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9 Strategic Alliances INTRODUCTION A good way to start this chapter is by using an example that most students can relate to. Until 2006, accompanying the release of every Disney movie was an avalanche of commercials by McDonalds promoting characters from the movie in its “Happy Meals.” Why did McDonalds do this? The two companies had entered into a strategic marketing partnership in 1996 for 10 years that was valued at $10 billion. The two companies agreed to promote Disney movies using a marketing campaign featuring television and radio spots and in-store giveaways. Both companies benefitted from this arrangement. Disney got to create awareness for its movies and McDonalds used recognizable characters to draw customers (particularly kids) to their restaurants. What McDonalds and Disney had was a strategic alliance. After you use this example (or the example of a similar tie-in between DreamWorks and Burger King or Visa and the NFL) to help students understand what an alliance is (in broad terms) and how commonplace they are, it is important to relate strategic alliances to the rest of Part 3 of the text. Strategic alliances are a means of vertical integration and/or diversification and hence are part of corporate-level strategy. In this sense, they are a mode of entry once a firm has made the decision to enter a new business. Slide 9-2 This slide provides some context for strategic alliances in the course and in the strategic management process. Emphasize that strategic alliances are an important consideration in corporate level strategy. WHAT IS A STRATEGIC ALLIANCE? Define A Strategic Alliance and Give Three Specific Examples Of Strategic Alliances It is important to define strategic alliances clearly at the outset. The term “strategic alliances” is a broad one and includes any kind of cooperative effort between two or more independent organizations. The effort may revolve around manufacturing or marketing or both. Slide 9-3 This slide will help you define strategic alliances. It is important to point out that the definition is broad enough to include all kinds of cooperative relationships between organizations. This sets the stage for the three categories of strategic alliances discussion that comes later. Why would firms enter into strategic alliances? Firms enter into strategic alliances because of two important motivations: to access complementary resources and capabilities (that they do not have) and/or to leverage existing resources and capabilities. Thus, Disney has the capability to produce movies with compelling characters that children can identify with while McDonalds provides grassroots marketing. The notion of comparative advantage from international trade can be used here to explain the motivation for strategic alliances. Slide 9-4 Use this slide to take students through the basic motivations for forming strategic alliances. Explain that in both accessing and leveraging resources, an economic exchange is taking place. There must be a gain from trade in this economic exchange for an alliance to make sense. Gains from trade exist because one firm is better at something than other firms. This is the notion of comparative advantage. The ‘advantage’ can be realized by combining the complementary resources of two or more firms. Take the case of two countries, Canada and Mexico. Assume that Canada has an advantage in the production of wheat while Mexico has the advantage in bananas. Each country can independently produce both wheat and bananas. But if the countries form a strategic alliance, they can become more efficient in the production of the two products. Canada can export wheat to Mexico and import bananas from Mexico. Each country saves time and increases productivity. Slides 9-5 and 9-6 These slides illustrate the concept of gains from trade and comparative advantage. Use these slides to bring home the point that cooperation must benefit both partners if an alliance is to be economically feasible. Explain that Canada and Mexico can choose how to spend 2 hours of labor. Each can produce both wheat and bananas, or each could choose to specialize in the commodity in which they have an advantage. Go on to show how specializing and then trading can make both partners better off. Once the concept of a strategic alliance is understood, move on to explain the different types of alliances. Figure 9.1 is useful in this discussion. When firms agree to work together to develop, manufacture, or sell products or services, they are engaged in a nonequity alliance. The Disney-McDonalds alliance alluded to earlier is an example of a nonequity alliance. Neither McDonalds nor Disney invested in the equity of the other – rather the two agreed to work with each other for a certain period of time. Such agreements could involving licensing (where one firm allows the use of its design or brand name to another), supply agreements (agreeing to supply inputs), or distribution agreements (agreeing to sell another company’s goods). When agreements to work with one another are supplemented with equity investments, equity alliances are formed. The Disney-Pixar alliance is an example. Back in 1986, Disney took a small equity position in Pixar as part of the terms of the strategic alliance. The alliance was prior to Disney’s acquisition of Pixar in 2006. The “Strategy in the Emerging Enterprise” box in the chapter describes the Disney-Pixar alliance in detail. A special form of equity alliance is a joint venture. Here, the cooperating companies (the “parents”) create a legally independent firm in which they invest and from which they share any profits created. For example, the two pharmaceutical companies, Johnson and Johnson and Merck, created a joint venture (called Johnson and Johnson Merck Consumer Pharmaceuticals) to market over-the-counter pharmaceuticals such as Mylanta. Slide 9-7 You can use this slide to point out the three types of strategic alliances and the important differences among them. Ask students how partners’ incentives might be different depending on which type of alliance is used. Emphasize that cross equity holdings and/or joint venture ownership bind partners together more tightly because the financial interests of the alliance and the financial interests of the partners are more closely aligned.  