MODULE 1: THE FUNDAMENTALS OF MANAGERIAL ECONOMICS

MANAGERIAL ECONOMICS Manager A person who directs resources and design incentive schemes to achieve a stated goal. (A manager plays many other roles, such as leadership, identifying problems and solving problemsbut these are not the focus of this course.) Economics The science of making decisions in the presence of scarce resources. Managerial Economics The study of how a manager may achieve a stated goal within a given set of resource constraints. IDENTIFYING GOALS AND CONSTRAINTS ound decision making involves having well defined goals! e.g. "hat to ma#imi$e or minimi$e% for instance ma#imi$e profits by minimi$ing operational e#penses, otherwise, ma#imi$e its profits or minimi$e losses. To be specific to increase &'( in the ne#t calendar year To enter in new product market To have international ventures )ther goals relating to market share, revenue growth, profit margin, return on investment.

*ence, there are also +oals )ther than ,rofit which we termed as -on .conomic )b/ectives such as! ,rovide a good place for employees to work ,rovide good products0services to our customers Act as a good citi$en in our society.

1n striving to achieve a goal, we often face Constraints, that such 2onstraints are a result of scarcity. .#ample can be! 3imited hours per day, week and year that an employee can work on any one goal4 2ost of money to devote to marketing, sales and operations.

NATURE OF ROFITS ro!i" is defined as gain. The e#cess of returns over e#penditure, the compensation to entrepreneur resulting from the assumption of risk, the e#cess returns from a business, advantage, benefits. (from "ebster 5ictionary) 1

Economic #s$ Acco%n"ing ro!i"s Accounting ,rofits % % % % % % Total revenue (sales) minus dollar cost of producing goods or services. 6eported on the firm7s income statement. Total revenue minus total opportunity cost The e#plicit costs of the resources needed to produce goods or services. 6eported on the firm7s income statement. The cost of the e#plicit and implicit resources that are foregone when a decision is made.

.conomic ,rofits Accounting 2osts

)pportunity 2ost

ro!i"s as a Signal ,rofits signal to resource holders where resources are most highly valued by society. % 6esources will flow into industries that are most highly valued by society.

UNDERSTANDING INCENTI&ES AND MAR'ET Incen"i#e is any factor that enables or motivates particular course of action, or count as a reason for preferring one choice to the alternatives. 1t is an e#pectation that encourages people to behave in a certain way. Incen"i#es in"o ( )roa* Classes: &. 6emunerative 1ncentives Are said to e#ist where an employee can e#pect some form of material reward.

8. 2oercive 1ncentives Are said to e#ist where a person can e#pect that a failure to act in a particular way will result in physical force being used against them by others in the community. 9. :oral 1ncentives Are said to e#ist where a particular choice is widely regarded as the right thing to do.

eo+le Res+on* "o Incen"i#es: 2

;ecause people make decisions by comparing costs and benefits, their behaviour may change when the costs or benefits change. Incen"i#e ro)lems: 1ncentive structures are notoriously trickier than they might appear to people who set them up. ,eople offering incentives are often unable to predict all of the ways that people will respond to them.

UNDERSTANDING MAR'ETS Mar,e" is a mechanism that allows people to buy and sell financial securities such as stocks, bonds, commodities and other fungible items of value. The aggregate possible buyers and sellers of a certain good or service and transaction between them. :arket is an actual place where buyers and sellers could engage in face to face bargaining. ( SOURCES OF RI&ALRY: &. 2)- <:.6%,6)5<2.6 61=A36> 2onsumers attempt to negotiate or locate low prices while producers attempt to negotiate high prices. "hen limited ?uantities of goods are available, consumers will compete with one another for the right to purchase the available goods. 9. ,6)5<2.6%,6)5<2.6 61=A36> +iven that customers are scarce producers compete with one another for the right to service to customers available. Role o! "-e rice in "-e Mar,e" ,rices represent the terms on which people and firms voluntarily e#change different commodities. ,rices serve as signals to producers that more supply is needed. ,rices are the balance wheel in the market mechanism. 8. 2)- <:.6%2)- <:.6 61=A36> -

Mar,e" Mec-anism :arket is an elaborate mechanism for coordinating people, activities and businesses through a system of prices and market. 1t is a communication device for pooling the knowledge and actions of diverse individuals. 1s a mechanism by which buyers and sellers can determine prices and e#change goods and services. 3

TIME &ALUE OF MONEY 6efers to the fact that the value of a dollar0peso to be received at different future dates will not be the same today. Therefore, it is necessary to develop techni?ues for measuring the value today(i.e. the present value)of dollar0peso to be received or paid at different points in the future. Time &al%e o! Mone. /A++lica"ions0Uses1 &. To pro/ect future dollar0peso amounts such as cash flows, incomes, prices. 8. To estimate e?uivalent current%period values based on pro/ected future values. 9. To evaluate business decisions where at least some of the cash flows occur in the future. Essen"ial "erms in a++l.ing "ime #al%e o! mone. +rinci+les: Ann%i".2 A series of e?ual payments per period for a specified length of time. @or e#ample! the repayment of a loan by making AB monthly payments of C8DDE is a form of annuity. Amo%n"2 A specific number of dollars0peso to be paid or received on a specific date. resen" &al%e / &1 2 The value today of an amount or an annuity, taking into consideration that interest can be earned. F%"%re &al%e /F&1 2 The value of an amount or an annuity, at a specified future date, taking into consideration that interest can be earned.

Time &al%e o! Mone. /3asic Conce+"1 A dollar0peso is worth more (or less) the sooner (later) it is received or paid due to the ability of money to earn interest. present value F interest earned G future value )r future value % interest lost 4

G present value The e?uation for the future value of any amount S for n periods at an interest rate of i is!

E4am+le /F%"%re &al%e o! an amo%n"1 <sing electronics calculator, especially those with built%in built in financial functions, the computations of a future value is made easy. Alternatively, tables of various present and future value factors can be used. 2onsider the future value of a sum of CA8,8&H in ten years at B percent interest. The e?uation would be!

Selec"e* F%"%re &al%e In"eres" Fac"ors erio*s 8% 2 4 6 8 10 &.&HHA &.9HD' &.'BHI &.B'DI 8.&'BI In"eres" Ra"e 10% &.8&DD &.AHA& &.JJ&H 8.&A9H 8.'I9J 12% &.8'AA &.'J9' &.IJ9B 8.AJHD 9.&D'B

;ecause S refers to an amount of money today, it is also the present value. Thus substituting the symbol PV (present value) for S and solving for ,=, the e?uation for the present value of sum is obtained!

E4am+le / resen" &al%e o! an amo%n"1 5

"hat is the present value of CI&,&AD in ten years if the discount rate is B percent per yearK

Selec"e* resen" &al%e In"eres" Fac"ors erio*s 8% 1 2 3 4 6 8 10 D.I8'I D.B'J9 D.JI9B D.J9'D D.H9D8 D.'AD9 D.AH98 In"eres" Ra"e 10% D.IDI& D.B8HA D.J'&9 D.HB9D D.'HA' DAHH' D.9B'' 12% D.BI8I D.JIJ8 D.J&&B D.H9'' D.'DHH D.AD9I D.988D

The process of reducing future values to their present values is often referred to as discounting. 1n this conte#t, the interest rate used in present value problems is sometimes referred to as a discount rate.

MARGINAL ANALYSIS 1mplies /udging the impact of a unit change in one variable on the other. :arginal generally refers to small changes .#amines es how the costs and benefits change in response to incremental changes in actions. "eighing the benefits out of the cost.

:arginal revenue is change in total revenue per unit change in output sold. :arginal cost refers to change in total costs per unit change in output produced ("hile incremental cost refers to change in total costs due to change in total output).

Analysis of Lmarginal7 costs and Lmarginal7 benefits due to a change. :arginal G additional or incremental. 2osts and benefits that are constant (i.e. fi#ed, don7t change) are e#cluded from the analysis. 2hanges occurring at Lthe margin7 are all that matter. Two important dimensions of change! direction, magnitude. E4am+le Ho%r Ho%rl. 5age (:arginal +ain0;enefit) *our & *our 8 *our 9 *our A *our ' *our H *our J *our B *our I *our &D *our && *our &8 C&D C&D C&D C&D C&D C&D C&D C&D C&' C&' C&' C&' C8 C8 C9 C9 CA C' CH CB CI C&8 C&B C8D CB CB CJ CJ CH C' CA C8 CH C9 C%9 C%' &al%e o! Time (:arginal 2ost) Ne" Gain03ene!i"

This marginal analysis suggests that rational maximizing behavior is to or! "or 10 hours#

ro*%c"ion ossi)ili". C%r#e0 ro*%c"ion ossi)ili". Fron"ier /

F1 7

% %

The trade%offs offs facing a society can be illustrated in a graph known as the production possibilities curve. The production possibilities curve shows the ma#imum ?uantity of goods and services that can be produced using limited resources to the fullest e#tent e#te possible.

6epresents the point at which an economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible.

MODULE 6: DEMAND AND SU

DEMAND

LY

5emand chedule Table that shows different ?uantities of goods that consumers are willing to buy at different pri$es at different time. 8

,rice ' A 9 8 &

Muantity 5emanded &D &J 8H 9B '9

5emand 2urve plotted diagram showing the relationship between the price and ?uantity demanded at a given time. H ' A ,612. 9 8 & D &D 8D 9D AD 'D HD M<A-T1T> 5.:A-5.5 3aw of 5emand states that ?uantity demanded moves in the opposite direction of price (all the other things held constant), and this effect is observed in the downward slope of the demand curve. De"erminan"s o! Deman*: 1ncome an increase in income shifts the demand curve of normal goods to the right. ,rices of 6elated +oods o ubstitutes an increase in the price of a substitute product increases demand, shifting the demand curve to the right. o 2omplements an increase in the price of a complement reduces demand, shifting the demand curve to the left

Advertising and 2onsumer Taste a favourable customer preference and a wide and effective advertising can increase the demand, shifting demand curve to the right. ,opulation an increase in population or market si$e shifts the demand curve to the right. 2onsumer .#pectations an e#pectation of pri$e changes can change the demand in anticipation of the change effects.

C-ange in 7%an"i". Deman*e* % A change in ?uantity demanded is a change from one price%?uantity pair on an e#isting demand curve to a new price%?uantity pair on the A:. demand curve. 1n other words, this is a movement along the demand curve. A change in ?uantity demanded is caused by a change in price. C-ange in Deman* % A change in demand is a change in the .-T16. demand relation. This means changing, moving, and shifting the entire demand curve. The entire set of prices and ?uantities is changing. 1n other words, this is a shift of the demand curve. A change in demand is caused by a change in the five demand determinants.

Cons%mer S%r+l%s % The difference between the ma#imum price that consumers are willing to pay for a good and the market price that they actually pay for a good. 2*A-+. 1- 5.:A-5! A shift of the demand curve caused by a change in one of the demand determinants. A change in demand is caused by any factor affecting demand .N2.,T price. A related, but distinct, concept is a change in ?uantity demanded. A change in demand is a change in the entire price%?uantity relation that makes up the demand curve. 1t means that a different ?uantity demanded is paired with a given demand price or that a different demand price is paired with a given ?uantity demanded. The result of this repairing of prices and ?uantities is a repositioning, or a shift, of the demand curve. 10

The five demand determinants (buyersO income, buyersO preferences, other prices, buyersO e#pectations, and number of buyers) are responsible for causing a change in demand. 1n fact, the only thing that 5). -)T cause a change in demand is the demand price. Deman* an* 7%an"i". Deman*e* To set the stage for an understanding of this difference, take note of two related concepts!

5emand! 5emand is the range of ?uantities that buyers are willing and able to buy at a range of demand prices. 1t is A33 points that make up a demand curve. Muantity 5emanded! Muantity demand is a specific ?uantity that buyers are willing and able to buy at a specific demand price. 1t is but )-. point on a demand curve.

Ma,ing C-anges o what happens when the phrase Pchange inP is placed in front of each termK

2hange in 5emand! A change in demand is a change in the .-T16. demand relation. This means changing, moving, and shifting the entire demand curve. The entire set of prices and ?uantities is changing. 1n other words, this is a shift of the demand curve. A change in demand is caused by a change in the five demand determinants.

2hange in Muantity 5emanded! A change in ?uantity demanded is a change from one price%?uantity pair on an e#isting demand curve to a new price%?uantity pair on the A:. demand curve. 1n other words, this is a movement along the demand curve. A change in ?uantity demanded is caused by a change in price.

2hanging 5emand A change in demand is a shift of the demand curve. A change in ?uantity demanded is a movement along a given demand curve. These alternatives can be illustrated with the negatively%sloped demand curve presented in this e#hibit. This demand curve captures the specific one%to%one, law of demand relation between demand price and ?uantity demanded. The five demand determinants are assumed to remain constant with the construction of this demand curve.

11

A Change in Demand

A 2hange in 5emand! A change in demand, which is triggered by a change in any of the five demand determinants, is a shift of the demand curve. A 2hange in Muantity 5emanded! A change in ?uantity demanded, which is only triggered by a change in demand price, is a movement along the demand curve.

An Im+or"an" Di!!erence "hy is this difference so importantK The answer is as simple as cause and effect. The demand curve is used (together with supply) to e#plain and analy$e market e#changes. The se?uence of events follows a particular pattern.

@irst, a demand (or supply) determinant changes. econd, this determinant change causes the demand curve (or supply curve) to shift. Third, the change in demand (or supply) causes either a shortage or a surplus imbalance in the market. The market is in a temporary state of dise?uilibrium. @ourth, the shortage and surplus imbalance causes the price of the good to change. @ifth, the change in price causes a change in ?uantity demanded (and supplied). i#th, the change in ?uantity demanded (and supplied) eliminates the shortage or surplus and restores market e?uilibrium.

The key conclusion is that demand (and supply) determinants, which induce changes in demand (and supply), are the source of instability in the market. The change in price, which induces a change in ?uantity demanded (and supplied) is the means of eliminating the instability and restoring e?uilibrium.

12

CONSUMER SURPLUS

The difference between the ma#imum price that consumers are willing to pay for a good and the market price that they actually pay for a good is referred to as the cons%mer s%r+l%s$ The determination of consumer surplus is illustrated in @igure & , which depicts the market demand curve for some good. good

Figure 1 Calculation of consumer surplus

The market price is C', and the e?uilibrium ?uantity demanded is ' units of the good. The market demand curve reveals that consumers are willing to pay at least CI for the first unit of the good, CB for the second unit, CJ for the third unit, and CH for the fourth unit. *owever, they can purchase ' units of the good for /ust C' per unit. Their surplus from the first unit purchased is therefore CI % C' G CA. imilarly, their surpluses from the second, third, third, and fourth units purchased are C9, C8, and C&, respectively. These surpluses are illustrated by the vertical bars drawn in @igure & . The sum total of these surpluses is the $onsumer sur%lus&

The value C&D, however, is only a crude appro#imation of the true consumer surplus in this e#ample. The true consumer surplus is given by the area below the market demand curve and above the market price. This area 13

consists of a triangle with base of length ' and height of length '. Applying the rule for the area of a triangleQone half the base multiplied by heightQone finds that the value of the consumer surplus in this e#ample is actually &8.'.

SU

LY upply, is the amount of some product producers are willing and able to sell at a given price all other factors being

held constant. <sually, supply is plotted as a supply curve showing the relationship of price to the amount of product businesses are willing to sell. Fac"ors a!!ec"ing s%++l. &. +oods own price 8. ,rice of related goods 9. 2onditions of ,roduction A. .#pectations '. -umber of suppliers
H.

+overnment policies and regulations

S%++l. c%r#e The relationship of price and ?uantity supplied can be e#hibited graphically as the supply curve. The curve is generally positively sloped. The curve depicts the relationship between two variables only4 price and ?uantity supplied. All other factors affecting supply are held constant. *owever, these factors are part of the supply curve and are present in the intercept or constant term T-e La8 o! Deman* The law of demand states that, if all other factors remain e?ual, the higher the price of a good, the less people will demand that good. 1n other words, the higher the price, the lower the ?uantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. T-e La8 o! S%++l. 3ike the law of demand, the law of supply demonstrates the ?uantities that will be sold at a certain price. ;ut unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the ?uantity supplied. ,roducers supply more at a higher price because selling a higher ?uantity at a higher price increases revenue. 14

Deman* A relationship between two variables, price and ?uantity demanded, with all other factors that could affect demand being held constant. Fac"ors A!!ec"ing Deman* &. +oodOs own price 8. ,rice of related goods 9. 1ncome A. Tastes or preferences '. 2onsumer e#pectations about future prices and income

MAR'ET E7UILI3RIUM :arket e?uilibrium, is the point at which total supply and demand within a market are e?ual, shown by the intercept of a demand curve and a supply curve when both are graphed on the same a#is.

E9%ili)ri%m "hen supply and demand are e?ual (i.e. when the supply function and demand function intersect) the economy is said to be at e?uilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is e#actly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding. S%r+l%s an* s-or"age % % 1f the market price is above the e?uilibrium price, ?uantity supplied is greater than ?uantity demanded, creating a surplus. :arket price will fall. 1f the market price is below the e?uilibrium price, ?uantity supplied is less than ?uantity demanded, creating a shortage. The market is not clear. 1t is in shortage. :arket price will rise because of this shortage. 15

C-anges in e9%ili)ri%m +rice an* 9%an"i". .?uilibrium price and ?uantity are determined by the intersection of supply and demand. A change in supply, or demand, or both, will necessarily change the e?uilibrium price, ?uantity or both. 1t is highly unlikely that the change supply and demand perfectly offset one another so that e?uilibrium remains the same. in

RICE CEILINGS AND RICE FLOORS ,rice ceiling and price floor is setting a price on a certain good. rice Ceilings The ma#imum legal price that can be charged. ,rice ceiling puts a ma#imum price limit the price canOt go higher than the price you have set. An effective price ceiling is where e?uilibrium price is above the price ceiling. 3etOs say the ma#imum price set is C8 but the e?uilibrium price is C'. This creates a shortage because the suppliers will supply when price is at C8 and many people will demand the good. This creates a shortage. E4am+les: +asoline prices in the &IJDs. *ousing in -ew >ork 2ity. ,roposed restrictions on AT: fees.

