Chapter 1

Overview of
Business Economics

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
Learning objectives
1. Summarize how goals, constraints, incentives, and market rivalry
affect economic decisions.
2. Distinguish economic versus accounting profits and costs.
3. Explain the role of profits in a market economy.
4. Apply the five forces framework to analyze the sustainability of an
industry’s profits.
5. Apply present value analysis to make decisions and value assets.
6. Apply marginal analysis to determine the optimal level of a
managerial control variable.
7. Identify and apply six principles of effective managerial decision
making.
2
 HEADLINE

On Tuesday software giant Amcott posted a year-end operating loss of

$3.5 million. Reportedly, $1.7 million of the loss stemmed from its foreign
language division. With short-term interest rates at 7 percent, Amcott
decided to use $20 million of its retained earnings to purchase three-year
rights to Magicword, a software package that converts generic word
processor files saved as French text into English. First-year sales
revenue from the software was $7 million, but thereafter sales were
halted pending a copyright infringement suit filed by Foreign, Inc. Amcott
lost the suit and paid damages of $1.7 million. Industry insiders say that
the copyright violation pertained to “a very small component of
Magicword.” Ralph, the Amcott manager who was fired over the incident,
was quoted as saying, “I’m a scapegoat for the attorneys [at Amcott] who
didn’t do their homework before buying the rights to Magicword. I
projected annual sales of $7 million per year for three years. My sales
3
 ECONOMIC VS. ACCOUNTING PROFITS

◎ Accounting Profits
○ Total revenue (sales) minus dollar cost of
producing goods or services.
○ Reported on the firm’s income statement
◎ Economic Profits
○ Accounting profit minus total opportunity cost

5
 TERMS
◎ Manager
○ A person who directs resources to achieve a stated goal
◎ Economics
◎ The science of making decisions in the presence of scarce
resources.
◎ Managerial economics
○ The study of how to direct scarce resources in the way that
most efficiently achieves a managerial goal. (Michael R.
Baye, Managerial Economics and Business Strategy, 6th
edition, McGrawHill/Irwin, p.25)

6
 MANAGERIAL ECONOMICS

A host of decisions to succeed as a manager:

1. Should you purchase components from other manufacturers or produce them
within your own firm?
2. Should you specialize in making one type of computer or produce several
different types?
3. How many computers should you produce, and at what price should you sell
them?
4. How many employees should you hire, and how should you compensate
them?
5. How will the actions of rival computer firms affect your decisions?

7
BUSINESS ENVIRONMENT

8
 OPPORTUNITY COST

◎ Accounting Costs: The explicit costs of the resources needed

to produce goods or services and reported on the firm’s income
Statement
◎ Opportunity Cost: The cost of the explicit and implicit
resources that are foregone when a decision is made.
○ Implicit costs are very hard to measure →managers often overlook them
○ Ex: what does it cost you to read a book?
○ Suppose you own a building in New York that you use to run a small
pizzeria. Food supplies are your only accounting costs. At the end of the
year, your accountant informs you that these costs were $20,000 and that
your revenues were $100,000. Thus, your accounting profits are $80,000.
Economic profits?
◎ Economic Profits: Total revenue minus total opportunity cost.
9
 SUBJECTS OF MANAGERIAL ECONOMICS
◎ Managerial Economics is concerned with economic
issues and problems related to business
organization, management, and strategy.
◎ Issues and problems include: an explanation of why
firms emerge and exist; why they expand:
horizontally and vertically; the role of entrepreneurs
and entrepreneurship; the significance of
organizational structure; the relationship of firms with
the employees, the providers of capital, the
customers, the government; the interactions between
firms and the business environment.
10
 THE ECONOMICS OF EFFECTIVE MANAGEMENT

An effective manager must:

1. Identify goals and constraints
2. Recognize the nature and importance of profits
3. Understand incentives
4. Understand markets
5. Recognize the time value of money,
6. Use marginal analysis.

11
 IDENTIFY GOALS AND CONSTRAINTS

◎ It is required to have a well-defined goal: achieving

different goals entails making different decisions.
○ Different units within a firm may be given different goals
◉ E.g.: marketing department maximizes sales or market share
◉ Financial group might focus on earnings growth or risk-
reduction strategies
◎ Decision maker faces constraints that affect the
ability to achieve a goal
○ Constraints are an artifact of scarcity

12
 “
“It is not out of the benevolence of the
butcher, the brewer, or the
baker, that we expect our dinner, but from
their regard to their own interest.”
Source: Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776.

13
 PROFITS AS A SIGNAL

◎ Profits signal to resource holders where resources

are most highly valued by society.
○ Resources will flow into industries that are most highly
valued by society
◉ The Five Forces Framework and Industry Profitability

14
THE FIVE FORCES FRAMEWORK

15
 TIME VALUE OF MONEY

◎ Problem 1-1:
The manager of Automated Products is contemplating the purchase
of a new machine that will cost $300,000 and has a useful life of
five years. The machine will yield (year-end) cost reductions to
Automated Products of $50,000 in year 1, $60,000 in year 2,
$75,000 in year 3, and $90,000 in years 4 and 5. What is the
present value of the cost savings of the machine if the interest rate
is 8 percent? Should the manager purchase the machine?

16
PRESENT VALUE OF INDEFINITELY LIVED ASSETS

17
 PRESENT VALUE OF FIRM

18
The examination of the costs and benefits
of a marginal (small) change in the
production of goods

19
 USE MARGINAL (INCREMENTAL) ANALYSIS

◎ Control Variable Examples:

○ Output
○ Price
○ Product Quality
○ Advertising
○ R&D.
◎ Basic Managerial Question: How much of the control
variable should be used to maximize net benefits?

20
 TERMS

◎ Marginal (incremental) benefit: The change in

total benefits arising from a change in the
managerial control variable Q.
◎ Marginal (incremental) cost (MC): The change in
total costs arising from a change in the managerial
control variable Q.
◎ Marginal net benefits: The change in net benefits
that arise from a one-unit change in Q
MNB = MB − MC
21
DISCRETE DECISIONS

22
 NET BENEFITS

◎ Net Benefits = Total Benefits - Total Costs

◎ Profits = Revenue - Costs

23
 “
Marginal Principle
To maximize net benefits, the manager should increase the managerial
control variable up to the point where marginal benefits equal marginal
costs. This level of the managerial control variable corresponds to the
level at which marginal net benefits are zero; nothing more can be gained
by further changes in that variable.

zz 24
 MARGINAL PRINCIPLE

◎ To maximize net benefits, the managerial control

variable should be increased up to the point where:
MB = MC
◎ MB > MC means the last unit of the control variable
increased benefits more than it increased costs.
◎ MB < MC means the last unit of the control variable
increased costs more than it increased benefits.

25
MARGINAL PRINCIPLE

26
DISCRETE DECISIONS

27
CONTINUOUS DECISIONS

28
 MARGINAL BENEFIT (MB)

29
 MARGINAL COST (MC)

30
 DEMONSTRATION PROBLEM

◎ An engineering firm recently conducted a study to

determine its benefit and cost structure. The results
of the study are as follows:
B (Y) = 300Y − 6 Y 2
C (Y) = 4 Y 2
◎ The manager has been asked to determine the
maximum level of net benefits and the level of Y
that will yield that result.

