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Economic environment of business

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Specialization, reduces opportunism, avoids skimping on specialized investments ... Reduces opportunism, avoids contracting costs. Lost specialization, ... – PowerPoint PPT presentation

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Title: Economic environment of business


1
Economic Environment of Business
  • Format 2nd half
  • Weekly lectures (weeks 48, 50, 3, 4, 5)
  • Tuesday, 9.30h-1230h, group A room JB-49
  • Tuesday, 13.30h-1630h, group B room JB-49
  • Teacher 2nd half
  • Pieter Gautier, Office H7-11 office hours
    Mondays, 1600h-1800h

2
Economic Environment of Business
  • Exams
  • multiple choice exam
  • December 2, mid-term
  • January 27, final exam
  • Book
  • M. R. Baye Managerial Economics and Business
    Strategy, Mc-Graw Hill, 2000.
  • Website RSM Blackboard System.

3
Why the economic environment of business is
useful?
  • We learn...
  • consumer behavior
  • firm behavior
  • how prices are determined in markets
  • how to make managerial decisions in different
    markets, advertising, product positioning,
    pricing etc.
  • is there a role for the government in markets?

4
Example Common Agricultural Policy (EU)
  • Farmers receive guaranteed price for their food
  • EU intervenes when price drops below threshold
  • Generates huge surpluses (why?) which are dumped
    on the world market
  • Incentive to produce quantity rather than
    quality
  • Costs for tax payer food storage, high prices
  • Half of EU budget, 65 bln euro

5
Example Finding a room in Rotterdam
  • Are rooms/flats/apartments really scarce (?)
  • Is there an information problem (?)
  • Would price be too high without intervention (?)
  • Is queuing a good allocation mechanism (?)
  • Is there a role for the government?

6
  • Lecture 1 (Gautier)
  • Summary last week
  • The Organization of the Firm
  • The Nature of Industry

7
Last week Production processExample Mars
  • Material inputs
  • chocolate and other food products
  • paper for wrapping the chocolates and hard paper
    for boxing them
  • Labor inputs
  • managers
  • assembly-line workers
  • mechanics
  • technicians ...
  • Capital inputs
  • manufacturing plant
  • wrapping machines

8
Mars
  • Over time Mars increased the ratio of machines
    and robots to workers. Why?
  • What is the best way to expand output in the
    short run? And in the long run?
  • How can Mars choose its least-costly production
    process among the possible ones?
  • How can Mars choose its level of production so as
    to maximize profits?

9
Production Analysis
  • Firms transform inputs or factors of production
    into outputs using a technology or production
    process.
  • Inputs are Capital (K), Labor (L) and Materials
    (M).
  • Technology is represented by a Production
    Function F
  • Q F (K,L,M)
  • The maximum amount of output that can be produced
    with K units of capital, M units of materials and
    L units of labor.
  • Example Cobb-Douglas Production Function
  • Q F(K,L) Ka L1-a

10
Cobb-Douglas Production Function, a1/2
11
Your role as a manager
  • Managers role given technology and a target of
    production, choose the right amount of inputs to
    produce at minimal cost.
  • The more time you have to change your input mix,
    the best for you.
  • Short-run fixed and variable factors or
    production.
  • Example Painting company
  • Fixed factors trucks, compressors, power sprayer
  • Variable factors hours of work of painters
  • Long-run decisions all factors are variable.

12
Economic Environment of Business
  • The Organization of the Firm

13
Overview
  • I. Methods of obtaining Inputs
  • Spot Exchange
  • Contracts
  • Vertical Integration
  • II. Transaction Costs
  • Specialized Investments
  • III. Optimal Procurement Input
  • IV. Principal-Agent Problem
  • Owners-Managers
  • Managers-Workers

14
Managers Role
  • Procure inputs in the least cost manner
  • Provide incentives for workers to put forth
    effort
  • Failure to accomplish this results in a point
    like A

Costs
C(Q)
A
100
B
80
Output
10
0
15
Methods of Procuring Inputs
  • Spot Exchange
  • When the buyer and seller of an input meet,
    exchange, and then go their separate ways.
  • Contracts
  • A legal document that creates an extended
    relationship between a buyer and a seller.
  • Vertical Integration
  • When a firm shuns other suppliers and chooses to
    produce an input internally.

16
Key Features
  • Spot Exchange
  • Specialization, avoids contracting costs, avoids
    costs of vertical integration.
  • Possible hold-up problem
  • Contracting
  • Specialization, reduces opportunism, avoids
    skimping on specialized investments
  • Costly in complex environments
  • Vertical Integration
  • Reduces opportunism, avoids contracting costs
  • Lost specialization, organizational costs

17
Transaction Costs
  • Costs of acquiring an input over and above the
    amount paid to the input supplier.
  • Includes
  • Search costs
  • Negotiation costs
  • Other required investments or expenditures

18
Specialized Investments
  • Investments made to allow two parties to exchange
    but has little or no value outside of the
    exchange relationship
  • Site specificity
  • Physical-asset specificity
  • Dedicated assets
  • Human capital
  • Lead to higher transaction costs and the problem
    of hold-up

19
The hold-up Problem
  • SIMPC is computer language only used by CPB
  • Cost to learn 100, benefits, 1000
  • Worker can earn 200 in- and outside CPB
  • Assume that worker learns SIMPC and becomes worth
    to the firm, 1000
  • How does firm respond when worker asks for a
    raise?