16

17

rice Floors The minimum legal price that can be charged. ,rice floors sets a minimum price limit that means the price canOt go lower than it possibly can. An effective price floor is where e?uilibrium price is below the price floor this causes a surplus. This is because even though e?uilibrium um price is ' for e#ample the minimum price it can go &D. This will create a surplus. E4am+les: :inimum wage. Agricultural price supports.

These pricing limits can create shortages and surpluses or it may have no effect depending on where supply and demand meet (e?uilibrium). ,rice floor above e?uilibrium G s%r+l%s ,rice floor below e?uilibrium G no e!!ec" ,rice ceiling above e?uilibriumG no e!!ec" ,rice ceiling below e?uilibrium G s-or"age LY

COM ARATI&E STATICS: CHANGES IN DEMAND AND SU Com+ara"i#e S"a"ic Anal.sis

18

A common method of economic analysis used to compare various points of e?uilibrium when certain factors change$ hows how the e?uilibrium price and ?uantity will change when a determinant of supply or demand changes. A !orm o! sensi"i#i". or 8-a" 8-a"2i! anal.sis.

A++lica"ions o! Deman* an* S%++l. Anal.sis E#en": months. Scenario 1: >ou manage a small firm that manufactures ,2s. Scenario 6: >ou manage a small software company. Use Com+ara"i#e S"a"ic Anal.sis "o see "-e 3ig ic"%re: Scenario 1: Im+lica"ions !or a Small C Ma,er tep &! 3ook for the R;ig ,icture.S tep 8! )rgani$e an action plan (worry about details). The 'S( reports that the prices of ,2 components are e#pected to fall by ' '%B percent over the ne#t si#

3ig ic"%re Anal.sis: C Mar,e" .?uilibrium price of ,2s will fall, and e?uilibrium ?uantity of computers sold will increase. <se this to organi$e an action plan contracts0suppliersK inventoriesK human resourcesK 19

marketingK do 1 need ?uantitative ve estimatesK

Scenario 6: So!"8are Ma,er :ore complicated chain of reasoning to arrive at the R;ig ,icture.S tep &! <se analysis like that in cenario & to deduce that lower component prices will lead to a lower e?uilibrium price for computers. a greater number of computers sold.

tep 8! *ow will these changes affect the R;ig ,ictureS in the software marketK

3ig ic"%re Anal.sis: So!"8are Mar,e" oftware prices are likely to rise, and more software will be sold. <se this to organi$e an action plan.

Concl%sion <se supply and demand analysis to clarify the Rbig pictureS (the general impact of a current event on e?uilibrium prices and ?uantities). organi$e an action plan (needed changes in production, inventories, raw materials, human resources, marketing plans, etc.).

RICE ELASTICITY :easures the sensitivity of the ?uantity demanded or the ?uantity supplied to the change in the price. 1n other words, how much will a change in price affect the ?uantity demanded or suppliedK 20

*ow responsive is variable R+S (?uantity demanded or ?uantity supplied) to a change in variable R S (price).
% G % S

E G ,S =

1f )*+S T D, then S and * are directly related. 1f .+, U D, then 1f .+, G D, then and + are inversely related. and + are unrelated.

RICE ELASTICITY OF DEMAND The law of demand states that as price increases, less ?uantity is demanded. This is why the demand curve slopes down to the right. ;ecause price and ?uantity move in opposite directions on the demand curve, the price elasticity of demand is always negative.
% QX = %PX
d

EQX , PX

Elas"ic:

EQX ,PX >1

Inelas"ic:

EQX ,PX <1

Uni"ar.:

EQX ,PX =1

+enerally, a curve is elas"ic i! i" is !la" and more inelas"ic i! i" is more #er"ical. *owever, this can be a little misleading. .ven on a linear (straight) demand or supply curve, the elasticity is not constant for the whole curve. The reason for this is that we are measuring the percentage change in both price and ?uantity. As you move along a linear curve and approach one of the a#es, the percentage changes in that a#is variable (either price or ?uantity) get smaller and smaller and the percentage changes of the opposite a#is get bigger and bigger.

ELASTICITY; TOTAL RE&ENUE AND MARGINAL RE&ENUE 1t is now time to develop some technical concepts that will be useful in later analysis. The first of these is the concept of elasti$ity. <ntil now we have described the shapes of demand and supply curves in terms of their slopes. I" is no" al8a.s meaning!%l "o *escri)e c%r#es as !la" or s"ee+; )eca%se 8-e"-er a c%r#e a++ears !la" or s"ee+ *e+en*s %+on "-e %ni"s in 8-ic- +rice an* 9%an"i". are meas%re*$

21

The slope of the demand curve is shown in @igure &. 3et V represent the words Psmall changeP. "e can then e#press the slope of the demand curve, denoted by the greek symbol W, as &. W G V, 0VM :easure the ?uantity of eggs in do$ens and the price of eggs in dollars. 1f, say, a rise in price of C&.DD reduces egg consumption by ' do$en as we move up along the demand curve, the slope will be %D.8.

-ow suppose that we measure the ?uantity in numbers of eggs and the price in dollars as before. The same demand curve will now be flatter%%%a rise in the price of C&.DD will reduce egg consumption by HD eggs, yielding a slope e?ual to %D.D&HHHJ. 1f, alternatively, we were to measure the price of eggs in cents and the ?uantity of eggs in do$ens, the slope of this same demand curve would then be %&DD0' G %8D. T-e a++aren" slo+e o! "-e line on "-e gra+- 8ill *e+en* as 8ell on -o8 8i*el. 8e s+ace "-e %ni"s o! +rice an* 9%an"i". along "-e a4es%%%if, for e#ample, the ?uantity units are spaced a ?uarter of an inch apart the curve will appear steeper than if they are spaced half an inch apart. ;y measuring the responsiveness of ?uantity to changes in price using the concept of elasti$ity, we avoid this dependence on units of measurement. The elasticity of demand is defined as the relative change (or percentage change) in ?uantity divided by the relative (or percentage) change in price$ 3et us use the greek symbol X to denote the elasticity of demand. Then we can write 8. X G ( VM 0 M ) 0 ( V, 0 , ) 22

ince dividing by a number is e?uivalent to multiplying by its reciprocal we can rewrite the above e?uation as 9. X G ( VM 0 M ) ( , 0 V, ) G ( VM 0 V, ) ( , 0 M ) ince the slope of the demand curve is e?ual to the change in price divided by the change in ?uantity, the term ( VM 0 V, ) in the above e?uation is the reciprocal of the slope. Then we can write .?uation 9 as A. X G ( VM 0 V, )( , 0 M ) G ( & 0 W )( , 0 M ) T-e elas"ici". is "-e reci+rocal o! "-e slo+e m%l"i+lie* ). "-e ra"io o! +rice o#er 9%an"i".$ All this is illustrated in @igure 8 where the elasticity of demand is measured relative to the initial price%?uantity combination ( ,D,MD ) . 1t turns out that the elasticity will not be constant as we move along the curve. As should be clear from .?uation A, given a constant slope, "-e elas"ici". 8ill *ecline as elas"ici". is <ero$ 0 7 *eclines as 8e mo#e *o8n "o "-e rig-" along "-e s"raig-"2line *eman* is <ero "-e c%r#e222a" "-e #er"ical a4is 8-ere 7 is <ero "-e elas"ici". is in!ini"e an* a" "-e 9%an"i". a4is 8-ere

As shown in @igure 9 below, the elasti$ity o" su%%ly is $al$ulated in exa$tly the same ay as the elasti$ity o" demand,,,the only di""eren$e is that the elasti$ity o" su%%ly is %ositive hile the elasti$ity o" demand is negative+ re"le$ting the "a$t that the su%%ly $urve is u% ard slo%ing and the demand $urve negatively slo%ed$ "e denote the slope of the supply curve by Y in the figure and measure the elasticity relative to the initial price%?uantity combination ( ,D , MD ) . T-e elas"ici". 8ill no" )e

23

cons"an" as 8e mo#e %+ along a s"raig-"2line s%++l. c%r#e %nless "-a" line +asses "-ro%g- "-e origin; in 8-iccase )o"- "-e slo+e an* "-e ra"io 0 7 8ill )e cons"an"$

The total revenue to the seller of a commodity, or total e#penditure by the purchaser, is obtained by multiplying the price by the ?uantity. 1t appears in @igure A as the area of a rectangle whose bottom left corner is the origin and top right corner is a point on the demand curve. The top left and bottom right corners e?ual price and ?uantity respectively. The shaded rectangle in @igure A, for e#ample, gives the total revenue at point c on the demand curve%%%the product of the price ,D and the ?uantity MD. The total revenue at point a is the rectangle ,& a M& =.

24

1t is also clear in the above @igure that the total revenue varies as we move along the demand curve. The total revenue at zero -uantity and %ri$e .m is zero# /s e move do n along the demand $urve+ the total revenue in$reases+ rea$hing its maximum at the %oint b 0 hi$h is middle,distant "rom the t o ends o" the $urve1 and then de$lines+ rea$hing zero again at %ri$e zero and -uantity 2m$ To"al re#en%e is +or"ra.e* in "-e Fig%re as "-e in#er"e* +ara)ola = g m - 7m 222i" is meas%re* on a *i!!eren" scale on "-e #er"ical a4is; o! co%rse; "-an is "-e +rice$ The shaded area ,D c MD = is e?ual to the distance MD. imilarly, the area of the rectangle under the demand curve at point ) e?uals the perpendicular distance between m and the hori$ontal a#is. And the area of the rectangle under the demand curve at point a e?uals the distance g M&. Marginal revenue is *e!ine* as "-e c-ange in "o"al re#en%e "-a" occ%rs 8-en 8e c-ange "-e 9%an"i". ). one %ni"$ "e can e#press the marginal revenue, denoted by :6, as '. :6 G VT6 0 VM

where T6 is total revenue. The marginal revenue is thus the slo%e o" the total revenue $urve in 3igure 4# /t -uantity zero+ the marginal revenue is e-ual to the %ri$e,,,selling the "irst unit adds one times the %ri$e o" that unit to the total revenue# /s -uantity in$reases the marginal revenue "alls be$ause as e add su$$essive units not only is the %ri$e o" the last unit lo er than the %ri$e o" the %revious unit but all %revious units have to be sold at this lo er %ri$e#

25

:arginal revenue for each ?uantity sold is given in @igure ' as the distance between the thick line and the hori$ontal a#is at that ?uantity. This distance is e?ual to the slope of the total revenue curve at that ?uantity. A" "-e +oin" o! ma4im%m "o"al re#en%e m "-e slo+e o! "-e "o"al re#en%e c%r#e is <ero an* "-e marginal re#en%e is "-ere!ore also <ero$ T-e marginal re#en%e c%r#e "-%s crosses "-e -ori<on"al a4is a" "-e 9%an"i". a" 8-ic- "-e "o"al re#en%e is ma4im%m$ 5-en "-e *eman* c%r#e is a s"raig-" line; "-is occ%rs a" "-e mi**le +oin" o! "-e c%r#e; a" a +oin" on "-e -ori<on"al a4is "-a" )isec"s "-e *is"ance = 7m$ ,ast the mid%point of a straight line demand curve, the marginal revenue becomes negative. 'hy is marginal revenue im%ortant5 This ?uestion is best answered by way of e#ample. 2onsider the market for fresh eggs in a locality. uppose that the government permits producers to establish an .gg :arketing ;oard with the power to set the price of eggs to the consumer and allocate output ?uantities to all individual producers. ,urchases of eggs from outside the local area are prohibited. This situation is shown in @igure H. The demand curve is given by the line 55 and the supply curve is the hori$ontal line 2D . A hori$ontal supply curve is a reasonable assumption here because most of the inputs used to produce eggs can be purchased by egg producers at fi#ed market prices%%%these inputs are used by other industries and producers of eggs use a small fraction of the available supply. This implies that chicks can be hatched and raised to hens at constant cost.

26

.gg producers like this arrangement because it enables them to sell their eggs to consumers at a price above the cost of production, yielding a profit indicated by the shaded area in @igure H. The problem faced by the :arketing ;oard, acting on their behalf, is to determine the ?uantity level that will ma#imi$e that profit. At a lower output ?uota there is a gain from a higher price, but the ?uantity producers sell will be less. The profit is the e#cess of total revenue, given by the area ,& a M& =, over total cost, given by the area 2D ) M&D. At every ?uota level the ;oardOs problem is to decide whether to increase the output ?uota by one unit. 1t will do this if the additional revenue from selling another unit to consumers%%%the marginal revenue%%%is greater than the additional to total cost from producing another unit%%%called the marginal $ost. The marginal revenue is given by the thick line in @igure H. The marginal cost is given simply by the hori$ontal supply curve%%%each additional unit produced adds = 2D to total cost. S"ar"ing !rom <ero; "-ere!ore; "-e 3oar* 8ill increase "-e 9%o"a; %ni" ). %ni"; %n"il the marginal revenue curve crosses the marginal cost curve (in this case, supply curve). )utput will e#pand until marginal re#en%e e9%als marginal cos"$ A" "-is o%"+%" le#el "-e +ro!i" "o egg +ro*%cers 8ill )e ma4imi<e*$ 1f, starting from the output M& in @igure H, the ;oard were to increase the output ?uota by one more unit, the increase in total revenue from selling that unit would be less than the increase in the total cost from producing it, making such an e#pansion of the ?uota not worthwhile. Alternatively, if it were to reduce the ?uota by one unit, the reduction in total revenue from selling one less unit would be greater than the reduction in the total cost from producing one unit less, making 27

the reduction in the ?uota not worthwhile. ,rofits are ma#imi$ed by ad/usting the ?uantity sold to e?uali$e marginal cost and marginal revenue. Economis"s -a#e a con#en"ion o! re!erring "o "-e elas"ici". o! *eman* as +osi"i#e n%m)er e#en "-o%g- i" is in !ac" nega"i#e$ "hen they talk about an elasticity of demand greater than & they really mean that the elasticity of demand is less than %&. 5-a" "-e. are re!erring "o is "-e a)sol%"e #al%e o! "-e elas"ici". o! *eman*$ The absolute value of %8 is 8, whereas its algebraic value is %8. "e obtain a numberOs absolute value by simply ignoring its sign. So 8-en economis"s sa. "-a" "-e *eman* is -ig-l. elas"ic "-e. mean "-a" "-e elas"ici". is a large n%m)er 8i"- a nega"i#e sign a""ac-e*$ 1t is test%time again. :ake sure that you think up an answer of your own before looking at the one provided. The following definitions apply to calculations of price elasticity! &) I! E+ > 1, 5emand is elastic. The percentage change in price will produce a greater percentage in ?uantity demanded. 1f the price goes up, then total revenues will go down. 1f the price goes down, then total revenues willincrease. 8) I! E+ ? 1, 5emand is inelastic. The percentage change in price will produce a lower percentage in ?uantity demanded. 1f the price goes up, then total revenues will go up. 1f the price goes down, then total revenues will decrease. 9) I! E+ @ 1, 5emand has unitary elasticity. A percentage in price will produce the e#act same percentage change in ?uantity. Therefore, changes in price will no have effect on total revenues. 5-. Economis"s Use Elas"ici".

.conomists want to compare apples and oranges all the time. 1s oil market demand more price sensitive than wheat demandK (no) 1s the labor supply of women more wage sensitive than the labor supply of menK (yes) An elasticity is a unit%free measure. ;y comparing markets using elasticities it does not matter how we measure the price or the ?uantity in the two markets. .lasticities allow economists to ?uantify the differences among markets without standardi$ing the units of measurement.

E4am+les o! Uni"2!ree Com+arisons

+asoline and /ewelry 28

o o o

1t doesnOt matter that gas is sold by the gallon for about C&.DI and gold is sold by the ounce for about C8ID. "e compare the demand elasticities of %D.8 (gas) and %8.H (gold /ewelry). +old /ewelry demand is more price sensitive.

,aintings and meat

o

1t doesnOt matter that classical paintings are sold by the canvas for millions of dollars each while beef is sold by the pound for about C&.'D. "e compare the supply elasticities of D (clas (classical paintings) and ' (beef). ;eef supply is more price sensitive.

o o

Inelas"ic Economic Rela"ions

"hen an elasticity is small (between D and & in absolute value), we call the relation that it describes inelastic. 1nelastic demand means that the ?uantity demanded is not very sensitive to the price. 1nelastic supply means that the ?uantity supplied is not very sensitive to the price.

Elas"ic Economic Rela"ions

"hen an elasticity is large (greater than & in absolute value), we call the relation that it describes elastic. .lastic demand means that the ?uantity demanded is sensitive to the price. .lastic supply means that the ?uantity supplied is sensitive to the price.

Si<e o! rice Elas"ici"ies

1nelastic! price elasticity less than & <nit elastic! price elasticity e?ual to &

.lastic! elasticity greater than &

price

29

FACTORS AFFECTING RICE ELASTICITY 5-a" De"ermines rice Elas"ici". o! Deman*A

T-e n%m)er o! close s%)s"i"%"es !or a goo* 0 %ni9%eness o! "-e +ro*%c" the more close substitutes in the market, the more elastic is the demand for a product because consumers can more easily switch their demand if the price of one product changes rela"i#e to others in the market. The huge range of package holiday tours and destinations make this a highly competitive market in terms of pricing many holiday makers are price sensitive

T-e cos" o! s8i"c-ing )e"8een *i!!eren" +ro*%c"s there may be significant "ransac"ions cos"s involved in switching between different goods and services. 1n this case, demand tends to be relatively inelastic. @or e#ample, mobile phone service providers may include penalty clauses in contracts or insist on &8%month contracts being taken out

T-e *egree o! necessi". or 8-e"-er "-e goo* is a l%4%r. goods and services deemed by consumers to be necessities tend to have an inelastic demand whereas lu#uries will tend to have a more elastic demand because consumers can make do without lu#uries when their budgets are stretched. 1.e. in an economic recession we can cut back on discretionary items of spending

T-e B o! a cons%merCs income alloca"e* "o s+en*ing on "-e goo* goods and services that take up a high proportion of a household7s income will tend to have a more elastic demand than products where large price changes makes little or no difference to someone7s ability to purchase the product.