31
 INCREMENTAL DECISIONS

◎ Sometimes managers are faced with proposals that

require a simple thumbs-up or thumbs-down
decision (yes-or-no decisions)
◎ Adopt project when incremental revenues exceed
incremental costs
◎ Incremental revenues: The additional revenues
that stem from a yes-or-no decision.
◎ Incremental costs: The additional costs that stem
from a yes-or-no decision.
32
 INCREMENTAL DECISIONS

To illustrate, imagine that

you are the CEO of Slick
Drilling Inc. and you must
decide whether or not to drill
for crude oil around the Twin
Lakes area in Michigan. You
are relatively certain there
are 10,000 barrels of crude
oil at this location. An
accountant working for you
prepared the information in
the Table below to help you
decide whether or not to
adopt the new project
33
On Tuesday software giant Amcott posted a year-end operating loss
of $3.5 million. Reportedly, $1.7 million of the loss stemmed from its
foreign language division. With short-term interest rates at 7 percent,
Amcott decided to use $20 million of its retained earnings to purchase
three-year rights to Magicword, a software package that converts
generic word processor files saved as French text into English. First-
year sales revenue from the software was $7 million, but thereafter
sales were halted pending a copyright infringement suit filed by
Foreign, Inc. Amcott lost the suit and paid damages of $1.7 million.
Industry insiders say that the copyright violation pertained to “a very
small component of Magicword.” Ralph, the Amcott manager who
was fired over the incident, was quoted as saying, “I’m a scapegoat
for the attorneys [at Amcott] who didn’t do their homework before
buying the rights to Magicword. I projected annual sales of $7 million
per year for three years. My sales forecasts were right on target.” Do
you know why Ralph was fired? 34
Summary
1. Summarize how goals, constraints, incentives, and market rivalry
affect economic decisions.
2. Distinguish economic versus accounting profits and costs.
3. Explain the role of profits in a market economy.
4. Apply the five forces framework to analyze the sustainability of an
industry’s profits.
5. Apply present value analysis to make decisions and value assets.
6. Apply marginal analysis to determine the optimal level of a
managerial control variable.
7. Identify and apply six principles of effective managerial decision
making.
35
Chapter 2
DEMAND ANALYSIS,
ESTIMATION AND
FORECASTING

Presenter: Vo Hoang Kim An

Foreign Trade University – Ho Chi Minh City – Vietnam
1.
Demand Analysis
By using elasticity of demand

37
 Price Elasticity of Demand (E)

◎ Measures responsiveness or sensitivity of

consumers to changes in the price of a good

◎ P & Q are inversely related by the law of demand

so E is always negative
○ The larger the absolute value of E, the more
sensitive buyers are to a change in price

6-38
RELATIVELY ELASTIC
As price changes, there is a
LARGE change in quantity
demanded for a good or
service
40
RELATIVELY INELASTIC
As price changes, there is a
SMALL change in quantity
demanded for a good or
service
UNIT ELASTICITY
As price changes, quantity
demand for a good or service
will change by the same
amount
 Price Elasticity of Demand (E)

Elasticity Responsiveness ⏐E⏐

Elastic
Unitary Elastic
Inelastic

6-43
 Calculating Price Elasticity of Demand
◎ Price elasticity can be calculated by multiplying
the slope of demand (ΔQ/ΔP) times the ratio of
price to quantity (P/Q)

◎ Given Q = a + bP where b = ΔQ/ΔP

6-44
 Group discussion

◎ What is the relationship between

elasticity of demand and total revenue?
Please give examples.

6-45
 Price Elasticity & Total Revenue

Elastic Unitary elastic Inelastic

Quantity-effect No dominant effect Price-effect dominates
dominates

Price rises No change in TR TR rises

TR falls

Price falls TR rises No change in TR TR falls

6-46
 Price Elasticity & Total Revenue
The manager at Borderline Video Emporium faces the demand
curve for Blu-ray DVD discs shown in Figure 6.1. Predict and
calculate the change in total revenue in below instances:
1. At the current price of $18 per DVD Borderline can sell 600
DVDs each week. The manager can lower price to $16 per DVD
and increase sales to 800 DVDs per week. Over the interval a to
b on demand curve D the price elasticity is equal to -2.43.
2. Now suppose the manager at Borderline is charging just $9 per
compact disc and sells 1,500 DVDs per week (see Panel B). The
manager can lower price to $7 per disc and increase sales to
1,700 DVDs per week. Over the interval c to d on demand curve
D, the elasticity of demand equals -0.50.
○ From those results, what do you infer?
6-47
Price Elasticity & Total Revenue

6-48
 Marginal Revenue
◎ Marginal revenue (MR) is the change in total
revenue per unit change in output
◎ Since MR measures the rate of change in total
revenue as quantity changes, MR is the slope of
the total revenue (TR) curve

6-49
 Marginal Revenue & Price Elasticity

◎ For all demand & marginal revenue curves, the

relation between marginal revenue, price, &
elasticity can be expressed as

6-50
2.
Demand Estimation
and Forecasting
By using regression and
statistical knowledge
51
 MR, TR, & Price Elasticity

Marginal Price elasticity of

Total revenue
revenue demand

TR increases Elastic Elastic

(⏐E⏐> 1)
MR > 0 as Q increases
(⏐E⏐> 1)
(P decreases)

Unit Unit
elastic (⏐E⏐= 1)
elastic
MR = 0 TR is maximized
(⏐E⏐= 1)
TR decreases as Inelastic (⏐E⏐< 1)
Inelastic
MR < 0 Q increases (⏐E⏐< 1)
(P decreases) 6-52
 Empirical Demand Functions

◎ Demand equations derived from actual market

data
◎ Useful in making pricing & production decisions
◎ In linear form, an empirical demand function can
be specified as

7-53
Example: Estimating the Demand for a Pizza Firm

Specify price-setting firm’s demand function

Q = a + bP + cM + dPAl + ePBMac
Where:
◎ Q = sales of pizza at Checkers Pizza
◎ P = price of a pizza at Checkers Pizza
◎ M = average annual household income in Westbury
◎ PAl = price of a pizza at Al’s Pizza Oven
◎ PBMac = price of a Big Mac at McDonald’s
6-54
Example: Estimating the Demand for a Pizza Firm

6-55
Example: Estimating the Demand for a Pizza Firm

◎ Test the significance of estimated slope

parameters?
◎ Is the model as the whole significant?
◎ Calculate the estimated demand elasticity at
values of P, M, PAl, and PBmac where P = 9.05, M
= 26,614, PAl = 10.12, and PBMac = 1.15.
◎ Explain the result?

6-56
 Time-Series Forecasts

◎ A time-series model shows how a time-ordered

sequence of observations on a variable is
generated
◎ Simplest form is linear trend forecasting
○ Sales in each time period (Qt ) are assumed to be
linearly related to time (t)

7-57
 Linear Trend Forecasting

○ If b > 0, sales are increasing over time

○ If b < 0, sales are decreasing over time
○ If b = 0, sales are constant over time

7-58
 Direct Methods of Demand Estimation
◎ Consumer interviews
○ Range from stopping shoppers to speak with them to
administering detailed questionnaires
○ Potential problems
◉ Selection of a representative sample, which is a sample (usually
random) having characteristics that accurately reflect the
population as a whole
◉ Response bias, which is the difference between responses given
by an individual to a hypothetical question and the action the
individual takes when the situation actually occurs
◉ Inability of the respondent to answer accurately

7-59
Forecasting Sales for Terminator Pest Control

7-60
 Direct Methods of Demand Estimation

◎ Market studies & experiments

○ Market studies attempt to hold everything
constant during the study except the price of
the good
○ Lab experiments use volunteers to simulate
actual buying conditions
○ Field experiments observe actual behavior of
consumers

7-61
Chapter 3
Production and cost analysis;
The organization of a firm

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
 “
Part 1.
Production and cost analysis

63
 Basic Concepts of Production Theory

◎ Inputs are considered variable or fixed depending on

how readily their usage can be changed
◎ Variable input
○ An input for which the level of usage may be changed quite
readily
◎ Fixed input
○ An input for which the level of usage cannot readily be changed
and which must be paid even if no output is produced
◎ Quasi-fixed input
○ An input employed in a fixed amount for any positive level of
output that need not be paid if output is zero

8-64
 Basic Concepts of Production Theory

◎ Short run
○ At least one input is fixed
○ All changes in output achieved by changing
usage of variable inputs
◎ Long run
○ All inputs are variable
○ Output changed by varying usage of all inputs

8-65
 Short Run Production

◎ In the short run, capital is fixed

○ Only changes in the variable labor input can
change the level of output
◎ Short run production function

8-66
1.
Production and Cost
in the Short Run

67
 Average & Marginal Products

◎ Average product of labor

○ AP = Q/L
◎ Marginal product of labor
○ MP = ΔQ/ΔL
◎ When AP reaches it maximum:
○ AP = MP
◎ Law of diminishing marginal product
○ As usage of a variable input increases, a point is
reached beyond which its marginal product
decreases
8-68
Total, Average & Marginal
Product Curves
o Increasing marginal
returns: Range of input
usage over which marginal
product increases
o Decreasing (diminishing)
marginal returns: Range of
input usage over which
marginal product declines.
o Negative marginal returns:
Range of input usage over
which marginal product is
negative.

8-69
 Phases of
Marginal Returns
As the usage of an input increases, marginal
product initially increases (increasing marginal
returns), then begins to decline (decreasing
marginal returns), and eventually becomes
negative (negative marginal returns).
70
The Role of the Manager in the
Production Process

8-71
 Profit-Maximizing
Input Usage
To maximize profits, a manager should use inputs at levels
at which the marginal benefit equals the marginal cost.
More specifically, when the cost of each additional unit of
labor is w, the manager should continue to employ labor
up to the point where VMPL = w in the range of
diminishing marginal product
72
 Short Run Production Costs

◎ Total variable cost (TVC)

○ Total amount paid for variable inputs
○ Increases as output increases
◎ Total fixed cost (TFC)
○ Total amount paid for fixed inputs
○ Does not vary with output
◎ Total cost (TC)
○ TC = TVC + TFC
8-73
 Short-Run Total Cost Schedules

Output (Q) Total fixed cost Total variable Total Cost

(TFC) cost (TVC) (TC=TFC+TVC)
0 $6,000 $ 0 $ 6,000
100 6,000 4,000 10,000
200 6,000 6,000 12,000
300 6,000 9,000 15,000
400 6,000 14,000 20,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000

8-74
Total Cost Curves

8-75
 Average Costs
•

8-76
 Short Run Marginal Cost

◎ Short run marginal cost (SMC) measures

rate of change in total cost (TC) as
output varies

8-77
 Average & Marginal Cost Schedules

Output Average Average Average total Short-run

(Q) fixed cost variable cost cost marginal cost
(AFC=TFC/ (AVC=TVC/Q) (ATC=TC/Q= (SMC=ΔTC/ΔQ)
Q) AFC+AVC)
0 -- -- -- --
100 $60 $40 $100 $40
200 30 30 60 20
300 20 30 50 30
400 15 35 50 50
500 12 44 56 80
600 10 56.7 66.7 120

8-78
Average & Marginal Cost Curves

8-79
Short Run Average & Marginal
Cost Curves

8-80
 Short Run Cost Curve Relations

◎ AFC decreases continuously as output

increases
○ Equal to vertical distance between ATC & AVC
◎ AVC is U-shaped
○ Equals SMC at AVC’s minimum
◎ ATC is U-shaped
○ Equals SMC at ATC’s minimum

8-81
 Short Run Cost Curve Relations

◎ SMC is U-shaped
○ Intersects AVC & ATC at their minimum points
○ Lies below AVC & ATC when AVC & ATC are
falling
○ Lies above AVC & ATC when AVC & ATC are
rising

8-82
Relations Between Short-Run Costs & Production

8-83
Relations Between Short-Run Costs & Production

◎ In the case of a single variable input, short-run

costs are related to the production function by
two relations

8-84
Short-Run Production & Cost Relations

8-85
 Relations Between Short-Run Costs
& Production
◎ When marginal product (average product) is increasing,
marginal cost (average cost) is decreasing
◎ When marginal product (average product) is decreasing,
marginal cost (average variable cost) is increasing
◎ When marginal product = average product at maximum
AP, marginal cost = average variable cost at minimum
AVC

8-86
 Summary of Short-Run Empirical
Production Functions

Short-run cubic
production equations
Total product

Average product of labor

Marginal product of labor

Diminishing marginal
returns
Restrictions on
parameters
10-
 Summary of Short-Run Empirical
Cost Functions

Short-run cubic
cost equations
Total variable cost

Average variable cost

Marginal cost
Average variable cost
reaches minimum at
Restrictions on
parameters
10-
 Sunk cost
A cost that is forever lost
after it has been paid.

89
 Fixed and Sunk Costs
Considering this illustration problem:
◎ ACME Coal paid $5,000 to lease a railcar from the Reading
Railroad. Under the terms of the lease, $1,000 of this
payment is refundable if the railcar is returned within two
days of signing the lease.
1. Upon signing the lease and paying $5,000, how large are
ACME’s fixed costs? Its sunk costs?
2. One day after signing the lease, ACME realizes that it has no
use for the railcar. A farmer has a bumper crop of corn and has
offered to sublease the railcar from ACME at a price of $4,500.
Should ACME accept the farmer’s offer?
8-90
Exercise 1

8-91
Exercise 1

a. What are the estimated total, average, and marginal product

functions?
b. Are the parameters of the correct sign, and are they significant
at the 1 percent level?
c. At what level of labor usage is average product at its maximum?
Assume that the wage rate for labor (w) is $200.
d. What is output when average product is at its maximum?

8-92
Exercise 2

8-93
Exercise 2
a. Do the parameter estimates have the correct signs? Are they
statistically significant at the 5 percent level of significance?
b. b. At what level of output do you estimate average variable cost
reaches its minimum value?
c. What is the estimated marginal cost curve?
d. What is the estimated marginal cost when output is 700 units?
e. What is the estimated average variable cost curve?
f. What is the estimated average variable cost when output is 700
units?

8-94
Typical Isoquants

9-95
2.
Production and Cost
in the Long Run

96
 Marginal Rate of Technical Substitution

◎ The MRTS is the slope of an isoquant & measures

the rate at which the two inputs can be substituted
for one another while maintaining a constant level
of output

9-97
 Marginal Rate of Technical Substitution

◎ The MRTS can also be expressed as the ratio of

two marginal products:

9-98
 Isocost Curves

•
○ Represents amount of capital that may be purchased if zero
labor is purchased
9-99
Isocost Curves

9-
Optimal Input Combination to Minimize
Cost for Given Output

9-
 Optimal Combination of Inputs

◎ Minimize total cost of producing Q by choosing the

input combination on the isoquant for which Q is just
tangent to isocost curve
◎ Two slopes are equal in equilibrium
◎ Implies marginal product per dollar spent on last unit
of each input is the same

9-
 DEMONSTRATION PROBLEM

Terry’s Lawn Service rents five small push mowers and

two large riding mowers to cut the lawns of neighborhood
households. The marginal product of a small push mower
is 3 lawns per day, and the marginal product of a large
riding mower is 6 lawns per day. The rental price of a small
push mower is $10 per day, whereas the rental price of a
large riding mower is $25 per day. Is Terry’s Lawn Service
utilizing small push mowers and large riding mowers in a
cost-minimizing manner?

