the implications of a fact or idea as far as possible are generally superior. Responsiveness -- does the comment react in an important way to what someone else has said? Analysis -- is the reasoning employed consistent and logical? Evidence -- have data from the case, from personal experience, from general knowledge been employed to support the assertions made? Importance -- does the contribution further our understanding of the issues at hand? Is a connection made with other cases we have analyzed? Clarity -- is the comment succinct and understandable? Does it stick to the subject or does it wander? All students will be formally called on, at random, to take the lead in various aspects of class discussions at least once or twice during the semester. If the student called upon is not present, is late, or is not sufficiently prepared to make a substantial contribution to the class discussion, he/she will lose points for class contribution. If the student makes helpful comments, he/she will accumulate points for class contribution. Since it is unlikely that there will be

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enough opportunities to call on each student more than once or twice, be warned that failure to be thoroughly prepared, on all occasions, can be devastating to your overall grade. Each student will receive a score for participation at the end of each lecture/discussion and case discussion session. No Credit Students, though present, who make no contributions, will receive no credit. A Little Credit The simple recitation of facts from the case will receive some credit toward the student’s class contribution score. More Credit Comments that do more than simply recite case facts will receive significantly greater credit towards a student’s class contribution score. For example, comments that provide synthesis or raise counterintuitive points, will add much more to a student’s class contribution score. Gold-Star Credit Students who substantially advance the learning of the whole class by providing non-intuitive analyses, profound insights, or “over the top” quantitative analyses, will receive maximum credit. Negative Credit Comments that contain factual misstatements, demonstrate lack of adequate preparation, or are distracting because they come too late in the discussion, will be penalized. Attempts to dominate class discussion rarely result in consistent and significant contributions. Participation Cards: At the end of each case discussion, students who actively participated in the discussion will be asked to turn in a “Participation Card”. These cards should list your name, the date, the case discussed that day, and a synopsis of your contributions during that day’s discussion. The Participation Cards will be used in combination with the instructor’s own daily evaluations to determine your participation grade for the day. For this purpose, please purchase a package of 3x5 index cards and bring them to each class. Group Article Presentations and Critiques: On days when additional articles have been assigned one group will be given the task of reviewing and critiquing each article. Groups should creatively think of ways to help the other students in class learn the assigned materials. These presentations will be evaluated and will factor into determining a students overall course contribution grade. Unannounced Quizzes: Short unannounced quizzes may be given at any time during the course to test the level of student preparation for lecture and case discussions. Multiple choice and short answer questions may be given at the beginning of classes where a case is assigned for class discussion. No make-up opportunities will be given to students who are absent or late. Student performance on these pop-quizzes will be used to determine a student’s participation grade. INDIVIDUAL CASE ANALYSIS Students must select a case and prepare a comprehensive external, competitive, and internal analysis, and provide appropriate strategic recommendations and implementation plans. The individual case analysis should include a “consulting format” report with a carefully prepared one page executive brief (attached to the front) containing the essence of the critical issues, analysis and strategic recommendations which have detailed in your report. A “consulting format” report should contain powerpoint slides which are essentially visual in appearance. Examples of reports will be presented in class. Please note carefully those cases which can be prepared as an individual analysis. They are designated by an “ica.” More detail will be given in class. The individual case analysis is 10 percent of the course grade. Students must be present in class to submit individual assignments, and they must be submitted at the beginning of class. Unfortunately, late individual assignments will not be accepted. Students may submit a second individual case assignment if they are not satisfied with the first grade received. The better of the two individual assignments will be used in determining your final course grade. GROUP CASE ANALYSIS I will assist all students in forming groups. I will attempt to ensure a proportional distribution of women and men in each group. In forming groups I will also ensure that no group has more than two non-native English speakers. Additionally, international students will be distributed across groups so as to ensure within-group diversity.

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The group case analysis should include a carefully prepared report with a two-page executive brief. Your report should be in “consulting format”. Please note carefully those cases that can be prepared as a group case analysis. They are designated by a “gca” on the course schedule. More detail will be given in class. The group case analysis is 10 percent of the course grade. Note: Each group must submit a GCA, in Modules I or II, before the first Mid-term Exam which is scheduled for Wednesday, February 14th. Late group case analyses will not be accepted. Groups may submit a second group case assignment if they are not satisfied with the grade received on the first. The better of the two grades will be used in determining the final course grade for all group members. INTERNATIONAL FIELD TRIP TO MEXICO This course includes a MANDATORY field trip to Tijuana and Ensenada, Mexico. The dates and length of the international field trip are still to be determined but are likely to be March 1-3. We are planning a two-day trip (Friday and Saturday) where we will study local Mexican businesses, Maquiladoras (multinational companies with facilities in Mexico which benefit from free trade agreements), meet with local Mexican government officials, and study local culture and business practices. The cost of the trip will be subsidized by USC’s CIBER (Center for International Business Education and Research) and the USC Marshall Undergrad Program, but will require students to contribute to the cost of the trip. The trip will require students to make arrangements to miss classes, and/or work obligations on those days. You should ask your professors and employers for permission to be absent now. Participation on the field trip to Mexico is mandatory. You must have a valid passport for this trip. If you DO NOT have a passport, you must apply for one IMMEDIATELY. DOING BUSINESS WITH MEXICO GROUP REPORT AND PRESENTATION Assignment: If you were advising a global company not already present in Mexico (or another country such as China), would you advise them to enter the “x” business sector? Why or Why not? If yes, How? If not, what would change your decision? Your analysis should consider how you would enter and market products to the lowest tiers for the consumer sector. [Where “x” represents an industrial, retail, financial, or service sector of your choice. For example, automotive sector, textile sector, tourism sector, electronics, retail, etc.] Creativity in framing your project is encouraged. While the primary assignment is to take a U.S. business (not currently doing business in Mexico) to Mexico and enter all segments of the Mexican market, you may structure your assignment differently. You could consider bringing a Mexican company to the US. Or you could consider taking a U.S. company to another global market instead of Mexico. Or you could consider bringing a non-US business to Mexico. Any variation on the topic should be outlined in a short memo and be presented in advance of all deadline to me for feedback and acceptance. Assess the opportunity for an existing global corporation, typically a U.S. firm in the same sector but not already present in Mexico. Prepare your report as if you were going to present your findings to the top management executive team of the global company. Your report should examine the challenges of entering all segments of the Mexican market place. You must consider how to enter the fourth and “fifth” tiers of the consumer market place. If you choose to enter, why and how do you enter this sector, i.e., a recommended entry strategy for the global firm including an analysis of which segment of the sector you would enter, the mode of entry you would choose. If not, why not? Is this decision contingent on some factors, and what are these factors? Regardless of whether you chose to enter or not to enter, what would make you change your decision? What indicators do you look for to change your decision?

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To support your recommendation, the following key dimensions should be addressed (Whenever possible, you should collect data and use statistical analysis to support your arguments. These data should be presented clearly in tables and figures both in the report and the presentation): 1) Market Potential: For example: Importance of sector to economy in terms of absolute size and percentage of the sector in the economy, employment and any other dimensions, growth rate of sector, profitability in then sector, foreign investment in sector, sources of foreign investment. 2) Competition in the Sector: For example: who are the players, their market shares, what types of strategies are they following, domestic players and multi-national players, countries of origin of key multi-national players, who are the major investors in the sector—domestic and multi-nationals, what are the primary ways in which they compete, sources of competitive advantage of key players, value chain configurations of key players. 3)

Strategic Importance to Mexico of the Sector: For example: does Mexico have factor endowment advantages in this sector, is Mexico a lead market for trends and developments in the sector, are there related and supporting industries that support the development of this industry in the country, how important is Mexico in the global competitive battles among major international players in this sector, how important is this market as a platform for expansion into surrounding countries.

4) Profitability and Growth rates: For example: current profitability of the sector as a whole, differences in the profitability of different strategies of competitors, attractive competitive positions of incumbents, potentially attractive strategic positions for new entrants. 5) Key Institutional Forces / Institutional Voids (Economic, Political, Legal, Technological, and Social Context) affecting Sector including any barriers to entry: For example: Economic policies, Political forces, Regulatory framework, Technological forces, Social changes; focus should be on laying out the current context and what is changing; focus should be on only the major issues not a laundry list; in particular, you should address key impediments or barriers to entry faced by foreign firms seeking to enter Mexico especially with respect to this particular sector. 6) Marketing Analysis: For example: what are the primary target markets, what are the needs and preferences of the target markets regarding the sector, what are customer attitudes and perceptions of the sector, what are the key trends in customer demand and behavior impacting the sector, how satisfied are customers with the sector, what products and services are typically offered, and how are the products and services priced, promoted and positioned relative to the competition. How is the consumer market segmented? What are lowest tiers of the consumer market like? 7) Comparison of Key Characteristics of Sector with Same Sector in the U.S. Economy: For example: a comparison of the key characteristics and features of the sector with the same sector in the U.S.; in particular, you may compare the structure of the industry, key operating characteristics, cost and quality competitiveness of the sector or key players in the sector; value chain configurations and so on. 8) Sector Evolution: For example: How is the sector likely to evolve in the future and why so; what key indicators of evolution should an analysis focus on to understand the changes in the industry; how is the structure of the sector likely to change? 9) Entry Strategy: For example: If you choose to enter the market, how does your entry strategy address the entry barriers described in section 5 and the evolution of the sector described in section 8? If you chose not to enter the market, come up with a strategy that would reduce the risk of entry if a U.S. company decided to enter the market in spite of your recommendations. Page Limit You should limit your report to 2 pages of executive summary, and up to 10-15 pages of appropriate “consulting format” presentation slides. Fewer pages would be better if you can more effectively present the data in

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diagrams and tables (and Powerpoint slides). Make use of tables and charts to present as much information as parsimoniously as possible. You will not have enough time to be able to provide a full comprehensive treatment of the assignment, so focus on the most important issues in each area outlined above. Please note: Cases are not good models for your group project because they are intendedly descriptive, and, on purpose lack substantive analysis. Your project should be long on analysis and short on description. The report and presentation is 25 percent of the course grade. Late projects will be penalized 10 percent per day late, including weekends. The 25 percent report grade will be divided into 15 percent for the written report, which I will assign, and 10 percent for the class presentation. The class presentation grade will be determined by the class as a whole. Member of the class will be required to rank all the group presentations. Your average presentation ranking will determine your presentation grade. The top ranked group will receive an A, the bottom ranked group will received a B-. In preparing your Doing Business in Mexico presentation you should carefully consider your audience; your classmates. Be sure to prepare your verbal/oral presentation in a way that teaches them something new and interesting. It is difficult to educate without entertaining, although it is easier to entertain without educating. Be careful to get the education part right. Your written reports should necessarily be more comprehensive, including all appropriate detailed analyses. However, an oral presentation, to your classmates who have also prepared similar reports, will necessarily be different than your written report. MID-TERM EXAMS Two mid-term exams have been scheduled for this course. These mid-terms will cover all the assigned readings, course lectures, and case studies in the modules preceding the mid-terms. The mid-term exams will consist of multiple choice questions, short answer and short essay questions on all assigned readings and cases. Students who miss mid-terms without prior arrangement will receive a grade of zero. See Course Schedule for the dates of the mid-term exams.

COURSE MATERIAL A series of cases and readings have been assigned for this course. They are available through University Partners in the University Book Store. When necessary, your instructors may place additional materials in the bookstore for you to purchase.

COURSE COMMUNICATION: BLACKBOARD An “Electronic Folder” has been created for this course in BLACKBOARD. You should begin the habit of checking the BLACKBOARD folder on a very regular basis. The course syllabus, case discussion and assignment information have been posted to the MOR 492 folder. Additional course lecture notes/materials, further details on assigned cases and the group projects, and general course announcements, will be posted to the folder throughout the semester.

STUDENT REPRESENTATIVE You will be asked to elect a Section Representative during our first session. The selected student representative will act as a liaison between the section and the instructor to provide informal feedback and communication, particularly on issues that individual students may not wish to raise personally with the instructor.

OFFICE HOURS AND APPOINTMENTS

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I have set aside the hour before lunch on Monday and Wednesday for “open” office hours, and 30 minutes before the afternoon class, for those who would like/need to discuss specific issues related to the course. I will also make appointments for those who cannot meet me during the “open” office hours.

ACADEMIC INTEGRITY The following information on academic integrity, dishonesty, and the grading standard are placed here at the recommendation of the School of Business Administration Faculty and are taken from the Faculty Handbook. “The University, as an instrument of learning, is predicated on the existence of an environment of integrity. As members of the academic community, faculty, students, and administrative officials share the responsibility for maintaining this environment. Faculty have the primary responsibility for establishing and maintaining an atmosphere and attitude of academic integrity such that the enterprise may flourish in an open and honest way. Students share this responsibility for maintaining standards of academic performance and classroom behavior conducive to the learning process. Administrative officials are responsible for the establishment and maintenance of procedures to support and enforce those academic standards. Thus, the entire University community bears the responsibility for maintaining an environment of integrity and for taking appropriate action to sanction individuals involved in any violation. When there is a clear indication that such individuals are unwilling or unable to support these standards, they should not be allowed to remain in the University.” (Faculty Handbook, 1994: 20) Academic dishonesty includes: (Faculty Handbook, 1994: 21-22) 1. 2. 3. 4.

Examination behavior - any use of external assistance during an examination shall be considered academically dishonest unless expressly permitted by the teacher. Fabrication - any intentional falsification or invention of data or citation in an academic exercise will be considered a violation of academic integrity. Plagiarism - the appropriation and subsequent passing off of another’s ideas or words as one’s own. If the words or ideas of another are used, acknowledgment of the original source must be made through recognized referencing practices. Other Types of Academic Dishonesty - submitting a paper written by or obtained from another, using a paper or essay in more than one class without the teacher’s express permission, obtaining a copy of an examination in advance without the knowledge and consent of the teacher, changing academic records outside of normal procedures and/or petitions, using another person to complete homework assignments or take-home exams without the knowledge or consent of the teacher.

The use of unauthorized material, communication with fellow students for course assignments, or during a mid-term examination, attempting to benefit from work of another student, past or present, and similar behavior that defeats the intent of an assignment or mid-term examination is unacceptable to the University. It is often difficult to distinguish between a culpable act and inadvertent behavior resulting from the nervous tensions accompanying examinations. Where a clear violation has occurred, however, the instructor may disqualify the student’s work as unacceptable and assign a failing mark on the paper.

STUDENTS WITH DISABILITIES Any student requesting academic accommodations based on a disability is required to register with Disability Services and Programs (DSP) each semester. A letter of verification for approved accommodations can be obtained from DSP. Please be sure the letter is delivered to me as early in the semester as possible. Your letter must be specific as to the nature of any accommodations granted. DSP is located in STU 301 and is open 8:30 am to 5:00 pm, Monday through Friday. The telephone number for DSP is (213) 740-0776.

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RETURNED COURSEWORK Returned paperwork, unclaimed by a student, will be discarded after 4 weeks and hence, will not be available should a grade appeal be pursued following receipt of his/her grade.

ABOUT YOUR PROFESSOR Carl Voigt is an Associate Professor of Strategy (Clinical) in the Management and Organization Department. He also received his Ph.D. from the Anderson School at UCLA in strategy and organization. He is a native New Zealander, although he completed his undergraduate work at Avondale College in New South Wales, Australia. Dr Voigt specializes in teaching competitive and global strategy, and management courses in both the undergraduate and MBA programs here at USC. His academic interests are in business, corporate and global strategy, and in particular in entrepreneurship. Dr. Voigt has consulted with firms and organizations in the entertainment, food processing, tourism, health care, engineering, telecommunications, defense, and not-for-profit sectors. He has also conducted numerous seminars for teams of managers in the areas of management and strategy. He is an academic consultant with the F.T.C. Line of Business program. Initially, Dr. Voigt began his career as a high school teacher. His first job was teaching high school business subjects on Guadalcanal in the Solomon Islands. During that time he also served as Chair of the Business Studies Curriculum Development Committee and a member of the National Secondary School Curriculum Committee for the Solomon Island government. Dr. Voigt has been awarded two Marshall’s Golden Apple teaching awards: one from the Marshall MBA students in 2001, and one from the Marshall undergrads in 2005. Dr. Voigt has previously been an Associate Dean of our Marshall Undergrad Program, MBA.PM and EMBA Programs, and Marshall MBA Program. He has also successfully coached several teams of Marshall undergraduates to world prominence in different case competitions. In April 2001 he helped coach four Marshall undergraduates to first place in McGill’s international case competition. In February 2000 he coached Marshall’s team to first place in the Marshall International Case Competition. And he also coached Marshall undergraduate teams to a second place finish in 1998, and a final four finish in 1999. In a “past” life, he was heavily involved in coaching basketball; having coached at the high school, college and international levels. While in the Solomon Islands he coached their national basketball team for 2 ½ years. Today, he is first and foremost a father. He spends most of his free time, now, organizing and coaching and refereeing in recreational programs for his children (He has three sons: 22, 17 and 13 years old, and a 12 year old daughter). Dr. Voigt’s wife, Diane, teaches grades 7-10.

TENTATIVE COURSE SCHEDULE** ** Please note that this is a tentative course schedule. Changes may be necessary relative to coordinating our International Field Trip to Mexico. Additionally, some cases may be changed by the instructor.

For those without a current valid passport, you must apply for a Passport. You will need this for our field trip to Mexico in March. You must expedite your passport Session Date

Case / Topic

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1

1/8

Course Introduction Lecture/Discussion: What is Globalization and the Global Marketplace, really? Read: Gupta and Govindarajan. “Managing Global Expansion: A Conceptual Framework”

I.

COMPETING IN THE GLOBAL MARKETPLACE

2

1/10

Review/Introduction: First Principles and Core Concepts of Strategy Read: Siegel, Introduction to Global Strategy

1/15

MLK HOLIDAY

3

1/18

Case:

Jollibee Food Corporation: International Expansion

Immigration Documents

4

1/22

Case:

Global Wine Wars: New World Challenges Old (A)

gca/ica

5

1/24

Case: Read:

BRL Hardy: Globalizing an Australian Wine Company Ghemawat, “Regional Strategies for Global Leadership”

gca/ica

II.

GLOBALIZATION IN CONTEXT

6

1/29

Lecture/Discussion: Global Environmental Analysis: Frameworks for Analyzing Global Regions, Countries, Industries and Markets Read: Ghemawat, “Distance Still Matters: The Hard Reality of Global Expansion Note on Political Risk Analysis

7

1/31

Case: Read:

8

2/5

Lecture/Discussion: Country Analysis: Analyzing Opportunities and Challenges Case: Mexico: Unfinished Business Read: “Country Analysis”

Photo and Bio

Toys “R” Us Japan Prahalad and Lieberthal, “The End of Corporate Imperialism”

ica

Selection of economic sector and focal company for doing business in Mexico project due 9

2/7

Case: Read:

The Competitive Advantage of China Porter, “The Competitive Advantage of Nations”

10

2/12

Case:

AmorePacific: From Local to Global Beauty

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2/14

FIRST MID-TERM EXAM

2/19

P R E S I D E N T S’ D A Y H O L I D A Y

III.

***

gca/ica

CREATING GLOBAL COMPETITIVE ADVANTAGES

12

2/21

Lecture/Discussion: Global Strategy: Creating Global Advantages and Building Strategic Multinational Capabilities Read: Ghemawat, “The Forgotten Strategy”

13

2/26

Case:

S.A. Chupa Cups

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3/1-3 15

IV. 16

3/5

Read:

Bartlett and Ghoshal, “Going Global: Lessons from Late Movers”

Case: Read:

The Globalization of CEMEX MacMillan, van Putten, McGrath, “Global Gamesmanship”

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gca

Mandatory ica

Haier: Taking a Chinese Company Global

GLOBAL ENTRY STRATEGIES AND STRATEGIC ALLIANCES 3/7

Lecture/Discussion: Global Entry Strategies: Exporting, Foreign Direct Investments, Joint Ventures and Strategic Alliances Read: Hamel, Doz and Prahalad, “Collaborate with Your Competitors – and win” Working Outline, with designation of individual responsibilities, of “Doing Business in Mexico” course group project due.

***

3/10-18 S P R I N G B R E A K 17

3/19

No Class Work on your “Doing Business in Mexico Project”

18

3/21

Case:

Louis Vuitton Moet Hennessy: Expanding Brand Dominance in Asia

ica

19

3/26

Case:

Hong Kong Disney (A): The Walt Disney Perspective

ica

20

3/28

Case:

Flextronics International, Ltd.

V.

MANAGING AND ORGANIZING MULTINATIONAL CORPORATIONS

21

4/2

Lecture/Discussion: Global Business Management: Designing and Managing Multinational Corporations Read: Bartlett and Ghoshal, “What is a Global Manager?”

22

4/4

Case:

P&G Japan: The SK-II Globalization Project

23

4/9

Case:

Timberland: Commerce & Justice

24

4/11

SECOND MID-TERM EXAM

25

4/16

No Class: Work on Doing Business in Mexico Group Assignment **

VI.

gca

ica

DOING BUSINESS IN MEXICO PROJECT PRESENTATIONS

26

4/18

Final Presentations: Doing Business in Mexico

27

4/23

Final Presentations

28

4/25

Final Presentations

Report Due

FINAL EXAM PERIOD (see Spring Schedule of Classes for date)

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Scheduled Feedback Sessions on Presentations and Report

Please Note: Submitting Group Case Analyses All groups must submit a group case analysis (gca) before the first Mid-Term Exam. I will assist you with a within-group peer performance appraisal. You should plan on using this group peer evaluation intervention to give open, honesty, and constructive feedback to each other based on performance to this point in our class. It is better to deal with within-group issues earlier rather than later! Submitting Individual Case Analyses ica/gca: In modules I & II, you may submit an individual case analysis (ica), if your group choose not to prepare and submit a gca. Note, however, that you may not submit an ica at the same time your group submits a gca. Submit Photo and Bio by January 10 (Session 2) Please prepare a 5 x 7 inch card with a picture of yourself (depicted anyway you like so long as you are recognizable), with some brief information about yourself such as country of origin, languages you speak, your major, your short-term and long-term career goals, hobbies, eccentricities, and anything else that is interesting about yourself that you would like to share with me. Immigration Documents by January 18 (Session 3) You will need legal documents for our trip to Mexico in October. A current passport is required and/or alien resident card. As of January U.S. citizen must travel to and from Mexico with a valid passport. Please turn in a clear photocopy of your passport, alien resident card, or a copy of you application for a passport, on Wednesday, January 18th. Note:

All cases and articles are in the Case Package available from the University Book Store.

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Wednesday, 1/18

The Jollibee case traces the international expansion of Jollibee Foods Corporation, a Philipines based fast food company led by entrepreneur Tony Tan Caktiong (or TTC) that is expanding within Asia, and now beyond. The case begins with Noli Tingzon, the new general manager of the international division, facing three investment decisions. He has opportunities to expand into Papua New Guinea (PNG), Hong Kong, or the United States, and recognizes that his decision on which project to back will probably shape the broader strategic agenda and organizational model that the company’s international operations will follow. The Jollibee case will also give us practice at identifying a competitive strategy, drawing a business model, evaluating the sustainability of competitive advantages, and thinking critically about how far a company’s strategy can “travel” without modification.

Read

Gupta and Govindarajan. “Managing Global Expansion: A Conceptual Framework” Seigel “Introduction to Global Strategy”

Case

Jollibee Foods Corporation: International Expansion

Discussion Questions 1. How was Jollibee able to build its dominant position in fast food in the Philippines? What sources of competitive advantage was it able to develop against McDonald’s in its home market? 2. How would you evaluate Tony Kitchner’s effectiveness as the first head of Jollibee’s international division? Does his broad strategic thrust make sense? How effectively did he develop the organization to implement his priorities? 3. As Noli Tingzon, how would you deal with the three options described at the end of the case? How would you implement your decision? 4. Provide advice to the top management team at Jollibee. What should Tingzon do to ensure global success? Which option should he select? What competitive advantages does he have to build on? What global competitive advantages can Tingzon exploit to improve its global position?

No formal turn-in assignment This is our first case and we will use it to get used to doing a case analysis.

Reminder: Immigration Documents Please bring to class one of the following: (1) a clear photo copy of the information page from your passport (the copy of your photo should be recognizable), or (2) a copy of your birth certificate and one government issued photo ID. If you are an international student or an international exchange student (that is, a student on any type of visa), we need a copy of your visa, too.