T-e "ime +erio* allo8e* !ollo8ing a +rice c-ange demand tends to be more price elastic, the longer that we allow consumers to respond to a price change by varying their purchasing decisions. 1n the short run, the demand may be inelastic, because it takes time for consumers both to notice and then to respond to price fluctuations

5-e"-er "-e goo* is s%)Dec" "o -a)i"%al cons%m+"ion when this occurs, the consumer becomes much less sensitive to the price of the good in ?uestion. .#amples such as cigarettes and alcohol and other drugs come into this category

ea, an* o!!2+ea, *eman* % demand tends to be price inelastic at peak times a feature that suppliers can take advantage of when setting higher prices. 5emand is more elastic at off%peak times, leading to lower prices for consumers. 2onsider for e#ample the charges made by car rental firms during the course of a week, or the cheaper deals available at hotels at weekends and away from the high%season. Train fares are also higher on @ridays (a peak day for travelling between cities) and also at peak times during the day

30

T-e )rea*"- o! *e!ini"ion o! a goo* or ser#ice if a good is broadly defined, i.e. the demand for petrol or meat, demand is often fairly inelastic. ;ut specific brands of petrol or beef are likely to be more elastic following a price change.

CROSS RICE ELASTICITY OF DEMAND :easures the responsiveness of demand for +ood N following a change in the price of +ood > (a related good). 2,e5 G ( change in ?ty demand of +ood N ( change in price of +ood > 2alculating the ,ercentage 2hange in Muantity 5emanded of +ood N ZM5emand(-.") % M5emand()35)[ 0 M5emand()35)[ 2alculating the ,ercentage 2hange in ,rice of +ood >

E rice/NE51 2 rice/OLD1F 0 rice/OLD1F SU3STITUTE0 COM LEMENT GOODS: 1f two goods are substitutes, we should e#pect to see consumers purchase more of one good when the price of its substitute increases. imilarly if the two goods are complements, we should see a price rise in one good cause the demand for both goods to fall. .lasticity of 5emand (2,ed) F G ubstitutes

2ross .lasticity of 5emand (2,ed) % G 2omplements

ubstitutes! "ith substitute goods such as brands of soda, an increase in the price of one good will lead to an increase in demand for the rival product "eak substitutes inelastic 2,ed 2lose substitutes elastic 2,ed

2,e5 G ( change in ?ty demand of +ood N G 'D( G .'D G '.'H ( change in price of +ood > I( .DI

31

( change in ?ty demand of +ood N(,., 1) ZM5emand(-.") % M5emand()35)[ 0 M5emand()35)[ Z&'DD &DDD[0 &DD[ G 'D( ( change in price of +ood > (2)\.) Z,rice(-.") % ,rice()35)[ 0 ,rice()35)[ Z &8%&&[0&8 G I(

S u b s titu t es
P r ic e o f G ood Y (C O K E Tw o Clos e S u bs titu tes De m a nd

G oo ds C O K E a nd P E P S I a re c los e s u bs titu tes A ris e in th e p ric e of G oo d Y lead s to a highe r r is e in t he dem a nd for go od X T he c ro s s pr ic e e las tic ity o f dem a nd will be po s itive

P2 P1

Q uan tity d em and ed o f G o od X (P E P S I)

P EP SI & C O KE .50 = 5.56 .09

32

Substitutes
Price of Good Y(COKE Two Weak Substitutes Demand

Goods COKE and RC are weak substitutes A rise in the price of COKE leads to a small rise in the demand for RC The cross price elasticity of demand will be positive but the coefficient of elasticity will be less than one

P2 P1

Quantity demanded of Good X(RC)

RC & COKE 0.02 = 0.22 0.09

Cross rice Elas"ici". o! Deman* /C e*1 2 @ Com+lemen"s Com+lemen"s: +oods that are in complementary demand "eak complements inelastic 2,ed 2lose complements elastic 2,ed

33

Com plem ents

Priceo f Go odsX a ndYa reclo se co m plem e nts Afall inth ep riceof go odX le adsto ala rg e riseinthe dem a ndfo r goodY Th e cross p rice e lasticityof dem a ndw ill b en eg ativean d thecoe fficie nt o fe la sticityw ill bem orethanon e Com ple m e ntsaresaid tobe inJO INTD EM A ND Boracay& Air F lights! P1 P2 G oodX De m an d

Tw oC loseC om ple m en ts

A12%fall inthe priceof air fares leads toa 30%rise inthedem andfor B oracay +30/-12= -2.5

Q uan titydem a nde dof G oodY

34

Goods with zero cross-price elasticity of demand INDEPENDENT

Price of Demand Good A Goods A and B have no relationship. A fall in the price of good A leads to no change in the demand for good B Therefore the cross-price elasticity of demand is zero

P1

P2

P3

Apples and gloves!

Quantity demanded of Good B

INCOME ELASTICITY OF DEMAND This measures the responsiveness of demand to a change in income.

e.g. if your income increase by ' ( and your demand for mobile phones increased 8D( then the >.5 G 8D0 ' G A. >.5 G ( change ( change in 1ncome in M.5

673)8698 *99: This occurs when an increase in income leads to a fall in demand. Therefore >.5UD. ..g. clothes from charity shops, cheap bread. "hen your income increase you buy better ?uality goods.

35

798;/< *99: This occurs when an increase in income leads To an increase in demand for the good, Therefore >.5TD <=>=8? *99: This occurs when an increase in demand causes a bigger ( increase in demand, therefore >.5T&.

3u#ury goods will also be normal goods and we can say RThey will be income .lasticS 1ncome inelastic, this means an increase in income leads to a smaller ( increase in demand. Therefore DT

>.5 U&

@irms will make use of >.5 by producing more lu#ury goods during periods of economic growth, similarly

there will be less demand for inferior goods.

Positive Income Elastic Demand Diagram

ote the a!es are DI""E#E $%

36

Elastic or Inelastic & 'eD

Elastic goods ( are seen as LUXURIES )# SUPERIOR% Inelastic goods ( are seen as NORMAL or NECESSITIES.

egative Income Elasticity Diagram * Inferior

ote the different a!es labels

37

+ero Income Elasticity

$his occurs when a change in income has ) effect on the demand for goods, - rise of ./ income in a rich country will leave the Demand for toothpaste unchanged%

@)6 .NA:,3.! >ed G % D.H! +ood is an in!erior goo* but inelas"ic a rise in income of &D( would lead to demand falling by H( >ed G F D.A! +ood is a normal goo* but inelas"ic a rise in incomes of &D( would lead to demand rising by A( >ed G F &.H! +ood is a normal goo* and elas"ic a rise in incomes of &D( would lead to demand rising by &H( >ed G % 8.&! +ood is an in!erior goo* and elas"ic a rise in incomes of &D( would lead to a fall in demand of 8&(

Signi!icance o! Income Elas"ici". o! Deman* *igh 1ncome .lasticity 38

o o

5emand is sensitive to changes in real incomes 5emand is therefore c.clical in an economic e#pansion, demand will grow strongly. 1n a recession demand may fall 2an be difficult for businesses to accurately forecast demand and make capital investment decisions

3ow 1ncome .lasticity

o o o

5emand is more s"a)le *%ring !l%c"%a"ions in the economic cycle )ver time, the share of consumer spending on inferior goods and normal necessities "en*s "o *ecline 3ong run businesses need to invest in 0 focus on products with a higher income elasticity of demand if they want to increase total profits

OTHER ELASTICITIES rice Elas"ici"ies O8n rice Elas"ici". The Plaw of demand,P namely that the higher the price of a good, the less consumers will purchase, has been termed the Pmost famous law in economics, and the one that economists are most sure of. To predict consumer behavior, economists use well%defined techni?ues evaluating the sensitivity of consumers to changes in price. Cross rice Elas"ici". An economic concept that measures the responsiveness in the ?uantity demand of one good when a change in price takes place in another good. The measure is calculated by taking the percentage change in the ?uantity demanded of one good, divided by the percentage change in price of the substitute good! 2ross elasticity of demand is synonymous to Pcross price elasticity of demandP. The cross elasticity of demand for substitute goods will always be positive, because the demand for one good will increase if the price for the other good increases. DEMAND FUNCTIONS In"er+re"ing Deman* F%nc"ions The degree to which a demand or supply curve reacts to a change in price is the curveOs elasticity. .lasticity varies among products because some products may be more essential to the consumer. ,roducts that are necessities are more 39

insensitive to price changes because consumers would continue buying these products despite price increases. 2onversely, a price increase of a good or service that is considered less of a necessity will determine more consumers because the opportunity cost of buying the product will become too high. Linear Deman* F%nc"ions A linear demand function e#presses the demand as a linear function of the unit price. E4am+le o! Linear Deman* ] MdG &D %8,. ] )wn%,rice .lasticity! (%8),0M. ] 1f ,G&, MGB (since &D %8 G B). ] )wn price elasticity at ,G&, MGB! (%8)(&)0BG %D.8'. A linear demand function e#presses the demand ? (for e#ample annual sales) as a linear function of the unit price p. 1t has the form ? G mp F b. E4am+le! The annual sales of your computer game P2yber 6aptorP is given by ? G %ADp F B,DDD, where p is the price you charge per game. Thus, if you charge C9' per unit, you can e#pect to sell ? G %AD(9') F B,DDD G H,HDD games this year. Log2Linear Deman* "hen price and ?uantity observations are spread over a wide range of values, elasticities are likely to vary, and a linear specification with its varying elasticities is usually a more appropriate specification of demand. Alternatively, if the sample data are clustered over a narrow price (and ?uantity) range, a constant%elasticity specification of demand, such as a log%linear model, may be a better choice than a linear model. E4am+le o! Log2Linear Deman* 40

] ln(Md) G &D %8 ln(,). ] )wn ,rice .lasticity! %8 Concl%sion! .lasticities are tools you can use to -uanti"y the impact of changes in prices, income, and advertising on sales and revenues.

MODULE (: COSTS OF RODUCTION AND THE ORGANIGATION OF THE FIRM

THE RODUCTION FUNCTION 1n economics, the Co))HDo%glas functional form of +ro*%c"ion !%nc"ions is widely used to represent the relationship of an output to inputs. 1t was proposed by \nut "icksell (&B'&&I8H), and tested against statistical evidence by 2harles 2obb and ,aul 5ouglas in &IDD&I8B. @or production, the function is ? G /<^@_, where!

? G total production (the monetary value of all goods produced in a year) < G labor input @ G capital input / G total factor productivity ^ and _ are the output elasticities of labor and capital, respectively. These values are constants determined by available technology. 41

)utput elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production, ceteris paribus. @or e#ample if ^ G D.&', a &( increase in labor would lead to appro#imately a D.&'( increase in output. @urther, if! ^ F _ G &, the production function has constant returns to scale. That is, if 3 and \ are each increased by 8D(, > increases by 8D(. 1f ^ F _ U &, returns to scale are decreasing, and if ^ F _ T & returns to scale are increasing. Assuming perfect competition and ^ F _ G &, ^ and _ can be shown to be labor and capitalOs share of output. 2obb and 5ouglas were influenced by statistical evidence that appeared to show that labor and capital shares of total output were constant over time in developed countries4 they e#plained this by statistical fitting least%s?uares regression of their production function. There is now doubt over whether constancy over time e#ists.

THE ROFIT2MAIIMIGING LE&EL OF AN IN UT 1n economics, +ro!i" ma4imi<a"ion is the (short run) process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenuetotal cost method relies on the fact that profit e?uals revenue minus cost, and the marginal revenuemarginal cost method is based on the fact that total profit in a perfectly competitive market reaches its ma#imum point where marginal revenue e?uals marginal cost. 3asic *e!ini"ions Any costs incurred by a firm may be classed into two groups! fi#ed costs and variable costs. @i#ed costs are incurred by the business at any level of output, including $ero output. These may include e?uipment maintenance, rent, wages, and general upkeep. =ariable costs change with the level of output, increasing as more product is generated. :aterials consumed during production often have the largest impact on this category. @i#ed cost and variable cost, combined, e?ual total cost. 6evenue is the amount of money that a company receives from its normal business activities, usually from the sale of goods and services (as opposed to monies from security sales such as e?uity shares or debt issuances). 42

:arginal cost and revenue, depending on whether the calculus approach is taken or not, are defined as either the change in cost or revenue as each additional unit is produced, or the derivative of cost or revenue with respect to ?uantity output. 1t may also be defined as the addition to total cost or revenue as output increase by a single unit. @or instance, taking the first definition, if it costs a firm ADD < 5 to produce ' units and ABD < 5 to produce H, the marginal cost of the si#th unit is appro#imately BD dollars, although this is more accurately stated as the marginal cost of the '.'th unit due to linear interpolation. . 2alculus is capable of providing more accurate answers if regression e?uations can be provided. provid To"al re#en%e 2 "o"al cos" me"-o*

ro!i" Ma4imi<a"ion 2 T-e To"als A++roacTo obtain the profit ma#imi$ing output ?uantity, we start by recogni$ing that profit is e?ual to total revenue (T6) minus total cost (T2). +iven a table of costs and revenues revenues at each ?uantity, we can either compute e?uations or plot the data directly on a graph. @inding the profit profit%ma#imi$ing ma#imi$ing output is as simple as finding the output at which profit reaches its ma#imum. That is represented by output M in the diagram. There are e two graphical ways of determining that M is optimal. @irst, the profit curve is at its ma#imum at this point (A). econdly, at the point (;) the tangent on the total cost curve (T2) is parallel to the total revenue curve (T6), meaning that the surplus of revenue net of costs (;,2) is at its greatest. ;ecause total revenue minus total costs is e?ual to profit, the line segment 2,; is e?ual in length to the line segment A,M. 2omputing the price at which to sell the product re?uires knowledge of the firmOs demand curve. The price at which ?uantity demanded e?uals profit%ma#imi$ing ma#imi$ing output is the optimum price to sell the product. . 43

Marginal re#en%e2marginal marginal cos" me"-o*

ro!i" ma4imi<a"ion %sing "-e marginal a++roacAn alternative argument says that for each unit sold, marginal profit (:`) e?uals marginal revenue (:6) minus marginal cost (:2). Then, if marginal revenue is greater than marginal cost, marginal profit is positive, and if marginal revenue is less than marginal cost, marginal profit is negative. "hen marginal revenue e?uals marginal cost, marginal profit is $ero.Z ince total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a ma#imum where marginal profit is $ero % or where marginal cost e?uals marginal revenue. 1f there are two points where e this occurs, ma#imum profit is achieved where the producer has collected positive profit up until the intersection of :6 and :2 (where $ero profit is collected), but would not continue to after, as opposed to vice versa, which represents a profit minimum. . 1n calculus terms, the correct intersection of :2 and :6 will occur when!

The intersection of :6 and :2 is shown in the ne#t diagram as point A. 1f the industry is perfectly competitive (as is assumed in the diagram), the firm faces a demand curve (5) that is identical to its :arginal revenue curve (:6), and this is a hori$ontal line at a price determined by industry supply and demand. Average total costs are represented by curve AT2. Total economic profit are represented by area ,,A,;,2. The optimum ?uantity (M) is the same as the optimum ?uantity (M) in the first diagram. competitive market, minor changes would have to be made to the diagrams. @or 1f the firm is operating in a non%competitive e#ample, the :arginal 6evenue would have a negative gradient, due to the overall market demand curve. 1n a non non% competitive environment, more complicated licated profit ma#imi$ation solutions involve the use of game theory.

44

Ma4imi<ing Re#en%e Me"-o* 1n some cases a firmOs demand and cost conditions are such that marginal profits are greater than $ero for all levels of production. 1n this case the :` G D rule has to be modified and the firm should ma#imi$e revenue. 1n other words the profit ma#imi$ing ?uantity and price can be determined by setting marginal revenue e?ual to $ero. :arginal revenue e?uals $ero when the marginal revenue curve has reached its ma#imum value. An e#ample would be a scheduled airline flight. The marginal costs of flying the route are negligible. The airline would ma#imi$e profits by filling all the seats. The airline would determine the amax conditions by ma#imi$ing revenues. C-anges in To"al Cos"s an* ro!i" Ma4imi<a"ion A firm ma#imi$es profit by operating where marginal revenue e?ual marginal costs. A change in fi#ed costs has no effect on the profit ma#imi$ing output or price. The firm merely treats short term fi#ed costs as sunk costs and continues to operate as before. This can be confirmed graphically. <sing the diagram illustrating the total cost total revenue method the firm ma#imi$es profits at the point where the slope of the total cost line and total revenue line are e?ual. A change in total cost would cause the total cost curve to shift up by the amount of the change. There would be no effect on the total revenue curve or the shape of the total cost curve. 2onse?uently, the profit ma#imi$ing point would remain the same. This point can also be illustrated using the diagram for the marginal revenue marginal cost method. A change is fi#ed cost would have no effect on the position or shape of these curves.

ISO7UANTS AND ISOCOSTS Iso9%an"s The word O1 )O is of +reek origin and means e?ual or same and O?uantO means ?uantity. An iso9%an" may be defined as a curve showing all the various combinations of two factors that can produce a given level of output. The iso-uant shows the whole range of alternative ways of producing the same level of output. The modern economists are using iso?uant, or P1 )P product curves for determining the optimum factor combination to produce certain units of a commodity at the least cost. The concept of iso?uant or e?ual product curve can be better e#plained with the help of .schedule given below! Iso9%an" Sc-e*%le

Com)ina"ions

Fac"or I

Fac"or Y

To"al O%"+%" 45

A ; 2 5 .

& 8 9 A '

&A &D J ' A

&DD :.T.6 &DD :.T.6 &DD :.T.6 &DD :.T.6 &DD :.T.6

1n the table given above, it is shown that a producer employs two factors of production N and > for producing an output of &DD meters of cloth. There are five combinations which produce the same level of output (&DD meters of cloth). The factor combination A using & unit of factor N and &A units of factor > produces &DD meters of cloth. The combination ; using 8 units of factor N and &D units of factor > produces &DD meters of cloth. imilarly combinations 2, < and ., employing 9 units of N and J units of >, A units of N and ' units of >, ' units of N and A units of > produce &DD units of output, each. The producer, here., is indifferent as to which combination of inputs he uses for producing the same amount of output. The alternative techni?ues for producing a given level of output can be plotted on a graph.

The figure &8.& shows y the &DD units iso?uant plotted to 1 ) product schedule. The five factor combinations of N and > are plotted and are shown by points a, b, c, d and e. if we /oin these points, it forms an Oiso?uantO. An iso?uant therefore, is the graphic representation of an iso%product schedule. 1t may here be noted that all the factor combinations of N and > on an iso product curve are technically efficient combinations. The producer is indifferent as to which combination he uses for producing the same level of output. 1t is in this way that an iso product curve is also called Oproduction indifference 46

curveO. 1n the figure &8.&, 1 ) product 1, curve represents the various combinations of the two inputs which produce the same level of output (&DD meters of cloth). Iso9%an" Ma+ An iso?uant map shows a set of iso product curves. .ach iso?uant represents a different level of output. A higher iso?uant shows a higher level of output and a lower iso?uant represents a lower level of output.

1n the figure &8.8, a family of three 1so product curves which produce various level of output is shown. The iso product 1M& yields &DD units of output by using ?uantities of inputs N and >. o is also the case with iso?uant 1M9 yielding 9DD units of output. "e conclude that an iso?uant map includes a series, of /so%product curves. .ach iso?uant represents a different level of output. The higher the iso?uant output, the further right will be the iso?uant. ro+er"ies o! Iso9%an" The main +ro+er"ies o! "-e iso?uants are similar to those of indifference curves. These properties are now discussed in brief.

47

/i1 An Iso9%an" slo+es *o8n8ar* !rom le!" "o rig-": This implies that the 1so?uant is a negatively sloped curve. This is because when the ?uantify of factor \ (capital) is increased, the ?uantity of 3 (labor) must be reduced so as to keep the same level of output. The figure (&8.9) depicts that an iso?uant 1, is negatively sloped curve. This curve shows that as the amount of factor \ is increased from one unit to 8 units, the units of factor 3 are decreased from 8D to &' only so that output of &DD units remains constant. /ii1 An Iso9%an" "-a" lies a)o#e an* "o "-e rig-" o! ano"-er re+resen"s a -ig-er o%"+%" le#el:

1t means a higher iso?uant represents higher level of output. The figure &8.A represents this property. 1t shows that greater output can be secured by increasing the ?uantity combinations of both the factors N and >. The producer increases the output from &DD units to 8DD units by increasing the ?uantity combination of both the N and >. The combination of )2 of capital and )3 of labor yield &DD units of production. The production can be increased to 8DD units by increasing the capital from )2 to )2& and labor from )3 to )3. 48

/iii1 Iso9%an"s canno" c%" eac- o"-er:

The two iso?uants cannot intersect each other. 1f two iso?uant are drawn to intersect each other as is shown in this figure &8.', then it is a negation of the property that higher 1so?uant represents higher level of output to a lower 1so?uant. The intersection at point . shows that the same factor combination can produce &DD units as well as 8DD units. ;ut this is ?uite absurd. *ow can the same level of factor combination produce two different levels of output, when the techni?ue of production remains unchanged. *ence two iso?uants cannot intersect each other. /i#1 T-e iso9%an"s are con#e4 "o "-e origin: This property implies that the marginal significance of one factor in terms of another factor diminishes along an 1 ) product curve. 1n other words, the iso?uants are conve# to the origin due to diminishing marginal rate of substitution, 1n this figure &8.H :6
\3

diminishes from '!& to A!& and further to 9!&. This shows that as more and more units of capital (\) are

employed to produce &DD units of the product, lesser and lesser units of labor (3) are used. *ence diminishing marginal rate of technical substitution is the reason for the conve#ity of an iso?uant. /#1 Eac- iso9%an" is o#al s-a+e*: 49

The iso product curve, is elliptical. This means that the firm produces only those segments of the iso%product curves which are conve# to the origin and lie between the ridge lines. This is the economic region of production. ISOCOST LINE A firm can produce a given level of output using efficiently different combinations of two inputs. @or choosing efficient combination of the inputs, the producer selects that combination of factors which has the lower cost of production. The information about the cost can be obtained from the isocost lines.

3et us e#amine a firm which wishes to spend C&DD on a combination of two factors labor and capital for producing a given level of output. "e suppose further that the price of one unit of labor is C' per day. This means that the firm can hire 8D units of labor. )n the other hand if the price of capital is C&D per unit, the firm will purchase &D units of capital. 1n the fig. &8.J, the point A shows &D units of capital used whereas point T shows 8D units of labor are hired at the given price. 1f we /oin points A and T, we get a line AT. This AT line is called isocost line or outlay line. The isocost line is obtained with an outlay of C&DD. 3et us assume now that there is no change in the market prices of the two factors labor and capitab ;ut, the firm increases the total outlay to C&'D. The new price line ;\ shows that with an outlay of C&'D, the producer can purchase &' units of capital or 9D units of labor. The new price line ;\ hifts upward to the right. 1n case the firm reduces the outlay to C'D only, the isocost line 25 shifts downward to the left of original isocost line and remains parallel to the original price line.

50

MINIMIGING COST

The firm minimi$es its cost at the point ReS where the iso?uant M is tangent to the isocost line A;. The optimal combination of factors is )\ and )3. The optimal combination takes place at the point Le7 where the given output can be produced at the least cost. ,oints below OeO are desirable but are not attainable for output M. ,oints above OeO are on higher iso%cost lines and they show higher costs. *ence, the point OeO is the least cost point and it is the lowest cost combination of factors for producing the output M. 1t is produced by )\ amount of capital and )3 amount of labour. At the point of tangency, that is, at point OeO, the slope of isocost line is e?ual to the slope of the iso?uant. This is the first condition for the e?uilibrium. The second condition is that the iso?uant should be conve# to the origin at the point of e?uilibrium. Thus at the point ReS the ratio of marginal product of two factors is e?ual to the ratio of their factor prices.

COST MINIMIGATION The assumption that any enterprise will try to produce its output at the lowest possible cost. This is clearly desirable for a profit%ma#imi$ing firm. 1t is likely to appeal to public bodies also, as a saving of cost in any one pro/ect will either allow lower ta#es, or free resources for other desirable uses. 2ost minimi$ation does however have to be taken with some provisos. 1t is a $om%etitive strategy that is based on producing goods and services more cheaper than competitor firms. According to many commentators, cost minimi$ation is the dominant strategy within <\ business and is also a primary ob/ective of resource%constrained public services. 2ritics claim that it encourages the employment of low%wage and low% skilled labour and promotes adversarial, low%trust employment relations as companies seek continually to reduce head$ount and hold down labor costs. 51

The process or goal of incurring the least possible opportunity cost in the pursuit of a given activity. 2ost minimi$ation is comparable to other ob/ectives, including utility ma#imi$ation and profit ma#imi$ation. This goal, however, is generally used when circumstances constrain a decision. @or e#ample, a government agency has been assigned the task of building a bridge. 1t must now do so at the lowest cost possible.

ROFIT MAIIMIGATION A process that companies undergo to determine the best output and price levels in order to ma#imi$e its return. The company will usually ad/ust influential factors such as production costs, sale prices, and output levels as a way of reaching its profit goal. 1t is the ability for company to achieve a ma#imum profit with low operating e#penses. ,rofit ma#imi$ation is a good thing for a company, but can be a bad thing for consumers if the company starts to use cheaper products raise prices. or decides to

ro*%c" Ma4imi<a"ion ,roduction ma#imi$ation % 1s a direct analogy to utility ma#imi$ation. <tility ma#imi$ation % The process or goal of obtaining the highest level of utility from the consumption of goods or services.

Cos" Minimi<a"ion 1n cost minimi$ation we are doing the reverse4 we move the Rbudget constraintS until we find the optimum. 52

Ma4imi<e ro!i" 5-ile Minimi<e Cos"s Assessing organi$ations does not have to be time consuming or cost a lot of money, and consists of ?ualitative and ?uantitative analysis. 1t re?uires a multi%task analyst to get the /ob done ?uickly and at no cost. Mualitative assessment begins, as you approach the organi$ation, and before you park your vehicles, evaluate the location of the organi$ation, in terms of target customers, raw materials availability, consumer accessibility, product recourses, and ease of marketing. After parking your vehicle, and as you walk into the building, focus on the customer service relation. Assess the relationship between the employees and the customers, employees and employer, and team work among employees. *ow are you welcome, do you receive attention, how do they attend to their customers, and do you see any courtesy on the part of the employees and employerK The ne#t level is to move ahead and ask organi$ation related ?uestions. 1nterview the employer, employees, and when possible pass out a survey for confidential information. 1t is important to know whether the organi$ation is family owned or not. 1t makes a whole lot of difference in the world. 1f it is, the culture will be different regarding employeesO loyalty, rigidity in e#pansion, afraid of change to new ideas or technology, and organi$ation abuse by family members. Also, which member of the family has ultimate control of the businessK ome family members run their business with their hearts rather than their heads. 1ndividuals in this category only care about keeping the business running without consideration of the cost control, account receivables and payables. :ost of this information usually comes from employer or one loose employee in an organi$ation, who is willing to give out valuable information that will enhance the value of the organi$ation. Assessing an organi$ation is an indirect investigative /ob, but in this case is for the benefit of the organi$ation. The ?uantitative assessment involves the evaluation of the financial statement. This includes the balance sheet, income statement (,c3), and cash flow. .valuation of each document will give a general idea in a nut%shell of how 53

organi$ation is performing and where it stands. A look at the last three or four year financial statement will give an average of an organi$ationOs financial standing. 2alculating all the key indices will show where the linkages are, and the contributor of the linkages. ;y the time the analysis is complete, the following review would have been taken! labor cost, administration, operations, overhead, break%even utili$ation, sales and marketing, cash flow management, ta# planning, web site, material cost, productivity, incentives, cost controls, material flow, organi$ation re%engineering, possibility of e#pansion and globali$ation if applicable. These areas will give a snap%shot of how the organi$ation could be improved. .valuation will be performed to determine the problems and the cost associated (soft and hard problem costs) with them. Again, these potential problem costing areas will need to be calculated! productivity, pricing, safety, advertising, ?uality control, communication, meetings, training, employee turnover, compensation, incentives, depreciation, proper financing, purchasing, overtime, margin mi#, material wastes, cash management, billing procedures, collection procedure, and sweep account. At the end, focus will include the following! lost profits4 lost income4 e#cess inventory4 scrap, waste, rework4 productivity4 debt load4 attrition4 and hidden cost.

THE COST FUNCTION A mathematical formula created for the purpose of estimating a cost, e.g. the cost of making an observation when it varies from stratum to stratum of a collection of data. ratio o" total $ost to -uantity %rodu$ed 1t is derived from the production function, which describes the efficient method of production at any given time. A cost function may be either linear or nonlinear. The general formula for a linear relationship is y Ga F b#,

. @a J )4 aG intercept 54

bG slope #G activity The possible measures of activity # include! units of product machine%hours dollar sales volume mileage driven

Hig-2Lo8 Me"-o*

55

LONG2RUN OF COSTS ECONOMIES OF SCALE De!ini"ion o! Terms .conomies cale cope 1t is linked to the benefits gained by producing a wide variety of products by efficiently utili$ing to same operations. 1t is all about the benefits gained by the production of large volume of a product. 1t is all about effectiveness.

ECONOMIES OF SCALE

The advantages of large scale production that result in lower (average cost) (cost per unit) Average 2ost G Total 2ost0 Muantity 56

.conomies of cale spreads total costs over a greater range of output 6efer to the situation in which the cost of producing an additional unit of output (i.e., the marginal $ost) of a product (i.e., a good or service) decreases as the volume of output (i.e., the s$ale of production) increases

1t could also be defined as the situation in which an e?ual percentage increase in all inputs results in a greater percentage increase in output. The increase in efficiency of production as the number of goods being produced increases. Typically, a company that achieves economies of scale lowers the average cost per unit through increased production since fi#ed costs are shared over an increased number of goods.

.conomies of scale are production efficiencies reali$ed when per%unit costs are reduced as the ?uantity produced increases. 1n business, scale is si$e, and in many business situations, as a company produces more output, the average cost of that output declines. .conomies of scale are the result of efforts that improve efficiency. The basic notion behind economies of scale is well known! As a plant gets larger and volume increases, the average cost per unit of output is e#pected to drop. This is partially because relative operating and capital costs decline, since a piece of e?uipment with twice the capacity of another piece does not cost twice as much to purchase or operate. 1f average unit production cost G variable costs F fi#ed costs0output, one can see that as output increases the fi#ed costs0output figure decreases, resulting in decreased overall costs. 6n addition to s%e$ialization and the division o" labor+ ithin any $om%any there are various in%uts that may result in the %rodu$tion o" a good andAor servi$e#

Lo8er in+%" cos"s: "hen a company buys inputs in bulk % for e#ample, potatoes used to make @rench fries at a fast food chain % it can take advantage of volume discounts. (1n turn, the farmer who sold the potatoes could also be achieving . if the farm has lowered its average input costs through, for e#ample, buying fertili$er in bulk at a volume discount.)

Cos"l. in+%"s: ome inputs, such as research and development, advertising, managerial e#pertise and skilled labor are e#pensive, but because of the possibility of increased efficiency with such inputs, they can lead to a decrease in the average cost of production and selling. 1f a company is able to spread the cost of such inputs over an increase in its production units, . can be reali$ed. Thus, if the fast food chain chooses to spend more money on technology to eventually increase efficiency by lowering the average cost of hamburger assembly, it would also have to increase the number of hamburgers it produces a year in order to cover the increased technology e#penditure. 57

S+eciali<e* in+%"s: As the scale of production of a company increases, a company can employ the use of speciali$ed labor and machinery resulting in greater efficiency. This is because workers would be better ?ualified for a specific /ob % for e#ample, someone who only makes @rench fries % and would no longer be spending e#tra time learning to do work not within their speciali$ation (making hamburgers or taking a customerOs order). :achinery, such as a dedicated @rench fry maker, would also have a longer life as it would not have to be over and0or improperly used.

Techniques and Organizational inputs: "ith a larger scale of production, a company may also apply better organi$ational skills to its resources, such as a clear%cut chain of command, while improving its techni?ues for production and distribution. Thus, behind the counter employees at the fast food chain may be organi$ed according to those taking in%house orders and those dedicated to drive%thru customers.

Learning in+%"s: imilar to improved organi$ation and techni?ue, with time, the learning processes related to production, selling and distribution can result in improved efficiency % practice makes perfectb

T-ere are "8o ".+es o! economies o! scale: .#ternal economies % the cost per unit depends on the si$e of the industry, not the firm. 1nternal economies % the cost per unit depends on si$e of the individual firm.

In"ernal Economies Tec-nical Managerial <se of specialists accountants, marketing, lawyers, production, human resources, etc. pecialisation large organisations can employ specialised labour

1ndivisibility of plant machines can7t be broken down to do smaller /obs ,rinciple of multiples firms using more than one machine of different capacities % more efficient 1ncreased dimensions bigger containers can reduce average cost

Mar,e"ing0Commercial 58

 Financial Ris, 3earing

3arge firms can negotiate favourable prices as a result of buying in bulk 3arge firms may have advantages in keeping prices higher because of their market power

3arge firms able to negotiate cheaper finance deals 3arge firms able to be more fle#ible about finance share options, rights issues, etc. 3arge firms able to utilise skills of merchant banks to arrange finance

5iversification :arkets across regions0countries ,roduct ranges 6c5

E4"ernal Economies The advantages firms can gain as a result of the growth of the industry normally associated with a particular area upply of skilled labour 6eputation 3ocal knowledge and skills 1nfrastructure Training facilities

o"en"ial Limi"s "o Economies o! Scale :arket demand may be insufficient for businesses to fully e#ploit the scale economies. @alling demand in a recession % capital will be under%utilised leading to e#cess capacity and rising average total costs. R-iche marketsS allow smaller%scale producers to supply at higher cost because consumers are willing to pay a higher price. 59

ome large units of fi#ed capital may not be transferable to other uses if there is a sudden switch in consumer demand. A business may e#pand beyond the optimal si$e in the long run and e#perience diseconomies of scale.

Diseconomies o! Scale This occurs when production is less than in proportion to inputs. "hat this means is that there are inefficiencies within the firm or industry resulting in rising average costs. They could stem from inefficient managerial or labor policies, over%hiring or deteriorating transportation networks (e#ternal 5 ). @urthermore, as a companyOs scope increases, it may have to distribute its goods and services in progressively more dispersed areas. This can actually increase average costs resulting in diseconomies of scale.