Important Point: Although the strategic alliance partners own the joint venture, courts have ruled that the joint venture is a separate legal entity. When lawsuits were filed against Dow Corning in the silicone gel implant controversy, courts held that claimants cannot include the parent companies in the lawsuit.  Teaching Points • Emphasize the gains from trade and comparative advantage ideas to show how alliances can create value under certain conditions. • Point out that if a firm cannot identify a gain from trade from an alliance, the firm should not pursue that alliance. • Encourage students to consider specific examples of strategic alliances (such as Disney-McDonalds, Disney-Pixar) to understand the different types of alliances. • Make sure students understand that including equity in an alliance arrangement is a way to align the interests of the partners. • Point out that alliances are a very popular means to implement a firm’s strategy, and particularly so, in international markets. HOW DO STRATEGIC ALLIANCES CREATE VALUE? Describe The Nine Different Ways That Alliances Create Value For Firms and How These Nine Sources Of Value Can Be Grouped Into Three Large Categories The motivation to enter into a strategic alliance is value creation for the partners. How is value created in an alliance? Value is created in three broad ways: Helping firms improve the performance of their current operations Creating a competitive environment favorable to superior performance Facilitating entry and exit Students should be encouraged to think of these motivations as value creating opportunities. If sources of value creation and gains from trade cannot be identified in an alliance, then managers should be wary of entering into the alliance. Slide 9-8 This slide can be used to provide a quick signal to students about the three categories of value creation. Strategic Alliance Opportunities Alliances present great opportunities to benefit from economies of scale. Economies of scale (described in Chapters 2 and 4) exist when per unit cost of production falls as the volume of production increases. A single firm, for various reasons, may not have the scale to benefit from these economies. By combining with another firm, the efficient scale can be reached. Alliances may help improve operations because of learning opportunities. When firms work together, they can observe each other and transfer skills across firms. Such interactions help in learning. As the example of the NUMI alliance between General Motors and Toyota points out, both firms wanted to learn from each other. General Motors wanted to learn lean production techniques. Toyota, on the other hand, wanted to learn to operate manufacturing plants in the U.S., particularly to adapt their famed production technology to U.S. workers. Alliances are attractive when firms engage in projects that are expensive and where the risks are high. By combining forces, each firm reduces the downside risk if the project fails. Of course, this also means that the firms have to share the profits generated by the project. ► Example: Dreamworks SKG Dreamworks SKG is the movie company formed by the trio of Stephen Spielberg, Jeffrey Katzenberg, and David Geffen. From early on, the company decided to protect itself from the risk of a big budget movie failing at the box office. Established movie companies typically had a number of movies in various stages of production. Failure of one movie could be offset by succeeding releases. Also, old movies could be reissued on DVDs to provide a steady revenue stream. Since Dreamworks did not have a “library” of old movies nor a stream of movies under production, every big budget movie was a make or break event for the young company. The company decided to partner with other studios for such movies. By partnering, Dreamworks was able to reduce its exposure to the ups and downs of the movie business. Movies produced by Dreamworks under such alliances include The Gladiator, War of the Worlds, and Munich. Interestingly, this phenomenon is not limited to Dreamworks. The box office smash Titanic that cost more than $200 million was co-produced by 20th Century Fox and Paramount. (Variety, various issues). Slide 9-9 Point out that each of these operational sources of value creation is really a matter of there being a gain from trade for the partners. All partners contribute resources to the alliance that complement the resources committed by other partners. By trading, the partners develop something they couldn’t have developed on their own. The second category of value creation within strategic alliances is improvement of the competitive environment for the alliance partners. This can be done in two ways: setting