1 Economic Concepts For Strategy Besanko, Dranove, and Shanley Primer Chapter.
Economics of Strategy - kangwon.ac.krcc.kangwon.ac.kr/~kimoon/gmi/besanko-5/ch01.pdf · ·...
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Transcript of Economics of Strategy - kangwon.ac.krcc.kangwon.ac.kr/~kimoon/gmi/besanko-5/ch01.pdf · ·...
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Economics of Strategy Fifth Edition
Slides by: Richard Ponarul, California State University, Chico
Copyright 2010John Wiley Sons, Inc.
Chapter 1
Basic Microeconomic Principles
Besanko, Dranove, Shanley, and Schaefer
Business Strategy and Microeconomics
A firm’s management has control over functions like finance, marketing and production.
It has no direct control over profits or market share.
Economic relationships determine if the firm’s decisions translate into markers of business success.
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Microeconomic Principles
The cost functions
Demand, price and revenue
Price and output for a profit maximizing firm
The theory of perfectly competitive markets
Game theoretic models of market competition
Cost functions
The total cost function is the relationship between output and the lowest possible cost of producing a given output
Total cost = Fixed cost + Variable cost
Average cost = Total cost ÷ Quantity
Marginal cost = Rate of change in total cost with respect to output
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Total Cost
If the firm is producing efficiently, the total cost will have to increase with output
Costs can be classified into fixed and variable costs
Some costs may be semi fixed and they are constant over a range of output
When a firm increases its capacity fixed costs will not remain fixed
Total Cost Function
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Average Cost
Average cost (AC) Can vary with output. If it does not we have constant returns to scale.
When AC decreases (increases) with output there are economies (diseconomies) of scale.
A given process may have economies of scale over one range of output and diseconomies in another.
U-shaped Cost Curve
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Minimum Efficient Scale
Q’ = minimum efficient scale
Marginal Cost
Output is initially and it changes by
When AC is decreasing as output increases MC < AC
When AC is increasing as output increases MC >AC
If AC is independent of output MC = AC
MC QTC Q Q TC Q
Q( )
( ) ( )
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Marginal Cost and Average Cost
Marginal Cost and Average Cost
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Short-Run and Long-Run Cost Functions
In the short run as output varies all inputs except plant size vary
For each plant size there is a short run average cost function (SAC)
Long run cost curve (LAC) is the lower envelope of the SACs
Short-Run and Long-Run Cost Functions
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Short-Run Average Cost
Short run average cost has two components
Average fixed cost (AFC)
Average variable cost (AVC)
As output increases AFC falls
AVC increases with output
The result is a U shaped SAC
Sunk Cost
Costs that are unaffected by the decision at hand are sunk costs
Avoidable costs are the opposite of sunk costs
Fixed costs are not necessarily sunk costs
It is important to ignore the sunk costs when making decisions
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Accounting and Economic Costs
Accounting costs are based on the accrual principles and rely on historical costs
Economic cost of a resource is its value in the best foregone use (opportunity cost)
Good economic decisions consider opportunity costs
Accounting costs become useful in measuring the past performance of firms.
Accounting and Economic Profits
Accounting profit = Sales – Accounting cost
Economic profit = Sales – Economic cost
Economic profit = Accounting profit – (Economic cost – Accounting cost)
Ignoring opportunity costs may overstate the profitability of a firm
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The Demand Curve
The quantity of a product a firm is able to sell depends on The price of the product
The prices of related products
Income and taste of the consumers and so on
When all other variables are held constant the price the firms charges and the quantity the firm can sell are inversely related.
