Global Economy, Markets and Strategy
Agenda
- Case: TenAlpina Tools: The Entrepreneur's Dilemma.
- Ronald Coase's Theory of the Firm.
- Cost Structures of Vertical Integration.
- Economics of Markets with Superstar Firms.
A classic question in economics.
- Ronald Coase (1937): "Why do firms exist?"
- After all, competitive markets are incredible allocation mechanisms.
- Why not just use markets for all trades?
Theory of the Firm.
Firms operate in places where transaction costs dominate the benefits of fluid market pricing.
- Explains why (for example) most labor includes a contract to organize production.
- This theory informs us of what will cause firms to shrink/grow.
- It can guide our thinking on the case's integration problem.
- Reveals that firms and markets do not have identical incentives.
How does Giulia's firm change if she chooses to take over the forge?
Relevant changes to cost structure.
| Drivers of Cost | |
| Resource Intensity | |
| Unit Cost Structure | |
| Economies of Scale/Scope | |
| Fixed and Variable Costs | |
| Customer Acquisition Costs |
Relevant changes to revenue structure.
| Drivers of Revenue | |
| Consumer WTP | |
| Average Time to Sale | |
| Customer Lifetime Value |
Relevant changes to partnerships.
| Key Partners | |
| Key Resources from Partners |
Relevant changes to value proposition.
| Value of Product | |
| Product Differentiation | |
| Replication from Firms |
Option 1: Don't buy the forge, continue with on-demand sales.
Option 2: Buy the forge, take two year deal with customer.
| Option 1 | Option 2 | ||
| Price | |||
| Variable Costs | |||
| Fixed Costs | |||
| Profit Margin | |||
| Profit Equation | |||
| Breakeven Volume |
When does buying the forge become more profitable than not?
What advice would you give Giulia on her potential negotiations for the forge?
What, economically speaking, is it about TenAlpina and its market that keeps profit margins so low?
Superstar firms.
Even in competitive markets, some firms are able to simultaneously operate at a low average cost and a high marginal cost. A high marginal cost implies a high market price, and a low average cost implies enormous profit margins to the "superstar" firm.
Necessary conditions for Superstars.
- Positive network effects among consumers.
- Production technologies offer a "long tail" of economies of scale.
- Product/service is very difficult to imitate.
| Network Effect | Economies of Scale | Difficult to Imitate | Example |
|---|---|---|---|
| Yes | Yes | Yes | |
| Yes | Yes | No | |
| Yes | No | Yes | |
| Yes | No | No | |
| No | Yes | Yes | |
| No | Yes | No | |
| No | No | Yes | |
| No | No | No |
Implications for the labor market.
Alfred Marshall, 1947: "The relative fall in the incomes to be earned by moderate ability...is accentuated by the rise in those that are obtained by many men of extraordinary ability. There never was a time at which moderately good oil paintings sold more cheaply than now, and...at which first-rate paintings sold so dearly. A business man of average ability and average good fortune gets now a lower rate of profits...than at any previous time, while the operations, in which a man exceptionally favoured by genius and good luck can take part, are so extensive as to enable him to amass a large fortune with a rapidity hitherto unknown."
Key takeaways.
- Most competitive markets don't allow firms to produce large profits, such as TenAlpina.
- A few competitive markets have the necessary attributes to produce superstar firms that can be abnormally profitable. There is an appropriate analogy to some labor markets, such as in tech, finance, politics, and entertainment.
- These attributes include consumer network effects, long tails of economies of scale, and barriers for imitation.
- Superstar firms are inherently very risky, since small variations in the market can lead to large variations in earnings. However, they also generate large welfare gains for market participants.