8-
 Long-Run Costs

◎ Long-run total cost (LTC) for a given

level of output is given by:
LTC = wL* + rK*
◎ Where w & r are prices of labor & capital, respectively

9-
 Long-Run Costs
◎ Long-run average cost (LAC) measures the cost per
unit of output when production can be adjusted so
that the optimal amount of each input is employed
○ LAC is U-shaped
○ Falling LAC indicates economies of scale
○ Rising LAC indicates diseconomies of scale

9-
 Long-Run Costs
◎ Long-run marginal cost (LMC) measures the rate of
change in long-run total cost as output changes along
expansion path
○ LMC is U-shaped
○ LMC lies below LAC when LAC is falling
○ LMC lies above LAC when LAC is rising
○ LMC = LAC at the minimum value of LAC

9-
Long-Run Average & Marginal Cost

9-
 INSIDE BUSINESS
In industries with economies of scale, firms that produce greater levels of output produce at
lower average costs and thus gain a potential competitive advantage over rivals. Recently,
two international businesses pursued such strategies to enhance their bottom line.
Japan’s Matsushita Plasma Display Panel Company, Ltd., invested $835 million to build the
world’s largest plant for producing plasma display panels. The factory—a joint venture
between Panasonic and Toray Industries—had the capacity to produce 250,000 panels per
month by the late 2000s. This strategy was implemented in response to rising global demand
for plasma display panels, and a desire on the part of the company to gain a competitive
advantage over rivals in this increasingly competitive industry.
An automaker in India—Maruti Udyog Ltd.—produced tangible evidence that economies of
scale are important in business decisions. It enjoyed a 271 percent increase in net profits in
the mid-2000s, thanks to its ability to exploit these economies. The increase was spawned by
a 30 percent increase in sales volume that permitted the firm to spread its sizable fixed costs
over greater output. Importantly, the company’s reduction in average costs due to economies
of scale was more than enough to offset the higher costs stemming from increases in the
price of steel.
SOURCES: “Matsushita Plans Big Expansion of PDP Manufacturing,” IDG News Service, May 19, 2004; “MUL Gains from Cost-Saving Measures,”
Sify India, May 18, 2004. 108
 “
Part 2.
The organization of a firm

109
110
 OVERVIEW
I. Methods of Procuring Inputs
○ Spot Exchange
○ Contracts
○ Vertical Integration
II. Optimal Procurement Input
III. Principal-Agent Problem
○ Owners-Managers
○ Managers-Workers

111
 Learning objectives
1. Discuss the economic trade-offs associated with obtaining inputs
through spot exchange, contract, or vertical integration.
2. Identify four types of specialized investments, and explain how each
can lead to costly bargaining, underinvestment, and/or a “hold-up
problem.”
3. Explain the optimal manner of procuring different types of inputs.
4. Describe the principal–agent problem as it relates to owners and
managers.
5. Discuss three forces that owners can use to discipline managers.
6. Describe the principal–agent problem as it relates to managers and
workers.
7. Discuss four tools the manager can use to mitigate incentive
problems in 112
1.
METHODS OF
PROCURING INPUTS
1. Spot exchange
2. Contract
3. Vertical integration
113
 METHODS OF PROCURING INPUTS

Consider the manager of a car rental company. One

input needed to produce output (rental cars) is
automobile servicing (tune-ups, oil changes, lube jobs,
and the like). The manager has three options:
1. Simply take the cars to a firm that services
automobiles and pay the market price for the
services
2. Sign a contract with a firm that services automobiles
3. Create within the firm a division that services
automobiles 114
 METHODS OF PROCURING INPUTS

◎ Spot exchange: An informal relationship between a

buyer and seller in which neither party is obligated to
adhere to specific terms for exchange.
◎ Contract: A formal relationship between a buyer and
seller that obligates the buyer and seller to exchange
at terms specified in a legal document.
◎ Vertical integration: A situation where a firm
produces the inputs required to make its final
product.
115
 SPOT EXCHANGE (AT ARM’S LENGTH )
◎ Definition: An informal relationship between a
buyer and seller in which neither party is obligated
to adhere to specific terms for exchange.
○ Occurs when autonomous parties exchange goods or
services with no explicit or implicit agreement that the
relationship will continue into the future.
◎ Examples: Purchasing at Coop Mart, staying at New
World hotel for a night.
◎ Advantage: the firm gets to specialize in doing what it
does best

116
 CONTRACTS

◎ Definition: A contract is a legal agreement which defines the

conditions of an exchange or series of exchanges.
○ A formal relationship between a buyer and seller that obligates the
buyer and seller to exchange at terms specified in a legal document
◎ Examples: Bank loan, futures contract, marriage, etc.
◎ Advantage: purchase “nonstandard” inputs
◎ Disadvantage: costly to write; it takes time, and often legal
fee, extremely difficult to cover all the contingencies that could
occur in the future

117
 VERTICAL INTEGRATION (VI)

Definition: it is the situation where a firm shuns other

suppliers and chooses to produce an input internally.
◎ It alters control structures. Hidden information and hidden action
problems are reduced.
◎ Repeated interactions improve trust and coordination
◎ The integrated firm has a common set of goals.
◎ But remember the problems with making
Advantage: no longer has to rely on other firms
Disadvantage: loses the gains in specialization, has to
manage the production of inputs and final product
→bureaucratic costs associated with a larger
118
 PRACTICE

Determine whether the following transactions involve

spot exchange, a contract, or vertical integration:
1. Clone 1 PC is legally obligated to purchase 300 computer chips
each year for the next three years from AMI. The price paid in
the first year is $200 per chip, and the price rises during the
second and third years by the same percentage by which the
wholesale price index rises during those years.
2. Clone 2 PC purchased 300 computer chips from a firm that ran
an advertisement in the back of a computer magazine.
3. Clone 3 PC manufactures its own motherboards and computer
chips for its personal computers.

119
 TRANSACTION COSTS

◎ Definition: Transactions costs are costs associated

with acquiring an input that are in excess of the
amount paid to the input supplier (Coase, 1937).
◎ Obvious examples: Insurance, freight, damage, own
time.
◎ Other important examples: cost of searching for a
supplier willing to sell a specific input, negotiations
costs incl. opportunity cost of time, legal costs, costs of
maintaining assets required to engage in the
transactions.
120
 TRANSACTION COSTS

◎ Many transaction costs are obvious.

○ Ex: input supplier charges a price of $10 per unit
but requires you to furnish your own trucks and
drivers to pick up the input → transaction costs :
the cost of the trucks and the personnel needed to
“deliver” the input to your plant.
◎ Some important transaction costs are less obvious →
distinguish b/w transaction costs : specific to a
particular trading or general in nature → specialized
investment.
121
 SPECIALIZED INVESTMENT

◎ Definition: A specialized investment (SI) is an expenditure that

is made to allow two parties to make exchanges, but has less
value in alternative uses.
→ Examples: to ascertain the quality of chips, Apple spend $100 on a machine that
tests the chips’ quality:
○ If the machine is useful only for testing chips from TSM → SI.
○ If the machine can be resold at its purchase price or used to test the quality
of bolts produced by Intel Corp→ not a SI
→ Examples: Insuring assets (life or crops) when taking out a loan, building trust with
a supplier/customer, quality control investments required to access international
markets (food, toys, etc.).
◎ Definition: A relationship-specific exchange is one that occurs
when both parties to the exchange have made specialized
investments. These investments are called relationship-specific
122
investments (RSIs).
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

1. Site specificity
2. Physical asset specificity
3. Human asset
4. Dedication

123
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

◎ Site specificity: Here, assets are situated side-by-

side.
○ Examples: Coal mines and power plants, grain elevators
and rail-spurs, processes in steel or wine production

◎ Physical asset specificity: Here, the physical/

engineering/chemical properties of the asset are
tailored to a given set of transactions.
○ Examples: Dyes and molds, some genetically modified
organisms, software products

124
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

◎ Human asset specificity: Here, the SI is human in

nature.
○ Examples: Skill acquisitions, building trust
◎ Dedicated asset: is one that would be a complete
write-off if the transactions in question were
cancelled.

There are other types of specificities, and some

investments may express multiple forms

125
 USEFULNESS OF SIs

◎ SIs generally promote economic efficiency (increase

the welfare of society) in that they identify
collaborations between firms that reduce the cost of
producing the same amount of goods or increase the
amount of goods produced by the same level of
resources or do a bit of both (supply/demand
graphs).
◎ They are probably good for the firms in question
because the firms would likely not make the
investment otherwise.
◎ Problems may arise because SIs create vulnerability. 126
 IMPLICATION OF SI

◎ Specialized investments increase transaction costs

because they lead to
(1) costly bargaining: no other supplier capable of providing
the desired input at a moment’s notice → no “market price” for
the input → bargaining process costly
(2) underinvestment: the level of the specialized investment
often is lower than the optimal level.
(3) opportunism: When a SI existed, buyer/seller attempt to
capitalize on the “sunk” nature of the investment by engaging in
opportunism

127
 IMPLICATION OF SI

(3) opportunism:
→ The “hold-up problem”: Once a firm makes a
specialized investment, the other party may attempt to
“rob” it of its investment by taking advantage of the
investment’s sunk nature.
→ This behavior make firms reluctant to engage in
relationship-specific investments in the first place
unless they can structure contracts to mitigate the
hold-up problem.

128
1.
OPTIMAL INPUT
PROCUREMENT
When to use each form of input
procurement?

129
 OPTIMAL INPUT PROCUREMENT

Spot exchange
Jiffyburger, a fast-food outlet, sells approximately 8,000 quarter-
pound hamburgers in a given week. To meet that demand,
Jiffyburger needs 2,000 pounds of ground beef delivered to its
premises every Monday morning by 8:00 AM sharp.
1. As the manager of a Jiffyburger franchise, what problems would
you anticipate if you acquired ground beef using spot
exchange?
2. As the manager of a firm that sells ground beef, what problems
would you anticipate if you were to supply meat to Jiffyburger
through spot exchange?
130
 SPOT EXCHANGE

◎ Used if there are no transaction costs and there are

many buyers and sellers in the input market
◎ Price is determined by the market price (intersection
of the supply and demand curves)
◎ Easily to change to suppliers that offer lower prices
◎ Disadvantages: result in high transaction costs due
to opportunism, bargaining costs, and
underinvestment when input requires substantial
specialized investments
131
 CONTRACTS

◎ Overcome hold-up problem and the need to bargain

over price each time the input is to be purchased
◎ Can specify prices of the input before the parties
make specialized investments
◎ Reduces the incentive for either the buyer or the
seller to skimp on the specialized investments
required for the exchange
◎ How long should the contract last?

132
 CONTRACT LENGTH

◎ “Optimal” contract length: trade-off between the

marginal costs and marginal benefits of extending the
length of a contract.
◎ MC increases as contracts become longer
○ Contracts of long duration are more difficult to write because
it is harder to specify all contingencies, e.g., oil price rise,
new technology, etc; the less flexibility the firm has in
choosing an input supplier
◎ MB (avoided transaction costs of opportunism and
bargaining) vary with the length of the contract
○ For simplicity we can draw a flat MB curve
133
OPTIMAL CONTRACT LENGTH

134
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

135
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

136
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

137
 VERTICAL INTEGRATION

◎ Produce the input internally. Utilized when:

○ SIs generate transaction costs (due to opportunism, bargaining
costs, or underinvestment)
○ Product is extremely complex
○ The economic environment is plagued by uncertainty
◎ Advantage: mitigate transaction costs
◎ Disadvantages:
○ Managers must replace the discipline of the market with an internal
regulatory mechanism
○ The firm must bear the cost of setting up production facilities →firm
no longer specializes in doing what it does best
◎ VI should be undertaken only when spot exchange or
contracts have failed.
138
 OPTIMAL INPUT PROCUREMENT

Depend on the extent to which there is relationship-

specific exchange.

139
 EXAMPLE: GENERAL MOTOR AND FISHER BODY

◎ Early 20th century: specialized

investments were relatively unimportant
→ GM bought the bodies for its cars using
spot exchange
◎ Closed metal bodies for car
manufacturing → high degree of physical-
asset specificity → GM and Fisher Body
signed a 10-year contract
◎ Parties to engage in opportunism → GM
vertically integrated by purchasing
Fisher Body

140
 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

141
 KEY FEATURES

◎ Spot Exchange
○ Specialization, avoids contracting costs, avoids costs of
vertical integration.
○ Possible “hold-up problem.”
◎ Contracts
○ Specialization, reduces opportunism, avoids skimping on
specialized investments
○ Costly in complex environments
◎ Vertical Integration
○ Reduces opportunism, avoids contracting costs
○ Lost specialization and may increase organizational costs
142
 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).
◎ The Problem: Principal cannot determine whether a bad
outcome was the result of the agent’s low effort or due to bad
luck
◎ Manager’s must recognize the existence of the principal-agent
problem and devise plans to align the interests of workers with
that of the firm
◎ Shareholders must create plans to align the interest of the
manager with those of the shareholders.
143
144
Manager receive 10 percent of profits

145
 SOLVING THE PROBLEM BETWEEN OWNERS AND
MANAGERS

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

146
 SOLVING THE PROBLEM BETWEEN WORKERS AND
MANAGERS

◎ Profit sharing: Mechanism used to enhance workers’ efforts

that involves tying compensation to the underlying profitability of
the firm.
◎ Revenue sharing: Mechanism used to enhance workers’
efforts that involves linking compensation to the underlying
revenues of the firm.
◎ Piece rates: depend on the output produced
◎ Time clocks and spot checks

147
 CONCLUSION

◎ The optimal method for acquiring inputs

depends on the nature of the transactions
costs and specialized nature of the inputs
being procured.
◎ To overcome the principal-agent problem,
principals must devise plans to align the
agents’ interests with the principals.

148
Google Buys Motorola Mobility to Vertically Integrate In a bold
move, Google purchased Motorola Mobility—the recently spun-
off cellular arm of Motorola—for $12.5 billion. This move marks
an attempt by Google to vertically integrate into the smartphone
hardware market. Industry experts note that the purchase will
allow Google to build prototypes and advanced hardware
devices that will help to point its software business partners in
the direction Google wants to go. Google is banking on the
increased coordination between its software and Motorola’s
hardware and the reduction in risks associated with vertical
integration outweighing the costs.
If you were a decision maker at Google, would you have
recommended vertical integration?

149
Chapter 4
The Nature of Industry

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
 INDUSTRY ANALYSIS
◎ Market Structure: Factors that affect managerial
decisions
○ Number and size of firms
○ Industry concentration
○ Technological and cost conditions
○ Demand conditions.
○ Ease of entry and exit

151
 INDUSTRY CONCENTRATION

152
NUMBER AND SIZE OF FIRM

153
 EXAMPLE

154
155
 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

156
 PROS & CONS OF HORIZONTAL INTEGRATION

PROS CONS
◎ Lower costs → ◎ Destroyed value.
economics of scale / ◎ Legal repercussions.
scope. ◎ Reduced flexibility.
◎ Increased differentiation
◎ Increased market
power.
◎ Reduced competition.
◎ Access to new markets.