The Demand Curve
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The Demand Curve
The downward sloping demand curve exist for most products
The exceptions are when Price signals quality
Price implies prestige
The demand curve reports the quantity bought at various prices and
the highest price the market will bear for given output
Price Elasticity of Demand
Elasticity is the sensitivity of the demand to changes in price
The demand is elastic if
The demand is inelastic if
Q Q
P P
/
/
0
0
1
1
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Price Elasticity of Demand
Price Elasticity of Demand
Demand is elastic when
The product is undifferentiated
Expenditure on the product is a smaller fraction of the total expenditure
The product is an input in the production of a final good
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Price Elasticity of Demand
Demand is inelastic when Complexity of the product makes comparison difficult
Information about substitutes is scarce
Cost is not fully borne
Switching to other products is costly
Product is used jointly with other products to which the customer is committed
Price Elasticity of Demand
Demand is elastic in the brand level even when it may be inelastic at the industry level
If rivals match price changes by a firm industry level elasticity is relevant
If rivals do not match price changes the firm’s demand elasticity will be relevant.
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Total Revenue and Marginal Revenue
Total Revenue (TR) = P(Q) Q
Marginal Revenue (MR) = rate of change in TR
MR QTR Q Q TR Q
Q( )
( ) ( )
MR P
1
1
Marginal Revenue
Since
MR > 0 when
MR < o when
0
0
MR P
1
1
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The Marginal Revenue
Pricing and Output Decisions
Profits are maximized when MR = MC
If MR > MC the firm can increase profits by increasing output
If MR < MC the firm can increase profits by decreasing output
P MC1
1
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Pricing and Output Decisions
Pricing and Output Decisions
Price Cost Margin (PCM) =
If MC is constant , MC = C
If MR > MC then The firm should lower its price
If MR < MC then The firm should raise its price
At the optimal output the price elasticity is the inverse of the price cost margin
P C
P
1PCM
1PCM
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Perfect Competition
Perfect competition is a special case in the theory of the firm
Industry has many firms that produce an identical product
Firms can enter and exit at will
Each firm must charge the same price
Firm level elasticity of demand is infinite
Firm level demand curve is flat
Perfect Competition
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Industry Supply and Demand
Industry supply is the horizontal sum of the individual firms’ supply functions
Industry supply is more elastic than the individual firms’
The industry demand and industry supply determine the price
If price exceeds average cost, more firms enter and shift the industry supply to the right.
Perfect Competition
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Industry Supply and Demand
If industry demand were to fall price falls below average cost
Some firms exit and the industry supply shifts to the left
Industry shakeout continues until price equals average cost and profits are zero
Industry Supply and Demand
Perfectly Competitive Industry Prior to New Entry
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Industry Supply and Demand
Perfectly Competitive Industry at Long-Run Equilibrium
Industry Supply and Demand
Effect of a Reduction in Demand on the Long-Run Perfectly Competitive
Equilibrium
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Game Theory
When there are fewer firms in the industry firms will have to consider the reaction of the rivals
Game theory is useful in these “small numbers” contexts
In game theoretic models each player anticipates the actions and reactions of its competitors.
Game in Matrix Form
Beta
Do not expand Expand
Alpha Do not expand 18,18 15,20
Expand 20,15 16,16
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Game in Matrix Form
Two firms Alpha and Beta need to decide whether or not to expand
The pairs of numbers represent the profits to Alpha and Beta for each set of choices
Each firm maximizes profits given the rival’s strategy
Game in Matrix Form
The Nash equilibrium is {Expand, Expand}
Neither firm has the incentive to switch its strategy though if both switch they are both better off.
Expand is also the dominant strategy for each firm (best for each choice by the opponent)
Not all games have dominant strategies
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Game in Matrix Form
Beta
Do not expand Small Large
Alpha Do not expand 18,18 15,20 9,18
Small 20,15 16,16 8,12
Large 18,9 12,8 0,0
Modified game has no dominant strategy. The Nash equilibrium is Small, Small.
Game Tree for Sequential Game
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Game Tree for Sequential Game
Alpha makes the move first and then Beta makes the move to maximize its profits
The optimal responses by beta are
Alpha chooses Large to maximize its profits (Subgame Perfect Nash Equilibrium)
Alpha Beta Profits
Do not expand Small 15, 20
Small Small 16, 16
Large Do not expand 18, 9
Sequential Move Games and Simultaneous Move Games
In a sequential move game Alpha’s capacity choice has commitment value
Outcome for Alpha is better compared with simultaneous move game
In the simultaneous move game Beta cannot observe Alpha’s decision before making its own decision.