All.docx-19-20-busi 620.docx

Notes

Chapter 1

Economic decisions involve the allocation of scarce resources, and a manager’s task is to allocate

resources so as to best meet the manager’s goals. An effective manager must identify goals and

constraints, recognize the nature and importance of profits, understand incentives, understand

markets, recognize the time value of money, and use marginal analysis.

The first step in making sound decisions is to have well-defined goals because achieving different

goals entails making different decisions.

Different units within a firm may be given different goals; those in a firm’s marketing department

each input to use, how to react to decisions made by competitors, and so on.

The opportunity cost of using a resource includes both the explicit (or accounting) cost of the

resource and the implicit cost of giving up the best alternative use of the resource. The opportunity

cost of producing a good or service generally is higher than accounting costs because it includes

both the dollar value of costs (explicit, or accounting, costs) and any implicit costs.

Implicit costs are very hard to measure and therefore managers often overlook them. Effective

managers, however, continually seek out data from other sources to identify and quantify implicit

costs. Managers of large firms can use sources within the company, including the firm’s finance,

marketing, and/or legal departments, to obtain data about the implicit costs of decisions. In other

instances managers must collect data on their own.

business place, as it is and the way you wish it were.

The power, or bargaining position, of consumers and producers in the market is limited by three

sources of rivalry that exist in economic transactions: consumer–producer rivalry, consumer–

consumer rivalry, and producer–producer rivalry. Each form of rivalry serves as a disciplining

device to guide the market process, and each affects different markets to a different extent. Thus,

your ability as a manager to meet performance objectives will depend on the extent to which your

product is affected by these sources of rivalry.

Maximizing profits means maximizing the value of the firm, which is the present value of current

and future profits. If the growth rate in profits is less than the interest rate and both are

constant, maximizing current (short-term) profits is the same as maximizing long-term profits.

Chapter 2

the prices of other goods such as shirts, is held constant. In effect, the market survey does not ask

consumers how much they would buy at alternative levels of income or advertising; it simply seeks

to determine how much would be purchased at alternative prices. The market research reveals

that, holding all other things constant, the quantity of jeans consumers are willing and able to

purchase goes down as the price rises. This fundamental economic principle is known as the law of

demand: Price and quantity demanded are inversely related. That is, as the price of a good rises

(falls) and all other things remain constant, the quantity demanded of the good falls (rises).

When we graph the demand curve for good X, we hold everything but the price of X constant. A

representative demand curve is given by D0 in Figure 2–2. The movement along a demand curve,

such as the movement from A to B, is called a change in quantity demanded. Whenever advertising,

demand curve. Whether an increase in income shifts the demand curve to the right or to the left

depends on the nature of consumer consumption patterns. Accordingly, economists distinguish

between two types of goods: normal and inferior goods.

A good whose demand increases (shifts to the right) when consumer incomes rise is called a normal

good. Normal goods may include goods such as steak, airline travel, and designer jeans: As income

goes up, consumers typically buy more of these goods at any given price. Conversely, when

consumers suffer a decline in income, the demand for a normal good will decrease (shift to the left).

Changes in income tend to have profound effects on the demand for durable goods, and these

effects are typically amplified in developing countries and rural areas. In 2004, for instance,

farmers in India enjoyed higher incomes thanks to the impact on crops of beneficial monsoons. As a

good as an inferior good. Bologna, bus travel, and “generic” jeans are possible examples of inferior

goods. As income goes up, consumers typically consume less of these goods at each price. It is

important to point out that by calling such goods inferior, we do not imply that they are of poor

quality; we use this term simply to define products that consumers purchase less of when their

incomes rise and purchase more of when their incomes fall.

Changes in the prices of related goods generally shift the demand curve for a good. For example, if

the price of a Coke increases, most consumers will begin to substitute Pepsi because the relative

price of Coke is higher than before. As more and more consumers substitute Pepsi for Coke, the

quantity of Pepsi demanded at each price will tend to increase. In effect, an increase in the price of

Coke increases the demand for Pepsi. This is illustrated by a shift in the demand for Pepsi to the

right. Goods that interact in this way are known as substitutes.

Many pairs of goods readily come to mind when we think of substitutes: chicken and beef, cars and

trucks, raincoats and umbrellas. Such pairs of goods are substitutes for most consumers. However,

manner are called complements. Beer and pretzels are another example of complementary goods.

If the price of beer increased, most beer drinkers would decrease their consumption of pretzels.

Notice that when good X is a complement to good Y, a reduction in the price of Y actually increases

(shifts to the right) the demand for good X. More of good X is purchased at each price due to the

reduction in the price of the complement, good Y.

Another variable that is held constant when drawing a given demand curve is the level of

advertising. An increase in advertising shifts the demand curve to the right, from D1 to D2, as in

Figure 2–3. Notice that the impact of advertising on demand can be interpreted in two ways. Under

the initial demand curve, D1, consumers would buy 50,000 units of high-style clothing per month

when the price is $40. After the advertising, the demand curve shifts to D2, and consumers will now

Advertising can also influence demand by altering the underlying tastes of consumers. For example,

advertising that promotes the latest fad in clothing may increase the demand for a specific fashion

item by making consumers perceive it as “the” thing to buy. These types of advertising messages are

known as persuasive advertising.

The demand for a product is also influenced by changes in the size and composition of the

population. Generally, as the population rises, more and more individuals wish to buy a given

product, and this has the effect of shifting the demand curve to the right. Over the twentieth

century,

the demand curve for food products shifted to the right considerably with the increasing

population.

It is important to note that changes in the composition of the population can also affect the demand

for a product. To the extent that middle-aged consumers desire different types of products than

buying a car next year. If consumers expect future prices to be higher, they will substitute current

purchases for future purchases. This type of consumer behavior often is referred to as stockpiling

and generally occurs when products are durable in nature. We often see this behavior for less

expensive durables, too; consumers may stockpile laundry detergent in response to temporary

sales at grocery stores. The current demand for a perishable product such as bananas generally is

not affected by expectations of higher future prices.

affect demand.

One very simple but useful form is the linear representation of the demand function: Demand is

linear if Qdx is a linear function of prices, income, and other variables that influence demand. The

following equation is an example of a linear demand function: The αis are fixed numbers that the

By the law of demand, an increase in Px leads to a decrease in the quantity demanded of good X.

number, an increase in income (M) will lead to an increase in the consumption of good X, and good

X is a normal good. If αM is a negative number, an increase in income will lead to a decrease in the

consumption of good X, and good X is an inferior good.

The supply curve reveals how much producers are willing to produce at alternative prices. As

production costs change, the willingness of producers to produce output at a given price changes. In

particular, as the price of an input rises, producers are willing to produce less output at each given

price. This decrease in supply is depicted as a leftward shift in the supply curve.

Technological changes and changes in government regulations also can affect the position of the

supply curve. Changes that make it possible to produce a given output at a lower cost, such as the

ones highlighted in Inside Business 2–2, have the effect of increasing supply. Conversely, natural

disasters that destroy existing technology and government regulations, such as emissions standards

that have an adverse effect on businesses, shift the supply curve to the left.

The number of firms in an industry affects the position of the supply curve. As additional firms

enter an industry, more and more output are available at each given price. This is reflected by a

shifting the truck supply curve to the left.

Another form of tax often used by a government agency is an ad valorem tax. Ad valorem literally

means “according to the value.” An ad valorem tax is a percentage tax; the sales tax is a well-known

example. If the price of a good is $1 and a 10 percent ad valorem tax is attached to that good, the

unable to buy the good may offer producers a higher price in an attempt to get the product. As the

price rises from PL to Pe in Figure 2–10, producers have an incentive to expand output from Q0 to

Qe. Similarly, as the price rises, consumers are willing to purchase less of the good. When the price

rises to Pe, the quantity demanded is Qe. At this price, just enough of the good is produced to satisfy

this price. Thus, when the price is PH, there is a surplus of the good; firms are producing more than

they can sell at a price of PH.

price

in an attempt to reduce their unsold inventories. As the price falls from PH to Pe, producers have an

incentive to reduce quantity supplied to Qe. Similarly, as the price falls, consumers are willing to

purchase more of the good. When the price falls to Pe, the quantity demanded is Qe; quantity

demanded equals quantity supplied.

Thus, the interaction of supply and demand ultimately determines a competitive price, Pe, such that

there is neither a shortage nor a surplus of the good. This price is called the equilibrium price and

the corresponding quantity, Qe, is called the equilibrium quantity for the competitive market. Once

this price and quantity are realized, the market forces of supply and demand are balanced; there is

no tendency for prices either to rise or to fall.

government to intervene in the market by requiring producers to sell the good at a lower price.

This is only natural, for if we were unable to own a house because we had the wrong hair color, we

most certainly would attempt to get the government to pass a law allowing people with our hair

color to own a house. But then there would be too few houses to go around, and some other means

would have to be used to allocate houses to people.

let the price of the good be PL. This price corresponds to point B on the market demand curve;

consumers wish to purchase Q1 units of the good. Similarly, the price of PL corresponds to point A

on the market supply curve; producers are willing to produce only Q0 units at this price. Thus,

when the price is PL, there is a shortage of the good; that is, there is not enough of the good to

satisfy all consumers willing to purchase it at that price.

Do not be confused by the fact that the price ceiling is below the initial equilibrium price; the term

ceiling refers to that price being the highest permissible price in the market. It does not refer to a

price set above the equilibrium price. In fact, if a ceiling were imposed above the equilibrium price,

it would be ineffective; the equilibrium price would be below the maximum legal price.

In contrast to the case of a price ceiling, sometimes the equilibrium competitive price may be

considered too low for sellers. In these instances, individuals may lobby for the government to

legislate a minimum legal price for a good. Such a price is called a price floor. Perhaps the best-

known price floor is the minimum wage, the lowest legal wage that can be paid to workers.

If the equilibrium price is above the price floor, the price floor has no effect on the market. But if

the price floor is set above the competitive equilibrium level, such as Pf in Figure 2–12, there is an

effect. Specifically, when the price floor is set at Pf, quantity supplied is Qs and quantity demanded

is Qd. In this instance, more is produced than consumers are willing to purchase at that price, and a

there are jobs to go around at that wage, and unemployment results. In the context of a product

market, the surplus translates into unsold inventories. In a free market, price would fall to alleviate

the unemployment or excess inventories, but the price floor prevents this mechanism from working.

Buyers end up paying a higher price and purchasing fewer units.

When price floors are above the equilibrium price, there will be consumers with willingness-to-pay

that is more than production costs but is less than the price floor. These consumers will be unable

to purchase when the price floor is in place, which results in a loss of social welfare. The dollar

value of the lost social welfare is given by the blue triangle in Figure 2–12. Similar to the case of a

price ceiling, the lost social welfare is the vertical difference between the demand and supply curve

for all units between Qd and Qe. The difference is that the constraint on units purchased for a price

2.5 percent over the next year, and the number of individuals over 25 years of age will reach an all-

time high by the end of the year. We can use our supply and demand apparatus to examine how

these changes in market conditions will affect car rental agencies like Avis, Hertz, and National. It

seems reasonable to presume that rental cars are normal goods: A rise in consumer incomes will

most likely increase the demand for rental cars. The increased number of consumers aged 25 and

Quantity: Increases Quantity: Ambiguous

are necessary for your operations.

Whether the absolute value of the elasticity is greater or less than 1 determines how responsive G is

to changes in S. If the absolute value of the elasticity is greater than 1, the numerator is larger than

the denominator in the elasticity formula, and we know that a small percentage change in S will lead

to a relatively large percentage change in G. If the absolute value of the elasticity is less than 1, the

The econometrician uses a regression software package to find the values of a and b that minimize

the sum of the squared deviations between the actual points and the line. In essence, the regression

line is the line that minimizes the squared deviations between the line (the expected relation) and

the actual data points. These values of a and b, which frequently are denoted â and bˆ, are called

parameter estimates, and the corresponding line is called the least squares regression.

The standard error of each estimated coefficient is a measure of how much each estimated

coefficient would vary in regressions based on the same underlying true demand relation, but with

different observations. The smaller the standard error of an estimated coefficient, the smaller the

variation in the estimate given data from different outlets (different samples of data).

statistic is large, the standard error of the parameter estimate is small relative to the absolute value

In situations where transaction costs are low and the desired input is of uniform quality and sold by

many firms, the price of the input is determined by the forces of supply and demand. When

specialized investments are not required to facilitate exchange, very little time is expended

negotiating a price. The scenario differs, however, if specialized investments are required to obtain

Specialized investments imply that only a few parties are prepared for a trading relationship. There

is no other supplier capable of providing the desired input at a moment’s notice; obtaining the

input the buyer needs requires making a specialized investment before the input becomes

available.

Consequently, there generally is no “market price” for the input; the two parties in the relationship-

paying a price of p* per unit of input. If any supplier attempted to charge a price greater than p*, the

manager could simply decline and purchase the input from another supplier at a price of p*.

Why, then, would a manager ever wish to bear the expense of drafting a contract or have the firm

expend resources to integrate vertically and manufacture the inputs itself? The reason is that in the

presence of specialized investments, spot exchange does not insulate a buyer from opportunism,

and the parties may end up spending considerable time bargaining over the price and incur

substantial costs if negotiations break down. These problems will occur each time the buyer

attempts to obtain additional units of the input. Also, as we noted earlier, the input purchased may

be of inferior quality due to underinvestment in specialized investments needed to facilitate the

exchange.

Given the prospect of the hold-up problem and a need to bargain over price each time an input is to

be purchased, an alternative strategy is to acquire an input from a particular supplier under an

appropriately structured contract. While a contract often requires substantial up-front

employment with a particular firm for three years will have a greater incentive to invest in human

capital specific to that firm. Similarly, if the firm knows the worker will be around for three years, it

will be willing to invest in more training for the worker.

When specialized investments generate transaction costs (due to opportunism, bargaining costs, or

underinvestment), and when the product being purchased is extremely complex or the economic

environment is plagued by uncertainty, complete contracts will be extremely costly or even

impossible to write. The only choice left is for the firm to set up a facility to produce the input

internally. This process is referred to as vertical integration because it entails the firm moving

farther up the production stream toward increasingly basic inputs. For example, most automobile

manufacturers make their own fenders from sheet steel and plastics, having vertically integrated

The advantage of vertical integration is that the firm “skips the middleman” by producing its own

When the desired input does not involve specialized investments, the firm can use spot exchange to

obtain the input without concern for opportunism and bargaining costs. By purchasing the input

from a supplier, the firm can specialize in doing what it does best rather than spending money

writing contracts or engaging in vertical integration.

When substantial specialized investments are required to facilitate exchange, managers should

think twice about using spot exchange to purchase inputs. Specialized investments lead to

opportunism, bargaining costs, and underinvestment, and these transaction costs of using spot

exchange often can be reduced by using some other method to acquire an input. When the

The essence of the problem is that the manager likes to earn income, but he also likes to

consume leisure. Clearly, if the manager spent every waking hour on the job, he would be unable to

consume any leisure. But the less time he spends on the job, the more time he has for ball games,

fishing trips, and other activities that he values. The job description indicates that the manager is

Exactly what the manager does under the profit-sharing compensation scheme depends on

his preferences for leisure and money. But one thing is clear: If the manager wants to earn income,

he cannot shirk the entire day. The manager faces a trade-off: He can consume more leisure on the

job, but at a cost of lower compensation. For example, suppose the manager has carefully

evaluated the trade-off between leisure on the job and income in Table 6–2 and wishes to earn

$250,000. He can achieve this by working five hours instead of shirking all day. What is the impact

of the profit- sharing plan on the owner of the firm? The manager has decided to work five hours

to earn

$250,000 in compensation. The five hours of managerial effort generate $2.5 million in gross profits

for the firm. Thus, by making managerial compensation dependent on performance, the gross

The preceding analysis focused on factors within the firm that provide the manager with an

incentive to maximize profits. In addition, forces outside the firm often provide managers with an

incentive to maximize profits.

Managers have increased job mobility when they can demonstrate to other firms that they have the

managerial skills needed to maximize profits. It is costly to be an effective manager; many hours

must be spent supervising workers and planning production outlays. These costs represent an

investment by the manager in a reputation for being an excellent manager. In the long run, this

reputation can be sold at a premium in the market for managers, where other firms compete for

the right to hire the best managers. Thus, even when the employment contract does not explicitly

include a performance bonus, a manager may choose to do a good job of running the firm if he or

Another external force that provides managers with an incentive to maximize profits is the threat

When we introduced the principal–agent problem, the owner of the firm was viewed as having

workers’ compensation dependent on the underlying profitability of the firm. Offering workers

compensation that is tied to underlying profitability provides an incentive for workers to put forth

more effort.

than costs. For example, a restaurant manager can design a contract whereby servers get some

One problem with revenue-based incentive schemes is that they do not provide an incentive for

workers to minimize costs. For example, a food server may attempt to collect a big tip by offering

the customer larger portions, free drinks, and the like, which will enhance the tip at the expense of

the restaurant’s costs.

An alternative compensation method is to pay workers based on a piece rate rather than on a fixed

hourly wage. For example, by paying a data entry clerk a fixed amount per word entered into the

firm’s database, the payment to the clerk depends on the output produced. To earn more money, the

clerk must enter more words into the firm’s database during a given time period.

One advantage of revenue or profit sharing is that it reduces the incentive to produce low-quality

products. Lower quality reduces sales, thus reducing compensation to those receiving revenue- or

profit-sharing incentives.

Concentration ratios measure how much of the total output in an industry is produced by the

largest firms in that industry. The most common concentration ratio is the four-firm concentration

ratio (C4). The four-firm concentration ratio is the fraction of total industry sales produced by the

four largest firms in the industry.

arises when a single firm (with a market share of w1 = 1) exists in the industry. A value of

zero results when there are numerous infinitesimally small firms.

HHI is based on squared market shares, while the four-firm concentration ratio is not.

Consequently, the Herfindahl-Hirschman index places a greater weight on firms with large

market shares than does the four-firm concentration ratio. These two factors can lead to

differences in the ranking of firms by the C4 and the HHI.

Statistics and other data should always be interpreted with caution, and the preceding measures of

concentration are no exception. For instance, the HHI indexes reported in Table 7–2 are only

approximations because the Census Bureau uses data on only the top 50 firms in the industry

rather than data on all firms in the industry. In concluding our discussion of the concentration of

U.S. industries, it is important to point out three additional limitations of the numbers reported in

Table 7–2.

The four-firm concentration ratios and Herfindahl-Hirschman indexes reported in Table 7–

2 are based on a definition of the product market that excludes foreign imports. That is, in

Australia, and Asia. The four-firm concentration ratio based on both domestic and imported

beer would be considerably lower.

A second deficiency in the numbers reported in Table 7–2 is that they are based on figures

for the entire United States. In many industries, the relevant markets are local and may be

The geographic definition of the relevant market (local or national) can lead to a bias in

concentration ratios. Similarly, the definition of product classes used to define an industry also

affects indexes.

One measure of the elasticity of industry demand for a product relative to that of an individual

firm is the Rothschild index. The Rothschild index provides a measure of the sensitivity to price of

the product group as a whole relative to the sensitivity of the quantity demanded of a single firm

to a change in its price.

The Rothschild index takes on a value between 0 and 1. When the index is 1, the individual

firm faces a demand curve that has the same sensitivity to price as the market demand

curve. In contrast, when the elasticity of demand for an individual firm’s product is much

greater (in absolute value) than the elasticity of the market demand, the Rothschild index

is close to zero. In this instance, an individual firm’s quantity demanded is more sensitive

to a price increase than is the industry as a whole. In other words, when the Rothschild

products for a specified period of time.

Economies of scale also can create a barrier to entry. In some markets, only one or two firms exist

because of economies of scale. If additional firms attempted to enter, they would be unable to

generate the volume necessary to enjoy the reduced average costs associated with economies of

scale. As we will learn in subsequent chapters, barriers to entry have important implications for

the long-run profits a firm will earn in a market.

Lerner index takes on a value greater than zero, with the maximum possible value being

unity. The Lerner index therefore provides a measure of how much firms in an industry

mark up their prices over marginal cost. The higher the Lerner index, the greater the firm’s

markup. In industries in which firms rigorously compete for consumer sales by attempting

In the equation 1/(1 − L) is the markup factor. It defines the factor by which marginal cost

is multiplied to obtain the price of the good. When the Lerner index is zero, the markup

factor is 1, and thus the price is exactly equal to marginal cost. If the Lerner index is 1/2,

the markup factor is 2. In this case, the price charged by a firm is two times the marginal

Mergers can result from an attempt by firms to reduce transaction costs, reap the benefits of

economies of scale and scope, increase market power, or gain better access to capital markets. Some

mergers are “friendly” in that both firms desire to merge into a single firm. Others are “hostile,”

meaning that one of the firms does not desire the merger to take place.

of the firms is doing an inadequate job of managing the firm. In this instance, the benefit of the

takeover is the increased profits that result from “cleaning house,” that is, firing the incompetent

managers. Many managers fear mergers and acquisitions because they are uncertain about the

impact of a merger on their positions.

product are carried out in a single firm. For instance, an automobile manufacturer that

produces its own steel, uses the steel to make car bodies and engines, and finally sells an

automobile is vertically integrated. This is in contrast to a firm that buys car bodies and

merger in that it involves merging final products into a single firm. It differs from a

Performance refers to the profits and social welfare that result in a given industry. It is important for

future managers to recognize that profits and social welfare vary considerably across industries.

The Dansby-Willig (DW) performance index measures how much social welfare (defined as the sum

of consumer and producer surplus) would improve if firms in an industry expanded output in a

decisions, advertising decisions, and decisions to invest in research and development, among other

factors. Performance refers to the resulting profits and social welfare that arise in the market. The

structure–conduct–performance paradigm views these three aspects of industry as being

integrally related.

consumers. According to the causal view, this structure gives firms market power, enabling them to

charge high prices for their products. The behavior (charging high prices) is caused by market

structure (the presence of few competitors). The high prices, in turn, “cause” high profits and poor

performance (low social welfare). Thus, according to the causal view, a concentrated market

“causes” high prices and poor performance.

Today most economists recognize that the causal view provides, at best, an incomplete view of the

relation among structure, conduct, and performance. According to the feedback critique, there is no

one-way causal link among structure, conduct, and performance. The conduct of firms can affect

market structure; market performance can affect conduct as well as market structure. To illustrate

the feedback critique, let us apply it to the previous analysis, which stated that concentration

The structure–conduct–performance paradigm and the feedback critique are closely related to

When there is a single provider of a good or service in a market, there is a tendency for the

seller to capitalize on the monopoly position by restricting output and charging a price

above marginal cost. Because there are no other firms in the market, consumers cannot

switch to another producer in the face of higher prices. Consequently, consumers either buy

some of the product at the higher price or go without it. In monopolistic markets, there is

In a market characterized by monopolistic competition, there are many firms and consumers, just

as in perfect competition. Thus, concentration measures are close to zero. Unlike in perfect

A firm in a monopolistically competitive market has some control over the price charged for

Recall that in a simultaneous-move game, players must make decisions without knowledge of

the decisions made by other players. The fact that a game is “one-shot” simply means that the

players will play the game only once.

Knowledge of simultaneous-move, one-shot games is important to managers making

decisions in an environment of interdependence. For example, it can be used to analyze situations

where the profits of a firm depend not only on the firm’s action but on the actions of rival firms as

well.

What is the optimal strategy for a player in a simultaneous-move, one-shot game? As it turns out,

we will see in a moment, this approach is not generally the optimal way to play a game, but it is

useful to explain the reasoning that underlies this strategy. By using a secure strategy, a player

maximizes the payoff that would result in the “worst-case scenario.” In other words, to find a secure

Take, for example, we are considering a situation where the firms meet once, and only once, in the

market. Moreover, the game is a simultaneous-move game in that each firm makes a pricing

firm B charges a high price, firm A’s best choice is to charge a low price since 50 units of profits are

better than the 10 units it would earn if A charged the high price. Similarly, if firm B charges the low

price, firm A’s best choice is to charge the low price since 0 units of profits are preferred to the 10

units of losses that would result if A charged the high price. Similar arguments hold from firm B’s

perspective. Firm A is always better off charging the low price regardless of what firm B does, and B

is always better off charging the low price regardless of what A does. Hence, charging a low price is

a dominant strategy for both firms. To summarize, in the one-shot version of this game, each firm’s

best strategy is to charge a low price regardless of the other firm’s action. The outcome of the game

is that both firms charge low prices and earn profits of zero.

they have an incentive to live up to their promises? Consider firm A’s point of view. If it “cheated” on

The thing to notice is that both the worker and the manager want to keep their actions “secret”; if

the manager knows what the worker is doing, it will be curtains for the worker, and vice versa. In

such situations, players find it in their interest to engage in a mixed (randomized) strategy. What

this means is that players “randomize” over their available strategies; for instance, the manager

The value of a firm is the present value of all future profits earned by the firm. If the interest rate is i,

π0 represents profits today, π1 profits one year from today, π2 profits two years from today, and so

πT(1+i)T = ∑t = 0Tπt(1+i)t

by charging lower prices; and (3) when their rivals deviate from the collusive arrangement, so they

know when to begin the punishments. Furthermore, they must (4) be able to successfully punish

rivals for deviating from the collusive agreement—otherwise the threat of punishment would not

work. These factors are related to several variables reflected in the structure and conduct of the

industry.