ECONOMIES OF SCO E The average total cost of production decreases as a result of increasing the number of different goods produced .conomies of scope e#ist if a firm can produce several product lines at a given output level more cheaply than a combination of separate firms each producing a single product at the same output level. .conomies of scope occur where it is cheaper to produce a 8i*er range o! +ro*%c"s rather than speciali$e in /ust a handful of products. .conomies of scope can also operate through distribution efficiencies. .conomies of scope occur when there are cost%savings arising from by%products in the production process.

Diseconomies o! Sco+e :ulti%product production by a single firm that is less efficient than having separate firms each speciali$ing in the production of a single product. /t some %oint+ additional advertising ex%enditure on ne %rodu$ts may start to be less e""e$tive

METHODS OF ROCURING IN UTS

60

S OT EICHANGE is an informal relationship between a buyer and a seller in which neither party is adhere to specified terms for e#change. Advantages! This makes the firm speciali$es in doing what it does best % that is converting inputs into outputs.

obligated to

The parties are anonymous with each other has no long term commitment with each other, no deeper relationship with one another. ,arties can easily part ways, in case they are not satisfied with the transaction.

5isadvantages! )pen to opportunism. "aste of time in bargaining for cost. <nder investment

CONTRACT is a legal document or formal relationship between a buyer and a seller that obligates the buyer and seller to e#change at terms specified in a legal document. Advantages! This makes a firm speciali$es in doing what it does best% that is converting inputs into outputs There is long term commitment. 6educed the magnitude of opportunism.

+uaranteed price and time for both parties.

5isadvantages! 2ostly to write as you will be needing the service of a lawyer 5ifficult to cover all contingencies that may arise in the future.

&ERTICAL INTEGRATION a situation where a firm produces the inputs re?uired to make its final product. Advantage! -o need to rely on other suppliers to produce a desired input. This eliminates the middleman.

5isadvantages! The firm loses the gains in speciali$ation since it has to manage the production of inputs as well as the production of final products produced with those inputs. 61

2ostly

TRANSACTION COSTS cost associated with ac?uiring an input that are in e#cess of the amount paid to the input supplier such as!! The cost of searching for a supplier willing to sell a given input. The costs of negotiating a price at which the input will be purchased. This maybe in terms of cost of time and legal fees, )ther investment and e#penditures re?uired to facilitate e#change. .#ample ! if the input supplier re?uires you to furnish your own truck and driver to pick up the input with a unit cost of C&D.DD. The price of the input is C&D plus the cost of the truck and the driver. *owever, there are transaction costs that are less obvious. "e call it hidden cost. *idden costs are sometimes general in nature or specific to a particular trading relationship. The key to this distinction is the notion of a R peciali$ed 1nvestment.S S+eciali<e* In#es"men" is simply an e#penditure that must be made to allow two parties to e#change but cannot be recovered in another trading relationship.

E4am+les o! S+eciali<e* In#es"men": ite pecificity ,hysical Asset pecificity 5edicated Asset Im+lica"ions o! S+eciali<e* In#es"men"s 2ostly ;argaining e#. ,rice <nderinvestment e#. *uman capital )pportunism e#. 5iagnostic fee

O TIMAL IN UT ROCUREMENT "hen the desired input does not involve speciali$ed investments, the firm can use spot e#change to obtain the input without concern for opportunism and bargaining cost. ;y purchasing the inputs from the supplier the firm can speciali$e in doing what it does best rather than writing contracts or engaging in vertical integration. 62

"hen substantial speciali$ed investments are re?uired to facilitate e#change and the cost of writing a contract is less rather than the transaction costs associated with spot e#change, it is optimal to ac?uire the input through a contract. 1n this case the optimal contract length is determined by the intersection of the marginal cost and marginal benefits of writing a longer contract. @inally, when substantial speciali$ed investments are re?uired and the desired input has comple# characteristics that are difficult to specify in a contract or it is very costly to write into a contract all the clauses needed to protect the parties from changes in future conditions, the manager should integrate vertically to minimi$e the cost of ac?uiring inputs needed for production%provided the cost of integration is not too high.

MANAGERIAL COM ENSATION AND THE RINCI AL2AGENT RO3LEM 1n separating ownership from control, the owner usually will hire a manager to oversee the business. The owner is not around to monitor the manager, to get him to do what is in the best interest of the owner. The manager on the other hand likes to earn income, but he also likes to consume leisure. This is where the ,rincipal%Agent problem emerges. 1ndeed, there is a similar problem between the manager and the employees she or he supervises. Sol%"ions "o "-e rinci+al2Agen" ro)lem 1ncentive 2ontracts such as stock options and bonuses .#ternal 1ncentives demonstrate to other firms that managers have the managerial skills needed to ma#imi$e profits Takeovers

Sol%"ions "o "-e Manager25or,er rinci+al2Agen" ro)lem ,rofit haring 6evenue haring ,iece 6ate Time 2locks and pot 2hecks

63

MODULE K: MAR'ET STRUCTURES: RICING AND OUT UT DECISIONS

THE NATURE OF INDUSTRY *ow does market mechanism workK @irms and consumers are too small to affect the price in perfect competition. :ost industries are imperfectly competitive and are classified in three ma/or features of different market structures! monopoly, oligopoly, and monopolistic competition. 1mperfect competition prevails in industry whenever individual sellers can affect the price of their output.

TY ES OF MAR'ET STRUCTURES N%m)er o! ro*%cers an* *egree o! +ro*%c" STRUCTURE *i!!eren"ia"ion @inancial markets ,.6@.2T 2):,.T1T1)1:,.6@.2T 2):,.T1T1):any producers4 :onopolistic 2ompetition many real or perceived differences 6etail trade ome Advertising and ?uality rivalry4 64 :any producers4 identical products and agricultural products -one ar" o! econom. 8-ere +re#alen" FirmLs *egree o! con"rol o#er +rice :arket e#change or auction Me"-o*s o! Mar,e"ing

in product @ew producers4 little or no difference in )ligopoly product @ew producers4 products are differentiated teel, chemicals 2ars, word processing software @ranchise monopolies ingle producer4 product without close :onopoly substitutes (electricity, water, : windows, patented drugs)

administered prices

2onsiderable Advertising

ERFECT COM ETITION These are ideali$ed markets in which firms and consumers are too small to affect the price. 1n this market structure we analy$e how a competitive firm behaves, how much should the firm produceK *ow much product to produce if to sell at a certain dollar priceK Analy$ing perfectly competitive firms relies on two key assumptions. @irst, we will assume that our competitive "irm maximizes %ro"its# econd, we reiterate that perfect competition is a world of atomisti$ "irms ho are %ri$e ta!ers# ,erfect competition is the world of %ri$e,ta!ers# A perfectly competitive firm sells a homogeneous %rodu$t 0one identi$al to the %rodu$t sold by others in the industry1. The firm is so small relative to its market that it cannot affect the market price4 it simply takes the price as given. .#ample is @armer mith sells a homogeneous product like wheat4 it sells to a large pool of buyers at the market price of CH per bushel. dust as consumers must generally accept the prices that are charged by 1nternet access providers or movie theaters, so must competitive firms accept the market prices of the wheat or oil that they produce. "e can depict a price%taking perfect competitor by e#amining the way demand looks to a perfectly competitive firm. ;ecause competitive firms cannot affect the price, the price for each unit sold is the e#tra revenue that the firm will earn. @or 65

e#ample, at a market price of CAD per unit, the firm can sell all it wants at CAD. 1f it decides to sell &D& units rather than &DD units, its revenue goes up by e#actly CAD. C-arac"eris"ics o! er!ec" Com+e"i"ion &. There are many small firms, each producing an identical product and each too small to affect the market price. 8. The perfect competitor faces a completely hori$ontal demand (55) curve. 9. The e#tra revenue gained from each e#tra unit sold is therefore the market price.

3igure 8,1 Borizontal demand or :: $urve Com+e"i"i#e S%++l. 5-ere Marginal Cos" E9%als rice 7 D &,DDD 8,DDD 9,DDD 9,III A,DDD A,&DD ',DDD TC 9D,DDD 9',DDD HD,DDD ID,DDD &'I,IHD &HD,DDD &H',DDD 8&D,DDD ' 8' 9D JD AD 'D 'D 9'.DD 9D.DD 9D.DD AD.DD AD.DD AD.8A A8.DD AD.DD AD.DD AD.DD AD.DD AD.DD AD.DD AD.DD AD,DDD BD,DDD &8D,DDD &'I,IHD &HD,DDD &HA,DDD 8DD,DDD ',DDD 8D,DDD 9D,DDD D % (&,DDD.DD) (&D,DDD) MC0Uni" AC TR ROFIT

66

70.00 60.00 50.00 40.00 30.00 20.00 10.00 1,000 2,000

Perfect Competition-Maximum Profit

P MC/ Unit

3,000

3,999

4,000

4,100

5,000

The ma#imum profit comes at that output where marginal cost e?uals price. That is at CAD at ?uantity of A,DDD units. The firm selling at &,DDD%8,DDD units will gain a positive profit because :2<U,. elling at 9,DDDunits will result to a loss of C',DDD because :2<T,. The reason underlying this proposition is that the competitive firm can always make additional profit as long as the price is greater than marginal cost of the last unit. Total profit reaches its peak%is ma#imi$ed%when there is no longer any e#tra profit to be earned by selling e#tra output ma#imum profit is :2 per unit is e?uals to ,rice per unit. At the ma#imum profit point, the last unit produced brings in an amount of revenue e#actly e?ual to the unit7s cost. "hat is e#tra revenueK 1t is the price per unit. "hat is the e#tra costK 1t is the marginal cost.

IM ERFECT COM ETITION Oligo+ol.

67

An oligopoly is a market dominated by a few large suppliers. The degree of market concentration is very high (i.e. a large ( of the market is taken up by the leading firms). The important feature of oligopoly is that each individual firm can affect the market price. .#amples! 1n the airline industry, the decision of a single airline to lower fares can set off a price war which brings down the fares charged by all its competitors.

MONO OLY ,ure monopoly e#ists when a single firm is the sole producer of a product for which there are no close substitutes, single seller with complete control over an industry. They are very desirable from the point of view of a company and, usually, not very desirable for consumers. :ono% +reek word for RoneS ,olist% +reek word for RsellerS T-ree c-arac"eris"ics *e!ine +%re mono+ol.: &. 8. 9. There is a single seller. There are no close substitutes for the firm7s product. There are barriers to entry. "hereas the %er"e$tly $om%etitive "irm was a price taker, the mono%olisti$ "irm is a +rice ma,er. That is, it has control over the price. .#amples of monopoly are public utilities such as gas, electric, water, cable T=, and local telephone service companies, professional sports teams, 5e;eers, and Alcoa. Also, monopolies may e#ist at the local level because of geographic location. ;arriers to entry are the main line of defense for incumbent monopolies and may be of different types. )$onomies o" s$ale $onstitute one maCor barrier. They occur where decreases in unit costs depend on output si$e. 1n this case, because a large firm with a large market share is most efficient, new firms cannot afford to enter the market and gain market shares. ,ublic utilities are known as natural monopolies because they possess such economies of scale. ;arriers to entry also e#ist in legal forms as patents or licenses. ,atents grant the inventor the e#clusive right to produce a product for 8D years (new worldwide patent period established with a &II' +ATT agreement). 3icenses are granted by the government and allow only one or few firms to operate in a given market. @inally, barriers to entry may arise from the e#clusive ownership or control of essential resources. 68

ince there is only one company, the monopolist is a price maker. That is, the company controls output or price though not both. .ven the monopolist has to deal with its market conte#t. <ltimately, its profits depend on its ability to sell, that is, on the market demand for its product. *ow does a monopolist decide how much to produce and at what price to sellK As for perfect competition, crucial information is summari$ed by the demand curve. ince there is only one firm, in the case of the monopolist, the market and the company7s demand curves are identical. A monopoly demand is the industry (market) demand and is, therefore, illustrated by a downward sloping curve.

As in perfect competition, the profit ma#imi$ing solution for the monopolist is obtained when :2 G :6. <nlike imperfect competition, however, monopoly +rice e4cee*s marginal re#en%e because the monopolist must lower its price in order to increase sales. @or each price cut, revenue increases by an amount e?ual to the price of the last unit sold minus the sum of the price cuts which must be taken on all prior units of output. .verything works in reverse if we consider a price increase. The trade%off between price and sales is the reason why the marginal revenue is always below the demand curve. @inally, since the monopolist produces where :6 G :2 and , T :6, then , T :2 is also true. A monopolist charges a higher price than would competitive producers selling in the same market. @igure & illustrates profit ma#imi$ation under monopoly.

Profit Maximization under Monopoly

Fig%re 1 69

P
200 175 150 125 100

MC

Profit

ATC D

75 50 25

MR Q
0 1 2 3 4 5 6 7 8 9 10

2learly, the price elasticity of demand plays a crucial role in monopoly price setting. As long as demand is elastic, total revenue will rise when the monopoly lowers its price, but this will not be true when demand becomes inelastic. Therefore, the monopolist will e#pand output only in the elastic portion of its demand curve. A monopolist, like any other company, does not care about charging the highest price it can get, it cares about selling as close as possible to the ?uantity of output that ma#imi$e its profits. @inally, remember that, in monopoly, losses can occur. They are, in fact, relatively common in regulated monopoly where the government subsidi$es low per unit prices (e.g. utilities). 1f monopoly creates substantial economic inefficiency and appears to be long%lasting, antitrust laws can be used to break up the monopoly (:icrosoft). @igure 8 illustrates loss minimi$ation under monopoly.

Fig%re 6 Loss Minimization under Monopoly

P
200 175 150

Loss Per Unit

MC ATC
Loss

125 100 75 50

AVC D
70

MR = MC
25

MR

10

Ho8 Mono+olies can *e#elo+A Hori<on"al In"egra"ion. "here 8 firms /oin at the same stage of production, e.g. 8 banks such as T ; and 3loyds &er"ical In"egra"ion. "here a firm gains market power by controlling different stages of the production process. A good e#ample is the oil industry. "here the leading firms produce, refine and sell oil Legal Mono+ol.$ ..g. 6oyal :ail or ,atents In"ernal E4+ansion o! a !irm. @irms can increase market share by increasing their sales and possibly benefiting from economies of scale 3eing "-e Firs" Firm e.g. :icrosoft

A*#an"ages o! Mono+ol.

6esearch and 5evelopment. upernormal ,rofit can be used to fund high cost capital investment spending. uccessful research can be used for improved products and lower costs in the long term. ..g. Telecommunications and ,harmaceuticals.

71

.conomies of scale. 1ncreased output will lead to a decrease in average costs of production. These can be passed on to consumers in the form of lower prices.

1f a monopoly produces at output M&, average costs (A2 &) are much lower than if a competitive market had firms producing at M8 (A2 8).

1nternational 2ompetitiveness. A domestic firm may have :onopoly power in the domestic country but face effective competition in global markets. ..g. ;ritish teel

A firm may become a monopoly through being efficient and dynamic. A monopoly is thus a sign of success not inefficiency. @or e#ample % +oogle

A :onopolist is a price maker because he does not face any competitors.

Disa*#an"ages o! a Mono+ol.

72

+reen area G upernormal ,rofit (A6%A2) M ,ink area G 5eadweight welfare loss (combined loss of producer and consumer surplus) compared to competitive market *igher ,rice and 3ower )utput than under ,erfect 2ompetition. This leads to a decline in consumer surplus and a deadweight welfare loss

Allocative 1nefficiency. A monopoly is allocatively inefficient because in monopoly the price is greater than :2. , T :2. 1n a competitive market the price would be lower and more consumers would benefit

,roductive 1nefficiency A monopoly is productively inefficient because it is not the lowest point on the A2 curve. N % 1nefficiency. % 1t is argued that a monopoly has less incentive to cut costs because it doesnOt face competition from other firms. Therefore the A2 curve is higher than it should be.

upernormal ,rofit. A :onopolist makes upernormal ,rofit Mm e (A6 A2) leading to an une?ual distribution of income. 3ower ,rices to uppliers % A monopoly may use its market power and pay lower prices to its suppliers. ..g. upermarkets have been critici$ed for paying low prices to farmers.

5iseconomies of cale % 1t is possible that if a monopoly gets too big it may e#perience diseconomies of scale. % higher average costs because it gets too big

"orse products% 3ack of competition may also lead to improved product innovation. 2harge higher prices to suppliers. :onopolies may use their supernormal profits to charge higher prices to suppliers.

73

MONO OLISTIC COM ETITION

5-a" Does Monopolistic Competition MeanA A type of competition within an industry where! &. All firms produce similar yet not perfectly substitutable products. 8. All firms are able to enter the industry if the profits are attractive. 9. All firms are profit ma#imi$ers. A. All firms have some market power, which means none are price takers. :onopolistic competition differs from perfect competition in that %rodu$tion does not ta!e %la$e at the lo est %ossible $ost. ;ecause of this, firms are left with ex$ess %rodu$tion $a%a$ity# 1n this situation, a large number of sellers produce differentiated products. Di!!eren"ia"e* +ro*%c"s are ones whose important characteristics vary. ,ersonal computers for e#ample, have differing characteristics such as speed, memory, hard disk, modem, si$e, si and weight. ;ecause computers are differentiated, they can sell at slightly different prices. The classic case of monopolistic competition is the retail gasoline market. >ou may go to local hell station, even though it charges slightly more, because it is on your way to work. ;ut if the price at hell raises more than a few pennies above the competition, you might switch to the other station a short distance away. So%rces o! Mar,e" Im+er!ec"ions "hy do some industries display near%perfect near competition while others are dominated by a handful of large firmsK :ost cases of imperfect competition can be traced to two principal causes!

74

&. 2osts and :arket 1mperfection. 1ndustries tend to have fewer sellers when there are significant economies of large% scale production and decreasing costs. <nder these conditions, large firms can simply produce more cheaply and then undersell small firms, which cannot survive. 8. ;arriers to .ntry. :arkets tend toward imperfect competition when there are Rbarriers to entryS that make it difficult for new competitors to enter and industry. 1n some cases, the barriers may arise from government laws or regulations which limit the number of competitors. 1n other cases, there may be economic factors that make it e#pensive for a new competitor to break into a market.

