Gaining and Sustaining Competitive Advantage - Case Study Example

Strtegic Mngement [Nme of the school] [Nme of the Introduction It hs been recognized t lest since dm Smith tht profits re the driving force in cpitlist economy. There re no stte plnners to issue directives concerning the productive use of the stte's resources. Hbit, though not without importnce, cnnot be held responsible for the production nd exchnge of goods. nd benevolence, however widespred, does not supply sufficient inducement for individuls to use their own lbor nd property in generting output, especilly when there is no gurntee of reciprocl benevolence. It is insted the desire for personl gin, the promise of profit, tht motivtes orgniztions to initite productive ctivity. "The considertion of his own privte profit is the sole motive which determines the owner of ny cpitl to employ it either in griculture, in mnufctures, or in some prticulr brnch of the wholesle or retil trde." (Smith, 1965) In the following pper I will discuss the theories of profit mximiztion tht rgue bout different pproches to the question. Discussion includes Bumol's theory of sles mximiztion, mngeril utility theory by Willimson nd the theory of stisficing introduced by Simon. Bumol - Sles Mximistion Sles mximistion under profit constrint does not men n ttempt to obtin the lrgest possible physicl volume (which is hrdly esy to define in the modern multi-product firm). Rther it refers to mximistion of totl revenue (dollr sles) which, to the businessmn, is the obvious mesure of the mount he hs sold. Mximum sles in this sense need not require very lrge physicl outputs. To tke n extreme cse, t zero price physicl volume my be high but dollr sles volume will be zero. There will normlly be well determined output level which mximises dollr sles. This level cn ordinrily be fixed with the id of the well known rule tht mximum revenue will be ttined only t n output t which the elsticity of demnd is unity, i.e. t which mrginl revenue is zero. (Johnson, Scholes, 2006) The essentils of Bumol's model cn most esily be exmined with the help of digrm showing totl cost nd totl revenue curves. (Thompson, 2001) Hence Figure1 shows possible totl cost nd totl revenue curves for typicl price mker denoted s TC nd TR respectively. lso shown is profit curve () showing, for ech level of output, the difference between totl revenue nd totl cost. The output t which revenue is mximum in the cse illustrted is Q1, whilst the profit-mximizing level of output is Q3. However, the firm's choice of output lso depends upon the level of profit required to keep shreholders hppy, nd three possible cses re shown in the digrm. When the required level of profit is 1, it is less thn the profit erned t the revenue-mximizing output of Q1 nd so tht is the output produced. If, however, the required level of profit is 2, the profit t Q1 is insufficient to meet this requirement, nd the mximum revenue it cn obtin with profit of 2 is t output Q2, so tht is the chosen output in this cse. It should lso be pprent from the digrm tht s the required level of profit rises the output tht mximizes revenue subject to obtining the required profit flls nd, in the cse illustrted, when the required profit level rises to 3 the only wy the firm cn meet it is to mximize its profits nd produce n output of Q3. Similrly, of course, if the firm's opportunities to ern profits bove the level required by shreholders re restricted by competitive conditions, the possibility of pursuing other thn profit-mximizing objective will lso be limited. However, in less competitive environment this model predicts tht firms will produce n output greter thn the profit-mximizing output, which will hve to be sold t lower price. (Thompson, 2001) The model cn be elborted further to tke ccount of dvertising behviour nd the like, but the simple cse illustrted in Figure 1 is sufficient to demonstrte one interesting feture of the model relting to the response of the firm to profits tx. If such tx is imposed, whether it is lump-sum or proportionl tx on profits, the profits potentilly vilble to shreholders re the net-of-tx profits, which re less thn the gross profits by the mount of the tx. If, in the digrm, the dshed curve * represents the net-of-tx profits fter tx hs been imposed, it cn be seen tht when 1 is the required level of profits the firm hs to reduce its output to Q1 *, nd if 2 is the required level of profit output hs to be reduced to Q2 *. (Eden, ckermn, 1998) This is in mrked