Managerial Economics Exam questions Essay
Barriers to entry:
In theories of competition in economics, barriers to entry are the obstacles and hindrances that make it difficult for a company to enter a given market or industry. The most common barriers to entry include government regulation and economies of scale, but nowadays it is increasing for entry barriers to be viewed as a cost. Stigler defined barriers to entry as “A cost of producing which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry”. Therefore, these invisible shields protect incumbent firms and reduce competition within the market, which can often lead to market power and the existence of a monopoly. Barriers to entry are one of the key aspects in Porter’s five forces analysis, which is a framework for industry analysis and business strategy development based on the competitive intensity and therefore attractiveness of a market.
Different barriers will effect companies in different ways, to understand their impacts they are grouped into 3 categories known as consumer preference barriers, absolute cost advantages and scale economies. Preference and cost advantage barriers are present if established firms have lower average unit costs than potential entrants at any
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Perfectly competitive markets are said to have 0, or low, barriers to entry compared to monopoly industries which have very high barriers. It is possible for monopolies to own patents and intellectual property that give a firm the legal right to stop other firms producing a product for a given period of time, and so restrict entry into a market. Monopolies also have an established relationship with customers within the industry, making it hard for new entries to tease consumers away from this brand loyalty. This is true in the telecommunications industry which is run by a few giant companies like Vodafone and Orange. It would be very hard for a new company to attract customers away as long term contracts are signed which, provide switching barriers, and economies of scale help them maintain low prices. If these economies of scale are substantial, the industry may not be able to support more than one producer. Line D1 represents the industry demand curve and supernormal profits can be gained between points A and B. However if there were 2 firms each producing half the output and charging the same price, they would each face the demand curve D2 which means they would not be able to cover costs. This is known as a natural monopoly.
An example is two bus companies running the same routes, but half full buses makes business un- profitable compared to if there was one company running the routes with full buses. One tool companies companies can use to inhibit other firms entering the market is limit pricing. This is where a monopolist charges a price below the short run profit maximizing level to deliberately restrict it’s the size of its profits so as to not attract new entrants. Lowering of price will also restrict new entrants from competing in terms of price and increasing the number of customers the monopoly retains due to lower prices.
In other industries, markets with monopolistic competition tend to have low barriers to entry, whereas oligopolies,are normally surrounded by slightly higher barriers. In some cases, governments have reduced barriers to entry into these industries, but high sunk costs have discouraged entry. These costs cannot be recovered if a firm decides to leave the market, as they cannot be used elsewhere and an example is investment in oil refining machinery. To counter this, strategic behavior by firms in these industries can restrict companies expanding into the market and it helps them achieve some of the benefits of protection that a monopoly has. This is known as collusion and through successfully colluding oligopolies’ can charge a price considerably in excess of their average costs, therefore at a level which would hold if the industry was a monopoly.
This is contrast to perfect competition where price cannot for long exceed average costs since the appearance of new entrants will exert downward pressure on prices. Collusion goes against the theory of entry barriers which is based on one principal assumption known as the Sylos Postulate, which alleges that potential entrants expect firms to maintain their output levels and reduce their price to accommodate the entrant. According to the Sylos postulate the entrant must increase the industry’s total output and therefore the industry’s price must fall by a sufficient amount. The entrants demand curve is that segment of the total industry demand curve to the right of the ruling price. To ascertain whether or not to enter an industry, a potential entrant will compare this demand curve with his particular cost function.
Overall barriers to entry inhibit increased competition in a market and help keep prices high. Governments and the public encourage barriers to e knocked down in order to support smaller firms and drive down the average prices of goods and services within the economy.