The theory of infinitely repeated games can be used to analyze the desirability of firm policies such

as warranties and guarantees. Effectively, a game occurs between consumers and firms:

Consumers desire durable, high-quality products at a low price, while firms wish to maximize

profits. In a one- shot game, any profits made by the firm must be made today; there is no prospect

for repeat business. Thus, in a one-shot game, a firm may have an incentive to sell shoddy

sell a high-quality product. The reason is simple. By selling a shoddy product, the firm earns 10

instead of 1 that period. This is, in effect, “the gain to cheating” (selling a poor-quality product). The

cost of selling a shoddy product, however, is to earn zero forever after, as the firm’s reputation is

ruined by having sold such a product. When the interest rate is low, the one-time gain will be more

than offset by the lost future sales. It will not pay for the firm to “cheat” by selling shoddy

merchandise.

The lesson to be drawn from this example is twofold. First, if your firm desires to be a “going

concern,” that is, infinitely lived, it does not pay to “cheat” customers if the one-time gain is more

than offset by lost future sales. Notice that this is true even if your firm cannot be sued or if there

are no government regulations against selling shoddy merchandise.

Second, you should recognize that any production process is likely to have “bad runs,” in which

some low-quality products are produced out of honest error. Notice in this example that even if the

firm “tried” to produce high-quality merchandise but, due to an inadvertent error, one unit was

defective, that error could ruin the firm. To guard against this, many firms offer guarantees that the

Given such trigger strategies, does firm A have an incentive to cheat by charging a low

cheats today, it earns: ΠCheatFirm A = $50, regardless of whether the game ends after one play,

If firm A does not cheat, it earns $10 today. In addition, there is a probability of 1 − θ that the

game will be played again, in which case the firm will earn another $10. There is also a probability

of (1 − θ)2 that the game will not terminate after two plays, in which case A will earn yet another

$10. Carrying out this reasoning for all possible dates at which the game terminates, we see that

they will play again), and the profits of cooperating are greater than $10.

The important thing to notice is that when the game is repeated a finite but uncertain

number of times, the benefits of cooperating look exactly like the benefits of cooperating in an

infinitely repeated game, which are: PVCoopFirm A = 10 + 101 + i + 10(1+i)2 + 10(1+i)3 + ⋯=

10(1+i)i where i is the interest rate. In a repeated game with an uncertain end point, 1 − θ plays the

role of 1/(1 + i); players discount the future not because of the interest rate but because they are

not certain future plays will occur.

In a finitely repeated game with an unknown end point, firm A has no incentive to cheat if it

expects to earn less from cheating than from not cheating. For the numbers in our example, firm A

has no incentive to cheat if: ΠCheatFirm A = 50≤10θ = ΠCoopFirm A, which is true if θ ≤ 1/5. In

firm A will lose more by cheating than it will gain. Since firm B’s incentives are symmetric, the same

is true for B. Thus, when oligopolistic firms compete a finite but uncertain number of times, it is

possible for them to collude and charge high prices—to earn $10 each period—just as they can

when they know the game will be played forever. The key is that there must be a sufficiently high

Table 10–11 is that eventually a point will come when both players are certain there is no

tomorrow. At that point, any promises to “cooperate” made during previous periods will be

broken because there is no way a player can be punished tomorrow for having broken the

promise.

Effectively, a player has an incentive to break a promise in the second-to-the-last period since

there is no effective punishment during the last period. Because all the players know this, there is

effectively no tomorrow in the third period from the last. This type of “backward unraveling”

continues until the players realize no effective punishment can be used during any period. The

players charge low prices in every period, right up to the known last period.

When players know precisely when a repeated game will end, what is known as the end-of-period

What can the manager do to overcome this problem? One possibility is to “fire” the worker

find new workers to replace them.

To understand how multistage games differ from one-shot and infinitely repeated games, it is useful

to introduce the extensive form of a game. An extensive-form game summarizes who the players

are, the information available to the players at each stage of the game, the strategies available to the

players, the order of the moves of the game, and the payoffs that result from the alternative

A set of strategies constitutes a subgame perfect equilibrium if (1) it is a Nash equilibrium and (2)

at each stage of the game (decision node), neither player can improve her payoff by changing her

own strategy. Thus, a subgame perfect equilibrium is a Nash equilibrium that involves only

credible threats.

form game presented in Figure 10–2. Here, firm B is an existing firm in the market and firm A is a

potential entrant. Firm A must decide whether to enter the market (in) or stay out (out). If A

decides to stay out of the market, firm B continues its existing behavior and earns profits of $10

million, while A earns $0. But if A decides to enter the market, B must decide whether to engage in

a price war (hard) or to simply share the market (soft). By choosing hard, firm B ensures that firm

A incurs a loss of $1 million, but B makes only $1 million in profits. On the other hand, if firm B

It turns out that there are two Nash equilibria for this game. The first occurs where firm B

threatens to choose hard if A enters the market, and thus A stays out of the market. To see that

strategy; firm A earns $0, and firm B earns profits of $10 million.

However, this Nash equilibrium involves a threat that is not credible. The reason firm A

chooses not to enter is that firm B threatens to choose hard if A enters. Does B have an incentive to

carry through its threat of choosing hard if firm A enters? The answer is no. Given that firm A

enters the market, firm B will earn $5 million by choosing soft but only $1 million by choosing hard.

If firm A enters, it is not in firm B’s best interest to play hard. Thus, the outcome in which firm A

accept or reject the offer. If the offer is rejected, neither party receives anything. If the offer

is accepted, the union gets the amount specified and management gets the residual. To

simplify matters, suppose management can offer the union one of three amounts: $1, $50, or

$99.

The extensive form of this game is depicted in Figure 10–4. Notice that the union gets to

make its decision after it learns of management’s offer. For instance, if management offers the

union

$1 and the union accepts the offer, management gets $99 and the union gets $1. If the union rejects

the offer, both parties get $0.

an offer: “Give us $99 or else we will reject the offer.” What should you do? If you believe the union,

then if you offered it a lower amount, it would reject the offer and you would get nothing. Given the

union’s strategy, your best choice is to give the union $99 since that action gives you a payoff of $1

instead of $0. And given that you offer the union $99, its best choice is to accept the offer. Thus, one

Nash equilibrium outcome of this sequential bargaining process yields $1 for management and $99

for the union.