Keith Parker, University of Southern California

MOR-492: Reading Notes

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The Forgotten Strategy By Pankaj Ghemawat • • • • • •

In many if not most cases, companies see globalization as a matter of taking a superior business model and extending it geographically, with necessary modifications, to maximize the firm’s economies of scale The key strategic challenge is simply to determine how much to adapt the business model – how much to standardize from country to country versus how much to localize to respond to local differences Many companies have moved toward more localization and less standardization All companies that view global strategy in this way focus on similarities across countries, and the potential for the scale economies that such commonalities unlock, as their primary source of added value In their rush to exploit the similarities across borders, multinationals have discounted the original global strategy: arbitrage, the strategy of difference If they are to get their global strategies right in the long term, many companies will have to find ways to combine the two approaches, despite the very real tensions between them

The Strategy of Differences • • •



Arbitrage has been around for a very long time Many of the industries in which arbitrage has historically been applied – farming, mining, and textiles – are regarded as low-tech and mature There is also the sense that well-run global enterprises have already reaped what competitive advantage they can from arbitraging such generic factors of production as capital or labor, which, as one leading management guru has put it, can now be sourced efficiently with the click of a mouse The scope of arbitrage is as wide as the differences that remain among countries, which continue to be broad and deep o Cultural Arbitrage  Claims that the scope for cultural arbitrage is decreasing over time are clearly not true for all countries and product categories  Reduction in other dimensions of difference – tariffs or transport costs, for instance – can also increase the viability of cultural arbitrage o Administrative Arbitrage  Legal, institutional, and political differences from country to country open up a host of strategic arbitrage opportunities  Tax differentials are an obvious example (NewsCorp)  Few managers explicitly treat tax or other administrative arbitrages as a strategic tool, despite their potential  Executives are reluctant to draw attention to such arrangements for fear that they might be outlawed  In some cases, administrative arbitrageurs are actually breaking the law  Many forms of administrative arbitrage involve working with or around given rules  In some cases, companies can leverage political power to try and change the rules  The potential for using government influence to create administrative arbitrage opportunities remains high o Geographic Arbitrage  Transportation and communication costs have dropped sharply in the last few decades  But the drop does not necessarily translate into a decrease in the scope of geographic arbitrage strategies  Although communication costs have dropped more sharply than transportation costs, there are cases in the telecom sector where returns earned by focusing on residual distance have been higher than those gained by building or exploiting global connectivity  The geographic arbitrageurs that have lost some ground in recent decades are the great general trading companies of the past, which traditionally took advantage of large international variations in prices for a broad array of products by getting them from market A to market B

Keith Parker, University of Southern California

MOR-492: Reading Notes o

Economic Arbitrage  Refers to the exploitation of specific economic factors that don’t derive directly from a country’s culture, geography, or administrative context  These factors include differences in the costs of labor and capital, as well as variations in more industry-specific inputs such as knowledge or the availability of complementary products, technologies, and infrastructures  The best-known type of economic arbitrage is the exploitation of cheap labor, which is common in labor-intensive, capital-light industries like clothing  Labor arbitrage can be applied to R&D as well as to ongoing operations, as Emraer also demonstrates  One might argue that labor arbitrage is an unsustainable strategy in knowledge industries because labor costs quickly rise to match demand  Capital cost differentials would seem to offer slimmer pickings than labor cost differences; they are measured in single percentage points rather than multiples of ten or twenty  The subtlest forms of economic arbitrage involve the exploitation of knowledge differentials

Reconciling Difference and Similarity • • • • • • • • •

One would think that companies that try to exploit differences would not find it easy to exploit similarities as well Fundamental tensions between pursuing scale economies and playing the spreads exists The data indicates that there is some merit to classifying companies according to the primary way they add value through their international operations over long periods of time For a start, it’s possible to apply different strategies to different elements of a business The branded business grew to significant volumes but continued to generate losses because the competitive environment was particularly tough for a late mover The future of globalization process is by no means obvious Markets may integrate further once economic conditions improve Some argue that the process could actually shift into reverse, toward even greater economic isolation, if the experience between the two World Wars is any precedent The differences that make arbitrage valuable as well as the similarities that create scale economies will remain with us for the foreseeable future

Keith Parker, University of Southern California

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Going Global: Lessons from Late Movers By Christopher A. Bartlett and Sumantra Ghoshal • • • • •

Companies from developing countries have entered the game too late They don’t have the resources; they can’t hope to compete against giants There is plenty of evidence that the above is not true The writers studied 12 emerging multinationals in depth o They operate in wide range of businesses, but they are all based in countries that have not produced many successful multinationals The evolution into more-profitable product segments can be clearly tracked on what we call the value curve o All industries can be seen as a collection of product market segments o The value curve is a tool used to differentiate the various segments o The more profitable the segment, the more sophisticated are the capabilities needed to compete in it – in R&D, distribution, or marketing

A Model of Success •

Indian pharmaceutical company Ranbaxy o Moving into large markets like China and Russsia – required building new customer relationships, a strong brand image, and different distribution channels o U.S. and European markets – the company needed to meet much more stringent regulatory requirements o Their immediate challenge was to break out of the mind-set that they couldn’t compete successfully on the global stage o Once freed of that burden, they had to find strategies in which being a late moves was a source of competitive advantage rather than a disadvantage o They had to also develop a culture of continual cross-border learning

Breaking Out of the Marginal Mind-Set • • • • • •

Companies from peripheral countries can fall into several traps, which we call liabilities of origin Some companies feel as though they are locked in a prison of local standards because of the gap between technical requirements and design norms at home and world-class standards abroad If demand at home is strong, managers then can reasonably postpone the investments needed to comply with international standards Sometimes, management is either unaware of the company’s global potential or too debilitated by selfdoubt to capitalize on it There are a few companies for which the liability of origin derives from a limited exposure to global competition, leaving them overconfident in their abilities or blind to potential dangers Our emerging multinationals started to overcome them by creating a push from home and a pull from abroad o Push from home  Management’s greatest challenge is to shock or challenge the company to push it from its nest  Samsung example  Another way to create a push from home requires a leap of faith more than a shock of recognition  These leaps can be dramatic, and they are always risky, like performing on a trapeze without a net  Some CEO’s do this by investing far ahead of demand, even if doing so reduces the company’s responsiveness to its successful home market o Pull from abroad  Organizations need an engaged trading post, not just a passive listening post

Keith Parker, University of Southern California

MOR-492: Reading Notes  

Companies need offshore champions who can provide the young, overseas organization with credibility and confidence, both internally and externally Singh from Ranbaxy created an organization in which managers from other parts of the world had a seat at the table on key corporate decisions

Devising Strategies for Late Movers • •



The next major challenge is to choose a strategy to enter the global marketplace Benchmark and sidestep o Emerging multinationals can learn how to compete against the players in foreign markets simply by adapting and responding to those players as they enter the home market o They benchmark the established global players and then maneuver around them, often by exploiting niches that the larger companies have overlooked o Jollibee example Confront and challenge o When companies use their newcomer status to challenge the rules of the game, capitalizing on the inflexibilities in the existing players’ business models o A more radical strategy is to introduce new business models that challenge the industry’s established rules of competition o Though risky, this approach can be very effective in industries deeply embedded with tradition or comfortably divided among an established oligopoly o The typical business model in these industries has become inflexible o BRL Hardy example

Learning How to Learn • • •



The global marketplace is information based and knowledge intensive To survive in this environment you must learn how to learn: its is the central skill that allows a company to move up the value curve Protect the past o Too many companies become so focused on where they are going that they forget where they are coming from o With the Jollibee example, the new manager broke down the barriers between the international and domestic organizations and began building relationships that acknowledged his respect for their success and dependence on the home country’s expertise Build the future o Entering a new market requires considerably more than simply tweaking the home-market formula o Often companies lack the expertise needed to tailor the product or strategy to the new environment o So many emerging multinationals try to take a shortcut to learning by entering into a partnership with a foreign company o In theory, companies can sidestep the disadvantages of partnering by buying the necessary capabilities o After the false start, Hardy realized that in international business new capabilities cannot simply be installed; they must be developed and internalized

Having the Right Stuff • • • • •

Moving from the periphery into the mainstream of global competition is such a big leap that it was always led from the top The emerging multinationals always have leaders who drive them relentlessly up the value curve Their commitment to global entrepreneurialism was rooted in an unshakable belief that their company would succeed internationally Their operation expanded, they all exhibited a remarkable openness to new ideas that would facilitate internationalism – even when those ideas challenged established practice and core capabilities These leaders are models for the heads of thousands of marginal companies in peripheral economies that have the potential to become legitimate global players

Keith Parker, University of Southern California

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General Strategy • Managing the future Risk premiums, sustainable/renewable above normal returns •

ROA: Return on Assets

• •

ROIC EVA: Economic Value added

• •

Government no risk More risks with businesses

Willingness to buy • • •

Marketing, placement of staples in grocery stores Willingness to pay: Hospitals, we don’t shop around for the cheapest emergency room Harley Davidson tattoos, you can charge them whatever you want

Cost minimization • Fixed costs stay the same, economies of scale doesn’t affect fixed costs • Economies of scope, sharing fixed costs, so one item carries less of a burden o Trucking, want to fill up lorries so there is less cost on each product Not often is it possible to have both high volume and high margins • It’s not true at all that high market share equals high profit • •

There are two winning strategies One emphasize low price and high volume

Business Models • Very important to know the business model, for direction in decisions • Investment goes into uniqueness o Usually, some exceptions (R&D to lower costs) When you have a good thing in business, people will try to copy you

Keith Parker, University of Southern California

MOR-492: Class Notes



Rivals o Entrants o Buyers o Substitutes o Supply

• •

If there are many of these in some market, it is not attractive To solve this



Barrier to entry to block entrants

Targeting • •

Low Cost – Broad market focus: Ivory, Dial et cetera Low Cost – Focused market focus: The stuff you get in a hotel



Differentiated – Broad:

Drug industry can charge a lot, because insurance covers it • •

Most Pharmaceuticals are patent protected Huge barrier to entry when getting into this industry

Shocks and trends can have enormous affects on industries Attractive products • Valuable • •

Rare (non)Imitable



Organization

Strategy is your idea for making money • How to sustain it over time • Competitive threats, how to build up a defensible market position

Keith Parker, University of Southern California

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Global Expansion

February 12, 2007 Group 5 “The Seven Samurai”

Nan Wang Whitney Stambler Keith Parker Kerry MacDonald Gary Lilardi Chen Kang “CK” Hsu Mark Davenport

Decision Tree - Strategic Approach Vision: To become a top 10 company with $4 billion in sales by increases overseas sales from $100m to $1.2b.

Keith Parker, University of Southern California

MOR-492: Projects

Cosmetics – An Expanding Industry • AmorePacific is involved in 49% of the potential cosmetics product scope (green shaded slices). •Europe makes up the largest market followed by Asia with the US closely behind in third.

Expected expansion of cosmetics industry by 2009:

$180 Billion

Projected Performance From this analysis, AmorePacific is facing an overall medium competitive global cosmetic industry.

Porter’s 5 Forces • Low barriers to entry •Low restrictive regulation (FDA) • Low capital requirements

Bargaining power of Suppliers Low • Many suppliers • Fragmented • Low switching costs

• • • •

Oral supplements Tattooed make-up Plastic/dermatology surgery Spa treatments

Threat of New Entrants - High Rivalry among competitors High Threat of Substitutes Low

• L’Oreal, The Procter & Gamble, Unilever PLC, Shiseido Co. Ltd., The Estee Lauder Cos. Inc., Avon Products, Beiersdorf AG, Johnson & Johnson, Alberto-Culver Co., Kao Corp. •Similarity among brands •Increasing global concentration

Bargaining power of Buyers – High/Medium • Large selection of other labels • Low switching costs •Fragmented market • Some degree of customer loyalty

Keith Parker, University of Southern California

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CAGE Framework Distance between Korea and other countries

Korea vs. China

Korea vs. U.S

Culture Distance •Different languages •Korean herbal medicine system was based on China’s •Common Confucian tradition, colonial ties Administrative Distance •World Trade Organization •China open to foreign investment and competition Geographic Distance •Land borders •Northeast China is accessible from Korea, and shares much history and culture Economic Distance •Korea is a developed country, China is a developing country

Culture Distance •Different languages •Different religions and Value, Norms, and ethnicity •Korean based business on personal contact Administrative Distance •World Trade Organization •Korean government has heavy influence on economy •Relatively unstable political climate due to North Korea Geographic Distance •Long Distance •Korea has multiple American military bases Economic Distance •Rich-Rich: Replication •Korea has complicated social and distribution network

Korea vs. France Culture Distance : - Different languages - Different religions and Value, Norms, and ethnicity - France has a relatively lax work environment Administrative Distance - World Trade Organization - France has strict socialist labor laws - France has relatively unfriendly political environment for commerce Geographic Distance - Long Distance Economic Distance - Rich-Rich: Replication

Macro-Environment Analysis Political Environment

Economic Environment

United States: • Open trade • FDA approval required for most cosmetic products

United States: • Capitalist Economy

China: •Law banning door-to-door sales in 1996 •Shares much history and culture with Korea

China: •1980s and 1990s became more open to foreign investment and competition • High GDP growth rate

France: • Labor Union activity can affect production costs

France: •Strong currency (EU)

P.E.S.T. Analysis Social Environment

Technological Environment

United States: •Mixed cultural environment

United States: • High cosmetics R&D • Rapidly expanding Internet based economy

China: •Common Confucian tradition, colonial ties, and Korean herbal medicine systems comes from China •Growing popularity on South Korean culture France: •Prefer “Made in France” products •“the home of cosmetics”

China: •Evolving e-commerce France: • Advanced cosmetic industry R&D infrastructure

AmorePacific wants to expand their product line internationally. Therefore, the company needs to determine the right place to sell the maximum amount of their products to earn the highest profit. Even though there are cultural gaps between Korea the United States, China , and France, AmorePacific should be able to make a profit in these different regions through thorough research of where to enter the market in order to reach the widest consumer base.

Keith Parker, University of Southern California

MOR-492: Projects

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Business Model As a cosmetics company, AmorePacific relies on Differentiation-based model to attract customers and build consumer loyalty.

Door to Door Personal Selling

Loyal Consumers

Quality

Brand Marketing

Reputation

Extra Profits

R&D

Premium Prices

Increased Margins

Value Chain AmorePacific serves a wide range of customers by offering products of different quality and levels of innovation. Furthermore, AmorePacific’s unique culture of adaptability and unity has given more market sensibility. Combined with their strong home base, high levels of innovation, successful marketing strategy, expansive knowledge base, and a wide range of personalized products, AmorePacific is able to obtain its current success.

R&D

•Experience •Knowledge •Designated national research lab by Korean government •Nano structure technologies

Manufacturing

Distribution

Marketing

•Location

•location

•botanicals

•technology

•S cope of production line

•chemicals

•consolidation

•Differentiatio n •Brand marketing

Raw Materials

•transportation

Retail

•Customer relationship •Changing of consumer’s taste •Door to door personalized selling •High-end retail distribution

Keith Parker, University of Southern California

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Opportunities & Attractiveness US • Another world leader in cosmetic product development • Large number of Korean immigrants

Benefits Costs Risks

• High discretionary income

France

China • Market Size and Growth

• World center for cosmetic product development

• Growth potential, unsaturated

• Strong demand for cosmetics • Entry costs are high, especially in high profile targeted locations

• Joined the WTO

• Overcoming association with ‘newly developed country’ origins

• Reluctance to buy from newly developed country

• Access to majority of population is limited

• Trouble reaching mid-priced pharmacy channel

• Door-to-door sales illegal

• Brand confusion, with low-end products and high end offerings

• Different cosmetic product preferences

• Political stability • Economic freedom lacking • Unemployment levels high

• Reaching the non-immigrant market

•Flagship product, a fragrance, has low loyalty levels

• Highly regulated market

Well Equipped for High-End Market Unique Packaging •Designed in multiple layers •Protect products from light, heat, cold, and time •Packaging is the “shape of devotion”

New Products

DIFFERENTIATION STRATEGY

•Quick launch of high-end brands

Distribution •Single brand booths •High-tech door-to-door sales

•Innovative and research-based products

•Hue Place

R&D Center

Exclusive Ingredients

•Among the largest of any cosmetics company worldwide

•Only available in Korean farms

•Exclusive “Nano Delivery System”, 1/1000th the size of a skin cell •Maximizes nurturing at the cellular level

•Hand picked rare ginseng aged precisely 6 years •Unmatched perfect microclimate •Green tea extract harvested by hand during 1 st week of April

•First in sector designated “National Research Lab”

Keith Parker, University of Southern California

MOR-492: Projects

Success Factors Amore Pacific’s success is the contribution of several factors that helped them establish their brand in the Korean cosmetics market. Factors such as product quality, their market familiarity, and luck enables them to become Korea’s leading producer of skin-care and cosmetic producs.

Market Familiarity •Understand Korean women and their needs. •AmorePacific is a local Korean company with majority of their employees Korean. Hence, they are able to better understand their market’s needs.

Product Quality • High quality products that works. •Access to rare and quality ingredients.

Reputation

•Beauty professionals to provide customer service through spas, department store booths, etc.

Luck

•AmorePacific is the first company to provide skin-care and cosmetic products to the Korean market. •Korean Economic crisis and depression creates a larger entry barrier for large international competitior to enter Korea and enables AmorePacific to take advantage of their market dominance.

Global Strategy In order to understand AmorePacific’s strategy for going global, and what they wanted to achieve in their global businesses, close attention should be paid to their levels of local responsiveness and global coordination through this model.

High AmorePacific’s goal is to compete with the best international brands in the global cosmetic market. To do this, they must appeal to the different global consumer needs while keeping their costs at a minimum

Global Coordination

Transnational Global

AmorePacific (Tomorrow)

International

AmorePacific (Now)

Local Responsiveness Low

One solution for this is to move into a Transnational-type company. This would mean high product differentiation for each regional market (scope) while keeping high global coordination to take advantage of economies scale.

Multi-Domestic

High

Keith Parker, University of Southern California

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Initial Entry Strategy AmorePacific’s entry strategy for each of their global market were different to suit the heterogeneousity of consumer preference. These differentiations included: Marketing strategy (target market and entry market), Product lines, and Distribution/retail points.

Entry Market: High-M edium Asian market Products: Full line Skin-care and Cosmetics Marketing S trategy: • Target the Asian market within the US because they had more brand awareness •High priced skin-care products to promote youthfulness

Entry Market: High-M edium Income Products: Exclusive to Fragrances Marketing S trategy: •“M ade in France” Fragrances to create an exclusive image •Different brand name to better appeal to the local’s preference

Entry Market: Low-M edium Income Products: Skin-care and Cosmetics Marketing S trategy: •“Bottom-up” strategy •Used Korean marketing strategy because of similar market environmet. (eg.Korean M odels)

Recommendations

United States

• Strongest emphasis on the US market, large potential for high investment returns. •Top Down Approach. •Focus on High-End department stores and retailers. •Diversify marketing towards non-Asian and Korean consumers in US.

• Second strongest push for development in the French market, strategically necessary location for cosmetic companies.

France China

•Retain separation from Corporate to allow local decision making for the French market. •Expand product line to build from the foothold of fragrances. Bundle skincare products. • Emerging market offers strong potential for high market share, but many barriers still exists low-end targeting could influence global brand image •Retain “Made in Korea” to ride the “Korean Wave.” •Introduce higher-end products but retain accessibility to Tier 3 consumers.

Keith Parker, University of Southern California

MOR-492: Projects

Implementation France

China

•Exploit strong perfume market, but avoid cosmetics for the near-term

•Continue bottom  up penetration

•Huge mass market opportunities in the lower tiers through low-end niches •Sophisticated demand in perfume market can provide knowledge for introducing quality products for markets •Emphasize “Made in Korea” to appeal to in other countries All Global Markets young popular culture •Avoid “Made in Korea” concept •Emphasize quality

•Management should avoid reducing resource commitments because this will hinder goals to increase worldwide market share. The strong financial position currently doesn’t necessitate reductions. •Continue to pursue organic growth. Inorganic growth through acquisitions or joint ventures can lead to inconsistencies in operations and damage AmorePacfic’s global image. •Diverse entry strategies are necessary because of differences between cosmetic market maturity and consumer preferences by country.

United States •Potential for highest returns because of profit premiums on highend product lines with emphasis on research & technology •Resources should be dedicated to securing premium distribution channels for market introduction (i.e. Saks Fifth Avenue, BergdorfGoodman, Neiman Marcus, etc.) •Penetrate top  down by catering to 1st & 2nd tier customers

Conclusion • The United States would offer the highest returns on investments of resources and managerial emphasis. • France is strategically important in the global cosmetics market, as an industry focal point. • By moving from the multi-domestic to transnational approach, Suh Kyung-Bae should be concerned with maintaining local responsiveness and increasing global coordination. • Joint ventures and acquisitions could be considered, but not at the expense of losing control or sacrificing the company image.

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4 N Q\ r UFu k» u D scanR scanner scanr document scan scans doc documents [email protected] [email protected] Tuesday, February 06, 2007 Tuesday, February 06 07 Tue, Feb 6 Tue, Feb 6, 2007 02/06/2007 06/02/2007 2007/02/06 02/2007 02-06-2007 06-02-2007 2007-02-06 02-2007

02/06/07 06/02/07 07/02/06 02/07

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P&G in Japan: The SK-II Globalization Project Individual Case Analysis Keith Parker ID#6390.4899.77

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In deciding upon which markets to enter, two factors are important to consider. First, the individual country factors must be analyzed and compared with the core competencies of the P & G organization. Second, and just as important, one must understand the effects that entering either or both of these countries will have on the newly created strategic organizational structure of P & G’s entire group. In analyzing a potential move into the English market, it has become clear that many of the core competencies that SK-II holds in Japan do not travel to the European market. First, the four to six-step face washing program might be too intense for the casual European woman. Further, service at the point of sale, one of AK-II’s strong points, must be able to travel in order to ensure success. England, with its high minimum wage, does not provide the most attractive market for such a sales model. The consideration of entering the high-end Chinese market appears to be much more appealing than the entry into the English market. While the overall Chinese market may not be able to afford such expensive luxuries as the SK-II product line, the more sophisticated inner-city markets with a high discretionary income appear to be a great match for entry by SK-II. Olay has already done some of the work in testing the waters by borrowing the service-based sales model and putting it into practice in China. This model was highly successful, which lends to the idea that one of SK-II’s most important core competencies will travel to the Chinese market. Moving into the Chinese market seams to be a good move from most angles. When taking into account the new organizational structure of P & G, which emphases the firms’ ability to take successful products from separate GBUs and spread them across the globe, a move into the English market seems to be a good test of this organizational structure and may help newly appointed managers find their place in the organization.

Keith Parker, University of Southern California

MOR-492: Projects

Bringing SK-II into Europe and China

Keith Parker ID#6390.4899.77

Keith Parker, University of Southern California

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• • •



Overview

The core competencies of SK-II travel best to the Asian Market The European market has different preferences than the Asian market and very different competitive conditions Market share of SK-II is still low in Asia, and with its promise of success as shown by large growth in Japan, the market in Asia that might best be known for being home to some of Asia’s most sophisticated beauty product consumers, so growth should be focused in this region Nonetheless, with the new organizational structure of Proctor and Gamble supporting the widespread sale of successful P & G products, a weary entry into the English market might provide clues as to the potential for further expansion into other western markets

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SK-II Sources of Success

•Well researched and developed product; provides the multi-step process desired in the sophisticated beauty product market of Japan

•Service at the counter is strong, leading to customer loyalty

Advertising Advertising methods should travel well to China, but may require different mediums. In Europe, TV ads are too expensive- may be too difficult to establish recognition and build market share

Manufacturing

Will Likely travel successfully to both China and Europe

Distribution methods may need adjustment for Europe, but P&G’s knowledge with distribution in this market should make for a smooth transition

Distribution

High labor costs in the UK will make this very difficult to travel, though in China the opposite is true, as labor is much cheaper than in Japan

Service at Counter

•Innovative advertising appealed to Japanese market Research and Development

Will Likely travel to China, where preferences are similar. In Europe, though, preferences differ to the extent that products may not travel well to this area

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Industry Analysis Threat of Entry •Mostly a marketing-based industry, which requires heavy use of capital to gain a significant market share •Large amount of capital also required for research and development

Low Rivalry High Medium

High

•Firms compete heavily for market share •There are many players in the beauty products game, increasing rivalry; this is especially true in saturated markets

Buyer Power

•Buyers are customers at the end of the line •These customers have a fairly large amount of buying power, as beauty products are usually sold near competing beauty products so it is easy for the customer to walk away

•Depending on the market, substitutes may be common or rare In China, women may chose to instead use simple soap and water. In Japan, though, consumer sophistication lends to the idea that there is little substitution for beauty products

Substitutes

MediumHigh

•Boutique entrants may find niche markets, but in order to gain a significant market share it is important to be established and have a large capital base

Supplier Power •Suppliers are employees along the entire value chain, chemical suppliers, and suppliers of selling space •Those in control of selling space have a large amount of power as there is limited space and many people competing for it •Other suppliers don’t have very much power

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With the size of P & G’s operations in other and similar industries, the firm will be able to provide some of the flexibility needed in entering Europe and China

Non-market strategies are not substantial in this case

Location Drivers

Possible Entry Considerations Cost and Volume Drivers

Global learning will be seen most in entering Europe, and will be an important test of the new organizational structure of P & G

National differences will be limiting in Europe, but no so much in entering China

As initial expansion into these markets will only include one product line (SK-II), operations will not be benefited by economies of scope

By expanding operations, movement along the learning curve will increase economies of replication

As with economies of replication, and increase in total units sold after entering either of these markets will lead to benefit from economies of scale

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China’s top-tier market is more similar to Japan’s market. Although the overall market may differ, the target market (I.e. those in the big cities with large discretionary income) will most likely buy SK-II products. Evidence of this has arisen from Olay’s use of SK-II’s Japanese tactics in China in order to justify the price premium for their products. This has been wildly successful.

China

Region analysis

England Clearly, there are large cultural differences between the Asian beauty market and the European beauty market. While Japan may be the sophisticated market of Asia, where large amounts of development within the industry occur, France is the equivalent of Europe. Without being in France, SKII won’t be able to effectively compete with other European Beauty suppliers in England.

Japan

Japan’s market is sophisticated, has on average a relatively large amount of discretionary income, and has proven that SK-II, along with the services and marketing that accompany the product, can succeed in markets similar to this

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• • •

• •



Entering England

Although Europe may not be ideally suited as a potential location for expansion of the SK-II line, entry into this market may provide strategic benefit As most large beauty product companies are global in scale, SK-II can reap the benefits of knowledge transfer, economies of scope, et cetera If SK-II is to become a globally competitive brand, it must test the waters and make a presence in the western world England, with its concentrated department store channels that would allow limited high-cost service staff but similar service quality, would be a good choice While losses may occur, this is necessary in order to gain a strategic position in the world market Further, although SK-II’s premium positioning doesn’t fit well with P & G’s volume-based strategy, it will compliment Olay’s lower-cost volume strategy and provide economies of scope as well as stronger bargaining power with England’s very powerful concentrated retailers Further, as brand image and service quality are essential to the success of SK-II in the British market, ownership of these components should be as full as possible. A partner in entering this market would be a good idea for the other components of business operation, though, so as to minimize risk and provide for a smoother exit strategy

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Entering China

The Chinese market, though on average quite a bit different from the Japanese market in terms of personal spending power and sophisticated preferences, can still provide SK-II with a large amount of success in the Asian market In the largest, wealthies cities of China reside those who have preferences similar to the Japanese and the buying power to purchase items marked up as high as SK-II As service is such a large part of SK-II’s overall product offering and strategy, the ability to hire service workers at an extremely low price in China adds great appeal to entering the market Olay borrowed the service-based idea from SK-II and put it to work in China, to huge success; this alone is proof that one of SK-II’s strongest core competencies will travel into the Chinese market and meet success China’s potential for growth and profit is strong enough for one to suggest that P & G enter into the market without a partner in order to maximize profit (I.e. China is not a very risky entry)

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How Does This Fit Into The Organizational Structure?