contrst to the more trditionl profit-mximizing model, which predicts tht firms do not chnge their output following the imposition of profits tx, becuse the output t which before-tx profits re mximized is lso the mximum profits output fter tx. In the Bumol model the tx leds Figure 1: Bumol's Constrined Sles Mximiztion Model.1 to chnge in output unless either competitive pressures re such tht the firm is forced into profit-mximizing behviour to meet shreholders' requirements, or, t the other extreme, fter-tx profits re more thn enough to meet shreholders' requirements when sles revenue is mximized. Willimson - Mngeril Utility One obvious criticism of Bumol's model is tht it relies on n oversimplified mngeril utility function, which, becuse it contins only one independent vrible, does not llow ny ccount to be tken of the trde-offs between objectives tht re likely to be n importnt feture of mngeril nd indeed ny economic decision-mking. lter development by Willimson, now sometimes referred to s the expense-preference pproch, tkes explicit ccount of such trde-offs nd so is worth considering further. The bsis of Willimson's pproch is tht the vribles in the mngeril utility function re enhnced by certin types of expenditure. In his bsic model he identifies three types of expenditure tht he thinks re prticulrly relevnt. These re expenditure on stff, reflecting the ide tht mnger's slry nd sttus re greter the more stff he hs under his control; expenditure on mngeril perks, expense ccounts, compny crs nd the like; nd discretionry profit. The ltter is simply the profit left over fter ll costs hve been covered, ll tx libilities met, nd the shreholders pid dequte dividends. This residul is then t the disposl of mngers nd cn be spent on prestigious investment projects, the sponsorship of sporting or culturl events, contributions to politicl prties nd the like, or be used to build up reserves. Simplifying little, to fcilitte digrmmtic nlysis, we will ignore expenditure on mngeril perks, so tht the utility function tht mngers seek to mximize, subject to meeting the shreholders' minimum profit requirements, cn be expressed s U = U(S, D), where S is the stff vrible nd D is discretionry profit. S cn in fct be interpreted in vriety of wys. It could, for exmple, be the totl lbour force or it could be stff in prticulr ctegory, such s 'hedqurters' stff or 'professionl' stff. It could lso be defined in terms of expenditure rther thn numbers, but for present purposes we will define it in terms of numbers. Discretionry profit is simply ctul profit less the profit required to keep shreholders hppy. The ltter Willimson tkes to be fixed sum, s in the Bumol model. Willimson lso ssumes tht S is vrible in the demnd function operting like dvertising nd product vribles to increse the demnd for the firm's product t ny given price (they could lterntively be treted s n input into the production process). With this prticulr formultion, for ech level of S specific demnd nd mrginl revenue curve cn be derived nd the firm's objective requires tht, t the chosen level of S, mrginl cost equls mrginl revenue. We cn, therefore, first of ll find the profit tht is obtined t ech level of S when mrginl cost nd mrginl revenue re equl. We cn then subtrct the profits required by shreholders to obtin the vlue of D t ech level of S nd plot the reltionship between S nd D. The ltter will be of the form illustrted by the curve DP1 in Figure 2, rising to mximum t the profit-mximizing vlue of S, which is S0 in the digrm, nd declining therefter. If then, s seems resonble to suppose, the firm's utility function cn be represented by conventionl, downwrd-sloping, convex-to-the-origin indifference curves, its optimum position is t T1, where one of the firm's indifference curves is tngentil to DP1, involving the employment of S1 stff nd discretionry profits of D1. Moreover, it cn be seen tht, s long s the indifference curves re downwrd sloping (tht is, n increse in S yields positive utility), the preferred position must involve more thn the profit-mximizing level of stff, nd, s long s they dd to demnd, greter output. Hving derived the firm's optimum position we cn go on to consider the effects on tht position of prticulr chnges. Of prticulr interest in tht respect is, s in the previous model, the effect of tx on profits, becuse gin such tx is predicted to hve some effect on the firm's position. In this cse, however, distinction cn be mde between lump-sum tx nd proportionl one. Figure 2: Mngeril Utility model2 In Figure 2 the effect of lump-sum tx is simply to displce the curve DP1 downwrds by the mount of the tx, for exmple to the position indicted by the dshed curve DP2, nd is thus similr to the effect on the consumer of simple income chnge. In the digrm, the firm's preferred position moves to T2, where the indifference curve U0 is tngentil to DP2. The precise effect on S nd D thus clerly depends on the exct form of the curves, but so long s both vribles in the utility function re norml, which seems resonble ssumption, T2 must be below nd to the left of T1, suggesting reduction in both S nd D. In ddition, the reduction in S leds, in Willimson's formultion, to some reduction in the demnd for the firm's product nd hence its output. So, gin, contrry to the trditionl model, this model predicts n output chnge s result of lump-sum profits tx. The sme is lso the cse with proportionl tx on profits, except tht the direction of chnge is more mbiguous. The effects of proportionte tx on profits on the DP curve, t lest where D is positive, is indicted by the dshed curve DP3 in Figure 3. It will be noted tht this is fltter thn DP1 (the curve in the no-tx sitution) becuse, in bsolute terms, the greter the profits the higher the tx pyments. This mens tht the proportionl profits tx hs substitution s well s n income effect. Further, since the effect is to reduce the cost of stff reltive to discretionry profits (stff costs being deductible for tx purposes), the substitution effect tends to increse the firm's use of stff. The income effect, however, opertes s in the previous cse (gin ssuming stff is norml good) in the opposite direction. The net effect therefore depends on the reltive sizes of the two effects. The digrm illustrtes the cse where the income effect domintes, nd hence where the tx leds to reduction in the stff employed (nd hence in output). The opposite result is, of course, eqully likely, but the importnt point is tht the Willimson model gin points to the possibility of n output chnge. Figure 33: We hve looked t the model in firly simplified form, but clerly it cn be elborted nd its supporters rgue tht it does offer useful insights into the behviour of the firm. Moreover, the fct tht the predictions of the theory differ from those of the trditionl model would seem to provide useful bsis for testing the model empiriclly. However, in prctice it is not esy to mesure with ny degree of precision the relevnt vribles. Nevertheless, Willimson (1963), in one of his erly ppers on this pproch, did crry out some empiricl tests tht he thought were t lest suggestive of some support for his hypothesis. Simon - Stisficing Herbert Simon introduced the concept of "stisficing" nd the word "stisfice" in the contemporry theory of economics, the notion tht decision mkers seek lterntives tht re "good enough" rther thn "the best". In his two rticles (Simon 1955, 1956) one published in mjor economics journl, the other in mjor psychology journl he rgued tht the cognitive limittions of humn decision mkers were importnt constrints on rtionl ction, nd they developed the ide of "stisficing," Mrch (1978) summrized Simon's rgument: It strted from the proposition tht ll intendedly rtionl behvior is behvior within constrints. Simon dded the ide tht the list of technicl constrints on choice should include some properties of humn beings s processors of informtion nd s problem solvers. The imittions were limittions of computtionl cpbility, the orgniztion nd utiliztion of memory, nd the like. He suggested tht humn beings develop decision procedures tht re sensible, given the constrints, even though they might not be sensible if the constrints were removed. s short-hnd lbel for such procedures, he coined the term "stisficing." (590). more relistic pproch ws incorported into the theory of stisficing nd it is clled bounded rtionlity. (Thompson, 2001) Simon's theory of bounded rtionlity rgues for the rtionlity of following rules of thumb. (Wit, Meyer 2004). These re simple procedures tht fcilitte decision mking when the decision environment is too complex reltive to people's mentl nd computtionl cpbilities. When discussing the reltion between bounded rtionlity nd institutions, the first thing to note is tht these rules of thumb mybe followed by single individul, while the concept of institutions implies tht mny individuls re involved. Indeed, Simon's work hs been criticized by both old nd new institutionlists for not pying enough ttention to the socil context in which people