technology standards and facilitating tacit collusion. Standards are very important in certain industries, particularly in those where technology plays a key part. Technology-based industries are typically network industries. Network industries exhibit an important phenomenon called “increasing returns to scale.” This term was used frequently in the Justice Department’s case against Microsoft. Certain products are more valuable to a buyer if a network of owners exists for that product. This is because the product is used for communication (exchanging message, data files, etc.) or the product requires a complementary product (such as DVDs for a DVD player). When competing formats emerge for a particularly technology, customers may be unwilling to invest in that product for fear of being left out of the network if an alternate standard becomes more popular. How should the firm developing the new technology approach this problem? A good way is to form a strategic alliance with other players (competitors and producers of complementary products) to establish its technology as the widely accepted standard. Sony’s Betamax lost out to Matsushita’s VHS primarily because Matsushita was willing to forgo some of its profits to its alliance partners while Sony decided to go solo. VHS became the industry standard while Betamax became a cautionary tale and the butt of jokes on late night TV! When firms talk to each other to coordinate their strategic actions, they engage in collusion. Explicit collusion is when they communicate directly with each other about their competitive intentions. Explicit collusion is illegal in most countries. The choice available to managers, then, is tacit collusion – colluding indirectly by exchanging signals about intentions to cooperate. Strategic alliances help in tacit collusion because the alliance partners work closely with each other. This constant interaction allows for many opportunities to indirectly communicate their strategic intentions. Slide 9-10 Explain that strategic alliances offer partners a way to coordinate their efforts in a mutually beneficial way. Ask students to identify the gains from trade in the Blu-ray alliance. Partners are giving up a degree of independence in return for the increased probability that they will be part of the new technology standard. A third category of motivation for forming strategic alliances is its role in facilitating market entry and exit. Alliances facilitate low cost/low risk entry into a new market or industry. By partnering with a firm that has complementary skills, the chances of success in the new market/industry go up. ► Example: Smart Money When Dow Jones & Company (the publisher of The Wall Street Journal) wanted to enter the magazine market, it realized that its skills in producing a daily newspaper were not adequate to succeed in the monthly magazine market. It formed an alliance with the Hearst company (a successful publisher of magazines such as Cosmopolitan, Good Housekeeping, etc.) to pool the skills of the two organizations. The alliance partners developed a personal finance magazine called Smart Money that was one of the most successful magazine launches ever. (websites of Hearst and Dow Jones & Co.) Alliances also help in exiting industries and markets. By forming a strategic alliance, the company that desires to exit has allowed another player (a potential buyer) to examine closely how valuable the seller’s assets are. Such information may not be fully available to the market and therefore the seller may believe that it is not going to get full value for its assets. By operating a strategic alliance, the seller can hope to sell its business to the alliance partner at the market price. Alliances help in managing uncertainty. Back in 1986, when George Lucas (of Star Wars fame) formed a small company, Pixar, to experiment making animated movies using computer technology, the future of this technology was unknown. Disney managed this uncertainty by forming an equity alliance with Pixar. For a small investment, Disney got the option to benefit from this technology if it became popular. It stood to lose its small investment if the technology did not pan out. The success of Pixar’s movies from Toy Story to The Incredibles made Disney’s decision a profitable one. In this sense, strategic alliances allow a firm to use the real options approach to managing uncertainty. Real options are options embedded in decisions. Firms can exercise these embedded options if it is to their benefit. Slide 9-11 Use this slide to cover the points explained above. Emphasize the importance of the ‘real options’ approach to managing uncertainty that strategic alliances facilitate. By taking an ‘option’ position in several alliances, a firm can effectively hedge its position. When the standard is established, the firm exercises that option and lets the other options expire.  