•As this case analysis may have provided more concrete reasons to NOT enter England than vice versa, when taking into account P & G’s new organizational structure one finds that this is clearly not the case

•One of the core competencies of the new organizational structure of P & G is its ability to take a good idea from one GBU and mass market the same technology in different ways throughout the world; SK-II is the perfect product to challenge this new organizational structure and allow all of the newly appointed managers to establish their role in the organization

Keith Parker, University of Southern California

Mark Davenport, C.K. Hsu, Gary Lilardi, Kerry MacDonald, Keith Parker, Whitney Stambler, Nan Wang

Presented by

The Wahaha Group Mexican Expansion

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When entering into this new market, Wahaha should implement its old business model, but make some necessary small adaptations. In C hina, Wahaha targets the lower tiers in rural regions, but in Mexico, these areas are not as populated and population in rural areas continues to decline Therefore Wahaha will need

How to Enter into Mexico There are many options for Wahaha to consider before entering Mexico. However, out of the many possible paths the best choice is to joint venture with Groupe Danone. Wahaha and Danone have an existing relationship that was formed in 1996. C urrently, Danone owns 51% of Wahaha. With Danone's assistance, Wahaha was able to invest in advanced production lines, improve efficiency, and production doubled from 1996 to 1997. Danone has been operating in Mexico for over 30 years. With Danone’s experience in Mexico, Wahaha can use its knowledge of the market to have a greater chance at success. Wahaha will need to build a bottling plant, but with the high growth of the market, the breakeven should occur during the second year. Also, Danone already has a wide distribution and manufacturing network that can be used to distribute Wahaha products. Wahaha will be able to enter Mexico and know that they have a trustworthy partner with them.

Wahaha’s target customers are similar to who the company appeals to in C hina. The company will aim at the lower tiers of the market (tiers 3 and 4) where consumers are more price-sensitive. In Mexico, this target market represents a large percentage of the overall Mexican market (approximately 64%).

Mexico’s Attractiveness to Wahaha The Mexican soft drink market is an extremely attractive market for Wahaha. C urrently, Mexico is ranked the world’s second largest soft drink market. Within the soft drink industry, carbonated beverage category dominates with huge revenues representing over 60% of the market. C arbonates are particularly popular in Mexico due to the hot climate, compatibility with Mexican food, and the wide market penetration. In fact, carbonated drinks have become part of Mexican culture; “many Mexicans would find it difficult to imagine a gathering with friends without carbonates.”[1] Over the next few years, the soft drink market is expected to be valued at $20.3 billion, an increase of 27% since 2005. Meanwhile, sales volume is expected to increase by 28.6% to 49.6 billion liters. Wahaha should take advantage of the opportunity to enter in this growing economy.

Wahaha’s Company Background Wahaha is the leading beverage producer in C hina. Founded by Zong Qingou in 1989, the company has grown into a billion dollar industry. Wahaha has begun a limited expansion abroad by entering the United States and putting its products on shelves in New York and Los Angeles. Part of Wahaha’s strategy is to find markets with high growth opportunities.

Executive Summary

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[1 ] “S oft D rinks – M exic o.” E uromonitor I nternational. A ugus t 2 0 0 6 .

How to Succeed in Mexico In order to succeed in the Mexican carbonated drinks industry, Wahaha needs to build its global competitive advantage. In order to do this, the company can take advantage of its knowledge in creating economies of scale and scope that improved tremendously with their joint venture with Danone. Additionally, the way that Wahaha advertises will help spread its brand image. Wahaha will replicate the marketing strategy that it uses in C hina and use commercials, print ads, and celebrity endorsements. Danone’s 30-year experience in Mexico will also help Wahaha succeed in this new market and capture a portion of the soft drink industry.

Barriers to Wahaha’s Success in Mexico While Mexico holds great potential for Wahaha, there are factors that may hinder the success of the company. There are relatively high political risks and corruption within Mexico. There are also cultural distances because of the difference in language and Mexicans do not favor Asian products. However, by joint venturing with Danone, Wahaha can mitigate these cultural distances by learning from Danone’s experience and responding to these differences in the market.

Competitors Wahaha Will Face Wahaha faces major competition in Mexico. The largest are C oke and Pepsi who dominate the market with 63% combined market share. However, Wahaha will not be directly competing with these two companies. Instead, Wahaha will look to grab some of the market that the smaller brands reach. Big C ola is one of the smaller brands that Wahaha will be competing with and matching the price they put on its products. Market trends indicate that much of the increase in consumption volumes in Mexico is driven by low-price carbonates that are more affordable for consumers. In this sense, Wahaha will not be stealing market share from competitors as much, but expanding the market.

Executive Summary Continued

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Company Information

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 Looking for growth opportunities

 JV ownership: Zong Qinghou holds 49% and Danone holds 51%

 RMB 4.65 billion in total assets

 Responsible for 15.6% of China's total beverage production

 Manufactures non-alcoholic beverages and non-beverage goods including clothes, snacks, etc.

 Private-owned company and biggest beverage producer in China

 Found by Zong Qinghou in 1989

 “Wahaha” in Chinese refers to the sound kids make when they are happy and laughing

Who is Wahaha?

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Mexico

Partnership with local bottler or distributor (A RCA )

Joint Venture with existing f irm in Mexico (Danone)

A cquisition of a local brand

Direct investment without any strategic alliances

With D anone owning 5 1 % of Wahaha in C hina, the c ompanies ’ c los e relations hip would provide Wahaha an eas ier and more effec tive entry s trategy. I t allows them to be c ompetitive with loc al brands that are c ompeting in the low-c os t, high-volume s oft drink produc t.

A ll of thes e are viable entry s trategies . H owever, Wahaha needs to c arefully weigh the pros and c ons of eac h option to ens ure s uc c es s fulidering entry into M the exicoptions o. A fter c ons all of , we rec ommend that Wahaha enter the M exic an market through a joint venture with D anone. Wahaha’s exis ting relations hip with D anone mitigates muc h of the ris k of a partner holding up Wahaha bec aus e D anone is financ ially tied to Wahaha’s s uc c es s . Furthermore, Wahaha c ould take advantage of D anone’s already es tablis hed dis tribution c hannels in M exic o. D anone firs t entered M exic o in the 7 0 ’s as a wholly owned international s ubs idiary, and now has an extens ive network of dis tributors , retailers , and s upporting indus tries under its belt. T his would, in effec t, make Wahaha’s dis tribution in loc al s upermarkets and mom and pop s tores muc h eas ier than if they go in M exic o by thems elves .

Wahaha c ould c ons ider a s trategic allianc e s uc h as a joint venture with D anone or a partners hip with a loc al bottler/dis tributor s uc h as A RC A .

Rather than building their operations , Wahaha c ould ac quire a M exic an brand that is a direc t c ompetitor to Wahaha, but this c omes with the ris k of failing to integrate the c ompanies or overpaying for the c ompany.

T here are s everal entry s trategy options available for Wahaha for their move into M exic o. T he mos t c apital intens ive inves tment would be a wholly-owned s ubs idiary. A lthough this would give the c ompany c omplete c ontrol over their operations , this mode of entry is not advis able as Wahaha lac ks experienc e in expanding its bus ines s internationally.

How Wahaha Should Enter Mexico

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Extra Profits

Innovation and creativity for new tastes and products

R&D

Volume Num ber of visits And repeating visits

Price

Increased Margin

Improve brand awareness and use pull marketing to increase WTP

Advertising

Quality

Low Unit Cost

Economies Of scales

W ahaha ’s business m odel is transferable but sm all adaptations are necessary. In China, W ahaha targets the lower tiers in rural areas. However, in Mex ico, the rural areas are not as populated and the population in these areas is declining. For this reason, they m ust alter their strategy to reach the lower tiers in urban and suburban areas as well.

The ex hibit below is a depiction of W ahaha’s business m odel. The m ain focus of W ahaha is increasing sales volum e in creative and effective ways. Success in their m odel is driven by quality, R&D, advertising, and econom ies of scale.

Wahaha’s Business Model

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Many carbonated drinks taste similar. Brand image will drive increased sales and market share in the long run.

Brand Image

There are many determinants for the success of a company. In the case of Wahaha, the most important factor is sales volume which is essential to generating income. With volume being the focus, there are other factors that are supplementary. Advertising can increase brand equity and consumers’ willingness-to-pay. Good advertising builds a strong brand image, which drives volume. The channels for distribution are also extremely important—particularly in Mexico where it is a challenge to reach customers with so many small

When entering a new market, advertising is essential to building consumer awareness about the product. Increased awareness can also lead to an increased willingness-to-pay and higher profit margins.

Advertising

Critical Success Factors

Wahaha’s target market includes people living in tiers 3 & 4, and these customers often buy soda from among the many mom and pop stores in Mexico. It is imperative that Wahaha finds a way to distribute effectively to these scattered locations.

Distribution

Sales Volume

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Industry and Country Analysis

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In order to be successful in Mexico, it is imperative that Wahaha take full advantage of economies of scale.

We recommend that Wahaha limits their product line when entering Mexico. This is because one of the critical success factors for the industry is scale advantage and not scope. Therefore, once they have established the scale they needed, then they should start considering expansion to create scope.

Economies of Scope

Economies of Replication

Economies of scale are crucial for Wahaha as cost savings from scale effect is critical to stay competitive in the soft drink industry. By competing with high volume & low margin products, Wahaha has to have low cost of production to support the low prices that they charge

Economies of Scale

Wahaha’s product takes advantage of economies of replication as soft drinks are standardized and are manufactured through a fixed production process. Therefore, they require little modification and are simple to produce.

•Strategic alliance with Danone would provide them with a better understanding of their market

•Learns crucial information about the Mexican market (consumer preference, cultural differences, distribution channel effectiveness, etc.)

Learning

National Differences

•Different consumer taste and preference might affect sales.

•Language barrier that might affect the brand name

•Location Advantages: High volume of low-middle income consumers who are very price sensitive

•Risks may be reduced if bottling or other operations can be outsourced to a local partner.

•Very little flexibility as entering a new market in this industry requires very high capital costs.

Flexibility

Non-Market Strategy

•More than 90% of trade under free trade agreements •Member of WTO, therefore subject to regulations

This diagram of Volum e and Location drivers allows for an in-depth analysis of W ahaha’s operations and the advantages / disadvantages of m oving into another location. This will lead to a better understanding of the com pany’s com parative advantage.

Competitive Advantage & Location Drivers

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Compound A nnual Growth Rate

Global Soft Drink Sales (In billions US$)

•In 2002, the Mexican governm ent approved a 20 percent tax on soft drink m anufacturers who use fructose sweeteners, in order to help stim ulate the dom estic sugar industry

•In this sam e tim e period, sales volum e is ex pected to increase by 28.6% to 49.6 billion liters

•By 2010, the Mex ican soft drink m ark et is ex pected to be valued at $20.3 billion, an increase of 27% since 2005

•PepsiCo and Coca-Cola are both pursuing aggressive cam paigns to gain m ark et share in Mex ico, recognizing the high value of the m ark et

•Bottled water generates another 27.4% of sales of soft drink s in Mexico

•Carbonate sales proved to be the m ost lucrative in Mex ico, generating revenues of US$9.7 billion, or 60.6% of the soft drink m ark et

Mexico is the world’s 2nd largest soft drink market

Why Go To Mexico?

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Factor Conditions •Wahaha has the experience of doing business in a developing country. •Mexico is suited for their business model because of similar market.

Chance

Related and Supporting Industry •Danon could provide distribution channels for Wahaha •Large supermarket chains around the company to act as potential distributor (Calimax)

Firm Strategy, Structure, Rivalry •Rivalry from local colas (Big Cola) and leading cola brands (Coke, Pepsi). •Low-cost, High Volume strategy. •Targets middle-low income groups

Government

Demand Conditions •Growing market for soft drink industry in Mexico •Demand for low cost soft drink is high due to lower purchasing power of consumer

Porter’s diam ond analysis of com petitive factors allows us to analyze W ahaha’s com petitive advantages when the com pany m ak es the m ove. W ith good dem and conditions and supporting industries, we can conclude that there are significant factors that can potentially allow them to succeed in Mex ico.

The Key to Successful Market Entrance

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•Advertising is heavy from the m ajor com petitors, rivalry for m ark et share is very high The m arket has been recognized by m ajor players as a growing m ark et, spurning heavy investm ent to capture growth •Pepsi, Cok e, Big Cola

Rivalry- MediumHigh

•The buyers are bottling com panies and/or retailers •Threat of forward integration: m any large com panies are buying the bottlers they used to sell to •Bottlers are undifferentiated, can easily be substituted with another bottler in the area

Buyer Power - Low

•Many substitutes for soft drink s: W ater, juices, alcohol, and energy drink s •Private labels show threat within the soft drink m ark et (i.e. store-brand labels or ‘spin-offs’)

Substitutes - High

•Suppliers for sugar and other raw m aterials are m ostly undifferentiated and have little power •Em ployee are back ed by unions

Supplier Power – Medium / Low

•Fairly sim ple to enter as there are m any bottlers to contract with, but difficult to gain m ark et share without advertising capital

•O nly in the energy drink category do we see fragm entation

•Mostly a m ark eting-based industry, which requires heavy use of capital to gain a significant m ark et share

Threat of Entry - Low

Heavy rivalry and a high threat of substitutes offsets the low ratings for the other factors for new entrants. Low supplier and buyer power m ak e the industry attractive for established com petitors and those with large capital sources.

How Attractive is the Industry?

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•Pepsi and Cok e historically split up Mex ico into regions, where each would dom inate the m ark et; this has changed in recent years, increasing com petition

•There are about 43 soft drink com panies in Mex ico, though 70% of sales cam e from the top 8 com panies

•In the past, Cok e and Pepsi tried to prevent sm aller com panies from entering the m arket, but this behavior is no longer being tolerated. in 2005, the Mexican governm ent fined 15 Coke bottlers and distributors $15 m illion for anti-com petitive practices. The dealers “unfairly pressured m om -and-pop retailers not to carry Big Cola by threatening to stop Cok e deliveries and yank from their tiny stores

•Bottlers in Mex ico have been consolidating operations, leading to a possible strengthening of buyer power

•PepsiCo considers Mex ico its second m ost im portant m ark et outside of the US; in early 2002, PepsiCo announced its goal to invest m ore than US$1.2 billion in Mex ico by 2006

•In 2004, Coca-Cola em ployed 86,000 people in Mex ico

Soft Drinks Market Share

While Coke and Pepsi dominate the market, Wahaha will not be directly competing with them. Instead, Wahaha will focus on grabbing some of the market that the smaller brands reach. Therefore, Wahaha will be priced lower than Coke and Pepsi.

Competition in Mexico

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Background Facts – Bottled and marketed by Ajemax, a subsidiary of Peruvian firm Kola Real – Entered Mexican market in 2002 – Presently accounts for 5% of the Mexican drink market – Investment stands at $40 million in 2004 Target Market – 3rd & 4th tier of the pyramid, similar to Wahaha – “Tastes good as long as it is cold,” according to a consumer – Sold for $1.13, sometimes as low as 87 cents – Forced PepsiCo to lower prices Distribution – Considered a “counter-brand” – Only 28 distribution centers and sells to small grocery stores – Business model based on economics along value chain – Savings passed along to consumers – Uses freelance vendors who open up new markets for Big Cola

Wahaha will be directly competing with Big Cola, a Peruvian entrant into Mexico. Both share the same target market and will be competing fiercely to come out with the lowest prices in order to attract the price-sensitive consumers

Main Competitor:

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Soft Infrastructure • Logistical intermediaries – distribution channels are limited in rural areas •Legal system

Hard Infrastructure •Poor sanitation •Inadequate waste disposal facilities •Contaminated water •55% of Mexican households with access to piped water received services on an intermittent basis Country Factor Endowments •Unstable political environment

The most important challenges for Wahaha will be developing a on-site water purification system and working with the local government to ensure a regular water supply at their bottling plant. Moreover, Wahaha will need to rely on an established partner for adequate distribution. Building their own distribution channel will be too costly and time consuming.

Institutional Voids Analysis

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Political Environment •Federal Republic •Commercial and financial dependence on the US •Part of WTO, subject to regulations •Ranked as number 63 for index of economic freedom •Mixture of US constitutional theory and civil law system •Blue collar work force is up to a 6-day, 48hour work week •Mexican Federal Labor Law prevents unsafe working conditions •Foreigners are not allowed to own land in the restricted zone Social Environment •Mainly speak Spanish, and some English depending on area •Literacy rate was at 92.2% •No official religion •Dress and grooming are status symbols

Technological Environment •Use modern technology •Weak infrastructure in certain areas •Average water transportation

Economic Environment •Tourism in Mexico is a large industry, ranked third in importance •Free market economy •13th largest economy in the world •Established as an upper middle-income country •GDP - per capita: $10,600 •Unemployment rate: 3.2% •Underemployment of about 25% •Foreign Debt: $178.3 billion •Low labor wages •Stable inflation rate 5.4% •Growth rate 1.16%

P.E.S.T. Analysis

The economic conditions in Mexico make this an attractive market for Wahaha to enter. Although there are negative political and economic aspects in the Mexican market, Wahaha can mitigate these factors by implementing an appropriate entry strategy and, ultimately, lower the political risk and benefit from the growing economy.

Mexico’s Macro Environment

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High corruption and political risk Weak law enforcement

Do not favor Asian products Market dominated products: Coke and Pepsi

Majority of stores are small scale (Mom & Pop) Different language Different tastes & preferences

Administrative

Cultural

Water contamination Distribution mobility is limited in rural areas

Geographic

Ranked 9th most impoverished out of 102 developing countries 17.6% of the population is in extreme poverty Severe underemployment for much of the population Consumers are price sensitive

Economic

Based on this analysis, W ahaha should m ainly focus on how they will get their products to be as close as possible to the lower tiers because of the lim ited m obility. Their product is already priced low to appeal to the lower m ark et, so the financial situation in Mex ico should not be a m ajor hurdle to overcom e. W ahaha should be able to overcom e the m obility problem because they face the sam e situation in China when distributing to the lower tiers of the m ark et. Also, a partnership with a com pany that has been in Mexico for a while can help W ahaha learn and respond as necessary to the differences in the Mex ican m ark et.

Wahaha’s Distance Barriers

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• By 2010, sales volum e is to increase by 28.6% to 49.6 billion liters

• By 2010, Mex ican soft drink m ark et to be valued at $20.3 billion, an increase of 27% since 2005

• PepsiCo and CocaCola pursuing aggressive cam paigns to gain m ark et share, recognizing the high value of the m ark et

• Carbonate sales lucrative in Mex ico, generating revenues of US$9.7 billion

BENEFITS

• May not be able to penetrate m ark et dom inated by CocaCola and Pepsi

• Mex ican drink ers m ay not want to purchase a new drink from a Chinese corporation

RISKS

A TTRA CTIVENESS

• Lim ited purchasing power of 40% Mex ican households

• Mobility lim ited in rural areas

• Highly fragm ented com m and and com m unication structure

COSTS

Although there are obvious costs and risks (both market and non-market forces) involved in entering into Mexico’s soft drink market, the lucrative market offers tremendous benefits for a company to capitalize on, as a growing domestic demand makes it more worthwhile for new entrants into the industry.

Benefits Outweigh Costs & Risks

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Entry Strategy

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Goals for Distribution   Must establish a method to reach the mom and pop stores  Existing transportation  infrastructure can pose challenges to overcome  Access to bottling facilities which  are geographically disbursed  Access to water

Hot weather in Northern Mexico increases importance of Single Serve format and Coolers, Stable Pricing Environment  Prices do not fluctuate High Demand per Capita

Whichever distribution method Wahaha chooses, it must be able to effectively reach the channels shown in the chart below.

Distribution Channels in Mexico

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Disadvantages

Advantages

Less financial risk Because have partial ownership of W ahaha, they are m ore aligned with their core values Have a previously built relationship with distributors Share shelf space in stores

May not want to have a JV with W ahaha Less control over distribution Lim ited distribution to the rural areas

Low-cost Utilize ex isting e x pertise Relationships with stores already established Distribution infrastructure will already be in place Access to water rights is responsibility of partner Easy ex it strategy Lack of control over distribution Partner m ay not prioritize brand Must share shelfspace with the big brands. Their plants are only in the Northern region of Mex ico



JV Partnership w ith Danone

Contract w ith an Existing Distributor - ARCA Gain control over distribution Can focus on W ahaha brand instead of com peting with others Distribution Infrastructure will already be in place Can leverage ex isting relationships with stores Can leverage ex isting relationships High initial entry cost with consum ers Must m aintain infrastructure More difficult ex it strategy More financial risk if acquire a distributor

Acquire an Existing Distributor

Ex trem ely high entry cost Must secure access to water and other resources Must m aintain entire infrastructure Very difficult ex it strategy W ill have to work to establish new relationships with stores

Com plete control over entire distribution process Can concentrate on W ahaha brand only Ability to set up new channels with rural locations

Build Ow n Distribution Netw ork

Based on the pros and cons in this analysis, it com es down to deciding between contracting with ARCA or a JV with Danone. Therefore, a closer look at these two choices is needed to m ak e a final decision on which strategy to use.

Possible Ways to Distribute

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The Company distributes its products in northern Mexico, mainly in the states of Nuevo Leon, Coahuila, Sonora, Sinaloa, Baja California, Baja California Sur, and Tamaulipas. Currently, ARCA has 14 bottling plants and 61 distribution centers.

• Resulting from the merger of three of the oldest bottlers in Mexico – Argos, Arma and ProcorEmbotelladoras Arca, it was created in 2001.



Seeking opportunities to diversify portfolio • Recent new product launches: • Ciel Aquarius, Minute Maid, Purified Water. • Expansion to West Coast • Increase Advertising • Retailer Loyalty Programs

Second-Largest bottler in Latin America serving 16 million consumers and over 214,000 points-of-sale.

ARCA Distribution Partnership

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10,000 PO S to cater to rural areas by 12/2007

History of Cooperation  W ahaha form ed a Joint Venture in China with Groupe Danone SA in 1996  Invested in advanced production lines and im proved efficiency Danone’s Market Share Growth  Production doubled in just one year  Danone currently owns 51% of W ahaha 30 Years of Presence in Mexico  Entrance in 1976 “1 st Danone Com pany outside Europe ”  Pioneer in Corporate Social Responsibility  Mark et share leader in their industry (41.3% in 2006) Excellence in Execution  Shelf space leader  33.5% share of shelf spaces in leading superm arket chains (including Calim ax )

As there is already a history of successful cooperation between W ahaha and Danone in China, W ahaha can approach Danone in Mex ico and try to replicate their joint venture project. Having spent 30 years operating in Mex ico, Danone will be able to provide W ahaha with a solid foothold in the m ark et as they already have a wide distribution and m anufacturing network . In this way, W ahaha will be able to enter the new m ark et of Mex ico k nowing that they have a reputable and trustworthy partner to back them up.

: Using An Existing Relationship

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Exporting

L o

i

Local Responsiveness H

W ahaha will alter their entry strategy into Mex ico by shipping the soda concentrate to Danone. Danone will bottle and distribute the product. W ahaha will avoid shipping bottled soda because of the low value-to-weight ratio which m ak es it im practical.

L o

International

Global

L o

Political Risk

Wahaha & Danone JV

There are high political and financial risk s to entering the m ark et as a wholly-owned subsidiary. Therefore, to m itigate these risk s, W ahaha will J.V. with Danone.

L o

H i

H i

Global Coordination

After successfully m oving into Mex ico to com pete in the carbonated drink s m ark et, W ahaha can later introduce their other drink s including juices, tea, and sport drink s.

Adaptation & Political Risks Dictate Entry

Econ. Opportunity

H i

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Keith Parker, University of Southern California

Wahaha will target tiers 3 & 4 which includes 65.7 million people

Mexican Population (in millions)

Tier 5

Tier 4

Tier 3

Tier 1 & 2

Rather than competing head-to-head with Coca-Cola and Pepsi, Wahaha will aim for the lower tiers of the market with more price sensitive consumers. This represents a very large percentage of the overall Mexican market. However, our target market also cares about image, which is why Wahaha will use limited advertising to build a brand and differentiate from our key competitor, Big Cola.

Our Target Market

MOR-492: Projects Page 482

Keith Parker, University of Southern California

-

Mass market potential Priced lower than known comparable products Similar to Chinese market GDP per capita higher and median age lower

Target Market - Urban, Suburban, and Rural areas

Successful Marketing Strategy in China - Centralized marketing campaign - High cash investment (USD$60.5 Million) - TV: Brand awareness & recognition - Print Ads: Product functionality & promotions - 1st Chinese company to use celebrities’ endorsements

As Mexico possess a similar demographic to C hina, a similar marketing campaign can be instilled in the new market. The budget will be smaller, adjusted to the difference in population between the two countries. The marketing campaign can “kick-off” during the C opa Americas, which is the most watched television event in Mexico, similar to the rollout of Wahaha’s TV advertisements during the World C up of 2006.