ct nd interct (Lnglois 1986; Hodgson 1988), nd institutions re crucil component of this context. This criticism should be qulified by cknowledging t lest two things. First, Simon hs extensively reserched orgniztions, which must be recognized, even by those who prefer not to include them in the definition of institutions, s n importnt socil context in the economy. Second, there re lesser known pieces of Simon's work tht do py ttention to the socil environment where people ct nd interct nd to institutions in prticulr (prt from orgniztions), even if not in the wy institutionlists would do it. See, for exmple, Simon (1952) on socil interction nd especilly Simon (1958, 390-93) on institutions. In this ltter pper, Simon cme closer to the old, or originl, institutionlist view of institutions s ptterns of socil behvior nd rgued tht neoclssicl economist would correctly chrcterize his description of socil behvior s "institutionlist." These qulifictions notwithstnding, it seems right to sy tht Simon's theory tends to focus on fully conscious behvior. This implies reltive neglect not only of hbits (which, like Simon's rules of thumb, my be strictly individul) but lso of importnt spects of non-orgniztionl institutions (which some institutionlists, following Veblen, conceive of s socilly spred hbits nd which cn be more generlly conceived of s socilly shred nd/or prescribed stndrds of behvior nd thought) nd orgniztionl routines. Much of our rule-following behvior is subconscious, be it strictly individul or not. Furthermore, hbits nd institutions my embody tcit knowledge. This neglect on Simon's prt hs lso been criticized by both old nd new institutionlists (Lnglois 1986; Hodgson 1988). gin, the criticism must be qulified by repeting tht Simon's neglect of hbits is reltive rther thn bsolute. In ny cse, following socil rules my be simple, prcticl, stisfctory wy of behving in complex socil environment. In ddition to Simon nd some old institutionlists, other economists hve emphsized this, like Ronld Heiner (1983) who emphsized the rtionlity of rule following in situtions mrked by wht he clls competence-difficulty gp. This rtionliztion of rule following in complex situtions my be supported by the ide tht institutions reduce complexity (Beckert 1996). This ide needs to be spelled out, though. For exmple, Richrd Lnglois (1986) rgued tht institutions "serve to restrict t once the dimensions of the gent's problem sitution nd the extent of the cognitive demnds plced upon the gent." This does not necessrily men tht institutions mke the environment (s distinct from the decision problem) less complex. nyone rguing tht they do should explin specificlly how. In sum, firly brod reding of Simon's contributions revels tht he does mke importnt points regrding institutions. t the sme time, it lso revels tht there is still room for improving upon his tretment of institutions in reltion to bounded rtionlity. Considering the issues discussed in this section, revised theory of bounded rtionlity for complex socil world would highlight the prts of Simon's work tht focus on institutions nd on the socil environment nd would give more prominence to non-orgniztionl institutions, subconscious behvior, nd tcit knowledge thn Simon did. It would then rgue for the rtionlity of following socil rules, s distinct from strictly individul ones. However, this revised theory would still be indequte to study behvior under fundmentl uncertinty. Before incorporting fundmentl uncertinty into this discussion of rtionlity, it should be noted tht nother line of reserch links bounded rtionlity nd institutions by treting the former s reson for the existence of some of the ltter (with institutions defined in brod wy, which includes orgniztions). This line ppers, for exmple, in some strnds of new institutionl economics, notbly tht of Oliver Willimson (1985). In the more forml literture on incomplete contrcts, there re occsionl references to bounded rtionlity, but the difficulties in formlizing bounded rtionlity seem to hve plyed n importnt role in preventing it from becoming n integrl prt of the incomplete contrcting literture so fr. Moreover, Oliver Hrt (1990), for exmple, mintined tht bounded rtionlity is not importnt for theory of orgniztions such s the firm, lthough it my be crucil for theory of court intervention in contrctul disputes. Neoclassical theory "Neoclassical economics refers to a general approach in economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand. These are mediated