Theory of Principal Agent:
The principal- agent problem has been used by Jaffe in 1994 to discuss energy consumption, but in political sciences and economics it is the problem of motivating a party to act on behalf of another. It underlies the concepts of moral hazard, adverse selection and information asymmetry, which have caused the need to overcome contractual problems. The theory is also known as agency dilemma and it differs from dealing with normal contractual problems where parties have no similar risk preferences by treating the difficulties that arise under conditions of incomplete and asymmetric information. The principal hires the agent to into a job where the agent’s effort is unobservable, so managers need to understand how contracts can be written to overcome such circumstances of opportunistic behavior in order to ensure goal congruence when interests diverge. Principal-agent theory tackles a sub case of the strategic behavior called bounded rationality behavior. An agent is someone who carries out a task on behalf of another, for example a builder working for a property developer. In this case, the property developer is the principal and is the risk neutral party whereas the builder is the risk averse party to the contract. This is an employer- employee contract but the theory covers a wide range of relationships including shareholder- manager and insurer- insured. The power and risk is with the principal, as he can keep his wealth in well diversified portfolios, which in this case means the property developer has many employees to use whereas
the builder one has one job to lose. The problem with the agreement of the builder to work for the property developer is that the 2 parties may have different attitudes towards risk, so managers need to encourage workers to produce the same amounts of effort in the long run. The property developer needs to inject incentives to the contract to assist the business objectives, this can be done by transferring some of the risk to the agent/ builder. Builders are unwilling to provide effort without a suitable reward and their objective function is to maximize his own utility: U= f(w,e). So the builders satisfaction depends on wages (w) and effort (e). One characteristic of a risk averter is diminishing marginal utility, so as W is raised beyond a certain point, it will provide diminishing values of utility. Lets assume the builder can choose between 2 levels of effort, higher effort is assumed to result in greater build progress but it is also influenced by environmental factors such as the weather, quality of materials and other builders level of effort.
Expected build progress related pay
When E=1 the property developer receives £233 from the owner of the house and when E is twice as much the property developer receives £366. The builder does however require a minimum guaranteed opportunity wage to provide a minimum level of utility of 2, otherwise he would work elsewhere, this is £9. The wage needed to get A to work is determined by deriving A’s minimum
reservation wage given the knowledge his overall utility must be at least equal to 2.
P’s expected receivable is therefore £366 so profit is £330 and A’s incentive bonus is £27. This is a joint value maximizing contract since the alternative to pay A just £9 results only in a net profit of £224. But P is unable to set level of effort at E=2 and only the outcomes can be observed. A self-interested A would select E=1 and blame the external environment when £100 is received instead of £500. Therefore, a good outcome would result in exposing A to some risk so that it is in A’s interest to implement P’s desired effort and no shirking takes place. The principals problems is findings values of pay for different build receivables which meet both A’s incentive compatibility constraint ( ) and participation constraint( ).So now the agents income is dependent on the agents own efforts and not only on the environment, so an efficient sharing of risk has taken place. Y=is pay when £100 are received and z=pay when £500 is received. Solving simultaneously we have y=£ and z=£100, so on the occasion when £500 receivables are obtained the basic pay offered is £1 and the bonus pay is £99. In a full information setting, the risk averse agent bore no risk and the risk neutral principal bore all the risk. Now, in a situation of bounded rationality some risk has been shifted to provide an appropriate incentive alignment situation. Without contracting the principal would have settled for sales of £233 but with contracting at E=2 the expected sales rise to £366. The agents wage rises from £9 to £66.33. Joint value maximization has occurred given the construction of the appropriate incentive contract. Optimal transacting would not have occurred if fencing costs had exceeded £400 so joint value maximization would not have occurred. If we had relaxed our assumption of risk neutrality of the principal then the optimal risk sharing proportions would have been altered.
If average revenue = a-bq then marginal revenue = a-2bq:
In order to understand this theory we must firstly understand the three revenue concepts of total revenue, average revenue, marginal revenue and then progress onto the differences seen when price varies with output and when not.