Teaching Points • Emphasize that value creation is the key motivation for forming strategic alliances. • Point out that the nine motivations can be better understood when grouped under three broad categories. • Encourage them to look at business periodicals such as Bloomberg BusinessWeek, Fortune, and The Wall Street Journal for strategic alliance announcements and examine the motivation(s) for the alliance. • Stress the fact that a firm may form an alliance for more than one motivation. In other words, these motivations are not mutually exclusive. ALLIANCE THREATS: INCENTIVES TO CHEAT ON STRATEGIC ALLIANCES Describe How Adverse Selection, Moral Hazard, and Hold-Up Can Threaten The Ability Of Alliances To Generate Value Given the enormous benefits that firms can get by forming strategic alliances, as discussed in the previous section, why do a large number of alliances fail? Clearly, alliances may fail because the value creating potential may have been overestimated to begin with. However, there is also a second possibility. Alliances may fail because an alliance partner cheats – that is, not cooperate in a way that maximizes the value of the alliance. One of the key challenges to a successful strategic alliance strategy is that partners often face strong incentives to misappropriate the value created within an alliance. These challenges arise primarily because of the difficulties of monitoring the actions of other partners. Partners may take advantage of other partners at several points in an alliance relationship: in contributions to the alliance, in performance within the alliance, and in allocating the value created in the alliance. OPEC is an alliance of oil producing nations. Partners in this alliance have a history of cheating on one another. OPEC meets and decides to limit output by a certain number of barrels of production. OPEC members understand that if they limit output, prices will rise and benefit all the members simultaneously. However, as prices rise each member has a strong incentive to cheat by increasing output and selling more oil at the higher prices. There is no mechanism in OPEC to closely monitor the sales of any one country in a timely way. The cheating on quotas becomes apparent in time, but the individual cheaters are usually able to profit for awhile. This is a common problem in alliances. Collective action taken to improve the market for all members may be exploited (misappropriated) by individual members who take the opposite action. Slide 9-12 Emphasize that an alliance creates a context where cheating can occur primarily because of the difficulty in monitoring. Point out that the cheating can occur in input exchange, information flow, and in value appropriation. Refer to the OPEC example to explain why incentives to cheat may be so strong. Adverse Selection Firms enter into alliances to pool resources and skills. What happens when a firm promises certain resources to the alliance partner but does not deliver? This situation is called adverse selection. In many cases, particularly involving tangible resources, an alliance partner can determine exactly what its partner is bringing to the table. In such “observable” resource pooling, the possibility of adverse selection is minimized. If the resources that a potential partner has are not attractive, then the firm seeking a partner can look for other partners that have these resources. But the problem becomes much more challenging when the resources are intangible – knowledge of markets, human capital, contacts, etc. These are difficult to observe and so firms enter into the alliance hoping that the partner indeed has these resources. When this is not true, the value creation potential of the alliance is constrained. Moral Hazard In the case of adverse selection, the partner does not have the resources that it promised to contribute to the alliance. Moral hazard is when the partner has these resources but fails to make any or most of these resources available to the alliance partners. A partner may promise to send the best and brightest engineers to work in an alliance and then choose to actually send only mediocre engineers to work in the alliance. In a sense, the difference between adverse selection and moral hazard is this: adverse selection in an alliance is akin to an employee getting a job by falsely stating that he/she has certain skills important to the job. Moral hazard is when the person has these skills but chooses not to use them in the job. Holdup The concept of transaction-specific investments was introduced in Chapter 6 in the context of vertical integration. This concept also plays an important role in strategic alliances. Sometimes, the strategic alliance may call for one partner to make a transaction-specific investment. Transaction-specific investments introduce the possibility of holdup. Holdup occurs when a firm takes advantage of another’s transaction-specific investment to appropriate a large share of the value created. Holdup was seen as one of the instances where the market mechanism is likely to fail and make vertical integration the better option. Strategic alliances may be viewed as mid-range alternatives to market transactions and hierarchies. The partners in the alliance can anticipate the possibility of holdup by explicitly stating the terms in the alliance contract. Furthermore, equity holdings and trust may help to prevent holdup as well. Slide 9-13 Make sure that students understand the difference among adverse selection, moral hazard, and holdup. While all three results in one firm gaining an unfair advantage over another in the context of a strategic alliance, they are not the same. Point out that these forms of cheating usually end up hurting the alliance as a whole and in turn, the cheating partner. Once the three ways to cheat in an alliance are discussed, it is important to summarize the conclusion of the “Ethics and Strategy” box in the chapter. While cheating may help an alliance partner appropriate a larger share of the value created in an alliance, it reduces the possibility of the “cheater” finding a company to partner with it in any future alliance. Its reputation as a “cheater” will likely make other firms wary of partnering with it.  