Chapter Review&Answers - Brickeley et al V5
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Chapter Review&Answers - Brickeley et al V5

Course Number: ECO 271, Spring 2012

College/University: CUNY Hunter

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Chapter 01 - Introduction CHAPTER 1 INTRODUCTION CHAPTER SUMMARY This chapter introduces the book. It begins with the collapse of Enron Corporation in 2001. This example illustrates how a companys organizational design can affect its profit and likelihood of survival. It points to three critical elements of organizational design, which we refer to as organizational architecture. These elements include the...

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01 Chapter - Introduction CHAPTER 1 INTRODUCTION CHAPTER SUMMARY This chapter introduces the book. It begins with the collapse of Enron Corporation in 2001. This example illustrates how a companys organizational design can affect its profit and likelihood of survival. It points to three critical elements of organizational design, which we refer to as organizational architecture. These elements include the assignment of decision rights, the reward system, and performance evaluation system. The chapter discusses the basics ideas behind economic analysis and how this framework can be used by managers to make better organizational, production, and pricing decisions. The chapter introduces the important concept of economic Darwinism and provides an overview of the book. CHAPTER OUTLINES MANAGERIAL ECONOMICS AND ORGANIZATIONAL ARCHITECTURE Organizational Architecture Economic Analysis Academic Application: R&D and Executive Turnover Managerial Application: Economic Incentives and the Subprime Mortgage Crisis Managerial Application: Creative Responses to a Poorly Designed Incentive System ECONOMIC DARWINISM Managerial Application: Economic DarwinismGeneral Motors and Chrysler Survival of the Fittest Economic Darwinism and Benchmarking PURPOSE OF THE BOOK Managerial Application: Transfers of Organizational Architecture across the Global Economy Our Approach to Organizations Overview of the Book TEACHING THE CHAPTER Chapter 1 is an important chapter since it introduces the perspective that is used throughout the rest of the text. There are several Managerial Applications that can be used to generate class discussion. The examples from this chapter can also be referred to as these concepts are reintroduced later in the text. 1-1 Chapter 01 - Introduction There are two Self-Evaluation Problems and three Review Questions at the end of the chapter that can be used for class discussion to determine whether students understand the fundamental concepts of the chapter before discussing the Analyzing Managerial Decisions scenario presented at the end of the chapter. There are two Analyzing Managerial Decisions scenarios presented in the chapter. The first, Organizing Xerox Service Center, asks students to evaluate the incentives that result from the current compensation structure of the call center. The second scenario, Societe Generale, is a more comprehensive scenario that asks students to evaluate the organizational architecture of the firm and the role its architecture played in allowing the events to transpire. (See the Solutions Manual for the answers to these problems). REVIEW QUESTIONS 11: What are the three aspects of organizational architecture? The assignment of decision rights, the reward system, and the performanceevaluation system. 12: In the process of benchmarking, a colleague of yours notes that Lincoln Electric, a producer of electric arc welders, has much higher productivity than does your company. Unlike your firm, Lincoln has an extensive piece-rate compensation system; much of its employees total compensation is simply the number of units produced times the piece rate for that type unit. Your colleague recommends that your company adopt a piece-rate compensation system to boost productivity. What do you advise? Piece rates are one part of Lincoln Electrics organizational architecture. Piece rates work well for them because they fit well with Lincolns particular economic environment, business strategy, and other elements of the organizational architecture. It might be inappropriate to use Lincoln Electric as a benchmark if the firm is in a different environment or has a different business strategy. (Lincoln Electric will be discussed in more detail in Chapter 16.) 13: In the life insurance industry, we see two major ownership structurescommon stock insurers and mutual insurers. In the common stock companies, the owners its stockholdersare a separate group from its customersthe policyholders. In a mutual, the policyholders are also the owners of the company. It has been argued that mutual insurance companies are dinosaursthey are large, slow, bureaucratic, and inefficient. How would you respond to such an argument? 1-2 Chapter 01 - Introduction The initial reaction to this argument should be skepticism. Mutual insurance companies have existed for a long time in a competitive environment and thus are likely to have been an efficient form of organization in the past (economic Darwinism). It is possible that the environment has changed in a manner to make this form of organization undesirable. However, before this argument is accepted, it is important to identify these changes and to analyze carefully why mutual insurance companies are unlikely to survive in the changed environment. 1-3 Chapter 02 - Economists View Of Behavior CHAPTER 2 ECONOMISTS VIEW OF BEHAVIOR CHAPTER SUMMARY This chapter uses the cheating scandal at Merrill Lynch to illustrate how a managers view of behavior can affect decision making. It summarizes the economic view of behavior and contrasts it with other views. The chapter presents a graphical analysis of utility maximization and decision making under uncertainty. The concepts in this chapter are an important foundation for subsequent material in the book. CHAPTER OUTLINE ECONOMIC BEHAVIOR: AN OVERVIEW Economic Choice Marginal Analysis Managerial Application: Marginal Analysis of Customer Profitability Opportunity Costs Managerial Application: Opportunity Costs and V-8 Creativity of Individuals Managerial Application: Creative Gaming of the System GRAPHIC TOOLS Individual Objectives Indifference Curves Constraints Individual Choice Changes in Choice MOTIVATING HONESTY AT MERRILL LYNCH MANAGERIAL IMPLICATIONS Managerial Application: Medicare Creates Perverse Incentives for Doctors ALTERNATIVE MODELS OF BEHAVIOR Only-Money-Matters Model Happy-Is-Productive Model Managerial Application: Happy-Is-Productive versus Economic Explanations of the Hawthorne Experiments Good-Citizen Model Managerial Application: Culture and Behavior Product-of-the-Environment Model WHICH MODEL SHOULD MANAGERS USE? Academic Application: The Economic Framework and Criminal Behavior Academic Application: Criticisms of the Happy-Is-Productive Model 2-1 Chapter 02 - Economists View Of Behavior DECISION MAKING UNDER UNCERTAINTY Expected Value Variability Risk Aversion Certainty Equivalent and Risk Premium Risk Aversion and Compensation SUMMARY APPENDIX: CONSUMER CHOICE Marginal Utility Slope of an Indifference Curve Individual Choice Solving for the Optimal Consumption Bundle Demand Functions Income and Substitution Effects Magnitude of the Substitution Effect Additional Considerations Calculus Derivation of the Equal Marginal Principle TEACHING THE CHAPTER This chapter begins to focus on the economic tools that are used throughout the rest of the text. Depending upon the background of the students who are in the class and the importance of the topic to the overalls goals of the course, instructors will need to spend varying amounts of time on this chapter and will opt to cover the appendix in varying levels of detail. The utility-maximization framework is presented graphically and numerically, with a detailed presentation included in the appendix. Undoubtedly, this concept is the most difficult part of the chapter but this economic model is vital to understand. It is imperative that students not only understand how the tools are used for quantitative and graphical analysis, but also why these tools represent the concepts they are used to portray (such as opportunity cost). The remaining concepts of the chapter are not technical in nature so instructors can make use of the Managerial Applications to generate class discussion of these topics rather than lecturing on them. Alternative views of behavior are presented and their resulting managerial implications can be used for class discussion. The last section of the chapter focuses on how decisions are made when individuals face uncertainty. The Self-Evaluation Problems cover some of the quantitative tools introduced in the chapter, including consumer choice analysis, but there are numerous Review Questions that also cover the quantitative analysis and key concepts. It would be worthwhile to devote time in class to these questions since this chapter is the foundation for many of the chapters that follow. 2-2 Chapter 02 - Economists View Of Behavior There are five Analyzing Managerial Decisions Scenarios presented in the chapter. The first scenario, Marginal Analysis, is based on determining the relevant costs that should be considered when making decisions. The second scenario, Consumer Choice and Graphical Tools, asks students to graph indifference curves and budget constraints to explain the scenario. This scenario relies on graphical analysis of the problem, not a quantitative analysis. It also highlights the relationship between the economic model and what it represents. The third scenario, Interwest Healthcare Corp. asks students to consider the motivations for the workers who are not properly completing their tasks and how this behavior might be changed. The fourth scenario, Risk Aversion versus Risk Tasking, focuses on differences in behavior due to individuals varying levels of risk tolerance. This concept is important since it resurfaces in several chapters throughout the text. The final scenario, Consumer Choice, is located at the end of the chapter after the appendix. This scenario focuses on the quantitative analysis of consumer choice. Instructors should review this scenario and determine its relevancy to the course since it involves more complicated mathematical analysis than will be used in the rest of the text. However, instructors whose students have the appropriate mathematical background will likely want to review this scenario. (See the Solutions Manual for the answers to these problems). APPENDIX PROBLEMS 1. Define the following terms: marginal utility, ordinal utility, marginal rate of substitution, equal marginal principle, demand function, substitution effect, income effect, normal good, inferior good, perfect complement, and perfect substitute. Marginal utility measures the additional utility that is obtained by consuming one additional unit of a good, while holding all other goods constant. Ordinal utility yields the ranking of consumption bundles. Absolute comparisons based on the levels of utility cant be made. Marginal Rate of Substitution (MRS) is the absolute value of the slope of an indifference curve. Equal marginal principle (as used in this appendix) is the condition that the marginal utility per dollar is the same for all goods at the optimum. Demand function expresses the mathematical relation between the quantity demanded for a product (how many units consumers will purchase) and the factors that determine consumer choice (such as prices and income). Substitution effect is the change in the quantity demanded of a good when its price changes, holding the prices of other goods and utility constant. 2-3 Chapter 02 - Economists View Of Behavior Income effect is the change in the quantity demanded of a good because of a change in income, holding prices constant. Normal good is a good whose demand increases (decreases) with increases (decreases) in income. Inferior good is a good whose demand decreases (increases) with increases (decreases) in income. Perfect complements have indifference curves shaped as right angles. In this case, the two goods are used in fixed proportions. Perfect substitutes have indifference curve that are shaped as straight lines. In this case the consumer purchases only one of the two goods (unless the slopes of the budget line and indifference curve are the same). 2. Susan Pettits preferences for coffee (by the pound) and doughnuts (by the dozen), can be characterized as follows: MUcoffee = MUx = y2 MUdoughnuts = MUy = 2xy a. If the ratio of relative prices is (Px/Py) = 6/3 = 2, and Susans income is $90 per period, what combination of pounds of coffee and dozens of doughnuts will she choose? At Susans optimum: y2/2xy = 2 y = 4x (1) Given Susans income: 6x + 3 (4x) = 90 Coffee: X = 5 Doughnuts: Y = 20 (from equation 1) b. Now let the ratio of coffee to doughnut prices decline to unity (=1), holding the price of doughnuts constant. How does Susan respond to the reduction in the relative price of coffee? y2/2xy = 1 y = 2x 2-4 Chapter 02 - Economists View Of Behavior 3x + 3 (2x) = 90 Coffee: X = 10 Doughnuts: Y = 20 Thus, the decline in the price of coffee motivates Susan to increase her consumption of coffee to 10 units (she continues to consume 20 doughnuts) c. Redo parts (a) and (b) for the case of income of $60 per period Redoing part a: 6x + 3 (4x) = 60 Coffee: X = 3.33 Doughnuts: 13.32 units Redoing part b: 3x + 3 (2x) = 60 Coffee: X = 6.66 Doughnuts: Y = 13.32 units d. Derive Susans demand function for coffee. y/2x = px/py y = (2x)px (1) From the budget line: x = (I-pyy)/px (2) Substituting equation (2) into equation (1)and solving for y: Y = 2/3 (I/py) e. Is coffee a normal or inferior good for this consumer? Coffee is a normal good for Susan since its consumption increases with income. f. Does Susan consider coffee and doughnuts to be either perfect complements or perfect substitutes? Explain. No they are neither perfect substitutes are complements. Susan does not consume the two goods in fixed proportions (so they are not complements). She also does consume only one good as relative prices change (so they are not perfect substitutes). The marginal rate of substitution (y/2x) continuously declines as Susan consumes more x and less y along an indifference curve. 3. Susans demand function for coffee in the previous problem includes only the price of coffee and income. Thus changes in the price of doughnuts do not affect the demand for coffee. Does this imply that there is no substitution effect between the two goods? Explain. 2-5 Chapter 02 - Economists View Of Behavior No. The fact that the price of coffee is not in Susans demand curve for doughnuts does not imply that there is no substitution effect between the two products. With convex indifference curves there is always a positive substitution effect. The demand curve reflects both the income and substitution effects. Increasing (decreasing) the price of coffee motivates Susan to substitute toward (away from) doughnuts. However, this change in her demand for doughnuts is exactly offset by the income effect from the change in her effective income as the price of coffee changes. 