through a hypothesized maximization of income-constrained utility by individuals and of cost-constrained profits of firms employing available information and factors of production."4 Neoclassical economic theory leads to the basic conclusion that a perfectly competitive market system will lead to Pareto optimal outcomes. The theory embodies a defense of the social relation of private ownership of means of production, of the efficacy of Smith's invisible hand, and of the policy of minimum government intervention in the workings of the market process. Neoclassical theory generally posits a world in which individuals pursue their individual material interests, and in which the general welfare of the population will be promoted. The theory abstracts from internal societal conflicts (especially class conflicts) and postulates that any divergence from Pareto optimality is ephemeral and automatically corrected. Neoclassical economists advocate free trade as a logical extension of this framework arguing that gains for all parties can be made from it as long as each country specializes in products in which it has comparative advantages. Planned industrialization by countries lacking comparative advantage in industrial production will result in inefficiency and loss of output. Since the theory assumes Pareto-optimal equilibrium as a fundamental norm, the optimal role of government is minuscule. Neoclassical theorists however concede that in reality Pareto equilibrium may not be attained, because among other things, the selfish actions of some individuals may have negative effects on others. The usual proposals to address the externality problem, however, require a larger role for governments, creating tension over the postulate of minimal government proposition. Neoclassical economic theory accepts as a given the existing distribution of wealth and income. It assumes that production is unaffected by wealth distribution and that the competitive economy will work to maximize social welfare. The theory postulates a model of distributive justice as each factor used in production is paid an amount equal to the value of its marginal contribution to the production process. Neoclassical economic theory serves as an effective apologia for existing social relations. The theory accepts the capitalist system as the proper medium through which social order is promoted and maintained. Bibliography: 1. Adam Smith, Wealth of Nations ( New York: Modern Library, 1965), p. 355. 2. B. De Wit and R. Meyer. 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Hill, C.W.L. and Jones, G.R. (2000) Strategic Management: An Integrated Approach. (5th edn). Houghton-Mifflin, Boston. 10. Hodgson, G. Economics and Institutions. Philadelphia: University of Pennsylvania Press, 1988. 11. Johnson, G., Scholes, K. (2006) 'Exploring Corporate Strategy'' 7th Ed. FT Prentice Hall 12. Langlois, R. "Bounded Rationality and Behavioralism: A Clarification and Critique." Journal of Institutional and Theoretical Economics 146, no. 4 (1990): 691-95. 13. Langlois, R. "Rationality, Institutions, and Explanation." In Economics as a Process: Essays in the New Institutional Economics, edited by R. Langlois. Cambridge: Cambridge University Press, 1986. 14. March, James G. 1978. Bounded Rationality, Ambiguity, and the Engineering of Choice. Bell Journal of Economics 9: 587608. 15. Simon, H "The Role of Expectations in an Adaptive or Behavioristic Model." In Expectations. Uncertainty, and Business Behavior, edited by M. Bowman. New York: Social Science Research Council, 1958. 16. Simon, H. "A Behavioral Model of Rational Choice." Quarterly Journal of Economics 69 (1955): 99-118. 17. Simon, H. "A Formal Theory of Interaction in Social Groups," American Sociological Review 17 (1952): 202-11. 18. Simon, H. "Rational Choice and the Structure of the Environment." Psychological Review 63, no. 2 (1956): 129-38. Reprinted in Simon 1982b. 19. Thompson, J L (2001) Strategic Management. (4th Ed) Thomson Learning. London. 20. Wheelen, T.L. and J.D. Hunger, Strategic Management and Business Policy, 9th Edition, Prentice Hall, 2004. 21. Williamson, O. E. (1963), 'Managerial discretion and business behavior', American Economic Review, vol. 53, pp. 1032-57. 22. Williamson, O. E. (1964), The economics of discretionary behavior: managerial objectives in a theory of the firm (Englewood Cliffs, NJ: Prentice-Hall). 23. Williamson, O. The Economic Institutions of Capitalism. New York: Free Press, 1985. Read More