Marketing Strategy Replication

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MOR-492: Projects

Keith Parker, University of Southern California

Wahaha

Manufacture Concentrate

Danone

Bottling

Danone

Distribution

Wahaha

Marketing

Various

Retail

Wahaha will manufacture the syrup concentrate at the factories in China and export it to Danone’s bottling plant. Danone will then bottle and distribute the soda using their pre-existing distribution network. Wahaha will manage marketing efforts with input from Danone’s local management. A combination push and pull marketing will be used to gain shelf space at retail locations. Danone will use its clout and leverage to negotiate with retailers and Wahaha’s creative advertising will create a draw in demand by customers.

Wahaha’s Value Chain

MOR-492: Projects Page 484

Keith Parker, University of Southern California

317.89

149.8 1 77.90 71.911 20.00 3 65.00-. 0 1 9 3 0.00. 09 1 21. 1 1 1. 2 1 9 0. 6 9

Revenue

CO GS

Gross Margin Depreciation (Bottling Plant) SG&A (including m ark eting) 20.00

20.00

152.20

159.91

168.16

Total NPV

$0.34

Big Cola

$0.34

$0.38

Pepsi

Wahaha

$0.53

Coca-cola

Retail Price Per Liter Com parison (USD)

•Retail price: $0.34/liter •Market share: 1% in 2008, 2% in 2009, 3% in 2010 •Market growth (in v olume): 6.1% CAGR •Tax rate: 30% (same as Coca-Cola FEMSA) •Depreciation: $60M bottling plant straight-line depr. ov er 3 y rs •No interest expense (all-equity f irm)

Assumptions:

Year!

101.07

106.68

112.72

141.99

60.85

2ND

62.83

65.13

67.57

78.81

33.78

202.84

20.00

20.00

112.59

242.84

263.08

505.92

1488.0

2010E

152.59

Expected Breakeven in

NPV (12% discount rate)

NPV (10% discount rate)

NPV (8% discount rate)

Net Incom e

Tax es

O perating Incom e (EBIT)

935.0

440.6

165.30

2009E

2008E

Volum e (in m illions of liters)

Pro Forma Income Statement (millions of USD)

Financial Analysis

Page 485

MOR-492: Projects

Keith Parker, University of Southern California

 Worst case scenario, liquidate all remaining assets in Mexico

 Discount remaining inventory until all is sold off

 Sell off the bottling plant to Coca Cola, Pepsi, Big Cola, ARCA, or another company

Possible Exit Strategies

MOR-492: Projects

Keith Parker, University of Southern California

Page 486

CIA – The W orld Factbook – Mex ico, https://www.cia.gov/cia/publications/factbook /index .htm l Coca-Cola FEMSA, S.A.B. de C.V. 2006 Financial Results (Mex ican Stock Ex change tick er KO FL) Dick erson, Marla. “Upstart firm in Peru tak ing fizz out of cola giants: Cok e, Pepsi face unlik ely challenger.” Los Angeles Times. 30 Decem ber 2005. http://www.sfgate.com /cgibin/article.cgi?file=/chronicle/archive/2005/12/30/BUGV3GEUE41.DTL&type=business “Soft Drink s – Mex ico.” Eurom onitor International. August 2006. Hoovers.com Hum an Developm ent Report 2006, Hum an Developm ent Indicators: Country Fact Sheets, http://hdr.undp.org/hdr2006/statistics/countries/country_fact_sheets/cty_fs_MEX.htm l Index of Econom ic Freedom , http://www.heritage.org/research/features/index/country Index Mundi – Mex ico, http://www.index m undi.com / ISI Em erging Mark ets JP Morgan Equity Conference – Mex ico City, August 2006 Mex ico Connect, http://www.m ex connect.com /m ex _/laborlaw.htm l#SALARY Mex ico - Factfile & Statistics, http://www.m ex ico-child-link .org/m ex ico-factile-statistics.htm “Mex ico – Soft Drink s.” Datam onitor Industry Mark et Research. January 2002. W ahaha, http://en.wahaha.com .cn





























References

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Keith Parker, University of Southern California

MOR-492: Projects

AGENDA

COMPANY INFORMATION

Page 488

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

• Company Information

The Wahaha Group

• Country & Industry Analysis

Mexican Expansion

• Entry Strategy • Financial Analysis Presented by

Mark Davenport, C.K. Hsu, Gary Lilardi, Kerry MacDonald, Keith Parker, Whitney Stambler, Nan Wang

COMPANY INFORMATION

AGENDA

ANALYSIS

• Conclusion

FINANCIAL ANALYSIS

ENTRY STRATEGY

CONCLUSION

AGENDA

COMPANY INFORMATION

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

Who is Wahaha?

Company Information

COMPANY INFORMATION

AGENDA

ANALYSIS

FINANCIAL ANALYSIS

ENTRY STRATEGY

CONCLUSION



Private-owned company and biggest beverage producer (15.6% of total production) in China



Found by Mr. Zong Qinghou in 1989



“Wahaha” in Chinese is the sound happy kids make when they are laughing



Non-alcoholic beverages and non-beverage goods



$600M USD in total assets



JV ownership with Danone



Looking for growth opportunities

AGENDA

COMPANY INFORMATION

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

Wahaha’s Business Model Quality

Volume Num be r o f visits And re pe a ting visits

R&D Inno va tio n a nd cre a tivity fo r ne w ta ste s a nd pro ducts

Extra Profits

Advertising Im pro ve bra nd a wa re ne ss a nd use pull m a rk e ting to incre a se W TP

Economies Of scales

Price

Increased Margin

Country & Industry Analysis

Low Unit Cost

Critical Success Factors Advertising

Brand Image

Sales Volume

Distribution

1

Keith Parker, University of Southern California

MOR-492: Projects

Page 489

AGENDA

COMPANY INFORMATION

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

AGENDA

Why, or Why Not, Go to Mexico? •

Why? – Market Size – Market Value – Market Growth



Competitors – Market Concentration – Pepsi and Coca Cola – Recent Anti-competitive practices – Wahaha will compete more directly with more fragmented, smaller competitors

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

Threat of Entry: Low

Market Growth

Why Not? – Aggressive Competitor Campaigns – Government Imposed Tax

COMPANY INFORMATION

ANALYSIS

How Attractive is the Industry?



AGENDA

COMPANY INFORMATION

CONCLUSION

Supplier Power: Medium/ Low

Rivalry: Medium/ High

Buyer Power: Low

Substitutes: High

AGENDA

COMPANY INFORMATION

Wahaha’s Target Market

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

Main Competitor: Big Cola Wahaha will be directly competing with Big Cola in the same target market

Wahaha will target tiers 3 & 4 which includes 65.7 million people

Tiers 1 & 2 Tier 3

•Background Facts –Bottled and marketed by Ajemax, a subsidiary of Peruvian firm Kola Real –Entered Mexican market in 2002 –Presently accounts for 5% of the Mexican drink market

Tier 4

•Target Market –3rd & 4th tier of the pyramid, similar to Wahaha –Sold for $1.13, sometimes as low as 87 cents –Forced PepsiCo to lower prices

Tier 5

•Distribution –Considered a “counter-brand” –Business model based on economics along value chain –Uses freelance vendors who open up new markets for Big Cola

AGENDA

COMPANY INFORMATION

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

AGENDA

COMPANY INFORMATION

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

Wahaha’s Distance Barriers Cultural

Administrative

Geographic

Economic

•Do not favor Asian products •Market dominated products: Coke and Pepsi •Majority of stores are small scale (Mom & Pop) •Different language •Different tastes & preferences

•High corruption and political risk •Weak law enforcement

•Water contamination •Distribution mobility is limited in rural areas

•Ranked 9th most impoverished out of 102 developing countries •17.6% of the population is in extreme poverty •Severe underemployment for much of the population •Consumers are price sensitive

Entry Strategy

Partnership with a company that has been in Mexico for a while can help Wahaha learn and respond as necessary to the differences in the Mexican market.

2

Keith Parker, University of Southern California

MOR-492: Projects

COMPANY INFORMATION

AGENDA

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

AGENDA

Entering Mexico – How?

COMPANY INFORMATION

Page 490

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

Distribution Channels in Mexico Goals for Distribution • • • •

Direct investment Without any Strategic alliances Acquisition of a local Brand

Mexico

Must establish a method to reach the Mom and Pop stores Existing transportation infrastructure can pose challenges to overcome Access to bottling facilities which are geographically disbursed Access to water

Partnership with local bottler/distribution (ARCA) Joint Venture with Existing firms in Mexico (Danone)

COMPANY INFORMATION

AGENDA

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

AGENDA

Distribution Options

COMPANY INFORMATION

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

: Utilizing an Existing Relationship • History of Cooperation

Disadvantages

Advantages

Contracting with ARCA

• Less financial risk •Because have partial ownership of Wahaha, they are more aligned with their core values •Have a previously built relationship with distributors •Share shelf space in stores

•Lack of control over distribution •Partner may not prioritize brand •Must share shelf-space with the big brands. •Their plants are only in the Northern region of Mexico

•May not want to have a JV with Wahaha •Less control over distribution •Limited distribution to the rural areas

COMPANY INFORMATION

AGENDA

– – –

JV Partnership with Danone

•Low-cost •Utilize existing expertise •Relationships with stores already established •Distribution infrastructure will already be in place •Access to water rights is responsibility of partner •Easy exit strategy

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

Wahaha formed a Joint Venture in China with Groupe Danone SA in 1996 Invested in advanced production lines and improved efficiency Production doubled in just one year Danone’s Market Share Growth

• 30 Years of Presence in Mexico –

Market share leader in their industry (41.3% in 2006)

• Excellence in Execution

CONCLUSION



33.5% share of shelf space in leading supermarket chains



10,000 POS to cater to rural areas by 12/2007

AGENDA

COMPANY INFORMATION

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

Adaptation & Political Risks Dictate Entry Hi Global

Econ. Opportunity

Global Coordination

H i

Wahaha & Danone JV

Financial Analysis

International

L o

E

L o

Local Responsiveness H

Manufacture Concentrate

Wahaha

L o

i

Bottling

Danone

Distribution

Danone

Political Risk

L o

Marketing

Wahaha

H i

Retail

Various

3

Keith Parker, University of Southern California

MOR-492: Projects

Page 491

AGENDA

COMPANY INFORMATION

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

AGENDA

COMPANY INFORMATION

FINANCIAL ANALYSIS

ENTRY STRATEGY

ANALYSIS

CONCLUSION

Financial Analysis Capital Investments: $60M bottling plant, $60.5M advertising

Exit Strategies & Conclusion Retail Price Per Liter Comparison (USD) Coca-cola

$0.53

Pepsi

$0.38

Big Cola

$0.34

Wahaha

$0.34

Expected Breakeven in 2ND Year!

AGENDA

COMPANY INFORMATION

ANALYSIS

ENTRY STRATEGY

FINANCIAL ANALYSIS

CONCLUSION

AGENDA

COMPANY INFORMATION

Possible Exit Strategies

FINANCIAL ANALYSIS

ENTRY STRATEGY

ANALYSIS

CONCLUSION

Conclusion

Sell off the bottling plant to Coca Cola, Pepsi, Big Cola, ARCA, or another company

•Enter Mexico •JV with Danone

Discount remaining inventory until all is sold off

•Target tiers 3 & 4 Worst case scenario, liquidate all remaining assets in Mexico

•Start with carbonated products and later add teas, juices, etc.

Insure it, burn it, and move to New Zealand!

AGENDA

COMPANY INFORMATION

FINANCIAL ANALYSIS

ENTRY STRATEGY

ANALYSIS

CONCLUSION

Financial Analysis Pro Forma Income Statement (millions of USD) 2008E

Thank you! Xie Xie Questions?

2009E

2010E

440.6

935.0

1488.0

149.81

317.89

505.92

COGS

77.90

165.30

263.08

Gross Margin

71.91

152.59

242.84

Depreciation (Bottling Plant)

20.00

20.00

20.00

SG&A (including marketing)

65.00

20.00

20.00

-13.09

112.59

202.84

Volume (in millions of liters) Revenue

Operating Income (EBIT) Taxes

Assumptions: •Retail pric e: $0.34/liter •Market share: 1% in 2008, 2% in 2009, 3% in 2010 •Market growth (in volume): 6.1% CAGR •T ax rate: 30% (same as Coc a-Cola FEMSA) •Deprec iation: $60M bottling plant straight-line deprec iation over 3 years •No interest expense (all-equity firm)

0.00

33.78

60.85

Net Income

-13.09

78.81

141.99

NPV (8% discount rate)

-12.12

67.57

112.72

168.16

NPV (10% discount rate)

-11.90

65.13

106.68

159.91

NPV (12% discount rate)

-11.69

62.83

101.07

152.20

Total NPV

Expected Breakeven in 2 ND Year!

Retail Price Per Liter Comparison (USD) Coc a-c ola

$0.53

Pepsi

$0.38

Big Cola

$0.34

Wahaha

$0.34

4

Keith Parker, University of Southern California

MOR-492: Projects

Plantronics, Inc. (NYSE: PLT) Headquarters Address: 345 Encinal St. Santa Cruz, CA 95060 USA Tel: 831-426-5858 Toll Free: 800-544-4660 Fax: 831-426-6098 Web: http://www.plantronics.com

Mexico (dba Plamex, S.A. de C.V.) Address: Avenida Produccion, #12 Parque Industrial Internacional Tijuana Mesa de Otay Tijuana, Baja California 22390, Mexico Tel: +52 664-682-2798 Fax: +52 66-822796

Overview Plantronics, Inc. engages in the design, manufacture, and marketing of lightweight communications headsets, telephone headset systems, and accessories for the business and consumer markets under the Plantronics brand worldwide. It also manufactures and markets computer and home entertainment sound systems, portable audio products, and a line of headsets, headphones, and microphones for personal digital media under Altec Lansing brand. In addition, the company offers specialty telephone products, such as telephones for the hearing impaired, and other related products for people with special communication needs under Clarity brand. Further, Plantronics provides audio enhancement solutions to consumers, audio professionals, and businesses under Volume Logic brand. It distributes its products through a network of distributors, original equipment manufacturers, wireless carriers, retailers, and telephony service providers. (Yahoo Finance, 2007)

Finances (2006) Sales: $750.4M 1 yr sales growth: 34% Net Income: $81.2M

Miscellaneous Founded: 1961 Top competitors: GN Netcom, Logitech, Motorola Total employees: 7,300

People Chairman: Marvin Tseu President, CEO, & Director: S. Kenneth Kannappan SVP, Finance & Administration, CFO: Barbara Scherer SVP, Chief Marketing Officer: Mark Breier SVP, Operations: Terry Walters

Operations in Mexico Plantronics opened Plamex in Tijuana, Mexico, 35 years ago and since then the facility has been recognized worldwide for its commitment to quality and progressive employee programs. Plamex has won nine international manufacturing awards over the past two years, and was recognized twice by Mexico president Vicente Fox Quesada for its technology and quality leadership. Plamex is also the only manufacturing facility in the world to win both the Ibero American Quality Award and Asia-Pacific Quality Award for large manufacturing organizations. PLAMEX's 3,600 associates contribute to Plantronics' worldwide success by manufacturing more than 8,000 different models of headset products.

Keith Parker, University of Southern California

Page 492

MOR-492: Powerpoints

Page 493

COMPETITIVE STRATEGY

Overarching Goal • Above Normal Returns • Strategic Competitiveness • Sustainable/Renewable

A Primer

Sustainable/Renewable Above Normal Returns & Strategic Competitiveness

Profits = Q (R-C) X Time Margin • Aggressive Competition (all 5 forces) • Uncertain turbulent future

Willingness to Pay

R

Price/Revenue

• Premium prices • Branding • Monopoly situations – broken arm • Lifecycle costs of a product • Customer loyalty – Harley Davidson tattoos

Willingness to Buy

Q

Quantity

• Fast food – Size of the ticket • Discount Stores – volume purchasing • Staples are at the back of the store • Impulse buys • ADVERTISING!!!/POINT OF PURCHASE

Cost Minimization

C

Costs

• Scales

• Design

• Scope

• Productivity

• Location

• Capacity Utilization

• Experience

• HR Productivity

1

Keith Parker, University of Southern California

MOR-492: Powerpoints

Business Models: The Core of a Strategy

Sustainability

TIME

• A firm’s choice of relationship among these variables is its business model • Focus and tradeoffs among variables

•Competitive imitation •Substitution •Technological Obsolescence •Organizational Slack

• Two generic business models: • Cost-based • Differentiation-based

Illustration of tradeoffs in Q*Margin Hi

ad

e

in

a He

ve

Market Share-Profitability Relationship: “Porter’s Bucket”

High

n

Low Cost Leadership Strategies

Differentiationbased Strategies

Profitability

Margin

M

Page 494

Stuck-in-the-Middle

Lo Low Low

Lo

Hi

Business Models Quality

R&D

Advertising

Extra Profits

Business Models

Increased Margins

Loyal Consumers

Quality

Volume Price

High

Market Share (Quantity)

Volume

Economies of Scale

Low Unit Cost

R&D

Brand Mktg

Reputation

Investments Uniqueness

Extra Profits

Premium Prices

Increased Margins

2

Keith Parker, University of Southern California

MOR-492: Powerpoints

Page 495

Porter's Generic Strategies

Firm A:

Strategic Target

Strategic Advantage Uniqueness Perceived by the Customer

Industrywide

Particular Segment Only

Firm A has a cost advantage

Price Price

Firm B:

Low Cost Position

Price

OVERALL COST LEADERSHIP

DIFFERENTIATION

Value Chains for Cost Advantage and Differentiation Advantage

Firm C:

Firm C has a differentiation advantage

Price

Firm B:

FOCUS

Total cost to buyer Producer’s cost

Source: Porter (1980)

Producer’s margin

Buyer’s cost

Distribution of Industry Returns Average Return on Equity in US Industries, 1982-1993 90 80 70 Number 60 of 50 Industries 40

16.5%

11.7%

Sources of Above Normal Return

100

13.8%

Great Industries

First Quartile Average 22.2%

Fourth Quartile Average 9.3%

Average = 14.7% Median = 13.8%

30 20

Great Strategies

10 0 32%

28%

30%

26%

22%

24%

20%

16%

18%

14%

10%

12%

8%

6%

2%

4%

Return on Equity (Percent) Source: Jan W. Rivkin’s Analysis Based on Dun and Bradstreet Data

Profitability Differences Across Selected Industries

Note:

Return on Equity = Net Inc ome / Year End Shareholders’ Equity; Analysis based on sample of 593 industries

Superior Profitability

Pharmaceuticals

GATEWAY HP LENOVO???

Prepackaged software Semiconductors Women's clothing stores Dental equipment Eating places Drug stores Petroleum / natural gas Race track operations

WHY?

Trucking except local Engineering services Computer system design Cable TV service

COMMODORE WANG

DELL

Motor vehicles Scheduled airlines Source: Jan W. Rivkin based on Compustat

0

5

10

15

20

25

Operating Income / Assets, 1988-95 (%)

3

Keith Parker, University of Southern California

MOR-492: Powerpoints

Porter’s Five Forces Analysis

Determinants of Superior Performance

Threat of New Entry

• Profits earned are determined by: • Willingness-to-Pay: the value of the product/service to customers • Intensity of Competition • the relative Bargaining Power at different levels in the production chain

Bargaining Power of Suppliers • Differentiation of inputs • Switching costs • Presence of substitute inputs • Supplier concentration • Importance of volume to supplier • Cost relative to total purchases • Impact of inputs on cost or differentiation • Threat of forward integration

• Sources of profits above competitive level are determined by: • Industry attractiveness • Strategic group attractiveness • Competitive position attractiveness

SUPPLIER POWER LOW

THREAT OF ENTRY LOW •economies of scale •capital requirements for R&D and clinical trials •product differentiation •control of distribution channels •patent protection

INDUSTRY COMPETITIVENESS LOW •high concentration •product differentiation •patent protection •steady demand growth •no cyclical fluctuations of demand

•entrants have cost advantages •low capital requirements •little product differentiation •deregulation of governmental barriers

LOW No substitutes. (Changing as managed care encourages generics.)

• Industry growth • Fixed costs / value added • Overcapacity • Product differences • Brand identity

• • • • • •

Switching costs Concentration and balance Informational complexity Diversity of competitors Corporate stakes Exit barriers

• • • • • •

Threat of Substitutes

Buyer concentration Buyer volume Buyer switching costs Buyer information Ability to integrate backward Substitute products Price / total purchases Product differences Brand identity Impact of quality / performance Buyer profits

INDUSTRY COMPETITIVENESS HIGH •many companies •little product differentiation •excess capacity •high fixed/variable costs •cyclical fluctuations of demand

Airline Industry (ROE=-1%) THREAT OF SUBSTITUTES MEDIUM •autos for short distance travel

BUYER POWER MEDIUM/HIGH Buyers extremely price sensitive Good access to information Low switching costs 30

31

Issues with the Five-Forces Framework • Industry definition

Method for Neutralizing Force Erecting barriers (isolating mechanisms) create exploit economies of scale,

• Completeness (e.g., import competition)

aggressive deterrence, design in switching costs, etc

• Symmetry (e.g., buyer substitution vs. supplier substitution, complements)

Compete on nonprice dimensions: Improve attractiveness compared to substitutes: better service, more features, etc Reduce buyer uniqueness: forward integrate, differentiate product, new customers, etc

Suppliers

Bargaining Power of Customers • • • • •

Rivalry Among Existing Competitors

•strong labor unions •concentrated aircraft makers

THREAT OF ENTRY HIGH THREAT OF SUBSTITUTES

cost leadership, differentiation, cooperation, etc

Buyers

Capital requirements Access to distribution Absolute cost advantages Government policy Expected retaliation

SUPPLIER POWER HIGH

DRUG INDUSTRY (ROE=28%)

Neutralizing the Five Competitive Forces

Substitutes

• • • • •

Source: Michael E. Porter, Competitive Advantage (New York: Free Press, 1985)

BUYER POWER LOW

Rivalry

• Economies of scale • Proprietary product differences • Brand identity • Switching costs

• Relative price performance of substitutes • Switching costs • Buyer propensity to substitute

Physician as buyer: Not price sensitive No bargaining power. (Changing with managed care.)

Force Entry

Page 496

Reduce supplier uniqueness: backward integrate, obtain minority position, second source, etc

• Consistency (e.g., import strategic variety) • Duplication (e.g., switching costs)

• The role of informational conditions • The need for macroenvironmental analysis • Long-run focus vs. change • shocks • cycles • trends

• Product rather than resource focus

4

Keith Parker, University of Southern California

MOR-492: Powerpoints

Page 497

Coopetition and the Value Net A player is your competitor with respect to customers if customers value your product less when they have the other player’s product as well

Firm

Competitors A player is your competitor with respect to suppliers if it is less attractive for a supplier to provide resources to you when it is also supplying the other player

A player is your complementor with respect to customers if customers value your product more when they have the other player’s product as well

Customers

Suppliers

Complementors A player is your complementor with respect to suppliers if it is more attractive for a supplier to provide resources to you when it is also supplying the other player



Inventions & Discoveries



Technology



Laws, Tax Policy, Regulations

Uncertainty & Market Ignorance

Global Supply & Demand Conditions



• Shocks and Trends • TINAs

• Endogenous Changes • New innovations • New business models • New Supply chains

External “Triggers”

Shocks and Trends



• Exogenous Changes

• Etc.

Source: Adam Brandenburger and Barry Nalebuff, Co-operation (New York: Currency Doubleday, 1996)

Consumer Tastes

Continually Changing Industry Conditions

Relative Prices of Inputs

• “Triggering” shifts, shocks and trends, even in adjacent markets, may create uncertainties that allow/force firms to change their strategies • Shocks and Trends • changes in consumer tastes • changes in technology • changes in relative prices of inputs • changes in laws, regulations, and tax policy • inventions and discoveries • changes in global supply and demand conditions • Uncertainty and market ignorance create/produce the opportunity for firms to reformulate their strategies

Aggregating Demand in New Ways

Examples of Intelligent and Threatening

Competitors

5

Keith Parker, University of Southern California

MOR-492: Powerpoints

New Product Concept & New Business Model

Page 498

New Types of Arbritage Narayana Hrudayalaya Heart Hospital, India

Closing the “Global Distance”

New Strategic Groups

New Customer Segments

Complementary Products/Services

6

Keith Parker, University of Southern California

MOR-492: Powerpoints

Page 499

Strategic Map of the United States Airline Industry The Late 1970s International

Companies may take different approaches to competing in the same industry

Eastern United Delta

National

American

Continental Western

Republic Ozark

USAir Southwest

Full Service

Quality of Service

Strategic Map of the United States Airline Industry The Mid 1980s

X

International

Pan Am

T WA

United

X

North west

Delta American

National

Continental Western

Eastern Delta

National

Continental Republi c

Republic Ozark

USAir USAir

Southwest

Piedmont

Regional

No Frills

Regional

PSA

Full Service

Quality of Service

Strategic Map of the United States Airline Industry

AirCa l PSA

New Entrants

No Frills

Full Service

Quality of Service

Strategic Map of the United States Airline Industry

The Late 1980s

The Early 1990s

International

International American North west

T WA

National

Delta

Continental

USAir

Southwest

United

T WA

National

Kiwi MGM Gran d

No Frills

Quality of Service

Full Service

Regional

Delta

Continental

USAir

Southwest

Americ a West

Regional

American North west

Geographic Scope

United

Geographic Scope

Ozark

Piedmon t

Frontie r

AirCal

Frontier

New Entrants

North west

American

T WA

Geographic Scope

Eastern United

Southwest

AirCal

PSA

T exas Int’l

The Early 1980s

Geographic Scope

Piedmont

Frontier

No Frills

International

North west

Braniff

Regional

Strategic Map of the United States Airline Industry

Pan Am

T WA

World

Geographic Scope

Strategic Group Analysis

Laker

Reno

Mobility Barriers Americ a West

X

Others

No Frills

Quality of

Full ServiceService

7

Keith Parker, University of Southern California

MOR-492: Powerpoints

Page 500

Finding New Profit Pools within Industries Profits earned in different parts of the industry production chain can change over time

Operating Margin

The U.S. Auto Industry’s Profit Pool

0%

100%

Share of Industry Revenue Source: Gadiesh & Gilbert, 1998

Competitive Advantages

Great Strategies

Protected Competitive Positions Valuable Resources & Capabilities

Sources of Competitive Advantage Competitive Advantages (Sources of Rates of Profit in Excess of the Competitive Level)

Avoid Competitors (Position)

Get in first, Keep others out

A Three-Dimensional Business Landscape: Great Positions!!!