Teaching Points • Point out that while strategic alliances are tremendously popular, a lot of them fail and that the main reason for failure is one partner exploiting the others. • Explain that due diligence may be difficult to do when the resources pooled are intangible. This may lead to adverse selection, more so in international strategic alliances. • Stress that moral hazard can very often derail an alliance and typically no amount of due diligence can prevent one partner from not doing its best in the alliance. • Make sure students understand that alliances are another means of responding to the threat of holdup by relating it to the vertical integration discussion from Chapter 6. STRATEGIC ALLIANCES AND SUSTAINED COMPETITIVE ADVANTAGE Strategic alliances can be sources of sustained competitive advantage. The VRIO Framework can be used once again to examine this contention. By exploiting one or more of the opportunities and avoiding the threats discussed earlier, alliances create value. How about the other parts of the VRIO Framework? Describe The Conditions Under Which A Strategic Alliance Can Be Rare and Costly To Directly Duplicate The Rarity of Strategic Alliances Given the vast number of strategic alliances announced on a regular basis in the business press, it is clear that alliances per se are not rare, even within an industry. However, it is not the creation of strategic alliances that should be looked at. Rather, what makes an alliance rare is the motivation to form the alliance and the type of resources that partners pool to form the alliance. Look at this example: Let’s say that several firms in an industry enter into independent strategic alliances. Imagine that only one firm enters into an alliance for learning purposes. It cooperates with another firm that has valuable resources to offer in the area of learning. This would make this alliance rare. In those cases where there are only a few companies that have certain resources, firms that partner with such organizations create a rare alliance. The Johnson and Johnson-Merck alliance described earlier is a good example. Johnson & Johnson is arguably the leader in marketing health care products directly to the end user, while Merck has an enviable track record in developing new drugs. This combination is rare in that it combines the skills of two industry leaders. Slide 9-14 Explain that while alliances as such are not rare, their rarity has to be judged on the basis of the gains from trade being generated in the alliance. Private synergies refer to synergies that exist between or among a set of parties that do not exist between or among any other set of parties. For example, two firms may have key R&D engineers that were sorority sisters in college. A synergy exists between these two engineers that would not exist between either of the partners and any other firm. Such an alliance would be rare and costly-to-imitate. The Imitability of Strategic Alliances Strategic alliances can be imitated by direct duplication or by substitution. When these avenues are not possible (in that they don’t create the same value), the alliance passes the costly-to-imitate test. Once again, alliances can be imitated by direct duplication. If Firm A in an industry can form a marketing alliance, its competitor, Firm B can form a similar alliance. The test, though, is in combining the partners’ resources in such a way that value creation is maximized. Successful alliances are typically characterized by complex social relationships between the partners. There is usually a great amount of trust and information exchange among the partners. This may be difficult to imitate by others. Some firms may have tremendous expertise in forming and managing alliances and may benefit from the learning curve. This may be difficult for others to imitate. Slide 9-15 Point out to students that managers need to identify precisely the gains from trade in an alliance in order to be able to determine if the alliance is costly to imitate. The form is not costly to imitate, but the substance of the alliance may be costly to imitate if the underlying combination of resources are marked by social complexity, causal ambiguity, historical uniqueness, etc. Describe The Conditions Under Which “Going It Alone” and Acquisitions Are Not Likely To Be Substitutes For Alliances Internal development (“going it alone”) and acquisitions may be viable substitutes for strategic alliances. Instead of forming a strategic alliance, a firm may “go it alone,” in other words, vertically integrate into that activity. Conditions that favored vertical integration (described in Chapter 6) need to be revisited in this context. It is a good idea to use Table 9.4 as it succinctly captures the conditions that favor strategic alliances over “going it alone.” While the market mechanism is favored when there is no need for transaction-specific investment and vertical integration when the other extreme is present, alliances are the better option when moderate levels of transaction-specific investments need to be made. Alliances are preferred over “going it alone” when the exchange partner has valuable resources that are costly to acquire. Finally, alliances offer a great deal more flexibility as compared to “going it alone.” Acquisitions can be compared to strategic alliances using Table 9.5. Certain conditions favor strategic alliances over acquisitions. One is when there are legal (antitrust) constraints on acquisitions. The