Cos"s an* Mar,e" Im+er!ec"ion The technology and cost structure of an industry help determine how many firms that industry can support and how big they will be. The key is whether there are economies of scale in an industry. 1f there are economies of scale, a firm can decrease its average costs by e#panding its output, at least up to a point. That means bigger firms will have a cost advantage over smaller firms. "hen economies of scale prevail, one or a few firms will e#pand their outputs to the point where they produce most of the industry7s total output. The industry then becomes imperfectly competitive. ,erhaps a single monopolist will dominate the industry4 a more likely outcome is that a few large sellers will control most of the industry7s output4 or there might be a large number of firms, each with slightly different products. *ow the relationship between the si$e of the market and the scale of economies helps determine the market structureK The model of monopolistic competition puts our situation into a more familiar form of demand and cost curves. The illustration below shows a seller with a downward%sloping demand curve and a conventional marginal cost curve. ;ecause the demand curve slopes downward, the marginal revenue curve lies below it. The seller ma#imi$es profit by selecting that output at which marginal revenue e?uals marginal costs and charges as much as he can, which is price 6. 1n the long run, there can be no economic profit because there is free entry into the industry. 1f there are any profits, others will enter the industry, positioning them to take away customers from the most profitable sellers. The $ero profit condition implies that at e?uilibrium, average revenue (which is demand) must /ust e?ual average cost. "hen average revenue e?uals average cost, average profit is $ero, and so total profit must also be $ero.

75

The model of monopolistic competition was considered important when it was introduced for two reasons. @irst, the situation it described seemed the most common form of industry. ;oth the single sellers of monopoly and the many sellers of price%taking competition are uncommon in comparison. @urthermore, monopolistic competition describes more than traveling costs in a geographical sense. The distance between sellers can be in the minds of buyers. ,roduct differentiation, which results in many products that are similar but not identical, also creates a distance between products. 1t was this distance that seemed especially important to the developers of monopolistic competition.& econd, notice that because price e#ceeds marginal cost, the graph contains a gray area of 8el!are loss, an une#ploited value that neither firms nor customers obtain. ;ecause monopolistic competition was seen as both common and economically inefficient, it was argued that market systems were inherently inefficient. *owever, the welfare loss in the case of monopolistic competition may be illusionary. @irms could obtain this value if they could price discriminate, selling beyond 9M up to 9o. 1f they do not do so, then the resources needed to obtain the information re?uired to price in this fashion must be more valuable than the triangle of une#ploited value. )r consider possible government solutions. The problem is that sellers are too small and charge too high a price. The government could react by limiting the number of sellers and forcing them to charge lower prices. ;ut this policy would increase traveling costs of buyers. The market may not give the optimal number of sellers (and hence the optimal distance between them), but the cost of gathering the information that would let government decide the matter is almost certainly greater than any possible welfare gain (even ignoring the political incentives that always go with government solutions).

76

ome economists have argued that the distance between products is often phony, that firms differentiate products to fool consumers. Their argument is surely correct in many cases. 1n other cases, however, product differentiation e#ists because it reflects differences in peopleOs tastes. Again, there is a cost to deciding whether in each case product differentiation manipulates buyers or caters to them. 1t is not clear that any government policy that tries to eliminate PbadP differentiation will have benefits that e#ceed its costs. "hen the cost of correcting a problem e#ceeds the possible gain from the correction, is there any real welfare loss by allowing the problem to continueK The model of monopolistic competition shows that real market systems fall short of theoretical constructs that assume away the problems of information and of making agreements among people. ;ut any real%world system looks bad compared to theory that assumes away problems. @inally, the theory developed above does have at least one interesting use in e#plaining the real world. "hen traveling costs are reduced, people become more price%sensitive, which means that the demand curve facing each seller gets more elastic. As a result, the marginal revenue curve shifts upward and will intersect the marginal cost curve at a higher ?uantity (or greater distance). @or individual firms to e#pand sales when the industry sales are constant re?uires some firms to disappear. 6educing traveling costs reduces the number of firms, and development of the automobile and the highway system drastically cut traveling costs in the <nited tates. 3arriers "o En"r. Although cost differences are the most important factor behind market structures, barriers to entry can also prevent effective competition. These are the factors that make it hard f or new firms to enter an industry. "hen barriers are high, an industry may have few firms and limited pressure to compete. T.+e o! 3arriers 1$ Legal res"ric"ions$ +overnments sometimes restrict competition in certain industries. 1mportant legal restrictions included patents, entry restrictions, and foreign%trade tariffs and ?uotas. A %atent is granted to an inventor to allow temporary e#clusive use (or monopoly) of the product or process that is patented. .#amples, pharmaceutical companies are often granted valuable patents on new drugs in which they have invested high cost on research and development dollars. ,atents are one of the few forms of government% granted monopolies that are generally approved by economists. "ithout the prospect of monopoly patent protection, a company or a sole inventor might be unwilling to devote time and resources to research and development. The temporarily high monopoly price and the resulting inefficiency is the price of society pays for the invention.

77

+overnments also impose entry restrictions on many industries. Typically, utilities, such as telephone, electricity distribution, and water are given "ran$hise mono%olies to serve an area. 1n these cases, the firm gets an e#clusive right to provide a service, and in return the firm agrees to limit its prices and provide universal service in its region even when some customers might be unprofitable. 6$ Hig- Cos" o! En"r.$ This is the economic barrier. 1n some industries the price of entry simply may be very high. Take the commercial%aircraft industry, high cost of designing and testing new airplanes serves to discourage potential entrants into the market. 1t is likely that only two companies ;oeing and Airbus% can afford the C&D to C8D billion that the ne#t generation of aircraft will cost to develop. 1n addition, companies build up intangible forms of investment, and such investments might be very e#pensive for any potential new entrant to match. 2onsider the software industry. ($ A*#er"ising an* ro*%c" Di!!eren"ia"ion$ ometimes it is possible for companies to create barriers to entry for potential rivals by using advertising and product differentiation. Advertising can create product awareness and loyalty to well%known brands. @or e#ample, ,epsi and 2oca% 2ola spend hundreds of millions of dollar per year advertising their brands, which makes it very e#pensive for any potential rivals to entry the cola market.

Mono+ol. 3e-a#ior
"hat do monopolists doK 1f the monopolist is a private firm, generally we assume that it chooses the level of output to ma#imi$e profits. As an accounting matter, profits (,6) are e?ual to total revenue (T6) minus total costs (T2)! ,6 G T6 T2. @or any firm, not /ust a monopolist, it can be shown that profit will be ma#imi$ed at the ?uantity where marginal revenue is e?ual to marginal cost! :6 G :2 "hat makes a monopolist different from a competitive firm is that it faces a downward sloping demand curve! it knows that it will have to cut its price in order to sell more output. As a result, its :6 curve will slope down rather than being flat like competitive firms.

ro!i" Ma4imi<ing Con*i"ions *ow a monopolist should set its ?uantity and price if it wants to ma#imi$e profitsK ;y definition, total profits e?uals total revenue minus total costs4 T,GT6%T2G (, # M) % T2. :a#imum profit will occur when output is at that level where the firm7s marginal revenue is e?ual to its marginal cost. 7 D & 8 9 TC 9DD.DD 8B'.DD 9D'.DD 8J'.DD 98D.DD 8H'.DD 9A'.DD 8''.DD TR D.DD 8J'.DD '9D.DD JH'.DD '.DD 8J'.DD 9D'.DD 8J'.DD &'.DD 8''.DD &HD.DD 8H'.DD 8'.DD 89'.DD &&'.DD 8''.DD %9D.DD 8&D.DD A8D.DD 78 MC MR AC AR ro!i"

A ' H J B I &D && &8 &9 &A &'

9BD.DD 8A'.DD

IBD.DD

9'.DD 8&'.DD A'.DD &I'.DD ''.DD &J'.DD H'.DD &''.DD J'.DD &9'.DD B'.DD &&'.DD I'.DD I'.DD J'.DD ''.DD 9'.DD &'.DD %'.DD

I'.DD 8A'.DD B'.DD 89'.DD BD.DD 88'.DD JJ.BH 8&'.DD

HDD.DD J'D.DD BJD.DD IHD.DD

A8'.DD 89'.DD &,&J'.DD ABD.DD 88'.DD &,9'D.DD 'A'.DD 8&'.DD &,'D'.DD H8D.DD 8D'.DD &,HAD.DD JD'.DD &I'.DD &,J''.DD BDD.DD &B'.DD &,B'D.DD

JJ.'D 8D'.DD &,D8D.DD JB.99 &I'.DD &,D'D.DD BD.DD &B'.DD &,D'D.DD B8.8J &J'.DD &,D8D.DD B'.DD &H'.DD BB.DB &''.DD I&.A9 &A'.DD I'.DD &9'.DD IHD.DD BJD.DD J'D.DD HDD.DD

ID'.DD &J'.DD &,I8'.DD &D'.DD &,D8D.DD &H'.DD &,IBD.DD &&'.DD &,&A'.DD &''.DD 8,D&'.DD &8'.DD &,8BD.DD &A'.DD 8,D9D.DD &9'.DD &,A8'.DD &9'.DD 8,D8'.DD &A'.DD

300.00 250.00 200.00 150.00 100.00 50.00 0.00 1 -50.00 2 3 4 5 6

Monopoly Behavior

P MR MC

10

11

12

13

14

15

79

Monopoly- Proft and Loss

2,500.00

2,000.00

1,500.00
Profit

1,000.00

TR TC

500.00

0.00 1 -500.00 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Assumptions! dis$uss details and %ro$esses &. ,roduction is twice itself thus Mf8 8. A2 and A6 is divided at average M thus no need to f8 9. eller reached its ma#imum profit at M%&D A. ,rice is dropping and yet profit is getting lower. "hyK This is to sell more M (eco. inefficiency), to sell e#cess production price should be lower '. eller produced higher M due to hedging (discuss hedging c speculation activities of investor) H. 5iscuss theory of investorOs speculation vs law of demand c supply J. 5iscuss concept of Ospot marketO ! 3ondon%based 1nternational ,etroleum .#change (1,.) and the -ew >ork :ercantile .#change (->:.N) ;ut why is the oil crisis a global crisisK 1s it really beyond the government controlK The ,hilippines, like many other nations, buys the oil at the spot market. ;y PspotP is meant, that one buys the oil at a market only 8A to AB hours before one takes physical (spot) delivery, as opposed to buying it &8 or more months in advance. 1n effect, the spot market inserted a financial middleman into the oil patch income stream. Today, the oil price is largely set in the two futures markets! 3ondon%based 1nternational ,etroleum .#change (1,.) and the -ew >ork :ercantile .#change (->:.N). *ere, traders or investors buy or sell certain commodities like oil at a certain date in the future, at a specified price. ;asically, traders invest in the futures market by buying futures contracts called Ppaper oilP or simply paper claim against oil. The very purpose of buying oil is not to wait for the actual delivery of the 80

physical oil in the future, but to sell the paper oil to another trader at a higher price. ThatOs how investors engage in widespread speculation4 and it is becoming a viscous cycle. Almost all countries, including the ,hilippines, buy the oil at the spot market where the price is already at its peak. 1nsert concept of hedging hereb 1n a year 8DDD study, .#ecutive 1ntelligence 6eview (.16) showed that for every 'JD Ppaper barrels of oilP%that is futures contracts covering 'JD barrels%traded each year, there was only one underlying physical barrel of oil. The 'JD paper oil contracts pull the price of the underlying barrel of oil, manipulating the oil price. 1f the speculators bet long%that the price will rise%the mountain of bets pulls up the underlying price (=aldes 8DD'). This only disproves the popular assumption that oil price hike has something to do with the Plaw of supply and demand.P 1n fact, as much as HD( of todayOs crude oil price is pure speculation driven by large trader banks and hedge funds. 1t has nothing to do with the convenient myths of ,eak )il. 1t has to do with control of oil and its price (.ngdahl 8DDB). 1n its recent statement, 1;)- @oundation cited a study conducted by the <. . enate ,ermanent ubcommittee on 1nvestigations, which revealed that 9D percent or more of the prevailing crude oil cost is driven only by speculation. 1;)further cited that speculation adds about C9' to a barrel of crude oil (:artine$ 8DDB). Rela"e* Ar"icles Are Mono+olies al8a.s )a*A 6eaders Muestion! 1f monopoly is always bad, why do firms seek to become monopolists and why does government tolerate monopolyK 1t is true that :onopolies have many disadvantages for society! &. *igher prices than competitive markets 8. 5ecline in consumer surplus 9. 3ess incentive to be efficient. A. ,ossible diseconomies of scale. :ost of these disadvantages are, of course, for the consumer and society. @irms benefit from monopoly power because! &. They can charge higher prices and make more profit than in a competitive market. 8. The can benefit from diseconomies of scale 9. They can use their monopoly profits to invest in research and development and also have resources for if the firm does badly. 81

5-. Go#ernmen" Tolera"es Mono+oliesA &. 1t is difficult to break up monopolies. 8. +overnments can implement regulation of :onopolies e.g. )@"AT regulates the prices of water companies 9. :onopolies can be more efficient because of the advantages from economies of scale. This is particularly important for firms operating in a natural monopoly. @or e#ample, it wouldn7t make sense to have many small companies providing tap water. The large scale infrastructure makes it more efficient to /ust have & firm A. @irms with monopoly power are not necessarily bad. +oogle has monopoly power on search engines but can we say +oogle is an inefficient firm who don7t seek to innovateK Does Microso!" -a#e "oo m%c- mono+ol. +o8erA At one stage the < dustice 5epartment had nearly succeeded in getting :icrosoft broken up into 9 smaller companies. They argued that :icrosoft had abused its monopoly power to engage in illegal activities. These illegal activities included!

2ombining 1nternet .#plorer browser with the "indows operating system % This had violated anti%trust laws. -ote this is an e#ample of a monopoly using its power in one area to gain market share in another. ;ecause it had a monopoly in operating systems. 1t was able to use this to gain a monopoly for web browsers. 1t is a kind of vertical integration. % 2ontrolling different stages of production. -ew web browsers were at a disadvantage because it was too much effort to change from the default web browser.

The decision to break up :icrosoft was, under the ;ush administration, eventually reversed. *owever, the /udge did agree :icrosoft had violated antitrust laws

:icrosoft breakup repealed at ;;2 @riday, 8I dune, 8DD&, D'!8I +:T DH!8I <\ Microso!" )rea,2%+ r%ling o#er"%rne* A < appeals court has overturned a ruling that software giant :icrosoft must be broken up. 1n a damning indictment of the trial /udge, the court said the earlier ruling had been PtaintedP by the /udgeOs actions and it re/ected his conclusion that the software giant must be broken up. *owever, it agreed in part with the lower courtOs finding that :icrosoft had engaged in illegal anti%competitive behavior.

82

:icrosoft chairman ;ill +ates said he was Pvery pleasedP with the appeal courtOs decision which he said Plifts the cloud of break%upP. :r +ates told the ;;2 that :icrosoft was interested in seeking an out of court settlement to the long%running dispute but would not apologise for its behaviour towards competitors. P"e think that litigation is e#pensive and distracting and, if possible, we would like to see if a settlement can be reached,P he said. Analysts said the decision was a ma/or victory for :icrosoft and speculated a second break%up ruling was unlikely. The case will now be sent back to a lower court to be reconsidered by a different /udge. 1n a statement, the < dustice 5epartment said it too was PpleasedP with the appeals court, since it had agreed that :icrosoft had acted as an illegal monopoly. < attorney general dohn Ashcroft described the ruling as a Psignificant victoryP. Ga"es o+"imism :r +ates said that while :icrosoft was still reviewing the details of the courtOs ruling, it was clear it Psignificantly narrowsP the district courtOs decision. P1t sets a much higher standard for these issues than the district court applied,P he said. :r +ates said the past four years had been PchallengingP but he was Pincredibly optimisticP about :icrosoftOs future. The company would now take time to decide what further action needed to be taken on legal issues but the business would move ahead as planned. P"e are moving ahead with "indows N, as a product that has the features that consumers want,P :r +ates said. PThereOs nothing in todayOs ruling that changes our plan for our future products, including "indows N,.P Mar,e" s%rge -ews of the court ruling caused a surge in < stock markets. At the close, the 5ow dones industrial average was up &9& points at &D,'HH. The -asda? composite was up '& points at 8,&8H. Trading in :icrosoft shares on the -asda? was halted after the courtOs decision and resumed at about &B'D +:T, with dealers reporting heavy buying. The shares closed at CJ8.J&, up 8.8&( on the day. LSerio%s D%*icial miscon*%c"L The seven%strong panel at the < 2ourt of Appeals for the 5istrict of 2olumbia heard arguments at a two%day hearing in @ebruary. 1n dune last year, dudge Thomas ,enfield dackson had found :icrosoft to be guilty of abusing monopoly powers and ordered :icrosoft to be split in two.

