This summary of Managerial Economics and Business Strategy (Baye & Prince) is written in 2014

Chapter 1: Fundamentals of Managerial Economics

Manager – person who directs resources to achieve a stated goal. This includes all the people who:

• direct the efforts of others
• purchase inputs to be used in the production of goods and services
• are in charge of making other decisions

The manager generally isn’t only responsible for his or her own actions, but also for the actions of individuals, machines and other inputs under his or her control.

Economics - the science of making decisions in the presence of scarce resources.

Scarcity - involves making choice from alternatives available.

Resources – anything used to achieve a goal or produce a service or good.

Managerial economics – the study of how to direct scarce resources in the way that most efficiently achieves a managerial goal

Effective Managers must:

1. Identify goals and constraints You have to decide what you want to achieve and allocate your resources accordingly. The scarcity of the resources is the constraint. It is important to have well-defined goals.

2. Recognize the nature and importance of profits

• Accounting profits – Profits that appear on the income statement of a firm. Total Revenue (TR) – Total Cost (TC)

• Economic profits – Total Revenue (TR) – Total Opportunity Cost (TOC)

• Opportunity cost – Explicit Cost (accounting costs) + Implicit Cost (cost of giving up the best alternative use of the resource)

The TOC is generally higher than the accounting costs, because implicit resources (the alternative uses of a resource) are taken into account. Example: the opportunity cost of studying at university is the cost of tuition fee, books, living and food (explicit cost) plus the cost of giving up the alternative to work and earn money (implicit cost).

Principle: Profits are a signal

Profits signal where society’s scarce resources are best allocated. Profits also signal to the owners of resources where the resources are most highly valued by society.

Adam Smith described the goal of maximizing profits as an invisible hand because by pursuing self-interest a company ultimately meets the needs of society.

Five Forces Framework and Industry Profitability

• Entry – Factors: Entry cost, speed of adjustment, sunk cost, economies of scale, reputation. These factors affect the ease of entrance to an industry. If it is easy to enter the market, the industry profitability will be low

• Power of Input Suppliers – Factors: Supplier concentration, price of alternative inputs, relationship specific investments, supplier switching cost, government intervention. These factors affect the power of suppliers. If the suppliers have a high degree of power, the industry profitability will be low

• Power of Buyers – Factors: Buyer concentration, price of substitutes, relationship specific investment, consumer switching cost, government intervention. These factors affect the power of buyers. If buyers have a high degree of power, the industry profitability is low.

• Industry rivalry – Factors: Concentration, Price and products competition, degree of differentiation, information, etc. These factors affect the intensity of industry rivalry. If the rivalry is intense, the industry profitability is low.

• Substitutes and Complements – Factors: Price of substitutes and Complements, network effects. If there are plenty of substitutes, the industry profitability is low.

The aim is to have a sustainable industry profit.

The Fives Forces Model (by Michael Porter) is mainly a managerial tool to see the ‘big picture’.

3. Understand incentives. You must have a clear grasp of the role of incentives within an organization  Incentive plans (For example, bonuses). People tend to be self-directed and managers have to find a relation between the employee’s self-interest and the firm’s interest.

Incentives – how resources are used and how hard workers work.

4. Understand markets. There are two sides to every transaction in a market: For every buyer of a good there is a corresponding seller. There are 3 sorts of rivalry:

   • Consumer – Producer: Occurs because of the competing economic interests of both - consumer wants a low price, producer a high price – and leads to compromise, the equilibrium price.

   • Consumer-Consumer: Reduces the negotiating power of consumers in the marketplace. It arises because of the economic doctrine of scarcity.

   • Producer – Producer: Reduces the negotiating power of producers. Their disciplining device functions only when multiple sellers of a product compete in the market.

   • Government – Market: The government intervenes to discipline the market when agents on either side of the market find themselves disadvantaged.

5. Recognize the time value of money. The timing of many decisions involves a gap between the time when the costs of a project are borne, and the time when the benefits of the project are received.

• Present Value (PV) – The amount that would have to be invested today at the prevailing interest rate to generate the given future value (FV).

• (Opportunity Cost of Waiting) 

• PV = FV when i = 0 (i is the rate of interest, the opportunity costs of the fund)

• Present value of a stream =

• Net Present Value (NPV) – The present value of the income stream generated by a project minus the current cost of the project. NPV = PV (use the present value of a stream) – C (Current costs)

• The slope of a function is the derivative of that function:

• The slope of the total values curves are the marginal values curves.

• Incremental Revenues/Costs – The additional revenues/costs that stem from a yes-or-no decision

The terminology in economics has two purposes:

• The definitions and formulas economists use break down complex problems into manageable components.

• Precise terminology helps practitioners of economics to communicate more efficiently.

Chapter 2: Demand and Supply

Law of demand – As purchasing price increases (decreases) the quantity a consumer is willing to purchase decreases (increases). It is assumed that all other things remain constant.

Market demand curve – A curve (negative slope) indicating the total quantity of a good all consumers are willing and able to purchase at each possible price, holding the prices of related goods, income, advertising, and other variables constant.

Demand Shifters

Change in quantity demanded – Changes in the price of a good lead to a change in the quantity demanded of that good. This corresponds to a movement along a given demand curve.

Change in demand – Changes in variables other than the price of a good, such as income or the price of another good, lead to a change in demand. This corresponds to a shift of the entire demand curve.

• Shift to the right gives an increase in demand.

• Shift to the left gives a decrease in demand.

Demand shifters – Variables other than the price of a good that influence demand (demand curve moves to the right or to the left).

• Income

Normal good – A good for which an increase (decrease) in income leads to an increase (decrease) in the demand for that good.

Inferior good – A good for which an increase (decrease) in income leads to a decrease (increase) in the demand for that good.

• Prices of related goods

Substitutes – Goods for which an increase (decrease) in the price of one good leads to an increase (decrease) in the demand for the other good.

Complements – Goods for which an increase (decrease) in the price of one good leads to a decrease (increase) in the demand for the other good.

• Advertising and consumer tastes

An increase in advertising makes the demand curve shift to the right.

Informative advertising has two possible effects:

• Consumers buy the same quantity for a higher price.

• Consumers buy a larger quantity for the same price.

Persuasive advertising can influence demand by altering the underlying taste of consumers.

• Population

If the overall size of the population increases (decreases), the demand curve shifts to the right (left). The composition of a population can also affect the demand for a product.

• Consumer expectations

If the price of a product is expected to rise in the near future, people will substitute current purchases for future purchases (called stockpiling). The demand curve shifts to the right.

• Other Factors – Any variable that affects the ability or willingness to buy a good or service is a potential demand shifter.

Demand function – A function that describes how much of a good will be purchased at alternative prices of that good and related goods, alternative income levels and alternative values of other variables affecting demand.

Linear demand function – A representation of the demand function in which the demand for a given good is a linear function of prices, income levels, and other variable influencing demand.

Consumer surplus – The value consumers get from a good but do not have to pay for. This is the area above the price paid for a good, but below the demand curve.

Supply

Law of supply – As selling price increases (decreases) the quantity a supplier is willing to produce increases (decreases).

Market supply curve – A curve (positive slope) indicating the total quantity of a good that all producers in a competitive market would produce at each price, holding input prices, technology, and other variables affecting supply constant.

Change in quantity supplied – Changes in the price of a good lead to a change in the quantity supplied of that good. This corresponds to a movement along the supply curve.

Supply Shifters

Change in supply – changes in variables other than the price of a good, such as input prices or technological advances, lead to a change in supply. This corresponds to a shift of the entire supply curve.

• Shift to the right gives an increase in supply.

• Shift to the left gives a decrease in supply.

Supply shifters – variables that affect the position of the supply curve.

- Input prices As the price of input rises (falls), producers are willing to produce less (more) output at each given price.

• Technology or governmental regulations Technological advances and deregulation make it possible to lower the output cost, thus a shift to the right. Natural disasters and government regulations have an adverse effect, thus a shift to the left.

• Number of firms As the number of firms increases (decreases), there is more (less) output available at any given price and the supply curve shifts to the right (left).

• Substitutes in production Firms have technologies that are readily adaptable to several different products.

• Taxes Excise tax is a tax on each unit of output sold (e.g. gasoline). It shifts the supply curve upwards in a parallel way.

Ad valorem tax is a percentage of the price (e.g. goods and services tax). It rotates the supply curve counter clockwise.

• Producer expectations If the price of a product is expected to rise in the near future, producers will hold back outputs (if they are not perishable) and sell them at a later date. The supply curve shifts to the left.

Producer surplus – The amount producers receive in excess of the amount necessary to induce them to produce a good. Graphically, it is the area above the supply curve and below market price of the good.

Market equilibrium – The intersection point of the supply and the demand curve (Q^d = Q^s) in the point (Q^e, P^e). It happens when there is no surplus or shortage.

Surplus/shortage happens when the quantity supplied by the suppliers (demanded by buyers) is more than the quantity demanded (supplied)

Price Ceiling – The maximum legal price that can be charged in a market.

A price ceiling is effective if it is imposed below the equilibrium price.

When price ceiling is imposed there will be a loss of social welfare (“Deadweight loss”).

A price ceiling leads to a shortage because:

• the quantity supplied decreases

• the quantity demanded increases

Consumers are paying an implicit amount by waiting in line. A price ceiling discriminates against people who have a high opportunity cost of time and do not like to wait in lines.

Full economic price (P^F) – the pecuniary amount paid to a firm under a price ceiling (P^c), plus the non-pecuniary price paid by waiting in line (P^F – P^C). This price is higher than the initial market equilibrium price.

P^F = P^C + (P^F – P^C)

Non pecuniary price – A price not paid in dollars but through opportunity costs (P^c).

Price floor – The minimum legal price that can be charged in a market. (For example, minimum wage)

A price floor is effective if it is imposed above the equilibrium price

A price floor leads to a surplus because:

• the quantity supplied increases

• the quantity demanded decreases

Comparative Statics analysis – study of movement from one equilibrium to another (no restraints, free market system).

Market equilibrium

Change in Demand: if the demand curve shift rightwards (leftwards), the equilibrium price and quantity will increase (decrease)

Change in Supply: if the supply curve shifts rightwards (leftwards), the equilibrium price will decrease (increase) and the quantity will increase (decrease)

Changes in both Supply and Demand:

*Depends on the extent of shift of both supply and demand (ambiguous)

Chapter 3: Quantitative Demand Analysis

Own price elasticity (or point elasticity) – a measure of the responsiveness of the quantity demanded of a good to a change in the price of that good; the percentage change in quantity demanded divided by the percentage change in the price of the good.

• Perfectly elastic demand – Demand is perfectly elastic if the own price elasticity is infinite in absolute value. In this case the demand curve is horizontal.

• Perfectly inelastic demand – Demand is perfectly inelastic if the own price elasticity is zero. In this case the demand curve is vertical.

Three factors that affect (the magnitude of) the own price elasticity of a good:

1. Available substitutes. The more substitutes available for the good, the more elastic the demand for it. Hence, the demand for specific commodities is more elastic than the demand for broadly defined commodities; e.g. food in general is inelastic, while for example beef is elastic.

2. Time. The more time consumers have to react to a price change, the more elastic the demand for the good. Conceptually, time allows the consumer to seek out available substitutes.

3. Expenditure share. Goods that comprise a relatively small share of consumers’ budgets tend to be more inelastic than goods for which consumers spend a sizable portion of their incomes. Hence, the demand for food is more elastic than the demand for transportation.

Cross price elasticity’s play an important role in the pricing decisions of firms that sell multiple products.

Regression Analysis
Econometrics – statistical analysis of economic phenomena.

Regression Line – line that minimizes the squared deviations between the line (the expected relation) and the actual data.

Least squares regression: The line that minimizes the sum of squared deviations between the line and the actual data points. For the equation Y = a + bX + e, this is given by

The parameter estimates, the values of a and b, are often denoted by . They represent values of a and b that result in the smallest sum of squared errors between a line and the actual data.

Standard error - a measure of how much each estimated coefficient would vary in regressions based on the same underlying true demand relation, but with different observations.

Iid normal random variables – if errors are independently and identically distributed normal random variables.

Confidence intervals
 

The F-Statistic – provides a measure of the total variation explained by the regression relative to the total unexplained variation.

Multiple Regressions – regressions of a dependent variable on multiple explanatory variables.

Chapter 4: The Theory of Individual Behavior

Consumer – an individual who purchases goods and services from firms for the purpose of consumption.

Two distinct factors to consider while characterizing consumer behavior:

1. Consumer opportunities represent the possible goods and services consumers can afford.

2. Consumer preferences determine which of the affordable goods will be consumed.

If you would like to make a model of behavior, you should start with a simple model, i.e. assuming only two goods exist in our economy.

The preference ordering between two goods is assumed to satisfy 4 basic properties;

1. Completeness – Consumer is capable of expressing a preference for, or indifference among, all bundles. For two bundles A and B: Either A>B, B>A or A~B.

2. More is better – For two bundles A and B: if bundle A has at least as much of every good as bundle B and more of some good, bundle A is preferred over bundle B.

3. Diminishing marginal rate of substitution – As a consumer obtains more of good A, the rate at which he or she is willing to substitute good A for good B decreases.

4. Transitivity – The assumption of transitive preferences implies that indifference curves do not intersect one another. This eliminates the possibility that the consumer is caught in a perpetual cycle in which he or she never makes a choice. For three bundles A, B and C: if A>B and B>C, then A>C. Similarly, if A ~ B and B ~ C, then A ~ C.

Indifference curve – A curve that defines the combinations of two or more goods that give a consumer the same level of satisfaction. Curves farther from the origin imply higher levels of satisfaction than curves closer to the origin.

Marginal rate of substitution (MRS) – The rate at which a consumer is willing to substitute one good for another good and still maintain the same level of satisfaction. The marginal rate of substitution is the slope of the indifference curve.

Constraints – people have a certain limits; legal, time, physical and budget constraints.

Budget constraint – restrict consumer behaviour by forcing the consumer to select a bundle of goods that is affordable.

Consumer equilibrium – The equilibrium consumption bundle is the affordable bundle that yields the greatest satisfaction to the consumer. Consumers choose the consumption bundle that maximizes his or her utility or satisfaction (the equilibrium choice). An important property of consumer equilibrium is that the slope of the indifference curve is equal to the slope of the budget line.

MRS = Px / Py

Price changes and consumer behavior – The indifference curve analysis also allows us to see how changes in price and income affect the market rate.

• If the price of good X decreases (increases) the budget line rotates clockwise (counter clockwise) because more (less) goods X can be purchased at a lower (higher) price. The opportunity set of the consumer expands (shrinks) and the consumer can achieve a higher (lower) level of satisfaction. Goods X and Y are substitutes if an increase (decrease) in the price of X leads to an increase (decrease) in the consumption of good Y. Goods X and Y are complements if an increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y. Note that as the budget line rotates clockwise (counter clockwise) the slope of the budget line changes to become steeper (flatter).

• If the income of a consumer becomes increases (decreases) the budget line will shift to the right (left) because more (less) products can be purchased with more (less) money. The demand for normal goods will increase if income increases, while the demand for inferior goods will decrease if income increases. Note that the slope of the budget line remains the same whether the income increases or decreases.

Substitution effect – The movement along a given indifference curve that results from a change in the relative prices of goods, holding real income constant.

Income effect – The movement from one indifference curve to another that results from the change in real income caused by a price change. When prices increase (decrease) the consumer’s real income falls (rises).

Total effect of a price = substitution effect + income effect

“Buy one, get one free” marketing scheme - Customers buy more than they would buy because the new bundle lies on a higher indifference curve. The deal is not a 50 percent reduction in the price of two goods because it reduces only the price of the second good to zero. In fact, the deal does not change the price below one good and above two goods.

Cash gifts, in-kind gifts and gift certificates – Cash gifts are generally preferred to in-kind gifts or gift certificates of equal value because the consumer can purchase goods according to his or her preference and maximize the level of satisfaction. The greatest satisfaction is the tangent of the budget line and the highest indifference curve (consumer equilibrium).

Choices by Workers and Managers – Workers view both leisure and income as goods. The substitute between them at a diminishing rate along an indifference curve. This is a simplified model of the income-leisure choice.

Managers’ decisions depend on profits, output or both.

The Indifference curve and Demand curve – the indifference curve is the basis of the demand function. The shift in the indifference curve caused by the changes in price of one good indicates the different quantity demanded of that good in the individual demand curve. The horizontal summation of each individual demand curve gives the market demand curve.

Chapter 5: The Production Process and Costs

Technology summarizes the feasible means of converting raw inputs into an output. Most production processes involve capital (machinery) and labor (people).

Increasing marginal returns – Range of input usage over which marginal product increases. E.g. in the first hours you study for an exam you can concentrate very well and you increase your knowledge rapidly.

Decreasing (diminishing) marginal returns – Range of input usage over which marginal product declines. E.g. the longer you study the less you remember but still you gain more knowledge. You increase total knowledge, but at a decreasing rate. Marginal product declines but it is still positive.

Negative marginal returns – Range of input usage over which marginal product is negative. E.g. if you study too long you get tired and too much information is in your head in too little time. You get confused and reduce the total knowledge.

Phases of Marginal Returns – When there is an increase in the use of input, Marginal product changes from increasing to decreasing and further to negative.

The manager’s role in the production process:

1. Produce on the production function

It describes the maximum possible output that can be produced with given inputs. In case of labor, the manager has to think of an incentive system to ensure that employees are working at full potential.

2. Use the Right level of inputs

The manager has to determine how many units of input are needed to maximize total output. When a manager decides on how many employees that his/her firm needs to employ, he/she has to consider marginal returns. The value marginal product describes the value of the output produced by the last unit of an input.

Profit-Maximizing Input Usage – To maximize profits, a manager should use inputs at levels at which the marginal benefit equals the marginal cost. More specifically, when the cost of each additional unit of labor is w, the manager should continue to employ labor up to the point where in the range of the diminishing marginal product. E.g. it is profitable to hire additional units of labor as long as his/her contribution (value marginal product) is greater than his/her hiring costs.

Algebraic Forms of Production Functions

Optimal Input Substitution – To minimize the cost of producing a given level of output, the firm should use less of an input and more of other inputs when that input’s price rises.

For given input prices, different isoquants will entail different production costs, even allowing for optimal substitution between capital and labor. The higher isoquants will imply higher costs of production, even assuming the firm uses the cost-minimizing input mix.

The Cost Function

Fixed costs (FC) – Costs that do not change with changes in output; include the costs of fixed inputs used in production.

Variable costs (VC) – Costs that change with changes in output; include the costs of inputs that vary with output.

Short-run cost function – A function that defines the minimum possible cost of producing each level of output when variable factors are employed in the cost-minimizing fashion. Mathematically it is the sum of fixed and variable costs. TC = FC+VC

Average fixed cost (AFC) – Fixed costs divided by the number of units of output. Average fixed cost decrease as output increases.

Long-run average cost curve (LRAC) – A curve that defines the minimum average cost of producing alternative levels of output, allowing for optimal selection of both fixed and variable factors of production. The long-run average cost curve lies below every point on the short-run average cost curves.

Economies of scale – Exist whenever long-run average costs decline as output is increased. Diagrammatically, it is in the section of LRAC with negative slope.

Diseconomies of scale – After a certain point, the optimal production quantity Q*, further increases in output lead to an increase in average costs. Long run average costs rise as output is increased. Diagrammatically, it is in the section of LRAC with positive slope

Constant returns to scale – Exist when long-run average costs remain constant as output is increased. A firm produces at different levels of output at the same minimum average cost.

Accounting costs – Costs that appear on the income statements of firms.

Economic costs – The costs perceived of producing a certain product, while the opportunity to produce another product is forgone.

Multi-product cost function – A function that defines the cost of producing given levels of two or more types of outputs assuming all inputs are used efficiently.

Chapter 6: The Organization of the Firm

In this section the optimal way to acquire an efficient mix of inputs and the role of the management in achieving maximum productivity is discussed.

Principal-agent problem – when employees and owners of a firm have conflicting interests.

3 methods managers can use to obtain inputs needed in product:

1. Spot exchange – An informal relationship between a buyer and seller in which neither party is obligated to adhere to specific terms for exchange. Buyers and sellers essentially are anonymous.

Key advantage: A firm specializes in doing what it does best: converting the inputs into output.

2. Contracts – A formal relationship between a buyer and seller that obligates the buyer and seller to exchange at terms specified in a legal document. The firm enjoys the benefits of specializing in what it does best, because the other firm actually produces the inputs the purchasing firm needs.

Disadvantage: A contract is quite costly to write and it is difficult to cover all of the contingencies that could occur in the future.

3. Vertical integration – A situation where a firm produces the inputs required to make its final product.

The firm loses the gains in specialization it would realize were the outputs purchased from an independent supplier. Vertical integration also increases bureaucratic costs.

Advantage: The firm does not need to rely on other firms to provide them with inputs

Transaction costs – Costs associated with acquiring input that are in excess of the amount paid to the input supplier. They include:

1. The cost of searching for a supplier willing to sell a given input.

2. The costs of negotiating a price at which the input will be purchased (e.g. time, legal fees).

3. Other investments and expenditures required to facilitate exchange.

Specialized investment – An expenditure that must be made to allow two parties to exchange but has little or no value in any alternative use.

Relationship-specific exchange – A type of exchange that occurs when the parties to a transaction have made specialized investments.

Specialized investments can take many forms:

1. Site specificity – occurs when the buyer and the seller of an input must locate their plants close to each other to be able to engage in exchange.

2. Physical-Asset specificity – Refers to a situation where the capital equipment needed to produce input is designed to meet the needs of a particular buyer and cannot be readily adapted to produce inputs needed by other buyers.

3. Dedicated assets – Investments made by a firm that allow it to exchange with a particular buyer.

4. Human capital – Workers must learn a specific skill. These skills are not useful or transferable to other employees.

Specialized investments increase transaction costs because they lead to:

1. Costly bargaining

Where transaction costs are low and the desired input is of uniform quality and sold by many firms, the price of the input is determined by the forces of supply and demand. With specialized investments only a few parties are prepared for a trading relationship. Bargaining process takes place in this kind of situation which may be costly.

2. Underinvestment

When specialized investments are required to facilitate exchange, the level of the specialized investment is often lower than the optimal level. Specialized investments may be lower than optimal, resulting in higher transaction costs because the input produced is of inferior quality. This is especially true in the short time period

3. Opportunism

“Hold-up problem”: once a firm makes a specialized investment, the other party may attempt to “rob” it of its investment by taking advantage of the investment’s sunken nature. Both suppliers and consumers may engage in this opportunism

Optimal Input Procurement

• Spot exchange

This is the most straightforward way for a firm to obtain inputs for a production process. Spot exchange does not insulate a buyer from opportunism. Spot exchange is likely to result in high transaction costs due to opportunism, bargaining costs, and under investment in the event of specialized investment being used.

• Contracts

Although there are some costs in writing a contract, the advantages are that there will be less or no opportunism. The “optimal” contract length reflects a fundamental economic trade-off between the Marginal Costs and Marginal Benefits of extending the length of a contract. The longer the contract, the less flexibility the firm has in choosing an input supplier. The marginal benefit of extending a contract for another year is the avoided transaction costs of opportunism and bargaining. The optimal contract length will increase when the level of specialized investment required to facilitate an exchange increases. The optimal contract length also depends on factors that affect the MC of writing longer contracts.

The optimal length of contract is therefore the length of contract where the MC of extending contract = MB of extending contract

• Vertical integration

When complete contract will be too costly or impossible, due to very high transaction costs, complexity of the product and/or economic uncertainty, the best thing is to produce internally, thus vertical integration. The advantage of vertical integration is the elimination of “middleman” but it requires certain set up costs to install the whole process. But consider this as a last resort.

• Economic Trade-off

The cost-minimizing method of acquiring input depends on the characteristics of the input.

Use spot exchange when the input does not involve specialized investments. When specialized investments are involved, think twice, because bargaining costs and opportunism might be involved. When specialized investments are required and the desired input has complex characteristics, thus vertical integration (cost must not be too high).

Managerial compensation and the principal-agent problem

One characteristic of many large firms is the separation of ownership and control: The owners of the firm often are distantly located stockholders, and a manger runs the firm on a day-to-day basis. By creating a firm, an owner enjoys the benefit of reduced transaction costs.

A principal agent problem will exist when the ownership is separate from control. This will be avoided by making an incentive contract:

Forces that discipline Managers:

Incentive contracts – The height of the manager’s salary is based on the profits made by the firm.

External incentives – forces outside the firm often provide managers with an incentive to maximize profits.

• Reputation – Managers want to demonstrate their capabilities in running companies so that they have a good reputation and hence they can charge higher wages.

• Takeovers – If the manager is not working properly, investors will try to buy the firm and replace management. Managers do not want this, so they will work hard.

Manager-worker principal-agent problem

The manager cannot be everywhere at the same time.

Solutions:

• Profit sharing – Mechanism used to enhance workers’ efforts that involve tying compensation to the underlying profitability of the firm.

• Revenue sharing – Mechanism used to enhance workers’ efforts that involve linking compensation to the underlying revenues of the firm.

• Piece rates – Pay workers based on a piece rate rather than on a fixed hourly wage (You have to have quality control though, because otherwise people tend to produce quantity instead of quality).

• Time Clocks and Spot Checks – Not useful for avoiding the principal-agent problem, but they verify when an employee arrives and departs from a job.

Spot checks – The manager enters the workplace from time to time; cheap and effective. Nobody knows when the manager enters.

Spot checks work through threat, while performance bonuses work through a promise of reward. These two systems have a different psychological effect on employee.

Chapter 7: The Nature of Industry

Firms need to make decisions regarding their pricing policies and thus they need to know the optimal price. Nevertheless, it is the nature of the industry where the firm is operating that makes the pricing strategy of different firms differ.

Market Structure – Factors that affect managerial decisions, including the number of firms competing in a market, the relative size of the firms, technological and cost considerations, demand conditions and the ease with which firms can enter or exit the industry

The following are the factors that affect pricing decision:

• Firm size

Firm size affects how managers run the company and decide on the pricing strategy. Different industries give rise to different size of firms

• Industry concentration

This is about whether the industry has many small firms or few large firms.

Concentration ratios- Measures how much of the total output in an industry is produced by the largest firms in the industry

The four-firm concentration ratio- The fraction of total industry sales (S_t) generated by the four largest firms (S₁ to S₄) in the industry.

C₄ = (S₁ + S₂ + S₃+ S₄)/ S_t or C₄ = (W₁ + W₂ + W₃+ W₄) where W_n= S_n/S_t

The closer the C₄ is to 1 the higher the concentration of the industry

Herfindahl-Hirschman index (HHI) – The sum of the squared market shares of firms in a given industry multiplied by 10,000.

HHI = 10,000∑w_i²

The closer the HHI value to 10,000 means fewer firms exist in the industry

Limitation of concentration measures:

Global market – imports are often excluded from the analysis although it may constitute a large proportion of the industry.

Different markets - many relevant markets for industries are very local. Thus, even though in the national level the concentration may be low, that might not be the case in the regional or local market.

Industry definitions and product classes - depending on the definition of the industry, the concentration may differ. Hence, the more specific the market is the more concentrated the industry is.

• Technology

Technology is the one that makes industries differ from one another. Some industries need a lot of capital investment while others are more labor intensive. In the more technological-intensive industries, when one firm possesses a more efficient capital then the manager can really put the cost down and charge a lower price.

• Demand and Market Conditions

In the market where demand is relatively low, managers need to adjust the product price to compete in the market.

In the market where there is an ease of information flow, the consumers can compare price easily and thus managers need to actually take note of their competitors.

Elasticity of demand also varies across industries. In the market with many close substitutes, the price will generally be lower than those markets that have few substitutes.

Rothschild index – A measure of the sensitivity to price of a product group as a whole relative to the sensitivity of the quantity demanded of a single firm to a change in its price.

Rothschild index equation:

R = E_t / E_f

E_t is the elasticity of demand for the total market

E_f is the elasticity of demand of a firm
The value is between 0 and 1 and 1 shows that the elasticity of demand of the firm = elasticity of demand of industry

• Potential for Entry

Difference in the extent of barrier to entry affects managers’ abilities to set price high or low.

Examples of barrier of entry: Capital requirements, patents, economies of scale, etc.

Industries have different behaviors in terms of pricing behavior, merger decision, research and development and advertising.

Conduct (behavior) of firms differs across industries.

• Integration and Merger Activity

Integration - uniting productive resources. This can occur through a merger.

Merger - two or more existing firms unite (merge) into one firm.

3 types of Integrations/mergers:

Vertical integration – a situation where various stages in the production of a single product are carried out in a single firm.

It can also refer to an integration of two or more firms that produce components for a single product.

Vertical merger helps to reduce cost.

Horizontal integration – merging of the production of similar products into a single firm. When it takes place, it reduces the number of firms in the market, hence increases the four-firm concentration ratio and HHI. Government may intervene if they think that the firms that merge have too much market power. Horizontal integration enjoys cost savings of economy of scale/scope and enhances marker power.

Conglomerate mergers – integration of different product lines into a single firm.

For example, when a cars manufacturer merges with a laptop manufacturer.

No specific reason to do so except to create synergies to improve cash-flow.

• Research and Development

Different industries need different technologies. Technological advancement may help firms to reduce cost or have competitive advantage over the others in the same industry. However, the cost of conducting R&D is high. Optimum amount of R&D spending will depend on the characteristic of the industry.

• Advertising

Firms have varied advertisement spending.

Performance – profits and social welfare that result in a given industry.

Profit – profit is not related to the size of the firm but depends on the individual performance of the firm.

Social welfare – industry performance also considers social welfare as one of the factors.

Dansby -Willig performance index – ranks industries according to how much social welfare would improve if the output in an industry were increased by a small amount. If the index is 0, there are no gains to be obtained by inducing firms in the industry to alter their outputs. Consumer and producer surplus are maximized given industry demand and cost conditions.

The Structure-conduct-performance Paradigm – Views three aspects to be integrally related.

Structure – refers to the factors such as technology, concentration and market conditions.

Conduct – refers to how the firms will behave

Performance­ – refers to the resulting profits and social welfare that arise in the market.

The causal view – asserts that market structure causes firms to behave in a certain way and this behavior makes certain resources to be allocated in a certain way. This eventually leads to either satisfactory or unsatisfactory performance. According to this view, a concentrated market leads to a high price and poor performance.

The Feedback critique – there is no one-way causal link among structure, conduct, and performance. No obvious relation between concentration and high price as everything depends on the circumstances

Recollection of five-force framework – the five-forces framework is inter-related to the Structure-conduct-performance paradigm. The five-forces, namely entry, power of input suppliers, power of buyers, industry rivalry and substitutes and complements, captures elements of structure and conduct of firms in a given industry. The performance part of the paradigm is related to the level, growth and profit sustainability of the industry.

Brief overview of Market structures
Perfect Competition – Many firms and buyers, homogeneous products, no market power thus close to 0 concentration ratio, perfect information flow.

Monopoly – sole producers, high market power, extreme concentration ratio, P>MC

Monopolistic Competition – many firms and buyers, low concentration ratio thus very limited market power, products differentiation but close substitute of one another. Firms tend to advertise to make their brand known and preferred by consumers

Oligopoly – A few large firms, firms are mutually interdependent. This means that one firm action affects other firms. Firms interact with one another in oligopoly.

Chapter 8: Managing in Competitive, Monopolistic and Monopolistically Competitive Market

Perfectly competitive market – key conditions for perfect competition (e.g. agriculture and computer software/chips):

1. There are many buyers and sellers in the market, each of which is “small” relative to the market.

2. Each firm in the market produces a homogeneous (identical) product.

3. Buyers and sellers have perfect information.

4. There are no transaction costs.

5. There is free entry into and exit from the market.

The price is determined by the interaction of all buyers and sellers in the market. In a competitive market, price is determined by the intersection of the market supply and demand curves.

A firm’s demand curve, the demand curve for an individual firm’s product, in a perfectly competitive market is simply the market price.

The individual demand curve is perfectly elastic.

The pricing decision of the individual firm is trivial: charge the price that every other firm in the industry charges. All that remains is to determine how much output should be produced to maximize profits.

The profit-maximizing perfectly competitive firm produces the output at which price equals MC.

The short-run supply curve for a perfectly competitive firm is its MC curve above the minimum point on the AVC curve.

The market (or industry) supply curve is closely related to the supply curve of individual firms in a perfectly competitive industry. The horizontal sum of the MC of all firms determines how much total output will be produced at each price.

As more firms enter the industry in the long-run, the industry supply curve shifts to the right. If firms in a competitive industry sustain short-run losses, in the long run they will exit the industry since they are not covering their opportunity costs.

When firms exit the industry, market supply decreases, price rises, and profit rises.

Long-Run Competitive Equilibrium – in the long-run, perfectly competitive firms produce level of output such that:

1. P = MC

At P=MC, the cost that is incurred by the society (MC) equals to what the society value the goods (P). When P>MC, society values the goods more than what it costs, more production of that goods is beneficial for the society. When P<MC, society values the good less than what it costs, thus less goods should be produced.

2. P = Minimum of AC (all economies of scale have been exhausted).

A firm in a perfectly competitive industry earns zero economic profits in the long-run. This does not mean that accounting profits are zero; rather, zero economic profits implies that accounting profits are just high enough to offset any implicit costs of production, which include the opportunity costs. The firm earns no more and no less, than it could earn by using the resource in some other capacity. This is why they keep producing in the long-run.

Monopoly

Monopoly – A market structure in which a single firm serves an entire market for a good that has no close substitutes. The monopolist is restricted by consumers to choose those price-quantity combinations along the market demand curve.

The market demand curve of a monopoly is the market demand curve of the market.

These are four primary sources of monopoly power

1. Economic of Scale – exist whenever the long-run average costs decline as output increases. Sometimes the industry cannot support two or more firms but only one firm. Thus, there will only be one firm in the market.

2. Economies of Scope – exist when the total cost of producing two products within the same firm is lower than when the products are produced by separate firms. Thus this may hinder small firms from entering the market especially if the cost of capital is very high.

3. Cost complementarily – exist (in a multi-product cost function) when the marginal cost of producing one output is reduced when the output of another product is increased.

4. Patents and other legal barriers – patent gives the inventor the exclusive right to sell the product for a given time period. This gives the inventor temporary monopoly power. But patent protection does not make firms immune to competition.

Greater capital power exists more for multi-product firms than for single-product firms, this requirement can limit the ability of small firms to enter the market. This can result in a monopoly.

If MR was greater than MC, an increase in output would increase revenue more than it would increase cost. To maximize profits: MR=MC

Profit function – π= R (Q) – C (Q)

Monopolistic Competition
A market in which

1. There are many buyers and sellers;

2. Each firm produces a differentiated product;

3. There is free entry and exit.

There are numerous industries in which firms produce products that are close substitutes (e.g. fast-food restaurants). This implies that each firm faces a downward-sloping demand curve for its product.

Key difference between monopolistic competitive market and perfect competitive market is that each firm in monopolistic competitive market produces a slightly different product.

There are two differences between a monopolistically competitive market and a market serviced by a monopolist:

1. In a monopolistically competitive market a firm faces a downward-sloping demand for its product; there are other firms in the industry that sell similar products.

2. In a monopolistically competitive industry there are no barriers to entry.

The determination of the profit-maximizing price and output under monopolistic competition is precisely the same as for a firm operating under monopoly.

One important difference in the interpretation of the analysis; the demand and MR curves are used to determine the firm’s profit-maximizing output and price. But in a monopolistic competition price and output are not based on the market demand for the product but on the demand for the individual firm’s product.

Profit Maximization Rule for Monopolistic Competition:

To maximize profits, a monopolistically competitive firm produces where its MR equals MC. The profit-maximizing price is the maximum price per unit that consumers are willing to pay for the profit-maximizing level of output. In other words, the profit-maximizing output, Q*, is such that:, and the profit-maximizing price is.

Chapter 9: Basic Oligopoly Models

Oligopoly – A market structure in which there are only a few firms, each of which is large relative to the total industry.

Duopoly – An oligopoly composed of only two firms.

In determining what price and output to charge, the manager must consider the impact of his or her decision on other firms in the industry.

The demand for a firm’s product in oligopoly depends critically on how rivals respond to the firm’s pricing decisions.

Four Oligopoly settings (models)

1. Sweezy Oligopoly – A firm is characterized as a Sweezy oligopoly if:

   1. There are few firms in the market serving many consumers.

   2. The firms produce differentiated products.

   3. Each firm believes rivals will respond to a price reduction but will not follow a price increase.

   4. Barriers to entry exist.

Firms have an incentive not to change their pricing behavior, provided marginal costs remain in a given range.

Although this model has been criticized because it offers no explanation of how the industry settles on the initial price, it does show those strategic interactions among firms and a manager’s belief about rivals’ reactions can have a profound impact on pricing decisions.

2. Cournot Oligopoly (a quantity setting environment) – An industry is a Cournot oligopoly if:

   1. There are few firms in the market serving many consumers.

   2. The firms produce either differentiated or homogeneous products.

   3. Each firm believes rivals will hold their output constant if it changes its output

   4. Barriers to entry exist.

Sweezy ↔ Cournot Oligopoly

The Cournot model applies to situations in which the products are either identical or differentiated. It is relevant for decision making when managers make output decisions and believe that their decisions do not affect the output decision of rival firms.

yield a given firm the same level of profits.

• Every point on a given isoprofit curve yields the same level of profits.

• Isoprofit curves that lie closer to firm 1’s monopoly output are associated with higher profits.

• Isoprofit curves for firm 1 reach their peak when they intersect firm 1’s reaction function.

• The isoprofit curves do not intersect one another.

You can use the isoprofit curves to illustrate the profits of each firm in Cournot equilibrium.

Firm 1 maximizes profit, where only 2 firms exist, when the iso-profit function intersect/tangential to the given output of the firm 2. The iso-profit also needs to be as close as possible to the monopoly point for firm 1.

The reason for the difference between the preceding analysis and the analysis of Sweezy oligopoly is the difference in the way a firm perceives how other firms will respond to a change in its decisions.

It is really important to obtain an accurate grasp of how other firms in the market will respond to the manager’s decisions.

Collusion – Whenever a market is dominated by only a few firms, firms can benefit at the expense of consumers by agreeing to restrict output or, equivalently, charge higher prices. It is difficult for firms to reach such a collective agreement, because it is easy for one of the partners to cheat on the other.

3. Stackelberg oligopoly – Firms differ with respect to when they make decisions. An industry is characterized as a Stackelberg Oligopoly if:

   1. There are few firms serving many consumers

   2. Firms produce either differentiated or homogeneous products

   3. A single firm (the leader) chooses an output before rivals select their outputs.

   4. All other firms (the followers) take the leader’s output as given and select outputs that maximizing profits given the leader’s output.

   5. Barriers to entry exist.

Because the follower produces after the leader, the follower’s profit maximizing level of output is determined by its reaction function.

However, the leader considers the followers reaction while establishing its own profit maximization:

4. Bertrand Oligopoly (a price-setting environment)

The treatment here assumes that firms sell identical products and that consumers are willing to pay the (finite) monopoly price for the good. An industry is characterized as a Bertrand oligopoly if:

1. There are few firms in the market serving many consumers

2. The firms produce identical products at a constant marginal cost.

3. Firms engage in price competition and react optimally to prices charged by competitors.

4. Consumers have perfect information and there are no transaction costs.

5. Barriers to entry exist.

It is undesirable for the manager, because it leads to zero profits even if there are only two firms in the market. It is desirable for the consumer, because it leads to exactly the same outcome as a perfectly competitive market.

Bertrand oligopoly and homogeneous products lead to a situation where each firm charges Marginal Costs and economic profits are zero.

There are two ways a manager can mitigate this cutthroat competition:

1. Raise switching costs.

2. Eliminate the perception that products are identical.

Prices and rights vary according to the type of oligopolistic interdependence that exists in the market. When you are a manager in an oligopolistic market, it is important to recognize that your optimal decisions and profits will vary depending on the type of oligopolistic interaction that exists in the market.

Comparing Oligopoly Markets
The highest market output is produced in a Bertrand oligopoly, followed by Stackelberg, Cournot and as the last collusion. Profits are highest for the Stackelberg leader and collusion firms, followed by Cournot and than the Stackelberg follower. Bertrand oligopolies earn the lowest level of profits.

Contestable Markets

A market is contestable if:

1. All producers have access to the same technology.

2. Consumers respond quickly to price changes.

3. Existing firms cannot respond quickly to entry by lowering their prices.

4. There are no sunk costs.

If market is perfectly contestable, incumbents are disciplined by the threat of entry by new firms.

Chapter 10: Game Theory: Inside Oligopoly

Players – individuals (also: firms) who make decisions.

Strategies – planned decisions of the players.

In the context of oligopoly games:

1. Simultaneous-move game – games in which each player makes decisions without knowledge of the other players’ decisions.

2. Sequential-move game – game in which one player makes a move after observing the other player’s move.

One-shot game – Players will play the game only once.

Repeated game – The game is played more than once.

The type of pricing games which the move is made simultaneously is usually called Bertrand Duopoly Game.

Strategy – In game theory, a decision rule that describes the actions a player will take at each decision point.

Normal-form game – A representation of a game indicating the players, their possible strategies, and the payoffs resulting from alternative strategies.

Dominant strategy – A strategy that results in the highest payoff to a player, regardless of the opponent’s action. When you have a dominant strategy it is best to play it.

If you do not have a dominant strategy, look at the game from your rival’s perspective. If your rival has a dominant strategy, anticipate that he/she will play it.

It is smart to play a secure strategy if there is no dominant strategy.

Secure strategy – A strategy that guarantees the highest payoff given the worst possible scenario.

The secure strategy suffers from two shortcomings:

1. It is a conservative strategy and should be considered only if you have a good reason to be extremely averse to risk.

2. It does not take into account the optimal decisions of your rival and thus may prevent you from earning a significantly higher payoff.

Nash equilibrium – A condition describing a set of strategies in which no player can improve her payoff by unilaterally changing her own strategy, given the other players’ strategies. Each player is doing the best he can given what other players are doing.

Application of One-shot Games

Pricing decision - Collusion (which is illegal) is not a real option, because all parties have an incentive to cheat.

Advertising and Quality decisions - In oligopolistic markets, firms advertise and/or increase their product quality in an attempt to increase the demand for their products. However, there can be a situation where each firm advertises just to cancel out the effect of other firms’ advertising, resulting in high advertising expenditure with no change in demand and low profit.

Coordination decisions - In an environment where different appliances require different outlets, a consumer who desires several appliances would have to spend a considerable sum wiring the house to accommodate all of the appliances.

Monitoring employees - Game theory can also be used to analyze interactions between workers and the manager.

Mixed (randomized) strategy – A strategy whereby a player randomizes over two or more available actions in order to keep rivals from being able to predict his or her action.

Nash bargaining – Two players “bargain” over some object of value.

Infinitely repeated game – A game that is played over and over again forever and in which players receive payoffs during each repetition of the game.

In a one-shot game there is no tomorrow; any gains must be had today or not at all. In an infinitely repeated game there is always a tomorrow. Therefore firms must weigh the benefits of current actions against the future costs of those actions. The principal result of infinitely repeated games is that when the interest rate is low, firms may find it in their interest to collude and charge high prices, unlike in the case of a one-shot game.

It is easier to sustain collusive agreements via punishment strategies when firms know:

1. who their rivals are

2. who their rivals’ customers are.

3. when their rivals deviate from the collusive arrangement.

4. They must be able to successfully punish rivals for deviating from the collusive agreement.

The above mentioned factors are related to several variables:

1. Number of Firms

Collusion is easier when there are fewer firms than when there are many. The larger the number of firms (n) cooperating, the larger the number of monitors:. In the end, the costs of monitoring other firms will exceed the benefits of cooperating.

2. Firm Size

Economies of scale exist in monitoring. Monitoring and policing costs constitute a much greater share of total costs for small firms than for larger firms.

3. History of the Market

Firms learn from other firms in the market. Tacit collusion occurs when firms do not explicitly conspire to collude, but accomplish collusion indirectly.

4. Punishment Mechanisms

The pricing mechanisms firms use also affect their ability to punish rivals that do not cooperate.

You do not need to punish forever. It is long enough to take away the profits they earned by cheating.

The theory of infinitely repeated games can be used to analyze the desirability of firm policies such as warranties and guarantees.

It does not pay for firms to cheat on customers, i.e. selling low quality products, if its process is ongoing. This is especially true since if firms try to cheat, customers can choose not to buy from the same firm again in the future and can also bad-mouthing the firm.

Situations in which the End-of-Period plays a significant role:

• Resignations and quits of employees

• “Snake-Oil” Salesmen

• Sidewalk vendors

Multistage games differ from the class of games examined earlier in that timing is very important.

Extensive-form game – A representation of a game that summarizes the players, the information available to them at each stage, the strategies available to them, the sequence of moves, and the payoffs resulting from alternative strategies.

Sub game perfect equilibrium – A condition describing a set of strategies that constitutes a Nash equilibrium and allows no player to improve his own payoff at any stage of the game by changing strategies.

It does not pay to heed threats made by rivals when the threats are not credible.

Applications of Multistage Games

The entry game - Firms that want to enter the market may want to consider what the reaction of the existing firms and try to find the sub game-perfect equilibrium.

Innovation – A firm may not want to innovate if another firm can easily duplicate the innovation. Thus, any innovation needs to be patented.

Sequential Bargaining - The first mover in the bargaining game makes a take-it-or-leave-it offer. The second mover can accept the offer or reject it and receive nothing. The player making the take-it-or-leave-it offer extracts virtually the entire amount bargained over.

In bargaining processes, it is worthwhile to invest some time in learning about your opponent. This explains why there is a market for publications that specialize in providing information to consumers about the dealer cost of automobiles.

An important assumption in the bargaining process analyzed in this section is that bargaining terminates as soon as the second player rejects or accepts an offer.

The status-quo is the situation in which each firm keeps its current policy, and thus the change in payoffs is 0 for that cell of the matrix.

Chapter 11: Pricing Strategies for Firms with Market Power

Basic Pricing Strategies – Charge a single price to all customers such that MR equals MC.

Firms with market power face a downward-sloping demand for their products. By charging a higher price, the firm reduces the amount it will sell.

Often managers of small firms do not have enough money for a research department or for hiring economists to estimate cost and demand functions. These are necessary to calculate profit maximization.

When firms in a Cournot oligopoly sell identical products, the elasticity of demand for an individual firm’s product is N times the market elasticity of demand:.

Three aspects of the pricing rule for a Cournot oligopoly:

1. The more elastic the market demand, the closer the profit-maximizing price is to marginal cost.

2. As the number of firms increases, the profit-maximizing price gets closer to marginal cost, in extreme, if.

3. The higher the marginal cost, the higher the profit maximizing price in a Cournot oligopoly.

There are four pricing strategies, which can be used to yield profits above those earned by simply charging a single price, where.

1. Price Discrimination –The practice of charging different prices to consumers for the same good or service.

   • First-degree price discrimination (perfect price discrimination) – charge each consumer the maximum price he or she would be willing to pay for each unit of the good purchased. Thus, extracting all surpluses from consumer.

• Second-degree price discrimination – the practice of posting a discrete schedule of declining prices for different ranges of quantities (electric utility industry). Consumers purchasing small quantities pay higher prices than those who purchase in bulk. It can be implemented without knowing the identity of the consumers.

• Third-degree price discrimination – different groups of consumers are offered different prices for the same product. For example, student discount.

A necessary condition for third-degree price discrimination to enhance profits is that there are differences in the elasticity of demand of various consumers. The firm has some means of identifying the elasticity of demand by different groups of consumers. No type of price discrimination will work if the consumers purchasing at lower prices can resell their purchases to individuals being charged higher prices.

2. Two part pricing – Pricing strategy in which consumers are charged a fixed fee for the right to purchase a product, plus a per-unit charge for each unit purchased. A firm can enhance profits by engaging in two-part pricing: charge a per-unit price that equals MC, plus a fixed fee equal to the consumer surplus each consumer receives at this per-unit price. This way the producer manages to extract the entire consumer surplus from the consumer. Consumers do not need to have different elasticities of demand for the firm’s product.

3. Block pricing – Pricing strategy in which identical products are packaged together in order to enhance profits by forcing customers to make an all-or-none decision to purchase. Block pricing provides a means by which the firm can get the consumer to pay the full value of the units. By packaging units of a product and selling them as one package, the firm earns more than by posing a simple per-unit price. The profit-maximizing price on a package is the total value the consumer receives for the package, including consumer surplus.

Block pricing can enhance profits even in situations where consumers have identical demands for a firm’s product.

4. Commodity Bundling – The practice of bundling several different products together and selling them at a single “bundle price”. You can enhance profits even without distinguishing among the amounts different consumers are willing to pay for the firm’s products. However, in the case that managers know how much each consumer is willing to pay for each product, price discrimination may be a better alternative.

Pricing strategies for special cost and demand structures

1. Peak-load pricing – Pricing strategy in which higher prices are charged during peak hours than during off-peak hours.

2. Cross-Subsidies – Pricing strategy in which profits gained from the sale of one product are used to subsidize sales of a related product.

Two advantages:

1. 1. It permits the firm to sell multiple products, which leads to cost savings in the presence of economies of scope.

   2. If the two products have demands that are interdependent, the firm can induce consumers to buy more of each product than they would otherwise.

Whenever the demand for two products produced by a firm are interrelated through costs or demand, the firm may enhance profits by cross-subsidization: selling one product at or below cost and the other product above cost.

Transfer pricing – Pricing strategy in which a firm optimally sets the internal price at which an upstream division sells an input to a downstream division. It is important because most division managers are provided an incentive to maximize their own division’s profits.

By setting the transfer price at the upstream division’s MC of producing the firm’s profit-maximizing quantity of the input, the problem of double marginalization is avoided even though divisional managers operate independently to maximize their division’s profits.

Double Marginalization- occurs when there is double mark up in price in excess of MC.

Pricing strategies in markets with intense price competition.

Trigger-strategies in infinitely repeated games can work only if the interest rate is low and firms can effectively monitor the behavior of other firms in the market.

• Price matching – A strategy in which a firm advertises a price and a promise to match any lower price offered by a competitor. Price wars can start when people are in a one-shot Bertrand oligopoly, because someone offers a low price, the other one will match that price etc.

The firms need not monitor the prices charged by rivals. It is up to a consumer to show the firm that some rival is offering a better deal.

Before you adopt a price-matching strategy consider two things:

1. You must devise a mechanism that precludes consumers from claiming to have found a lower price when in fact they have not.

2. A competitor must not have lower cost than you have.

• Inducing Brand Loyalty.

Brand-loyal customers will continue to buy a firm’s product even if another firm offers a better price.

Several methods:

1. Engage in advertising campaigns that promote a firm’s product as being better than those of competitors. This method is more applicable for a heterogeneous goods

2. A frequent-filler/frequent-flyer strategy provides the consumer with an incentive to remain loyal to a particular firm even though it offers products identical to its rivals.

• Randomized Pricing – Pricing strategy in which a firm intentionally varies its price in an attempt to “hide” price information from consumers and rivals.

It is beneficial for two reasons:

1. Consumers cannot learn from experience which firm charges the lowest price in the market.

2. It reduces the ability of rival firms to undercut a firm’s price (in Bertrand oligopoly, a firm wishes to slightly undercut the rival’s price).

This randomized pricing may not be profitable since the firm needs to incur additional cost of hiring personnel.

Chapter 12: The Economics of Information

Mean (expected value) – The sum of the probabilities that different outcomes will occur multiplied by the resulting payoffs.

, where

Variance – The sum of the probabilities that different outcomes will occur multiplied by the squared deviations from the mean of the random variable.

Standard deviation – The square root of the variance.

Uncertainty and Consumer behavior.

Uncertainty affects economic decisions of both consumers and managers.

Risk Averse – Preferring a sure amount of $M to a risky prospect with an expected value of $M.

Risk Loving – Preferring a risky prospect with an expected value of $M to a sure amount of $M.

Risk Neutral – Indifferent between a risky prospect with an expected value of $M and a sure amount of $M.

Managerial decisions with Risk-averse Consumers

For gambles with nontrivial outcomes, most individuals are risk averse.

Product Quality

Two tactics to induce risk-averse consumers to try a new product:

• Lower price. Example: giving out free samples.

• Make it look like the quality of the new product is better (comparative advertising).

Chain Stores

The key thing to notice is that even if local stores offer a better product than the national chain, the national chain can remain in business if the number of out-of-town customers is large enough.

Insurance

The fact that consumers are risk averse implies that they are willing to pay to avoid risk.

Consumer Search

The analysis of consumers is different if the consumers do not know the prices charged by different firms for the same product.

Free recall – The consumer is free to return to the store at any time to purchase a certain good for a certain price. The consumer should search for a lower price as long as the expected benefits are greater than the cost of an additional search.

Replacement – the distribution of prices charged by other firms does not change just because the consumer has learned that one store charges certain price for a certain product.

Reservation price – The price at which a consumer is indifferent between purchasing at that price and searching for a lower price. If is the expected benefit of searching for a price lower than p, and c represents the cost per search, the reservation price satisfies the condition:

The Consumer’s Search Rule

The optimal search rule is such that the consumer rejects prices above the reservation price (R) and accepts prices below the reservation price. Stated differently, the optimal search strategy is to search for a better price when the price charged by a firm is above the reservation price and stop searching when a price below the reservation price is found.

If the costs of searching rise, this will result in a higher reservation price and consumers will search less intensively. If the costs decrease, the consumer will search more heavily for lower prices. This is a tool to help managers to set their prices. You must not price above customer reservation price, or you will find people going to other companies to find a lower price.

Uncertainty and the firm

The presence of uncertainty has direct impact on consumer behavior. The firm manager must take these effects into account to fully understand the nature of consumer demand.

Risk aversion

Manager is risk neutral: maximizing expected profits.

Manager is risk averse: safer project with lower expected value.

It is always important to carefully evaluate the risks and expected returns of the projects and then to document this evaluation, the mean-variance analysis.

Diversification – By investing in multiple projects, the manager may be able to reduce risk. Many managers are risk averse, because owners of the firm want the manager to behave in a risk-neutral manner.

Shareholders can pool and diversify risks by purchasing shares of many different firms to eliminate the systematic risk associated with the firm’s operation. If you, as a manager, are provided with incentives to maximize the expected profits of the firm, you will behave in a risk-neutral manner.

Producer Search – Producers search for low prices of inputs. (Same concept as consumer search)

Profit maximization – To maximize expected profits, the manager should equate expected marginal revenue with marginal cost in setting output: E[MR] = MC. Profit maximization under uncertain demand is very similar to profit maximization under certainty.

Uncertainty and the market

Problems with uncertainty:

• Asymmetric Information – When some people in the market have better information than others, the people with the least information may choose not to participate in a market.

Asymmetric information affects many managerial decisions, including hiring workers and issuing credit to customers.

Two specific manifestations of asymmetric information:

• Hidden Characteristics – Things one party to a transaction knows about itself but which are unknown by the other party.

• Hidden Action – Action taken by one party in a relationship that cannot be observed by the other party.

Those types of asymmetric information can lead to adverse selection and moral hazard.

• Adverse selection – Situation where individuals have hidden characteristics and in which a selection process results in a pool of individuals with undesirable characteristics.

• Moral Hazard – Situation where one party to a contract takes a hidden action that benefits him or her at the expense of another party.

Moral hazard is one factor that has contributed to rising medical costs during the past decade.

• Signaling and Screening

Incentive contract can be used to mitigate moral hazard problems that stem from hidden actions.

Signaling – An attempt by an informed party to send an observable indicator of his or her hidden characteristics to an uninformed party. In product markets:

• • Money-back guarantees

  • Free trial periods

  • The product has won “special awards”

For signal to provide useful information to an uninformed party, the signal must be observable by the other party. It must also have reliable indicators and is not easily mimicked by others.

Screening – An attempt by an uninformed party to sort individuals according to their characteristics. This may be achieved by a:

Self-selection device – A mechanism in which informed parties are presented with a set of options, and the options they chose reveals their hidden characteristics to an uninformed party.

Auctions

In an auction, buyers compete for the right to own a good, service or more generally anything of value. Different types of auctions can differ with respect to:

• The timing of bidder decisions

• The amount the winner is required to pay

There are four basic types of auctions:

1. English auction – An ascending sequential-bid auction in which bidders observe the bids of others and decide whether or not to increase the bid. The auction ends when a single bidder remains; this bidder obtains the item and pays the auctioneer the amount of the bid. Only in this auction, bidders continually obtain information about one another’s bids and not in other forms of auction.

A player’s optimal bidding strategy is to remain active until the price exceeds his or her own valuation of the object.

2. First-price; sealed bid auction – A simultaneous-move auction in which bidders simultaneously submit bids on pieces of paper. The auctioneer awards the item to the highest bidder, who pays the amount bid.

A bidder’s optimal strategy is to bid less than his or her valuation (v) of the item. If there are n bidders who all perceive valuations to be evenly (or uniformly) distributed between a lowest possible valuation of L and a highest possible valuation of H, then the optimal bid (b) is given by the following formula:

3. Second-price; sealed bid auction – A simultaneous-move auction in which bidders simultaneously submit bids on pieces of paper. The auctioneer awards the item to the high bidder, who pays the amount bid by the second-highest bidder.

A player’s optimal strategy is to bid his or her own valuation of the item. In fact, this is a dominant strategy.

4. Dutch auction – A descending sequential-bid auction in which the auctioneer begins with a high asking price and gradually reduces the asking price until one bidder announces a willingness to pay that price for the item.

See 2. First price; sealed bid.

Information Structures

Bidders rarely enjoy perfect information in an auction. Each bidder has information about his or her valuation or value estimate that is unknown by other bidders.

Independent private values – Auction environment in which each bidder knows his own valuation of the item but does not know other bidders’ valuations (private values), and in which each bidder’s valuation does not depend on other bidders’ valuation of the object (independent).

This means that even if a player could obtain information about other bidders’ valuations, his/her valuation of the object would not change. However, bidding behavior may change from less aggressive to more aggressive or vice versa.

Affiliated (correlated) value estimates – Auction environment in which bidders do not know their own valuation of the item or the valuation of others. Each bidder uses his or her own information to estimate their valuation, and these value estimates are affiliated: the higher a bidder’s value estimate, the more likely it is that other bidders also have high value estimates.

Common value – Auction environment in which the true value of the item is the same for all bidders, but this common value is unknown. Bidders each use their own (private) information to form an estimate of the item’s true common value. E.g. auctions to sell oil, gas and mineral rights.

Optimal bidding strategies for auctions with affiliated values are more difficult to describe, because:

• Bidders do not know their own valuations of the item, let alone the valuations of others. This may result in the ‘winner’s curse’ – the “bad news” conveyed to the winner that his or her estimate of the item’s value exceeds the estimates of all other bidders. To avoid the ‘winner’s curse’, a bidder should revise downward his or her private estimate of the value to account for this fact.

• The auction process itself may reveal information about how much the other bidders value the object.

Best auction method from the auctioneer’s point of view depends on the nature of the information.

In Independent private value, the revenue is the same regardless of the type of the auction being used.

In Affiliated value estimates, the expected revenues are as follows: English auction > Second price; sealed bid > First price; sealed bid = Dutch auction

Chapter 13: Advanced Topics in Business Strategy

Successful management brings about competitors.

Limit pricing to prevent entry

Manager may consider strategy such as limit pricing to prevent entry.

Limit Pricing – Strategy where an incumbent maintains a price below the monopoly in order to prevent entry.

Theoretical basis for limit pricing: by limiting the price in level that is below the monopoly price, the incumbent firm can force the potential entrance to get only the residual demand. In the event where this residual demand is less than the average cost, the potential entrance will stay away from the market.

Due to this reason, it is better if the incumbent can threaten to limit price without really do so. The profit it gets will be monopoly profit and no companies will try to enter if they believe the threat.

Effective limit pricing: for limit pricing to effectively prevent entry by rational competitors, the pre-entry price must be linked to the post-entry profits of potential entrants.

Linking the pre-entry price to post-entry profits > some conditions need to be meet to ensure that deterring entry is actually the best strategy.

• Commitment Mechanisms - the incumbent can commit to produce at least the post-entry output. This way the incumbent will actually earn more profit since if it does not commit and let the competitor to enter, the profit will be divided among the firms in the market.

• Learning curve effects - when a firm enjoys lower costs due to knowledge gained from its past production decisions. Having learning better method of production, the incumbent can lower its cost and then limits the price of the goods or services.

• Incomplete information - due to lack of complete information, the incumbent can purposefully limit price to make the potential entrants to reconsider their plan to enter the market.

• Reputation effects - if the incumbent has the reputation on being tough, it may prevent entry

Dynamic consideration

If the firm manage to maintain its monopoly, then the profit will be π = [(1+i)/i] π^m

If entry occurs, then the profit will be π = π^m + π^d/i

If the incumbent uses limit pricing, the profit will be π = [(1+i)/i] π^l

Limit pricing is profitable if

Predatory Pricing to Lessen Competition

Predatory pricing – strategy where a firm temporarily prices below its marginal costs to drive competitors out of the market.

It arises when a firm charges price below its marginal cost. In order to engage in predatory pricing, the ‘predator’ needs to be healthier than the ‘prey’.

Some counter strategies:

1. Since the predator is selling the product below cost, the prey might stop production or

2. Purchase the product from the predator and stockpile them.

Predatory pricing cannot be used if the prey is of similar size and situations

Predatory pricing can also be used to enter the market, by giving the product for free.

Raising Rivals’ Costs to Lessen Competition

Raising Rivals’ Costs – strategy in which a firm gains advantage over competitors by increasing their costs.

Strategies involving MC - by raising its rival’s MC, one firm shifts its rival’s reaction function down. The result is that the firm will have more market share and higher profit.

Strategies involving fixed costs - if the incumbent raises the fixed cost by asking for government to regulate the market, then it makes potential entrants to recalculate the profitability of entering the market.

Strategies for vertically integrated firms

Vertical foreclosure – strategy wherein a vertically integrated firm charges downstream rivals a prohibitive price for an essential input, thus forcing rival to use more costly substitutes or go out of business.

Price-cost squeeze – Tactic used by a vertically integrated firm to squeeze the margins of its competitors.

Price Discrimination as a Strategic Tool

The profitability of such measures mention above will increase if the firm can actually price discriminate by charging different customers different prices and also for the vertically integrated firm, it can charge different downstream rival differently.

Changing the Timing of Decisions or the Order of Moves

First mover advantages - it permits a firm to earn higher profit by committing itself before other firms. This is partly due to learning effect that reduces cost.

Second mover advantages - sometimes it is more beneficial to be the second mover as firm can learn from the mistakes of the first mover, hence producing better product at lower cost.

Penetration Pricing to Overcome Network Effects

Network - consists of links that connect different points (nodes) in geographic or economic space.

The simplest is one-way network such as water network. The more complicated one is two-way network such as telephone network.

Network externalities

Direct - The direct value enjoyed by the user of a network because others also use the network. A two-way network linking n user provides n (n - 1) potential connection services. If one new user joins the network, all existing users benefit by 2n

Indirect - The indirect value enjoyed by the user of a network because of complementarities between size of a network and the availability of complementary products or services

Note, however, negative externalities such as bottleneck can occur if the network grows up to the point where the infrastructure cannot handle anymore.

First-Mover Advantages Due to Consumer Lock-In

It is difficult for new networks to replace or compete with existing networks since there is no incentives for the old network users change network.

Using Penetration Pricing to ‘Change the Games’

Penetration pricing – Charging a low price initially to penetrate market and gain a critical mass of customers; useful when strong network effects are present.

Using the penetration pricing strategy will provide incentives for the old user to change to a new network. This will help gather a pool of new users.

Chapter 14: A Manager’s Guide to Government in the Marketplace

Market Failure

Market may fail to produce the socially optimal level due to following reasons:

1. Market Power - the ability of a firm to set its price above marginal cost

Monopoly usually has market power and thus the government creates regulation to ensure that the monopoly does not charge high price to the consumer. Charging at monopoly price is not the socially optimal price. Hence government takes action to correct this, to increase social welfare.

Regulation: anti-trust Policy - government policies designed to keep firms from monopolizing their market. The government attempts to eliminate deadweight loss of monopoly by making it illegal for firms to engage in activities that foster monopoly power. Such activities include: collusion, price discrimination, merger and acquisition.

Price regulation

Sometimes due to the benefits of Economies of scale, it is better for one firm to serve the entire market. In this case, the government can regulate the price that the monopoly can charge. Problem arises when the ATC is higher than the price. The monopoly would not want to produce the product since it is making a loss. The government needs to subsidize the monopoly which then can lead to complacency that hinders the monopoly to reduce costs.

2. Externalities

Negative externalities - Costs borne by parties who are not involved in the production or consumption of a good. For example, pollution.

In the existence of externalities, the free market equilibrium is not the socially efficient output. Third party can be affected by the transaction made by the producer and consumer. Hence, in order to mitigate this problem, government attempts to govern the waste disposal and pollution matter.

The Clean Air Act (in the United States of America)

It is passed on to make sure that companies need to consider the effect of their activities to the environment. Companies can trade the permit to pollute with one another after they obtain the permit from the government. This way, each company has the incentives to develop a less-polluting production method to be able to sell the permit and recover some money from it.

3. Public good - a good that is non-rival and non-exclusionary in consumption.

Non-rival consumption: The consumption of the good by one person does not preclude other people from consuming the good.

Non-exclusionary consumption: No one can be excluded from consuming the good once it is provided.

‘Free-ride’ problem occurs when people refrain from paying as the he/she can enjoy the good once it is available.

It is important for the government to provide public goods as if it is leaved to the free market mechanism, there will be no goods being produced. Government can use the tax to pay for the provision of public goods. However, the government may not produce in the socially efficient level.

A corporation can also produce public goods as it can be used as advertising strategy and lobbying effort to the government.

4. Incomplete Information

When the participants in the market have incomplete information about certain products, the result will be inefficiencies in input usage and in firms’ output.

Rules against Insider Trading – the government tries to make it illegal to make insider trading in the stock exchange. Insider trading can destroy the market since those people who have no such inside information would not want to trade there as they will lose out.

Certification – the government makes use of certification to create certain minimum standard so as to assure the customers about the products. Without certification, there will be inefficiencies

Truth in Lending - it is in regards to the regulation for the creditors. Creditors oblige to provide information determined on the regulation created by government to make the debtors fully informed about all clausal in the agreement.

Truth in Advertising - it is about creating a truthful advertisement so that the consumers will not be harmed by the advertisement. The regulation allows government to make a lawsuit against the firm if the advertising is false and misleading.

Enforcing Contracts - another way to solve incomplete information is through the use of contracts. The government, in this case, becomes the enforcer of the contract so that no one can break the contract without any consequences

Rent Seeking - selfishly motivated efforts to influence another party’s decision.
Rent seeking is done by firms in order for the politicians to pass on bills that are advantageous to them. Firms are usually for powerful persuader since they are usually smaller in number compares to the consumers.

Government Policy and International Markets

Quotas - a restriction that limits the quantity of imported goods that can legally enter the country. Using a quota will make quantity traded decreases while the price increases. This benefits the domestic producers at the expense of the domestic consumer and foreign producers.

Tariffs

Lump-sum tariff: A fixed fee that an importing firm must pay the domestic government in order to have the legal right to sell the product in the domestic market

The effects are removing the foreign supply if the price is lower than the AC after tariffs and to restrict the amount imported.

Per-unit (excise) tariff: The fee an importing firm must pay to the domestic government on each unit it brings into the country.

Domestic producers again benefit at the expense of domestic consumers and foreign producers.