second is that acquisitions allow for less flexibility under conditions of uncertainty. The third is that an acquisition may bring “unwanted” parts of the acquired firm to the acquiring firm. This “baggage” may make the acquisition less valuable. Finally, in some cases, the value of a firm is maximized when it is an independent entity. This value may be reduced when it is owned by another firm. Since strategic alliances allow the firm to retain its independent status, they may be preferred over acquisitions. Slide 9-16 Notice that this slide describes the conditions under which internal development and acquisitions may be viable substitutes for alliances. It therefore presents the flip side of Tables 9.4 and 9.5 in the text. Make sure that students understand that if the conditions listed on the slide hold, then internal development or acquisition can be substitutes for alliances. If these conditions do not hold, then alliances will be preferred over internal development and acquisition. Emphasize the concept of uncertainty. Alliances will be preferred when there is high uncertainty about the value of an exchange because of the flexibility and lower cost as compared to internal development and acquisition.  Teaching Points • Emphasize that the VRIO Framework can be applied to alliances in an effort to assess the likelihood of competitive advantage. • Point out that judging the rarity and imitability of alliances based on the organizational form per se is not sufficient. Rather, the underlying resource pooling and gains from trade should be the focus of the rareness and costly-to-imitate questions. • Remind students that alliances can be an attractive mode of entry into new businesses and/or geographic markets. Make sure students understand the conditions under which alliances will be preferred over internal development and acquisitions. Relate this discussion back to your discussion on vertical integration. Signal to students that mergers and acquisitions is the focus of the next chapter. Point out that they will then be able to make informed decisions about the most appropriate way for a firm to enter a new business. ORGANIZING TO IMPLEMENT STRATEGIC ALLIANCES Describe How Contracts, Equity Investments, Firm Reputations, Joint Ventures, and Trust Can All Reduce The Threat Of Cheating In Strategic Alliances To maximize the value of a strategic alliance, it must be organized in a way that opportunities are exploited and threats are avoided. The “O” in the VRIO Framework, thus, is a very critical component of strategic alliance success. Many alliances fail because of governance problems. It is a good idea to first list all of the organizing options by dividing them into formal and informal categories. Formal options are: explicit contracts and legal sanctions, equity investments, and joint ventures. The informal ones are: trust and firm reputation. Explicit Contracts and Legal Sanctions The threats that adversely affect the success of an alliance (adverse selection, moral hazard, and holdup) can be anticipated and the alliance contract can explicitly provide remedies for them. The contract can include legal sanctions for breach of these provisions. Table 9.6 in the text provides a long list of provisions commonly found in strategic alliance agreements. If time permits, go through some of these to illustrate how contract provisions can prevent problems between alliance partners.  Important Point: Reiterate that explicit contracts and legal sanctions are not likely to anticipate each and every scenario that may unfold over the course of an alliance. Also, firms may cheat in subtle ways that may not be covered by the contract. The point is, that contracts are necessary in alliance agreements but contracts alone do not make for successful governance. Equity Investments Equity investments increase the stake for firms involved in the alliance. Because Firm A has invested in the equity of Firm B as part of the alliance (called equity alliances), Firm A is not likely to cheat Firm B. If it does, then its equity in Firm B loses value. Equity arrangements are particularly common among Japanese companies. These cross holdings (the network is called a keiretsu) reduce the incentives for one firm to cheat the other for short-term gains. Joint Ventures Just as equity alliances minimize the possibility of cheating because of the financial impact to both firms, joint ventures are a good organizational option for the same reason. Both firms have a financial interest in the joint venture. If one cheats the other, the joint venture suffers. Losses incurred by the joint venture affects the financials of both firms. Joint ventures are the preferred mode of alliances when the possibility of cheating is high. Slide 9-17 Inform students that almost every alliance uses a contract. At a minimum the contract serves to establish mutual understanding. In some alliances, the contract plays a central role in governance – being referred to often to resolve conflict and guide behavior. In other alliances, the contract is seldom looked at or referred to once it is signed. Joint venture ownership has a direct effect on constraining cheating in an alliance because the would-be cheater is also an owner of the alliance. Equity alliances have a more indirect effect because the equity held is in the partner as opposed to the alliance proper. Discussion & Activity: The Prisoner’s Dilemma This activity will help students realize the importance of the subjective notions of reputation and trust. Divide the class