Theory of the Firm. Winter Semester 2009 / Economics of Strategy - Prof. Dr. Christian Ernst

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1 - Economics of Strategy - Winter Semester 2009 / 2010

2 Contents I. Introduction & Basics I.I Introduction: Strategy and Economics Why do we adopt an Economics Perspective? The need for principles I.II Economic Primer: Economic Concepts for Strategy Costs Economic Costs and Profitability Demand and Revenues - Pricing and Output Decisions Perfect Competition Game Theory II. The Evolution of the Modern Firm Doing business in 1840 (U.S.) Doing business in 1910 (U.S.) 2

3 Literature and further Reading Besanko, David et al. (2007): Economics of Strategy, 4th Ed., Evanston, Illinois. Saloner, Garth/ Shepard, Andrea/ Podolny, Joel (2001): Strategic Management, 2nd. Ed., New York. Brickley, James A./ Smith, Clifford W./ Jerold L. Zimmermann (2008): Managerial Economics and Organizational Architecture, 5th Ed., New York. 3

4 Further Information Homepage: Password: Nonprofit22 Exam: To be determined 4

5 Further Information/ Schedule Guest Lecture Pharmaceutical Industry Studies Drug Discovery Processes has been postponed from December 8 th ( ) to December 9 th ( ). The lesson will take place at HS 09. 5

6 Introduction Introduction: Strategy & Economics WHY ECONOMICS? 6

7 Why do we adopt an Economics Perspective? Firms (corporations) can be analyzed from numerous perspectives Possibilities include: Game theory (choice situations that involve rivalry) Psychology (what individual motivations and behaviors shape organizations and their performance?) Organizational Perspective (Need for performance measures in expert dominated organizations like universities, hospitals) Political Science, Anthropology etc. etc. 7

8 Why do we adopt an Economics Perspective? Something to be said for multi-discipline approach BUT danger that we sacrifice depths for breadth deep knowledge permits powerful hypotheses on firm decision making firm behavior. Economics perspective requires analyst be explicit about key elements of the process considered, for instance: Decision makers (who are active players? Whose decisions are fixed?) Goals (what are dm s objectives, profit maximizers vs. multiple objectives) Choices (what possible actions?, what strategic variables like prices (DRGs)?, time horizon for decision under consideration) Relationship between choices and outcomes (Uncertainty?, complexity?) 8

9 Why do we adopt an Economics Perspective? Economic theory is distinctive answers to these questions almost always obtained as part of theory development clear link between assumptions and conclusions Audit trail of thought that allows to distinguish between logically-derived propositions and mere conjectures. Example: Profit-maximizing (goal), monopolist (decision maker), Cournot (quantity) competition (choices) under certainty (relationship): Demand function: p = A-b x; A > o, b > 0, x > 0 (relation) Cost function: K(x) = K f + k v x; Kf > 0, k v > 0 and A k v > 0 (relation) Profit: p(x) = p x- K(x) Max p(x) = A-2 b x- k v = 0 (p <0) x*(a,b,k v ) = (A- k v )/ 2 b = 0 Logically-derived proposition: Fixed costs K f are not decision-relevant in a Cournot-monopoly situation u. certainty Conjecture 1: Fixed costs K f are not decision-relevant under oligopolistic competition Conjecture 2: Fixed costs K f are not decision-relevant under uncertainty and risk-aversion Conjecture 3: Firms that base short-term decisions on variable costs are always correct (Cost accounting 101) 9

10 The need for principles Multi-billion $ question: What drives business success? Often-made (fallacious) assumption: Watch and imitate successful firms Whole industry and management concepts based on this (Benchmarking) Peters/Waterman (1982) In Search of Excellence, NY Harper N = 43 long-term superior performing firms (profitability and growth) Success-drivers: close to customer, Stick to the knitting and Bias for action Wiersema (2001), The New Market Leaders, NY Free Press Studies leading firms in the New Economy (Internet, IT) New market leaders are close to customer, skilled at segmenting markets. Develop new products, intensive advertising, Outsource core activities 10

11 The need for principles Collins (2001) Good to Great NY Harper Firms that went from good (above-average) performance to 15 years of great performance (stock return 3 x that of general market) Walgreens, Wells Fargo, Phlipp Morris and Abbott qualified. Success-drivers: leaders shun spotlight and work for firm, Staffing is crucial = right people in right place, Technology supports strategy. So what s the problem? Using currently successful firms as a standard for action Conjecture: Other firms can obtain similar results by mimicking them. Problem 1: Reasons for success often unclear and complex The Rise and Fall of the New Economy s Darling: The Enron Story 11

12 Why do we adopt an Economics Perspective? Example: August 2000: Enron Stock trades for $90.56 on NYSE Praised as one of the most innovative and firms in the world great example for other firms January 2002: Enron, in Chapter 11 bankruptcy (what is that?) ceased trading at NYSE at $ 0.67 per share Until then: biggest bankruptcy in U.S. history (until Lehmann Brothers 2008) More than people lost jobs, life-savings and health care benefits Investors lost more than $ 75 billion Most of Enron success stories relied on accounting tricks (off the balance sheet financing; special purpose entities) Auditor Arthur Andersen convicted ending of a world-famous accounting firms A good brief summary of the complete story is: Wikipedia, Entry Enron scandal More details at: Healy, Paul M.; Krishna G. Palepu (Spring 2003). "The Fall of Enron" (PDF). Journal of Economic Perspectives 17 (2) Real danger that you look up to the wrong idols 12

13 Why do we adopt an Economics Perspective? Problem 2: Successful firm may have a great internal management system that promotes innovation (not easily identifiable from outside) Problem 3: Are industry situation and market conditions comparable for would-be imitators? Problem 4: Idiosyncratic factors (an engineering or design genius is impossible to imitate!) Problem 5: Successful strategies vs. unsuccessful ones that have been tried Example: The problem of hindsight : XYZ Inc. considers adoption of risky but innovative new technology, (business software other than Oracle or SAP ) Scenario 1: Gamble pays off huge success technology supports its strategy (good thing: gurus will praise it) Scenario 2: Software is a disaster but it may be rational to stick with it (sunk costs) gurus: this firm lets technology determine its strategy (bad thing) Real mistake was selecting the bad technology, not its ongoing application. Managers cannot decide what to invest in/what people to hire after the fact that s why manager work is risky and well-paid Conclusion: There is value in studying firm behavior to identify general principles, NOT to develop al list that is a blueprint for success (there is no such list) 13

14 Why do we adopt an Economics Perspective? Further problems: For every winner, there is a loser, often using the same approaches (Wal-Mart vs. KMart) Bewildering variety of successes and failures (strategies) Markets change: Time-traveling manager (U.S. Steel) from 1901 when firm was first whose annual sales exceeded $ 1 billion, today USX has to sell oil to stay in top 25 of U.S. firms Interpretation 1: Firm success and firm strategy is so complex that it is a matter of luck (lecture ends here) Interpretation 2: Firm succeeded because their chosen management strategies best allowed them to exploit profit opportunities that existed at the time or adapted to changing circumstances I (and you since I am the professor ) buy into interpretation 2 firm success can be understood by studying decision-making in terms of consistent principles of market economics and strategic action odds for success increase when managers apply these principles to the conditions and opportunities they face. What are these consistent principles? 14

15 Why do we adopt an Economics Perspective? Principles concern the big issues a firm faces: Boundaries of the firm: What should the firm do? How large should it be? What business should the firm be in? Market and competitive analysis: Nature of markets in which firm competes? What Competitive interactions prevail in those markets? Position and dynamics: How should the firm position itself to compete, what should be The basis of its competitive advantage, and how should it adjust over time? Internal organization: How should the firm organize its structure and systems internally? 15

16 Why do we adopt an Economics Perspective? Boundaries of the firm: Boundaries define what the firm does in three dimensions: Horizontal: how much if its product market does firm serve (size)? Vertical: what does the firm do itself, what is purchased from specialty firms? Corporate: what is the set of distinct businesses the firm competes in? Examples: Boston Consulting Group 1960s Learning curve & market growth addresses horizontal boundaries Planning tools like growth-share-matrices (BCG-matrix) address corporate boundaries Virtual corporations (Amazon) address vertical boundaries 16

17 Why do we adopt an Economics Perspective? Market and competitive analysis: Role of industry structure: M. Porter (1980) in Competitive Strategy : Performance across industries is not a matter of chance or accident! Examples: Even mediocre firms in the pharmaceutical industry have (by economy wide standards) impressive profitability performance Even top performing airlines achieve low profitability in the best of times Why is that? 17

18 Why do we adopt an Economics Perspective? Position and dynamics: Position (static): Is the firm (at a given point in time) competing as a cost leader or using a differentiation strategy? What resources and capabilities are in place? Dynamics: How does the firm accumulate resources and capabilities over time? How does the firm (over time) adjust to changing circumstances? (J. Schumpeter: the impulse of alluring profit & creative destruction ) Examples: Think up some of your own (position and dynamics) and fill them in! (Boeing vs. Airbus?, Pharmaceuticals? Car Industry?) 18

19 Why do we adopt an Economics Perspective? Internal Organization: If concepts exist for boundaries, markets, position, (expected) dynamics, firms must decide what organizational structure is needed to implement concepts Examples: Direct monetary incentive and reward systems vs. intrinsic motivation? Resource allocation within the firm? (Internal capital markets) Divisional organization vs. centralized structures Flow and processing of information within organization (not IT!) 19

20 Economic Primer Economic Primer: ECONOMIC CONCEPTS FOR STRATEGY 20

21 Economic Primer: Economic Primer This chapter lays out the basic economic tools that will be used to develop the principles you will study in this course. The five main parts will be: Costs Demand, prices and revenues The theory of price and output determination by a profit-maximizing firm The theory of perfect competitive markets Game Theory Basic Equation: Profit = Revenue Costs 21

22 Economic Primer: Costs Costs Statement of Costs Presentation of costs most Managers are familiar with Information about what happened during the past year Essentially retrospective information But what if a firm needs to know how its total costs would change if it increased production above the previous year s level? 22

23 Economic Primer: Costs Total Cost Function Total cost function TC(Q) represents the relationship between a firm s total costs (TC), and the total amount of output (Q) it produces in a given time period. For each level of output the firm might produce, the graph associates a unique level of total cost Efficiency relationship between total cost and output (assuming that the firm produces in the most efficient manner possible, given its current technological capabilities) The only way to achieve more output is to use more factors of production (labor, machinery, materials) therefore the total cost function must slope upward 23

24 Economic Primer: Costs Fixed and Variable Costs Variable Costs direct labor commissions to salespeople Variable and Fixed Costs maintenance advertising and promotional costs Fixed Costs general and administrative expenses property taxes Semifixed Costs interval costs (cargo per truck) Casting moulds Fixed costs affected by other dimensions of the firm s operations Electric utility the costs to hook up houses to the local grid depend primarily on the numbers of subscribers to the system (not to the total amount of electricity sold) Whether costs are fixed or variable ultimately depends on the time period in which decisions regarding output are contemplated. 24

25 Economic Primer: Costs Average Cost Functions The average cost function AC(Q) describes how the firm s average or per-unit-of-output costs vary with the amount of output it produces: If total costs were directly proportional to output for example: or more generally: then average cost would be a constant. This is because: 25

26 Economic Primer: Costs Average Cost Functions Often, however, average cost will vary with output. Average cost may rise, fall, or remain constant as output goes up. When average cost decreases as output increases, there are economies of scale When average cost increases as output increases, there are diseconomies of scale When average cost remains unchanged with respect to output, we have constant returns to scale A production process may exhibit economies of scale over one range of output and diseconomies of scale over another. Output level Q is the smallest level of output at which economies of scale are exhausted and is thus known as the minimum efficient scale. 26

27 Economic Primer: Costs Marginal Cost Functions Marginal cost may be thought of as the incremental cost of producing exactly one more unit of output. When output is initially and changes by output level, marginal cost may be calculate as fallows: units and one knows the total cost at each Example: 27

28 Economic Primer: Costs Relationship Between Total Cost Function and Marginal Cost Marginal cost often depends on the total volume of output. The marginal cost function MC(Q) is based on the total cost function TC(Q). Because the total cost function becomes steeper as Q gets larger, the marginal cost curve must increase in output. Therefore, at higher levels of output, such as Q, a oneunit increase in output has a greater impact on total cost, and the corresponding marginal cost is higher. 28

29 Economic Primer: Costs Average and Marginal Cost Functions Businesses often use information about average cost to estimate the marginal cost of a change in output. But average cost is generally different from marginal cost. The exception is when total cost vary in direct proportion to output: Basically: When average cost is a decreasing function, marginal cost is less then average cost When average cost is an increasing function, marginal cost is greater than average cost When average cost neither increase nor decrease in output because it is either constant or at a minimum point marginal cost is equal to average cost. 29

30 Economic Primer: Costs Long-Run versus Short-Run Average Cost Functions The curves labeled,, are the short-run average cost functions associated with small, medium and large plants, respectively. For any level of output, the optimal plant size is the one with the lowest average cost. The long-run average cost function is the lower envelope of the short-run average cost functions. This curve shows the lowest attainable average cost for any output when the firm is free to adjust its plant size optimally. The long-run average cost function exhibits economies of scale. 30

31 Economic Primer: Costs Long-Run versus Short-Run Average Cost Functions Short-run average costs are the sum of average fixed costs (AFC) and average variable costs (AVC) : As the volume of output increases, average fixed costs become smaller, which tends to pull down SAC. Offsetting this is the fact that average variable costs rise with output, which pulls SAC upward. 31

32 Economic Primer: Costs Sunk versus Avoidable Costs Sunk costs are investment costs incurred before a certain activity takes place which cannot be recovered by the possible sale of the asset they produced. Highly specific investment (e.g. R&D) are usually sunk costs Sunk costs represent barriers to exit. A firm which has incurred high sunk costs will have difficulties in deciding to exit the market even if it sees good opportunities outside Therefore, when weighing the costs of a decision, the decision maker should ignore sunk costs and consider only avoidable costs A firm that is deciding whether to enter into a certain business will have to consider with a particular attention the sunk costs and the risk that during the operations period they might not be recovered. Sunk costs, in this perspective, represent barriers to entry In the case of an exporter, an example of sunk costs could be the costs of analyzing the market and of exploring opportunities and seeking commercial partners. 32

33 Economic Primer: Economic Costs and _Profitability Economic versus Accounting Costs Accounting costs, like statements of costs, are grounded in the principles of accrual accounting, which emphasize historical costs. But accounting statements are designed to serve an audience outside the firm, for example, lenders and equity investors. Business decisions require the measurement of economic costs, which are based on the concept of opportunity costs! This concept says that the economic cost of deploying resources in a particular activity is the value of the best foregone alternative use of those resources. Consider the resources that have been purchased with funds that stockholder provide to the firm. To attract these funds, the firm must offer the stockholders a return on their investment that is 33

34 Economic Primer: Economic Costs and _Profitability Economic versus Accounting Costs Consider the resources that have been purchased with funds that stockholder provide to the firm. To attract these funds, the firm must offer the stockholders a return on their investment that is at least as large as the return that they could have received from investing in activity of comparable risk. Example: Firm s asset (could have been liquidated) : $100 million By tying their funds up in the firm, investors lose the opportunity to invest in an activity providing an 8 percent return. Because of wear and tear of plant and equipment, the value of the assets decline by 1 percent over the year. The annualized cost of the firm s assets is then: ( ) x $100 million = $9 million per year 34

35 Economic Primer: Economic Costs and _Profitability Economic Profit versus Accounting Profit Accounting Profit = Sales Revenue Accounting Cost Economic Profit = Sales Revenue Economic Cost = Accounting Profit (Economic Cost Accounting Cost) Example: Consider a small software development firm that is owner operated. Revenue of Incurred expenses on supplies and hired labor of Owners best outside employment opportunity - a salary of Accounting Profit: = Economic Profit: = The Software business destroyed of the owner s wealth. 35

36 Economic Primer: Economic Costs and _Profitability Economic Profit and Net Present Value Economic Profit is closely related to the concept of net present value from finance. Example: Consider a firm that contemplates constructing a plant with capacity to produce 100,000 units per year: Production expenses (when producing at capacity) are $5 per unit of output Market price is $25 per unit Cost of building the plant is $15 million Infinity long live (i.e., it does not depreciate) Cost of capital is 10 percent This rate reflects what the firm s investors could make from alternative investments and thus reflects the appropriate opportunity cost for evaluating the investment in the plant. 36

37 Economic Primer: Economic Costs and _Profitability Economic Profit and Net Present Value Should the firm build the plant? Economic Profit Total Revenue: Total production cost (accounting cost): Annualized opportunity cost: $2.5 million per year $500,00 per year $15 million x 0,1 = $1,5 million Economic Profit: 2.5 0,5 1.5 = $0.5 million per year Since the investment in the plant is expected to yield a positive economic profit year after year, the firm should build it. 37

38 Economic Primer: Economic Costs and _Profitability Economic Profit and Net Present Value Net Present Value (NPV) The Present value of a cash flow C received in t years at an interest rate i is equal to the amount of money that must be invested today at the interest rate i, so that in t years the principal plus interest equals C: The present value of a stream of cash flow received over a period of years is the sum of the present value of the individual sums: Which can be written more compactly: 38

39 Economic Primer: Economic Costs and _Profitability Economic Profit and Net Present Value Net Present Value (NPV) The net present value of an investment is simply the present value of the cash flows the investment generates minus the cost of the investment: The term in the summation is the present value of perpetuity. A perpetuity is a level cash flow received each year forever. The present value of a perpetuity is equal to the cash flow divided by the interest rate, C/i. With this formula, we can rewrite NPV as: Since the net present value is positive, the firm should undertake it. Note that the calculation NPV and economic profit are similar (What is exact relation?) 39

40 Economic Primer: Demand and Revenues Demand Curve The Demand function describes the relationship between the quantity of product that the firm is able to sell and all the variables that influence that quantity. Of special interest is the relationship between quantity and price. The demand curve is generally downward sloping: The lower the price, the greater the quantity demanded This relationship is called the law of demand The law of demand may not hold if high prices confer prestige or enhance a product s Image or if price signals quality. 40

41 Economic Primer: Demand and Revenues The Price Elasticity of Demand The price elasticity of demand η is the percentage change In quantity brought about by a 1 percent change in price: Thus over the range of price between $5,00 and $5,75, quantity demanded falls at a rate 1.33 percent for every 1 percent increase in price. If η is less then 1, we say that the demand is inelastic D A If η is greater then 1, we say that the demand is elastic D B 41

42 Economic Primer: Demand and Revenues High price sensitivity: - standardized products (airfare, movie tickets, paper for printers) - durable consumer goods (cars, major appliances) - price of inputs for sensitive end products (gold jewelry, crude oil gasoline) Low price sensitivity: - information-intensive products, products with spot demand (legal/tax services) (search goods vs. experience goods vs. credence goods) - Goods subject to Moral Hazard (Health Insurance, Subsidies) - Goods with high switching costs - Goods with commitment effects (DVD, Blu-Ray and relevant disks) 42

43 Economic Primer: Demand and Revenues Brand-Level versus Industry-Level Elasticities Just because the demand for a product is inelastic, the demand facing each seller of that product doesn t have to be inelastic, too. Example: Demand for Cigarettes well below one General increase in price only modestly affect overall cigarette demand Only one brand increases prices demand for that brand would probably drop substantially because consumers would switch to the now lower priced brands. Brand-Level elasticities are higher than industry-level elasticities because consumers can purchase other brands when only one brand raises its price. 43

44 Economic Primer: Demand and Revenues Total Revenue and Marginal Revenue Functions A firm s total revenue function, denoted by TR (Q), indicates how the firm s sales revenues vary as a function of how much product it sells: A firm s marginal revenue MR(Q) is analogous to its marginal cost. It seems plausible, that total revenue would go up as the firm sells more output, and thus MR would always be positive. But with a downward sloping demand curve, this is not necessarily true. 44

45 Economic Primer: Demand and Revenues Total Revenue and Marginal Revenue Functions To sell more, the firm must lower its price. Thus, while it generates revenue on the extra units of output it sells at the lower price, it loses revenue on all the units it would have sold at the higher price. In general, whether marginal revenue is positive or negative depends on the price elasticity of demand: When demand is elastic, so that η > 1, it follows that MR > 0. In this case, the increase in output brought about by a reduction in price will raise total sales revenues. When demand is inelastic, so that η < 1, it follows that MR < 0. Here, the increase in output brought about by a reduction in price will lower total sales revenue. 45

46 Economic Primer: _Pricing and Output Decisions Pricing and Output Decisions The theory of the firm assumes that the firm ultimate objective is to make as large profit as possible. But how is the optimal output determined? Change in Total Revenue Change in Total Cost Change in Total Profit If MR > MC, the firm can increase profit by selling more (QΔ > 0), and to do so, it should lower its price. If MR < MC, the firm can increase profit by selling less (QΔ < 0), and to do so, it should raise its price. If MR = MC, the firm cannot increase profits either by increasing or decreasing output. It follows that output and price must be at their optimal level 46

47 Economic Primer: _Pricing and Output Decisions Pricing and Output Decisions An alternative way of thinking about these principles is to express MR in terms of the price elasticity of demand. Then the term MR = MC can be written as: Total variable costs are supposed to be directly proportional to output, so that MC = c. The percentage contribution margin PCM on additional units sold is the ratio of profit per unit to revenue per unit, or PCM = (P-c) / P. Algebra establishes that: A firm should lower its price whenever the price elasticity of demand exceeds the reciprocal of the PCM on the additional units it would sell by lowering its price. A firm should raise its price when the price elasticity of demand is less than the PCM of the units it would not sell by raising its price 47

48 Economic Primer: _Pricing and Output Decisions Pricing and Output Decisions Example: P = $10 c = $5 PCM = 0.50 The firm can increase profits by lowering its price if its price elasticity of demand η exceeds 1/0.5 = 2. P = $10 c = $8 PCM = 0.20 In this case, the firm should cut its price if η > 5 The lower a firm s PCM (e.g., because its marginal cost is high), the greater its price elasticity of demand must be for a price-cutting strategy to raise profits. 48

49 Economic Primer: Perfect Competition Perfect Competition A special case of the theory of the firm is the theory of perfect competition: An industry with many firms producing identical products (consumers choose among firms solely on the basis of price) Firms can enter or exit the industry at will Because firms in a perfectly competitive industry produce the same identical products, each firm must charge the same price. The firm takes the market price as given and thus faces a horizontal demand curve at the market price. This horizontal line also represents the firm s marginal revenue curve MR. 49

50 Economic Primer: Perfect Competition Perfect Competition A single firm s supply curve is shown in the graph on the left. The industry s supply curve SS is shown in the graph on the right. These graphs an industry of 1,000 identical firms. Thus, at any price the industry supply is 1,000 times the amount that a single firm would supply. 50

51 Economic Primer: Perfect Competition Perfect Competition Complemented by the demand curve: At the price P*, each firm is producing its optimal amount of output q* The quantity demanded equals the quantity Q* supplied by all firms in the industry Each firm is earning a positive profit because at q*, the price P* exceeds cost AC(q*), resulting in a profit on every unit sold New firms would thus like to enter this industry. 51

52 Economic Primer: Perfect Competition Perfect Competition At price P*, new entrants are attracted to the industry. As they come in, the industry s supply curve shifts to the right, resulting in a reduction in market price Entry ceases to occur when firms are earning zero economic profit (price equals average cost) Firms are choosing the optimal output and earning zero economic profit when they produce at the point at which market price equals both marginal cost and average cost (also at minimum efficient scale). 52

53 Economic Primer: Perfect Competition Perfect Competition When Demand falls, the demand curve shifts from D 0 to D 1, and price would initially fall to P. Firms would earn less than they could earn elsewhere and would eventually begin to leave the industry As this happens, the supply curve shifts to the left from SS to SS 1 The industry shakeout ends when price is again P** (Implications of zero profit) 53

54 Economic Primer: Game Theory Game Theory The perfect competitive firm faces many competitors, but in making its output decisions it does not consider the likely reactions of its rivals. This is because the decisions of any single firm have a negligible impact on market prices. The key strategic challenge of a perfectly competitive firm is to anticipate the future path of prices in the industry and maximize against it. But in many strategic situations there are only a few players: Power Supply Pharmaceutical Industry In such cases, the firm has to get inside the minds of its competitors. Game theory is most valuable in precisely such contexts. It is the branch of economics concerned with the analysis of optimal decision making when all decision makers are presumed to be rational, and each is attempting to anticipate the actions and reactions of its competitors. 54

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