This post was published to Tender Coconut at 11:05:11 PM 12/1/2007
Managerial Economics summary


Managerial Economics

1: Introduction

Organizational Architecture: systematic framework for addressing important organizational issues. The framework identifies three critical aspects of corporate organization:
(1) the assignment of decision rights within the company
(2) the methods for rewarding individuals
(3) the structure of systems to evaluate the performance of both individuals and business units.

The basic argument is that successful firms assign decision rights in ways that effectively link decision authority with the relevant information for making good decisions. When assigning decision rights, however, senior management must also ensure that the company's reward and performance-evaluation systems provide decision makers with appropriate incentives to make value-increasing decisions. Different circumstances will generally cause firms to adopt different organizational architectures. Successful firms must ensure that the three elements of organizational architecture are coordinated.


Economics: provides a theory of how individuals make choices and respond to incentives. The text uses economics to examine how managers can structure organizational architecture to motivate individuals to make choices that increase firm value.

Economic Darwinism
Survival of the Fittest. Competition in the marketplace "weeds out" inefficient firms.
To survive, firms must be able to sell products at competitive prices that exceed costs. Given the business strategy and product mix, a firm's organizational architecture can have an important impact on profitability and value.

Economic Darwinism and Benchmarking.
Adaptation in economic systems is voluntary and purposeful.

Benchmarking: Managers look for those companies that are doing something "best" and learn how they do it in order to emulate them.
When benchmarking, managers must be careful to coordinate the different elements of the firm's architecture.

The concept of economic Darwinism has important managerial implications.
existing architectures are not random; there are sound economic explanations for the dominant organization of firms in most industries.
surviving architectures at any point in time are optimal in a relative rather than absolute sense; that is, they are best among the competition, not necessarily the best possible. Managers should understand the history of the firm's current architecture and should not be quick to replace it without careful analysis.

Approach to Organizations.
The approach is based on two basic notions:
people act in their own self-interest
information is often asymmetric, individuals do not all share the same information.

Successful organizations assign decision rights to those with the relevant information and develop performance-evaluation and reward systems to provide them with appropriate incentives. The complexity of organizations requires simplification to effectively examine the real and important issues.

2: Economists' View of Behavior

Managers rely on assumptions about what motivates employees. In economics, we assume that individuals (consumers, entrepreneurs, managers, or employees) are motivated by self-interest.

Economic Behavior: An Overview

Economic Choice.
Individuals have unlimited wants for tangible (e.g. cars) and intangible (e.g. self-esteem) things, but have limited resources by which these can be acquired. When faced with this problem of scarcity, individuals must choose between the available and affordable options.

Economists assume that an individual chooses the alternative that yields the greatest individual happiness given resource constraints. Individuals are creative and resourceful in maximizing personal happiness subject to resource constraints.

Marginal Analysis and Opportunity Costs
Opportunity costs: Additional benefit comes with an opportunity cost, the value of using a resource in the next best alternative. This cost may (explicit cost) or may not (implicit cost) require a direct outlay of money.

Marginal beniftit/ cost Additional benefit and cost are called marginal benefit and cost, respectively. If the marginal benefit of a decision exceeds the marginal cost, then the decision causes a net increase in a person's happiness. One must be careful, however, to only consider only the relevant benefits and costs.

Sunk costs and benefits Non-recoverable expenditures or receipts, are generally irrelevant to decisions.

Graphical Tools
The utility function relates total utility to the amount of each good (things that people value) an individual has. This utility function is determined by individual preferences for the goods available and can be pictured graphically with an indifference curve. For instance, if an individual gets satisfaction/happiness from two goods, food and clothing, the indifference curve shows the combinations of food and clothing that yield the same amount of utility. Since a decrease in the amount of one good reduces satisfaction, an individual must have more of the other good in order to remain indifferent. The negative slope of the indifference curve represents the amount of one good the individual would be willing to give up for a small increase in the other, holding utility constant. The convexity of indifference curves implies that the amount of one good an individual is willing to give up for one more unit of another good decreases as less of the first good and more of the second is obtained along the indifference curve. Every point in a diagram lies on some indifference curve in a set of indifference curves representing a consumer's preferences. Combinations on indifference curves farther to the northeast in a diagram yield greater utility to the consumer.

Obviously, the consumer would prefer combinations of goods on indifference curves farthest to the northeast to those that are closer. However, a consumer's budget limits the choice to only those combinations that are affordable.

An individual's optimal choice of goods can be found by locating the point in the budget constraint which allows him or her to be on the indifference curve farthest to the northeast. When income or prices change, ceteris paribus, we can describe how consumers respond by changing the amount of each good purchased.

Motivating Honesty at Sears
This section focuses on an example of how the economic framework can be used to analyze and address management issues. Employees, like consumers, care about their own happiness. Their happiness depends on a variety of factors (goods), such as income, decision-making authority, self-esteem, and integrity. Most employees get at least some satisfaction from having more of each. The utility an employee derives from various combinations of these things may be represented by indifference curves. For instance, an employee may be willing to tradeoff integrity for increases in monetary income. Their choices are constrained by the composition of compensation and other contracts. Higher monetary income comes at the expense of integrity when commissions are based on total sales. Rational employees will choose individually optimal combinations of money and integrity. For many, the optimal combination has less than complete integrity. Depending on preferences, some employees are willing to trade integrity for money in order to increase personal satisfaction (move to a higher indifference curve). Managers applying the economic model should respond to this problem by changing the compensation scheme (constraint) to shift the optimal combination in favor of integrity and away from money.

Alternative Models of Behavior
Models are used for managerial decision making.

Model
Basic Assumption
Management Recommendations
Economic
employees pursue self-interest
change costs and benefits of actions
Only-Money-Matters
level of monetary compensation is the only important job component
increase the level of pay
Happy-is-Productive
happy employees are more productive
improve employee satisfaction with job
Good-Citizen
employees want to do a good job and excel, and have pride in their work
communicate goals and objectives and help employees discover how to achieve them; provide feedback
Product-of-the-Environment
behavior is predetermined by
upbringing
fire employees with negative traits and hire those with good ones

Decision Making Under Uncertainty
The concepts introduced in this may be adapted to help understand behavior when decision makers face uncertain outcomes from their choices.

The expected value of an uncertain payoff: calculating the weighted average of all possible
outcomes, where the weights are the probability each outcome will occur.

Variance the expected value of the squared difference between each possible payoff and the expected value.

Standard deviation the square root of the variance.

A risk averse person prefers higher expected value, but lower standard deviation. If the expected payoff with uncertainty were the same as a certain payoff, the risk averse person would prefer the certain outcome unless a risk premium is offered.

3: Markets, Organizations, and the Role of Knowledge

Individual decisions are organized in societal or organizational economic systems. Assuming the underlying goal is efficiency, this introduces the importance of property rights, specialization, and the role of knowledge in determining the relative advantages of the decentralized market systems over centralized economic planning. In the process, important managerial concepts are introduced. These include demand/supply and transaction costs.

Goals of an Economic System
Economic entities (national economies, firms, or households) must somehow choose what to produce, how to produce it, and how to allocate the final output. Central economic planning and free markets are alternative ways of organizing to respond to these questions. But which way is the best? If the only criterion is Pareto-efficiency, then free markets perform best in larger economies (for reasons described below).

Pareto efficient: A distribution of resources is said to be Pareto efficient if there does not exist an alternative distribution that makes one better off without making another worse off.


Property Rights and Exchange in a Market Economy

A property right: socially enforced right to select the uses of an economic good or resource.

In free markets, property rights are private (assigned to a specific person) and alienable (can be transferred to others). The right to use a resource is often separated from the right to sell (alienability) a resource or good. An owner may be permitted to do one, but not the other.

Trade takes place because gains from trade make both parties better off. These gains from trade come from differences in preferences and specialization according to comparative advantage. Trade not only allows individuals to take advantage of existing gains, but also provides incentives to create value by moving resources to more productive uses.

Basics of Supply and Demand

In competitive markets,
demand curve shows the quantity of a good that consumers are willing to buy at each price
supply curve shows the quantities that sellers are willing to sell at each price.

With price measured on the vertical axis and quantity measured on the horizontal axis, the demand curve slopes downward as consumers typically buy more when the price falls and less when the price rises. Alternatively, the supply curve slopes upward as sellers are willing to sell less when price falls and more when price rises.

At the market clearing (equilibrium) price, the quantity demanded equals the quantity supplied. Price always tends toward the equilibrium level.

Surplus: If the current price is higher than the market clearing price, the resulting surplus (excess supply) puts downward pressure on the price.
Shortage: If price currently below the equilibrium price, price would tend to rise due to shortages (excess demand).

Demand and supply tend to shift over time. This causes the equilibrium price and the quantity to change. The figure below summarizes the effects of changes in demand and supply.


Prices as Social Coordinators
Price adjustments provide signals to producers and consumers about the relative scarcity and value of the goods. For instance, a decrease in price due to a surplus will signal producers to apply resources to more valuable alternative uses and consumers to increase consumption. In the end, quantity demanded will equal quantity supplied.

When acting and reacting according to their individual self-interest, consumers and producers exhaust all mutually beneficial trades. It is no longer possible to change the final distribution to make one better off without making another worse off. In order to increase their own gains from trade, firms produce the right mix of goods in the most efficient way possible.

Externalities and the Coase Theorem.
An externality exists when one individual's choices affect the benefit or cost to another outside of the exchange relationship.

Prior to the Coase Theorem, many believed that externalities could prevent a free market from allocating resources efficiently. Government intervention was necessary to reduce production when there are external costs and increase production when there are external benefits.

The Coase Theorem proved that, under certain conditions, government intervention is not necessary (and may even be harmful) to preserve efficiency.
The Theorem states that, as long as property rights are clearly assigned and exchangeable and transaction costs are sufficiently low, the most efficient resource allocation will result, regardless of how the initial property rights are assigned. Property rights will be traded to the individual who places the highest value in its use.


Markets versus Central Planning
In large economies, markets have been more successful than central planning because:
(1) the price system causes knowledge and information to be used more efficiently
(2) it provides stronger incentives for individuals to make productive decisions.

General versus Specific Knowledge.
General knowledge is defined as essentially free to transfer.
Specific knowledge is defined as expensive to transfer. The cost of transfer is determined by the level of similarities between the communicators, technology for communication, and the type of knowledge being communicated.

Knowledge which is unique to particular circumstances (idiosyncratic), scientific in nature, or assembled from previous experience is generally more expensive to transfer, other things being equal.


Better economic decisions are made when decision makers possess the relevant knowledge.

Friedrich Hayek, assuming that specific knowledge is dispersed between individuals in any society, argues that centrally planned economies must either bear the high cost of knowledge transfer or ignore it.

In market economies, decisions are decentralized to those who have the relevant specific knowledge. Markets coordinate these decisions, while prices economize on the costs of information transfer.

The incentives for decentralized decision makers to use specific knowledge effectively are provided by private property rights. Owners of resources bear the wealth effects of their own decisions.

Contracting Costs and the Existence of Firms
If markets are the best way to organize economic activity, why do we have firms characterized by administrative decision making? According to Ronald Coase, firms exist to economize of the costs of transactions. These costs are associated with search and information transfer, bargaining and decisions, and policing and enforcing decisions. Firms may be able to reduce the number of required transactions and allow efficient informational specialization. Finally, firms may reduce risk from asset specificity and provide a vehicle for carrying reputation.

If firms can reduce the costs of transactions, then why do we not have just one firm (complete centralization)? The reason is that as firms become larger, it becomes more difficult for managers to make efficient and timely decisions. This translates into increasing internal transaction costs of resource allocation.

Individuals have incentives to introduce and implement cost-reducing methods of organization because there are more gains to be shared. Not only will economic activity be internalized in the firm to lower transaction costs, but also firms will be designed to maximize efficiency. Later in the text, it is discovered that when managers are not the major owners of firms, these incentives may be weakened. In the next few s, however, efficiency is assumed while examining optimal input, output, and pricing decisions in more detail.

4: Demand

Understanding demand is very important for managers, especially those responsible for making price recommendations or decisions.

Demand function: mathematical representation of the relations between the quantity demanded of a product and all factors that influence this demand, such as: the price of the product; prices of related products; incomes of individuals; advertising expenditures; tastes and preferences; and consumer expectations.

Product demand curve: shows how many units will be purchased at each possible price, over some particular length of time, holding all other factors fixed.

The Law of Demand: states that as the price falls the quantity demanded rises and as the price rises the quantity demanded falls.

Changes in quantity purchased due to changes in price are referred to as changes in the quantity demanded. The slope of the demand curve shows whether consumers will buy more or less, but does not provide a good measure of the sensitively of quantity demanded to price.

Price-elasticity of demand (h):
provide a good measure of the sensitively of quantity demanded to price, defined as:
%DQ
%DP

The price-elasticity of demand may be approximated between any two points on a demand curve using the arc elasticity formula shown in the textbook. The resulting number is used to measure of the responsiveness (sensitivity) of quantity demanded to price. The higher the number the more sensitive consumers are to changes in the price. The following table summarizes some useful definitions, the determinants of price-elasticity of demand, and the importance of price-elasticity in determining how price affects total revenue.

If
Demand is:
Determinants of price-elasticity
If price
increases
If price decreases
h < -1
elastic
Demand tends to more elastic when there are more good substitutes, represent more important purchases in the typical budget, and in the long run.
total revenue
decreases
total revenue increases
h = -1
unitary elastic

total revenue
remains the same
total revenue
remains the same
0 < h < -1
inelastic
Demand tends to less elastic when there are fewer good substitutes, it consumes a relatively small proportion of a typical budget, and in the short run.
total revenue increases
total revenue decreases


Marginal revenue is the additional revenue from a unitary change in quantity.

· elastic above the midpoint of demand curve
This implies that at prices above the midpoint, total revenue will increase when price decreases (marginal revenue) to sell one more unit.

· unitary elastic at the midpoint of demand curve
At the midpoint, total revenue will remain the same when price changes.

· inelastic below the midpoint of demand curve
At prices below the midpoint, total revenue increases when price increases to reduce purchases by one unit. Thus, total revenue in maximized when the price is at the midpoint of the linear demand curve.

Other Factors that Influence Demand
The demand for a product is affected by the prices of related goods, either substitutes or complements. The effect of income on demand depends on whether the good is normal or inferior. The following table summarizes these effects.


substitute
complement
normal good
inferior good
Demand increases if
the price of a substitute increases
the price of a complement decreases
if income increases
if income decreases
demand decreases if
the price of a substitute decreases
the price of a complement increases
if income decreases
if income increases
measure of sensitivity
cross elasticity is positive
cross elasticity is negative
income elasticity is positive
income elasticity is negative

Industry versus Firm Demand
Information about industry demand is useful because it may help managers understand the size of potential markets and trends. This information usually can be obtained inexpensively from outside analysts and business publications. Industry demand is likely to be less elastic that any individual firm's demand because there are fewer substitutes available.

The cross elasticity of demand may help managers define the relevant product and geographic market area. Relatively high cross elasticities mean the products are pretty good substitutes and should be considered part of the same market.

Network Effects
For some products, demand increases with the number of users. These products tend to have relatively elastic demands. If price decreases, consumers buy more because of the lower price and because the network of users expands. In designing these types of products, companies must make important decisions regarding compatibility with older versions of the same product and with competing products produced by other companies.

Product Attributes
In addition to the price, other product attributes (such as product design, packaging, promotion and advertising, and distribution channels) also affect demand. We took these attributes as given in our initial analysis of demand. Marketing managers are responsible for understanding how these attributes are important to customers. This is important because the firm has the power to affect demand by adjusting these attributes. Later in the text, it shown that organizational design should be appropriate to incorporate knowledge about consumer demand in decision making.

Product Life Cycles
The product-life-cycle hypothesis describes the demand for a product as it goes through four main phases.
introduction stage
growth phase, industry-level demand increases rapidly
maturity, demand continues to increase and then begins to decrease.
final phase, decline, demand continues to fall and eventually is withdrawn from the market.

It is important for managers to recognize these phases in planning new product introductions and making entry, exit, and pricing decisions. For instance, substantial entry and intense competition typically occurs during the growth phase. Firms may want to be the first to introduce a new product and may want to develop some competitive advantage over rivals in the industry.

Demand Estimation
Managers often must estimate their demand functions. The three major techniques used to do this are: the interview, price experimentation, and statistical approaches. The table below summarizes the basic ideas, advantages and limitations of each approach.
Approaches to Estimating Demand

Approach
Basic Idea
Advantages
Limitations
Interview
Attempts to estimate demand through customer surveys, interviews, simulations, questionnaires, and focus groups.
Can be easy to perform and quick; Can play important role in discovering what attributes are valued by customers.
People have incentive to lie in order to get lower prices; People can have difficulty forecasting what they would actually purchase in the market; Can be inaccurate if sample is not chosen appropriately

Price experimentation
Attempts to estimate demand by changing prices in one market and recording changes.
The observed reactions are actual purchasing decisions
Demand can differ depending on whether customers view price change as temporary or permanent; Tests are not controlled;
Statistical
Attempts to estimate demand by using standard statistical techniques such as regression analysis.
Increasingly viable and inexpensive with computers and large databases; Can control the effects of other factors; Can get fairly reliable results with large samples.
Important variables may be omitted leading to incorrect conclusions and bad decisions; If important variables are highly correlated it may be impossible to separate their effects; If demand is not stable may have difficulty "identifying" the demand curve.



5: Production and Cost

An understanding of production technology and its relation to costs is important to managers for a variety of reasons. It helps them choose the optimal mix of inputs and respond to changes in the economic environment.

Production Functions
production function specifies the maximum feasible output that can be produced using any combination of input.

Returns to scale refers to the relationship between changes in output from proportional changes in all inputs. The following table describes increasing, constant, and decreasing returns to scale.

Returns to Scale
Definition
Example
Notes
increasing returns to scale (IRS)
output expands more than proportionately with changes in all input quantities
output increases by 110 percent when inputs increase by 100 percent
Firms typically experience this initially as they increase production.
constant returns to scale (CRS)
output expands proportionately with changes in all input quantities
output increases by 100 percent when inputs increase by 100 percent
Firms typically experience this over a broad range of output after IRS are exhausted.
decreasing returns to scale (DRS)
output expands less than proportionately with changes in all input quantities
output increases by 90 percent when inputs increase by 100 percent
The evidence regarding DRS is mixed. Firms may or may not experience DRS after CRS.


Returns to a Factor When all other inputs are held fixed, the relationship between the quantity of an input and output may be examined.

Total product the output from each quantity of the input.

Marginal product the change in total product from a one-unit change in the input.

Average product the total product divided by the quantity of the input employed.

Law of diminishing returns While marginal product initially may increase as more input is employed, it must eventually decline.

Average product must rise if marginal product is greater than average product. Average product must fall if marginal product is less than average product. Of course, average product remains the same if marginal product equals average product.

Choice of Inputs
isoquant shows all the combinations of inputs that produce the same quantity of output, given the production function. Isoquants slope downward in a diagram with the quantity of inputs measured on the axes. It is often assumed that isoquants are convex with respect to the origin. This implies that the substitutability of one input for another declines as less of the first input is used.

Isocost Lines Given the prices of inputs, we can describe the combinations of inputs that cost the same amount with an isocost line. The ratio of input prices (negative one times the ratio of input prices) describes the amount of one input that must be given up to purchase one more unit the other input. By holding the prices constant and varying the cost we can derive a family of parallel isocost lines. Holding cost constant, varying the price of one input causes the isocost line to become steeper or flatter.

Cost Minimization.
Given any quantity of output and its corresponding isoquant, the cost-minimizing combination of inputs can be found by locating the isocost line closest to the origin and touching the isoquant at exactly one point. This point shows the cost minimizing quantity of inputs.

Changes in Input Prices.
The optimal combination of inputs changes when the prices of inputs or production technology changes. When the price of one input increases, the firm adjusts by using less of that input and more of the others to produce the same quantity of output. This is known as the substitution effect. The corresponding minimum cost of producing a given quantity of output will increase when the price of the input increases. If production technology improves, the isoquant for any quantity of output will shift in, allowing the firm to move to a lower cost combination of inputs.

Costs
Cost Curves
The total cost curve shows the minimum cost of producing any quantity of output.

The marginal cost curve shows the change in total cost from a one-unit change in the quantity of output at any level of production.

The average cost curve shows the total cost divided by the quantity of output at any level of production. Average cost is generally assumed to decrease initially as the firm experiences increasing returns to scale or as the prices of inputs decline with volume purchases. Eventually, however, average cost increases due to decreasing returns to scale or the bidding-up of input prices as demand for the inputs rises. Thus, average cost curves are assumed to be U-shaped.

It is important to remember that the only relevant costs for decision making are opportunity costs, the value of resources in their next best alternative use. Opportunity cost is reflected most accurately by the current market prices for inputs and not historical costs.

Short Run versus Long Run
The short run defined as an operating period during which at least one input (typically capital) is fixed in quantity. Short-run cost curves are sometimes called operating curves.
The long run defined as a period such that all inputs can be varied. Long-run cost curves are sometimes called planning curves.

These definitions are not based on calendar time, but rather represent two models that differ in terms of the flexibility a firm has in adjusting the quantity of inputs employed.

In the short run, fixed costs do not change with output. Variable costs are those costs that change with the level of output. Short-run cost curves may be depicted on a diagram measuring the quantity of output on the horizontal axis and the cost per unit of output on the vertical axis.

The law of diminishing returns implies that marginal cost must eventually slope upward. This means that average cost initially declines with increases in output, but also must eventually increase as marginal cost rises above it. This relationship also holds for average variable cost (total variable cost divided by output).

Average variable cost lies below the average cost curve. The vertical distance between average cost and average variable cost is average fixed cost (total fixed costs divided by output) for any quantity of output. This distance decreases as output increases because total fixed costs do not change.

The long-run average cost curve may be derived from a careful examination of several short-run cost curves, each representing a different quantity of capital (plant sizes, for instance).
The long-run average cost curve can be found by tracing out the lower envelope of the short-run cost curves. As the number of plant sizes increases, the curve smoothes out.

Minimum Efficient Scale.
The average cost curve has a U-shape, reflecting increasing then decreasing returns to scale. The minimum efficient scale is defined as the plant size (quantity of capital) at which the long-run average cost first reaches its minimum point. Up to the minimum efficient scale, per-unit costs decrease and the firm is experiencing economies of scale.

Learning curve shows the relationship between average cost and the cumulative volume of production. With experience in production (especially at early stages of production), a firm's average cost generally shifts down. Learning curve effects decrease, however, as the firms continues to produce the product.

Economies of scope exist when the cost of producing two or more products jointly is less that the cost of producing the products separately. The sources of these economies include the common use of production facilities, marketing programs, management systems, and unavoidable byproducts in production.

Profit Maximization
Total revenue is the price of the product multiplied by the quantity produced (and sold).

Marginal revenue the change in total revenue from a one-unit change in output. Marginal revenue may stay constant or decrease with output (discussed in next ).

Profit is maximized at the output that causes marginal revenue to equal marginal cost.
If marginal revenue exceeds marginal cost, then profit would increase if the firm increases production. If marginal revenue were less than marginal cost, then profit would increase by producing less output.

Factor Demand Curves
When a firm employs the optimal input mix, it can be shown that the marginal revenue product (MRP- the incremental revenue generated from employing one more unit of the input) just equals the price of each input. If the MRP of an input exceeds its price, increasing the use of the input would increase profit. If the MRP of an input is less than its price, decreasing the use of the input will increase profit.

Cost Estimation
Managers should know their costs in order to make important production decisions and to have a better understanding of their production technology.
Regression analysis is the most commonly used technique for estimating costs. However, problems similar to those discussed in the demand estimation section and other unique problems (such as joint production) indicate that caution should be applied in using this technique.


6: Market Structure

Firms operate in a variety of market environments. The market environment affects managerial decisions about prices, output, entry, advertising, product packaging, cooperation, and a variety of other strategic variables. This provides a description how decisions may vary according the level of competition, degree of product differentiation, ease of entry and exits, and the availability of information.

Markets

A market consists of all firms and individuals that are willing and able to buy or sell a particular product. Market structure refers to the: (1) number of buyers, sellers, and potential entrants; (2) degree of product differentiation; (3) amount and cost of information about product price and quality; and (4) conditions for entry and exit.

Competitive Markets

Competitive markets are characterized by a large number of buyers and sellers, product homogeneity, the rapid dissemination of accurate information at low cost, and free entry and exit. These characteristics cause individual buyers and sellers to be price takers. This implies that the firms faces a horizontal demand curve and product price equals marginal revenue and average revenue.

Firm Supply. To maximize profit in the short run, the firm should produce the output which makes marginal revenue (price) equal short-run marginal cost, as long as price is above the minimum average variable cost. When price is above average variable cost, then revenue is sufficient to cover the variable costs of production and there is some left over to pay at least part of the fixed costs. If the fixed costs can be covered completely, the residual revenue is profit. If price is less than the minimum average variable cost, the firm should shut down and produce zero output because the firm cannot pay for the variable costs of production. In the long run, as long as price is not less than long-run average cost, the firm should produce the output that makes marginal revenue equal long-run marginal cost.

Competitive Equilibrium Market price is determined by the intersection of industry demand (which shows the total quantity demanded by all buyers) and industry supply (sum of all individual supply decisions). In equilibrium, market price will equal long-run marginal cost and long-run average cost. Each firm will earn zero economic profit (just normal profit). If not initially in equilibrium, a price adjustment occurs as firms enter in pursuit of above-normal profit or firms exit in response to less-than-normal profit. Managers in competitive markets must move quickly to take advantage of transitory opportunities and strive for efficiency to help their firms remain competitive.

Barriers to Entry

Barriers to entry must exist in industries where firms have market power. Entry decisions depend on likely incumbent reactions, incumbent advantages, and the costs of exit. Under incumbent reactions, entry is less likely to be successful if existing firms have invested heavily in specific assets, experience significant economies of scale, have reputations for fighting entry with price cuts or have excess capacity. Under incumbent advantages, entry tends to be more difficult when existing firms have advantages derived from long-term (pre-commitment) contracts with suppliers, licenses or patents, learning curve effects, or significant brand recognition (pioneering brand advantages). Firms also may be less likely to enter industries when exit is costly or difficult.

Monopoly

In monopoly there is one firm in the industry and one or more barriers limit entry. Industry and firm demand are the same under these conditions.

Profit Maximization. If the firm charges the same price to all customers, profit is maximized with the choice of price and quantity such that marginal revenue equals marginal cost. Since marginal revenue is less than the price, customers pay a price greater than marginal cost (and average cost) and output is lower than the competitive level. The firm under these conditions earns positive economic profit.

Profit-maximizing monopolists choose higher prices and lower production levels compared with competitive markets. There are customers who do not purchase the product, but are willing to pay less than the monopoly price and more than the marginal cost to the monopolist. The mutual gains from these transactions are not realized when the firm charges the same price to all customers.

Monopolistic Competition

There are many firms in the industry, but product differentiation gives each firm some market power. Thus, the demand each firm faces is downward sloping and fairly elastic. However, there are no significant barriers to entry or exit. Profits will tend to zero and entry occurs in response to profits and exit occurs in response to losses. Firms with more distinctive brands or with more efficient production techniques may enjoy some economic profit.

Oligopoly

Oligopoly markets are characterized by few firms producing homogeneous or differentiated products, with barriers to entry. Unlike the other market structures, firm decisions in oligopoly elicit competitor responses which must be anticipated.

Nash Equilibrium A set of choices by each firm in an oligopoly market is a Nash equilibrium if each firm is choosing what is best for itself given the choices by all other firms. The Nash definition may sometimes result in multiple equilibria or an equilibrium that is Pareto inefficient.

Output Competition (Cournot Model). In this model of oligopoly, each firm treats the output level of each of its competitors as fixed and then decides how much to produce. A Nash equilibrium can be found by setting the marginal revenue equal to marginal cost for each firm and substituting to derive the reaction curve. Equilibrium quantity levels can be found by solving for the intersection of the reaction curves. Note that the Cournot-Nash equilibrium has higher prices, higher profits, and lower output than in perfect competition; but has lower prices, lower profits, and higher output than in monopoly. Much empirical evidence is consistent with this model's predictions.

Price Competition (Bertrand Model). If each firm selects price and treats the current price of competitors as fixed, then Nash equilibrium occurs with each firm choosing price equal to marginal cost and industry quantity is the same as in perfect competition. When price equals marginal cost, it is not possible for either firm to increase profit by cutting price and capturing the entire industry sales.

Cooperation and the Prisoner's Dilemma. The Cournot and Bertrand models demonstrate that both firms can be better off by cooperating to reduce industry output or increase price. Alternatively, the firm may merge to earn monopoly profits. Of course, this type of cooperation and merger to create a monopoly is restricted by antitrust laws. The Prisoner's Dilemma illustrates, however, that cooperative arrangements may be difficult to achieve and maintain even without restrictive laws. Unfortunately for the firms, after agreeing to cooperate by reducing output or raising price (cartel), each firm can increase its profit by increasing output or lowering price (cheating). Producing more or charging less is also better for each firm if the others cheat. Thus, producing more or charging less is a dominant strategy in these oligopoly models. The end result is lower profits for all firms. This result may be different if interaction between the firms takes place on a repeated basis. Repetition allows firms to recognize and punish cheaters. Firms may also facilitate cooperation by using most-favored-nation or meet-the-competition clauses in contracts with buyers.

7: Pricing with Market Power

Pricing Objective

A firm has market power if it faces a downward-sloping demand curve. This means that it can increase price without losing all of its customers to competitors. The objective is to choose a pricing policy that maximizes the fin-n's value. Standard economic analysis assumes managers seek to maximize profits over a single period.

The potential gains from trade are represented by the difference between what consumers are willing to pay and the marginal cost of production. This represented by the area under the demand curve and above the marginal cost curve. Consumer surplus is defined as the difference between what consumers are willing to pay for a product and what they actually pay. If the firm were to sell the product at marginal cost, consumers would receive all the potential gains from trade in the form of consumer surplus. The firm earns zero profit in this case. Profit maximizing managers try to devise pricing strategies to capture as much of the potential consumer surplus for the firm as possible.

Benchmark Case: Single Price per Unit

This analysis assumes that all consumers are charged the same price, the firm sells only one product, the demand curve is for a single period, and the prices of competing products are constant. As learned in the previous , profits are maximized when the price and output combination in which marginal revenue equals marginal cost is selected. It is important to note that sunk costs are not relevant for decision making. Only incremental costs matter. Also note that opportunity costs, not accounting costs, are relevant for managerial decision making.

The monopolist's optimal pricing policy of setting marginal revenue to marginal cost can be written as follows:

P=MC/(1+1/h)
where P is the profit-maximizing price, MC is the marginal and h is the price-elasticity of demand, both evaluated at the optimal output level. Note that no firm should operate on the inelastic portion of its demand curve. If it did so, then it would be possible to increase profits by increasing price and reducing output. Revenue would increase and costs would decrease.

It is easy to demonstrate using the above equation that firms with substantial market power face less elastic demand and, thus, have higher markups over marginal cost. Firms with limited market power face more elastic demands and have lower markups.

Estimating the Proflt-Maximizing Price

Practical problems (e.g. do not have precise information about the demand curve) often prevent managers from using the marginal cost and marginal rule in real-world decision making. Alternative methods may assist managers to select prices. In the linear approximation method, the manager combines an estimate of the quantity sold when price changes with current information about price, quantity sold and the marginal cost of production. Based on the assumption that demand is linear, it is easy to derive the demand equation. The accuracy of this demand equation will depend on the accuracy of cost and sensitivity estimates, and on whether the true demand curve is close to being linear. Managers that use cost-plus pricing calculate average total cost, then markup the price to yield a target rate of return. A major problem with this method is that it ignores incremental costs and demand sensitivities. Managerial experience and implicit consideration of market demand in choosing target return and sales volume may mitigate this problem. Markup pricing consists of substituting an estimate of the current price elasticity and marginal cost into P=MC/(1+1/h) and solving for the optimal price. This procedure will yield a good estimate of the optimal price only when the estimated elasticity is close to the elasticity at the optimal price and quantity.

Potential for Higher Profits. When a firm charges a single price, it captures some, but not all of the potential gains from trade. Some customers value the product above marginal cost but do not purchase the product at the optimal price. The remainder of the considers ways to capture more of the gains in the form of profits.

Homogeneous Consumer Demands

This section considers situations when individual customers have similar demand for a product.

Block Pricing. Conceptually, the firm could capture all of the potential gains from trade by charging the maximum value that each consumer places on each unit. With declined demands, this would mean lowering prices to sell each additional unit. Practical considerations preclude such a pricing policy. As an alternative, block pricing means charging a higher price for an initial purchase block (up to a certain amount), with lower prices for purchases of subsequent blocks. Product packaging strategies often assist the firm to implement such strategies by forcing customers to purchase products in blocks.

Two-Part Tariffs. With a two-part tariff, a customer pays an up-front fee for the right to purchase each unit of product. If consumers have similar demands, setting the fee equal to individual consumer surplus and price equal to marginal cost allows the firm to extract the entire consumer surplus. When customer demands vary widely, setting the fee too high may result in reduced sales to those with low demands. In these cases, it often is best to charge a low entry fee, then charge a price higher than marginal cost.

Price Discrimination - Heterogeneous Consumer Demands

Price Discrimination. Price discrimination occurs when a firm charges differential prices across customers that are not related to differences in production and distribution costs. Successful price discrimination requires the firm to identify distinct submarkets with different price-elasticities of demand and restrict resale across the submarkets. When customers have different price-elasticities, it is generally more profitable to charge higher prices to those customers who are less sensitive to price.

Exploiting Information about Individual Demands. In personalized pricing (first-degree price discrimination), the firm charges the maximum each customer is willing to pay for each unit of the product. Thus, the firm extracts the entire gains from trade. Note that the outcome is efficient, as all gains from trade are exhausted. Although rare, new technologies are making it easier for companies to customize quoted prices.

Group pricing (third-degree price discrimination) results when the firm uses a variety of characteristics (e.g. age, time of purchase and income) to separate its customers into several groups and sets different prices for each group. The optimal price/quantity makes marginal revenue in each market equal to marginal cost. Markets with less elastic demands have higher prices.

Using Information About the Distribution of Demands. Even if managers do not have enough information to divide customers into meaningful groups, they might have enough information about the range or distribution of individual demands to engage in profitable price discrimination. With menu pricing (second degree price discrimination), all potential customers are offered the same menu of purchase options. Customers select the menu option that is best for them. By carefully constructing the menu of options, the company can earn higher profits than under the single price case. A related strategy is to offer potential customers a menu of price-quality combinations. Some firms use coupons and rebates to make price discounts available to those with more elastic demands (those who have lower opportunity costs of time). This form of price discrimination may be expensive, but has the benefit of possibly increasing future profits from new customers who start using the product during the promotion.

Bundling

When customers have opposite relative valuations of two products, firms may increase profits by bundling the products for sale. If one group values both products higher than the other group, there would be no gains from bundling. Optional bundling can be more profitable than pure bundling when some customers value one product highly, but value the other product below the marginal cost of the production.

Other Concerns

Managers are concerned not only with sales in the current period but in future periods as well. For example, sometimes firms offer their products at prices below marginal cost with the expectation that they will learn how to use the product. The idea is that they may be less inclined to switch to competing products, which require time to learn. This sometimes is referred to as the "lock-in" effect. Firms also may charge prices lower than optimal single-period prices if they are concerned about maintaining customer goodwill or the reactions of "public-interest" groups and government regulators. In some cases,
it may make sense for a firm to charge low prices and produce a high volume to take advantage of leaming effects that result in lower costs. If the product is storable, temporary price reductions may, in addition to the normal downward-sloping demand effect, cause the quantity demanded to rise because customers purchase additional units to be consumed at later dates. This implies that, for storable goods, the variation over time in sales is greater than the variation in consumption.

Strategic Interaction. The analysis in this starts with a demand curve for the product and holds the price of substitute products constant. In many markets, however, managers must anticipate the reactions of rivals when making price decisions. Game theory, which will be introduced in an upcoming , can be helpful to managers making decisions in such interactive settings.

Legal Issues. Laws restrict the ability of firms to charge different prices to different customers. For example, the Robinson-Patman Act limits the ability of firms in the United States to charge different prices to customers in wholesale markets. Laws also can limit price levels and constrain pricing policies to in a variety of other ways.

Implementing a Pricing Strategy

Actual pricing decisions are more complicated than indicated in this . While each pricing policy was analyzed in isolation, they often are used in combination. Although the policies focused on individual products, most firms sell a variety of products whose demands and costs interact to affect the optimal pricing strategy. Finally, optimal pricing policies may change over time and legal and strategic issues must be considered in pricing decisions.

8: Economics of Strategy

Creating and Capturing Value

This looks at the ways companies can create and capture value by examining the economics of strategy.

Strategy

Strategy refers to the general policies that managers adopt to generate profits. Strategies evolve over time. Along with organizational architecture, strategy is a key determinant of success or failure. To realize sustained profits, the ultimate objective of strategic decision making, managers must devise ways of creating and capturing value.

Value Creation

Consumer-bome and producer-bome transaction costs play a large role in the perceived value of a product. Lower consumer transaction costs would increase the amount that consumers would be willing to spend on a good. The total value that is created by the industry is the sum of producer and consumer surplus. An important first step in making profits is to create value. There are four general ways that managers can increase value: lower production costs or producer transaction costs; implement policies that reduce consumer transaction costs; take actions other than reducing consumer transaction costs to increase demand; and devise new products or services.

New technology can reduce production costs and increase value. Managers also can devise ways to increase value by reducing supplier transaction costs. Reducing consumer transaction costs also can increase value. This might, for example, be accomplished by reducing the amount of time it takes to purchase products. Companies increasingly are using the Internet to reduce consumer transaction costs. By using information about consumer behavior and markets, companies can locate and offer the most valuable products for individual customers. Managers can increase the effective demand and, thus total value, by increasing the perceived quality of the product, reducing the prices of complementary products and, if possible, increasing price (or reducing the availability) of substitutes. Creating a new product or service also can increase value.

ing. Companies that produce complementary products can cooperate to increase value. There also are opportunities for cooperation between a firm and its customers, suppliers, or even competitors. Competitors can cooperate in development projects to reduce joint costs. Although antitrust laws limit cooperation between competitors, there still are many forms of cooperation that are legal and beneficial to producers and consumers.

Capturing Value

Creating value is the first step in generating profits, but managers must create ways to capture value to sustain profits for the firm.

Market Power. Without entry barriers, competition from new firms tends to erode profits. Entry barriers exist when it is difficult or uneconomic for potential entrants to replicate the position of exiting firms (incumbents). Examples of entry barriers were presented in a previous . The results of empirical research are consistent with the theory that profit tends to be higher in industries with entry barriers, such as economies of scale or advertising.

In addition to entry barriers, there are at least four factors that are important to sustaining profits. Fewer competitors (greater concentration) make it more likely that firms will recognize the mutual dependence and refrain from intense competition. In some industries, a large dominant firm may take the lead in setting prices and sanction others that do not follow. High fixed costs, lack of product differentiation and slow growth each tend to increase rivalry in industries. The threat of new substitutes also can limit market power. A few powerful customers and large, concentrated or organized key suppliers also can limit market power. To summarize, firms sometimes can increase economic profit by erecting or promoting entry barriers, reducing intraindustry rivalry, limiting the availability of substitutes or reducing buyer/seller power. Managers have found that creating entry barriers and otherwise limiting competition is increasingly difficult and that regulators extract much of the gains in exchange for encouraging the adoption and enforcement of entry restrictions. Thus, much of the contemporary focus in strategy is on building superior resources.

Superior Factors of Production. Human and physical assets vary in productivity. Competition in wellfunctioning markets for resources that increase profit by offering superior productivity will result in the entire gain accruing to the responsible asset. The wealth of the owners of scare resources increases as the price of the asset is bid up. It may make sense for the firm to sell the asset to another firm if, for example, the benefit of using the asset internally is less than the revenue foregone from not selling it. Managers should make business decisions based on opportunity costs, not accounting costs.

In competitive auctions, the bidder that values the asset more can obtain it by bidding only slightly more than the person with the second highest value for the asset. This implies that the producer surplus is limited to the difference between the value in the asset's first-highest use and second highest use. The rest of the value will be reflected in the price of the superior asset.

The value of a firm's inputs as a team sometimes can be greater than the simple sum of the values if each worker and asset were employed in its next best use across other firms. A firm with team production capabilities can capture value only if competing firms cannot assemble comparably productive teams. Unique team production capabilities are created by the cumulative choices that a firm makes about products, markets to enter, executive hires and capital acquisitions. Difficulties in pinpointing the exact source of synergies make it difficult or expensive to duplicate a firm's team production capabilities. It is also often necessary to change multiple systems in the organizational architecture to duplicate team production capabilities.

The business environment constantly changes making it unlikely that any competitive advantage will last forever. That is, unless the firm can produce new value-increasing strategies in succession.