Be Better Than Competition (Capability)

Better, Faster, Cheaper

Sustainability of Superior Performance Based on Impediments to Imitation Attractive Industry protected by Entry Barriers

AND/OR Attractive Strategic Groups (within Industry) protected by Mobility Barriers

AND/OR Attractive Competitive Positions (within Strategic Group) protected by Isolating Mechanisms

8

Keith Parker, University of Southern California

MOR-492: Powerpoints

Page 501

Isolating Mechanisms • • • • • • • •

Information Impactedness Response Lags Economies of Scale and Scope Producer Learning Buyer Switching Costs Reputation Buyer Evaluation Costs Advertising and Channel Crowding

COMPETENCIES & CAPABILITIES: Outperforming Competitors Building and Renewing Distinctive Competencies & Organizational Capabilities

Sourc e: Ric hard Rumelt, 1987

Building Cost and Differentiation Strategies Differentiation Cost Reduction Total Quality Management Just-In-Time Time Management Geographic Location Business Re-engineering

• Cheaper • Better • Faster

Mass Customization

etc.

• Integration

• Economies of scope

• Policies

• Learning • Pattern of capacity utilization

• Timing • Location • Institutional factors

• Interrelationships Source: Michael E. Porter, Competitive Advantage (New York: Free Press, 1985)

The Nature of Differentiation “Differentiation means providing something unique that is valuable to the buyer beyond simply offering a low price.” (M. Porter) THE KEY IS CREATING VALUE FOR THE CUSTOMER

Observable product characteristics: • size, color, materials, etc. • performance • packaging • complementary services

• Economies of scale

• Linkages

etc.

TANGIBLE DIFFERENTIATION

Cost Drivers

INTANGIBLE DIFFERENTIATION Unobservable and subjective characteristics relating to image status, exclusively, identity.

The Sources of Differentiation Advantage • Observable Goods: – Buyer Learning – Buyer Switching Costs – Advertising Economies • Experience Goods: – Reputation – Credibility • Communication Goods: – Relative Base

TOTAL CUSTOMER RESPONSIVENESS: Differentiation not just about the product, it embraces the whole relationship between the supplier and the customer.

9

Keith Parker, University of Southern California

MOR-492: Powerpoints

The Value Chain as a Framework for Creating Competitive Advantages

The Porter Value Chain Firm Infrastructure Human Resource Management Technology Development

The McKinsey Business System

Procurement

Inbound Logistics TECHNOLOGY

PRODUCT DESIGN

MANUFACTURING

MARKETING

Page 502

DISTRIBUTION

Operations

Marketing & Sales

Outbound Logistics

Service

SERVICE

Marketing Management

Adv ertising

Source: Michael E. Porter,

Using The Value Chain To Analyze Costs Value Chain

Cost Analysis

Cost Advantage

• Identify activities

• Assign costs, assets

• Cost position of competitors

• Identify cost drivers

• Control drivers

Sales Sales Force Force Administration Operations

Competitive Advantage,

Technical Literature

Promotion

1985.

Stages In Value Chain Analysis • Disaggregate firm into separate activities • Establish relative importance of activities • Identify cost drivers

• Competitive scope

• Identify linkages • Examine scope for reducing costs

• Change chain

Source: Susan Polk, 1991

Be Better Than Competitors (1)

Southwest Airlines’ Activity System

In individual elements of value chain

Limited passenger amenities

No seat assignments

(2)

Frequent, reliable departures

In coordinating elements of value chain

High compensation of employees

(3)

No baggage transfers

No meals

15-minute gate turnarounds

Lean, highly productive ground and gate crews

Limited use of travel agents

Automatic ticketing machines

No connections with other airlines

Standardized fleet of 737 aircraft

Short-haul, point-to-point routes between midsize cities and secondary airports

Very low ticket prices

In selecting elements of value chain (make vs. buy)

X

X

Flexible union contracts

High level of employee stock ownership

High aircraft utilization

“Southwest, the low-fare airline”

Source: Michael E. Porter “What is Strategy” Harvard Business Review, Nov-Dec 1966

10

Keith Parker, University of Southern California

MOR-492: Powerpoints

Page 503

Reversion to the Mean

Four Threats to Sustainability Imitation

40

ROI%

30

Substitution Added Value

20

Appropriated Value

10

0

1

2

3

4

5

6

7

8

9

Slack

10

Holdup

Year Source: Pankaj Ghemawat, Commitment (New York: The Free Press, 1991)

Responding to the Threats to Sustainability Responses to Substitution

Responses to Imitation Building Barriers • Economies of scale and scope • Learning/private information • Contracts and relationships • Network externalities • Threats of retaliation • Time lags • Strategic complexity • Upgrading

Responses to Slack • Gathering information • Monitoring behavior • Offering performance incentives • Shaping norms • Bonding resources • Changing governance • Mobilizing for change

Added Value Appropriated Value

• Not responding • Fighting • Switching • Recombining • Straddling • Harvesting

Strategic Renewal

Responses to Holdup • Contracting • Integrating • Building bargaining power • Bargaining hard • Reducing assetspecificity • Building relationships • Developing trust

The Strategic Task

The Strategic Task Keep developing new sources of competitive advantage!

EXTENT OF ADVANTAGE

EXTENT OF ADVANTAGE HIGH

HIGH

LOW

LOW

TIME

TIME Sourc e: Marvin Lieberman, 1997

Sourc e: Marvin Lieberman, 1997

11

Keith Parker, University of Southern California

MOR-492: Powerpoints

Page 504

The Hexagon of Competitive Advantage: Potential Sources for Creating Advantages

Customer / Market Scale / Scope

Competitive Advantage

Competitor / Partner Interaction

Product / Service

Business System / Value Chain Assets / Resources

Sourc e: George Yip, 1997

12

Keith Parker, University of Southern California

MOR-492: Powerpoints

Voigt, Spring 2007

Marshall School of Business Page 505 Department of Management and Organization

Country Analysis Framework

Session Agenda

Country Analysis

 Analyzing

the “Meet” Dimension  Country Analysis  Institutional Differences & “Voids” Analysis  Getting to Know the Data Workshop

Analyzing the Attractiveness of Regions, Economies, Industrial Sectors, and Markets for Global Business

GSBA 582: GLOBE

MOR 492: Global Strategy

Meet Question?

Country Analysis Framework

Meet question?

Analyzing the Global Market: Regional Analysis



Global Economics of Region



Macroeconomic Policies



Country Analysis Industrial Sector Competitiveness Analysis

 

Industry Analysis Market Potential Analysis



Profitability Analysis

Competitor Analysis MOR 492: Global Strategy

3

Meet Question?

Country Analysis Framework

Country Analysis

What will the firm meet?

Feasibility Analysis

Country Analysis Framework

ASEAN, NAFTA, APEC, etc. Political Agenda Fiscal & Monetary Policies Policies toward foreign investments & control

Political Risk Analysis  Institutional Voids Analysis 

MOR 492: Global Strategy

Meet Question?

Diamond of Global Competitiveness Chance

2

4

Country Analysis Framework

Examining Relevant “Distances”

Firm Strategy, Structure, and Rivalry

 CAGE

Framework (Ghemawat)

Cultural Distance  Administrative Distance  Geographic Distance  Economic Distance • Global strategy must exploit/mitigate relative “distance” between the firm and the global market • CAGE can be applied at the Country level, industrial sector, industry, and firm level 

Factor Conditions

Demand Conditions

Related and Supporting Industries

Government

Source: Porter (1990)

MOR 492: Global Strategy

GSBA 582: GLOBE

5

MOR 492: Global Strategy

6

Keith Parker, University of Southern California

1

MOR-492: Powerpoints

Marshall School of Business

Department of Management and Organization

Country Analysis Framework

Country Analysis Framework

Country Analysis Framework

Business “Context” Business Strategy & Operations “Soft” Infrastructure “Hard” Infrastructure

Comparing and Contrasting Opportunities and Differences

Professions, Debt & Equity Credentialing Markets, Search Firms Venture Capital Schools, Banks & Financial Physical & Roads, Rail Property Universities, Institutions, & Ports Rights Security Training Regulators

Logistics Intermediaries

Country Factor Endowments

Land

Labor

Capital Markets

Spec ialized Consultants Ac c ountants & Legal System

Functioning Independent Legal System

Political & Social Systems

MOR 492: Global Strategy

7

MOR 492: Global Strategy

Country Analysis Framework



 

Country Effects Matter

Countries continue to achieve remarkably different rates of economic growth Countries differ in size, geographic location, resource endowments, historical experiences, cultures and income levels, and these difference are important for global strategy decisions The profit performance of similar industries differs widely from one country to another “Country effects” matter

MOR 492: Global Strategy

 

    9

Nation States make the “rules” by which businesses must abide Country “Institutions” (courts, laws, capital markets, law & order enforcement, unions, governments, etc) create the context for business and markets Countries “do” compete with each other for resources Countries do have “strategies” too Governments do play an active role Country borders (degree of openness) do matter

MOR 492: Global Strategy

Country Analysis Framework

Country Borders Matter countries, economic forces work efficiently to bring convergence  Across countries, global economic forces are impeded by barriers to trade, capital flows and immigration and convergence is mitigated

GSBA 582: GLOBE

10

Country Analysis Framework

Foreign Direct Investment Distribution

 Within

MOR 492: Global Strategy

8

Country Analysis Framework

Why Country Analysis? 

Voigt, Spring Page 2007 506



Theory suggests that capital should flow to where the arbitrage opportunities are greatest 



11

However, low wages may be offset by institutional voids which raise overall costs

In reality, most FDI is between “rich” countries, and a select group of emerging economies (e.g. China, Brazil, Mexico, Singapore, Indonesia, Malaysia, Saudi Arabia, Argentina)

MOR 492: Global Strategy

12

Keith Parker, University of Southern California

2

MOR-492: Powerpoints

Voigt, Spring 2007

Marshall School of Business Page 507 Department of Management and Organization

Country Analysis Framework

Country Analysis Framework

Institutional Voids 



Country Analysis Framework

Institutional voids are the absence of intermediaries between buyers and sellers Examples: Venture Capital Firms Private Equity Providers Finance

 Identification

Strategy Context  Performance  

Mutual Funds Banks Auditors

Management Talent

Business Schools Certification Agencies Headhunting Firms Relocation Services

Products

Certification Agencies Consumer Reports Regulatory Authorities Extra-judicial dispute resolution

MOR 492: Global Strategy

Context

 Prediction

13

MOR 492: Global Strategy

14

Country Analysis Framework

Performance 

        



Strategy

Formal economy, grey market, black market Economic Performance Measures 



Vision – guiding motivating values 

Output Prices Employment Savings Investment Productivity Wages increases Unit labor costs Utilization of capital Distribution of income

Community solidarity vs. individual achievement

Goals  Policies – policy mix  Foreign/Defense Policies  Fiscal Policy 



Spending priorities, types of taxes, balanced/ deficit/ surplus budgets

Net inflows vs outflows of capital, labor, etc.

MOR 492: Global Strategy

15

MOR 492: Global Strategy

16

Country Analysis Framework

Country Analysis Framework

Strategy (continued)  

Context

Monetary Policy Income Policies 



Performance

 Evaluation

Country Analysis Framework



Strategy





Redistribution of incomes



Foreign Trade and Investment Policies 



Import vs. Export Orientation



Education, Population, Health Care, Religion

MOR 492: Global Strategy

GSBA 582: GLOBE

17

Trading Blocs Historical ties

Domestic Context 

Industrial Policy  Social Policies 



International Context

Political – strong or weak governments, ability to bring about reform Institutional Context – Government, legal, financial, agricultural, transportation, energy, infrastructure. Other institutions like union, religions

MOR 492: Global Strategy

18

Keith Parker, University of Southern California

3

MOR-492: Powerpoints

Voigt, Spring Page 2007 508

Marshall School of Business

Department of Management and Organization

Country Analysis Framework

Country Analysis Framework

Context (Continued)  Ideological

Context (Continued)

Context

 Resources

– The equipment and recruiting system

Rights vs. Obligations  Individual vs. Group (minority rights protection) 

 International 



Human capital, physical capital, natural resource wealth, and technological skills

 The

Context

GATT, WTO, IMF



MOR 492: Global Strategy

19

Players in the Game

Firms, government actors, and nongovernment organizations

MOR 492: Global Strategy

20

Country Analysis Framework

Country Analysis Framework FRAMEWORK FOR COUNTRY ANALYSIS

Context (Continued) 

The Rules of the Game  





Performance

National Resources

Economic

Higher per-capita income lev el and growth, equality of income, stability , autonomy , def ense, etc.

Labor, capital, natural resources, technology , geography

GNP

Policies

Players in the Games

Prices

Fiscal & monetary policies

Firms

Inf lation

Exchange rate policies

Gov ernment actors

Unemploy ment

Trade and inv estment policies

Non-state organizations:

Laws, property-rights

Sectoral policies

Constitutional ref orm

Business practices which come for culture heritage



Rules define what is possible and what is not

Fertility , mortality , literacy , etc.

economic (e.g. property rights, contract law), political ( e.g. federal system, separation of powers), treaties

Political

Inf ormal rules

Political stability , political f reedom, etc.

- conventions, culture, religious beliefs, ideology

Role of multinational corporations International organizations like IMF, World Bank, WTO

MOR 492: Global Strategy

Social Income distribution

Rules of the Game Formal rules

International Dimension 

Unions, employer associations, religious groups, political parties, etc.

Industrial policies

Informal 

Context

Goals

National income accounts

Written and unwritten rules of conduct Formal 



Strategy

International

21

MOR 492: Global Strategy

International

Balance of pay ments

Location

Exchange rates

International Organizations

Tarif f s, quotas

Treaties on Trade and Inv estment, International Monetary Sy stem

22

Country Analysis Framework

Framework for Analyzing the “Fitness” of Emerging Markets

Institutional Voids Analysis 

Examining the Institutional Context for Business in New and Emerging Markets

The creation or replication of a global business strategy in a new market presupposes the existence of supporting “infrastructure” and complementary “institutions” 



Firms have three choices:   

GSBA 582: GLOBE

GSBA 582: GLOBE

Physical infrastructure, specialized intermediaries, legal support, contract-enforcing mechanisms, dispute mediation, regulatory systems, etc. Adapt to local “institutional voids” and market conditions Change the local markets and “fix” the institutional voids Stay out of the market altogether

MOR 492: Global Strategy

24

Keith Parker, University of Southern California

4

MOR-492: Powerpoints

Marshall School of Business Page 509 Department of Management and Organization

Country Analysis Framework

Country Analysis Framework

Spotting Institutional Voids: Hard Infrastructure

Business “Context” 

Political and Social System 

Business Strategy & Operations





“Hard” Infrastructure

Professions, Debt & Equity Credentialing Markets, Search Firms Venture Capital Schools, Banks & Financial Physical & Roads, Rail Property Universities, Institutions, & Ports Rights Security Training Regulators

Logistics Intermediaries

Country Factor Endowments

Land

Capital Markets

Labor



Spec ialized Consultants Ac c ountants & Legal System



Quality of ports, roads, rail Energy, water, housing stock, etc.

Personal and Property Protection 

Functioning Independent Legal System

Role of government in supporting/controlling business/market activities Transparency in regulatory environment

Physical Infrastructure 

“Soft” Infrastructure

 

Personal safety – atmosphere of security, law & order Health care Legal protection of personal property, intellectual property, etc.

Political & Social Systems

MOR 492: Global Strategy

25

MOR 492: Global Strategy

Country Analysis Framework

Spotting Institutional Voids: “Soft” Infrastructure

Openness      



Role of media, non-government institutions, churches, social groups, etc. Restrictions on foreign investment, repatriation of profits, etc. Restrictions on foreign intermediaries (e.g. auditing firms, ad agencies, consulting firms, banks, insurance, etc. Free trade agreements (WTO compliant, FTAs, RTAs) Freedoms on business activities – restrictions on where and in what sectors foreign businesses are allowed to invest Freedom of foreigners and locals to travel within, and into and out of country

Product Markets      





27

Existence of reliable data on consumer behavior Access to quality raw materials, local manufacturing of components Quality of retail sector Consumer credit (credit cards, cheques, etc.) Regulation of quality standards, product content, etc. Environment and safety standards

Supply Chain Intermediaries 

MOR 492: Global Strategy

Logistics and transportation specialists Distribution channels, wholesale markets, warehousing

MOR 492: Global Strategy

Country Analysis Framework

Spotting Institutional Voids: “Soft” Infrastructure 

Labor Markets 

Quality of basic and specialized education  

     



Prevalence of “English” (Int’l language of Business) Free movement of employees Compensation practices (merit pay, seniority based, stock options) Enforcement of labor contracts Workers’ rights, Unions Regulations on layoffs, etc.

GSBA 582: GLOBE

Capital Markets 

Technical and professional training Accreditation of education

MOR 492: Global Strategy

28

Country Analysis Framework

Spotting Institutional Voids: “Soft” Infrastructure 

26

Country Analysis Framework

Spotting Institutional Voids: Hard Infrastructure 

Voigt, Spring 2007

   

29

Prevalence and effectiveness of banks, insurance companies, savings & loan institutions Access to banking for consumers, businesses Transparency in Banking practices Debt & equity raising, venture capital Standards of financial reporting, protection for stockholders, bankruptcy laws/protections Market for acquisitions/takeovers

MOR 492: Global Strategy

30

Keith Parker, University of Southern California

5

MOR-492: Powerpoints

Marshall School of Business

Department of Management and Organization

Page 510 Mayer & Voigt, Term IV, 2001

Geographic Scope

Geographic Scope

Geographic Scope of Competition

Geographic Scope of Competition and Strategy



Effective geographic scope of competition     

MOR 492 Global Strategy

1



Local Regional National International global

Geographic Scope is influenced by:   

Economics Politics Corporate Strategy

MOR 492 Global Strategy

2

Geographic Scope

Geographic Scope

Drivers of Change in Scope

Geographic Scope of Competition  Geographic

scope of competition tends to expand with:





Increases in economies of scale, scope, and learning  Reductions in logistical constraints  Reductions in the distinctiveness of local markets – differences in consumers tastes  Reductions in barriers to competition





MOR 492 Global Strategy

Exogeneous drivers



Endogeneous drivers:  



3

Changes in government policies Reductions in trade barriers New technologies Adoption of strategies requiring large fixed investments Decisions to enter new markets

MOR 492 Global Strategy

4

Geographic Scope

Geographic Scope

Geographic Scope of Strategy  Firms

Geographic Scope Choices

choose:



Overall geographic scope of firm’s strategy  The markets to compete in  The location of important activities  The organization and coordination of these activities 

Geographicallyfocused    



MOR 492 Global Strategy

GSBA 515 GLOBAL STRATEGY

5

Serving local markets Distinct products/services Localized marketing Satisfying local regulatory requirements Local distribution

MOR 492 Global Strategy



Advantage  



Strong local responsiveness Strong differentiated market position

Dangers 

Scale, scope and learning advantages of global competitors may overtake local advantages

6

Keith Parker, University of Southern California

1

MOR-492: Powerpoints

Marshall School of Business Page 511 Department of Management and Organization

Mayer & Voigt, Term IV, 2001

Geographic Scope

Geographic Scope

Configuration and Coordination of Firm Activities

Geographic Scope Choices 

Global Strategy 

  



Serving universal needs across borders Same product everywhere Global customers Global product varieties – slightly modified for local markets requirements Global marketing approach



Advantage 







Exploit scale, scope, and learning economies Capture global low-cost leadership position

  

Dangers 

Location of firm activities are influenced by:



Inability to compete with locally responsive differentiated firms

MOR 492 Global Strategy





7

Market conditions Regulatory barriers Tax regimes Wages rates Locations of specific pockets of expertise

Firms can choose to locate activities in single or disperse locations

MOR 492 Global Strategy

Geographic Scope

Geographic Scope

Configuration and Coordination of Firm Activities 



 The

scope of competition may expand globally as firms match/mirror the moves of rivals  Firms feel compelled to match the rivals to avoid cross-subsidization

Tight coordination 

Important decisions centrally managed from home nation

Loose coordination 



Competitive Interaction and Multi-market Competition

Two extremes 

Important decisions decentralized to many nations

The appropriate form of coordination will depend on the relative importance of pressures for global coordination and pressures for local responsiveness

MOR 492 Global Strategy

GSBA 515 GLOBAL STRATEGY

8

9

MOR 492 Global Strategy

10

Keith Parker, University of Southern California

2

MOR-492: Powerpoints

Marshall School of Business

Department of Management and Organization

Strategic Alliances

Voigt, Fall, Page 2000512

Strategic Alliances

THE COLLABORATIVE CHALLENGE:

STRATEGIC ALLIANCES

JOINT VENTURES AND STRATEGIC ALLIANCES

STRATEGIC CHALLENGE  Pre 1980s  Protect

profits from erosion through competition/bargaining

“Companies are just beginning to learn what nations have always known -- in a complex, uncertain world filled with dangerous opponents, it is best not to go it alone.”



 Pursue

multiple sources of competitive advantage reliance on competition and collaboration [Coopetition]

 Simultaneous

Kenichi Ohmae, McKinsey - Japan MOR 492 Global Strategy

1980s and 1990s

1

MOR 492 Global Strategy

2

Strategic Alliances

STRATEGIC ALLIANCES

Strategic Alliances

TYPES OF STRATEGIC ALLIANCES

QUESTIONS

 JOINT

entity jointly owned by two or more firms Shared or 50-50 ventures Dominant ventures

 What

types of arrangements are most appropriate?

 What

can we learn from the experience of others?

 INFORMAL  Cooperation

 How

do we successfully manage these alliances?

MOR 492 Global Strategy

VENTURES

 New

without any formal contractual

obligations 3

MOR 492 Global Strategy

4

Strategic Alliances

TYPES OF STRATEGIC ALLIANCES

STRATEGIC ALLIANCES Foreign company offers Know -how: Technology; concept

Local company offers

Know how

Access to business system

 MINORITY

Access to business system: Customers; distribution; manufacturing

Joint development

Traditional Joint Venture

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

Strategic Alliances

INVESTMENTS

 Firm

buys stock in another  Often access to resources for capital  Stronger mutual commitment

Alliances offering access to markets in return for technology

 TWO-WAY

INVESTMENTS

 Reciprocal

Exchange of access

 Less

5

equity stakes/cross-ownership concern about dominance

MOR 492 Global Strategy

6

Keith Parker, University of Southern California

1

MOR-492: Powerpoints

Marshall School of Business Page 513 Department of Management and Organization

Strategic Alliances

Strategic Alliances

WHY STRATEGIC ALLIANCES?

WHY STRATEGIC ALLIANCES?

TRADITIONAL REASONS  Sharing of resources and risks  Host government requirements  Overcoming strong nationalistic sentiments  Quicker entry  Benefit from partner’s local knowledge

EMERGING REASONS 

Learning from one another



Attain global scale economies  

7

Raw material/ Component supply Marketing and distribution



Rising R&D costs and technological interdependence



Industry convergence



MOR 492 Global Strategy

Voigt, Fall, 2000

Short product life cycles

MOR 492 Global Strategy

8

Strategic Alliances

Strategic Alliances

STRATEGIC ALLIANCES –

WHY STRATEGIC ALLIANCES?

POTENTIAL RISKS

Industry Globalization and Global Competition  Improved  Stronger

product line

 Superior

timing

 Shaping

competitive rivalry

 Keeping

key competitors at bay

 Reduced

 Partner

market access

opportunism and loss of competitive

edge  Strategic  Conflict

and organizational complexity

of interest problems

 Decreasing

partner commitment

transaction and other costs

MOR 492 Global Strategy

9

MOR 492 Global Strategy

Strategic Alliances

10

Strategic Alliances

MAKING STRATEGIC ALLIANCES WORK

MAKING STRATEGIC ALLIANCES WORK

ASSESSING NEED  Do you need a partner? How big is the payoff?  How likely is success? PARTNER SELECTION  Does the partner share your goals and objectives?  Does strategic synergy exist?  Is the partner compatible?

DEFINING GOALS AND OBJECTIVES  Clarify and resolve separate interests  Develop mutual trust and understanding DESIGNING AN ALLIANCE  Define role of each partner  Define venture boundaries  Identifying champion(s)  Trust versus legal considerations  Allow for termination

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

11

MOR 492 Global Strategy

12

Keith Parker, University of Southern California

2

MOR-492: Powerpoints

Marshall School of Business

Department of Management and Organization

Strategic Alliances

MAKING STRATEGIC ALLIANCES WORK

Strategic Alliances

MAKING STRATEGIC ALLIANCES WORK MANAGING THE ALLIANCE

MANAGING THE ALLIANCE 

Achieving operating momentum



Managing cultural differences



Recognize alliance needs



Flexibility



Assuring continued commitments



Increasing willingness to learn



Avoiding bottleneck dependence





Policies



Resources (inc. human resources)

Voigt, Fall, Page 2000514

Overcoming reluctance to give up autonomy

MOR 492 Global Strategy

13

MOR 492 Global Strategy

14

Strategic Alliances

STRUCTURING ALLIANCES TO REDUCE OPPORTUNISM Walling off Critical technology

Probability of Opportunism by Alliance Partner Reduced By

Establishing contractual safeguards Agreeing to swap valuable skills and technologies Seeking credible commitments

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

15

Keith Parker, University of Southern California

3

MOR-492: Powerpoints

Voigt, Fall, 2000

Marshall School of Business Page 515 Department of Management and Organization

Generic Global Strategies

Generic Global Strategies

Generic Global Strategies

FOUR BASIC STRATEGIES

strategy strategy  Choice -- Global versus Multidomestic  Transition -- Multidomestic to Global  Transnational strategy

GLOBAL

TRANSNATIONAL

INTERNATIONAL

MULTIDOMESTIC

 Multidomestic  Global

MOR 492 Global Strategy

Efficiency benefits from global integration

1

MOR 492 Global Strategy

Benefits from national responsiveness

Generic Global Strategies

Generic Global Strategies

Location and Coordination Issues LOCATION Production facilities



Product line, market selection



Location of service organization



Number and location of R&D centers



PRESSURES: NATIONAL RESPONSIVENESS

COORDINATION



Location of purchasing function



Networking of international plants



Commonality of brand name, similarity of channels etc.