4. Mario Casali is a TV newscaster who gets an annual clothing allowance to buy suits that he must wear during his televised forecasts. He allocates the allowance each year between expensive Italian suits and cheap American suits. Marios utility function for suits is IA.5 where I is the number of Italian suits bought and A is the number of American suits bought. Last year, Mario bought two Italian suits and four American suits. [Note: MUI = A.5 and MUA = .5IA(-.5)] a. If Mario was maximizing his utility last year, what was the ratio of the price of an Italian suit to the price of an American suit (PI/PA)? At Marios optimal choice: MUI/MUA = PI/PA A.5/.5A(-.5)I = PI/PA A/.5I = PI/PA 4/.5(2) = 4 = PI/PA b. What was Marios clothing allowance last year if the price of an Italian suit was $1,000? PI = $1000 implies that PA = $250 (from part a) Clothing allowance = $1000 2 + $250 4 = $3000 2-6 Chapter 02 - Economists View Of Behavior c. If Mario has the same allowance this year as last year, and American suit prices have not changed, how high would the price of Italian suits have to rise in order for Mario to want to buy exactly one Italian suit this year? As given in the problem, let I = 1 From the budget line: $250 A + PI 1 = $3,000 A = 12 (PI/250) From the optimal condition stated in part a: (12 (PI/250)/.5 = PI/250 PI = $2000 (Alternatively, the optimal condition in part a implies that PAA = .5IPI; this implies that Mario will always spend 1/3rd of his budget on A and 2/3rd if budget on I; thus P = $2000 when the I = 1 and the clothing allowance is $3,000) REVIEW QUESTIONS 21. Which costs are pertinent to economic decision making? Which costs are not relevant? The marginal (incremental) costs and benefits are pertinent to economic decision making. Sunk costs and benefits are not relevant. In economics, bygones are forever bygones. 2-7 Chapter 02 - Economists View Of Behavior 2-2. A noted economist was asked what he did with his free time. He responded by saying that time is not free. Explain this response. Time is finite. If it is used for one activity it cannot be used for another activity. Thus using time for one activity involves an opportunity cost (the value of using the time for the best alternative use). For example, if you spend an hour of time managing your own business when you could have used the hour to earn $20 working for someone else, the opportunity cost of working in your own business is $20/hour. 2-3. The Solace Company has an inventory of steel that it originally purchased for $20,000. It currently has an offer to sell the steel for $30,000. Should Solaces management agree to sell? Explain. You cannot answer this question without additional information. The historic cost of the steel is irrelevant. What is important is the current opportunity cost of the steel. For example, if the current market price of steel is $40,000 you should not sell the steel for $30,000. 2-4. Suppose that you have $900 and what to invest the money for one year. There are three existing options. (a) The city of Rochester is selling bonds at $90 per unit. The bonds pay $100 at the end of one year when they mature (no other cash flows). (b) Put the money under your mattress. (c) The one-year interest rate of saving in the Chase Bank is 7 percent. Which one will you choose? What is the opportunity cost of your choice? Explain. Choose option (a). By definition, opportunity cost is the value of the best foregone option. So the opportunity cost of (a) is the value of (c) in this case, $63 = $900 7%. 2-5. Suppose Juans utility function is given by U = FC, where F and C are the two goods available for purchase: food and clothing. a. Graph Juans indifference curves for the following levels of utility: 100, 200, and 300. 2-8 Chapter 02 - Economists View Of Behavior Juans indifference curves for U = 100, 200 and 300 are pictured as follows. The general formula for the graph of an indifference curve for a given level of utility, U*, is F=U*/C (since U* = F x C). For example, the indifference curve for U* = 100 is given by the formula: F = 100/C. b. Are these curves convex or concave to the origin? What does this shape imply about Juans willingness to trade food for clothing? The curves are convex to the origin. This implies that Juans willingness to trade food for clothing falls when the amount of food that he has declines relative to the amount of clothing. He is willing to give up a relatively large amount of food for a unit of clothing when he has lots of food and little clothing. This is not true when he has little food and numerous clothing. c. Suppose Juans budget is $100 and the prices of F and C are both $5. the budget constraint. 2-9 Graph Chapter 02 - Economists View Of Behavior Juans budget constraint (I = $100 and PC = PF = $5) is pictured as follows: d. How many units of food and clothing will Juan purchase at these prices and income? Show graphically. What is his corresponding level of utility? Juan will purchase 10 units of food and 10 units of clothing. This provides Juan with 100 units of utility. Note that at current prices he can buy a total of 20 units of the two goods (in any combination). Any other combination produces lower utility. For example, 9 units of one good and 11 units of the other produces 99 units of utility. Graphically: 2-10 Chapter 02 - Economists View Of Behavior e. The Johnson Company is the sole producer of clothing. What can the company do to induce Juan to purchase more clothing? Show graphically. (The graph does not have to be exact.) It can lower the price of clothing. Graphically (does not have to be exact) 2-6. Suppose that Bobs indifference curves are straight lines (as opposed to being convex to the origin). What does this imply about Bobs willingness to trade one good for the other? Give examples of goods where this type of behavior might be expected? Straight line indifference curves indicate that Bobs willingness to trade one good for the other does not depend on the amount of each good he currently owns. This is the case of perfect substitutes. Consider the example of $5 bills and $10 bills. Your willingness to trade $5 bills for $10 bills is likely to remain at two for one, independent of how many bills of each kind you have. For example, if you have no $10 bills and a bunch of $5 bills you are still unlikely to trade more than two $5 bills to obtain a $10 bill. Another example is two brands of orange juice that you like equally as well. 2-7. Suppose that Bobs indifference curves are perfectly L-shaped with the right angle occurring when Bob has equal amounts of both goods. What does this imply about Bobs willingness to trade one good for the other? Give examples of goods where this type of behavior might be expected? 2-11 Chapter 02 - Economists View Of Behavior Perfectly L-shaped indifference curves imply that the Bob considers the two goods to be perfect complements. His utility does not increase if receives more of one of the goods without receiving more of the other good. One potential example is left and right shoes. Obtaining additional left shoes without obtaining matching right shoes is unlikely to increase a persons utility very much (assuming the person has two feet). 28. a. Briefly describe the five models of behavior presented in this chapter. Economic Model: People are creative maximizers of their own personal happiness (utility). Happiness can depend on many factors, including wealth, integrity, community respect, and so on. Only-Money-Matters Model: All people care about is money. People act to maximize their monetary income. Same as economic model except that people care only about money. Happy-is-Productive Model: Happy employees are more productive than unhappy employees. Good-Citizen Model: Employees want to do a good job. Managers simply need to communicate the goals and objectives of the organization to the employees. Product-of-the-Environment Model: The behaviors of individuals are largely determined by their upbringings. b. What are the implications of these models for managers attempting to influence their employees' behavior? The economic model suggests that managers should focus on incentives (monetary or otherwise) in trying to motivate behavior. The only-moneymatters model suggests that managers should use only monetary incentives in trying to motivate behavior. The happy-is productive model suggests that productivity can be increased by enriching jobs and engaging in other activities to increase employee happiness. The good-citizen model suggests that managers should focus on communicating firm goals to employees. The product-of-the environment model suggests that managers should focus on hiring employees with a strong work ethic. 