Economics of Diversification

Benefits of Diversification. Economies of scope are the primary reason why that diversification might enhance value. Economies of scope exist when a firm can produce multiple products at lower cost than separate firms could produce the products. These economies may occur anywhere along the vertical chain of production and have multiple sources, such as volume purchasing discounts, lower transportation costs, joint production and expanding productivity of sales staff. Activities also may be combined through cooperative arrangements rather than combining them within a single firm. Diversification may support efforts to promote complementary products.

Costs of Diversification. As a firm grows, managers often are faced with challenges associated with entrenched bureaucracies, management expense, unaligned incentive compensation and development of common personnel, communication, information and operating systems.

The reduction of earnings volatility is often offered as justification for diversification. This justification is faulty because shareholders can diversify their own portfolios with little cost.

Related diversification occurs when the businesses serve common markets or use related technologies. Net benefits are likely to be greater in related rather than unrelated diversification because economies of scope are more likely to develop and complementarities are more likely to exist. Value is increased from diversification only if the benefits exceed the costs. Empirical evidence suggests that diversified firms have not performed well. Even if diversification does create value, the owners of diversified firms may not be in a position to capture the value.

Strategy Formulation

An understanding of the firm's internal resources and the external business environment is crucial to the development and implementation of strategies that increase value. An important first step is to understand the firm's physical, human and organizational capital. Analysis should include both tangible and intangible assets and be evaluated based on opportunity cost. To be effective and identify opportunities for value creation, managers also must continuously monitor the business environment of the firm, including the input and output markets in which it operates, technology, and government
regulation. Strategic choices require managers to combine environmental and internal analyses. In making strategic choices it is important for managers to anticipate how others will react to their choices and to be forward-looking.

Both strategy and organizational architecture are determinants of firm value. Organizational design often is based on the firm's strategy.

Economic theory suggests that superior strategic choices will not lead to sustainable profits. When other managers can adopt the same strategies, competition will result in only normal rates of return. Without special resources or capabilities, firms will not likely earn above a normal return. Indeed, if not quick to adapt to the changing environment, a firm may find itself out of business.

10: Incentive Conflicts and Contracts

Up to now, "firms" made decisions, not people. In reality complex interactions between individuals, each with different goals and objectives and facing different constraints, occur within a firm's boundaries. Studying the firm with this in mind reveals interesting incentive conflicts, informational problems, and management issues. Contracts become an important, but somewhat imperfect, control mechanism. In order to make good decisions, managers should understand the complex environment which surrounds them.

Firms

Unlike the characterization in previous s, the decision-making process is complicated by the (1) large number of decision makers, (2) conflicting objectives of decision makers, and (3) use of internal price systems to allocate internal resources. To examine organizational issues within the firm, it is useful to define the firm as a focal point for a set of contracts.

Incentive Conflicts within Firms

Owner/Manager Conflicts. Owners are likely to be interested in firm decisions being made to maximize profits and firm value, but delegate decision authority to professional managers. Conflicts may arise as managers make choices to maximize their own utility. They may put forth less effort, take extra perquisites, act more risk averse, choose short-term goals over long-term interests, and be more reluctant to reduce the size of the firm. All at the expense of firm value. Other conflicts may arise between buyers and sellers in the choice of quality and price. Similarly, individuals working together may run into freerider problems in the choice of effort levels.

Controlling Incentive Problems through Contracts

A firm's organizational architecture - decision rights, performance evaluation, and reward systems - is defined by its contracts. Contracts provide important constraints and incentives to reduce incentive problems like those discussed above.

Costless Contracting. Incentive conflicts can sometimes be resolved with little cost by choosing appropriate contracts. For example, when profit depends only on decisions made by managers, then by making compensation depend on profit, owners can align the managers objectives to their own.

Costly Contracting and Asymmetric Information. In reality, contracts are costly to negotiate, write, administer, and enforce. An important factor affecting the ability of contracts to resolve incentive conflicts is costly information. For example, one party in a transaction might have more or better information than the other (asymmetric information).

Postcontractual Information Problems. In an agency relationship, a principal engages an agent to perform a service on the principal's behalf. An agency problem exists when the agent has an incentive to choose actions, after contracting, which increase the agent's utility at the expense of the principal's utility. This is possible when the principal cannot freely observe the actions taken by the agent. The principal may try to resolve the problem by increasing efforts to monitor the agent or by requiring the agent to post a bond. The costs of these activities plus the dollar value of the unresolved reduction in utility (residual loss) is known as total agency costs. It is in the self-interest of both the principal and the agent to resolve agency problems in the least costly manner (Value Maximization Principal). Contracts often can be used to provide monitoring and bonding activities to develop efficient solutions to agency problems.

Precontractual Information Problems. Asymmetric information may cause parties in a transaction to not reach an agreement, even it is mutually advantageous. In these bargaining failure situations, the buyer has an incentive to understate the maximum he is willing to pay and the seller has an incentive to overstate the minimum she will accept, each in order get the best deal possible.

Adverse Selection refers to the incentive for individuals with private information to make offers (to contract) that are detrimental to the trading partner. A market failure may result as individuals respond to these incentives. Individuals without private information may use valuable resources to become better informed prior to contracting, or may offer a clever menu of contracts to motivate others to self-select and reveal their private infon-nation (screening). Alternatively, individuals may choose other actions, which others cannot choose, to credibly reveal their private information (signaling) to those without private information.

Implicit Contracts and Reputational Concerns

Implicit contracts consist of promises and understandings that are not backed up by formal legal documents. They are difficult to enforce in court and depend on the private incentives of individuals to honor the terms of the contract. The market can impose substantial costs on those who do not honor these contracts, especially if information is rapidly and widely distributed to potential trading partners. Reputational concerns are more likely to be effective in ensuring compliance with implicit contracts if the gains from cheating are small, the likelihood of detecting cheating is large, and the relationship is long and repeated.

Incentives to Economize on Contracting Costs

Everyone has an incentive to resolve contracting problems in the least costly manner, thus maximizing the gains from trade to share among participants. Incentives exist to negotiate contracts that provide monitoring and bonding activities to the point where their marginal cost equals the marginal gain from reducing the residual loss. These ideas are reflected in the value maximization principal stated above.