4.Course Name: Managerial Economics

anilgoud89

4.Discussion.docx

Home >Business & Finance homework help >Economics homework help >4.Course Name: Managerial Economics

Lesson 4 Discussion Forum

Discussion assignments will be graded based upon the criteria and rubric specified in the Syllabus.

For this Discussion Question, complete the following.

Question

Read the short explanation of the 4 basic types of economies. Research two of these types further.

Instructions:

1. Locate one journal article for each of your two chosen economic types. You need to focus on the Abstract, Introduction, Results, and Conclusion. For our purposes, you are not expected to fully understand the Data and Methodology.

2. Summarize these journal articles. Please use your own words. No copy-and-paste. Cite your sources.

3. During the second week of the Module, you will need to reply to the posts of two of your peers. Your replies must focus on increasing knowledge of the class and must advance the discussion further. Simply affirming your peers does not count as a substantive reply.

4.Please post (in APA format) your article citation.

5. Please provide 2 references under the discussion

6. Please post replies to 2 of my classmates each 250 words and their discussions are provided below.

Supplemental Resources: - Material Chapter 7 and 8:

Reading Assignment:

Please read Chapters 7 & 8 from the Managerial Economics and Strategy textbook

Classmate post 1

: by Bindiya Marneni - Tuesday, 28 July 2020, 11:26 PM

Number of replies: 0

Four types of Economic Systems

Abstract

Different types of economic systems how are they useful in the world for the government on what basis they are categorized into different types of the economic system and how they will fit into the real world.

Introduction

An economic system means which are governments organization and distribution of all sorts of available resources and services or trade goods across the world regardless of the geographic region or the country. An economic system will contain many agencies, institutions, and all sorts of entities.

Results

There are many different types of economic systems throughout the world each will have its own characteristics and features. The economic systems are divided into four main types

Traditional Economic system

Command Economic System

Market Economic System

Mixed System

Traditional Economic System

This economic system is based on goods services and works with certain trends to follow. It doesn’t have a lot of people working on it.T here will be only specific people who are experts in that part of the field. The traditional economic system is the very ancient of all the four economic system.there are some parts of the world where they follow the traditional economic system.this type of trend is followed in second and third nations of the world nations where there is mostly farming as the income and any more traditional income.

Command Economic system

This Economic system is also called as a planned System. This is a dominant system where the authority is with the government. This type of economic system is mostly observed in communist countries as the decisions are pretty much in the hands of the government then the people.

Market Economic system

This economic system is based on free markets what that means is the government will not intervene in the public matter even if they want to a very little;e amount of the economic decisions are made by the government.T he most of the decisions are made by people and supply and demand relationship.

Mixed System

This mixed system is also called a dual system because it is a combination of market and command systems. Which means the market or the economy is under the strict rule of laws. Many west countries follow this sort of system. In those countries, most of them are private industries but the rest will be in public services which are controlled by the government.

Conclusion

The government should always have to come up with the types of economic systems that help the world to grow the economy and help in improvising the standard of living.

-------------------------------------------------------------------------------------------------------------------------------------

Classmate post2:

by Jyothsna Malluri - Friday, 24 July 2020, 9:20 PM

Number of replies: 0

Abstract

For different countries to be able to operate effectively, the different basic types of economies should be considered. It is the role of the government to ensure that the right measures are brought in place for the purposes of ensuring that the economies are made effective therefore improving the standards of living of the people.

Introduction

There are different types of economies which should be considered for the success of different businesses to be achieved. The basic types of economies which should be considered in different cases include;

· Command economic system

· Market economic system

· Traditional economic system

· Mixed economic system

Results

As far as the Command economic system is concerned, it is the economic system in which the means of production and the economic activities in a country are controlled by a central authority. The central authority helps in ensuring that the quantitative production goals are assigned and the raw materials provided to the organization for the purposes of ensuring that the rates of production are increased. As a result of the Command economic system, low unemployment levels are experienced in a country, therefore, reducing the causes of social issues experienced by the members of the public. On the other hand, the Command economic system helps in the reduction of the causes of inequality. This is achieved by the fact that the government plays significant roles in ensuring that the means of production are controlled hence determining who works in the market (Quandt, 2019).

The another basic type of economy is the Market economic system which ensures that the goods and services are exchanged freely in an open market. Most parts of the world including the United States make use of the Market economic system for the purposes of ensuring that the good public relations are brought in place. The Market economic system plays significant roles in ensuring that innovation for a competitive edge is brought in place. The increased innovation helps in ensuring that the shortage of products in the market is reduced therefore ensuring that the needs of the people are reduced and addressed accordingly. The Market economic system is again important in that it brings about the efficiency of the business.

Moreover, the Traditional economic system is the type of an economy which relies on the history, customers as well as time-honoured beliefs. This type of economy guides the economy by ensuring that quality decisions are made in an effective manner hence ensuring that the rates of production and distribution are increased.

Finally, the mixed economic system is the type of economy characterized by free-market elements as well as socialistic elements. On the other hand, private ownership, as well as control of the means of production means, is experienced therefore contributing to the success of the businesses in a given country. the industries which produce public goods are therefore selected hence ensuring that the needs of the people are addressed (Silver, 2019).

Conclusion

The government should put in place measures of ensuring that the economy is made effective. This will help in ensuring that the living standards of the people are improved.

References

Quandt, R., & Triska, D. (2019). Optimal Decisions in Markets and Planned Economies. Routledge.

Silver, L., Smith, A., Johnson, C., Taylor, K., Jiang, J., Anderson, M., & Rainie, L. (2019). Mobile connectivity in emerging economies. Pew Research Center, 7.

Managerial Economics and Strategy

Third Edition

Chapter 7

Firm Organization and Market Structure

If this PowerPoint presentation contains mathematical equations, you may need to check that your computer has the following installed:

1) MathType Plugin

2) Math Player (free versions available)

3) NVDA Reader (free versions available)

Managerial Problem

Amazon’s Delivery Services

Amazon is too large to continue relying for shipping on U P S, FedEx, and U S P S.