Total revenue is a firms total earnings from a specified level of sales within a specified period. It is calculated by multiplying price by quantity (TR= PxQ), an example is if a company sells 1000 apples per month at a price of £5 each, then total revenue is £5000. The amount earned per unit sold is known as average revenue (TR/Q) and in this case is £5, which is simply price! Finally, marginal revenue is the extra revenue gained by selling one more one more unit per period of time. It is calculated using the change in total revenue divided by the change in total output, so if an extra 20 apples are sold this month bringing in an extra £100, then marginal revenue is £5. Now, let us look at how each varies with output, this will depend on the market conditions under which the firm operates. If a firm is small relative to the market, it is likely to be a price taker. Being so small it can sell as much as it can produce as it experiences a horizontal demand curve, its output is insignificant in influencing market price as average revenue is constant. However, if a firm has a relatively large market share, price does vary with the firms output, meaning the price must be lowered in order to sell more. Firms in this situation include monopoly firms such as Coca Cola. This type of firm face a downward sloping demand curve, which shows them how much is sold at each price level. Saying this, a monopolist cannot charge any price it wants if its objective is to maximize profits. To maximise, the monopolist must determine its cost and characteristics of market demand, which are crucial for economic decision-making. The monopolist must then decide how much to produce and sell, the price per unit then follows directly from the market demand curve. The monopolists average revenue curve is precisely the market demand curve and in order to know its profit maximising level of output the marginal revenue must be determined.
Consider a firm following the demand curve P=6-Q, the table below shows the behaviour of the total, average and marginal revenue curves for this demand curve. PRICE
We can see that when marginal revenue is positive revenue is increasing with quantity, but when marginal revenue is negative revenue is decreasing. If the demand curve is written so that price is a function of quantity (P=A-bQ), then total revenue is given by PQ=aQ-bQ². Using calculus marginal revenue is d(PQ)/dQ= a-2bQ. In the example above, demand is P=6-Q and therefore marginal revenue is MR=6-2Q. Setting marginal revenue equal to
zero we obtain the revenue maximising quantity for the monopoly which is 3. From this several things are evident. First, the marginal revenue curve has the same y intercept as the inverse demand curve. Second, the slope of the marginal revenue curve is twice that of the inverse demand curve. Third the x intercept of the marginal revenue curve is half that of the inverse demand curve. What is not quite so evident is that the marginal revenue curve is below the inverse demand curve at all points. Since all companies maximize profits by equating MR and MC it must be the case that at the profit maximizing quantity MR and MC are less than price, which further implies that a monopoly produces less quantity at a higher price than if the market were perfectly competitive. We can also use the data above to find the marginal revenue curve when only an average curve is known. At Q1, total revenue is equal to the area contained by the rectangle OACQ1. In order to draw a marginal revenue curve we must do so in a way that at output Q1, revenue represented by OBDQ1 is equal to OACQ1. This will only be so if the triangles ABE and CDE are equal. We must make sure that BD cuts AC at its midpoint so that AE=EC. The curve is found by drawing a straight line between a straight line from where the average curve cuts the vertical axis to any midpoint of any horizontal line from the average curve to the y axis. This shows that the -2 means the slope is negative and twice as steep as the slope of the demand curve. So for every £1 increase in output, marginal revenue decreases by £2.
If demand is written so that price is a function of Q then
since TR =PQ = (a-bQ)Q = aQ-bQ2
MR is ?TR/?Q or using calculus
d(PQ)/dQ = a-2bQ
Demand in the market place is the foundation on which all of managers decisions must ultimately rest. The theory of demand highlights that managers need to consider the individual demand as well as examine total
market demand. The theory suggests that market behaviour is merely the behaviour of aggregates of individuals and acknowledging this enables us to apply the theory to simple decision making in the market place.
Consumers make decisions based on the satisfaction they gain from consuming goods and services, which is known as utility. A consumer will allocate his expenditure among a range of purchase options in such a way that his total utility is maximised. The more realistic ordinal theory argues that satisfaction is subjective and incapable of precise measurement, which is what occurs in the cardinal theory. Consumers therefore can only rank the degree of satisfaction associated with a range of commodities. The use of indifference curves enables us to adapt the ordinal approach to demand theory. Indifference curves assume there are only 2 products but represent all the combinations of these goods or services that provide consumers with the same level of utility. The curves are a locus of points showing what the consumer wishes to have, each line represents a combination of commodities such that the consumer is indifferent between any of these combinations. Level of utility is measured in utils, from the diagram we can see that at point R, with 5 units of A and 3 units of B, the same satisfaction is derived at point X where he obtains 2 units of A and 8 units of B.