Similarity of service standards



Coordination of pricing



Coordination of suppliers

MOR 492 Global Strategy

 Differences

in consumer preferences

 Infra-structural  Government  New

demands

manufacturing technology

 Organizational  Managerial 3

differences

limitations

resistance

MOR 492 Global Strategy

4

Generic Global Strategies

MULTIDOMESTIC STRATEGY  Customized

2

Generic Global Strategies

MULTIDOMESTIC STRATEGY

product

Unit 1

 Countries

-- selected on their standalone potential

 Units

independent

 Low

coordination; high dispersion

 Few

inter-subsidiary transfers

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

HQ Unit 2

5

MOR 492 Global Strategy

Unit 3

6

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Marshall School of Business

Department of Management and Organization

Generic Global Strategies

MULTIDOMESTIC STRATEGY

Generic Global Strategies

INDUSTRY GLOBALIZATION POTENTIAL MARKET DRIVERS

Competitive advantage from  Local

responsiveness

COST DRIVERS

 Goodwill

-- local government, customers

COMPETITIVE DRIVERS Industry Globalization Potential

 Lower

costs -- avoiding shipping costs and tariffs

response to local market situations MOR 492 Global Strategy

GOVERNMENT DRIVERS

 Quick

7

MOR 492 Global Strategy

8

Generic Global Strategies

PRESSURES: GLOBAL INTEGRATION 

Generic Global Strategies

PRESSURES: GLOBAL INTEGRATION

COST DRIVERS

Economies of scale Economies of scope  Decreased transportation costs 



  

Homogenization of product needs Global customers  Improved product quality  Reduced adaptation costs 

Learning and experience Lower communication costs

GOVERNMENT DRIVERS



Reduced tariffs, quotas  Compatible technical standards 

MOR 492 Global Strategy

MARKET DRIVERS 



COMPETITIVE DRIVERS  

9

Global competitors Increased formation of global alliances

MOR 492 Global Strategy

10

Generic Global Strategies

GLOBAL STRATEGY

GLOBAL STRATEGY 

Central control over country operations



Central surveillance of resource allocation and performance



Standardized products



Extensive transshipments



Cross-subsidization



Activities located in country(ies) providing comparative advantage

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

Generic Global Strategies

Unit 1

HQ Unit 2

11

MOR 492 Global Strategy

Unit 3

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Generic Global Strategies

GLOBAL STRATEGY

Generic Global Strategies

TRANSITION: MULTIDOMESTIC TO GLOBAL

Competitive advantage from 

Lower cost structure   

Economies of scale Less duplication of activities Lower inventories

Improved quality  Increased competitive leverage  Greater bargaining power  Quick response -- R&D concentration 

MOR 492 Global Strategy

13

MULTIDOMESTIC AND GLOBAL STRATEGIES

Determine where the benefits of globalization lie



Establish mandate for each subsidiary



Reduce strategic autonomy of subsidiaries



Rotate country managers to help them develop a global vision



Change reward and evaluation system to fit the mandate

MOR 492 Global Strategy

14

Generic Global Strategies

MULTIDOMESTIC

GLOBAL

Strategic Arena



Selected Target Countries



Most countries which constitute critical markets

Business Strategy



Custom strategies; little coordination



Same basic strategy worldwide

Product-line strategy



Adapted to local needs



Standardized products

Production Strategy



Plants scattered across many host countries



Plants located on the basis of competitive advantage

Sources of supply



Suppliers in host country preferred



Attractive suppliers from anywhere

Marketing



Adapted to local  Worldwide coordination; practices and culture minor adaptation

Organization



Autonomy

MOR 492 Global Strategy





Central control

Generic Global Strategies

CONSUMER ELECTRONICS Matsushita

Global Integration

Philips General Electric

Local Responsiveness 15

MOR 492 Global Strategy

16

Generic Global Strategies

Generic Global Strategies

CONSUMER ELECTRONICS:

“You want to be able to optimize a business globally -- to specialize in the production of components, to drive economies of scale as far as you can ....But you also want to have deep local roots everywhere you operate ... If you build such an organization, you create a business advantage that’s damn difficult to copy.”

TRANSITION TO TRANSNATIONALITY Matsushita Global Integration

Percy Barnevik, CEO, ABB MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

17

MOR 492 Global Strategy

Philips

Local Responsiveness 18

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Generic Global Strategies

TRANSNATIONAL STRATEGY

TRANSNATIONAL STRATEGY 

Greater emphasis on differentiated products than in “pure” global industries



Greater demand for global efficiency and lower costs than in “pure” multidomestic industries



Greater sensitivity to governmental demands



Units coordinate activities with HQ and with one another



Units may adapt to special circumstances only they face

MOR 492 Global Strategy

Generic Global Strategies

Unit 1

HQ Unit 2

19

Unit 3

MOR 492 Global Strategy

20

Generic Global Strategies

FOUR BASIC STRATEGIES

TRANSNATIONAL CORPORATION 





Generic Global Strategies

Each national unit is a source of ideas and competencies that can be harnessed for the benefit of the corporation National units achieve global scale by making them the company’s world source for particular product, component or activity

Efficiency benefits from global integration

New, highly-complex managing roles which coordinates relationships between units in a flexible way

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

21

MOR 492 Global Strategy

GLOBAL

TRANSNATIONAL

INTERNATIONAL

MULTIDOMESTIC

Benefits from national responsiveness

22

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Global Competitive Advantage

Global Competitive Advantage

Creating Competitive Advantage

Creating Global Competitive Advantage

 Most

markets have local, regional, and global aspects  Example

Building Multinational Competencies

MOR 492 Global Strategy

1

National Industry Characteristics

Global Industry Characteristics

• Differentiated markets

• Interdependent markets

• National scale economies

• Extra-national scale

• Local competition

• Cross-market competition

MOR 492 Global Strategy

Global Competitive Advantage

Global Competitive Advantage

Strategies for Globalization

Logic of Global Advantages

Exploit similarities across countries

Adaptation

Global Standardization

Arbitrage

MOR 492 Global Strategy

Arbitrage  Adaptation/Replication  Aggregation  Transformation (“ARAT” Model) 

Globalization

Localization

Aggregation

Local Customization

2

Exploit differences across countries

3

MOR 492 Global Strategy

Global Competitive Advantage

From Ghemawat, “ Global Advantage…”

4

Global Competitive Advantage

Arbitrage

Three Kinds of Arbitrage

Taking advantage of supply and demand mismatches  Taking advantage of national differences 

  



Classic Trading Arbitrage Relocation Arbitrage  Production Integration Arbitrage  

Factor endowments Industry clusters, etc. Unique consumer demand

Consolidated and coordinated global operations

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

5

MOR 492 Global Strategy

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Page 520 Voigt, Fall, 2003

Department of Management and Organization

Global Competitive Advantage

Global Competitive Advantage

Classic Trading Arbitrage

Relocation Arbitrage

Taking advantage of supply and demand mismatches through trading  Taking advantage of national differences in supply and demand prices and qualities 

  

 

Factor endowments: Raw materials, Labor Unique consumer demand: US Surfboards in Japan, Unique production capability: Japanese textiles, French and Belgian goldsmithing

Taking advantage of differences in endowments through activity relocation Activity location depends on country differences:     

MOR 492 Global Strategy

7

Cost and quality of inputs and processes Porter’s Diamond Factors Risks and Uncertainties Transport costs Tariffs

MOR 492 Global Strategy

Global Competitive Advantage

Global Competitive Advantage

Production Integration as Arbitrage  



Integration and the Value Chain

Economies of scale or scope across countries/regions/globe Where integrating and trading outperforms replication

REMEMBER: Integration can take place at any point in the value chain:  Local

selling, global sourcing selling, local sourcing  Global selling, global sourcing

TENSION between scale/scope economies on the one hand and commitment, tariffs, and transport costs on the other

MOR 492 Global Strategy

 Global

9

MOR 492 Global Strategy

Global Competitive Advantage

Other Forms of Arbitrage

Deciding Tradeoffs in Activity Integration



Administrative arbitrage



Geographic arbitrage



Economic arbitrage



Activity 2



Activity 3



11

Examples: French Culture, US Culture, Brazilian lifestyle



Activity 1

MOR 492 GLOBAL STRATEGY

Cultural arbitrage 

National Regional Global

MOR 492 Global Strategy

10

Global Competitive Advantage

Integration and Extensibility Local

8

Examples: tax differentials, smuggling Examples: international flower markets Examples: lower cost labor, cheaper capital

MOR 492 Global Strategy

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Keith Parker, University of Southern California

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Voigt, Fall, 2003

Global Competitive Advantage

Global Competitive Advantage

Adaptation

Replication (with Adaptation)  

Applying a successful model in multiple national environments; “transfering DNA” Taking advantage of similarities among nations   

 

 “Think

Global, act local (and adjust)”  Strategic action on both the global and local levels

Product Segment similarity Value Chain similarity Customization/Standardization tension

Replication will almost always require some adaptation to local market conditions Multi-divisional organization in order to focus on national organizations

MOR 492 Global Strategy

13

MOR 492 Global Strategy

Global Competitive Advantage

Global Competitive Advantage

Transformation

Forms of Adaptation       

Decentralization – moving decision-making from HQ to the field Partitioning – separating choice elements Modularization – separating and designing standard interfaces Recombination – melding elements of the parent business model with new possibilities Innovation – deliberate local-for-local innovations Transformation of context – reduce the need for adaptation by changing tastes Scope selection – reduce need for adaptation by focusing on a narrow geographic area similar to domestic market

MOR 492 Global Strategy

 Trying

to simultaneously take advantage of differences and similarities among nations Utilize arbitrage strategies where nations have different and strategically significant characteristics (e.g., differences in production costs or natural resources)  Utilize replication strategies to capitalize on what has worked in other settings 

15

MOR 492 Global Strategy

Global Competitive Advantage Economic Implications of Arbitrage and Replication Strategies

Arbitrage

International differences in absolute costs

Benefit Drivers

Country-of-origin effects

Key Metrics

Spread/Margin

Volume/Market Share

Hedging (e.g., Enron)

Spreading risks across markets

Risk Mgmt

Aggregation Finding scale and scope opportunities in new markets/nations  Aggregation mechanisms that operate at levels intermediate to one country and the whole world.  Like a transnational mentality  Deals with the integration-responsiveness trade-off 

International economies of scale and/or scope Nature, amount, & effects of standardization

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

From Ghemawat, “ Global Advantage…”

16

Global Competitive Advantage

Replication

Cost Drivers

14

17

MOR 492 Global Strategy

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3

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Marshall School of Business

Page 522 Voigt, Fall, 2003

Department of Management and Organization

Global Competitive Advantage

Global Competitive Advantage

Bases for Creating Global Advantage

Location Drivers

Economies of Replication

Global Learning © Voigt, Mayer & Liebeskind, 2006

Economies of Scale

National Differences

Non-Market Strategies

National Differences

Global Learning

Global Flexibility Economies of Scope

MOR 492 Global Strategy

Non-Market Strategies

Global Flexibility

© Voigt, Mayer & Liebeskind, 2006 19

MOR 492 Global Strategy

20

Global Competitive Advantage

Global Competitive Advantage Economies of Replication

Cost and Volume Drivers Economies of Replication

Non-Market Strategies

National Differences

Global Learning

Economies of Scale MOR 492 Global Strategy

Economies of Scale

Economies of Scope © Voigt, Mayer & Liebeskind, 2006

21

MOR 492 Global Strategy

Economies of Scale

Comparative advantage



Natural factor endowments and Societal endowments









Lower labor costs, lower cost of capital, tax advantages, availability of land, etc. 

“Relatively “ high willingness-to-pay



Higher volume helps firms exploit benefits of accumulated learning

Value-added Chain 

Location advantages

Expand output in order to achieve lower production costs Lowering costs by expanding in one area

Experience or learning effects 

Differences in consumer demand 

Economies of scale 

Scarce or abundant resources  Cost differences in factors of production 



22

Global Competitive Advantage

National Differences 

Economies of Scope

© Voigt, Mayer & Liebeskind, 2006

Global Competitive Advantage



Global Flexibility

Selecting components of chain to specialize in, and exploiting coordination benefits across activities

Lower transportation costs, etc.

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

23

MOR 492 Global Strategy

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Voigt, Fall, 2003

Global Competitive Advantage

Global Competitive Advantage

Examples of Scope Economies

Economies of Scope Economies of scope Expand into different activities in order to maximize utilization of resources and lower total costs Lowering costs by expanding into different areas Sharing investments and costs across the same or different value chains

Shared Physical Assets

Multi-Market Scope Advantages

A factory that can produce several different products or product variations (e.g., Ford)

Global brand name (Coca-Cola)

Using common distribution Shared External channels for multiple products (e.g., Matsushita) Relations

Sources Shared physical activities Shared external relations Shared learning

Shared R&D across multiple products (e.g., NEC computer & communications LOBs)

Shared Learning

MOR 492 Global Strategy

Multi-Product Scope Advantages

25

MOR 492 Global Strategy

Global Competitive Advantage

Pooling knowledge developed in different markets (e.g., P&G) From Bartlett and Ghoshal, “ T ransnational Management”

Global Learning & Innovation 

successful profit-making activities in new locations  May also involve learning advantages – costing of replicating a business may fall with cumulative experience

Transfer of learning & innovations across markets

 Duplicating

From the center to the subsidiaries From the periphery to the center  Throughout the network of locations  



Organizational challenges 

Putting the right incentives and processes in place Decentralize collection of knowledge Centralize processes for sharing knowledge across markets and divisions  Local loyalties, turf protections, NIH (not-invented here)  



27

Intelligence gathering of market opportunities

 Identification MOR 492 Global Strategy

28

Global Competitive Advantage

Global Competitive Advantage

Creating Worldwide Innovations

Global Flexibility and Adaptiveness

 Capture  

external diversity

  



Worldwide stimuli as potential source of competitive information advantage Need to convert “delivery pipelines” into “sensory feelers”

 Leverage



internal variety

MOR 492 GLOBAL STRATEGY

Managing diversity and volatility across markets – manage the risk/exploit the opportunities 



Worldwide human resources and capabilities as potential sources of competitive advantage Opportunity to leverage central and local innovations Create true global innovations by linking sensing, response and implementation capabilities

MOR 492 Global Strategy

26

Global Competitive Advantage

Economies of Replication

MOR 492 Global Strategy

Servicing multinational customers worldwide (e.g., Citibank)

Competitive actions  



Cross-parrying, multi-market retaliation, etc. Cross-market subsidization (e.g. cross-market cash-flows)

Internal markets for resources 

29

Portfolio of national and product markets Minimize impact of adverse conditions (political or economic) in a single market

Labor, capital, etc.

MOR 492 Global Strategy

30

Keith Parker, University of Southern California

5

MOR-492: Powerpoints

Marshall School of Business

Department of Management and Organization

Global Competitive Advantage

Global Competitive Advantage

Global Flexibility  Macroeconomic 



 Taking

advantage of government protection, subsidies, tax holidays, interest-free loans, etc.  Taking advantage of government rulemaking that creates barriers for new competitors

Risks Risks

Uncertainties of competitors actions & reactions

 Resource 

Risks

Actions of national governments

 Competitive 

Non-Market Strategies

Shocks and major trends in macro-environment

 Political

Page 524 Voigt, Fall, 2003

Risks

Scarcity of strategic resources

MOR 492 Global Strategy

31

MOR 492 Global Strategy

Global Competitive Advantage

Global Competitive Advantage

Global Strategy Perspectives High

MultiDomestic

International

Low

Low MOR 492 Global Strategy

The Four Strategies and ART

TransNational

Global

Global Coordination, Integration

National Differentiation, Responsiveness

32

High 33

GLOBAL

TRANSNATIONAL

Product Replication; Value Chain Arbitrage through integration

Transformation: Products and Value Chain

INTERNATIONAL

MULTIDOMESTIC

Arbitrage through exporting

Product And Value Chain Arbitrage through RDI

MOR 492 Global Strategy

34

Global Competitive Advantage

The Four Strategies: Replicating Versus Responding REPLICATE

RESPOND

Global Strategy

Transnational Strategy

International Strategy

Multidomestic Strategy

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

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Global Context

Global Context

Overview

Globalization in Context MOR 492 Global Strategy

 Analyzing

the Global External Environment  Globalization and “Distance”  National Competitiveness: Competitive and Comparative Advantage of Nations  Non-Market Strategy  Political Risk 1

MOR 492 Global Strategy

2

Global Context

Country’s Overall Attractiveness BENEFITS

• Size of market • Growth rate • Economic System

Macro-environmental Analysis

COSTS ATTRACTIVENESS

• Political factors • Economic underdevelopment • Legal system

Analyzing Similarities and Differences

RISKS

MOR 492 Global Strategy

• Political • Economic • Legal

3

GSBA 492 Global Strategy

Global Context

Global Context

Global External Environment

Political Environment

First Cut Analysis



Macro-environmental (PEST) Analysis    



Political Environment Economic Environment Social Environment Technological Environment

  

Political Alliances  Legal Infrastructure

Competitive and Competitor Analysis Similarities, Differences, and Rate/Velocity of Change  Shocks and Trends 

MOR 492 GLOBAL STRATEGY

Stability Political goals/agenda Succession and transfer of power





MOR 492 Global Strategy

Type of Government





5

Contract enforcement

Nature and extent of Regulation

MOR 492 Global Strategy

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Keith Parker, University of Southern California

1

MOR-492: Powerpoints

Marshall School of Business

Page 526 Voigt

Department of Management and Organization

Global Context

Global Context

Political Environment 

Business-government relationships 



 

Role of business in political agenda

Role of Public Sector 



Legal Environment 

Privatization

 

Influence Activities  



Lobbying Bribery/corruption

  

MOR 492 Global Strategy

7

Property Rights Intellectual Property Rights - Patent, trademark, copyright laws Contract Law – common law and civil law Tariffs, quotas and trade barriers Restrictive trade practices legislation Taxation Product liability, civil and criminal laws Labor laws Laws governing business practices

MOR 492 Global Strategy

Global Context

Global Context

Political Systems

Political Environment

Political System – the system of government in a nation

POLITICAL SYSTEMS 

Individualism

Collectivism • Socialism • Communism • Social Democracy



• Individual Freedom & Self-Expression • Economic Selfinterest (invisible hand) 

MOR 492 Global Strategy

9

Democracy – representative democracy Totalitarianism  Communist  Theocratic  Tribal  Right-wing Others (e.g., Oligarchy)

MOR 492 Global Strategy

Global Context

  

     

Economic Systems 

Economic growth; stage of economic development GDP per capita (income) Financial Institutions – stock exchanges, banks, etc. Monitoring Institutions 







Combination of market and command economies – both private ownership and free markets and government planning

State-Directed Economy 

11

Government moderates the activities of different economic systems – quantity produced and prices charged set by government

Mixed 



Free interplay of demand and supply No restrictions on supply

Central Command 

Money supply and monetary stability Balance of payments; foreign debt “Hard” currency reserves Exchange rate fluctuations Fiscal policies, interest rates, taxation Unemployment levels

MOR 492 GLOBAL STRATEGY

Market Economy 

SEC, Auditors, GAAP

MOR 492 Global Strategy

10

Global Context

Economic Environment 

8

State plays a significant role in directing the investment activities of private enterprise through “industrial policy” and other wise regulating business activity in accordance with national goals

MOR 492 Global Strategy

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Keith Parker, University of Southern California

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Voigt

Global Context

Global Context

Culture : Silent Language

Social/Cultural Environment Language



Time



Space



Things



Friendships



Agreements



Norms, Value Systems, Attitudes and Beliefs

Education



CULTURE





Social structure

Work Place Values



Meaning of delays, deadlines, schedules Size, conversation distance Material possessions, language of money Meanings of “friends”, expectations “Verbal” versus “written” agreements

Religion

MOR 492 Global Strategy

13

MOR 492 Global Strategy

14

Global Context

Demographic Environment  Population  Education  Age

CAGE Framework

growth

and literacy

distribution and changes

 Population

Pankaj Ghemawat, “Globalization and Distance”

shifts

MOR 492 Global Strategy

15

GSBA 492 Global Strategy

Global Context

Global Context

CAGE Framework for Thinking about Distance(Closeness) at Country Level

Country Level Influences on Bilateral Trade Flows            

Economic Size: GDP (1% increase) Income Level: GDP per capita Distance: 1% increase Geographic size Landlockedness Common Land Border Common Language Common Regional Trading Bloc Colony/Colonizer Common Colonizer Common Polity Common Currency

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

+0.8% +0.7% -1.1% -0.2% -50% +80% +200% +330% +900% +190% +300% +340%



Cultural Distance 



Administrative Distance 

Administrative attributes encompass laws, policies and institutions that emerge from the political process



Geographic Distance



Economic Distance





17

Cultural attributes of society that are sustained by general social interaction

Geographic attributes include natural constraints and physical differences Economic Factors

MOR 492 Global Strategy

18

Keith Parker, University of Southern California

3

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Marshall School of Business

Page 528 Voigt

Department of Management and Organization

Global Context

Global Context

Cultural Distance 









Example: Spanish companies invest more in South America which is geographically further away than Asia



Common (Lack) Colonial Ties Shared Regional Trading Agreements 

 

Others:



Examples: Pakistan vs. India, Pariah States

restrictions on foreign trade & investment, discrimination against foreign companies,  limits on currency convertibility/remittance,  poor institutional quality – bribery/corruption  poor contract enforcement MOR 492 Global Strategy 

Examples: values (Confucian vs Western), norms (insiders vs outsiders), average disposition (materialism, individualism, or risk-taking)



Other:

 Insularity, traditionalism MOR 492 Global Strategy

NAFTA, Mercosur, ASEAN, European Union

Common Currencies Political Climate (hostility)



Lack of connective ethnic or social networks Immigrant populations can substitute for language-related links

Common (Different) Religions Common (Different) Values, Norms, and Dispositions 





Common (Different) Ethnicity 



Administrative Distance

Common (Different) Languages

19

Global Context

Global Context

Geographic Distance

Economic Distance

Physical Distance Land Borders  Differences in Climates/Disease Environments  Others: 





   

Rich/Poor Differences 



landlockness lack of internal navigability geographic size absolute remoteness

MOR 492 Global Strategy

20



Others:   

21

80% of the trade/FDI of high-income countries is directed at other high-income countries Rich-Rich is “replication”, Rich-Poor is “arbitrage” factor endowments infrastructure advanced factors

MOR 492 Global Strategy

22

Global Context

National Competitiveness Comparative and Competitive Advantages GSBA 492 Global Strategy

MOR 492 GLOBAL STRATEGY

Comparative Advantages: Factor Endowments 







Natural Resources  Land, climate, mineral resources, water, demographics, location, etc. National Infrastructure  Ports, transportation system, energy, telecommunications, banking system, etc. Labor Productivity  Education levels, skill levels, labor costs, etc. Advanced Factors  Research facilities, technical know-how, court system etc.

MOR 492 Global Strategy

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Keith Parker, University of Southern California

4

MOR-492: Powerpoints

Marshall School of Business Page 529 Department of Management and Organization

Global Context

Voigt

Determinants of National Competitive Global Context Advantage of Nations: Porter’s Complete System

Competitive Advantage of Nations 

Japan Inc., Taiwan Dragon, “The German Machine” etc.

Why Competitive Clusters? 



Firm Strategy, Structure, and Rivalry

What explains: 



Chance

Factor Conditions

Silicon Valley, French Wines, Italian Ceramics, UK Formula I Racing, etc.

Demand Conditions

Why do some nations have such negative inertia? 

India, Mexico, Russia, China, etc.

Related and Supporting Industries

Source: Porter (1990)

MOR 492 Global Strategy

25

Government

MOR 492 Global Strategy

26

Porter’s Five Forces Framework

Government as Supplier

SUPPLIERS

Non-Market Strategy

Global Context

Bargaining power of suppliers Threat of new entrants POTENTIAL ENTRANTS

MARKET COMPETITORS SUBSTITUTES Rivalry among existing firms

Non-market Influences on Global Economic Activities

Threat of substitute products or services

Bargaining power of customers

BUYERS

Government as Buyer

Source: Porter (1980)

GSBA 492 Global Strategy

MOR 492 Global Strategy

Government as a Sixth Force

Global Context

Global Context

Disaggregating Non-Market Influences

SUPPLIERS Bargaining power of suppliers Threat of new entrants POTENTIAL ENTRANTS

 MARKET COMPETITORS

Government: Player and/or Rulemaker

Government Roles 

SUBSTITUTES Rivalry among existing firms

28

Transactor (Government entities) vs. Rulemaker

National vs. Regional vs. Local Government  Politicians vs. Bureaucrats  Stakeholders 

Threat of substitute products or services

Bargaining power of customers

 BUYERS

Regulators, partners, competitors, unions, media, consumers, communities, interest groups/activists

Source: Porter (1980)

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

29

MOR 492 Global Strategy

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Department of Management and Organization

Global Context

Global Context

Government as a Rulemaker   

   

Government as a Rulemaker

Taxes and subsidies Price/profit restrictions Disclosure requirements and other financial regulations Product/process regulation Local content requirements Trade/industrial policy Governmental ownership by statute

MOR 492 Global Strategy

    



31

Local ownership/partnership requirements Competition policy Restrictions on entry/expansion Patent law Intellectual property right recognition and enforcement Technology transfer policies

MOR 492 Global Strategy

32

Global Context

Non-market Strategy Responses

Political Risk Analysis

Lobbying Political Contributions, bribery  Advocacy advertising  Public exposure  Constituency influence  Collegial persuasion  Litigation  Collective organizing  Official testimony  

MOR 492 Global Strategy

33

GSBA 492 Global Strategy

Global Context

Global Context

Political Risk US Intelligence Sources (1985) estimated that 80 percent of foreign contracts for large scale capital projects were won by firms paying bribes.