According to the union, if management offered the union $1, the union would reject the offer. But

by rejecting such an offer, the union would earn $0 instead of the $1 it could earn by accepting it.

Thus, it is not in the union’s best interest to reject the offer.

In fact, the unique subgame perfect equilibrium for this sequential bargaining game is for

preferred to the $0 it would earn by rejecting the offer. In this sequential-move bargaining game,

the unique subgame perfect equilibrium results in management getting $99 and the union getting

$1.

Second, an important assumption in the bargaining process analyzed in this section is that

bargaining terminates as soon as the second player rejects or accepts an offer. If this were not the

case, the person making the decision to accept or reject the offer might reason as follows: “If I reject

Firms in perfect competition have no control over the prices they charge for their products;

prices are determined by market forces. Therefore, the pricing decision in perfect competition is

simple: Charge the same price other firms in the market charge for their products.

In contrast, firms with market power have some influence over the prices they charge.

Therefore, it is important for you, as a manager, to learn some basic pricing strategies for

maximizing a firm’s profits. This chapter provides practical advice that you can use to implement

such pricing strategies, typically using information that is readily available to managers. For

instance, we will see how a manager can use publicly available information about demand

elasticities to determine the profit-maximizing markup used to set product price.

The most basic pricing strategy used by firms with market power: Charge a single price to all

customers such that marginal revenue equals marginal cost.

selling many units at a low price and selling only a few units at a high price.

Output is set at the point where marginal revenue (MR) equals marginal cost (MC). The profit-

maximizing price is the maximum price per unit that consumers will pay for this level of output.

The marginal revenue for a firm with market power is given by: MR = P x [1 + EFEF], where EF is

the own-price elasticity of demand for the firm’s product and P is the price charged.

MC, where K = EF / (1 + EF). The number K can be viewed as the profit-maximizing markup factor.

elastic when there are many available substitutes for a product, managers that sell such products

should have a relatively low markup. In the extreme case when the elasticity of demand is perfectly

elastic (EF = −∞), this markup rule reveals that price should be set equal to marginal cost. A

perfectly competitive firm that faces a perfectly elastic demand curve charges a price equal to

marginal cost.

the demand function is linear, demand is more elastic at higher prices than at lower prices. In this

case, a slight increase in price will lead to a slight increase in the elasticity of demand, which in turn

makes the optimal markup slightly lower than that calculated based on the original estimate of the

elasticity of demand. For this reason, if you have an estimate of the demand function, you may more

The pricing rule given for a firm in Cournot oligopoly has a very simple justification. When firms in

The final type of price discrimination is commonly practiced by firms that recognize that the

demand for their product differs systematically across consumers in different demographic groups.

In these instances, firms can profit by charging different groups of consumers different prices for

the same product, a strategy referred to as third-degree price discrimination. For example, it is

To see why third-degree price discrimination enhances profits, suppose a firm with market

Since MR1 = MC and MR2 = MC, it follows that the firm will allocate output between the two

groups such that MR1 = MR2. To see why, suppose the marginal revenue for group 1 is 10 and the

marginal revenue for group 2 is 5. If one less unit were sold to group 2, revenue from that group

would fall by 5. If the extra unit of output were sold to group 1, revenue would increase by 10. Thus,

Another strategy that firms with market power can use to enhance profits is two-part pricing. With

two-part pricing, a firm charges a fixed fee for the right to purchase its goods, plus a per-unit

units of a good. Notice that block pricing can enhance profits even in situations where

consumers have identical demands for a firm’s product.

Another strategy managers can use to enhance profits is commodity bundling. Commodity bundling

Many markets have periods in which demand is high and periods in which demand is low. Toll

roads tend to have more traffic during rush hour than at other times of the day; utility companies

tend to have higher demand during the day than during the late-night hours; and airlines tend to

have heavier traffic during the week than during weekends. When the demand during peak times is

The next pricing strategy we will discuss—cross-subsidies—is relevant in situations where a firm

Thus far, our analysis of pricing decisions has presumed that a single manager is in charge of

pricing and output decisions. However, most large firms have upstream and downstream managers

Transfer pricing is important because most division managers are provided an incentive to

maximize their own division’s profits. As we will see, if the owners of a firm do not set optimal

transfer prices, but instead let division managers set the prices of internally manufactured inputs so

as to maximize their division’s profits, the result might be lower overall profits for the firm.

Signaling occurs when an informed party sends a signal (or indicator) of his or her hidden

characteristics to an uninformed party in an attempt to provide information about these hidden

characteristics. In product markets, firms use a host of devices to signal product quality to

consumers: money-back guarantees, free trial periods, and packaging labels that indicate the

A simple example will illustrate how an uninformed manager can use a self-selection device to gain

information about the hidden characteristics of workers. Suppose two workers—Fred and Mitchell

—have different characteristics: Fred is the better administrator and Mitchell is the better

salesperson. Fred and Mitchell know what they do better, but their personnel director does not.

Specifically, Fred knows the firm’s profits would increase by $20,000 if he were employed as an

administrator and that he would be unable to generate any sales if he were employed as a

salesperson. Mitchell knows the firm’s profits would increase by $15,000 if he were employed as an

administrator and that he could generate $1 million in sales if he were employed as a salesperson.

The personnel director, Natalie, wants to place each worker in the position that adds the most value

to the firm, but she lacks the information needed to make these assignments.

Natalie can overcome her lack of information by offering Fred and Mitchell different employment

options and letting them self-select into the job that is best for them as well as for the firm. In

particular, suppose Natalie uses a self-selection device whereby she announces the following

compensation for administrators and salespeople: Administrators earn a fixed salary of $20,000;

There are four basic types of auction: English (ascending-bid); first-price, sealed-bid; second-

price, sealed-bid; and Dutch (descending-bid) auctions. These auctions differ with respect to (1)

the timing of bidder decisions (whether bids are made simultaneously or sequentially) and (2) the

amount the winner is required to pay. Keep these two sources of differences in auctions in mind as

The auction you probably are most familiar with is the English auction. In an English auction, a

single item is to be sold to the highest bidder. The auction begins with an opening bid. Given

knowledge of the opening bid, the auctioneer asks if anyone is willing to pay a higher price. The

bids continue to rise in a sequential fashion until no other participants wish to increase the bid. The

highest bidder—the only bidder left—pays the auctioneer his or her bid and takes possession of the

Notice that in an English auction, the bidders continually obtain information about one

million, and firm C values it at $1.5 million. Which firm will acquire the machine, and at what price?

All three firms will bid up to $1 million for the machine. Once the bid is slightly above this

amount, firm A will drop out since it values the machine at $1 million. When the bid reaches $1.5

million, firm C will drop out, which means firm B will acquire the machine for $1.5 million (or

ever participated in an auction on eBay, chances are you have participated in a second-price auction.

eBay’s incremental bidding mechanism permits a bidder to submit his reservation price or

“maximum bid.” This amount is kept secret by eBay’s system. The system automatically updates the

bid, using the smallest increment required above the previous high bid. This process continues until

the bid required exceeds the reservation price.

This environment is essentially a second-price auction, and the optimal reservation price to

submit early in the auction is your true valuation of the item. As eBay explains on its website:

our system incrementally increase your bid for you, as necessary. As the listing proceeds, we

compare your bid to those of other bidders. When you’re outbid, we automatically bid on your

behalf up to your maximum bid. We increase your bid by increments only as much as necessary to

maintain your position as highest bidder. Your maximum bid reflects the amount you’re willing to

pay for an item, but you could end up paying less.

Thus, in a first-price, sealed-bid auction, the highest bidder wins the item just as in an

English auction. However, unlike in an English auction, the bidders do not know the bids of other

auction. If Firm A bids $1 million, Firm B bids $2 million, and Firm C bids $1.5 million, then the high

bidder—Firm B—wins the item, but it pays only the second highest bid, which is $1.5 million.

The information available to bidders in a Dutch auction is identical to that in a first-price,

sealed-bid auction. In particular, no information is available about the bids of other players until

the auction is over, that is, when the first bidder speaks up. Consequently, a Dutch auction is

what he or she bid for the item. In terms of optimal bidding behavior and the profits earned by the

auctioneer, the Dutch auction and first-price, sealed-bid auctions are identical.

The auction just described is one in which bidders have independent private values. The

term private value refers to the fact that the item’s worth to an individual bidder is determined by

personal tastes that are known only to that bidder. The fact that these private values are

change. This information might, however, induce him or her to bid differently in the auction.

valuation of the item. Furthermore, the bidders’ value estimates are correlated, or, more precisely,

affiliated: The higher one bidder’s value estimate, the more likely it is that other bidders also have

high value estimates.

A special case of this environment, the common-value auction, arises when the true

underlying value of the item is the same for all bidders. In this case, individual tastes play no role in

shaping the bidders’ value estimates. The uncertainty stems purely from the fact that different

bidders use different information to form their estimates of the common value of the item.

A good example of a common-value auction is the government’s use of auctions to sell oil,

gas, and mineral rights to prospective firms. The true value of these rights (the amount of oil, gas, or

ore underneath the earth) is unknown to the bidders, but whatever the amount, the value is the

same for all bidders. Each bidder forms an estimate of the true common value by taking seismic

readings and performing other tests. Even though the true value is the same for all bidders, each

bidder will likely obtain different estimates through its own tests.

Consider first an English auction, in which the auctioneer starts with a low price and gradually

raises it until only one bidder remains. A bidder who remains in the auction after the price exceeds

Next, consider a second-price, sealed-bid auction: The highest bidder wins and pays the amount bid

bidder, just as in the English auction.

Why should players bid their true valuation in a second-price auction? The reason is quite

simple. Since the winner pays the bid of the second-highest bidder, not his or her own bid, it does

not pay for players to bid more or less than their own valuations. To see this, suppose a player bid

more than the item was worth to him to increase the likelihood of being the high bidder. If the

second-highest bid is less than his valuation, this strategy yields no additional returns; he also

Finally, consider a first-price auction (which as we have seen is strategically equivalent to a Dutch

auction). In this case, the high bidder wins and pays his or her own bid. Since players do not know

the valuations or bids of others and must pay their own bid if they win, players have an incentive to

bid less than their own valuation of the item. By bidding less than his or her own valuation of the

item, a player reduces the probability of submitting the highest bid. But the profit the bidder earns

if he or she does win more than offsets the reduced probability of winning. The amount by which a

bidder shades down his bid depends on how many other bidders are competing for the item. The

more competitive the auction (that is, the greater the number of other bidders), the closer a

player should bid to his or her true valuation. The following principle includes a formula you can

use to explicitly compute your optimal bid in situations in which you and other bidders perceive

that the lowest possible valuation of other bidders is L and the highest possible valuation is H.

Optimal bidding strategies with affiliated (or correlated) values are more difficult to describe, for

two main reasons. First, the bidders do not know their own valuations of the item, let alone the

valuations of others. This not only makes it difficult for players to determine how much to bid, but

as we will see, it makes them vulnerable to what is called the winner’s curse. Second, the auction

process itself may reveal information about how much the other bidders value the object. When

players’ value estimates are affiliated, optimal bidding requires that players use this information

Suppose the differences in their estimates of the amount of oil in the ground are due purely to

learn nothing useful about the item’s worth during the auction process. As we saw in the previous

section, the price ultimately paid by the winner in an English auction is the second-highest

valuation—the price at which the last competitor drops out. This is also the case in a second-price

auction. In particular, each player bids his or her own value, and thus the price paid by the winner

(the second-highest price) is the second-highest valuation. It follows that, with independent

revenues for the auctioneer when bidders have independent private values.

aware, rules and regulations that are passed and enforced by government enter into almost every

decision firms and consumers make. As a manager, it is important to understand the regulations

passed by government, why such regulations have been passed, and how they affect optimal

managerial decisions.

We will begin by examining four reasons why free markets may fail to provide the socially

efficient quantities of goods: (1) market power, (2) externalities, (3) public goods, and (4)

incomplete information. Our analysis includes an overview of government policies designed to

alleviate these “market failures” and an explanation of how the policies affect managerial decisions.

The power of politicians to institute policies that affect the allocation of resources in markets

provides those adversely affected with an incentive to engage in lobbying activities.

Social welfare—defined as the sum of consumer and producer surplus—is maximized at the output

where price equals marginal cost. The socially efficient price and output arise naturally if the

Notice in Figure 14–1 that the area of triangle ABC is the deadweight loss of the monopoly—welfare

welfare loss to society.