20
The Hold-up Problem
  • Firm will refuse
  • Workers outside option has not changed
  • Workers anticipate this and will not pay for
    specialized investments

21
Specialized Investments and Contract Length

MC
MB1
Due to greater need for specialized investments
MB0
Longer Contract
Contract Length
L0
0
L1
22
Optimal Input Procurement
23
Example Amacon
  • Bicycle manufacturer
  • Produces 5,000 bikes per month
  • Needs 10,000 rubber tires the last Thursday of
    each month
  • Pros and cons of spot exchange?
  • Pros and cons of using contract?
  • Pros and cons of vertical integration?

24
Example Amacon
  • What would you do as a manager?
  • - If there are many suppliers of tires and the
    tires you require are standard, use the spot
    market. Else seek individual supplier and use
    contract

25
The Principal-Agent Problem
  • Occurs when the principal cannot observe the
    effort of the agent
  • Example Shareholders (principal) cannot observe
    the effort of the manager (agent)
  • Example Manager (principal) cannot observe the
    effort of workers (agents)
  • The Problem Principal cannot determine whether
    a bad outcome was the result of the agents low
    effort or due to bad luck

26
The IT Bubble and asymmetric information
  • Share holders observe profitability of sector,
    not of individual firms
  • good firms are under-valued, bad firms are
    over-valued
  • Bad firms benefit from emissions and grow
  • This reduces profitability and bubble
    collapses

27
Solving the Problem Between Owners and Managers
  • Internal incentives
  • Incentive contracts
  • Stock options, year-end bonuses
  • External incentives
  • Personal reputation
  • Potential for takeover

28
Points for discussion
  • What does a manager, who requires a high firing
    premium, signal?
  • What do companies mean by a fixed bonus?
  • Is it important for shareholders to know the
    exact bonus scheme of a manager?

29
Solving the Problem Between Managers and Workers
  • Profit sharing
  • Revenue sharing
  • Piece rates
  • Time clocks and spot checks

30
Why dont we observe piece rates more often?
  • incomplete contracts, requires relative
    performance pay (i.e. tournaments)
  • multiple tasks
  • measurement costs
  • risk averse workers

31
Example Performance PaySafelite Glass
  • Installs automobile glass in 600 small repair
    centers
  • In 1994, installers switch from fixed to
    performance pay system
  • Guaranteed base salary of 11 per hour
  • Productivity rose by 36!!
  • 2/3 due to existing workers working harder
  • 1/3 due to selective new workers

32
Example Performance paySafelite Glass
  • Pay for average employee increased by 9
  • How can quality be guaranteed?
  • Installers must redo their own defective
    installations without pay

33
Economic Environment of Business
  • Chapter 7
  • The Nature of Industry

34
Overview
  • I. Market Structure
  • Measures of Industry Concentration
  • II. Conduct
  • Pricing Behavior
  • Integration and Merger Activity
  • III. Performance
  • Social Welfare
  • IV. Preview of Coming Attractions

35
Industry Analysis
  • Market Structure
  • Number of firms, size, etc.
  • Conduct (Behavior)
  • Pricing, advertising, RD, etc.
  • Performance
  • Profitability, consumer surplus, social welfare.

36
The Structure-Conduct-Performance Paradigm
  • The Causal View

Market Structure
Conduct (Behavior)
Performance
  • The Feedback Critique
  • No one-way causal link.
  • Conduct can affect market structure.
  • Market performance can affect conduct as well as
    market structure.

37
Industry Concentration
  • Four-Firm Concentration Ratio
  • The sum of the market shares of the top four
    firms in the defined industry C4 w1 w2
    w3 w4
  • Herfindahl-Hirschman Index (HHI)
  • The sum of the squared market shares of firms in
    a given industry, multiplied by 10,000 HHI
    10,000 ? S wi2
  • Limitations
  • Market Definition National, regional, or local?
  • Global Market Foreign producers excluded
  • Industry definition and product classes

38
Rothschild Index
  • A measure of the elasticity of industry demand
    for a product relative to that of an individual
    firm R ET / EF
  • ET elasticity of demand for the total market
  • EF elasticity of demand for the product of an
    individual firm.
  • R has a value between 0 (perfect competition) and
    1 (monopoly).
  • When an industry is composed of many firms, each
    producing similar products, the Rothschild index
    will be close to zero.

39
Own-Price Elasticities of Demand and Rothschild
Indices
40
Pricing Behavior
  • The Lerner Index
  • L (P - MC) / P
  • A measure of the difference between price and
    marginal cost.
  • An index from 0 to 1.
  • Markup Factor
  • Rearranging the above formula,
  • P (1/(1-L)) MC
  • 1/(1-L) is the markup factor.

41
Lerner Indices Markup Factors
42
Integration and Merger Activity
  • Vertical Integration
  • Where various stages in the production of a
    single product are carried out by one firm.
  • Horizontal Integration
  • The merging of the production of similar products
    into a single firm.
  • Conglomerate Mergers
  • The integration of different product lines into a
    single firm.

43
Merger Guidelines, US and EC
  • Based on HHI 10,000 S wi2
  • Merger may be challenged if
  • HHI exceeds 1800 (US) and 2000 (EC)
  • Merger increases the HHI by more than 100 (US)
    150 (EC)
  • But...
  • Recognizes efficiencies The primary benefit of
    mergers to the economy is their efficiency
    potential...which can result in lower prices to
    consumers...In the majority of cases the
    Guidelines will allow firms to achieve
    efficiencies through mergers without
    interference...

44
Performance
  • Performance refers to the profits and social
    welfare that result in a given industry
  • Social Welfare CS PS
  • Dansby-Willig Performance Index
  • Ranks industries according to how much social
    welfare would improve if firms within each
    industry expanded output in the socially
    efficient manner.

45
Dansby-Willig Performance Index
46
Preview of Coming Attractions
  • Discussion of optimal managerial decisions under
    various market structures, including
  • Perfect competition
  • Monopoly
  • Monopolistic competition
  • Oligopoly
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