83

)n Thursday, the federal appeals court said! PAlthough we find no evidence of actual bias Zin the earlier ruling[, we hold that the actions of the trial /udge seriously tainted the proceedings before the 5istrict 2ourt and called into ?uestion the integrity of the /udicial process.P

The court said dudge dackson was guilty of Pserious /udicial misconductP in making derogatory comments about :icrosoft. 1t said this Pwould give a reasonable, informed observer cause to ?uestion his impartiality in ordering the company split in twoP. The decision to reverse dudge dacksonOs ruling was unanimous, by a J%D vote. The court said the case should now be reconsidered by a different /udge. Im+ro+er mono+oli<a"ion 1n their ruling, the appeal court /udges agreed in part with the lower court that :icrosoft had acted illegally. They said the company had improperly monopoli$ed the computer operating system market. ;ut they reversed the finding that packaging the 1nternet .#plorer browser with the "indows operating system had violated anti%trust laws. They also said a third violation cited by the lower court should be /udged under a different standard. 3egal e#perts had predicted that the break%up order would be overturned on appeal but that :icrosoft would still face restrictions on its business conduct. 1n the @ebruary appeal, :icrosoft alleged that dudge dackson had been biased against :icrosoft. The company cited reports where he had compared :icrosoft e#ecutives to children and :r +ates to -apoleon. The < dustice 5epartment % which had brought the case with &J states % countered that the dudgeOs decision had been prompted by the clear evidence that :icrosoft was abusing its position. A++eal +rocess The < 5epartment of dustice had originally hoped to put the appeal process on a fast%track by sending the case straight to the upreme 2ourt % the countryOs highest legal authority. +overnment lawyers had argued that any delay would give :icrosoft valuable time to consolidate its dominant position in the market. The upreme 2ourt however ruled that the software giantOs appeal should first be heard by a lower court. This lower court was e#pected to be more sympathetic to :icrosoft, as it had previously ruled in :icrosoftOs favor in

a different but similar case.

84

MODULE N: GAME THEORY AND RICING STRATEGIES

Game T-eor. 1s an operations research techni?ue that deals with competitive situations where two or more participants pursue conflicting ob/ectives. The theory attempts to provide optimal strategies for the participants. 1n games, the participants are competitors. Thus, the success of one is usually at the e#pense of the other. SIMULTANEOUS MO&E; ONE SHOT GAMES C-arac"eris"ics o! Game En#ironmen"
,layers7 planned decisions are called ST8/T)*6)S# ,ayoffs to players are the profits or losses resulting from strategies. )rder of play is important !

1:<3TA-.)< %:)=. +A:. 0 TAT12 +A:.! .ach player makes decisions without knowledge of other players7 decisions. e.g. games of war and rock%scissors%paper. .M<.-T1A3%:)=. +A:. 0 :<3T1 TA+. )6 5>-A:12 +A:. ! )ne player observes its rival7s move prior to selecting a strategy. e.g. most board games, such as chess, checkers and monopoly.
@re?uency of rival interaction !

)-.% *)T +A:. ! game is played once. 6.,.AT.5 +A:. ! game is played more than once4 either a finite or infinite number of interactions

Sim%l"aneo%s2Mo#e; One S-o" Game 1n a simultaneous%move, one shot game, two or more players make a single decision, at the same time. 85

)xam%le& Toyota and Bonda "a$ed the de$ision o" hether to build a ne auto,assembly %lant# The table sho s the %otential im%a$t o" the t o "irmsD $a%a$ity ex%ansion de$isions# )a$h "irm has t o $hoi$es or strategies+ build a ne %lant or do not build+ and this gives rise to "our $a%a$ity ex%ansion s$enarios# / %layerDs strategy in a game s%e$i"ies the a$tions that the %layer might ta!e under $on$eivable $ir$umstan$e that the %layer might "a$e# 6n a one,shot+ simultaneous move game+ strategies are sim%le& they $onsist o" a single de$ision# Ca+aci". E4+ansion Game )e"8een To.o"a an* Hon*a Toyota ;uild a -ew ,lant *onda ;uild a -ew ,lant 5o -ot ;uild &H,&H &',8D 5o -ot ;uild 8D,&' &B,&B

e,ayoffs are in millions of dollars. Nas- E9%ili)ri%m -ash .?uilibrium a situation in which each player in a game chooses the strategy that yields the highest payoff, given the strategies chosen by other players. +ame theory seeks to answer the ?uestion, what is the likely outcome of a gameK To identify Rlikely outcomeS of games, game theorists uses the concept of a -ash .?uilibrium. At a -ash .?uilibrium, each player chooses a strategy that gives it the highest payoff, given the strategies of the other players in the game. 1n the previous table, the -ash e?uilibrium strategy for each firm is Rto build a new plant.
+iven that Toyota builds a new plant, *onda7s best response is also to build a new plant. 1t gets a profit of &H million if it builds but only &' million if it does not build.

Toyota ;uild a -ew ,lant *onda Build a New Plant !,&H 5o -ot ;uild 8D,&' 86

5o -ot ;uild

",8D

&B,&B

+iven that *onda builds a new plant, Toyota7s best response is to build. 1t gets a profit of &H million if it builds versus the&' million it gets if it does not e#pand its capacity.

Toyota Build a New Plant *onda ;uild a -ew ,lant 5o -ot ;uild &H, ! &',8D 5o -ot ;uild 8D, " &B,&B

The -ash .?uilibrium represent a plausible outcome of a game because its7 most compelling property is that the -ash .?uilibrium outcome is self%enforcing. 1f each party e#pects the other party to choose its -ash .?uilibrium strategy, then both parties will, in fact, choose their -ash .?uilibrium strategies. At the -ash .?uilibrium, then e#pectation e?uals outcome e#pected behaviour and actual behaviour converge. This would not be true at non%-ash .?uilibrium outcomes. 1f Toyota (perhaps foolishly) e#pects *onda not to build a new plant but builds a new plant of its own, then *onda pursuing its self%interest% would confound Toyota7s e#pectations, build a new plant, and make Toyota worse off than it e#pected be. Dominan" S"ra"eg. A dominant strategy is a strategy that is better than any other strategy a player might choose, no matter what strategy the other player follows. "hen a player has a dominant strategy, that strategy will be the player7s -ash .?uilibrium strategy.

E4ercise on Nas- E9%ili)ri%m RICE COM ETITION 3ET5EEN CO'E AND E SI CO'E C &D.'D C &&.'D O 16$N= C &9.'D 87

C H.8' C J.8' E SI O P$6N C I.8'

HH, &ID JI, 8D& P6, 8&8 J', 889

HB, &II B8, 8&& PQ, 88A BD, 89J

JD, &IB B', 8&A R=, 66R B', 8AA

J9, &I& BI, 8DB RN, 88' I&, 8A'

,epsi7s dominant strategy is at C B.8' and its dominated strategy is at C H.8', C J.8' and C I.8'. 2oke7s best response is to set the price at C &8.'D.

3ASIC RICING STRATEGIES ;asic ,ricing trategy of a firm under monopoly and monopolistic competition.
3imit ,ricing strategy to set less than monopoly prices in an effort to deter market entry by new and viable competitors. ,redatory ,ricing pricing below marginal cost to knock out rivals and subse?uently raising prices to obtain monopoly profits. :arket ,enetration ,ricing pricing strategy of charging very low initial prices to create a new market or grab market share.

A Sim+le Mar,%+ R%le

uppose the elasticity of demand for the firm7s product is .f. ince :6 G , (&F.f)0.f etting :6G:2 and simplifying yields this simple pricing formula ! , G (.f0(&F.f)) # :2. The optimal price is a simple markup over relevant costs :)6. .3A T12 the demand, 3)".6 :A6\<,. 3. .3A T12 the demand, *1+*.6 :A6\<,

e#g# )lasti$ity o" demand "or @oda! "ilm is ,2#

. E 0)"A01F)"11 x ;C#

. E 0,2A01,211 x ;C . E 2 x ;C
,rice is twice the marginal cost. @ifty percent of \odak7s price is margin above manufacturing costs.

3asic ricing S"ra"eg. o! a Firm %n*er Co%rno" Oligo+ol.

88

According to the 2ournot model, rival firms choose not to alter their production levels when one firm chooses a different output level. 2ournot thus focuses on ?uantity competition rather than price competition. Mar,%+ R%le !or Co%rno" Oligo+ol.
*omogeneous product 2ournot oligopoly. - G total number of firms in the industry. :arket elasticity of demand .m .lasticity of individual firm7s demand is given by .f G - # .m. ince, , G (.f0(&F.f)) # :2. Then, , G (-.m0(&F-.m) # :2. The +6.AT.6 the number of firms, the 3)".6 the profit%ma#imi$ing markup factor.

)xam%le&
Bomogeneous %rodu$t Cournot industry+ 3 "irms# ;C E G 10 )lasti$ity o" mar!et demand E ,1A2# :etermine the %ro"it,maximizing %ri$e5 )" E 7)m )" E 3 x ,1A2 E ,1#4 . E 0)"A01F)"11 x ;C#

. #0,1#4A01,1#411 x 10 .E#3 x 10 E G30

STRATEGIES THAT YIELD E&EN GREATER ROFIT everal pricing strategies can be used to yield profits above those earned by simply charging a single price where :6G:2. ,ricing strategies are price discrimination, two%part pricing, block pricing, and commodity bundling which are appropriate for firms with various cost structures and degrees of market interdependence. Thus, these strategies can enhance profits of firms in industries with monopolistic, monopolistically competitive, or oligopolistic structure. 89

rice Discrimina"ion ,rice 5iscrimination is defined as the act of selling the same good or service, produced under a single control (i.e. by a monopolist), at different prices to different buyers. ,rice 5iscrimination e#ists when a multiproduct firm prices closely% related product in such a manner that the differences in their prices are not proportional to the differences in their marginal costs of production and distribution. ,rice 5iscrimination can be encountered in the!
@irst 5egree! eparate prices for each consumer. This creates ma#imum profits for sellers. econd 5egree! ;lock%rates or ?uantity discounts based on usage. e.g. electric utilities Third 5egree! 5ifferent prices for each customer class defined on the basis of age, se#, income, etc. This is the most common type of price discrimination. .#amples are (&) tores offer Rstudent7s discountsS, (8) *otels and restaurants offer senior citi$en discounts, and (9) Telephone companies charge lower rates on weekends than during the day, implying that businesses may pay a higher price for telephone services than households.

1n ,rice 5iscrimination, the following should be taken into consideration!

(&) 1f the following conditions are satisfied, a firm can enhance profits by engaging in price discrimination ! (a) There is no resale market for the product. (b) The firm has a good idea of identifying who belongs to which consumer type. (c) 2onsumers are divided into two or more types, with one type having a more elastic demand than the others. (8) A firm that can segment its market will ma#imi$e profits by operating in such a way that :6G:2 in each market segment.

3loc, ricing Hlo$! %ri$ing is another way a firm with market power can increase profits. An e#ample is the purchase of toilet paper in packages of three rolls or cans of soft drinks in a si# pack. ;y packaging units of a product and selling them as one package, the firm earns more than by posting a simple per unit price. ;lock pricing enhances profits by forcing consumers to make all%or%none decisions to purchase units of a good. T8o2 ar" ricing 2ompanies with market power can magnify profits using t o %art %ri$ing. "ith two part pricing, a firm charges a fi#ed fee for the right to buy its products or services, plus a per unit charge for each unit purchased. This pricing strategy is commonly used by such establishments as athletic clubs, golf courses and health clubs. They typically charge a fi#ed Pinitiation feeP plus a charge (either per month or per visit) to use the facilities. ;uying clubs are another good e#ample. ;y paying a membership fee in those clubs, members get to buy products at gPwholesale cost.P 90

Commo*i". 3%n*ling Commodity bundling reflects the practice of bundling two or more different products together and selling them at a single Pbundle price.P @or e#ample, travel agencies often sell Ppackage dealsP that include airfare, hotel, and meals at a bundled price instead of pricing each component of a vacation separately. ,2 makers bundle computers, monitors, and software and sell them at a bundled price. :any car dealers bundle options such as air conditioning, power steering, and automatic transmission and sell them at a Pspecial package price.P

RICING STRATEGIES FOR S ECIAL COST AND DEMAND STRUCTURES There are pricing strategies available to firms with special cost and demand structures to ma#imi$e profits. They include peak load pricing and cross subsidi$ation. ea, Loa* ricing "hen demand is higher at some times of the day than at other times, a firm may enhance profits by %ea! load %ri$ing. This practice involves charging a higher price during peak times than is charged during off peak times. :any markets have periods in which demand is high and periods in which demand is low. Toll roads, utility companies, and airlines all tend to have this feature. "hen the demand during peak times is so high that the capacity of the firm cannot serve all customers at the same price, the firm can use peak load pricing to enhance its profits. NOTE: ,eak load pricing is similar to price discrimination but, due to capacity limitations, the firm is unable to fully e?uate the marginal revenues of those who purchase at different times.

91

:iagram 1& 'hen+ demand during %ea! times is higher than the $a%a$ity o" the "irm+ the "irm should engage in %ea!,load %ri$ing# 2harge a higher price (,*) during peak times (5*) 2harge a lower price (,3) during off%peak off times (53)

Cross S%)si*i<a"ion "henever the demand for two products made by a company are interrelated through costs or demand, the firm may increase profits by $ross subsidization. 1t involves selling one product at or below cost and the other product above cost. This way, the companygs s profits made with one product are used to subsidi$e sales of another product. 2onsider a firm that sells two different types of computer software. )ne type is a "indows system, and the other is an application that runs on the window (say, a spreadsheet). 2learly there are economies of scope and cost complementarities in making the two products /ointly4 cost savings arise due to designing the software within the firm. @urthermore, the demand for the two products is likely to be interdependent4 the spreadsheet eet is valuable to a consumer only to the e#tent that it runs on a version of the window. 1n such instances, a firm may find it profitable to sell one of the products at (or below) cost and charge a relatively higher price for the other product. @or instance, ce, the firm may price the "indows system at (or below) cost to induce numerous consumers to use it to run their computers. )nce consumers commit to the companygs version of "indows, the firm can charge a higher price for its applications software.

92

NOTE: The advantages of cross subsidi$ation are! it allows the company to sell multiple products, which leads to cost savings in the presence of economies of scope. 1f the two products have demands that are interdependent, the firm can induce consumers to buy more of each product than they would otherwise.

Trans!er ricing "hen a large firm is having different divisions and each division makes their own price and output decisions, the above pricing strategies are not suitable. 1n such case, R"rans!er +ricingS strategy is most suitable. As per this pricing strategy, pricing decisions on commodities or services are taken that are e#changed between various divisions or subsidiaries of a decentrali$ed organi$ation. A ma/or goal of transfer pricing is to enable divisions that e#change commodities or services to act as independent business. @or e#ample TATA motors have upstream managers who control the production of inputs (like car or truck engines) produced in Lupstream divisions7. These inputs are transferred to Ldownstream divisions7, where downstream managers operate plants that use the inputs to produce the final output (i.e. automobiles). An important issue in this setting is to decide the optimal transfer pricing (i.e. the internal price at which an upstream division should sell inputs to the firm7s downstream division to ma#imi$e the overall profit of the firm). This price of pricing is important because most division managers are provided an incentive to ma#imi$e their own division7s profit. NOTE:
The transfer price is calculated as the outside mar!et %ri$e o" the same %rodu$t less $osts saved by dealing ithin the $om%any.(e.g. transportation costs, advertising, salesperson salaries). 1f the two division managers (i.e. buying and selling managers) cannot agree on a price, one will be arbitrated by upper management. "hen an outside market price is not available, S)%*ge"e* cos" +l%s mar,2%+ +ricingC strategy may be used so that cost efficiencies at the selling division are still maintained.

The internal price at which an upstream division sells inputs to a downstream division in order to ma#imi$e the overall profits of the firm. 1n order to ma#imi$e profits, the upstream division produces such that its marginal cost, :2u, e?uals the net marginal revenue to the downstream division (-:6d)! -:6d G :6d % :2d G :2u

This permits the firm to avoid double%marginali$ation (when both divisions mark up prices in e#cess of marginal cost. 93

Do%)le Marginali<a"ion A wholesaler (or upstream firm) marks up its price when selling to a retailer (or downstream firm) The retailer (or downstream firm), in turn, further marks up price. 5ouble marginali$ation results in lower profits for the wholesaler. "hyK

An .#ample! "holesaler7s ,roblem 5emand for the final product , G &D % 8M 2(M) G 8M uppose the wholesaler sets :6 G :2 to ma#imi$e profits &D % AM G 8, so Me G 8 ,e G &D % 8(8) G CH, so wholesaler charges the retailer CH per unit

6etailer7s ,roblem 5emand for the final product , G &D % 8M 6etailer7s marginal cost is the CH charged by the wholesaler 6etailer sets :6 G :2 to ma#imi$e profits &D % AM G H, so Me G & ,e G &D % 8(&) G CB, so retailer charges CB per unit

Anal.sis This pricing strategy by the wholesaler results in less than optimal profitsb "holesaler needs the price to be CH and the ?uantity sold to be 8 units in order to ma#imi$e profits. <nfortunately, The retailer sets price at CB, which is too high4 only & unit is sold at that price. The wholesaler7s profits are CH & % 8(&) G CA instead of the monopoly profits of CH 8 % 8(8) G CB )ver all firm profit is CA F C8 G CH.

"holesaler7s :onopoly ,rofit 94

5iagram 8 "holesalers ,rofit when 6etailer7s mark price up to CB

5iagram 9 Sol%"ions !or "-e 5-olesaler @orce retailers to charge CH. *owK R uggested retail pricesKS =ertical price restraintsK =ertical ?uantity restraintsK 1ntegrate into retailingK 95

RICING STRATEGIES IN MAR'ETS 5ITH INTENSE RICE COM ETITION This topic discussed Lprice matching7. Linducing brand loyalty7 and Lrandomi$ed pricing7, which are useful for firms competing in oligopoly (i.e. the market where firms sell similar products and involve in price competition). rice Ma"c-ing 1n )ligopoly market, when two or more firms complete by producing a homogenous product, the -A e?uilibrium for each firm is to charg e a price e?ual to its marginal cost and earn $ero profits. 1f an in"initely re%eated game, firms can maintain collusive outcomes by adopting trigger strategies, which punish rivals that deviate from the high price. This strategy can work only if the interest rate is low a firms can effectively monitor the behavior of other firms in the market. *owever, when the game is not in"initely re%eated of the firms cannot monitor other firms7 behavior, there is another way firms can attain higher profits by advertising a Lprice matching7 strategy. A firm, who follows this pricing strategy, advertises a price and promises to match any lower price offered to its competitors. In*%cing 3ran* Lo.al". The pricing strategy of inducing brand loyalty can be followed by a firm to reduce the tension of competition. "e know that a brand loyal customer will continue to purchase a firms7 product even if another firm offers a (slightly) better price. ;y inducing brand loyalty, a firm reduces the number of customers who will Lswitch7 to another firm if it is reduces the price. 5ifferent firm use different methods to induce brand loyalty. )ne of the common methods to promote the firm7s product is better than those of its competitors through advertisement.

