Economic environment of business

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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

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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.

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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?

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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

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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?

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

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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

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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?

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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

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Cobb-Douglas Production Function, a1/2
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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.

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Economic Environment of Business

• The Organization of the Firm

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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

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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
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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.

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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

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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

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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

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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?

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The Hold-up Problem

• Firm will refuse
• Workers outside option has not changed
• Workers anticipate this and will not pay for
  specialized investments

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Specialized Investments and Contract Length

MC
MB1
Due to greater need for specialized investments
MB0
Longer Contract
Contract Length
L0
0
L1
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Optimal Input Procurement
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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?

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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

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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

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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

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Solving the Problem Between Owners and Managers

• Internal incentives
• Incentive contracts
• Stock options, year-end bonuses
• External incentives
• Personal reputation
• Potential for takeover

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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?

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Solving the Problem Between Managers and Workers

• Profit sharing
• Revenue sharing
• Piece rates
• Time clocks and spot checks

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Why dont we observe piece rates more often?

• incomplete contracts, requires relative
  performance pay (i.e. tournaments)
• multiple tasks
• measurement costs
• risk averse workers

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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

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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

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Economic Environment of Business

• Chapter 7
• The Nature of Industry

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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

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Industry Analysis

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

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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.

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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

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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.

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Own-Price Elasticities of Demand and Rothschild
Indices
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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.

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Lerner Indices Markup Factors
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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.

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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...

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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.

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Dansby-Willig Performance Index
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Preview of Coming Attractions

• Discussion of optimal managerial decisions under
  various market structures, including
• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly