Class 1: The Economics of Relationships
Textbook reading: Kreps, Preface and Chapter 1, “The Economics of Relationships (and Porter’s Five Forces).”
Key Ideas
The profitability puzzle
- Some industries are lucrative and stay that way for decades
- Average return on equity (annual profit as a share of the owners’ invested capital), every firm, 1990 to 2010:
- Tobacco: above 30%
- Pharmaceuticals: near 20%
- Automobiles: around 10%
- Airlines: around negative 9%
- Twenty-year averages across whole industries, so it is not one clever CEO: something about the industry itself makes it lucrative or miserable
Porter’s Five Forces (plus one)
A checklist for finding that something. More yeses, more profit.
- Entry. Is it hard for newcomers to enter?
- Substitutes and complements. Do customers have few good substitutes, and cheap complements?
- Suppliers. Are suppliers numerous and interchangeable, so they cannot pull profits upstream?
- Customers. Are customers numerous and interchangeable, so they cannot bargain profits away downstream?
- Rivalry. Is competition among incumbents restrained, not a running price war?
- Environment (Kreps’s addition). Is the legal, political, and social environment favorable?
The checklist is only a start
- Every item is a tendency, not a law
- Every item is really a question about a relationship
- Relationship with rivals
- Relationship with suppliers
- Relationship with customers
- Relationship with the government
Where supply equals demand stops working
- In Principles, you learned equilibrium is where supply meets demand
- But that was about large anonymous markets, identity irrelevant, one price clears
- It says nothing about the impact of these dynamic relationships on profitability
- Unit 1: build a language for the Economics of Relationships
Problems of the Day
Q1: The Profitability Puzzle
Two business school professors measured how profitable the firms in different industries have been, averaged over roughly two decades. Cynthia Montgomery, using return on equity from 1990 to 2010, found tobacco above 30%, pharmaceuticals near 20%, automobiles around 10%, and airlines around negative 9%. Michael Porter, using return on invested capital from 1992 to 2006, found pharmaceuticals at 31.7% and airlines at 5.9%. The measures differ, but the ordering doesn’t move.
These are averages across every firm in the industry over twenty years, so this is not about one well-run company. Something about the industry itself makes tobacco and pharmaceuticals lucrative and airlines miserable. For each of the four industries in Montgomery’s list, write down the single most important reason you can think of for its position.
Pick an industry not on the list and predict its profitability using Porter’s five forces. Go force by force: for each one, decide whether it pushes the industry’s profits up or down, and how hard. Then commit to a prediction: well above average, about average, or well below average. You might pick:
- Prepackaged software (Microsoft, Oracle, Adobe)
- Hotels
- Grocery Stores
- Child day care centers
Compare to the data. Porter’s own measure, average return on invested capital across every U.S. firm in the industry from 1992 to 2006, with 14.9% the average across all industries:
| Industry | ROIC, 1992 to 2006 |
|---|---|
| Prepackaged software | 37.6% |
| Child day care centers | 17.6% |
| Grocery stores | 16.0% |
| Hotels | 10.4% |
- You can look up estimated average ROICs for any industry. Does this mean you should buy stocks in tobacco and pharmaceuticals and avoid airlines and hotels?
Q2: The Third Coffee Shop
There are two coffee shops within a block of campus. Both are visibly busy, both charge $5.50 for a latte, and a friend with access to their books tells you each clears about $150,000 a year in profit for the owner. A storefront between them has just come up for lease. You have the savings to open a third shop.
Before you sign the lease, list at least 5 specific questions you would have. Which could you actually answer by doing research, and which could you only answer by guessing?
Focus on the two existing shops. The day you open, what could they do to you? Now go back a step: what could they do today, before you have signed anything, to convince you not to open at all?
Suppose the two existing shops are owned by the same person. Does that make entry more or less attractive? Why?
What if instead, the two existing shops are fierce rivals who have been in a price war for a year. Does that make entry more or less attractive? Explain.
Answers
- 1A:
- Tobacco: addictive product, advertising bans freeze entry, few substitutes.
- Pharma: patents block entry; sick patients and insurers have weak bargaining power.
- Autos: capital intensive and few substitutes, BUT powerful unions and dealers, intense rivalry.
- Airlines: easy entry with leased planes, unions and Boeing/Airbus upstream, price-sensitive customers with perfect price comparison.
- 1B:
- Software: near-zero marginal cost, locked-in customers make competitors poor substitutes
- Grocery stores: low barriers to entry, customers are price-sensitive, and many suppliers are strong (Coke, Kellogg’s, Tide, Frito-Lay), but many suppliers are also weak (milk, produce, eggs, flour, meat come from farmers).
- Day cares: low barriers to entry, but customers (families) have weak bargaining power, as do suppliers (labor).
- Hotels: heavy fixed capital makes entry hard, but customers are price sensitive and there is cyclical demand.
- 1C:
- No. This data is public, so tobacco’s high profits are already built into its share price: you pay a high price for a high-profit firm and a low price for a low-profit one, and neither is an especially good bargain. A stock is a good buy only if you expect the firm to do better than the market expects (and you end up being right). The five forces are for managers deciding how to compete, not investors deciding what stocks to buy.
- Question 2:
- Foot traffic, rent, lease terms, wholesale costs, wages: researchable. How the two shops will react: a guess.
- After entry: price cuts, loyalty cards, longer hours. Before entry: signal that they will fight. Cheap signals (a sign in the window) are not credible; costly ones (a visible price cut now, leasing the empty storefront themselves) are.
- Less attractive. One owner can credibly coordinate a price war and absorb losses at both shops.
- Can be less attractive even though the incumbents are weaker: there is no margin left to take, and they have already shown they fight, which makes the threat to fight a third shop fully credible.