Economic Concepts For Strategy

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Economic Concepts For Strategy

• Besanko, Dranove, Shanley, and Schaefer Primer
  Chapter

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Agenda

• Strategy Defined
• Review the Concepts Related to Costs
• Profitability, Revenue, and Demand
• Pricing and Output Decisions
• Game Theory

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Perspective 1 of Strategy Taken From Besanko

• the determination of the basic long-term goals
  and objectives of an enterprise, and the adoption
  of courses of action and the allocation of
  resources necessary for carrying out these
  goals. Alfred Chandler

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Perspective 2 of Strategy Taken From Besanko

• the pattern of objectives, purposes or goals,
  and the major policies and plans for achieving
  these goals, stated in such a way as to define
  what business the company is in or should be in
  and the kind of company it is or should be.
  Kenneth Andrews

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Perspective 3 of Strategy Taken From Besanko

• what determines the framework of a firms
  business activities and provides guidelines for
  coordinating activities so that the firm can cope
  with and influence the changing environment.
  Strategy articulates the firms preferred
  environment and the type of organization it is
  striving to become. Hiroyuki Itami

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Key Points of Strategy

• Strategy focuses on long-term goals and
  objectives.
• Strategy develops action plans.
• In essence, strategy can be defined as the action
  plans that move the company towards its long-term
  goals and objectives within a particular
  environment.

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Benchmarking Versus Principles

• Benchmarking is where you examine how successful
  companies operate and attempt to imitate them.
• It assumes that the keys to success can be
  measured and are knowable.
• Principles, as related to strategy, are a set of
  guidelines that work across time in many
  differing environments.

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Besankos Framework for Strategy

• Boundaries of the firm
• What should the firm do and how large should it
  be?
• Market and competitive analysis
• What is the nature of the markets and the
  interaction between firms?

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Besankos Framework for Strategy Cont.

• Position and dynamics
• How and on what basis does the firm compete?
• Internal organization
• How should the firm be internally organized and
  managed?

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Total Cost Function

• The total cost function is the summation of all
  fixed (including sunk) and variable costs.
• It is usually represented as the following TC(Q)
  VC(Q) FC(Q)
• Where VC(Q) denotes the variable costs
• Where FC(Q) denotes the fixed costs

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Graphical Depiction of the Total Cost Function
TC(Q)
Total Cost
Output (Q)
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Variable and Fixed Costs

• A variable cost is a cost that is zero if no
  production occurs.
• A fixed cost is a cost that exists whether
  production occurs or not.
• Fixed costs can be broken down further into sunk
  costs.
• There tends to be more fixed costs in the
  short-run compared to the long-run.

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Sunk Costs

• A sunk cost is a cost that cannot be recovered.
• A sunk cost is always considered a fixed cost,
  but a fixed cost does not necessarily imply being
  sunk.
• Sunk costs can have a significant impact on how
  you choose strategies.

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Strategy and the Cost Function

• The types of strategies you have as a firm can be
  dictated by your present and future cost
  functions.
• Why?

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Average and Marginal Costs

• Average cost can be defined as the total cost
  divided by output.
• Marginal cost is the change in total cost divided
  by the change in output.

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Relationship Between Average and Marginal Cost

• If marginal cost is below average cost then
  average cost is decreasing.
• When average and marginal cost are equal, then
  marginal cost is at a minimum.
• When marginal cost is above average cost, the
  average costs are increasing.

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Graphical Depiction of Average and Marginal Costs

MC
AC
Q
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Long-Run Average Cost Curve

• The long-run average cost curve can be defined as
  the envelope of all possible short-run average
  cost curves.
• By envelope we mean the minimum amount that can
  occur given a particular level of output.

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Scale of Economics

• When examining the long-run average cost curve,
  the economics of scale examines what happens to
  average cost as output is increased.
• There are three general types of scale
• Economies of scale
• Minimum efficient scale
• Diseconomies of scale

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Economies of Scale

• Economies of scale are said to exist when by
  increasing output, the long-run average costs
  decrease.
• This implies that AC(Q1) gt AC(Q2) when Q1 lt Q2
  and you move from Q1 to Q2.

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Minimum Efficient Scale

• Minimum efficient scale is said to exist when by
  increasing output, the long-run average costs
  does not change.
• This implies that AC(Q1) AC(Q2) when Q1 lt Q2
  and you move from Q1 to Q2.

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Diseconomies of Scale

• Diseconomies of scale are said to exist when by
  increasing output, the long-run average costs
  increase.
• This implies that AC(Q1) lt AC(Q2) when Q1 lt Q2
  and you move from Q1 to Q2.