Antitrust policy attempts to eliminate the deadweight loss of monopoly by making it illegal for

managers to engage in activities that foster monopoly power, such as price-fixing agreements and

other collusive practices. The cornerstone of U.S. antitrust policy is contained in Sections 1 and 2 of

the Sherman Antitrust Act of 1890.

an increase in the HHI of between 100 and 200 points also potentially raises antitrust concerns. If a

merger increases HHI by more than 200 and leads to a highly concentrated market, it is presumed

to be likely to enhance market power.

domestic or foreign firms, an emerging new technology, or increased efficiency, or one of the firms

has financial problems.

In the presence of large economies of scale (as is the case for some utility companies), it may be

desirable for a single firm to service a market. In these instances, government may allow a firm to

wastes that either do not easily biodegrade or have harmful effects on other resources, it does not

pay the full cost of production. For example, a firm that produces textiles usually creates waste

products that contain dioxin, a cancer-causing chemical. When a textile manufacturer can dispose

of this waste “for free” by dumping it into a nearby river, it has an incentive to dump more waste

into the river than is socially optimal. While the firm benefits from dumping waste into the river,

the waste reduces the oxygen content of the water, clogs normal waterway routes, and creates

reproduction problems for birds, fish, reptiles, and aquatic animals. These results negatively affect

The basic reason for the “market failure” is the absence of well-defined property rights; the steel

firms believe they have the right to use the river to dump waste, and environmentalists believe they

have the right to a clean river. This failure often can be solved when government defines itself to be

the owner of the environment. It can then use its power to induce the socially efficient levels of

Permits can be sold by one firm to another both within and across industries. This does two things

create cleaner production methods.

means that when you consume the good, another person is unable to consume it as well. For

Nonrival goods include radio signals, lighthouses, national defense, and protecting the

environment. When you receive a radio signal in your car, you do not prevent other drivers from

picking up the same station in their cars. This is in sharp contrast to your purchasing a pair of shoes.

Goods and services such as clean air, national defense, and radio waves are nonexclusionary

goods. For example, when the air is clean, everyone gets to consume the clean air; it cannot be

allocated to a single person.

What is it about public goods that leads the market to provide them in inefficient quantities?

The answer is that since everyone gets to consume a public good once it is available, individuals

have little incentive to purchase the good; rather, they prefer to let other people pay for it. Once it

becomes available, they can “free ride” on the efforts of others to provide the good. But if everyone

thinks this way, no one will buy the good and it will not be available. One person alone may be

unable to afford to purchase the good.

nonexclusionary in nature and therefore benefit persons other than those who buy the goods.

Public goods differ from most goods you consume, which are rivalrous in nature. This simply

means that when you consume the good, another person is unable to consume it as well. For

example, when you buy and wear a pair of shoes to protect your feet, you prevent someone else

from wearing the same pair; the consumption of shoes is rivalrous in nature.

The second aspect of a public good is that it is nonexclusionary: Once a public good is made

available, everyone gets it; no one can be excluded from enjoying the good. Most goods and services

are by nature exclusionary. For example, when a car manufacturer produces a car, it can keep

people from using the car by putting a lock on the door and giving the key only to the person who is

Goods and services such as clean air, national defense, and radio waves are nonexclusionary

What is it about public goods that leads the market to provide them in inefficient quantities?

thinks this way, no one will buy the good and it will not be available. One person alone may be

The socially efficient level of streetlights is at point A in Figure 14–7, where the marginal cost of

producing streetlights exactly equals the total demand for streetlights. Algebraically, if the marginal

neighborhood can achieve the socially efficient quantity of lights is to pool their resources. If they

accomplish this and each pays $18 per light, each will enjoy a consumer surplus of the shaded

region in Figure 14–7, which is $72.

We conclude by pointing out that it may be advantageous for a firm to contribute to public goods in

its market area. Doing things such as cleaning up a local park or giving money to public television

numerous consumers and thus may be a useful advertising strategy in some situations. Another

advantage is that it may put the firm on more favorable terms with politicians, who have

considerable latitude in affecting the environment in which the firm operates. Unfortunately, there

is no easy way to explicitly calculate the optimal amount that a firm should voluntarily contribute to

public goods. But ultimately, if the firm’s goal is to maximize profits, the last dollar spent on

contributions to public projects should bring in one additional dollar in revenue.

Consider the consumption of cigarettes. If individuals are not told that cigarettes are

serves as a provider of information in many markets, dispensing information to consumers about

the ingredients of certain foods, the dangers of certain products and drugs, and the like. Firms print

some of this information on the labels of their products due to regulations imposed by government.

dangers of chemicals such as asbestos and the benefits of precautions such as wearing hard hats in

construction jobs. In these instances, the regulations are carried out by the Occupational Safety and

Health Administration (OSHA).

One of the more severe causes of market failure is asymmetric information, a situation

presence of asymmetric information can lead buyers to refuse to purchase from sellers out of fear

that the seller is willing to get rid of the product because it is worth less than they are willing to pay.

In the extreme case, the market can collapse altogether. For this reason, several government

asymmetric information is the law against insider trading in the stock market. The purpose of the

law is to ensure that asymmetric information (better information by insiders) does not destroy the

market by inducing outsiders to stay out of it.

such as those for schools and physicians. The purpose is to assure consumers that the products or

services have been certified as meeting a certain set of minimum standards. Without a central

authority to fulfill this information-gathering role, each individual would have to pay the cost of

gaining knowledge about the quality of a product or service. This would lead to inefficiencies due to

A set of legislation over the years has made gathering information for borrowing purposes less

difficult. Confusion caused by the Truth in Lending Act (1969) led Congress to pass the Truth in

Lending Simplification Act (TLSA) in 1980. TLSA is enforced by the Federal Reserve Board (FRB)

and has been revised several times. In 1980, the FRB passed Regulation Z to provide guidelines for

enforcement; it amended Regulation Z in 1982.

Regulation Z and TLSA require that all creditors comply with the act. A creditor is defined as

anyone who loans money subject to a finance charge, where the money is to be paid back in four or

law is to ensure that all debtors are given an opportunity to understand all aspects of borrowing

money from a specific creditor, thus creating more symmetric information between borrowers and

lenders.

knowledge reduces the risk involved in repayment for the borrower. The reduced risk shifts the

demand curve for loans to the right. The suppliers of loans (creditors) are affected mainly by the

increased cost of complying with the government regulations. This shifts the creditors’ supply

curve to the left. Since the demand curve for loans shifts to the right and the supply curve shifts to

the left, the effect of this law is to increase the price of loans (the interest rate).

most cases are filed in civil court by those harmed by deceptive advertising rather than by the FTC.

The Lanham Act, in concert with the Clayton Act, allows someone who is harmed by false or