2-12 Chapter 02 - Economists View Of Behavior 29. Employees in a plant in Minnesota are observed to be industrious and very productive. Employees in a similar plant in Southern California are observed to be lazy and unproductive. Discuss how alternative views of human behavior and motivation might suggest different explanations for this observed behavior. The economic model suggests the employees in the two locations have different compensation or incentive schemes. Incentives to be productive appear to be higher at the Minnesota plant. Or, if the compensation plans are the same, the alternative employment opportunities differ so that individuals with different talents are attracted to the two plants. The only money-matters model is similar to the economic model in its explanation. However, the focus is exclusively on monetary incentives. The happy-is productive model suggests that employees are happier at the Minnesota plant. The good-citizen model suggests that employees at the Southern California plant do not realize that it is important to the firm for them to work hard. The product-of-theenvironment model suggests that the employees at the two plants are from different backgrounds. The employees at the Minnesota plant have a stronger work ethic. 210. Employees at a department store are observed engaging in the following behavior: (a) they hide items that are on sale from the customers, and (b) they exert little effort in designing merchandise displays. They are also uncooperative with one another. What do you think might be causing this behavior, and what might you do to improve the situation? The employees apparently are paid in a way that motivates this behavior. For instance, they might be paid a large sales commission on their personal sales. This commission plan might motivate employees to hide items on sale so that they can convince customers to buy higher-priced items. The commission scheme also might provide limited incentives to engage in nonselling activities, such as designing merchandise displays or helping coworkers. It is also likely that employees do not expect to work for the store for a long time period (turnover is high). Otherwise, they would have an incentive to build longer-term relationships with customers (to increase future sales commissions) and co-workers. The situation might be improved by changing the compensation scheme to increase the incentives to engage in nonselling activities and to consider the long-term implications of an action (such as creating customer expectations that the store will be out of items that are on sale). 2-13 Chapter 02 - Economists View Of Behavior 211. One of the main tenets of economic analysis is that people act in their own self interest. Why then do people leave tips in restaurants? If a study were to compare the size of tips earned by servers in restaurants on interstate highways with those in restaurants near residential neighborhoods, what would you expect to find? Why? When a customer comes into a restaurant in the U.S. they have an implicit contract with the waiter to tip for good service. A customer might honor this contract for two reasons. First, the person might value being fair and not want to shirk on the implicit agreement (economics allows for people to care about fairness). Second, the customer will realize that if he shirks on the tip the next time he comes back to the restaurant the waiter will shirk on service. Tips are likely to be higher at restaurants in residential neighborhoods because the second effect (the repeat-customer effect) is likely to be large. Restaurants on interstate highways will be frequented by many customers who will not return. These customers have large incentives to shirk on the tip unless they care significantly about fairness to the waiter. 212. Several school districts have attempted to increase teacher productivity by paying teachers based on the scores their students achieve on standardized tests (administered by outside testing agencies). The goal is to produce higher quality classroom instruction. Do you think that this type of compensation scheme will produce the desired outcome? Explain. Compensation plans of this type provide incentives for teachers to emphasize the material covered in the texts. Yet such plans sometimes produce bad side effects. Teachers will have strong incentives to focus on test scores. This focus does not necessarily produce better teaching. In part, it depends on how well the tests measure learning. Moreover, some teachers are likely to discover ways to game the compensation scheme. For instance, in some school districts, this type of compensation scheme has motivated teachers to teach the material to be tested rather than provide a more general education. In extreme cases, teachers get advanced copies of the exam and give the answers to students before the test. 213. A company recently raised the pay of employees by 20 percent. Employee productivity remained the same. The CEO of the company was quoted as saying, "it just goes to show that money does not motivate people." Provide a critical evaluation of this statement. 2-14 Chapter 02 - Economists View Of Behavior According to the economic model simply raising pay by 20 percent is unlikely to increase productivity. The employees may be happier but not more productive. What is important is tying the pay raise to productivity. In this case, employees would be expected to exert more effort to increase the likelihood of the pay raise. 214. One physician who worked for a large health maintenance organization was quoted as saying: One day I was listening to a patient's heart and realized there was an abnormal rhythm. My first thought was that I hoped that I did not have to refer the patient to a specialist. Indeed, HMO physicians have been criticized for not making referrals when they are warranted. How do you think the physician was compensated by the HMO? Explain. The physician was obviously concerned about treatment expenses. Presumably, the HMO was paying the physician based on the total treatment costs for the patient. For example, the HMO might be paying the physician a fixed fee for treating each patient minus some function of any treatment costs (for example, payments to other specialists, and so on). 215. Insurance companies have to generate enough revenue to cover their costs and make a normal profit otherwise, they will go out of business. This implies that the premiums charged for insurance policies must be greater than the expected payouts to the policyholders. Why would a person ever buy insurance, knowing that the price is greater than the expected payout? Risk-averse people are willing to pay a premium for insurance. They prefer a certain outcome to a less certain outcome and are willing to give up some expected value in order to reduce risk. 216. Critically evaluate the following statement: Risk-averse people never take gambles. 