in half. Choose five people from each half of the class to come to the front of the class. Have each of these groups sit in front of their respective halves of the class. Explain that this activity’s name comes from the interrogation of two prisoners who must decide whether to stick to an agreed upon story with their partner in crime or rat out their partner in crime. If both partners stick to their story, then both partners will get a fairly light sentence because the state will be unable to vigorously prosecute them due to lack of evidence. If both partners rat out the other, then both partners will get more severe sentences because the state will have ample evidence; however, the sentences will not be the most severe possible because, after all, both prisoners helped the state make its case. A third possibility is that one partner rats out the other while the other sticks to the story. If Partner A testifies against Partner B and Partner B sticks to the agreed upon story and refuses to testify against Partner A, then Partner A goes free and Partner B gets the most severe sentence possible. Table 9.3 is a payoff matrix showing a monetary representation of the Prisoner’s Dilemma described above. Slide 9-22 also contains this payoff matrix. Assign the two groups to be Firm One and Firm Two. Tell the teams that the objective is to maximize your payoff. If they ask if you mean the total payoff for both teams or their own payoff simply repeat, “your payoff,” and keep it purposefully vague. Explain that each firm gets to choose in each round of play whether they want to choose Strategy A (cooperate) or Strategy B (cheat). If both firms cooperate, they would both receive $3,000 (the equivalent of a light sentence for both). If Firm One cooperates and Firm Two cheats, then Firm One receives $0 and Firm Two receives $5,000 (a severe sentence for Partner A and freedom for Partner B). If Firm One cheats and Firm Two cooperates, then Firm One gets $5,000 and Firm Two receives $0 (freedom for Partner A and a severe sentence for Partner B). If both firms choose to cheat, then both firms receive $1,000 (a moderate sentence for both). Tell students that you will play six rounds. Randomly choose which team gets to go first. Tell them that they get to choose how to communicate their answers to you. They can answer secretly or call out their answer and make it public. (There are several ways to play the game. Some people impose secrecy.) Alternate who gets to go first in each round of play. Slides 9-22 and 9-23 can be used to show students the payoff matrix and the tally sheets. Make a transparency of Slide 9-23 and use an overhead projector so that you can write in the pay offs in each round of play. Encourage the two halves of the class to help their teams make their decision in each round of play. Once you have gone through six rounds of play, add up the dollars earned by each team. Of course, there are many possible outcomes after six rounds. Ask students for their observations about how the game was played. You will usually get students telling about how someone did or said something that either built or destroyed trust. Ask students about the signals sent when someone either gave you their answer secretly or broadcast it to the class. Ask students about the reputations that were developing for the two teams. Call attention to any communication that occurred. Was it simply signals or were there overt attempts to communicate with the other team? Remember that you didn’t give them any restriction on communication. Ask students about how a team responded to the other team’s cheating, if this happens. Be sure to point out that if both teams cooperated in all six rounds, both teams would have earned $18,000. Even if the teams could have somehow agreed to trade the $5,000 win evenly, they would have each only earned $15,000. Call attention to the fact that maximizing the payoff of the alliance would have meant also maximizing the payoff of each team, unless one of the teams was irrationally benevolent. There is a great temptation to cheat in the final round. Pay special attention to what happens in the final round. Ask students what the behavior of each team did to the reputation of each team. Pose the question: What if we were going on to a seventh round? This activity usually results in some good-natured banter, but at the same time makes a powerful point about the importance of reputation and trust in relationships. Firm Reputations If a firm seeks to use strategic alliances as a means to compete in its industry, needless to say, it should maintain a reputation as a reliable partner. If it maximizes its value in a specific alliance through cheating, it is unlikely to find companies willing to partner with it in the future. It behooves a firm to maintain its reputation so as not to preclude the possibility of forming alliances in the future. This threat, that of a smeared reputation, is likely to have a greater effect in some cases, then what is contractually written. However, the possibility of a tarnished reputation may not work to prevent opportunistic behavior in some cases. Obviously, subtle cheating is less likely to draw the same attention as overt cheating. Also, the information about a firm cheating must be made public in order for it to be a threat. Some firms may not be well connected in a network to enable this. Finally, tarnished reputation (or the fear of it) may not help the affected partner in the current alliance. In short, this is not a panacea for alliance