VALUE FOR STAKEHOLDERS STRATEGY STRUCTURE SALESSYSTEMS &PROCESSES PEOPLE LEADERSHIP ORGANIZA- TIONALCULTURE

ECONOMIC FOUNDATION OF STRATEGY

2018-02-05


by: Karol Zalewski-Biziuk 15 September 2015

I believe that a strategy is a coherent plan of creating values for stakeholders based on logical cause and effect relationships. And by “value” I mean “economic profit”. The latter, as opposed to book profit, takes into account the opportunity cost of an investor. 
What I would like to suggest now is a sort of a thought experiment. Let’s imagine a sector where none of the companies has a strategy or all of the companies have identical strategies. What happens? To illustrate this situation I will use the model of “a perfectly competitive market” which suits our analysis perfectly. A perfectly competitive market is one of the extreme markets (Begg, 1993, p. 218). It has a large number of sellers and buyers of a product. Both the companies operating on such a market and the consumers assume that their actions have no influence on the market price. Both groups are the so-called “price takers”. The participants of the market have perfect information on the situation on the market. There are no barriers of entry and exit. Nobody needs a strategy here.
In the light of the basics of microeconomics the initial situation in any sector (including the perfectly competitive) is illustrated by Fig. 1:



The Y-axis illustrates various prices of the product. The X-axis illustrates various quantities of the same product. Then, we have the S curve which represents the quantity of the product which the producers are willing to provide at a given price. Finally, there is the D curve which illustrates the quantity required (“absorbable”) by the market, also at various price levels. The point where the S curve and the D curve cross is the point of the so-called equilibrium price of supply and demand. The market requires Q1 quantity and is ready to “absorb” it at a P1 price. At the same time the producers are willing to provide such quantity at such price. The inclination angle of the curves is a result of a simple relationship. If the price drops, the market wants a larger quantity of the product and the other way round. If the price increases, the producers are ready to provide more products and the other way round. This is what the situation looks like in the entire sector. What does it mean for a company operating in such a sector? It is illustrated by Fig. 2. Here we have another two curves: MC and AC. The MC curve represents the so-called “marginal cost”, i.e. the cost of production of another (additional) product unit. The AC curve represents the average cost of sale of a product unit at different sales volumes. The shape of the MC curve is a result of the diminishing returns. The shape of the AC curve results from the structure of the total costs which at first decrease with the increase in the quantity of sold products and then increase as the limit of the company’s manufacturing capacities gets nearer. What quantity is the company willing to manufacture and sell at P1 price? We will now make a calculation.Profit equation:


Profit (P) = revenue – variable costs (VC) – fixed costs (FC),
Or in more “mathematical” terms: P = P1 x q – [VC(q) + FC]
It is simply the profit function from “q” quantity, P(q). As we all remember from our Maths classes in secondary school, each function has a maximum where its derivative equals 0. Therefore, to find the maximum of the P(q) function we have to calculate its derivative based on “q” and reach zero:
dP/dq = d{P1 x q – [VC(q) + FC)]}/dq = 0 that is: P1 – VC’(q) = 0 P1 = VC’(q) = MC
To maximize the profits our company, the “price taker”, will manufacture such a quantity of products where the price = marginal cost.
In such a way we realize profit = P1 x q1 – total costs (Fig.1). Everything is fine. But we are operating on the perfectly competitive market. Someone has realized that we are doing well and decides to manufacture and sell the same product in the same way we do it. What happens then? A larger quantity of the product is available on the market at various prices. The supply curve moves downwards (Fig. 3). At the same time the demand curve does not move because the number of consumers has not changed. The aggregate demand is at the initial level. As a result, as the S curve moves downwards, the equilibrium price drops and the aggregate demand increases. There is a positive reaction of the market to the lower price.



At some point, a new competitor moves the supply curve to the S2 level (Fig.3). How does it influence our company? As a “price taker” the company has to accept the new P2 price if it wants to sell anything. At the same time the profit optimization principle, price = marginal cost, is still valid. When adjusting the production volume to the level imposed by P2 price, the company reduces its economic profit to 0: turnover (P2 x q2) = total cost (Fig.4). From that moment on, the sector is at “equilibrium” because it would not be profitable for any new competitor to enter such sector.

There is the following conclusion from this analysis:
None of the companies generates economic profit on the perfectly competitive market. Or to put it in other words, if everybody does the same thing (has the same strategy or has no strategy at all), nobody will earn.
An example of such a situation is the sector of construction of small football pitches which came into being and developed dynamically in Poland in 2007-2012 as a result of the “Orlik 2012” national programme. At first, the construction of such facilities was very profitable. Even more so considering the fact that the pitches were built on the basis of a standard project. As a result, every year there were more and more companies willing to join the sector. Theoretically speaking a company standing as a candidate to build such a football pitch should demonstrate appropriate experience and have assets which would guarantee proper realization of the project. However, the (quite amusing) phenomenon of the so-called “exchange of references” between the companies permitted by the public procurement laws and low capital demand reduced the entry barrier to zero. In 2011-2012 there were tens of companies that fought for each contract for building a small football pitch, including local automobile repair shops and hair salons (!). As a result in 2011 construction of small football pitches did not bring any profits. Unfortunately, in this instance the market did not “stop” at the equilibrium point of a perfectly competitive market. The value erosion proceeded throughout the entire 2012. In consequence, the majority of the companies involved in the “Orlik 2012” programme in 2011-2012 ceased to exist.


There is only one logical conclusion. In a hypothetical world where all the companies in a given sector would have the same strategy or would have no strategy at all, it would not make any sense to do business. Especially in the long term.


Luckily, the majority of current markets demonstrate a number of imperfections” and do not suit the “perfect competition” model. Why? It seems that it is a consequence of the variety of strategies of the companies operating there. Individual strategies in the business are like the wind in sailing. A drive. A “summary vector” of all strategies of the companies operating within the sector generates the “wind”, the imperfection of the sector. The latter is, in turn, a direct cause for the existence of the economic profit pool (as opposed to the perfectly competitive sector where the profit in the long term is non-existent). The more clever the strategy of the company, the more it will “take” from such pool for its stakeholders. The intellectual effort required to create and implement a good strategy is thus the best investment a company can make.


References:
D. Begg, „Ekonomia”, tom 1, Państwowe Wydawnictwo Ekonomiczne, 1993