Political Risk arises from the vagaries of governmental action:        

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

35

Policy changes Leadership changes Nationalization of private property Expropriation of foreign holdings Civil strife Currency inconvertibility War Etc.

MOR 492 Global Strategy

36

Keith Parker, University of Southern California

6

MOR-492: Powerpoints

Marshall School of Business Page 531 Department of Management and Organization

Voigt

Global Context

Global Context

Political Risks -- Macro Causes

Political Risks -- Micro

Form

Competing political philosophies  Armed conflicts and rebellion  Social unrest and disorders  New international alliances 



Causes Changing social values  Unstable economic conditions  Vested interests 

Confiscation, national expropriation



Damage to property, persons



Loss of transfer freedoms

MOR 492 Global Strategy

 



37

Quasi-political Local business

Latent hostility towards foreigners

HIGHER

 





LOWER



  

   39

External political relations  Prospects of border warfare  Regional political alliances  Trade disputes and economic warfare

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY



Discrimination



Operating restrictions 38

MOR 492 Global Strategy

40

Global Context

Political Risk Rating Agencies

Political Risk Forecasting



Breach/revision of contracts

Stay ahead -- technical and managerial capabilities Multiple sourcing of products Raise political costs of intervention JVs with politically connected local companies Maximize debt investment from local sources Significant exports “Good citizen” -- public services

Global Context

Internal stability  Prospects of domestic violence  Demonstrations, riots, strikes  Terrorisms, assassinations



Global Context



Globally, integrated firm High technology firm



High inflation, currency instability

Political Risk -- Defensive Strategies

“Critical” industries Entirely foreign or entirely local management Control over foreign firm’s access to market, raw materials etc.

MOR 492 Global Strategy



MOR 492 Global Strategy

Global Context

Political Risk -- Vulnerability

Form

Business Environment Risk Intelligence: BERI Index  Bank of America World Information Services: Country Risk Monitor Rankings  Economist Intelligence Unit (EIU): Country Risk Ratings  Euromoney: Country Risk Ratings  Institutional Investor: Country Credit Ratings 

41

MOR 492 Global Strategy

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Page 532 Voigt

Department of Management and Organization

Global Context

Global Context

Example: Business Environment Risk Intelligence (BERI) Political Risk Index

Example: The Economist Rankings 



Politics (50 points) Society (17 points)  Being near a superpower or troublemaker  Pace of urbanization  Authoritarianism  Islamic fundamentalism  Longevity of regime  Corruption  Illegitimacy  Ethnic tension  General in power  War/armed insurrection Economics (33 points)  Falling GDP per capita  High inflation  Capital flight  High and rising foreign debt as a proportion of GDP  Decline in food production per capita  Raw material as a high percent of exports

MOR 492 Global Strategy



Internal Causes of Political Risk      



External Causes of Political Risk  



Importance of hostile major power Negative regional influences

Symptoms of Political Risk  

43

Political fractionalization Ethnic fractionalization Coercive measures required for retaining power Mentality, including xenophobia, nationalism, corruption, nepotism Social conditions, including population density and wealth distribution Radical left

Societal conflict involving demonstrating, strikes, and street violence Instability as perceived by non-constitutional changes, assassinations, and guerilla wars

MOR 492 Global Strategy

44

Global Context

Country’s Overall Attractiveness BENEFITS

• Size of market • Growth rate • Economic System

COSTS ATTRACTIVENESS

• Political factors • Economic underdevelopment • Legal system

RISKS

MOR 492 Global Strategy

• Political • Economic • Legal

MOR 492 GLOBAL STRATEGY

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COMPETITIVE ADVANTAGE OF NATIONS This is presentation is based on Michael E. Porter’s book: The Competitive Advantage of Nations, Free Press, 1990

Source: The presentation slides were prepared by George Yip, UCLA

Porter’s Competitive Advantage of Nations







Extends and modifies traditional theory of comparative advantage to take into account the following factors: Competitive advantage is about companies -- the importance of the national environment is providing a home base for the company Sustained competitive advantage depends upon dynamic factors -- innovation and upgrading of firm’s resources and capabilities The critical role of the national environment is its influence upon the dynamics of innovation and upgrading MOR 492 Porter on Global Strategy 2 Voigt, 2002

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The Determinants of National Advantage Firm Strategy, Structure, and Rivalry

Factor Conditions

Demand Conditions

Related and Supporting Industries Source: Porter (1990)

MOR 492 Porter on Global Strategy 3 Voigt, 2002

Factor Conditions

MOR 492 Porter on Global Strategy 4 Voigt, 2002

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Page 535

Demand Conditions

MOR 492 Porter on Global Strategy 5 Voigt, 2002

Related and Supporting Industries Leather Footwear

Parts of Footwear

Leather Working Machinery

Source: Porter (1990)

Design Services

Processed Leather

MOR 492 Porter on Global Strategy 6 Voigt, 2002

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Internationally Competitive Related Industries

MOR 492 Porter on Global Strategy 7 Voigt, 2002

Firm Strategy, Structure and Rivalry

MOR 492 Porter on Global Strategy 8 Voigt, 2002

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Estimated Number of Japanese Rivals in Selected Industries, 1987

MOR 492 Porter on Global Strategy 9 Voigt, 2002

The Complete System Chance

Firm Strategy, Structure, and Rivalry

Factor Conditions

Demand Conditions

Related and Supporting Industries Source: Porter (1990)

Government MOR 492 Porter on Global Strategy 10 Voigt, 2002

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Company Strategy

MOR 492 Porter on Global Strategy 11 Voigt, 2002

Competitive Advantage in International Competition 1. Competitive advantage grows fundamentally out of improvement, innovation, and change. 2. Competitive advantage involves the entire value system. 3. Competitive advantage is sustained only through relentless improvement. 4. Sustaining advantage demands that its sources be upgraded. 5. Sustaining advantage ultimately requires a global approach to strategy.

MOR 492 Porter on Global Strategy 12 Voigt, 2002

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MOR-492: Powerpoints

Pressures For Innovation

MOR 492 Porter on Global Strategy 13 Voigt, 2002

Perceiving Industry Change

MOR 492 Porter on Global Strategy 14 Voigt, 2002

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Predicting the Behavior of Foreign Rivals Firm Strategy, Structure and Rivalry

MOR 492 Porter on Global Strategy 15 Voigt, 2002

Predicting the Behavior of Foreign Rivals, cont. FACTOR CONDITIONS What is the direction of industry-related research in the nation and the types of training received by new employees? How will pressures from selective factor disadvantages modify strategies?

MOR 492 Porter on Global Strategy 16 Voigt, 2002

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MOR-492: Powerpoints

Predicting the Behavior of Foreign Rivals, cont. DEMAND CONDITIONS Which industry segments are likely to be emphasized because of their importance domestically? What trends in domestic buyer needs will shape competitor perceptions of new product directions?

MOR 492 Porter on Global Strategy 17 Voigt, 2002

Predicting the Behavior of Foreign Rivals, cont. RELATED AND SUPPORTING INDUSTRIES How will developments in local supplier industries skew the direction of technical development? How will entry from related industries redefine the nature of domestic rivalry or pressure firms to change?

MOR 492 Porter on Global Strategy 18 Voigt, 2002

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Choosing Industries and Segments For Which the Nation is a Favorable Home Base

MOR 492 Porter on Global Strategy 19 Voigt, 2002

Choosing Industries and Segments For Which the Nation is a Favorable Home Base, cont.

MOR 492 Porter on Global Strategy 20 Voigt, 2002

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MOR-492: Powerpoints

Choosing Industries and Segments For Which the Nation is a Favorable Home Base, cont.

MOR 492 Porter on Global Strategy 21 Voigt, 2002

Choosing Industries and Segments For Which the Nation is a Favorable Home Base, cont.

MOR 492 Porter on Global Strategy 22 Voigt, 2002

11

Keith Parker, University of Southern California

MOR-492: Powerpoints

Voigt, Fall, Page 2005544

Marshall School of Business

Department of Management and Organization

Introduction: What is Globalization?

Outline

What is Globalization and the Global Marketplace, really?

MOR 492 Global Strategy

Introduction: What is Globalization?

 What

is Globalization?  Drivers of Globalization  The Changing Demographics of the Global Economy  The Globalization Debate: Prosperity or Improverishment?  Managing in the Global Marketplace 1

MOR 492 Global Strategy

Introduction: What is Globalization?

Introduction: What is Globalization?

What is Globalization?

Definition of Globalization 



 The

Globalization is the trend toward a more integrated global economic system Examples: telecommunications, automobiles, computers, credit cards, fast food, etc.

MOR 492 Global Strategy

Globalization of Markets

The merging of historically distinct and separate national markets into one huge global market place  Convergence of consumer tastes and preferences 



3

Citicorp credit cards, Coca-Cola, Levis, Sony Walkman, Nintendo, McDonalds, etc.

MOR 492 Global Strategy

Introduction: What is Globalization?

 Globalization 

Markets for Commodities



Markets for Industrial Products



Markets for Financial Assets









The tendency of firms to source goods and services from different locations around the globe to take advantage of national differences in the cost and quality factors or production (such as labor, energy, land, and capital)



Almost irrelevant to speak about American products, Chinese products, Japanese products, Italian products

microprocessors, DRAMs, commercial jet aircraft



T-bills, Eurobonds, futures

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

5

of Production



aluminum, oil, wheat

Same multinationals compete with each other in multiple national markets

4

Introduction: What is Globalization?  Globalization

of Markets (Continued)

The most global of markets are for industrial goods and materials 

2

Global web of suppliers

MOR 492 Global Strategy

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Keith Parker, University of Southern California

1

MOR-492: Powerpoints

Voigt, Fall, 2005

Marshall School of Business Page 545 Department of Management and Organization

Introduction: What is Globalization?

Introduction: What is Globalization?

Drivers of Globalization

Semi-Globalization

 Declining

Trade (tariffs) and Investment Barriers

 Globalization

vs Semi-Globalization  Semi-Globalization is a state between completely integrated markets and completely independent localized markets  Regionalization – NAFTA, EU, Mercosur MOR 492 Global Strategy

 

General Agreement on Tariffs and Trade (GATT) World Trade Organization (WTO)

The lowering of trade and investment barriers has allowed firms to locate production optimally almost anywhere in the world  “Home” markets are now under attack from foreign competitors 

7

MOR 492 Global Strategy

8

Introduction: What is Globalization?

 The 



 The

Role of Technological Change

Role of Technological Change

(continued)

Microprocessors and Telecommunications 

Introduction: What is Globalization?



As costs of telecommunications fall, so do the costs of coordinating and controlling global organizations

Transportation Technology Development of commercial aircraft and superfreighters  Containerization (simplifying transshipments)  Commercial jet travel (reducing time to travel) 

Internet and the World Wide Web Information backbone of the global economy Greatly increased across-border transaction  Location, scale and time no longer become major competitive advantages  

MOR 492 Global Strategy

9

MOR 492 Global Strategy

10

Introduction: What is Globalization?

Introduction: What is Globalization?

 Implications

for the Globalization of

Production 

Containerization Development of commercial aircraft and superfreighters  Containerization (simplifying transshipments)  Commercial jet travel (reducing time to travel) 



Information Technology Real costs of info processing and communication have fallen dramatically  Ability to manage globally dispersed production systems 

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

11

MOR 492 Global Strategy

12

Keith Parker, University of Southern California

2

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Voigt, Fall, Page 2005546

Marshall School of Business

Department of Management and Organization

Introduction: What is Globalization?

 Implications

Introduction: What is Globalization?

for the Globalization of

Changing Demographics of the Global Economy

Markets 

Containerization and Low-cost Transportation 



Low-cost Global Communication



Low-cost Jet Travel





eCommerce



reduced cultural distance between countries creating a worldwide culture

Emergence of global markets for consumer products

MOR 492 Global Strategy

In the 1960s world stylized facts characterized the demographics of the global economy: 1. US dominance of the world economy and world trade 2. US dominance of world foreign direct investment 3. Dominance of international business by large US multinational corporations 4. Approximately half of the world was under the control of centrally-planned communist economies which were off-limits to US businesses

mass movement of people between countries 





Economical to ship products around world

13

MOR 492 Global Strategy

14

Introduction: What is Globalization?

Introduction: What is Globalization?

The Changing Pattern of World Output and Trade

 Changing

World Output and World Trade Patterns

Country

Share of World Output, 1963

Share of World Output, 1997+

Share of World Exports, 1998

40.3%

20.8%

12.7%

Japan

5.5

8.3

7.26

Germany*

9.7

4.8

10

France

6.3

3.5

5.7

United Kingdom

6.5

3.2

5.1

Italy

3.4

3.2

4.5

Canada

3

1.7

4.0

China++

NA

11.3

3.4

South Korea

NA

1.7

2.45

United States

Decline of US of world output (and other traditionally dominant economies) relative to emerging economies such as Asia  Decline of US as leading exporter relative to Japan, Germany, South Korea, China, etc.  Emerging regions and economies such as those of South America, Eastern Europe, and Asian Pacific have further eroded US position 

MOR 492 Global Strategy

*1963 figure for Germany refers to the former West Germany. + Output is measured by gross national product. The 1997 estimates are based on purchasing power parity (PPP) statistics that adjust GNP for differences in prices (the cost of living) between countries. ++ The Chinese figures are somewhat suspect. When calculated using unadjusted GNP data, China's share of world output shrinks to 3.1 percent. Thus, China's high share of world output on a PPP basis is partly due to the relatively low cost of living in China. Source: Export data from World Trade Organization, A nnual Report, 1999 and Statistics, 1996 (Geneva: WTO, 1996). World output data from CIA factbook, 1999.

15

MOR 492 Global Strategy

Introduction: What is Globalization?  Changing

Foreign Direct Investment

Introduction: What is Globalization?  Changing

Nature of the Multinational Enterprise

Picture Relative decline to US foreign direct investment  Emergence of non-US firms investing acrossborders

Definition: A multinational corporation (MNC) is any business that has productive activities in two or more countries  Two important trends:







Emergence of non-US MNCs



Growth of mini-MNCs





MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

16

17

Japanese and European MNCs Medium and small businesses with as few as 25 employees

MOR 492 Global Strategy

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Marshall School of Business Page 547 Department of Management and Organization

Introduction: What is Globalization?

The National Composition of the Largest Multinationals United States

Of the Top 260 in 1973

Of the Top 500 in 1997

126 (48.5%)

162 (32.4%)

Japan

9 (3.5)

126 (25.2)

Britain

49 (18.8)

34 (6.8)

France

19 (7.3)

42 (8.4)

Germany

21 (8.1)

41 (8.2)

Introduction: What is Globalization?

 Changing







MOR 492 Global Strategy

Between 1989-1991 a series of democratic revolutions swept the communist world 

Source: The 1973 figures from Hood and Young, The Economics of the Multinational Enterprise (New York: Longman, 1979). The 1997 figures from "The Global 500," Fortune, August 4, 1997, pp. 130-31.

19

Collapse of the Soviet Union Numerous European and Asian countries with a commitment to free-markets creates international business opportunities

Quieter revolutions in China and Latin America

MOR 492 Global Strategy

Introduction: What is Globalization?  The

Introduction: What is Globalization?

Global Economy of the 21st Century (Continued)

Barriers to the free flow of goods, services, and capital have come down  The volume of cross-border trade and investment grew more than global output





privatization of state-owned businesses deregulation  removal tariffs and other barriers 



More nations have joined the ranks of the developed world 

Widespread adoption of liberal economic policies 

indicates national economies are becoming more closely integrated into a single, interdependent, global economic system

New countries are expected to build powerful market economies 

e.g. Korea, Taiwan

MOR 492 Global Strategy

21

Czech Republic, Poland, Brazil, China, South Africa

MOR 492 Global Strategy

Introduction: What is Globalization?

The Globalization Debate: Prosperity or Impoverishment

Global Economy of the 21st Century (Continued) Russia appears to be backing away from a market economy  Financial crises such as the Asian crisis of 1998 spread very quickly across borders, driving economies to recession  Some South American countries seem to be reversing course 

MOR 492 GLOBAL STRATEGY

22

Introduction: What is Globalization?

 The

MOR 492 Global Strategy

20

 The

Global Economy of the 21st Century





World Order

 Pros:

Lower prices for goods or services Economic growth resulting in increased household incomes  Job creation from international trade  Countries that conduct a lot of trade together usually don’t go to “war” with each other  Promotes cross-cultural understanding  

23

MOR 492 Global Strategy

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Keith Parker, University of Southern California

4

MOR-492: Powerpoints

Marshall School of Business

Department of Management and Organization

Introduction: What is Globalization?

Introduction: What is Globalization?

The Globalization Debate: Prosperity or Impoverishment (Continued)

The Globalization Debate: Prosperity or Impoverishment (Continued)

 Cons:

 Cons:

Destroys manufacturing jobs in developed countries  Wages rates of unskilled workers in developed countries have declined 





Movement of manufacturing facilities of advanced nations to developing countries exploitation of labor and environmental abuse in developing countries  “fleeing” to avoid perceived burdensome regulations 

Growing inequality between skilled and unskilled workers wages 

Economic power and sovereignty is being challenged by supranational organizations 

MOR 492 Global Strategy

25

WTO, EU, UN

MOR 492 Global Strategy

26

Introduction: What is Globalization?

Managing in the Global Marketplace  International 



Business and MNCs

 Strategic

Challenges

Profound and enduring differences in cultures, political systems, economic systems, legal systems,and levels of economic development 

International business must vary practices country by country

MOR 492 Global Strategy

Questions

Where in the world to produce to minimize cost and maximize added-value?  How to best coordinate and control the globally dispersed production activities?  Which foreign to enter and which to avoid?  What mode of entry? 

Any firm that engages in international trade or investment

 Managerial

Introduction: What is Globalization?

Managing in the Global Marketplace

Definition of international business 

Voigt, Fall, Page 2005548



27

Export? License? Joint Venture? Whollyowned subsidiary?

MOR 492 Global Strategy

Introduction: What is Globalization?

Managing in the Global Marketplace  Across-border

financial transaction

 Differences

between international business and domestic business

Government restrictions on international trade and investment  Foreign exchange rate movements  Restrictions on the repatriation of profits

1. Countries are different 2. The range of problems confronted by a manager in an international business is wider and the problems are more complex 3. An international business must find ways to work within the limits imposed by government intervention in the international trade and investment system 4. International transactions involve converting money into different currencies



MOR 492 GLOBAL STRATEGY

Introduction: What is Globalization?

Managing in the Global Marketplace

challenges

MOR 492 Global Strategy

28

29

MOR 492 Global Strategy

30

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Voigt, Fall, 2005

Introduction: What is Globalization?

Who is us? AND Who is them? MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

31

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MOR-492: Powerpoints

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Department of Management and Organization

Page 550 Voigt, Fall, 2002

Global Entry Mode

Modes of Global Market Entry

OVERVIEW: ENTRY STRATEGIES 

EXPORT ENTRY 



Direct and indirect exporting

CONTRACTUAL ENTRY  

Licensing/franchising, technical agreements Contract manufacturing, turnkey projects



STRATEGIC ALLIANCES



INVESTMENT ENTRY 

Wholly owned subsidiaries

GSBA 492 Global Strategy

GSBA 492 Global Strategy

2

Global Entry Mode

Choice of International Entry Mode TRANSACTIONS EXPORTING: Spot Transactions

EXPORTING: EXPORTING: LICENSING with with TECHNOLOGY Long-term foreign contracts distributor/ag and ent TRDAEMARKS

EXPORT STRATEGIES

DIRECT INVESTMENT FRANCH -ISING

JOINT VENTURE

Market -ing & Dist’n only

Fully integrated

FULLY OWNED SUBSIDIARY Market -ing & Dist’n only

Fully integrated

Key Issues: Is the firm’s competitive advantages based upon firm-specific or country-specific resources and capabilities Is the product tradable and what are the barriers to/costs of trade? Does the firm possess the full range of resources and capabilities needed to serve the overseas market?

GSBA 492 Global Strategy

3

GSBA 492 Global Strategy

Global Entry Mode

Global Entry Mode

EXPORT - APPROACHES

EXPORT - ADVANTAGES

DIRECT 



Firm handles entire export operations itself

 

INDIRECT 

Lower per unit cost Economies of scale Better capacity utilization



Overcome domestic market size limitations

Manufacturers' export agents





Export commission agents



Offset market cyclicality Low asset exposure to political risk



Export merchants



Exports using 

GSBA 492 Global Strategy

MOR 492 GLOBAL STRATEGY

5

Flexibility of switching the geographical direction of products

GSBA 492 Global Strategy

6

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1

MOR-492: Powerpoints

Marshall School of Business Page 551 Department of Management and Organization

Voigt, Fall, 2002

Global Entry Mode

Global Entry Mode

EXPORT -- QUESTIONS

EXPORT -- DISADVANTAGES 

Costs associated with trade barriers



Lower control over market



Local government objections



Transportation costs



Costs associated with locating and maintaining relationships with importer(s)



Conflicts-- exporters’ and importers’ goals

GSBA 492 Global Strategy

7



Will there be sustainable competitive advantage in export markets? Why?



What exports markets and segments will value our products sufficiently?



Standard product with standard marketing mix or tailored products?



What trade barriers impede export?



What are the appropriate channels for distribution?

GSBA 492 Global Strategy

8

Global Entry Mode

LICENSING: ADVANTAGES

LICENSING



Extends product life cycle



Allows penetration of small markets



Helps build goodwill for MNC’s products



Limited exposure to political risks



Reduces loss due to “piracy”



Requires limited resources



Quick entry

GSBA 492 Global Strategy

GSBA 492 Global Strategy

10

Global Entry Mode

Global Entry Mode

LICENSING PROCESS

LICENSING: DISADVANTAGES 

Lost control over technology



Difficulty in maintaining quality standards



Government restrictions/ high taxes on royalties



Development of potential competitors



Opportunity costs



Post-agreement costs 

Protecting industrial property



Backup services

GSBA 492 Global Strategy

MOR 492 GLOBAL STRATEGY

Assessing potential in target market

11

GSBA 492 Global Strategy

Finding suitable licensing candidates

Negotiating a licensing agreement

Building a working partnership with licensee

12

Keith Parker, University of Southern California

2

MOR-492: Powerpoints

Marshall School of Business

Department of Management and Organization

Page 552 Voigt, Fall, 2002

Global Entry Mode

WHEN IS LICENSING EMPLOYED?       

CONTRACT MANUFACTURING

Firm lacks capital, managerial resources or knowledge of foreign markets Testing and developing a market that can be later exploited by direct investment Technology involved is not central to the licensor’s core business Prospects of “technology feedback” are high Host-country government restricts imports or FDI Licensee unlikely to become a future competitor Pace of technological change is rapid

GSBA 492 Global Strategy

Beamish (1994) 13

GSBA 492 Global Strategy

Global Entry Mode

CONTRACT MANUFACTURING ADVANTAGES  Limited commitment of resources  Quick entry  Avoids ownership problems  Cost reduction  Access to technology

GSBA 492 Global Strategy

Global Entry Mode

GLOBAL SOURCING STRATEGY

DISADVANTAGES  Time and effort required to develop manufacturer  Adverse sentiment domestically  Potential loss in flexibility and control  Expense -- negotiating, maintaining and enforcing contracts  Creation of future competitor

DOMESTIC Domestic purchasing agreement

OUTSOURCING FOREIGN Offshore outsourcing 15

GSBA 492 Global Strategy

16

Global Entry Mode

STRATEGIC ALLIANCES

STRATEGIC ALLIANCES

• Enable firms to shares risks and resources to expand into international ventures • Most joint ventures (JVs) involve a foreign company with a new product or technology and a host company with access to distribution or knowledge of local customs, norms or politics • May experience difficulties in merging disparate cultures • May not understand the strategic intent of partners or experience divergent goals

GSBA 492 Global Strategy

MOR 492 GLOBAL STRATEGY

GSBA 492 Global Strategy

18

Keith Parker, University of Southern California

3

MOR-492: Powerpoints

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Voigt, Fall, 2002

Global Entry Mode

Global Entry Mode

WHY STRATEGIC ALLIANCES?

WHY STRATEGIC ALLIANCES? EMERGING REASONS

TRADITIONAL REASONS  Sharing of resources and risks  Host government requirements  Overcoming strong nationalistic sentiments  Quicker entry  Benefit from partner’s local knowledge

GSBA 492 Global Strategy



Learning from one another



Attain global scale economies  



Rising R&D costs and technological interdependence



Industry convergence



19

Raw material/ Component supply Marketing and distribution

Short product life cycles

GSBA 492 Global Strategy

Global Entry Mode

WHY STRATEGIC ALLIANCES?

20

Global Entry Mode

RISKS OF STRATEGIC ALLIANCES

Industry Globalization and Global Competition



Partner opportunism and loss of competitive edge



Strategic and organizational complexity

Shaping competitive rivalry



Conflict of interest problems



Keeping key competitors at bay



Decreasing partner commitment



Reduced transaction and other costs



Improved market access



Stronger product line



Superior timing



GSBA 492 Global Strategy

21

GSBA 492 Global Strategy

22

Global Entry Mode

Global Entry Mode

MAKING STRATEGIC ALLIANCES WORK

MAKING STRATEGIC ALLIANCES WORK DEFINING GOALS AND OBJECTIVES  Clarify and resolve separate interests  Develop mutual trust and understanding

ASSESSING NEED  Do you need a partner? How big is the payoff?  How likely is success? PARTNER SELECTION  Does the partner share your goals and objectives?  Does strategic synergy exist?  Is the partner compatible? GSBA 492 Global Strategy

MOR 492 GLOBAL STRATEGY

DESIGNING AN ALLIANCE  Define role of each partner  Define venture boundaries  Identifying champion(s)  Trust versus legal considerations  Allow for termination 23

GSBA 492 Global Strategy

24

Keith Parker, University of Southern California

4

MOR-492: Powerpoints

Marshall School of Business

Page 554 Voigt, Fall, 2002

Department of Management and Organization

Global Entry Mode

Global Entry Mode

MAKING STRATEGIC ALLIANCES WORK

MAKING ALLIANCES WORK MANAGING THE ALLIANCE

MANAGING THE ALLIANCE 

Achieving operating momentum



Managing cultural differences



Recognize alliance needs



Flexibility



Assuring continued commitments



Increasing willingness to learn



Avoiding bottleneck dependence





Policies



Resources (inc. human resources)

Overcoming reluctance to give up autonomy

GSBA 492 Global Strategy

25

GSBA 492 Global Strategy

26

Global Entry Mode

STRUCTURING ALLIANCES TO REDUCE OPPORTUNISM

DIRECT INVESTMENT STRATEGIES

Walling off Critical technology

Probability of Opportunism by Alliance Partner Reduced By

Establishing contractual safeguards Agreeing to swap valuable skills and technologies Seeking credible commitments

GSBA 492 Global Strategy

27

GSBA 492 Global Strategy

Global Entry Mode

FULLY-OWNED SUBSIDIARIES: GREENFIELD INVESTMENTS ADVANTAGES Total control

 Host government objections



Lack of partner commitment not a concern

 Large investment required





FULLY-OWNED SUBSIDIARIES: ACQUISITIONS

DISADVANTAGES



Global Entry Mode

ADVANTAGES  Total control  Quick entry

evaluate

problems

 Vulnerability to political risk Greater learning about  Time required to establish foreign markets competitive advantage No loss of technology

MOR 492 GLOBAL STRATEGY

 Acquisitions difficult to  Post-acquisition assimilation

 Labor union objections

GSBA 492 Global Strategy

DISADVANTAGES

 Vulnerability to political risk  Can be considered as “anti-

social”

29

GSBA 492 Global Strategy

30

Keith Parker, University of Southern California

5

MOR-492: Powerpoints

Marshall School of Business Page 555 Department of Management and Organization

Voigt, Fall, 2002

Global Entry Mode

ENTRY STRATEGIES Level of Investment Risk High

GLOBAL MARKET ENTRY CHOICES

WHOLLY OWNED SUBSIDIARY STRATEGIC ALLIANCES

Medium

LICENSING

Limited

EXPORTING

Limited

Medium

GSBA 492 Global Strategy

Global Entry Mode

RESPONSE TO GOVERNMENTAL BARRIERS

EXTERNAL FACTORS  Target country environment    



TRADE BARRIERS  Tariffs and quotas  Domestic content restrictions  Government procurement restrictions

Government policies/regulations Economy Socio-cultural factors Institutional voids Political risk

Market factors   

Size/attractiveness of markets Competitive structure Marketing infrastructure

GSBA 492 Global Strategy

33

BUSINESS RESPONSE  Establish manufacturing operations in country  Acquire local firm  Subcontract or purchase locally  Develop products jointly  Shift to higher-priced exports (for quotas)

GSBA 492 Global Strategy

Global Entry Mode

ENTRY STRATEGY: CHOICE INTERNAL FACTORS  Technology and product characteristics

BUSINESS RESPONSE  Enter into a JV  Franchising/ licensing agreements  Set up affiliate relationships with local firms  Shift high value-added activities to low-tax nations

GSBA 492 Global Strategy

MOR 492 GLOBAL STRATEGY

34

Global Entry Mode

RESPONSE TO GOVERNMENTAL BARRIERS INVESTMENT BARRIERS  Limits on foreign ownership  Restrictions on repatriation of earning  Fear of expropriation  Tax barriers

32

Global Entry Mode

ENTRY STRATEGY: CHOICE 

High

Ownership and control of foreign operations GSBA 492 Global Strategy

   



Resource and commitment factors   

35

Product factors Pre and post purchase services Technological intensity Minimum efficient scale Resource availability Willingness to take risks Corporate goals

GSBA 492 Global Strategy

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Keith Parker, University of Southern California

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MOR-492: Powerpoints

Marshall School of Business

Page 556 Voigt, Fall, 2002

Department of Management and Organization

Global Entry Mode 





High ENTRY MODES AND DEGREE OF CONTROL

Country risk; Cultural distance; Market potential; Market Knowledge

ECONOMIC OPPORTUNITY

Venture-specific Factors 



ENTRY STRATEGY SELECTION

Industry growth; Global industry concentration; Technical intensity; Advertising intensity

Location-specific Factors 



Firm Size; Multinational Experience

Industry Factors 



CHOICE OF ENTRY STRATEGY

Firm Capability

Global Entry Mode

Low

Contractual risk; Venture size; Tacit nature of know-how

• Joint Venture • Wholly owned subsidiaries

• Joint Venture • Contract manufacturing • Exporting

• Licensing • Exporting

• Licensing • Contract manufacturing • Exporting

Strategic Factors 

Low

Global strategic motivation; Global synergy

High POLITICAL RISK

GSBA 492 Global Strategy

37

GSBA 492 Global Strategy

38

Global Entry Mode

ENTRY STRATEGY SELECTION High RISK OF HOLD-UP BY TRADING PARTNER Low

Wholly Owned Subsidiary

Export Delay Entry Get Creative

Market Transaction

Joint Venture/ Strategic Alliance

Low

High POLITICAL RISK

GSBA 492 Global Strategy

MOR 492 GLOBAL STRATEGY

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Keith Parker, University of Southern California

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MOR-492: Powerpoints

Marshall School of Business Page 557 Department of Management and Organization

The Global Organization and Management Challenge:

OVERVIEW

Organizational Design, Coordination, and Control

MOR 492 Global Strategy

1



The Business Manager (Global scale & competitiveness)



The Country Manager (Local responsiveness & flexibility)



The Functional Manager (Linking functions worldwide)



The Corporate Manager (Transnational mission)









Control: Essence of Implementation



Global Managers



Organization Design



Organization Systems



Organization Culture

MOR 492 Global Strategy

High

Strategist+Architect+Coordinator

Scanner+Cross-Pollinator+Champion

INTERNATIONAL

Leader+Talent Scout+Developer

TRANSNATIONAL

MULTIDOMESTIC

Low EXPORT -ING

MOR 492 Global Strategy

3

Low

Importance of Local Responsiveness MOR 492 Global Strategy

High 4

Aligning Managers Responsibility and Decision-making Discretion with Organizational Arrangements

Four Basic Global Organizational Designs

High

High CENTRALIZED GLOBAL BUSINESS UNITS

GLOBAL NETWORKS

INTERNATIONAL FUNCTIONAL

DECENTRALIZED AREAFOCUSED

Low

Importance of Local Responsiveness MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

GBU Manager Dominant

Efficiency, Global Scale, Low Cost, Global Integration

International Functional Manager Dominant

Networked Team

Country Manager Dominant

Low

Low EXPORT -ING

GLOBAL

Efficiency, Global Scale, Low Cost, Global Integration

Sensor+Builder+Contributor

Efficiency, Global Scale, Low Cost, Global Integration

2

Four Basic Global Strategies

Global Managers 

Voigt, Fall, 2004

EXPORT -ING

High 5

MOR 492 Global Strategy

Low

Importance of Local Responsiveness

High 6

Keith Parker, University of Southern California

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MOR-492: Powerpoints

Marshall School of Business

Department of Management and Organization

Global Strategy Prescriptions

Successful Multinational Execution 

Important but not sufficient – Formal Control Mechanisms



Due Process in Global Strategic Decision-making



    



Incentives, compensation, monitoring systems, rewards & punishments



Head office is familiar with subsidiaries local situation Two-way communication exists in the global strategy-making process Head office is relatively consistent in making decisions across subsidiaries Subsidiary units can legitimately challenge HQ views and decisions Subsidiary units receive an explanation for final strategic decisions

MOR 492 Global Strategy

Voigt, Fall, Page 2004558





7

Locate each value-added activity in the country that has the least cost for the factor that activity uses most intensely Dexterously shift capital and resources across national markets, cross-subsidizing global units Institutionalize fully standardized product offerings, marketing approaches, and commonly used distribution systems worldwide to allow maximum global efficiencies Consciously consolidate worldwide knowledge, technology, marketing and production skills to build reservoirs of distinctive core competencies that can act as engines for continuous new business development, innovation and enhanced customer value

MOR 492 Global Strategy

8

CONTROL How do you execute them?

IMPEDIMENTS  Historical

evolution of headquarterssubsidiary relationship

Increasing sacrifice of subsystem for system priorities and considerations  Swift actions in a globally coordinated manner  Effective and efficient exchange relations among the nodes of the multinational’s global network Multinational enterprises need subsidiary managers with a sense of commitment, trust and social harmony 

 HQ

managers may lack understanding of skills and limitations involved in operating in dissimilar environments

 Presence  Host

governments like to influence strategy at subsidiary level

- compulsory vs. voluntary execution

MOR 492 Global Strategy

of JV partners

9

ORGANIZATION STRUCTURE

MOR 492 Global Strategy

10

EXPORT ORGANIZATION

Name Title

 International  Worldwide  Global

Disadvantages

Name

Name

Name

Title

Title

Title

Area

Name

Name

Title

Title

Product Division

 Matrix



Export manager may have insufficient clout



Export orders may receive low priority



Domestically oriented organization not supportive of foreign market requirements

 Network MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

11

MOR 492 Global Strategy

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MOR-492: Powerpoints

Voigt, Fall, 2004

Marshall School of Business Page 559 Department of Management and Organization

INTERNATIONAL DIVISION

TRADITIONAL SOLUTION: STRUCTURAL MERRY-GO-ROUND Worldwide Product Division

CEO/ PRESIDENT

Global Matrix DOMESTIC DIVISION A

FOREIGN PRODUCT DIVERSITY

DOMESTIC DIVISION B

DOMESTIC DIVISION C

INTERNATIONAL DIVISION

Area Division

International Division

Germany

Japan

Brazil

FOREIGN SALES AS PERCENTAGE OF TOTAL SALES

MOR 492 Global Strategy

13

MOR 492 Global Strategy

14

INTERNATIONAL DIVISION ADVANTAGES

· Focus on

international opportunities

· Greater “weight” in hierarchy

· Establishment of formal control procedures

WORLDWIDE AREA

DISADVANTAGES

CEO/ PRESIDENT

· International-

domestic split

· Domestic

North America

divisions exert greater power

· Manager needs to understand product market strategies of all divisions

MOR 492 Global Strategy

15

WORLDWIDE AREA ADVANTAGES

· Local sensitivity · More efficient

use of resources within country

· Motivated country managers

Europe

South America

Asia

Country Manager: U.S.

Germany

Brazil

India

Canada

Spain

Argentina

Japan

MOR 492 Global Strategy

16

WORLDWIDE PRODUCT DIVISION

DISADVANTAGES

CEO/ PRESIDENT

· Country

considerations dominate over global

Product Division A

· Country managers

may not have adequate knowledge of all products

Product Division B

Product Division C

Product Division D

Area Product Manager: U.S.

Area Product Manager: U.S.

Area Product Manager: U.S.

Area Product Manager: U.S.

Area Product Manager: Japan

Area Product Manager: Japan

Area Product Manager: Japan

Area Product Manager: Japan

· Duplication at HQ

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

17

MOR 492 Global Strategy

18

Keith Parker, University of Southern California

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MOR-492: Powerpoints

Voigt, Fall, Page 2004560

Marshall School of Business

Department of Management and Organization

PORTFOLIO- WORDWIDE BUSINESS MANAGER

WORLDWIDE PRODUCT DIVISION ADVANTAGES

DISADVANTAGES

· Better

Worldwide Business Manager

· Duplication at

coordination within product groups

country level

· Coordination across

Country 5

Country 1

product groups

· Global view of

· Less subsidiary

competition

initiative

· Facilitates

Country 2

technology transfer across country border

MOR 492 Global Strategy

19

MOR 492 Global Strategy

PORTFOLIO- COUNTRY MANAGER

CEO/ PRESIDENT

Business 5

Business 1

Subs. Mgr. Japan

Business 4

Business 3

MOR 492 Global Strategy

· Combines

positives of product and area structures · May be suitable for transnational strategies

Product Division A

Product Division B

Product Division C

Manager A

Manager B

Manager C

Subs. Mgr. Germany

21

MOR 492 Global Strategy

22

ORGANIZATIONAL IMPLICATIONS: THE INTEGRATED NETWORK

GLOBAL MATRIX ADVANTAGES

20

GLOBAL MATRIX

Country Manager

Business 2

Country 4

Country 3

DISADVANTAGES

· Dual reporting can

MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

DECENTRALIZED FEDERATION

CENTRALIZED HUB

cause confusion · Slow decision making · Requires high horizontal and vertical coordination

THE INTEGRATED NETWORK

23

MOR 492 Global Strategy

COORDINATED FEDERATION

24

Keith Parker, University of Southern California

4

MOR-492: Powerpoints

Marshall School of Business Page 561 Department of Management and Organization

NETWORK Business manager

Business manager

TRANSNATIONAL MANAGEMENT

Business manager

BUILDING AND MANAGING THE TRANSNATIONAL Business manager

Corporate Management

Business manager

Business manager

MOR 492 Global Strategy

25

STRATEGIC CAPABILITY OF THE TRANSNATIONAL: The New Multi-layered Game 

Sensitivity, flexibility, and responsiveness to local needs



Global scale efficiency and competitive response capability



27

A new structural anatomy

* Redefining information flows and relationships

Requires an integrated approach - Building the Transnational Anatomy - Shaping the Transnational Physiology - Moulding the Transnational Psychology

MOR 492 Global Strategy

28

- Don’t search for a standard coordination process: Develop and apply different tools to different tasks

A new cultural psychology * Readjusting mentalities and beliefs

MOR 492 GLOBAL STRATEGY



- Don’t let a single perspective dominate: Legitimize business, area and functional management

A new process physiology

MOR 492 Global Strategy

Building an organization More than Installing a Structure

- Don’t manage like the United Nations: Differentiate roles and responsibilities

* Redistributing assets and responsibilities





Building and Managing the Transnational

BUILDING AND MANAGING THE TRANSNATIONAL: A Biological Metaphor



MOR 492 Global Strategy

Developing Transnational Organization

Worldwide innovation skills and learning capabilities

MOR 492 Global Strategy



Voigt, Fall, 2004

- Focus beyond structure and systems: Build a matrix in managers’ minds 29

MOR 492 Global Strategy

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Keith Parker, University of Southern California

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MOR-492: Powerpoints

Voigt, Fall, Page 2004562

Marshall School of Business

Department of Management and Organization

Building and Maintaining Multiple Strategic Capabilities Require Protecting the Legitimacy of Multiple Management Tasks

The New Organizational Roles and Responsibilities Company M atsushita

Business

Research

M edical Telecom

GE

Function Purchasing Development

Lighting

BUSINESS MANAGEMENT

Geography Taiwan Singapore

UK

FUNCTIONAL MANAGEMENT

France

Australia Brazil

Sales Service

India

MOR 492 Global Strategy

WORLDWIDE INNOVATION AND LEARNIING 31

- Intense cross-border flows -

-

33

MOR 492 Global Strategy

-

Blunt instrument of change

-

Deny, oversimplify or compartmentalize complexity

-

Reinforce parochial, hierarchical, adversarial mentality

With flexibility to match roles and tasks Leaders and black holes: Socialization dominates Contributors: Centralization dominates Implementers: Formalization dominates

MOR 492 GLOBAL STRATEGY

34

Structure and systems

Formalized coordination Centralized coordination Socialized coordination

MOR 492 Global Strategy

Centralization in Japanese centralized hubs Formalization in American coordinated federations Socialization in European decentralized federations

Traditional Solution: Structural Merry-Go-Round

Portfolio of tools, selectively applied

-

Goods: Materials, components, products Resources: Financial, human Knowledge: Technology, expertise, Intelligence

- Administrative heritage influences coordination

Transnational Coordination Mechanisms Goods flows: Resource flows: Knowledge flows:

32

Transnational Coordinate Mechanisms

- Build legitimacy and credibility of nondominant groups: Coopt specific individuals Provided required mandate - Provide access to information channels Modify existing channels Create new channels - Create influence in decision processes Use micro-structural tools Use both visible and invisible hands - Maintain balance over time Manage ambiguity and flux Develop fit and flexibility MOR 492 Global Strategy

AREA MANAGEMENT

MOR 492 Global Strategy

Building and Balancing Multiple Organizational Perspectives

-

NATIONAL RESPONSIVENESS

Production

Consumer Electronics

M arketing Phillips

GLOBAL EFFICIENCY

35

MOR 492 Global Strategy

36

Keith Parker, University of Southern California

6

MOR-492: Powerpoints

Marshall School of Business Page 563 Department of Management and Organization

INSTALLING THE TRANSNATIONAL STRUCTURE LIMITS OF TRADITIONAL CHANGE MODELS

CHANGING ATTITUDES AND BEHAVIORS: The Foundation Stone of Change 





•Classic change process driven by structural reconfiguration

Developing shared values and purpose * Clarity, Continuity, Consistency

Assumptions of change model: Change in formal structure/responsibilities

Building multi-dimensional perspectives, capabilities * Expand career paths, assignments, education

reshapes

Organizational processes/relationships

Helping the organization embrace, not deny, complexity * “Create a matrix in managers’ minds”

MOR 492 Global Strategy

Voigt, Fall, 2004

redefines

Individuals attitude/mentalities 37

MOR 492 Global Strategy

38

BUILDING THE TRANSNATIONAL ORGANIZATION:

The Alternative Approach

• Recognizes structures as a blunt instrument of change * Simultaneous changes organization's anatomy, Physiology, psychology Modify individual attitudes/mentalities (Psychology) Develop new processes/relationships (Physiology) Confirm with redefined structures/responsibilities (Anatomy) MOR 492 Global Strategy

MOR 492 GLOBAL STRATEGY

39

Keith Parker, University of Southern California

7

MOR-492: Powerpoints

Marshall School of Business

Department of Management and Organization

Voigt, Term Iv, Page 2006564

WBMH Framework

The “Radio” Model Framework

WBMH Framework

W B M H

An Overview Framework for Global Strategy Analysis

Why?

WBMH Framework

Motivations/Imperatives





“Arbitrage” is using involved in some way Minimum efficient scale may be bigger than any single market



   

Globalization of Competitors:

Rivals may capture global first mover advantages Rival may be able to use multi-market presence to cross-subsidize an attack on a firm’s home market MOR 492 Global Strategy 

3

WBMH Framework

Transferring Competitive Advantages, Core Competencies and Capabilities across Borders 

Knowledge Imperative: continuous learning



reducing distribution costs, inventory costs, etc

Bring?

WBMH Framework

markets change, consumer’s tastes and needs change,  competitors innovate and adapt,  technology “jumps”  Globalization of Customers: when customers start to go global, firms must keep pace with them or lose overseas and domestic business to new rivals

Imperative:

MOR 492 Global Strategy

2



economies of scale and scope 

Sourc e: WBMH is built on idea from Porter



pursuing low cost raw materials, labor, etc. 



How should the firm enter the global market? How should it organize itself?

Why?



“Replication” of existing business model in new location

 Efficiency

What will/should/can the firm expect to meet when it goes global?

Motivations/Imperatives (Continued)

for “Becoming” Global

Imperative: pursuing new sources of volume by finding “Q” in new global markets 

What does the firm bring (and what will “travel”) to the global market opportunity?

MOR 492 Global Strategy

MOR 492 Global Strategy

  Growth

Why go global? What is the motivation, goals, intended end outcomes?

Bring?

4

WBMH Framework

Global “Generic” Strategies

What “travels” from a firm’s strategy (business model) to the new global market? What can the firm “take” with it? What can the firm replicate in the local market? What can the firm adapt to the local market? What resources and skills will not travel?

 Source

of Global Strategies are in two

areas: Arbitrage Replication  Transformation (third area which combines first two)  

Asking and answering the “Taco Stand” question is critical to determining what the firm can “bring” global MOR 492 Global Strategy

GSBA 519b Corporate & Global Strategy

5

MOR 492 Global Strategy

6

Keith Parker, University of Southern California

1

MOR-492: Powerpoints

Marshall School of Business Page 565 Department of Management and Organization

Bring?

WBMH Framework

Meet?

WBMH Framework

Analyzing the Global Market:

Bases for Global Advantage

What will the firm meet?

Economies of Replication

Regional Analysis Country Analysis

Non-Market Strategies

National Differences

Voigt, Term Iv, 2006

Industrial Sector Competitiveness Analysis Industry Analysis Global Learning © Voigt, Mayer & Liebeskind, 2006

Feasibility Analysis

Global Flexibility

Economies of Scale

7

Meet?

WBMH Framework

MOR 492 Global Strategy

Meet?

Global Competitiveness

Economics of Region Policies

Relative competitiveness of “Country” Relative competitiveness of “Industries”  Use Porter’s Diamond of Global Competitive Advantage 

 Macroeconomic  



Political Agenda Fiscal & Monetary Policies Policies toward foreign investments & control

 Political

Risk Analysis  Institutional Voids Analysis

Also important to examine sources leading to “un”competitiveness of country or industry

MOR 492 Global Strategy

9

Meet?

8

WBMH Framework

Country Analysis 

Profitability Analysis

Competitor Analysis

Economies of Scope

MOR 492 Global Strategy

 Global

Market Potential Analysis

WBMH Framework

MOR 492 Global Strategy

Meet?

10

WBMH Framework

Diamond of Global Competitiveness Chance

Examining Relevant “Distances”

Firm Strategy, Structure, and Rivalry

 CAGE

Framework (Ghemawat)

Cultural Distance  Administrative Distance  Geographic Distance  Economic Distance 

Factor Conditions

Demand Conditions

Related and Supporting Industries

Global strategy must exploit/mitigate relative “distance” between the firm and the global market

Government

Source: Porter (1990)

MOR 492 Global Strategy

GSBA 519b Corporate & Global Strategy

11

MOR 492 Global Strategy

12

Keith Parker, University of Southern California

2

MOR-492: Powerpoints

Voigt, Term Iv, Page 2006566

Marshall School of Business

Department of Management and Organization

How?

WBMH Framework

How?

“How” to Become Global?

WBMH Framework

Four Basic Global Strategies High

 Choice

of Global Strategy  Choice of Entry Mode  Choice of Organizational Structure

TRANSNATIONAL

GLOBAL

Efficiency, Global Scale, Low Cost, Global Integration

INTERNATIONAL

MULTIDOMESTIC

Low EXPORT -ING

MOR 492 Global Strategy

13

How?

WBMH Framework

How?

EXPORTING: Spot Transactions

FRANCH -ISING

JOINT VENTURE

Market -ing & Dist’n only

Fully integrated

Structural “Merry-go-round” Worldwide Product Division

FULLY OWNED SUBSIDIARY Market -ing & Dist’n only

Fully integrated

Is the product tradable and what are the barriers to/costs of trade?

FOREIGN SALES AS PERCENTAGE OF TOTAL SALES

Does the firm possess the full range of resources and capabilities needed to serve the overseas market? 15

WBMH Framework

MOR 492 Global Strategy

WBMH Framework

Worldwide Area

CEO/ PRESIDENT

DOMESTIC DIVISION B

DOMESTIC DIVISION C

Germany

16

How?

International Division

DOMESTIC DIVISION A

Area Division

International Division

Is the firm’s competitive advantages based upon firm-specific or country-specific resources and capabilities

How?

Global Matrix

FOREIGN PRODUCT DIVERSITY

Key Issues:

MOR 492 Global Strategy

14

WBMH Framework

DIRECT INVESTMENT

EXPORTING: EXPORTING: LICENSING with with TECHNOLOGY Long-term foreign contracts distributor/ag and ent TRDAEMARKS

High

Traditional Solution:

Choice of International Entry Mode TRANSACTIONS

Low

Importance of Local Responsiveness MOR 492 Global Strategy

CEO/ PRESIDENT

INTERNATIONAL DIVISION

Japan

North America

Brazil

MOR 492 Global Strategy

GSBA 519b Corporate & Global Strategy

17

Europe

South America

Asia

Country Manager: U.S.

Germany

Brazil

India

Canada

Spain

Argentina

Japan

MOR 492 Global Strategy

18

Keith Parker, University of Southern California

3

MOR-492: Powerpoints

Voigt, Term Iv, 2006

Marshall School of Business Page 567 Department of Management and Organization

How?

WBMH Framework

How?

WBMH Framework

Worldwide Product Division

Global Matrix

CEO/ PRESIDENT

Product Division A

Product Division B

CEO/ PRESIDENT

Product Division C

Product Division D

Area Product Manager: U.S.

Area Product Manager: U.S.

Area Product Manager: U.S.

Area Product Manager: U.S.

Area Product Manager: Japan

Area Product Manager: Japan

Area Product Manager: Japan

Area Product Manager: Japan

MOR 492 Global Strategy

Subs. Mgr. Japan

WBMH Framework

Network Business manager

Product Division B

Product Division C

Manager A

Manager B

Manager C

Subs. Mgr. Germany

19

How?

Product Division A

MOR 492 Global Strategy

How?

20

Organizational Implications: The Integrated Network

Business manager DECENTRALIZED FEDERATION

CENTRALIZED HUB

Business manager

WBMH Framework

Business manager

Corporate Management

THE INTEGRATED NETWORK

Business manager

Business manager

MOR 492 Global Strategy

GSBA 519b Corporate & Global Strategy

21

MOR 492 Global Strategy

COORDINATED FEDERATION

22

Keith Parker, University of Southern California

4

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