What issues should Amazon consider in deciding whether to rely primarily on other delivery services or develop its own capabilities? How should Amazon decide whether this investment is worthwhile?

Solution Approach

In pursuing a firm’s objectives, such as profit maximization, managers must decide on the vertical structure of the firm—whether the firm produces needed inputs internally or buys them.

Empirical Methods

Ownership and governance of firms affect the firm’s objectives.

In the pursuit of profit maximization, owners and managers use present value to make investment decisions and compare relative costs to decide make or buy decisions. Relative costs vary with size of the market, market structures, and disruptive innovations.

Learning Objectives (1 of 2)

7.1 Ownership and Governance of Firms

Explain how firms differ by type of ownership and organization

7.2 Profit Maximization

Determine a firm’s profit-maximizing output

7.3 Profits Over Time

Use present values to compare costs and revenues that occur at different times

Learning Objectives (2 of 2)

7.4 The Make or Buy Decision

Discuss profit-maximizing vertical organization

7.5 Market Structure

Describe the four main types of market structure

7.1 Ownership and Governance of Firms (1 of 5)

Private, Public, and Nonprofit Firms

The private sector consists of firms that are owned by individuals or other nongovernmental entities and whose owners may earn a profit.

Examples are Apple, Heinz, and Toyota. In almost every country, this sector provides most of that country’s gross domestic product (75% of G D P U S A).

The public sector consists of firms and other organizations that are owned by governments or government agencies, called state-owned enterprises.

Examples are the armed forces, the court system, most schools, colleges, universities, and Amtrak. This sector may be small or large (12% of G D P U S A).

The nonprofit sector consists of organizations that are neither government-owned nor intended to earn a profit, but typically pursue social or public interest objectives (nongovernment, not-for-profit sector).

Examples include Greenpeace, Alcoholics Anonymous, the Salvation Army, and other charitable, educational, health, and religious organizations.

7.1 Ownership and Governance of Firms (2 of 5)

Ownership of For-Profit Firms

Sole proprietorships are firms owned and controlled by a single individual.

Parternships are businesses jointly owned and controlled by two or more people operating under a partnership agreement.

Corporations are firms owned by shareholders, who own the firm’s shares or stocks.

Each share is a unit of ownership in the firm. Therefore, shareholders own the firm in proportion to the number of shares they hold.

Shareholders elect a board of directors to represent them. In turn, the board of directors usually hires managers who manage the firm’s operations.

The legal name of a corporation often includes the term Incorporated (Inc.) or Limited (Ltd) to indicate its corporate status.

7.1 Ownership and Governance of Firms (3 of 5)

Publicly Traded and Closely Held Corporations

Shares of public corporations can be readily bought and sold by the general public.

Shares may be available at the New York Stock Exchange, the N A S D A Q, the Tokyo Stock Exchange, the Toronto Stock Exchange, or the London Stock Exchange.

Shares of closely held corporations are not available for purchase or sale on an organized exchange.

Typically, its stock is owned by a small group of individuals (private equity).

To make the transition from privately held to publicly traded status, the closely held firm makes an initial public offering (I P O) of its shares on an organized stock exchange.

One major advantage of going public is to raise money. However, a major disadvantage is that ownership of the firm becomes broadly distributed, possibly causing the original owners to lose control of the firm.

It is also possible for a publicly traded firm to go private and convert to closely held status. Examples are Toys-R-Us and Burger King.

7.1 Ownership and Governance of Firms (4 of 5)

Liability

Owners of a corporation are not personally liable for the firm’s debts. They have limited liability: personal assets cannot be taken to pay a corporation’s debts even if it goes into bankruptcy.

Owners of sole proprietorships and partnerships were fully liable, individually and collectively, for any debts of the firm. Now they can be a limited liability company (L L C). The precise regulations for L L Cs vary from country to country and from state to state within the United States.

Firm Size

According to the 2015 ProQuest Statistical Abstract of the United States, most large firms are corporations.

U.S. corporations are only 18% of all nonfarm firms but make 81% of sales revenue and 58% of net income. Nonfarm sole proprietorships are 72% of firms but make only 4% of the sales revenue and earn 15% of net income.

Corporations that earn over $50 million are less than 1% of all corporations, but they make 77% of revenue.

7.1 Ownership and Governance of Firms (5 of 5)

Firm Governance

In a small private sector firm with a single owner-manager, the governance of the firm is straightforward.

The owner-manager makes the important decisions for the firm.

In publicly traded corporations, the shareholders own the corporation. However, most of them play no meaningful role in day-to-day decision making or even in long-range planning.

Shareholders elect a board of directors and delegate many of their ownership rights to them.

The board of a large publicly traded corporation normally includes outside directors and inside directors, such as the chief executive officer (C E O) of the corporation and other senior executives.

7.2 Profit Maximization (1 of 8)

Profit

Revenue (R) is price times quantity (p × q).

Cost(C) is the opportunity cost: The value of the best alternative use of any input the firm employs. The full opportunity cost of inputs used might exceed the explicit or out-of-pocket costs recorded in financial accounting statements.

Profit (π) is Revenue minus Cost. If π < 0, the firm makes a loss.

To add profits over time, calculate the present value in which future profits are discounted using the interest rate.

7.2 Profit Maximization (2 of 8)

The Profit We Refer Is Economic Profit

Economic profit = Revenue minus Opportunity Cost

Opportunity Cost = Explicit Costs + Implicit Costs

Accounting Profit = Revenue minus Explicit Costs

If implicit costs are left out, then accounting profit > economic profit

Common Confusion: You should operate your firm if you are making an accounting profit.

For small firms owned and managed by one person, the main difference between explicit and implicit costs is the opportunity cost of the owner-manager’s time.

If the owner-manager invests other resources, the opportunity cost of these other resources is also implicit costs.

Normal profit is the amount needed to cover all implicit costs of the owners. Economic profit is the amount above the normal profit.

7.2 Profit Maximization (3 of 8)

Two Steps to Maximizing Profit:

Profit varies with the level of output because both revenue and cost vary with output.

So, a firm decides how much q to sell to maximize profits.

And, to maximize profits, any firm must answer two questions.

First Step: Output Decision

What is the output level, q, that maximizes profit or minimizes loss?

Second Step: Shutdown Decision

Is it more profitable to produce q or to shut down and produce no output?

7.2 Profit Maximization (4 of 8)

Output Rules

Output Rule 1: Set output where profit is maximized.

If the firm knows its entire profit curve (Figure 7.1), it sets output at q*

to get π*.

Output Rule 2: Set output where M π = 0

Marginal profit,

is the slope of the profit curve.

The maximum profit occurs where the slope is zero.

Output Rule 3: Set output where M R(q) = M C(q)

Marginal Profit = M R − M C. The extra income raises profit but the extra cost reduces profit. Maximum profit occurs at M R(q) = M C(q).

Using calculus:

Figure 7.1 Maximizing Profit

7.2 Profit Maximization (5 of 8)

Managerial Implication: Marginal Decision Making

Marginal analysis is very valuable to managers.

If a manager knows the entire profit function, it’s easy to choose the profit-maximizing output.

However, many managers are uncertain about what profit would be at output levels that differ significantly from the current level.

By experimenting, the manager can determine if increasing output slightly raises profit (Marginal profit >0, or M R>M C).

If so, the manager should continue to increase output until the marginal profit is zero or M R = M C.

If marginal profit is negative, the manager should decrease output until marginal profit is zero.

7.2 Profit Maximization (6 of 8)

Shutdown Rules

Should the firm shut down if its profit is negative? It depends.

Shutdown Rule 1: Shut down only if loss can be reduced.

This rule applies to the short run and long run alike.

Shutdown Rule 2: Shut down only if revenue is less than avoidable cost.

In the short run, variable costs are avoidable but fixed costs are unavoidable (sunk costs).

As long as revenue covers variable costs and some fixed costs, no shutdown occurs.

In the long run, all costs are avoidable; shutting down eliminates all costs.

7.2 Profit Maximization (7 of 8)

Corporate Social Responsibility (C S R)

C S R is the pursuit of social objectives rather than profit maximization. It could be also E S G (environmental, social, and governance objective).

While Milton Friedman argued the social responsibility of businesses is to increase its profits (sole responsibility with the owners of the firm), Edward Freeman argued managers have obligations with shareholders, workers, customers, and the communities where firms reside and operate.

Charitable Activities

C S R or E S G contributions may reduce returns to shareholders and generate court litigations. Courts have increasingly decided that businesses have implicit obligations to various stakeholders that often go beyond what is explicitly covered in formal contracts.

Strategic E S G

C S R activities intended to increase profits are called strategic C S R, “doing well by doing good.”

7.2 Profit Maximization (8 of 8)

Forcing Firms to Maximize Profit: The Survivor Principle and Competition for Corporate Control

Not all private-sector managers try to maximize profits. Why, then, do economists assume that most private-sector firms maximize profit?

Survivor Principle

In perfectly competitive markets, the only firms that survive are those that maximize profit. Firms that fail to maximize profit lose money and are driven out of business.

The Struggle for Corporate Control

Outside investors could buy enough shares to take over control of an underperforming publicly traded firm (market for corporate control).

Firms can defend with a shareholder rights plan (poison pill defense) in the United States. Poison pills may not prevent a takeover, but usually benefits the original managers or board of directors. See Table 7.1 for a list of takeover defense terminology.

Table 7.1 Some Takeover Defense Terms (1 of 2)

back-end plan: Provision that gives shareholders the right to cash or debt securities at an above-market price previously defined by the company’s board in the event of a hostile takeover.

dead-hand: Provision that allows only the directors who introduce the poison pill to remove it for a fixed period after they have been replaced, thereby delaying a new board’s ability to sell the firm.

flip-in: Provision that gives current shareholders of the firm other than the hostile acquirer the right to purchase additional shares of stocks at a discount price after the acquirer obtains a certain percentage of the firm’s shares (usually between 20% and 50%).

flip-over: Provision that allows shareholders to buy the acquiring firm’s shares at a discount price after a merger or takeover.

Table 7.1 Some Takeover Defense Terms (2 of 2)

golden handcuffs: Employment clauses that require top employees to give back lucrative bonuses or incentives if they leave the firm within a specified period. As a poison pill, these clauses cease to hold after a hostile takeover so that the employees may quit immediately after cashing their stock options.

macaroni defense (similar to a flip-over): The issuance of many bonds with the condition they must be redeemed at an above-market price if the company is taken over.

poison pill, porcupine provision, shareholder rights plan, or shark repellent: Defensive provisions that corporate boards include in the firm’s corporate charter or bylaws that make a takeover less profitable.

poison puts: The issuance of bonds that investors may cash before they mature in the event of a hostile takeover attempt.

7.3 Profits Over Time (1 of 4)

Interest Rates

Virtually everyone believes that a dollar today is more valuable than a dollar in the future. Consequently, a bank will only agree to loan you $1,000 for a year if you agree to return the $1,000 at the end of the year plus some additional amount.

This additional amount is the interest rate: the percentage more that must be repaid to borrow money for a fixed period.

Suppose a firm borrows $10,000 from a bank for one year at an annual interest rate of 5% (= 0.05). At the end of the year, the firm must pay the

bank $10,500

which is the $10k it borrowed plus the

interest it owes, $500.

In general, the amount of money the firm borrows today is the present value (P V) and the amount it must repay is the future value (F V).