157
 TYPE OF MARKET STRUCTURE

◎ Economists have developed four primary models

of market structures: perfect competition,
monopoly, oligopoly, and monopolistic competition
◎ This system of market structure is based on two
dimensions:
○ The number of firms in the market (one, few, or
many)
○ Whether the goods offered are identical or
differentiated
158
TYPE OF MARKET STRUCTURE

This system of market

structure is based on two
dimensions:
• The number of firms in
the market (one, few, or
many)
• Whether the goods
offered are identical or
differentiated
Differentiated goods are
goods that are different but
considered somewhat
substitutable by consumers159
160
 PERFECT COMPETITION

◎ A price-taking producer is a producer whose

actions have no effect on the market price of the
good it sells
◎ A price-taking consumer is a consumer whose
actions have no effect on the market price of the
good he or she buys
◎ A perfectly competitive market is a market in
which all market participants are price-takers
◎ A perfectly competitive industry is an industry in
which producers are price-takers. 161
 PERFECT COMPETITION
Two Necessary Conditions for Perfect Competition
1. For an industry to be perfectly competitive, it must
contain many producers, none of whom have a large
market share.
◉ A producer’s market share is the fraction of the total
industry output accounted for by that producer’s
output.
2. An industry can be perfectly competitive only if
consumers regard the products of all producers as
equivalent.
○ A good is a standardized product, also known as
a commodity, when consumers regard the 162
 PERFECT COMPETITION

Free entry and exit

◎ There is free entry and exit into and from an
industry when new producers can easily enter into
or leave that industry
◎ Free entry and exit ensure:
○ That the number of producers in an industry
can adjust to changing market conditions
○ That producers in an industry cannot artificially
keep other firms out.
163
 MONOPOLY

◎ A monopolist is a firm that is the only producer of a

good that has no close substitutes. An industry
controlled by a monopolist is known as a
monopoly, e.g. De Beers
◎ The ability of a monopolist to raise its price above
the competitive level by reducing output is known
as market power.
◎ What do monopolist do with this market power?

164
 MONOPOLY

Why do monopolies exist?

◎ A monopolist has market power and as a result will charge
higher prices and produce less output than a competitive
industry. This generates profit for the monopolist in the short
run and long run
◎ Profits will not persist in the long run unless there is a barrier
to entry. This can take the form of:
○ Control of natural resources or inputs
○ Increasing returns to scale
○ Technological superiority
○ Government-created barriers including patents and
copyrights 165
 MONOPOLY

Disadvantages
◎ Exploitation of consumer – higher prices
◎ Potential for supply to be limited – less choice
◎ Potential for inefficiency – X-inefficiency – complacency
over controls on costs

166
 MONOPOLY

Advantages
◎ May be appropriate if natural monopoly
◎ Encourages R&D
◎ Encourages innovation
◎ Development of some products not likely without some
guarantee of monopoly in production
◎ Economies of scale can be gained – consumer may benefit

167
 OLIGOPOLY

◎ Oligopoly is a common market structure. It arises

from the same forces that lead to monopoly, except
in weaker form. It is an industry with only a small
number of producers. A producer in such an
industry is known as an oligopolist.
◎ When no one firm has a monopoly, but producers
nonetheless realize that they can affect market
prices, an industry is characterized by imperfect
competition.
168
 OLIGOPOLY

Is it an Oligopoly, or Not?
◎ According to Justice Department guidelines, an
HHI below 1,500 indicates a strongly competitive
market, between 1,500 and 2,500 indicates a
somewhat competitive market, and over 2,500
indicates an oligopoly.
◎ In an industry with an HHI over 2,500, a merger
that results in a significant increase (about 200
points) in the HHI will receive special scrutiny and
is likely to be disallowed.
Source: The United States Department of Justice, 2018
169
 OLIGOPOLY
The HHI for some oligopolistic industry
Industry HHI Largest firms
PC Operating systems 9,182 Microsoft, Linux
Wide-body aircraft 5,098 Boeing, Airbus
Diamond mining 2,338 De Beers, Alrosa, RioTinto
Automobiles 1,432 GM, Ford, Chrysler, Toyota, Honda, Nissan, VW
Buena Vista, Sony Pictures, 20th Century Fox, Warner
Movie distributor 1,096
Bros, Universal, Paramount, Lionsgate
Internet service provider 750 SBC, Comcast, AOL, Verizon, Road Runner,…

Retail grocers 321 Walmart, Kroger, Sears, Target, Costco, Walgreens,

Sources: Canadian Government; Diamond Facts 2006; [Link]; Planet retail; Autodata; Reuters; ISP Planet; Swivel. Data cover 2006-2007

170
 MONOPOLISTIC COMPETITION

Monopolistic competition is a market structure in

which:
◎ There are many competing producers in an
industry
◎ Each producer sells a differentiated product
◎ There is free entry into and exit from the industry
in the long run

171
 SUMMARY

Perfect
Monopolistic
Competition Oligopoly Monopoly
Competition

Large number of buyers Few sellers

Single producer and seller
MARKET and sellers Many sellers Homogeneous or
differentiated product No close substitutes
Homogeneous product Differentiated product available
STRUCTURE Perfect substitutes
available
Close substitutes available
Interdependent decision-
making Impossible entry (pure
monopoly), or may face
Relatively free entry and
S Free entry and exit exit
Substitutes may or may
not be available
threat of potential entrants
(contestable monopoly)
Perfect knowledge and Non-price competition in Very difficult entry and exit Usually regulated public
innovation the form of advertising and utilities (natural
Strategic pricing-output monopolies that produce
No advertising or product product innovation decision and marketing essential goods)
innovation effort

172
 SUMMARY
1. There are four main types of market structure based on the
number of firms in the industry and product differentiation:
perfect competition, monopoly, oligopoly, and monopolistic
competition
2. In a perfectly competitive market all producers are price-
taking producers and all consumers are price-taking
consumers – no one’s actions can influence the market
price
3. There are two necessary conditions for a perfectly
competitive industry: there are many producers, none of
whom have a large market share, and the industry produces
a standardized product or commodity. A third condition is
often satisfied as well: free entry and exit into and from the 173
 SUMMARY
4. A monopolist is a producer who is the sole supplier of a
good without close substitutes. An industry controlled by a
monopolist is a monopoly.
5. Many industries are oligopolies: there are only a few
sellers. In particular, a duopoly has only two sellers.
Oligopolies exist for more or less the same reasons that
monopolies exist, but in weaker form. They are characterized
by imperfect competition: firms compete but possess
market power.
6. Monopolistic competition is a market structure in which
there are many competing producers, each producing a
differentiated product, and there is free entry and exit in the
long run. 174
Chapter 5
Pricing, Advertising and
Investment policies in business

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
1.
Pricing policies

176
HEADLINE: Mickey Mouse Lets You Ride “for Free” at Disney
World

Walt Disney World Theme Parks offer

visitors a wide variety of ticket choices.
The one thing these ticket options
have in common is that they entail a
fixed entrance fee and allow customers
to take as many rides as they want at
no additional charge. For instance, by
purchasing a 1-Day ticket for about
$105, a customer gains unlimited
access to the park of her choice for
one day.
Wouldn’t Disney earn higher profits if it
charged visitors, say, $10.50, each
time they went on a ride? 177
 OVERVIEW
1. Basic pricing strategies
○ Perfect competition
○ Monopoly & Monopolistic Competition
○ Cournot Oligopoly
2. Strategic pricing for greater profits
○ Price Discrimination o Two-part pricing
○ Block Pricing o Commodity Bundling
3. Pricing strategies for special structure of cost and
demand structures
○ Peak-Load Pricing
○ Cross -Subsidies
178
 “
BASIC PRICING
STRATEGIES

179
 PERFECT COMPETITION
S
Price (dollars)

Price (dollars)
P0
P0 D = MR

0 Q0 0 Quantity
Quantity Panel B – Demand curve facing
Panel A – a price-taker 181
 PERFECT COMPETITION

Short-run Output Decision

◎ AVC tells whether to produce
○ Shut down if price falls below minimum AVC
◎ SMC tells how much to produce
○ If P ≥ minimum AVC, produce output at which
P = SMC
◎ ATC tells how much profit/loss if produce
•
182
PERFECT COMPETITION

Total revenue
Profit =$36 -x 600
= $21,600
$11,400 = $21,600 =
$10,200

Total cost = $19 x 600

= $11,400

183
 PERFECT COMPETITION

Profitcost
Total = $3,150
= $17-x$5,100
300
==-$1,950
$5,100

Total revenue = $10.50 x

300 = $3,150

184
LONG-RUN PROFIT-MAXIMIZING EQUILIBRIUM

Profit = ($17 - $12) x

240 = $1,200

185
Short-Run Profit Maximization for Monopoly

186
Maximizing Profit at Aztec Electronics: An Example

◎ Aztec possesses market power via patents

◎ Sells advanced wireless stereo headphones
◎ Using time-series data over the ten-year time
period 1994-2004, estimated demand function:
Q = 41.000 - 500P + 0,6M - 22,5Pr
○ Q: Output; P: Price of advanced wireless stereo
headphones; M: Consumer Income; Pr: Price of
signal tuning tool

187
Maximizing Profit at Aztec Electronics: An Example

◎ From a consulting firm, Aztec predicted consumer

income and price of signal tuning tool in 2002 are
$45.000 and $800, respectively.
◎ Aztec estimated their average variable cost function:
AVC = 28 - 0,005Q + 0,000001Q2
Requests:
◎ What is Aztec’s optimal decision in 2005, knowing that
their estimated fixed cost is $270.000?
◎ What is Aztec’s decision when the demand function
changes as a result of reduced consumer income?
P = 80 – 0,002Q 188
 Profit Maximization at Aztec
Electronics

189
 A SIMPLE MARKUP RULE

◎ Homogeneous product Cournot industry, 3 firms.

◎ MC = $10.
◎ Elasticity of market demand = - ½.
◎ Determine the profit-maximizing price?
◎ EF = N EM = 3 × (-1/2) = -1.5.
◎ P = [EF/(1+ EF)] × MC.
◎ P = [-1.5/(1- 1.5] × $10.
◎ P = 3 × $10 = $30.
190
AN EXAMPLE

191
192
 MARKUP RULE FOR COURNOT OLIGOPOLY

193
 AN EXAMPLE
◎ Homogeneous product Cournot industry, 3 firms.
◎ MC = $10.
◎ Elasticity of market demand = - 1/2.
◎ Determine the profit-maximizing price?

14-
 BASIC PRICING
◎

195
 “
STRATEGIC PRICING
FOR GREATER PROFITS

196
STRATEGIC PRICING FOR GREATER PROFITS
◎ Most models examined to this point involve a
“single” equilibrium price
◎ In reality, there are many different prices being
charged in the market
1. Price discrimination
2. Two-part pricing
3. Block pricing
4. Commodity bundling
197
 PRICE DISCRIMINATION

Price discrimination: The practice of

charging different prices to consumers for
the same good or service.
3 basic forms:
1. First-degree price discrimination
2. Second-degree price discrimination
3. Third-degree price discrimination
198
 FIRST-DEGREE (PERFECT) PRICE
DISCRIMINATION
◎ Every unit is sold for the
maximum price each
consumer is willing to pay
○ Allows the firm to capture entire
consumer surplus
◎ Difficulties
○ Requires precise knowledge
about every buyer’s demand for
the good
○ Seller must negotiate a different
price for every unit sold to every
14-
buyer
 SECOND-DEGREE PRICE DISCRIMINATION

◎ Lower prices are offered for larger

quantities and buyers can self-select
the price by choosing how much to
buy
◎ Given the posted schedule of prices,
consumers sort themselves
according to their willingness to pay
for alternative quantities of the good.
◎ The firm charges different prices to
different consumers, but does not
need to know specific characteristics
of individual consumers.
◎ Example: electric utilities 14-
AN EXAMPLE

You are a pricing analyst for QuantCrunch Corporation, a company that

recently spent $15,000 to develop a statistical software package. To
date, you only have one client. A recent internal study revealed that this
client’s demand for your software is Qd = 300 – 0.2P and that it would
cost you $1,000 per unit to install and maintain software at this client’s
site. The CEO of your company recently asked you to construct a report
that compares (1) the profit that results from charging this client a single
per-unit price with (2) the profit that results from charging $1,450 for the
first 10 units and $1,225 for each additional unit of software purchased.
Construct this report, including in it a recommendation that would result
in even higher profits.

14-
 THIRD-DEGREE PRICE DISCRIMINATION

◎ If a firm sells in two markets, 1 & 2

(consumer in different demographic
groups)
○ Allocate output (sales) so MR1 = MR2
○ Optimal total output is that for which MRT = MC
◎ For profit-maximization, allocate sales of
total output so that
MRT = MC = MR1 = MR2
14-
 THIRD-DEGREE PRICE DISCRIMINATION

14-
 AN EXAMPLE
◎

14-
 THIRD-DEGREE PRICE DISCRIMINATION

Conditions for the pricing strategy to be effective

◎ Differences must exist in the elasticity of demand
of various consumers.
◎ The firm must have some means of identifying the
elasticity of demand by different groups of
consumers
◎ Consumers purchasing at lower prices cannot
resell their purchases to others.
14-
ALLOCATING SALES BETWEEN MARKETS

14-
CONSTRUCTING THE MARGINAL REVENUE CURVE

14-
PROFIT-MAXIMIZATION UNDER THIRD-
DEGREE PRICE DISCRIMINATION

14-
 TWO-PART PRICING
◎ Two-part pricing: Pricing strategy in which
consumers are charged a fixed fee for the right to
purchase a product, plus a per-unit charge for each
unit purchased.
○ Example: Athletic club memberships.

14-
 “
Two-Part Pricing:
A firm can enhance profits by engaging in
two-part pricing: charge a per-unit price that
equals marginal cost, plus a fixed fee equal
to the consumer surplus each consumer
receives at this per-unit price.

210
 A NUMERICAL EXAMPLE
Assume that an individual’s inverse demand curve is
given by: P = 20 – 2Q, and the cost function is C(Q) =
2Q. The firm seeks to find the optimal, profit-maximizing
two-part pricing. Find the optimal price and initiation fee
for this product.

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 BLOCK PRICING
◎ Block pricing:
Pricing strategy in
which identical
products are
packaged together in
order to enhance
profits by forcing
customers to make an
all-or-none decision to
purchase.
E.g. Paper, Six-packs of soda,
Different sized of cans of green 14-
 AN ALGEBRAIC EXAMPLE
◎ Typical consumer’s ◎ Optimal Quantity To
demand is P = 10 - Package: 4 Units
2Q
◎ C(Q) = 2Q
◎ Optimal number of
units in a package?
◎ Optimal package
price?

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 AN ALGEBRAIC EXAMPLE
◎ Optimal Price for the ◎ Costs and Profits with
Package: $24 Block Pricing

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 “
Block Pricing: By packaging units of a
product and selling them as one package,
the firm earns more than by posting a
simple per-unit price. The profit-
maximizing price on a package is the total
value the consumer receives for the
package.
215
 COMMODITY BUNDLING
◎ Commodity Bundling: The practice of bundling
several different products together and selling them
at a single “bundle price.”
○ E.g. Vacation packages, Computers and software, Film and
developing.

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DEMONSTRATION PROBLEM

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 PRICING STRATEGIES FOR SPECIAL COST
AND DEMAND STRUCTURES

1. Peak-Load Pricing
2. Cross-subsidization

218
 PEAK-LOAD PRICING
◎ Peak-load Pricing:
Pricing strategy in
which higher prices
are charged during
peak hours than
during off-peak
hours.

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 “
Peak-Load Pricing: When demand is
higher at some times of the day than at
other times, a firm may enhance profits by
peak-load pricing: charging a higher price
during peak times than is charged during
off-peak times.

220
“

221
 CROSS-SUBSIDIES PRICING
◎ Principle: Whenever the demands for two
products produced by a firm are interrelated
through costs or demand, the firm may enhance
profits by cross-subsidization: selling one product
at or below cost and the other product above cost.
○ E.g.: Browser and server software, Drinks and meals at
restaurants.

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EXAMPLE
◎ The demand for electricity is Q =5-P in peak periods and Q
=4-2P in off-peak periods. Both periods take up half of each
day. Variable cost is 0.25 per unit of output per period and
capital cost capacity are 0.75 per unit of capacity per day.
Capacity costs are sunk and cannot be adjusted between
periods
◎ Find the optimal capacity, peak price and off-peak price

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 CONCLUSION
◎ First degree price discrimination, block pricing,
and two part pricing permit a firm to extract all
consumer surplus.
◎ Commodity bundling, second-degree and third
degree price discrimination permit a firm to
extract some (but not all) consumer surplus.
◎ Simple markup rules are the easiest to
implement, but leave consumers with the most
surplus and may result in double-
marginalization.
◎ Different strategies require different 14-
 ANSWERING THE headLINE
Why does Disney World charge a cover fee for entering
the park and then let everyone who enters ride for
free? The answer lies in the ability to extract consumer
surplus by engaging in two-part pricing. In particular,
the marginal cost of an individual ride at an amusement
park is close to zero, as in Figure. If the average
consumer has a demand curve like the one in Figure,
setting the monopoly price would result in a price of
$10.50 per ride. Since each customer would go on five
rides, the amusement park would earn $52.50 per
customer. (This ignores fixed costs, which must be paid
regardless of the pricing strategy.) But this would leave
the average consumer with $26.25 in consumer
surplus. By charging an entry fee of $105 but pricing
each ride at $0, each consumer rides an average of 10
rides and the park extracts all consumer surplus and
earns higher profits
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2.
Advertising policies
in business
1. Advertisement and its roles
2. Economic analysis of advertising in
business

226
 ADVERTISEMENT
◎ Definition: expenditure undertaken by a firm to
promote the sales of its products or services.
○ E.g.: paid-for space in print, radio or television
media; promotional activity
◎ Advertising is intended to influence consumer
choice in favor of the advertiser’s product or
service.

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Graphical Analysis of Advertising

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 OPTIMAL ADVERTISING DECISIONS
◎ To maximize these profits, managers should
advertise up to the point where the incremental
revenue from advertising equals the incremental
cost
○ Incremental cost of advertising: the dollar cost of the
resources needed to increase the level of advertising
(e.g.: fees paid for additional advertising space)
○ Incremental revenue: the extra revenue the firm gets as
a result of the advertising campaign.

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 OPTIMAL ADVERTISING DECISIONS
◎

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 DEMONSTRATION PROBLEM

Corpus Industries produces a product at constant

marginal cost that it sells in a monopolistically
competitive market. In an attempt to bolster profits, the
manager hired an economist to estimate the demand
for its product. She found that the demand for the
firm’s product is log-linear, with an own price elasticity
of demand of –10 and an advertising elasticity of
demand of 0.2. To maximize profits, what fraction of
revenues should the firm spend on advertising?
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3.
Investment policy
in business
Investment appraisal in business
1. Investment with risk and uncertainty

232
 BASIC STEPS IN INVESTMENT APPRAISAL
1. Defining the objectives: decide the type of investment
projects.
○ Replacement investment: old equipment has to be
replaced
○ Expansionary investment: firm expands its capacity to
meet growing demand
○ Other investments: health and safety or environmental
reasons.
2. Identifying options: consider the various ways in
which the objective might be met.
3. Identifying the costs, benefits, timing and
uncertainties of each option.
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BASIC STEPS IN INVESTMENT APPRAISAL
4. Choosing the method of appraisal: discounted
cash flow techniques, internal rate of return,
payback or the accounting rate of return
5. Choosing the cost of capital: to choose a
value to represent the opportunity cost of the
resources
6. Test of viability: whether projects are
individually worth while and ranked in order of
merit.
7. Presenting the results: The present value of
each of the projects should be presented to 14-
 AN INVESTMENT EXAMPLE
◎ Step 1: An electricity supplier has decided to
build a new power station
◎ Step 2: The alternative technologies available
should be considered
◎ Step 3: Costs of undertaking each alternative
plan, variable costs of producing electricity,
expected revenues, anticipated life of the
project (25 years for a power station), costs
in closing the power station
○ Estimating the cash flows of a project: capital costs,
○ operating costs, revenues and decommissioning costs
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 AN INVESTMENT EXAMPLE
◎ Step 4: Choosing the method of
appraisal:
○ Discounted cash flow techniques (NPV)
○ Internal Rate of Return (IRR)
○ Payback
○ Accounting rate of return

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 “
Rules to choose project
Discounted cash flow techniques (NPV):
1. Projects have positive NPV should all be
undertaken
2. Projects having a negative NPV should be
rejected
3. Projects have higher NPV
237
should be preferred
14-
14-
 INTERNAL RATE OF RETURN (IRR)

◎ The rate of discount that makes the NPV

of the cash flow of a project equal to
zero.
◎ Projects with higher IRR are preferred.

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 DEMONSTRATION PROBLEM

◎ According to the IRR method, which project if

preferred?

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 PAYBACK METHOD

◎ Calculates the time in years or months

that projects have to run before they
cover their original capital outlay
◎ Criticisms:
○ It does not discount the cash flows.
○ It ignores all returns after the payback period

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RECOGNIZE THE TIME VALUE OF MONEY

243
244
 THE ACCOUNTING RATE OF RETURN

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NON-DISCOUNTING METHODS OF INVESTMENT APPRAISAL
◎ Payback method
◎ Accounting rate of return.

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 SUMMARY

◎ 4 methods of investment appraisal:

○ Discounting methods:
◉ Net present value (NPV)
◉ Internal rate of return (IRR)
○ Non-discounting methods:
◉ Payback method
◉ The accounting rate of return

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 PROJECTS RANKING AND CAPITAL RATIONING

14-
DEMONSTRATION PROBLEM

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 SUMMARY

1. Pricing strategies:
a) Basic pricing strategies
◉ Monopoly & Monopolistic Competition
◉ Cournot Oligopoly
b) Strategic pricing for greater profits
◉ Price Discrimination o Two-part pricing
◉ Block Pricing o Commodity Bundling
c) Pricing strategies for special structure of cost
and demand structures
◉ Peak-Load Pricing o Transfer Pricing
◉ Cross Subsidies
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 SUMMARY

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 SUMMARY

3. Methods of investment appraisal:

a) Discounting methods
◉ Net present value (NPV)
◉ Internal rate of return (IRR)
b) Non-discounting methods
◉ Payback method
◉ The accounting rate of return

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 PRACTICE
Using the following data for project A and B:
◎ Calculate the net present value for each project, assuming a cost of capital
of 15%.
◎ Calculate the internal rate of return for each project.
◎ Which project should the firm choose based on using net present value
and the internal rate of return?
◎ If the cost of capital were to increase to 20%, would project A or B be
preferred?

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