The consumer will always prefer to have more of A and B so indifference curves which lie above and to the right represent some higher level of satisfaction. So point L is preferred over point M. As we can see from the diagram the indifference curves do not intersect. This is because the consumer’s choice is rational and there is transitivity between the consumers preferences. For example: if the consumer is indifferent between products j and k, and he is also indifferent between products k and l, then the consumer must be indifferent between l and j. When dealing with indifference curves we must assume a diminishing marginal rate of substitution (MRS). The MRS is the concept that obtaining more of B demands giving up units of A. It is the change in the consumption of one good
necessary to offset a given change in consumption of another good, if overall utility is to remain the same. The MRS measures the slope of the indifference curve, which is normally negative. The marginal revenue gained must equal marginal revenue lost so…..
From this we can understand that at point R, the marginal utility of B will be high, relative to that of A which is in plentiful supply. Here the consumer is willing to give up 2 units of A to obtain one unit of B. But at position X, where product A is scarcer and B is more plentiful than at R, the consumer is only willing to forfeit 1 unit of A to obtain one unit of B. As a consequence of this indifference curves are convex to the origin and will never intersect. MRS of B for A is equal to the ratio of their marginal utilities. Using indifference curves we can determine the consumers optimal combination of goods, which is where the IC is tangential to a budget line. Indifference curves are integrated with budget lines to find the optimal basket of goods which is achieved where marginal utility is proportional to price. Budget Lines:
If indifference curves are what the consumers wish to have, then budget lines show what the consumer can actually have given income. They represent all the combinations of goods that can be purchased given a fixed amount of income and is calculated by adding total spending on A with total spending on B, BL= (PA*A) + (PB*B).
Any point within the area of CDE is a possible choice of combinations for the consumer. Point D represents the number of units of A the consumer can buy if he or she spends the entire budget on commodity A, at price Pa. In the reverse point E indicates the maximum units of B he could purchase with the entire budget. A mathematical way to calculate the budget line is by knowing that it is equal to the inverse of the ratio of the prices of A and B. Given an income and the related utility function, we can use the budget line to determine the purchase combination that will be most satisfying for the individual. Within the range of choice available, the highest attainable indifference curve will be the one tangential to the price line. The individual will only reach equilibrium, the position that cannot be improved
on, when he or she reaches point F. At point F the slope of the indifference curve and the budget line are equal and the slope of the indifference curve at point F is equal to the MRS of B for A at that point.
There are 2 major dimensions that influence the position of the optimal combination of goods. If price rises the overall consumption of goods falls. This shifts consumers to a lower indifference curve and is known as the income effect. The substitution effect occurs when a certain price change means more consumption of one good and less of the other. It usual occurs where cheap goods are exchanged for more expensive goods and cause movements along the same indifference curve. In the end the optimal combination is found in order to maximise the consumers utility. Another way to determine this point is where the utility on the last £1 of each product is equal. This is known as the equi-marginal principle.
The 3 single period business objective models(profit maximising, Baumol, Williamson) all aim to maximise their respective objectives. Explain the predictions in terms of exogenous variables: Berle and Means(1932) suggest the theory of separation between ownership of firms and its control which causes organisations and manager has different objectives to one another, each greatly influenced by a range of internal and external factors. Managers have varying levels of information to help them achieve their goals so the use of models helps the process of decision making and strategy implementation. Models help management in a typical firm produce comparative static predictions of the qualitative changes in the equilibrium values of endogenous variables (those which the model explains) when exogenous variables (those outside the model) change. An example of this would be when corporation tax rises, the typical firm will reduce output. So models show managers in which direction policy variables should change to achieve or continue achieving their chosen goal.
