University of Waterloo Economics Case Study

Economics of Strategy
Seventh Edition
Besanko, Dranove, Shanley, and Schaefer
Economics Primer:
Basic Principles
Copyright ? 2016John Wiley ? Sons, Inc.
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.
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
Total Cost
? If the firm is producing efficiently, the total cost will
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
Average Cost
? Average cost (AC) Can vary with output. If it does not it
has 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 Average Cost Curve
Minimum Efficient Scale
Q? = minimum efficient scale
Marginal Cost
? Output is initially Qand it changes by
?
MC(Q) =
?Q
TC(Q + ?Q) – TC(Q)
?Q
? 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
Marginal Cost and Average Cost
Marginal Cost and Average Cost
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
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 Versus Avoidable Costs
? 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
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
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
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
?
?Q / Q0
?=
?P / P0
? The demand is elastic if
? ?1
? The demand is inelastic if
? ?1
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
? There are readily available substitutes.
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 in market price
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 at 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
brand level elasticity will be relevant.
Total Revenue and Marginal Revenue
? Total Revenue (TR) = P(Q) Q
? Marginal Revenue (MR) = rate of change in TR
TR(Q + ?Q) – TR(Q)
MR(Q) =
?Q
?
1?
MR = P? 1 – ?
? ??
Marginal Revenue
? Since
?
1?
MR = P? 1 – ?
? ??
? MR > 0 when
??0
? MR < o when
??0
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
?
1?
P? 1 – ? = MC
? ??
Pricing and Output Decisions
Pricing and Output Decisions
? Price Cost Margin (PCM) =
? If MC is constant , MC = C
??
P-C
P
1
PCM
? If MR > MC then
? The firm should lower its price
??
1
PCM
? 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
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
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 lowering market price.
Perfect Competition
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
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
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
? 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
Beta
Alpha
Do not expand
Expand
Do not expand
18,18
20,15
Expand
15,20
16,16
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
Game in Matrix Form
Beta
Alpha
Do not expand
Small
Large
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
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
Beta
Profits
Do not expand
Small
15, 20
Small
Small
16, 16
Large
Do not expand
18, 9
? Alpha chooses Large to maximize its profits
(Subgame Perfect Nash Equilibrium)
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.
Copyright ? 2016 John Wiley & Sons, Inc.
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