Ran*omi<e* ricing The firms those are following randomi$ed pricing strategy vary their prices most fre?uent (i.e from hour to hour, from day to day). This strategy increases the profit of the firm because! i. ii. 2ustomers cannot learn from e#perience which firm charges the lowest price in the market 1t reduces the ability of rival firms to engage in a price war.

6andomi$ed pricing can work when prices are entered in a computer and not directly on the products. 1t can also work when firms advertise sales in a daily newspaper. @or e#ample, airline industry follows this type of pricing strategy.

96

MODULE Q: THE ECONOMICS INFORMATION AND THE ROLE OF GO&ERNMENT IN THE MAR'ET LACE
ASYMMETRIC INFORMATION 1n all markets that we7ve studied so far, the buyer and the seller are well informed about the features and the value of the goods, services or the factor of production being traded. ;ut in some markets, either the buyers or the sellers%usually sellers are better informed about the value of the items being traded than the person on the other side of the market. 1nformation about the value of the item being traded that is processed by only buyers or sellers is called +ri#a"e in!orma"ion, and when either buyers or sellers have private information the market has as.mme"ric in!orma"ion$ .#ists when either the buyer of the seller in a market e#change has some information that the other does not have. 1n other words, some information is RhiddenS. 97

A situation in which one party in a transaction has more or superior information compared to another

)xam%le+ the seller o" the house may have in"ormation about the house that the buyer does not have+ su$h as that the roo" lea!s a"ter the heavy rain"all# As.mme"ric In!orma"ion can lea* "o "8o main +ro)lems: 1$ A*#erse selec"ion2 is the tendency for people to enter into agreement in which they can use their private information to their own advantage and to the disadvantage of the less%informed party. .#amples! % 6" (a$!ie advertises Cobs "or sales%eo%le at a "ixed age+ she ill attra$t lazy sales%eo%le# Bard or!ing sales%eo%le ill %re"er not to or! "or (a$!ie be$ause they $an earn more by or!ing "or someone ho %ays by results# The "ixed, age $ontra$t adversely sele$ts those ith %rivate in"ormation 0!no ledge about their or! habits1 ho $an use that !no ledge to their o n advantage and to disadvantage o" the %arty#

Se""ing

Hi**en In!orma"ion

In!orme* ar".

Unin!orme* ar".

<sed car market 2redit market 3abor market 3ife 1nsurance

Muality of car 6isk of default "orker productivity ,robability of claim

)wner ;orrower "orker 1nsurance buyer

;uyer 3ender .mployer 1nsurance company

6$ Moral Ha<ar*% is the tendency for people with private information, after entering into an agreement, to act in ways that impose costs on the less%informed party to the agreement. :oral ha$ard arises because it is too costly for the in/ured party to monitor the actions of the advantaged party. .#amples! (a$!ie hires ;it$h as a sales%erson and %ays him a "ixed age regardless o" ho mu$h he sells# ;it$h "a$es moral hazard# Be has an in$entive to %ut in the least %ossible e""ort+ bene"itting himsel" and lo ering (a$!ieDs %ro"its# 3or 98

this reason+ sales%eo%le are usually %aid by "ormula that ma!es their in$ome higher+ the greater is the volume 0or value1 o" their sales# 6" someone has "ire insuran$e they may be more li!ely to $ommit arson to rea% the bene"its o" the insuran$e#

ossi)le Sol%"ions: Signaling2 :ichael pence originally proposed the idea of signaling. *e proposed that in a situation with information asymmetry, it is possible for people to signal their type, thus believably transferring information to the other party and resolving the asymmetry. This idea was originally studied in the conte#t of looking for a /ob. An employer is interested in hiring a new employee who is Pskilled in learning.P )f course, all prospective employees will claim to be Pskilled at learningP, but only they know if they really are. This is an information asymmetry. pence proposes, for e#ample, that going to college can function as a credible signal of an ability to learn. Assuming that people who are skilled in learning can finish college more easily than people who are unskilled, then by finishing college the skilled people signal their skill to prospective employers. -o matter how much or how little they may have learned in college, finishing functions as a signal of their capacity for learning. /ttem%t by an in"ormed %arty to send an observable indi$ator o" his or her hidden $hara$teristi$s to an unin"ormed %arty# Car dealers $an signal the -uality o" a used $ar by o""ering a arranty

Screening2 doseph .. tiglit$ pioneered the theory of screening. 1n this way the underinformed party can induce the other party to reveal their information. creening refers to activities undertaken by the party without private information in order to separate different types of the informed party along some dimension.

la.er @irm with limited knowledge of worker

Screening De#ice 3abor contracts with different degrees of fi#ed wage and bonus

productivity

99

1nsurance company with limited knowledge of client7s risk

1nsurance

contracts

with

different

deductible0premium

AUCTIONS Although most of us more accustomed to buying goods either from merchants who post prices on a take%it%or%leave% it basis or in bilateral negotiations with the seller. An a%c"ion is a process of buying and selling goods or services by offering them up for bid, taking bids, and then selling the item to the highest bidder. 1n economic theory, an auction may refer to any mechanism or set of trading rules for e#change. There are several variations on the basic auction form, including time limits, minimum or ma#imum limits on bid prices, and special rules for determining the winning bidder(s) and sale price(s). ,articipants in an auction may or may not know the identities or actions of other participants. 5epending on the auction, bidders may participate in person or remotely through a variety of means, including telephone and the internet. The seller usually pays a commission to the auctioneer or auction company based on a percentage of the final sale price. Common %ses !or a%c"ions The anti?ue business, where besides being an opportunity for trade they also serve as social occasions and entertainment. 1n the sale of collectibles such as stamps, coins, classic cars, fine art and lu#ury real estate. @or the sale of consumer second%hand goods of all kinds, particularly farm (e?uipment) and house clearances and online auctions. ale of industrial machinery, both surplus or through insolvency. 1n commodities auctions, like the fish wholesale auctions

MaDor ".+es o! A%c"ion: 100

Englis- a%c"ion, also known as an o%en as$ending %ri$e au$tion. This type of auction is arguably the most common form of auction in use today. ,articipants bid openly against one another, with each subse?uent bid higher than the previous bid. An auctioneer may announce prices, bidders may call out their bids themselves (or have a pro#y call out a bid on their behalf), or bids may be submitted electronically with the highest current bid publicly displayed. 1n some cases a ma#imum bid might be left with the auctioneer, who may bid on behalf of the bidder according to the bidderOs instructions. The auction ends when no participant is willing to bid further, at which point the highest bidder pays their bid. Alternatively, if the seller has set a minimum sale price in advance (the OreserveO price) and the final bid does not reach that price the item remains unsold. ometimes the auctioneer sets a minimum amount by which the ne#t bid must e#ceed the current highest bid. The most significant distinguishing factor of this auction type is that the current highest bid is always available to potential bidders. The .nglish auction is commonly used for selling goods, most prominently anti?ues and artwork, but also secondhand goods and real estate. At least two bidders are re?uired.

] An ascending se?uential bid auction. ] The item is sold to the highest bidder. D%"c- a%c"ion also known as an o%en des$ending %ri$e au$tion. 1n the traditional 5utch auction the auctioneer begins with a high asking price which is lowered until some participant is willing to accept the auctioneerOs price. The winning participant pays the last announced price. The 5utch auction is named for its best known e#ample, the 5utch tulip auctions. (P5utch auctionP is also sometimes used to describe online auctions where several identical goods are sold simultaneously to an e?ual number of high bidders.) 1n addition to cut flower sales in the -etherlands, 5utch auctions have also been used for perishable commodities such as fish and tobacco. 1n practice, however, the 5utch auction is not widely used. ] A descending price auction. ] The auctioneer begins with a high asking price. ] The bid decreases until one bidder is willing to pay the ?uoted price. Seale* !irs"2+rice a%c"ion, also known as a "irst,%ri$e sealed,bid au$tion (@, ;). 1n this type of auction all bidders simultaneously submit sealed bids so that no bidder knows the bid of any other participant. The highest bidder pays the price they submitted. This type of auction is distinct from the .nglish auction, in that bidders can only submit one bid each. @urthermore, as bidders cannot see the bids of other participants they cannot ad/ust their own bids accordingly. This kind of

101

bid produces the same outcome as 5utch auction. ealed first%price auctions are commonly used in tendering, particularly for government contracts and auctions for mining leases. ] An auction whereby bidders simultaneously submit bids on pieces of paper. ] The item goes to the highest bidder. ];idders do not know the bids of other players. &ic,re. a%c"ion, also known as a sealed,bid se$ond,%ri$e au$tion. This is identical to the sealed first%price auction e#cept that the winning bidder pays the second highest bid rather than his or her own. This is very similar to the pro#y bidding system used by e;ay, where the winner pays the second highest bid plus a bidding increment (e.g., &D().Although e#tremely important in auction theory, in practice =ickrey auctions are rarely used. In!orma"ion S"r%c"%res: ] ,erfect information% .ach bidder knows e#actly the items worth. ] 1ndependent private values% ;idders know their own valuation of the item, but not other bidders7 valuations. %;idders7 valuations do not depend on those of other bidders. ] Affiliated (or correlated) value estimates ;idders do not know their own valuation of the item or the valuations of others. ;idders use their own information to form a value estimate. =alue estimates are affiliated! the higher a bidder7s estimate, the more likely it is that other bidders also have high value estimates. Common values is the special case in which the true (but unknown) value of the item is the same for all bidders.

THE ROLE OF GO&ERNMENT IN THE MAR'ET LACE I$ Mar,e" Fail%re

Mar,e" o8er 1n economics, mar,e" +o8er is the ability of a firm to alter the market price of a good or service. 1n perfectly competitive markets, market participants have no market power. A firm with market power can raise prices without losing its 102

customers to competitors. :arket participants that have market power are therefore sometimes referred to as Pprice makers,P while those without are sometimes called Pprice takers.P A firm with market power has the ability to individually affect either the total ?uantity or the prevailing price in the market. ,rice makers face a downward%sloping demand curve, such that price increases lead to a lower ?uantity demanded. The decrease in supply as a result of the e#ercise of market power creates an economic deadweight loss which is often viewed as socially undesirable )xam%le& Student 3inan$ial /id& Several %o er"ul big,name s$hools re-uire "amilies to reveal $on"idential in$ome in"ormation be"ore o""ering the best %ri$e# 3amilies that $an a""ord to %ay more are $harged substantially more "or the same servi$e# /s a result+ these s$hools $an ma!e more money# Hut an un"ortunate result is that these s$hools attra$t mostly ri$h and %oor "amilies+ hile "or$ing middle $lass "amilies to ma!e tough de$isions# ;iddle $lass "amilies may have to sa$ri"i$e many o" the amenities they or!ed hard to earn+ hile %oor "amilies "a$e no su$h $hoi$es+ and ri$h "amilies may be able to a""ord the "ull %ri$e or $an "ind better value in other s$hools# An"i"r%s" olicies ubstance and practice of competition law varies from /urisdiction to /urisdiction. ,rotecting the interests of consumers (consumer welfare) and ensuring that entrepreneurs have an opportunity to compete in the market economy are often treated as important ob/ectives. S-erman Ac" /1PR=12 ections & and 8 prohibits price%fi#ing, market sharing and other collusive practices designed to Rmono%olize+ or attem%t to mono%olizeS a market. The herman Act is divided into three sections. ection & delineates and prohibits specific means of anticompetitive conduct, while ection 8 deals with end results that are anticompetitive in nature. Thus, these sections supplement each other in an effort to prevent businesses from violating the spirit of the Act, while technically remaining within the letter of the law. ection 9 simply e#tends the provisions of ection & to <. . territories and the 5istrict of 2olumbia. Se$tion 1& I)very $ontra$t+ $ombination in the "orm o" trust or other ise+ or $ons%ira$y+ in restraint o" trade or $ommer$e among the several States+ or ith "oreign nations+ is de$lared to be illegal#IJ13K Se$tion 2& I)very %erson ho shall mono%olize+ or attem%t to mono%olize+ or $ombine or $ons%ire ith any other %erson or %ersons+ to mono%olize any %art o" the trade or $ommer$e among the several States+ or ith "oreign nations+ shall be deemed guilty o" a "elony J# # # KI 103

Cla."on Ac" /1R1K1 2 The 2layton Antitrust Act, passed in &I&A, proscribes certain additional activities that had been discovered to fall outside the scope of the herman Antitrust Act. @or e#ample, the 2layton Act added certain practices to the list of impermissible activities!

price discrimination between different purchasers, if such discrimination tends to create a monopoly e#clusive dealing agreements tying arrangements mergers and ac?uisitions that substantially reduce market competition. ection 9 ,rohibits e#clusive dealing and tying arrangements where the effect may be to Rsubstantially lessen $om%etition.S

E4"ernali"ies 1n economics, an e4"ernali". (or transaction s+illo#er) is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit. A cost borne by people who neither produce nor consume the good. )xam%le& .ollution Caused by the absen$e o" ell,de"ined %ro%erty rights# The $onsum%tion o" al$ohol by bar,goers in some $ases leads to drin!ing and driving a$$idents hi$h inCure or !ill %edestrians and other drivers# *overnment regulations may indu$e the so$ially e""i$ient level o" out%ut by "or$ing "irms to internalize %ollution $osts %)lic Goo*s A good that is nonrival and nonex$lusionary in consumption. -onrival! That consumption of the good by one individual does not reduce availability of the good for consumption by others .#ample! 6adio signals, national defense .#ample! 2lean air 104 -one#clusionary! -o one is e#cluded from consuming the good once it is provided. The Clean /ir /$t o" 1LM0

TFree Ri*erU ro)lem P@ree ridersP are those who consume a resource without paying for it, or pay less than the full cost of its production. @ree riding is usually considered to be an economic PproblemP only when it leads to the non%production or under%production of a public good or when it leads to the e#cessive use of a common property resource. The !ree ri*er +ro)lem is the ?uestion of how to limit free riding (or its negative effects) in these situations. The name Pfree riderP comes from a common te#tbook, e#ample! someone using public transportation without paying the fare. 1f too many people do this, the system will not have enough money to operate. Incom+le"e In!orma"ion +overnment serves as a provider of information to combat the inefficiencies caused by incomplete and0or asymmetric information Go#ernmen" olicies Designe* "o Mi"iga"e Incom+le"e In!orma"ion Ren" See,ing An economic agent is said to e#hibit ren"2see,ing behavior whenever it attempts to derive economic rent by manipulating the social0political environment in which economic activities occur. ,ossible cause! 6ent%seeking may be initiated by government agents, such agents soliciting bribes or other favors from the individuals or firms that stand to gain from having special economic privileges, which opens up the possibility of e#ploitation of the consumer. .2 2ertification Truth in lending Truth in advertising 2ontract enforcement

105

II$

Go#ernmen" olic. an* In"erna"ional Mar,e"s 7%o"as

3imit on the number of units of a product that a foreign competitor can bring into the country. 6educes competition, thus resulting in higher prices, lower consumer surplus, and higher profits for domestic firms. Tari!!s L%m+ s%m "ari!!! a "ixed fee paid by foreign firms to enter the domestic market. E4cise "ari!!! a %er unit fee on each imported product.

106

2ase tudy! "eatherburn Aircraft .ngine 2ompany

1n dune, &I'J, The "eatherburn Aircraft .ngine 2ompany received an order for ten spare ring gears from ierra Airlines. The ring gears was the largest and most e#pensive of the gears in the system which drives the propeller. The "eatherburn company carried in stock part -o. 8&'J9, the gear blanks from which the ring gears would be made. This is great blank was standard si$e, used in many airplanes. The number of teeth, however, was nonstandard, and "eatherburn had designed a special gear train accordingly. -o other airlines used this ratio, and ierra was on the point of converting its fleet of aircraft to /et operations. <pon in?uiry of the production manager of "eatherburn company learned that the lot of ten ring gears would almost certainly last until ierra7s current aircraft had been entirely replaced. The gear blanks cost "eatherburn about C'D each to make. The first step in the machining process was hobbing. etup for this operation was very e#pensive, costing about C'DD, but the direct cost of hobbing an e#tra gear was negligible so long as the machine7s capacity of 8' gears at one time was not e#ceeded. After hobbing, each gear was individually sub/ected to a series of drilling, grinding, and finishing operations, the total cost of which was CID per gear. 1n addition, there was a setup cost of C8'D associated with these operations. The machined gears were then heat%treated at a cost of about C&D per gear, after which they were sub/ected to a hardness test the ost of which was negligible. After hobbing and before the remaining operations, the gears were sub/ected to a &DD( inspection. 1n the past, an average of A( of all the hobbed gears failed to pass this inspection and had to scrapped. The heat% treating operation was much more difficult to control. The test for hardness had rigid specifications, and the "eatherburn company had had considerable difficulty in meeting standards on this type of gear in the past4 only BD( of the gears had proved acceptable.

$uestion 5ecide on a scheduling policy to meet the order from ierra Airlines. <sing a table of random numbers, simulate about 8D production runs according to the policy you have decided on. Assuming that any shortage on the first run can be made up exa$tly on the second run (i.e., no overage and underage on the second run), use the data you have simulated to calculate the ex%e$ted $ost of your policy. (7ote! 1f you prepare this case in a group, it is suggested that each group member use a different policy in order to provide a comparison of e#pected costs for different policies.)

107

108