One obvious consideration when choosing models is whom the model is predicting. If the prescriptions of other firm responses are the aim then the chosen model should be the one which has achieved this aim more frequently than any other model. On the other hand, when normative
prescriptions are to be deduced, the model which assumes the goal most desired by management should be chosen. Management must bear in mind the reasons the model may not be as useful as first hoped, the fact that there is such a vast number of factors which effect the firms responses to exogenous factors may influence the model. Another problem is that the firm is seen as a nexus of contracts of people with different objectives, these may be conflicting, so managers need to address the principal agent problem. Single period profit maximising models are usually used by monopoly firms to determine the greatest distance between total revenue and total cost. The model is used to predict what the management response should be in order to continue maximising profits. It is possible to determine this profit maximising point by looking at where the gradient of the 2 curves are equal. Using these 2 curves it is possible to determine the total profit curve by subtracting total cost from total revenue. Maximum profits occur where the profits curve peaks. TR= 500Q-2Q²
Total Profit= TR-TC
Total profit= -400Q+1.5Q²-4
Solving for Q gives the profit maximising rate of output as 133 units. The model should therefore be used to predict the response management should implement if an exogenous factor changes output away from the profit maximising point. An example would be exogenous variables such as rises in variable costs, materials and wages, then the cost of producing one additional unit will be greater than it was originally. The marginal cost curve rises and since marginal revenue remains the same MC equals MR at a lower output. Diagram from page 77:
This neoclassical theory of the firm has some drawbacks, the problem with using this model is that it says little about the relationships and power struggles between various groups both inside and outside the firm. So managerial models where created as substitutes to overcome the downfalls of the profit maximising model. These models argue that some companies depart from the profit maximising behaviour due to a lack or absence of competitive
policies. These models emphasise the fact managers have other goals apart from single period profits, such as sales maximising. Baumol 1959 argued that in oligopolistic industries mangers aim to maximise sales revenue. So in this model companies should produce where the Total revenue peaks which is different to the profit maximising model where companies should produce at MR=MC. Graph from page 80:
An extra dimension of this model is that Baumol argued there is a minimum level of profits which must be earned called a profit constraint. The position of this constraint depends on the firms desire to keep share prices and dividends sufficient to encourage future investment. After this profit constraint has been earned, profits become subordinate to sales in the firms hierarchy of goals. In the graph above, 0 is above the the level of profits where marginal revenue equals 0, so the revenue maximiser is constrained and will produce at Q3. If is less than this point then the revenue maximiser is unconstrained to produce at Q1.
According to Baumol, the sales maximiser will spend more on advertising than then the profit maximising firm. Here the business man increases advertising until prevented by the profits constraint. Another difference between the 2 models is explained in the graph below. Equilibrium for the constrained sales maximiser is Q1 and it is Q3 for the profit maximiser. If fixed costs rise the profits curve fall parallel, so the gradient of the curve at Q3 is still 0 but the profit constraint can only be met at a lower output. Since demand is unchanged, the constrained revenue maximiser would raise the price to sell the reduced output, the profit maximiser would not. If variable costs increased the output of both will fall.
Another hypothesis developed by Oliver Williamson argues that profit maximisation would not be the objective of mangers in a joint stock organisation. Like other managerial theories of the firm it assumes utility maximisation is the managers sole objective. A self interested manager can maximise his own utility as their exists a separation of ownership and control. Williamson argues that managers use their discretion to execute policies which maximise utilities rather than maximising shareholders
utilities. The principal- agent problem could threaten their jobs if a minimum level of profit is not attained. The model based on many assumptions similar to those in Baumols model, but it announces reported profits and not actual profits like the other theories. The model argues that the managers objective of utility is obtained through 3 dimensions. Firstly additional expenditure on staff (S) enables managers to be promoted and increases confidence in the department to deliver excellence and survive. Secondly, managerial emoluments (M) are those perks managers receive such as a personal secretary and a company car etc. Finally, discretionary investment (Id) is the extra investment which exceeds the level necessary to achieve minimum profits demanded by shareholders. This expenditure allows managers to pursue pet projects and reduces stress. These are the variables that appear in the managerial utility function: U= f(S,M,ID)
To develop Williamsons model we must understand the different profit terms. Discretionary profit is the amount of profit left after minimum profits and tax, which are used to increase the managers utility in ways such as managerial emoluments and to make discretionary investments. Discretionary Profit = Actual Profit-minimum profit-Tax
But what is used in the utility function is discretionary investment and not discretionary profit so we must distinguish between the 2. So from the equation below we can see the difference between discretionary profit and discretionary investment is the amount of managerial slack. Discretionary investment= reported profits-minimum profits- Tax. So Discretionary Profit= Discretionary Investment- Management Slack. But for simple representation of the model management slack is considered to be equal so discretionary investment and profit are equal. This means the utility function of the manager becomes U= f(S,Id) and there is a trade-off between these two variables. An increase in one would require a decrease in the other, so managers must choose the correct combination of these 2 variables to obtain the desired utility. The relationship between the two variables is determined by the profit function which isinturn dependant on staff expenditure. So in this model managers try to maximise their utility given
the profit constraint. Utility Indifference Curves: combinations of discretionary profits and staff expenditure
Discretionary Profit Curve: Assuming the firm is producing optimum level of output. This shows relationship between staff expenditure and discretionary profits. With the increase in profits, staff expenditure and discretionary profits also increase up until point B. Staff expenditure continues to increase as output increases but a fall in discretionary profits is noticed. Therefore a Williamson firm will choose a higher value of S than the profit maximising firm. Staff expenditure either side of A and C would not be feasible as it would not satisfy the minimum profit constraint and threaten job security of managers
Equilibrium of the firm: Williamson model
To find the equilibrium in the model we combine the 2 graphs above. The equilibrium point is the point where the discretionary profit curve is tangent to the highest indifference curve, which is point E. In this case the highest attainable level of utility is U3. The equilibrium point is always to the right of the maximum profit point. Thus the model shows the higher preference of managers for staff expenditure as compared to the discretionary investments.
In Oligopoly, collusion decreases uncertainty. Discuss the 2 main types of collusion and how the collusive price/ quantity is determined. An oligopoly occurs when just a few firms share a large proportion of the industry. In these industries organisations produce differentiated products such as in the car industry and most of the competition comes in the form of marketing the firms brands. There are relatively high barriers to entry which creates a mutually dependant relationship between firms. Organisations are interdependent and each firm will be effected by the actions of its rivals. These factors lead to an important management decision, do we collude and act as a monopoly in order to jointly maximise industry profits, or do we compete with rivals to gain a bigger share of industry profits. In the Study of Economics and Market Competition collusion is when rival companies cooperate for their mutual benefit. It is sometimes illegal and is when an
agreement is made between 2 or more parties to limit open competition by misleading others of their legal rights in order to gain an unfair advantage. Firms within a collusive oligopoly agree on output, prices, market share, advertising etc. This reduces a firms fear of engaging in competitive price cutting or retaliatory advertising. One way companies can reduce uncertainty is by signing a Cartel, such as OPEC the Oil price cartel. The cartel helps maximise profits as the firms come together to act like a single firm.
Profits are maximised where MC=MR, so members must restrict total output to Q1. The cartel must therefore set a price of P1. The members may then compete against each other using non price competition in order to gain a larger share of the resulting sales.
In most countries collusion is illegal. Companies get around this by tacitly colluding by watching each other’s prices and keeping theirs similar in order to avoid price wars. Dominant price leadership is where one firm, usually the largest takes a senior role in setting the price which the rest of the industry should follow. The dominant firm supplies the remainder of the market not satisfied by the fringe companies. The figure below shows total market demand and supply of all followers. The leaders demand curve can be seen as the portion of the market demand unfilled by other firms supply. At P1 the whole market demand is supplied by other firms but at point P2 the other firms supply 0 and the leader faces full market demand, meaning the leaders demand curve connects these 2 points. The leaders profit will be maximised where its MR=MC so we need to add the MR and MC curves of the leader to the graph. These 2 lines cross at QL so the leader sets a price of PL and other firms follow and then supply output QF.
If one of the smaller firms within the industry decides to take the initiative and set a price to be followed by others it is called barometric price leadership. This is a firm which is followed even if it does not have a substantial market share, this may be beneficial as the collusion may be more easily spotted by the Fair Trade Commission if set by the industry leader. The firm simply estimates its demand and marginal revenue curves and
produces where MR=MC and sets price accordingly. The firm must be acknowledged by the rest of the group as having expertise in detecting changes in demands and costs, on top of being trusted to work towards the common interests. Figure 7.5 page 193:
Overall collusion, whether it be formal or tacit, relies on trust agreements between organisations. In industries where there are significant barriers to entry and where companies have similar production methods, collusion a safer option. The oil cartel was so successful in driving up the price of oil because the market was stable and the products being produced are homogenous. There were no secretive actions and the collusion was only between a few very dominant firms which were not under strict government regulations. If collusion does not occur then firms have to participate in the long and expensive process of predicting its competitors moves, using Cournots duopoly model and game theory.
Cournots Duopoly Model:
Within an oligopolistic industry a company can choose not to collude and try to compete in order to gain increased market share over competitors. There may be few factors favouring collusion so price competition is greater. There is now emphasise on the prediction of rivals behaviour using past occurences, when deciding own strategy. The Cournot Model (1838) assumes rivals will produce at a particular quantity. The task for managers is therefore to decide the companies own price and quantity given the presumed output of its competitors. This model assumes the simplest case of just 2 firms, a duopoly, supplying the whole industry. The diagram below shows the profit maximising output for firm A and the market demand curve, D. Firm A believes that its rival, firm B, will produce Q units, so its is possible to derive its own demand curve, D1. From this demand curve it is possible to derive the marginal revenue curve and the point where this intersects the marginal cost curve is the profit maximising output level of Q1. If firm A believed firm B would produce more than Q1, the profit maximising quantity and price would be lower.
Reaction functions can be used to show the amount of output the respective
firm will produce in the light of how much it perceives the other firm will produce. For example of firm A assumes firm B will produce at point Qb, it will choose to produce at point Qa Eventually the firms will reach a point where neither organisation will choose to adjust output. Tis is known as the Cournot Equilibrium and is represented by point F.
Ronald Coase’s (1937), transaction cost theory of the firm was one of the first neo-classical attempts to define the firm theoretically in relation to the market. Coase argues that firms and hierarchies exist and replace market transactions when the cost of transacting exceeded the cost of internal organization. Coase begins from the standpoint that markets could, in theory, carry out all production and goes on to identify the main reason why firms arise as they provide a system of long-term contracts that emerge when short-term contracts are unsatisfactory. The unsuitability of short term contracts arise from the costs of collecting information and the costs of negotiating contracts. He assumed that all parties to a contract have value maximization as an objective and that if the parties bargain efficiently, a contract will be drawn up which maximizes the aggregate value achievable by all. Transaction costs themselves refer to the cost of providing some good or service through the market rather than having it provided from within the firm, they can include search and information costs, bargaining and decision costs and finally policing and enforcement costs. Coase argues that without taking into account transaction costs it is impossible to understand the working of the economic system and have a sound basis for establishing economic policy. The Coase Theorem split overall transaction costs into 2 main categories: co-ordination costs and motivation costs. Coordination costs outside the firm are the costs of using the price system, which includes the gathering of information about what markets best to supply. Within the firm, co-ordination costs include the transmission of info downwards to subordinates and the transmission of information upwards to enable central decision makers to carry out central plans. These costs include time delays, information distortion and bounded rationality.
Motivation costs arise from 2 main sources, information asymmetries and
imperfect commitments. When parties to a potential trade do not have access to the same information, value maximising contracts may not occur because one or the other party fears being adversely exploited. Imperfect commitments are when parties fear the agreement can breached and hence they shy away from value maximizing behavior and decision-making. In this situation the fear of opportunistic behavior is in the future.
Transaction cost analysis: 5 Dimensions-
Specific assets- that require high invesments would lose most of their value outside the specific transaction require that the cost be incurred contractually to protect the investor against opportunistic future behaviour. Frequency and Duration- When the trade is a one off the least cost method will be to use existing frameworks. But when the trade is carried out frequently over a long period of time the traders are more likely to develop specific routines. Standardised and uncomplex- products such as gold contracts only specify the date of delivery and the price, very little else. When Performance measurement is difficult contracts are written differently because of incentives and principal agent problems. When performance can be readily gauged, rewards will often be linked to results, to provide incentive for contract fulfillment. Transaction costs may be Design Connected e.g motor vehicle assembly. Firm should be fully integrated and centralised so that all components are designed to be assembled into the given model. We can see from Coase Theorem that the main reason to establish a firm is to avoid some of the transaction costs of using the price mechanism. It shows that we can therefore think of a firm as getting larger or smaller based on whether the entrepreneur organizes more or fewer transactions. Transactions costs are seen as clogging the wheels of wealth and to counter the theory there have been many criticisms or alternative dimensions. Klein (1983) argues that transactions occurring within the firm are representing market relationships, the costs involved in such relationships are the transaction costs.