problems. Trust Examining the issue of trust is a good way to complete the discussion on organizing the alliance. This is because research has indicated that the one characteristic that is common in most successful alliances appears to be a significant amount of trust placed by the partners in each other. Beyond contractual provisions, trust is what is likely to bind the two firms in a cooperative relationship and take care of everyday problems that may surface. Firms that have a successful track record of alliances seem to excel in this area. Research suggests that trust in an alliance can serve as a substitute for more formal governance mechanisms like contracts. Even though almost every alliance has a contract, the role of the contract in the alliance can vary a great deal – from being relied upon almost daily to never being referenced once it is signed. In those alliances where the contract is seldom looked to after the creation of the alliance, trusting relationships are relied upon to guide the behavior of partners. One of the greatest benefits of trust in an alliance is that it may allow alliance partners to pursue opportunities that would be economically infeasible in the absence of trust. Suppose two partners, one based in the U.S. and the other based in Bolivia, recognize an opportunity in developing a new drug based on a rare plant found only in remote areas of the Amazon River Basin. One partner has the capability to find and harvest the plant and the other partner has the capability to manufacture and market the drug. Neither partner can successfully develop the new drug without the other partner. In the absence of trust, these partners would have to rely on contracts and monitoring that would be expensive due to the geographic distance between operations. Careful analysis shows that if the partners have to incur these costs of governance, the alliance is unlikely to be profitable. The partners would rationally choose not to pursue the alliance. However, if the partners can rely on trust between them, the alliance is likely to be profitable. Slide 9-18 Explain that the shadow of the future means that a firm’s reputation will influence business opportunities in the future. Firms with reputations as good alliance partners will have more opportunities to benefit from gains from trade than those with poor reputations. Also, explain how trust can influence the governance of alliances. Be sure to discuss how alliances marked by trust can feasibly pursue opportunities that alliances lacking trust could not. Slide 9-19 Use this slide to summarize this section by pointing out that these organizational arrangements are not mutually exclusive. Most firms rely on more than one option. Emphasize the point that these governance arrangements may themselves be sources of competitive advantage if they meet the VRIO criteria.
 Teaching Points • Explain that the organizational choices for strategic alliances fall into two broad categories: formal and informal. • Point out that equity alliances and joint ventures are quite useful ways to ensure that firms do not cheat because there is a financial issue involved. • Emphasize that joint ventures are useful when transaction-specific investment is required by one party. • Help students recognize that subjective issues like reputation and trust are critically important in the management of alliances. SUMMARY Alliances are becoming increasingly popular as vehicles for a variety of strategic purposes. There are a number of ways by which alliances create value. However, it is important that a firm approach alliances using the VRIO lens. Alliances have to create value, be rare and costly-to-imitate, and be organized in such a way that it achieves its purpose. Students must understand that alliances are a form of organizing economic exchange. These economic exchanges should produce gains from trade. Students should be encouraged to identify the resource combinations that form the basis for gains from trade in any alliance. Furthermore, students should be aware that simply identifying the gains from trade is not enough to ensure alliance success. The exchange must be managed in an appropriate way if the gains from trade are to be realized. As with other strategy concepts covered in the course, alliances require firm capabilities. Some firms will be better at creating and managing alliances than others. Remind students that you have shown them a way to analyze alliances that will allow students to draw well-informed conclusions as to whether or not an alliance will result in competitive advantage. Slide 9-20 This slide serves as a summary of the chapter by stating what managers must do in order to create value through an alliance strategy. Emphasize the importance of identifying gains from trade that will lead to value creation. Recognizing the challenges to value creation is also critical to success. Finally, alliance success depends on managers’ ability to choose and implement governance responses to these challenges. Slide 9-21 Remind students that the VRIO logic can be applied to alliance strategies to assess whether a firm’s alliance is likely to generate competitive advantage. Emphasize once again that alliance success is a matter of identifying a valuing-creating exchange and then managing that exchange in a value-creating way. Instructor Manual for Strategic Management and Competitive Advantage Concepts and Cases Jay B. Berney, William S. Hesterly 9781292060088, 9781292258041

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