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Short-Run Average Costs for Differing Firms
SRAC1
Cost per unit
SRAC5
SRAC2
LRAC
SRAC3
SRAC4
Q
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A Possible LRAC
/per unit
LRAC
Note The section of output between A and B is
known as the minimum efficient scale.
Y
A
B
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Profit

• There are two ways to define profits.
• In general, profit is defined as total revenue
  minus total costs.
• ? TR - TC
• The two ways of defining profits are
• Accounting Profit
• Economic Profit

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Accounting and Economic Profit

• Accounting profit can be defined as sales revenue
  minus accounting costs.
• Accounting costs do not usually take into account
  opportunity costs.
• Economic profit can be defined as sales revenue
  minus economic costs.
• Economic costs are equal to accounting costs plus
  all opportunity costs.

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Present Value

• When you want to know what the value of something
  in the future is worth to you today, you can use
  the idea of present value.
• Present value takes a value in the future and
  converts it to what it is worth to you today.

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Present Value Cont.
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Net Present Value

• When you want to know what the value of a set of
  income streams is worth to you today, you can use
  the idea of net present value.
• Net present value takes a set of income streams
  in the future and converts it to what it is worth
  to you today.

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Net Present Value Cont.
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Demand Function

• The demand function is a function that gives the
  relationship between quantity demanded and all
  the variables that affect that quantity demanded.
• The demand function usually examines the
  relationship between price and quantity.
• The Law of Demand states that there is an inverse
  relationship between price and quantity demanded
  holding all other variables fixed.

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Consumer Surplus

• Consumer surplus is a measure of the difference
  between the amount of money a person was willing
  to pay to buy a quantity of good and the actual
  price they paid.
• This measure is used as a tool in policy
  analysis.
• Consumer surplus is represented graphically as
  the area underneath the demand curve above the
  price paid for the goods.

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Graphical Representation of Consumer Surplus
P
Consumer Surplus
p 5
q 5
Q
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Price Elasticity of Demand

• This measures the sensitivity of quantity
  demanded due to a change in price.

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Price Elasticity of Demand Cont.

• When ? gt 1, then demand is said to be elastic.
• When ? 1, then demand is said to be unitary
  elastic.
• When ? lt 1, then demand is said to be inelastic.

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Price Elasticity of Demand Cont.

• There is a relationship between revenue,
  elasticity, and price.
• When ? gt 1, then revenue can be increased by
  decreasing price.
• When ? lt 1, then revenue can be increased by
  increasing price.
• When ? 1, then revenue is maximized for the
  given price.

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Causes of Price Sensitivity

• The commodity is considered homogeneous or near
  homogenous to its rival products.
• The price of the product is a large proportion of
  the buyers expenditure.
• The product is an input of a very elastic product.

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Causes of Price Insensitivity

• Very few or no substitute products.
• A substitute product is much more costly.
• There are incentives that reduce the effective
  price of the product.
• The product is a complementary product to a
  product that is highly inelastic.

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Total and Marginal Revenue

• Total revenue is defined as price times quantity
  where price is a function of quantity.
• TR P(Q)Q
• Marginal Revenue is the change in total revenue
  due to a change in quantity.

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Relationship Between Elasticity and Marginal
Revenue

• When demand is elastic, i.e., ? gt 1, then
  marginal revenue is positive when quantity is
  increased.
• When demand is elastic, i.e., ? lt 1, then
  marginal revenue is negative when quantity is
  increased.

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Pricing and Output Decisions

• Change in profit (?) can be defined as the change
  in quantity times the difference between marginal
  revenue and marginal cost, i.e., ?? (MR-MC)?Q.
• When MR gt MC, the firm can increase profits by
  decreasing price and selling more.
• When MR lt MC, the firm can increase profits by
  increasing price and selling less.
• When MR MC, the firm cannot increase profits.

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Price Elasticity and the Output Decision

• The following relationships can be derived
• MR MC gt 0, when PCM gt 1 / ?.
• MR MC lt 0, when PCM lt 1 / ?.
• Where PCM, the percentage contribution margin, is
  defined as (P c) / P.
• P is the price of the product.
• c is the marginal cost.

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Price Elasticity and the Output Decision Cont.

• When the percentage contribution margin is
  greater than the reciprocal of the price
  elasticity of demand, then prices should be
  decreased to increase profitability.
• When the percentage contribution margin is less
  than the reciprocal of the price elasticity of
  demand, then prices should be increased to
  increase profitability.