2-15 Chapter 02 - Economists View Of Behavior Risk-averse people do take gambles. The expected return, however, has to be sufficiently high to offset the increased risk the person accepts. Note: There is frequently a difference between attitudes toward risk with respect to an individuals investment portfolio as opposed to placing a bet on a sports contest. We believe that this distinction can be used to motivate a discussion of the multifaceted nature of consumption. If placing a bet on the Super Bowl or world cup makes watching the game more interesting, then only part of the benefit of the bet comes from the expected cash payoff the other part is the enhanced enjoyment of the game. 217. Suppose that an investment can yield three possible cash flows: $5,000; $1,000; or $0. The probability of each outcome is 1/3. a. What is the expected value and standard deviation of the investment? expected value = $2,000; standard deviation = $1,825 b. How much would a risk-neutral person be willing to pay for the investment? $2,000 (ignoring the time-value of money) c. How much would a risk-averse person be willing to pay for the investment? Something less than $2,000 (the exact amount depends on the level of risk aversion). 218. In order to spur consumer spending in 1998, the Japanese government considered an $85 billion voucher system whereby every Japanese consumer would receive a shopping voucher that could be used to purchase Japanese products. For simplicity, assume the following: each consumer has wealth of 1 million yen, consumers must allocate this wealth between consumption now (c1), and consumption later (c2), the interest rate is zero, the voucher is worth 100,000 yen, and it can be spent only in the current period. If it is not spent, it is lost. a. Plot a budget line for a representative consumer both before and after the voucher program (c1 and c2 are on the axes). 2-16 Chapter 02 - Economists View Of Behavior b. Do you expect that current consumption of a typical consumer will increase by the full 100,000 yen of the voucher? Explain. While in principle it could it depends on the tangency points between the indifference curves and the budget lines most likely consumption in the current period will not increase by the full 100,000. Rather, some will be saved for the future. c. How does the impact of this 100,000-yen voucher differ from simply giving the individual 100,000 yen? It will have the same effect unless the average consumer wants to save more than 1,000,000 for the future (out of a 1,100,000 budget). The budget line with a pure cash supplement would be the same as pictured above except that it would fully extend to the y-axis. As long as the tangency point between the indifference curve and budget line occurs at a point where future consumption is below 1,000,000, there will be no difference. If the tangency occurs in the extended region, the consumer will save the maximum possible (1,000,000 and spend 100,000 in the current period a corner solution). 219. People give to charity. a. Is this action consistent with the economic view of behavior? Explain. There is nothing in the Economic View that says that people cant gain utility from contributing to good causes. Also they may be doing this to create good will in the community. This might result in more business opportunities, less government red tape in completing transactions, etc. 2-17 Chapter 02 - Economists View Of Behavior b. Suppose that there is a big drop in charitable giving. At the same time there has been no decline in per capita income or total employment. Using the economic model, what potential factors might have led to this decline in giving? Economic analysis focuses on how changes in constraints (rather than preferences) effect behavior. One potential variable that might have changed is the tax code. For instance, deductions may have been eliminated making it more expensive to give to charity. The economic view would not typically make arguments like peoples preferences changed and thus they no longer felt like giving to charity. c. How might the decline in giving be explained by the product-of-the environment model? The product-of-the-environment model argues that peoples behavior is explained by their upbringing and social background. Under this view, some people who were brought up to care about others give to charity, while others do not. Perhaps while per capita income has not changed, there has been a shift in income away from the giving group to the nongiving group, making giving less likely. Also, there may have been demographic changes due to relocations, deaths, etc. 2-20. The Japanese are very good at returning lost property to local police stations. If you lose a wallet filled with cash in Japan it is likely to be turned into the police. This is true even though the person finding it could keep it without anyone else knowing. This behavior is not what you would find in New York City. a. Does this observation about Japan imply that the economic model does not explain behavior in Japan? Explain. The economic model of behavior asserts that individuals are interested in maximizing their own utility. In making decisions, individuals consider the incremental costs and benefits and make decisions only when the incremental benefits are larger than the costs. Decisions can change with changes in the incremental costs or benefits. Turning in wallets full of cash is not inconsistent with the economic model. The marginal disutility from being dishonest might be larger than the benefits of the extra money given the typical Japanese utility function (given the typical amount of money found in the wallets). There is nothing in the economic model to say that people only care about money. 2-18 Chapter 02 - Economists View Of Behavior b. Police stations in Japan are filled with lost umbrellas. It used to be that the typical Japanese would make a trip to the local police station to search for a lost umbrella. Now they dont. Explain this behavior using the Economic Model. The economic model predicts that peoples behavior can change with changes in incremental costs or benefits. In the case of going to search for an umbrella there are a number of possibilities. First with increases in income of the typical Japanese worker, the opportunity cost of taking time to search for an umbrella has increased. This increase in marginal costs makes the choice less likely. Another possibility is that the price of replacing an umbrella has decreased so that the marginal benefit of finding an umbrella is smaller. c. Do you think that the typical Japanese is more likely to come to a police station to find a lost cell phone or a lost umbrella? Explain using the Economic Model. The marginal costs of going to the police station are likely to be the same in either case. However, the price and nonpecuniary costs of replacing a lost cell phone are likely to be higher than for an umbrella. Since the marginal benefits are more likely to exceed the marginal costs for retrieving cell phones, the economic model predicts that people are more likely to search for cell phones. 221. Some states in the U.S. allow citizens to carry handguns. Citizens can protect themselves in the case of robberies by using these guns. Other states do not allow citizens to carry handguns. Criminals, however, tend to have handguns in all states. Use economic analysis to predict the effects of handgun laws on the behavior of the typical criminal. In particular: (1) Do you think criminals will commit more or fewer robberies in the states with the laws? (2) How do you think the laws will affect the types of robberies criminals commit? Be sure to explain your economic reasoning. Based on the economic model, criminals are expected to consider the marginal costs and benefits of their actions in choosing the level and type of crime. Allowing citizens to carry handguns increases the marginal costs of robberies, since the criminals are more likely to get hurt or killed. Thus the economic model predicts that there will be fewer robberies in the states where handguns are allowed. The laws affect the marginal costs of some types of crimes more than others. Crimes involving personal contact are the ones most likely to be affected by the laws. Therefore, the economic model suggests that criminals will substitute away from crimes involving personal contact to crimes of stealth in states where handguns are allowed. 2-19 Chapter 02 - Economists View Of Behavior Note: a study was conducted on this topic and both predictions were supported by the data. 222. Discuss the following statement: Sunk costs matter. People who pay $20,000 to join a golf club play golf more frequently than people who play on public golf courses. People who pay $20,000 to join a golf club are likely to have a greater than average interest in playing golf. They may still consider only the marginal costs (e.g., time) and benefits in choosing how much to play. However, given their interest in golf (marginal benefits are high) they will tend to play frequently. Thus, the observation is more likely to reflect self selection than sunk costs. 2-23. Jenny is an investor in the stock market. She cares about both the expected value and standard deviation of her investment. Currently she is invested in a security that has an expected value of $15,000 and a standard deviation of $5,000. This places her on an indifference curve with the following formula: Expected Value = $10,000 + Standard Deviation. a. Is Jenny risk averse? Explain. Yes, Jenny is risk averse. She is willing to take on more risk only if it is associated with a sufficiently higher expected return. b. What is Jennys certainty equivalent for her current investment? What does this mean? The certainty equivalent is $10,000. She would be willing to accept a certain return of $10,000 (the vertical intercept of her indifference curve) in lieu of her current risky investment which has an expected return of $15,000 and a standard deviation of $5,000. c. What is the risk premium on her current investment? The risk premium on her current investment is $5,000. This is the difference in the expected return of her risky investment and the riskfree investment. The $5,000 risk premium is what it takes in expected return to make her indifferent between the risk and risk free investments. 2-20 Chapter 02 - Economists View Of Behavior 2-24. Accounting problems at Enron ultimately led to the collapse of the large accounting firm Arthur Andersen. When the Enron scandal first became public, Andersens top management blamed one rouge partner in the Houston office who they claimed was less honest than other partners at the firm. They fired the partner and asked that people not hold the remaining partners accountable for one bad apple. What model of behavior was Andersens management using when it analyzed the source of the problem? According to the economic view of behavior, what was the more likely cause of the problem? Andersens statement is most consistent with the product-of-the environment model. According to this view, there was a rogue partner who was not raised with the same moral and ethical values as most of the other partners. In this case, Andersens future problems would be solved by firing the bad apple and hiring a replacement with higher ethical values. The economic view of behavior would suggest that partners were acting in their own self interest given the costs and benefits that they faced. The capstone case at the end of Part 3 of the book provides a detailed study of Arthur Andersen. The evidence in this case suggests that the partners were motivated to be overly lenient on audits because of Andersens performance evaluation system which encouraged them strongly to obtain additional business from their audit customers. One potential way to attract additional business from companies is to be easy on them in annual audits. 2-25. According to a recent article in The Atlanta Journal-Constitution (Jan., 29th 2004), materialism, not necessity, gave birth to dual-income families. In supporting the argument, the author cites the following figures from the Department of Commerce: in 1970 the average wage per job was $6,900, which in 2001 dollars (adjusting for inflation) amounts to $31,500. In 2001, the average wage per job was $35,500. The main thesis of the article is that dual-income families are a result of a shift in consumer preferences toward consumption as opposed to leisure time/time spent with the family. (a) Assume the average person worked 250 days during a year both in 1970 and 2001, and that, as reported in the article, only one person worked in the average family in 1970, while both parents did in 2001. Provide a graphical analysis of the typical familys choice between family income and combined parent leisure time that supports the authors argument, relying on the tools presented in class. Be careful in labeling your graph(s), and provide a clear and concise explanation for your graph(s). Note that there are 365 days in a year so that the total parent leisure time that is possible is 730 days (assuming neither spouse works). Assume it is possible for each family member to work anywhere from 0 to 365 days a year (at the going salary rate) if they choose to do so. 2-21 Chapter 02 - Economists View Of Behavior In the figure above, the curves corresponding to the average 1970 family are given by the dashed lines, while the curves corresponding to the average 2001 family are given by the full lines. In particular, if both parents worked 365 days per year (i.e. 0 days of leisure combined), the family would earn $91,980 in 1970, while in 2001 the same family would earn $103,660, given the figures in the article, and assuming average daily income did not vary with the number of days worked. If neither parent worked any day of the year, the combined number of leisure days is 730 and the total income is 0 in both years. The two indifference maps (i.e. sets of indifference curves) drawn for the typical 1970 and 2001 family are consistent with the authors argument that families preferences have changed over time. Indeed, since the indifference curves of the typical 1970 family cross those of the typical 2001 family, they could not be representing the same set of preferences, as this would violate one of the 3 basic assumptions underlying well-behaved preferences (transitivity). 2-22 Chapter 02 - Economists View Of Behavior It should be noted that although the authors argument is consistent with consumer optimization behavior, this does not mean that it is the only plausible explanation. In particular, as reported in the article, the average daily income has increased from 1970 to 2001 and, thus, the price of leisure has increased. Therefore, even holding preferences constant over time, it could be that families choose now to work more because the opportunity cost of not working has increased. See the next question for further details on this argument. (b) Assume that in 1971 the average single person worked 220 days per year, while the same person worked 260 days per year in 2001. Moreover, suppose the average daily wage in 2001 dollars was $125 in 1970 and $140 in 2001. Show graphically how the authors argument would not necessarily apply to the average single person (i.e. assume preferences are unchanged). Explain clearly and concisely why the average worker may be choosing to work more in 2001 and carefully label your graph. As the figure above shows, it is very well possible that the same person (i.e. having identical preferences) chooses two different bundles of income and leisure time after a wage rate change. 