At an interest rate of i, at the end of the first year, the firm must repay

7.3 Profits Over Time (2 of 4)

Compounding

Now suppose that the firm borrows the $10k for two years. Because it didn’t pay the $500 interest owed at the end of the first year, it is essentially borrowing $10.5k for the second year. Thus, for the second year, it owes interest on the $10k initial amount and on the $500 deferred interest payment. That is, it owes “interest on the interest” or compounding.

Generalizing, if the firm were to borrow for t years, it would owe

at the end of the last year.

Using Interest Rates to Connect Present and Future Values

In general

where t is the number of years.

The P V of future payments is

For a perpetual income flow of Y per period,

7.3 Profits Over Time (3 of 4)

Investing and Profit Maximizing Over Time

How does a firm profit maximize over time?

Shareholders of a firm may value a stream of profits over time by calculating the present value, in which future profits are discounted using the interest rate.

Present Value:

For example, if the interest rate is i, and the firm expects its profit to be

in the first year,

in the second year,

in the third year, and zero

thereafter, then the present value of this stream of profits is

In Excel, you can also calculate P V by using the function Present Value.

7.3 Profits Over Time (4 of 4)

Managerial Implication: Stock Prices Versus Profit

Should a manager be more concerned about a firm’s stock price than its profit?

It makes no difference whether the manager maximizes the stock price or profit if the stock price reflects the firm’s profit, in which case the cumulative value of the firm’s stock is the present value of owning the firm.

However, if a firm’s profit flow varies over time, then the link between a firm’s profit and its stock price is more complex, and the stock price might be more relevant to managers than the current profit.

7.4 The Make or Buy Decision (1 of 8)

Managers make decisions that affect two dimensions of the firm:

Horizontal dimension: Size of the firm in its primary market

Vertical dimension: Stages of the production process in which the firm participates

Supply chain management: To produce and sell a good involves many sequential stages of production, marketing, and distribution activities.

A manager decides how many stages the firm will undertake itself. Otherwise, the firm will pay for it to be done by others.

Stages of Production

Figure 7.2 illustrates the sequential or vertical stages of a relatively simple production process (such as bread).

At the top of the figure, in the upstream, firms use raw inputs (such as wheat) to produce semi-processed materials (such as flour).

Then, in the downstream, the same or other firms use the semi-processed

materials and labor to produce the final good (such as bread),

In the last stage, the final consumers buy the product.

Figure 7.2 Vertical Organization

7.4 The Make or Buy Decision (2 of 8)

Vertical Integration

A firm that participates in more than one successive stage of the production or distribution of goods or services is vertically integrated.

A firm may vertically integrate backward and produce its own inputs, or forward and buy its former customer.

A firm can be partially vertically integrated. It may produce a good but rely on others to market it. Or it may produce some inputs itself and buy others from the market.

Quasi-Vertical Integration

Some firms buy from a small number of suppliers or sell through a small number of distributors. These firms often control the actions of the firms with whom they deal with by writing contractual vertical restraints that create quasi-vertical integration (franchisor and franchisee).

7.4 The Make or Buy Decision (3 of 8)

Contracts Versus Spot Markets

Firms, instead of using contracts for quasi-vertical integration, can sign long-term contracts to secure inputs at specified quantities and prices.

Finally, firms willing to avoid any contract at all, can just buy inputs at spot markets or cash markets.

Degrees of Vertical Integration

All firms are vertically integrated to some degree.

At one extreme, we have firms that perform only one major task and rely on markets and outsourcing for all others. For example, a computer retailer.

At the other extreme, we have firms that perform most stages of the production process. For instance, Foster Farms.

However, no firm is completely integrated: It would have to run the entire economy. As Carl Sagan observed, “If you want to make an apple pie from scratch, you must first create the universe.”

7.4 The Make or Buy Decision (4 of 8)

Profitability and the Supply Chain Decision

Firms decide whether to vertically integrate, quasi-vertically integrate, or buy goods and services from markets or other firms depending on which approach is the most profitable.

Key considerations for profitable vertical integration:

First, the firm has to take into account all relevant costs including some that are not easy to quantify such as transaction costs.

Second, the firm must ensure a secure and flexible supply of needed inputs to its production process.

Third, the firm may vertically integrate even if doing so raises its cost of doing business so as to avoid government regulations.

7.4 The Make or Buy Decision (5 of 8)

Transaction Costs and Opportunistic Behavior

Important reasons to integrate are to reduce transaction costs and avoid opportunistic behavior.

Transaction costs are especially the costs of writing and enforcing contracts.

Opportunistic behavior refers to others take advantage of the firm when circumstances permit.

A manufacturing firm may decide to vertically integrate forward (downstream) into distribution if the expense from trying to prevent opportunistic behavior by these firms is high.

Opportunistic behavior is particularly likely when a firm deals with only one other firm: a classic principal-agent problem.

If an electronic game manufacturer can buy computer chips from only one firm, it is at the mercy of that chip supplier. To prevent the supplier taking advantage of it, the game manufacturer may vertically integrate.

7.4 The Make or Buy Decision (6 of 8)

Security and Flexibility of Supply

A common reason for vertical integration is to ensure supply of important inputs.

Having inputs available on a timely basis is very important. Costs would skyrocket if a car manufacturer had to stop assembling cars while waiting for a part. Backward integration (upstream integration) to produce the part itself may help to ensure timely arrival of parts.

Backward vertical integration is common in the aluminum industry. Each firm’s production process includes four stages: mining, refining, smelting, and fabricating.

Alternatively, this problem may be eliminated through quasi-vertical integration contracts (reward prompt delivery and penalize delays), or just-in-time systems.

It is also important to be able to vary production quickly. A firm may want to cut output during a recession and reduce its use of essential inputs. By vertically integrating, firms may gain greater flexibility.

7.4 The Make or Buy Decision (7 of 8)

Government Regulations

Firms may also vertically integrate to avoid government price controls, lower their taxes, and avoid regulations that limit profits.

A vertically integrated firm avoids price controls by selling to itself. For example, steel buyers bought steel producers that didn’t want to sell as much as before the U.S. government price controls.

More commonly, firms integrate to lower their taxes. Tax rates vary by country, state, and type of product. A vertically integrated firm can shift profit from a high-tax country/state to a low-tax country/state by changing its transfer price between the firm’s divisions.

When one type of business is regulated but not others, firms may also want to vertically integrate their businesses to shift profits from the regulated division to the unregulated division.

7.4 The Make or Buy Decision (8 of 8)

Market Size and the Life Cycle of a Firm

If there is relatively little demand for a product at current prices, the entire industry is small, each firm produces all successive steps of the production process. All firms are vertically integrated.

Vertically integrated firms can take advantage of specialization and division of labor internally. Adam Smith saw it in the production of pins in the 1700s and Henry Ford applied it to the car mass production in the early 1900s.

As the market and the industry grows, firms vertically disintegrate. Each firm buys services or products from specialized firms.

When the market for cars is big, a separate tire, or parts manufacturers develop and there is further specialization.

As an industry matures further, new products often develop and reduce much of the demand for the original product. The industry shrinks in size. Firms vertically integrate again.

7.5 Market Structure (1 of 2)

When making horizontal and vertical decisions, managers need to consider the behavior of actual and potential rival firms.

The behavior of firms depends on market structure: The number of firms in the market, the ease with which firms can enter and leave the market, and the ability of firms to differentiate their products from those of their rivals.

The Four Main Market Structures

Perfect competition, monopoly, oligopoly, and monopolistic competition (Chapters 8–13).

Comparison of Market Structures

Main characteristics and differences are summarized in Table 7.2.

Perfectly competitive firms are price takers, all the others are price setter.

Perfectly competitive and monopoly firms charge lower and higher prices, respectively.

Oligopolistic and monopolistically competitive firms must pay attention to rival firm’s behavior. The others ignore it.

Table 7.2 Properties of Monopoly, Oligopoly, Monopolistic Competition, and Perfect Competition

Blank	Monopoly	Oligopoly	Monopolistic Competition	Perfect Competition
1. Ability to set price	Price setter	Price setter	Price setter	Price taker
2. Price level	Very high	High	High	Low
3. Entry conditions	No entry	Limited entry	Free entry	Free entry
4. Number of firms	1	Few	Few or many	Many
5. Long-run profit	greater than or equal to 0	greater than or equal to 0	0	0
6. Strategy dependent on individual rival firms’ behavior	No (has no rivals)	Yes	Yes	No (cares only about market price)
7. Products	Single product	May be differentiated	May be differentiated	Undifferentiated
8. Example	Producer of patented drug	Automobile manufacturers	Plumbers in a small town	Apple farmers

7.5 Market Structure (2 of 2)

Disruptive Innovations and the Evolution of Market Structure

Market structure is not static and can be affected by technological or organizational innovation. Most innovations are incremental, but some are sufficiently disruptive to dramatically change the way an industry is structured—or even to create new industries and destroy old ones.

Joseph Schumpeter (1942) referred to this process as creative destruction, while Christensen (1997) called it disruptive innovation.

A market disruption often arises from using “off-the-shelf” technologies in new and creative ways.

Small start-up companies often have a stronger incentive to innovate than incumbents.

Disruptions may change the industry from oligopoly to more competitive (Apple initially and before forming a new oligopoly).

Disruptions may also transform competitive industries into more concentrated markets (Uber and Amazon).

Managerial Solution

Amazon’s Delivery Services

What issues should Amazon consider in deciding whether to rely primarily on other delivery services or develop its own capabilities? How should Amazon decide whether this investment is worthwhile?

Solution

Amazon should consider relative costs. Relying on U P S, FedEx, and U S P S means high shipping costs, low flexibility, and risk of opportunistic behavior. Amazon’s Flex reduces shipping costs, increase flexibility, and reduces opportunistic behavior.

Amazon’s “Shipping with Amazon” vertical integration requires significant initial

investment

If the P V is greater than this initial investment, then the

investment pays.

With a two-year planning horizon, this option is good if

This work is protected by United States copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted. The work and materials from it should never be made available to students except by instructors using the accompanying text in their classes. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials.

()()()

qRqCq

p=-

p/, where 1,

DDD=

d /d d /dd /d

()()()()(

)

qqRqqCqqMRqMCq

p=-==

$10,000 * 1

(

.05,

)

(

)

FVPVi

$10,0001.05

(

)

FVPVi

(

)

PVFVi

PVYi

(

)

PVFVi

()

iii

=++

+++

(,).

qfML

=+>

.MsftOfcThm_Text1_Fill { fill:#000000; } .MsftOfcThm_MainDark1_Stroke { stroke:#000000; }

Perloff_mes3_PPT_0

8.pptx

Managerial Economics and Strategy

Third Edition

Chapter 8

Competitive Firms and Markets

If this PowerPoint presentation contains mathematical equations, you may need to check that your computer has the following installed:

1) MathType Plugin

2) Math Player (free versions available)

3) NVDA Reader (free versions available)

Managerial Problem

The Rising Cost of Keeping on Truckin’

In recent years, federal and state fees have increased substantially and truckers have had to adhere to many new regulations.

What effect do these new fixed costs have on the trucking industry’s market price and quantity? Are individual firms providing more or fewer trucking services? Does the number of firms in the market rise or fall?

Solution Approach

We need to combine our understanding of demand curves with knowledge about firm and market supply curves to predict industry price, quantity, and profits.

Empirical Methods

The relevant market structure is perfect competition where buyers and sellers are price takers and firms have a horizontal demand.

To maximize profit in the short run, the firm takes the price from the market and with marginal cost determines its output.

Firms have zero economic profit in the long run.

Perfect competition maximizes economic well-being of the society.

Learning Objectives (1 of 2)

8.1 Perfect Competition

Describe the characteristics of perfect competition

8.2 Competition in the Short Run

Graphically identify the competitive equilibrium and derive the short-run supply curve

Learning Objectives (2 of 2)

8.3 Competition in the Long Run

Contrast the short-run and long-run competitive equilibria and supply curves

8.4 Competition Maximizes Economic Well-Being

Use the concept of surplus to show the main advantage of perfect competition

8.1 Perfect Competition (1 of 3)

Perfect competition is a market structure in which buyers and sellers are price takers.

A price-taking firm cannot affect the market price for a product, it faces a horizontal demand and it sells at the market price.

Characteristics of a Perfect Competitive Market

Large Number of Buyers and Sellers

If the sellers in a market are small and numerous, no single firm can raise or lower the market price.

Identical Products

Buyers perceive firms sell identical or homogeneous products. Granny Smith apples are identical, all farmers charge the same price.

Full Information

Buyers know the prices charged by all firms and that products are identical. No single firm can unilaterally raise its price above the market equilibrium price.

8.1 Perfect Competition (2 of 3)

Negligible Transaction Costs

Buyers and sellers do not have to spend much time and money finding each other or hiring lawyers to write contracts to make a trade.

Perfectly competitive markets have very low transaction costs.

Free Entry and Exit

The ability of firms to enter and exit a market freely in the long run leads to a large number of firms in a market and promotes price taking.

Perfect Competition in the Chicago Mercantile Exchange

It has the five characteristics of perfect competition: many buyers and sellers; they trade identical products; have full price information; waste no time to make a trade; and anyone can be a buyer or seller.

8.1 Perfect Competition (3 of 3)

Deviations from Perfect Competition

Many markets possess some but not all of the characteristics of perfect competition. But, buyers and sellers are, for all practical purposes, price takers.

Cities use zoning laws and fees to limit the number of stores or motels, yet there are many sellers and all are price takers.

From now on, we will use the terms competition and competitive to refer to all markets in which no buyer or seller can significantly affect the market price—they are price takers—even if the market is not perfectly competitive.

8.2 Competition in the Short Run (1 of 7)

How Much to Produce

How much to produce is the 1st step in the two-step decision-making process to determine how to maximize profit.

As we know from Chapter 7: to maximize profit, find q where M R(q) = M C(q)

A competitive firm has a horizontal demand, it can sell any q at the market price, p. Given that revenue R = p q, then M R = p

A profit-maximizing competitive firm produces the amount of output, q, at which p = M C(q)

Graphical Presentation

In Figure 8.1, the market price of lime is p = $8 per metric ton (horizontal demand). The M C curve crosses the horizontal demand curve at point e where the firm’s output is 284 units.

The π = $426,000, shaded rectangle in panel a. Panel b shows that this is the maximum profit.

Figure 8.1 How a Competitive Firm Maximizes Profit

8.2 Competition in the Short Run (2 of 7)

Whether to Produce

Once a firm determines the output level that maximizes its profit or minimizes its loss, it must decide whether to produce that output level or to shut down and produce nothing.

Of course, if the firm is making a profit, it will produce Q.

But, if it is making a loss in the short run, should the firm shutdown?

Common Confusion: A firm should shut down if it is making a loss.

This intuition holds if the firm is making a loss in the long run, but it may be wrong in the short run.

In the short run, a firm should operate if it can cover more than its variable cost, even if it cannot fully cover its unavoidable fixed cost.

8.2 Competition in the Short Run (3 of 7)

Whether to Produce

Whether to produce is the 2nd step in the two-step decision-making process to determine how to maximize profit.

Shutdown rule: R < V C (Chapter 7).

Shutdown rule for a competitive firm:

The Market Price Is Above Minimum A C

In Figure 8.2, if price above $6 (point b), the firm operates with a positive profit.

The Market Price Is Between Minimum A C and The Minimum A V C

In Figure 8.2, the competitive firm still operates if price between $5 and $6, (points a and b). It loses money but operates to minimize the loss.

The Market Price Is Less Than the Minimum A V C

In Figure 8.2, the competitive firm shuts down if market price is below $5, (below point a).

Figure 8.2 The Short-Run Shutdown Decision

8.2 Competition in the Short Run (4 of 7)

Managerial Implication:

Sunk Costs and the Shutdown Decision

When making shutdown decisions, good managers ignore unavoidable (sunk) fixed costs (Chapter 6).

The manager of a competitive firm should continue operating if price at least equals average variable cost and revenue is not sufficient to fully cover the sunk fixed costs.

As long as price exceeds average variable cost, the firm at least partially offsets the sunk fixed costs by operating instead of absorbing the entire amount as a loss.

8.2 Competition in the Short Run (5 of 7)

The Short-Run Firm Supply Curve

A competitive firm chooses its output to maximize profit or minimize losses when p = M C(q).

Graphical Presentation

In Figure 8.3 the market price increases from p1 = $5 to p2 = $6 to p3 = $7 to p4 = $8. The respective profit-maximizing outputs are e1 through e4.

As the market price increases, the equilibria trace out the marginal cost curve.

The competitive firm’s short-run supply curve is the marginal cost curve above its minimum average variable cost (red line that starts at point e1 in Figure 8.3).

Figure 8.3 How the Profit-Maximizing Quantity Varies with Price

8.2 Competition in the Short Run (6 of 7)

The Short-Run Market Supply Curve

Market supply curve: horizontal sum of the supply curves of all the individual firms in the market.

Short-Run Market Supply with Identical Firms

In the short run, the maximum number of firms in a market, n, is fixed. In panel a of Figure 8.4, there is one firm and in panel b, there are 4 firms identical to the one in panel a.

If all firms are identical, each firm’s costs are identical, supply curves are identical. The market supply at any price is n times the supply of an

individual firm; flatter. In panel b of Figure 8.4,

is the market supply of 4

identical firms.

Short-Run Market Supply with Firms That Differ

If the firms have different costs functions, their supply curves and shutdown points differ. Figure 8.5 in the textbook shows this market supply; flatter.

Figure 8.4 Short-Run Market Supply with Five Identical Lime Firms

Figure 8.5 Short-Run Market Supply with Two Different Lime Firms

8.2 Competition in the Short Run (7 of 7)

Short-Run Competitive Equilibrium

By combining the short-run market supply curve and the market demand curve, we can determine the short-run competitive equilibrium.

Graphical Presentation

Suppose that there are five identical firms in the lime manufacturing industry. Panel a of Figure 8.6 shows the short-run cost curves and the

supply curve,

for a typical firm, and panel b shows the corresponding

short-run competitive market supply curve, S.

If the market demand curve is

the short-run equilibrium is E1, the

market price is $7, and market output is Q1 = 1,075 units (panel a). Each firm takes the market price, maximizes profit at e1, and no firm wants to change its behavior, so e1 is the firm’s equilibrium.

If the demand curve shifts to

the market equilibrium is p = $5 and

Q2 = 250 units (panel a). At that price, each firm produces q = 50 units and loses $98,500, area A + C. However, they do not shut down.

Figure 8.6 Short-Run Competitive Equilibrium in the Lime Market

8.3 Competition in the Long Run (1 of 6)

Long-Run Competitive Profit Maximization

Objective: Firms want to maximize long-run profit and all costs are variable or avoidable.

Decision 1: How Much to Produce

To maximize profit or minimize a loss, firm operates where long-run marginal profit is zero―where M R (price) equals long-run M C.

Decision 2: Whether to Produce

After determining the output level,

the firm shuts down if its revenue

is less than its avoidable cost (all costs). So, it shuts down if it would make an economic loss by operating.

The Long-Run Firm Supply Curve

It is the firm’s long-run marginal cost curve above the minimum of its long-run average cost curve.

It forecasts the plant size that could maximize profit.

8.3 Competition in the Long Run (2 of 6)

The Long-Run Market Supply Curve

The competitive market supply curve is the horizontal sum of the supply curves of the individual firms.

However, in the long run, firms can enter or leave the market.

Thus, before the horizontal sum, we need to determine how many firms are in the market at each possible market price.

Entry and Exit

In the long run, each firm decides whether to enter or exit depending on whether it can make a long-run profit.

In perfectly competitive markets, firms can enter and exit freely in the long run.

A shift of the market demand curve to the right attracts firms to enter the market (π > 0) until the last firm makes zero long-run profit.

A shift of the market demand curve to the left forces firms to exit the market (π < 0) until the last firm makes zero long-run profit.

8.3 Competition in the Long Run (3 of 6)

Long-Run Market Supply with Identical Firms and Free Entry

The long-run market supply curve is flat at the minimum of long-run average cost if firms can freely enter and exit the market, an unlimited number of firms have identical costs, and input prices are constant.

Graphical Presentation

In Figure 8.7, panel a, the individual supply starts at the minimum long-run average cost ($10) and each firm produces 150 units. The market supply curve is horizontal at $10 (panel b), n firms will produce 150n units.

Figure 8.7 Long-Run Firm and Market Supply with Identical Vegetable Oil Firms

8.3 Competition in the Long Run (4 of 6)

Long-Run Market Supply When Entry Is Limited

When entry is limited, long-run market supply curves slope upward (horizontal sum of few individual supply curves).

The reasoning is the same as in the short run, panel b of Figure 8.4.

The number of firms is limited because of government restrictions, resource scarcity, or high entry cost.

Long-Run Market Supply When Firms Differ

When firms are not identical, long-run market supply curves slope upward.

Firms with relatively low minimum long-run average costs are willing to enter the market at lower prices than others.

The long-run supply curve is upward sloping only if lower cost firms cannot dominate the market because of their limited capacity and limited number.

8.3 Competition in the Long Run (5 of 6)

Long-Run Competitive Equilibrium

Equilibrium occurs at the intersection of the long-run market supply and demand curves.

With identical firms, constant input prices, free entry/exit: equilibrium price equals minimum long-run average cost.

A shift in the demand curve affects only the equilibrium quantity and not the equilibrium price.

Because the market supply curve is different in the short run than in the long run, the long-run competitive equilibrium differs from the short-run equilibrium.

8.3 Competition in the Long Run (6 of 6)

Zero Long-Run Profit with Free Entry

The long-run supply curve is horizontal if firms are free to enter the market, firms have identical cost, and input prices are constant. All firms in the market are operating at minimum long-run average cost (cost efficient).

That is, they are indifferent between shutting down or not because they are earning zero economic profit.

Any firm that does not maximize profit loses money.

So, to survive in a competitive market in the long run, a firm must maximize its profit (P=M C and be cost efficient).

8.4 Competition Maximizes Economic Well-Being (1 of 10)

We study competition in a book on managerial economics because of two reasons:

First

Many sectors of the economy are highly competitive including agriculture, parts of the construction industry, many labor markets, and much retail and wholesale trade.

Second

Perfect competition serves as an ideal or benchmark for other industries.

Most important theoretical result in economics: a perfectly competitive market maximizes an important measure of economic well-being (consumer surplus, producer surplus, and total surplus).

Government intervention in a perfectly competitive market reduces a society’s economic well-being. However, it may increase economic well-being in noncompetitive markets, such as in a monopoly.

8.4 Competition Maximizes Economic Well-Being (2 of 10)

Consumer Surplus (C S), monetary difference between what a consumer is willing to pay for the quantity of the good purchased and what the consumer actually pays. $-gain from trade for the consumer.

Producer Surplus(P S), monetary difference between the amount a good sells for and the minimum amount necessary for the producers to be willing to produce the good (profit). $-gain from trade for the firm.

Total Surplus (T S), monetary measure of the total benefit to all market participants from market transactions (gains from trade). Total surplus implicitly weights the gains to consumers and producers equally.

8.4 Competition Maximizes Economic Well-Being (3 of 10)

Consumer Surplus

The demand curve reflects a consumer’s marginal willingness to pay: the maximum amount a consumer will spend for an extra unit (marginal value for the last unit).

Measuring Consumer Surplus using a Demand curve

Graphically, the consumer surplus is the area below the demand curve and above the market price up to the quantity actually consumed.

In Figure 8.8, panel a, the consumer surplus from the 1st, 2nd, and 3rd magazines is $3 ($2+$1+$0).

In panel b, the consumer surplus, C S, is the area under the demand curve and above the horizontal line at the price p1 up to the quantity he or she buys, q1.

C S has two advantages over utility as a measure of economic benefit:

It is comparable and summable among consumers

It is relatively easy to calculate

Figure 8.8 Consumer Surplus

8.4 Competition Maximizes Economic Well-Being (4 of 10)

Managerial Implication: Willingness to Pay on eBay

For a product sold on eBay, a manager can use the information that eBay reports to quickly estimate the market demand curve for the product.

On its website, eBay correctly argues (Chapter 12) that the best strategy for bidders is to bid their willingness to pay: the maximum value that they place on the item.

If bidders follow this strategy, we know the maximum bid of each person except the winner.

The figure arranges the bids for an A.D. 238 Roman coin from highest to lowest. Each bar indicates the bid for one coin, so, it is the market demand curve.

8.4 Competition Maximizes Economic Well-Being (5 of 10)

Effects of a price change on Consumer Surplus

If the supply curve shifts upward or a government imposes a new sales tax, the equilibrium price rises, causing the consumer surplus to fall.

Suppose that the introduction of a new tax causes the wholesale price of roses to rise from the original equilibrium price of 30¢ to 32¢ per rose stem, a movement along the demand curve in Figure 8.9.

The consumer surplus at the initial price of 30¢ is area A + B + C = $173.74 million per year.

At a higher price of 32¢, the consumer surplus falls to area A = $149.64 million.

Thus, the loss in consumer surplus from the increase in price is B + C = $24.1 million per year.

Figure 8.9 Fall in Consumer Surplus from Roses as Price Rises

8.4 Competition Maximizes Economic Well-Being (6 of 10)

Producer Surplus

By definition, the total producer surplus is the area above the supply curve and below the market price up to the quantity actually produced.

Measuring Producer Surplus Using a Supply curve

The firm’s producer surplus in panel a of Figure 8.10 is the area below the market price, $4, and above the marginal cost (supply curve) up to the quantity sold, 4. The area under the marginal cost curve up to the number of units actually produced is the variable cost.

The market producer surplus in panel b of Figure 8.10 is the area above the supply curve and below the market price, p*, line up to the quantity sold, Q*. The area below the supply curve and to the left of the quantity produced by the market, Q*, is the variable cost.

Using Producer Surplus

We can use P S to study the effects of variable cost changes in profits for all the firms in a market.

Figure 8.10 Producer Surplus

8.4 Competition Maximizes Economic Well-Being (7 of 10)

Competition Maximizes Total Surplus

By definition, total surplus is the sum of the areas of C S and P S.

Perfect competition maximizes total surplus. Producing less or more than the competitive output lowers total surplus.

Graphical Presentation

In Figure 8.11, at the competitive equilibrium e1, with Q1 and p1, T S1 = A + B + C + D + E.

Producing less at e2, Q2 and p2, T S2 = A + B + D. T S2< T S1.

As a consequence of producing less, C + E are lost.

C + E is the deadweight loss (D W L)

Figure 8.11 Reducing Output from the Competitive Level Lowers Total Surplus

8.4 Competition Maximizes Economic Well-Being (8 of 10)

Deadweight Loss (D W L)

D W L is the net reduction in total surplus from a loss of surplus by one group that is not offset by a gain to another group from an action that alters a market equilibrium.

The deadweight loss results because consumers value extra output by more than the marginal cost of producing it. In Figure 8.11, between Q2 and Q1, consumers value the extra output by C + E more than it costs to produce it.

Society would be better off producing and consuming extra units of this good than spending this amount on other goods.

In short, the deadweight loss is the opportunity cost of giving up some of this good to buy more of another good.

8.4 Competition Maximizes Economic Well-Being (9 of 10)

The Deadweight Loss of Holiday Gifts

Waldfogel (2005), found that consumers value their own purchases at 10% to 18% more, per dollar spent, than items received as gifts.

He concluded that a conservative estimate of the deadweight loss of holidays with gift-giving rituals is about $12 billion. And that’s not counting about 2.8 billion hours spent shopping.

8.4 Competition Maximizes Economic Well-Being (10 of 10)

Effects of Government Intervention

A government policy that limits trade in a competitive market reduces total surplus.

Effects of Government Intervention: Price Ceiling

A price ceiling sets a limit on the highest price a firm can legally charge.

If the government sets the ceiling below the precontrol competitive price, consumers want to buy more than the precontrol equilibrium quantity but firms supply less than that quantity.

Price Ceiling and Deadweight Loss

Fewer units are sold with a price ceiling than at the precontrol equilibrium.

Deadweight loss: Consumers value the good more than the marginal cost of producing extra units. Producer surplus must fall because firms receive a lower price and sell fewer units.

Managerial Solution

The Rising Cost of Keeping on Truckin’

In recent years, federal and state fees have increased substantially and truckers have had to adhere to many new regulations.

Solution

The trucking industry is a very competitive industry, trucks of certain size are identical and higher fees increase average but not marginal costs.

An increase in fixed cost causes the market price and quantity to rise and the number of trucking firms to fall, as expected.

In addition, it has the surprising effect that it causes producing firms to increase the amount of services that they provide.

pAVCVCq

.MsftOfcThm_Text1_Fill { fill:#000000; } .MsftOfcThm_MainDark1_Stroke { stroke:#000000; }

Perloff_mes3_PPT_0

7.pptx