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Game Theory

• Game theory is the study of a set of tools that
  can be used to analyze decision-making by a set
  of players who interact with each other through a
  set of strategies.

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Tools Used in Game Theory

• Matrix Form of a Game
• Dominant Strategy
• Dominated Strategy
• Nash Equilibrium
• Game Trees
• Subgame Perfection

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Matrix Form of the Game

• The matrix form of a game represents the
  strategies and payoff of those strategies in a
  matrix.
• The key components of this is the players, the
  strategies, and the payoffs of the strategies.
• The matrix form is a useful tool when the players
  of the game must move simultaneously.

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Matrix Form of the Game Cont.
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Matrix Form Example

• Suppose there were two producers of hogs, Farmer
  A and Farmer B.
• Assume that there are two strategies that each
  farmer can do be large or be small.
• If each farmer chooses the same size, they will
  split the demand for there product evenly.

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Matrix Form Example Cont.

• If both producers are small, then the market is
  worth 100.
• If both producers are large, then the market is
  worth 80.
• If one chooses to be large and the other chooses
  to be small, then the market is worth 90.
• When one farmer is small and the other is large,
  the large producer obtains 2/3 of the market
  leaving the rest to the small farmer.

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Matrix Form Example Cont.

• Players Farmer A, Farmer B
• Strategies Large, Small
• Payoffs
• Large, Large implies (40, 40)
• Large, Small implies (60, 30)
• Small, Small implies (50, 50)
• Small, Large implies (30, 60)

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Matrix Form Example
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Dominant and Dominated Strategies

• Dominant Strategy
• Given a set of strategies, a dominant strategy is
  one that is better than all other strategies in
  that set.
• Dominated Strategy
• Given a set of strategies, a dominated strategy
  is one that is worse than all other strategies in
  that set.

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Nash Equilibrium

• A Nash Equilibrium is said to occur when given
  the strategies of the other players are held
  constant, there is no incentive for a player to
  change his strategy to get a higher payoff.
• In essence, a Nash Equilibrium occurs when all
  players in the game do not want to change their
  strategies given the other players strategies.

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Nash Equilibrium Cont.

• A Nash Equilibrium will be in a Dominant
  Strategy.
• A Nash Equilibrium will never be in a dominated
  strategy.

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Matrix Form Example with Nash Equilibrium
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Prisoners Dilemma

• A Prisoners Dilemma occurs when all parties
  through noncooperative strategies obtain a less
  than optimal solution due to their self interest.
• In the previous example, the Nash Equilibrium
  occurred at a sub-optimal solution for the game
  where both farmers chose large.
• They both would have been better off by choosing
  small.

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Game Trees

• A Game Tree is a way of representing a sequential
  move game.
• There are four components to a Game Tree.
• Players
• Payoffs
• Nodes
• A node represents a position within the game.
• Actions
• An action is a move that moves from one node to
  the next.

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Representation of Game Tree
Player 2
Player 1 Payoff, Player 2 Payoff
Action 3
Player 1
Action 4
Player 1 Payoff, Player 2 Payoff
Action 1
Player 1 Payoff, Player 2 Payoff
Action 5
Action 2
Action 6
Player 1 Payoff, Player 2 Payoff
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Game Tree Representation Using Previous Example
Assuming Farmer A Moves First
Farmer B
40, 40
Large
Farmer A
Small
60, 30
Large
30, 60
Large
Small
Small
50, 50
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Subgame Perfection

• When working with a Game Tree, an important
  equilibrium concept is the Subgame Perfect Nash
  Equilibrium (SPNE).
• A SPNE is said to exist if each player chooses
  an optimal action at each stage in the game that
  it might conceivably reach and believes that all
  other players will behave in the same way.
  (Besanko)

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Subgame Perfection Cont.

• Subgame Perfection can be found by using a method
  called the fold-back method.
• In the fold-back method, you start at the end of
  the tree and work your way back to find the best
  strategies for each node.

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Subgame Perfection Example 2
Farmer B
50, 50
Large
65, 55
Medium
100, 60 SPNE
Small
Farmer A
55, 65
Large
Large
90, 90
Medium
Medium
120, 70
Small
60, 100
Small
Large
70, 120
Medium
110, 110
Small
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Subgame Perfection Example 2

• The SPNE is where Farmer A becomes large and
  Farmer B becomes small.
• This gives a payoff of 100 to Farmer A and a
  payoff of 60 to Farmer B.
• If this was a simultaneous move game, what would
  the outcome had been?