2-23 Chapter 02 - Economists View Of Behavior In particular, an increase in the daily wage produces two distinct effects: first, the person is able to earn more after the increase, holding constant the number of leisure days he/she chooses to enjoy, or, similarly, the person could earn the same total income while enjoying more leisure time. However, at the same time, an increase in the daily wage rate increases the opportunity cost of leisure time. Whether a person will choose to work more or less after the change depends on which of these two effects dominates, given the persons preferences. The indifference map in the graph above represents a set of preferences such that the second effect (increase in the relative price of leisure substitution effect) dominates the first (the increase in income income effect). The picture and explanation above complement the argument offered in the previous answer. That is, the higher number of dual-income families in recent year, which is documented in the article, is not necessarily the result of changing preferences. On the contrary, it could well be that, given the average familys preferences, higher wages cause families to choose to work more. 2-24 Chapter 03 - Markets, Organizations, And The Role Of Knowledge CHAPTER 3 MARKETS, ORGANIZATIONS, AND THE ROLE OF KNOWLEDGE CHAPTER SUMMARY This chapter answers three primary questions: How do market systems work? What are the relative advantages of market systems compared to central planning in large economies? Why do we observe so much economic activity conducted within firms in market economies? In addition to covering the basic principles of exchange and supply-and-demand analysis, the chapter introduces two concepts that are critical to the subsequent development in the book: specific knowledge and contracting costs. The chapter also makes the important point that individuals have incentives to choose value-maximizing organizational arrangements. An appendix presents the basics of present value analysis and the valuation of common stock. It also discusses the concept of stock market efficiency. This appendix provides useful background material (for example, when instructors want to discuss the stock market reactions to events). CHAPTER OUTLINE GOALS OF ECONOMIC SYSTEMS PROPERTY RIGHTS AND EXCHANGE IN A MARKET ECONOMY Dimensions of Property Rights Managerial Application: Patent for Priceline.com Managerial Application: Property Rights Insecurity in Columbia Gains from Trade Managerial Application: While Animosity between the Governments of Venezuela and the U. S. Grow, So Does Trade Managerial Application: Strategic Business PlanningIgnoring Economics of Trade Academic Application: Gains from Trade BASICS OF SUPPLY AND DEMAND The Price Mechanism Managerial Application: Shifts in Demand, Quantity, and Price at the PGA Tournament Linear Supply and Demand Prices as Social Coordinators Managerial Application: Supply of Online Resumes Bogs Down Employers Measuring the Gains from Trade Government Intervention Price Controls Price Floors Academic Application: Labor Unions and Minimum Wage Laws Externalities and the Coase Theorem 3-1 Chapter 03 - Markets, Organizations, And The Role Of Knowledge Academic Application: Property Rights in Russia Academic Application: The Coase Theorem and the Fable of the Bees Managerial Application: Property Rights Help Make Niger Greener MARKETS VERSUS CENTRAL PLANNING General versus Specific Knowledge Managerial Application: Topic-Specific Search Engines Managerial Application: The Dynamic Nature of Specific Knowledge Managerial Application: Use of Specific Knowledge at Apple Computer Knowledge Creation Academic Application: Markets versus Central Planning in Russia Managerial Application: Converting IT Wetware into Software Specific Knowledge and the Economic System Managerial Application: FiatUsing Specific Knowledge about Developing Markets Incentives in Markets Managerial Application: Japan, Computers, and Industrial Policy CONTRACTING COSTS AND EXISTENCE OF FIRMS Contracting Costs in Markets Academic Application: Herbert Simon on Organizations and Markets Contracting Costs within Firms Efficient Organization Academic Application: Corporate Focus and Stock Returns Managerial Objectives Academic Application: CEO Turnover and Firm Profits Academic Application: Firms versus MarketsWhen Markets Ruled MANAGERIAL DECISIONS Managerial Application: Hewlett-Packard and Corporate Focus SUMMARY APPENDIX: SHAREHOLDER VALUE AND MARKET EFFICIENCY Present Value Share Value Stock Market Efficiency TEACHING THE CHAPTER Students are likely to be familiar with many of the concepts presented in the chapter, but it is important to review these concepts before proceeding with the rest of the text. This chapter reviews many economics basics such as using markets to allocate resources, the importance of private property rights, and how applying the principle of comparative advantage can increase gains from trade. Students are introduced to functional forms of supply and demand curves in this chapter and students with less extensive economics backgrounds might not be familiar with this analysis. However, this concept is not one that causes difficulty for most students. Instructors can use the Managerial Applications to generate class discussion, particularly for the non-quantitative topics such as property rights. The final sections of the chapter are particularly relevant to the material presented in the rest of the text since they focus on the creation and use of knowledge and how it is used to make decisions by individuals in markets and within firms. 3-2 Chapter 03 - Markets, Organizations, And The Role Of Knowledge There are numerous problems that can be assigned to determine how well students understand the material. The Self-Evaluation Problems review the quantitative tools presented in the chapter. The Review Questions review both the graphical and quantitative analyses presented in the chapter. These questions can be used in class to review the major concepts of the chapter in place of extensive lecturing depending on the background of the students and the instructors goal for the course. There are five Analyzing Managerial Decisions scenarios presented in the chapter. The first, Comparative Advantage in the Workplace, asks students to determine each employees comparative advantage and to determine how work activities can be reassigned to be more productive. The second scenario, Ethanol and Pork Prices, asks students to conduct a graphical analysis of how government legislation will likely affect the supply and demand in two markets. The third scenario, Nobel Prize-Winner F. A. Hayek on the Miracle of the Price System, asks students to consider the difference between decentralizing economic decision making in a market and decentralizing it in a firm. What is different about a firm that can make the link between decentralization and efficiency less clear? The fourth scenario, Property Right Security in Russian Deprivatization is a more comprehensive scenario that asks students to consider how deprivatization will likely affect a variety of economic actors and why a policy of deprivatization might be adopted. The final scenario, Shareholder Value and Market Efficiency, is located at the end of the chapter after the appendix. This scenario reviews the concepts and quantitative tools presented in the appendix. (See the Solutions Manual for the answers to these problems). REVIEW QUESTIONS 31. What is Pareto efficiency? Why do economists use this criterion for comparing alternative economic systems? An allocation of resources is Pareto efficient when there is no alternative that keeps all individuals at least as well off, but makes at least one person better off. One reason that economists use this criterion for comparing economic systems is that it is relatively uncontroverisial. Stronger criteria are likely to be met with more disagreement. 