Chapter 5 405

Why would a firm choose to allocate economic value towards consumer surplus rather than producer surplus?

(1) It can charge higher prices to reflect the higher value and thus increase its profitability, or (2) it can charge the same price as competitors and thus gain market share. Given this, the strategic objective is to maximize (V−C), or the economic value created.

What are the advantages and disadvantages of using economic value creation to measure firms' competitive advantage?

Advantages: It provides the foundation upon which to formulate a firm's competitive strategy of cost leadership or differentiation. For now, it is important to note that a firm has a competitive advantage when it creates more economic value than rival firms.

What are the advantages and disadvantages of accounting measures?

Advantages: easy to compute, less volatile, relative profitability Disadvantages: historical data-thus looking backwards, Do not conside off balance sheet items, do not consider cost of capital, focuses on tangible assets.

3. Are firms with the following financial results earning below normal, normal, or above normal economic performance? a. ROA = 14.3%, WACC = 12.8% b. ROA = 4.3%, WACC = 6.7% c. ROA = 6.5%, WACC = 9.2% d. ROA = 8.3%, WACC = 8.3%

Answers a. Above normal economic performance b. Below normal economic performance c. Below normal economic performance d. Normal economic performance

Disadvantages:

Determining the value of a good in the eyes of consumers is not a simple task, The value of a good in the eyes of consumers changes based on income, preferences, time, and other factors, To measure firm-level competitive advantage, we must estimate the economic value created for all products and services offered by the firm.

What are economic measures of competitive advantage?

If a firm earns a 20 percent return on equity and the firm calculates that its cost of capital is only 12 percent, then we would conclude that the firm has a competitive advantage. Economic measures are a matter of comparing a firm's returns to its cost of capital. a firm's cost of capital reflect the markets' expectations about the firm and other similar firms. If a firm earns in excess of that cost of capital, the firm has bested the markets expectations—indicating that the firm has an advantage over other firms.

Below Normal Return

Of course, a firm earning less than its cost of capital is said to be earning a below normal economic return. Firms cannot survive long if they are earning below normal economic returns. Investors will take their capital elsewhere.

What are business models? What is their relationship to strategy?

Organizational plan that details the firm's competitive tactics and initiatives (how the firm intends to make money)

What does each category of ratios (i.e. profitability, liquidity, leverage, activity) tell you about the firm?

Profitability: most commonly used Liquidity: a firms ability to met its short term financial obligations Leverage: firms level of financial flexibility Activity: level of activity in a firm's business. Accounting ratios of the focal firm are simply compared to industry averages of those ratios to determine if the focal firm is achieving better than average performance.

Above Normal Economic Return

Specifically, a firm is said to be earning an above normal economic return if the firm is earning more than its cost of capital. An above normal economic return is indicative of a competitive advantage. By definition, such a firm is said to be exceeding the expectations of the market. This is another important indicator of competitive advantage. The firm is doing better than the market expects a firm to do in its particular industry. Such a firm will likely attract new capital as investors will be eager to get in on the higher returns of this firm.

Important point

The relationships between types of competitive advantage, accounting performance, and economic performance are fairly straightforward. A competitive advantage is said to lead to above average accounting performance and above normal economic performance. Competitive parity leads to average accounting performance and normal economic performance. Of course, competitive disadvantage is said to lead to below average accounting performance and below normal economic performance.

Normal Economic Return

When a firm just earns its cost of capital it is said to be earning a normal economic return. Such a firm is meeting the expectations of the market with regard to the level of risk an investment in such firm entails. Another way of looking at this idea is that if a firm is earning a normal return, investors are just barely willing to keep investing in the firm. If the firm were to earn any less, investors would pull their capital out of the firm.

What is consumer surplus?

diff. btwn value a consumer attaches to a good or service (V) - what they paid for (P)

What is producer surplus?

price - cost

Understand the economic value creation approach to measuring competitive advantage: how is it measured?

the dollar amt a consumer would attach to a good/service, the consumer's maximum willingness to pay aka reservation price. difference btwn value and costs (V-C) aka economic contribution