Discuss the theory of price discrimination and how the organisation determines the optimum levels of output and price? Stigler(1966) defined price discrimination as the sale of technically similar products which are
not proportional to their marginal costs. In most economic theories we have assumed companies sell output at a single price. However, one characteristic of a monopoly is that it allows firms to use their monopoly power to price discriminate. The National Bureau of Economic Research defines this ability as the practice of a firm selling a homogeneous commodity at the same time to different purchasers, at different prices. So price discrimination is where alternative prices are charged either to all customers or to different groups of customers in order to further increase profits. Firms do this even though the production costs of all output remains the same and an example is where a can of coke is $0.20 in the Caribbean, but around $1.20 in New York. It may be hard for governments o regulate price discrimination across national borders, but they can create policies to inhibit the 3 necessary conditions that must be met for a firm to be able to price discriminate. Firstly, the firm must be able to set its own price, this is one characteristic of a monopoly and so is not possible under perfect competition where firms are price takers. The second condition is that the markets must be separable, meaning that the consumers in one market must not be able to resell the product in another market. For example a child should not be able to resell a “half price” children’s cinema ticket to an adult. Finally, the demand elasticity for the product must differ in each market. Within a market where demand is elastic, a higher price can be charged. Third degree price discrimination is where consumers are grouped into independent markets and a separate price is charged in each. Firms can discriminate in terms of age, occupation, location but a good example is bus fares for adults and children. This type of discrimination is much more common as it includes price differentiation between countries.
First degree price discrimination is where the firm charges each consumer the maximum price he or she is prepared to pay for each unit. An example of this is a market street stall where parties partake in bartering. In this case we assume we know the demand curve so the organisation can determine the highest price customers are willing to pay. Here consumers are willing to pay more for the first unit than for the second and so one so arbitrage must be prevented. This means that consumers each have a different reservation price for each unit otherwise they would not be willing to pay a different
price for each unit.
Second Degree price discrimination as where afirm charges different prices according to how much cusdtomers purchase. A higher price is charged for the first so many units and cheaper prices for volumes above this level. Example is electricity companies charging £2 for the first 100 units and £0.2 for every unit after this. This is known as a block tariff and brings a discusson of equity as poorer people who use less pay a higher rate than a single rich pensioner who uses more. This example shows that there is no price discrimination between consumers but there is between blocks of output. Price discrimination can be practised more affectively by actually incurring costs to seal off market segments. 6 occasions where different prices can be charged for same product, is when there are differences in Quantity- bulk buying
Product type- varying the basic product slightly i.e. models of cars. Location- charging each customer differently for delivery
Time-must be non-storable such as holidays
Products use- demand elasticities of 2 consumers differ i.e. seat on train.
A common example of price discrimination is peak-load pricing where a higher price is charged during peak periods such as train tickets.
Multi period model- managers aim to maximize utility which is determined by firms growth, subject to a security constraint. Assumes firms growth rate remains constant and indefinite in all areas.
Supply growth relationship- greater profitability allows faster growth as more is retained and reinvested. Graph page 95:
-Demand growth relationship- Main growth is through diversification. -If firm adopts maximum diversification strategy consistent with profitability, at low rates of growth the relationship between P and G is direct. Slow diversification rate allows new products to earn monopoly power and at
higher growth rate managerial inefficiencies occur.
-Management wish to maximise growth rate subject to minimum valuation ratio constraint. The supply growth line is that which is pivoted as far clockwise as manager believe leaves them safe from takeover. -Supply gwoth curves anywhere within the shaded areas are safe.