32. What is a property right? What role do property rights play in a market economy? A property right is a socially-enforced right to select the uses of an economic good. A property right is private when it is assigned to a specific person. Property rights are alienable when they can be transferred (sold or given) to other individuals. Since owners bear the wealth effects of their actions, there are strong incentives to rearrange property rights in market transactions to increase efficiency and value. 3-3 Chapter 03 - Markets, Organizations, And The Role Of Knowledge 33. Twin brothers, Tom and Bill, constantly fight over toys. For instance, Tom will argue it his turn to play with a toy, while Bill argues it is his turn. Their parents frequently have to intervene in these disputes. Their mom has conceived an idea that might reduce these conflicts. In particular, every toy in the house would be "owned" by one of the boys. The owner would have complete authority over the use of the toy. The mom reasons that ownership would cut down on disputes. Any time, there is an argument over a toy, the owner gets the final and immediate say. The boys dad is concerned that this idea will prevent the boys from learning to share. He envisions that under the new system, Tom will not allow Bill to play with his toys and Bill will not allow Tom to play with his toys. The current system forces them to figure out a way to share the toys. Do you think that their dad's concerns are valid? Explain. The dad does not foresee that the boys are likely to find it in their self interest to share. Bill will allow Tom to play with some of his toys, so that he can play with some of Toms toys (there are gains from trade). The mom is likely to be right that ownership will cut down on the number of disputes and will reduce the parents role in intervening in disputes. The parents, however, will be charged with helping to enforce the property rights. 3-4. Many economists favor free trade between nations. They argue that free trade will increase total world output and make people of trading nations better off. Discuss how this argument relates to concepts presented in this chapter. Free trade allows countries to concentrate on producing goods and services for which they have a comparative advantage. This specialization increases the total production of goods in the global economy. Thus, each nation can be better off with free trade than if they individually tried to be self sufficient. (Free trade increases the size of the total pie; thus allowing all countries to have a bigger piece.) 35. What do you think will happen to the price and quantity of DVD players if: a. The availability of good movies to play on DVD players increases? An increase in good movies is likely to increase the demand for DVD players and thus their quantity and price. b. Personal income increases? An increase in personal income is likely to increase the demand for DVD players and thus their quantity and price. c. The price of inputs used to produce DVD players decreases? 3-4 Chapter 03 - Markets, Organizations, And The Role Of Knowledge The decrease in input prices is likely to increase the supply of DVD players and thus quantity is likely to increase, while price is likely to decrease. d. Ticket prices at local movie theaters decline substantially? The decline in movie ticket prices might reduce the demand for DVD players and thus the quantity and price are likely to decrease. 3-6. Suppose that the U.S. government caps the price of milk at $1.00/gallon. Prior to the cap milk sold for $1.00/gallon. Picture the effects of the price cap using a supply and demand graph. Explain how the cap affects consumers and producers. P Price Q Qs QD As pictured in the graph, the price cap (assuming it is below the equilibrium price) creates a shortage where the quantity demanded is greater than the quantity supplied. Total surplus is reduced by the price cap. The lost total surplus is pictured by triangle b (lost consumer surplus) and triangle d (lost producer surplus). The lost surplus reflects the forgone gains from trade due to the cap (consumers in this region are willing to pay more for the milk than what it costs for producers to make it, but trade does not take place because of the price cap). There is also a transfer from producers to consumers as pictured by rectangle c. Thus, some consumers are potentially made better off by the price cap since they are able to buy milk at below the free market price. However, they may have to incur costs to get the regulation passed. 37. a. What is an externality? An externality is when one partys action affects the utility or profits of another party. Externalities might be positive or negative. b. Why might externalities lead a firm to discharge too much pollution into a river? Some of the costs of the pollution are borne by others (there is an externality), and so the firm does not consider these costs in its decision making (unless the costs are low for negotiating with the harmed parties in which case the firm faces an opportunity cost of not being paid to lower the pollution level). 3-5 Chapter 03 - Markets, Organizations, And The Role Of Knowledge c. Congress has passed a law that limits the level of cotton dust within textile factories. Why might a textile firm allow too much cotton dust within its workplace? Since the firm must hire the workers who would be exposed to the air pollution within the factory, there is no externality. Lower air quality makes the job less attractive and thus raises the wage the firm has to pay its employees. Thus, there are private incentives for the firm to choose the efficient level of air quality within the factory. 38. What is the difference between general and specific knowledge? How can specific knowledge motivate the use of decentralized decision making? General knowledge is inexpensive to transfer, while specific knowledge is expensive to transfer. If individuals have important specific knowledge, it can be efficient to grant them decision rights so that they can act on this information. Prices or information from administrators can be used to coordinate the actions of these decentralized decision makers. As discussed in more detail in subsequent chapters, however, it is also important to consider incentives. Decentralized decision makers require proper incentives to motivate them to make productive use of their specific information. 39. Evaluate the following statement: Using free markets and the price system always results in a more efficient resource allocation than central planning. Just look at what happened in Eastern Europe. The demise of many centrally-planned economies suggests that central government planning in a large economy is likely to be inefficient. Nevertheless, the observation does not suggest that all central planning is bad. Sometimes it can reduce transaction costs relative to the use of markets. This argument provides an explanation for the existence of firms where there is often central economic planning. (But in a market economy, these firms constantly face competition from markets and other firms as alternate methods of organizing production; this ongoing competition provides powerful incentives to maintain efficient markets.) 310. a. What are contracting costs? Contracting costs include search and information costs, bargaining and decision costs, and policing and enforcement costs. b. Give a few examples of contracting costs? 3-6 Chapter 03 - Markets, