WEEK 9 - Competitive Advantage and Principle Agent Problem Flashcards
Why is it difficult for a firm to maintain a competitive advantage?
- Rivals can imitate the formula for success
- Rivals can use new tech, products and business practises to erode comp adv of industry leaders
How have companies like Coca cola and Dell been able to maintain their advantage?
Using strategies like patents, trademarks and industrial secrets
What play a large role in maintaining comp advantage?
Market structure
In a perfectly competitive market does competitive advantage exist?
No, not while firms are price takers
In imperfect competition, does competitive advantage exist?
- Firms sell horizontally differentiated products to consumers who differ in their tastes.
- Each seller faces a downward sloping demand curve due to product differentiation
- Sellers get to set the price above marginal cost but there is no guarantee of economic profits.
- Entrants can slightly differentiate their products from the incumbents’ and create their own niche.
What does the resource based theory of the firm explain?
Explains sustained comp advantage in terms of heterogeneity in resources and capabilities
What do resources and capabilities have to be to maintain comp advantage?
- Scarce
- Imperfectly Mobile
- Unavailable in the open market
What are Isolating Mechanisms?
They limit the rivals from eroding firm’s competitive advantage
What are the two distinct types of isolating mechanisms?
- Impediments to imitation
- Early mover advantage
What exactly are impediments to innovation?
These mechanisms impede the potential entrants from duplicating the resources and capabilities of the incumbent firm
What are the 4 types of impediment?
- Legal Restriction
(Patents, Copyrights, Govt regulation like Licensing) - Superior access to inputs/customers
- Market size and scale economies
(Scale based barriers may come down if market experiences growth and entry becomes profitable) - Intangible Barriers
(Barriers to imitation, intangible if firm’s advantage lies in distinctive organisational capabilities)
Why is Innovation so important?
Increasing importance of intangible assets (Human knowledge/IP)
- Knowledge may also be created collectively (Open Source software
- Innovation = Source of econ growth
How does market structure affect incentives for R&D?
• Nature of technical progress: R&D investment
determines (instantaneously and for sure) the
size of the innovation; only a single firm ends up
using the innovation.
How is the incentives for R&D measured?
-Measured by the profit increase gained from the
innovation
How can innovation influence market structure?
• Races to be the first to innovate
• Nature of technical progress: ‘tournament
technical progress’; timing of innovation is
uncertain and depends on the R&D investments
of all firms; size of the innovation is fixed.
How do firms use R&D strategically?
Nature of technical progress: like 1st issue + size of innovation depends on the intensity of the firm’s
R&D investment (and potentially on the other
firms’ investments as well); firms have simultaneous opportunities to achieve competing innovations.
What are the two types of innovative environments?
- Ideas are scarce
- No substitute idea addresses the same econ need - Ideas are common knowledge
- Any good idea is likely to be had and implemented by someone else
What is Product Innovation?
Introduces new products or changes outward character of an old one
What is Process Innovation?
Reduces the cost of turning out an existing product
What are the differences between Process Innovation and Product Innovation?
Process innovation: generation, introduction and diffusion of a new production process (with the products remaining
unchanged).
Product innovation: generation, introduction and
diffusion of a new product (with the production process
being unchanged).
What is Drastic Process Innovation?
Allows the innovator to
behave as a monopolist without being constrained by price competition in the industry.
(SEE GRAPHICAL REPRESENTATION IN NOTES)
What is Nondrastic process innovation?
Innovator may gain
some cost advantage over its rivals but competition
constrains the innovator
(SEE GRAPHICAL REPRESENTATION IN NOTES)
What is Schumpeter’s view on innovation?
Stresses link between market structure and R&D
◦ Necessity of tolerating the creation of monopolies as a way to encourage the
innovation process.
(Larger firms innovate more)
What is Schumpeter’s theory of creative destruction?
Process where:
- Good products become monopolies
- Those products destroyed by better products and they become monopolies
- Rewards innovators and punishes firms that produced old technologies
What is one major downside to the theory of Creative destruction?
- Monopolies can build entry barriers
What are some more elements on the Schumpeterian view?
- Perfect competition is not the ideal market structure
- Large firms are able to spread fixed cost of research over a larger sales base
- Large firms have advantages in financial markets
- Large firms are better able to exploit economies of scale and scope in research
What is the replacement effect?
It indicates the lower incentive to innovate that a monopolist has, as compared to an entrant, when the innovation is drastic
A competitive firm places a larger value on a minor
process innovation than a monopoly does. (In terms of having sole use of innovation)
What is the model for the Replacement effect?
Homogeneous product, constant marginal cost of production
◦ Minor innovation ↓ cost from c0 to c1 < c0
◦ Profit incentive: willingness to pay for the innovation measured by the increase
in profit that the innovation generates
SEE GRAPHICAL REPRESENTATION IN NOTES
Why is the social value of the innovation higher than the value for the competitive firm?
Competitive firm fails to appropriate the increase in consumer surplus (Area 3)
How are patents transferable rights?
Via licenses
What is the importance of transferability?
Ensures that innovations and artistic creations used by the agents who value them most
- Additional source of profit to innovator
What are the differing modes of patent licensing?
- Royalty per unit of output produced with technology (influences price of final product)
- Fixed Fee: Influences the division of profits
- Combination of the two
What is the social viewpoint of Patents and Licensing?
Licenses increase diffusion and use of knowledge
What is the Private viewpoint of Patents and Licensing?
Additional source of profits for the innovators
◦ Only effect if licensee operates in a totally
different market from the licensor.
◦ Potential negative effect if licensor and licensee are direct competitors
◦ Net effect depends on
◦ Size of innovation
◦ Market structure
What does the net effect for patents and licensing depend on?
Net effect depends on
◦ Size of innovation
◦ Market structure
How do incomplete contracts affect the principal agent problem?
If one of the parties in an exchange or in a transaction has more complete knowledge than does the other, this generates an asymmetry condition which is costly to overcome (Akerlof, 1970)
How do firms respond to the asymmetry in info that can lead to the principal agent problem?
an incentive response (Jensen & Meckling)
2. a metering response (Alchian & Demsetz)
How can motivation problems cause a principle agent problem?
When asymmetric info and players are opportunistic
A self-interested person focuses on his own interests, while honouring
(implicit and explicit) agreements and showing respect for others.
An opportunistic person focuses on his own interests, and uses all possible means (including not honouring agreements, manipulating, cheating, stealing, etc.) to achieve them.
What exactly is the Principal Agent problem?
the principal wants the agent to perform an action costly to the agent, but the action is not directly observed by the principal.
When do agency problems arise?
The objectives of the principal and the agent are different and
o The actions of the agent are not observable by the principal or
o The information possessed by the agent is not observable by the principal
What is the typical process when two parties have asymmetric info? (Common Structure)
— Principal offers a contract to the agent
— Agent chooses an action
— Action of agent (or his type) is not observed by principle
Example of Principle agent problem and responses (Common structure)
Example 1: Manager and worker
— Manager employs worker and offers wage
— Worker exerts effort (not observed)
— Manager pays worker as function of output
Example 2: Shareholders and CEO
— Shareholders choose compensation for CEO
— CEO puts effort
— CEO paid as function of stock price
What is one of the issues to the way firms typically respond to the principal agent problem?
occasionally an agent that put a lot of
effort but has bad luck is ‘punished’
o Also, agents that shirked may instead be compensated
These problems called Hidden Action or Moral Hazard
Where does this Moral Hazard problem result from
the fact that the
agent has different objectives from the principal (min effort vs max profit)
observed especially in the presence of hidden
information
It’s a selfish behaviour which contracts cannot prevent
EXAMPLE OF HIDDEN TYPE OR ADVERSE SELECTION (MORAL HAZARD)
Example 1: Manager and worker
o Manager employs worker and offers wage
o Worker can be hard-working or lazy
Example 2: Shareholders and CEO
o Shareholders choose compensation for CEO
o CEO is high-quality or thief
What is the Agency problem of Observability?
actions are difficult and costly to observe and
outcomes, when they can be measured, might not be the result of effort exclusively (e.g. luck or fluctuations in
demand)
What is the remedy to the Agency problem of Observability?
Optimal reward scheme – provides high-powered
incentives
But:
might not guarantee efficient level of effort. Any piece rate
scheme that leaves the principal with a profit does not give the agent full benefit for effort (marginal benefit from 1 unit of output < marginal cost of effort)
◦ might lead to excess production (e. g. stockbrokers placing
excess buy or sell orders)
How do you combat agency problems?
To mitigate hidden action and hidden info is to:
- Monitor
- Watching employees or gather info - Pay-for-performance incentives
- Monetary Incentives - Bureaucracy
What are the problems with monitoring?
- Monitoring can be expensive
-Monitoring can be imperfect
-Monitoring can add an extra layer in the agency
relationship
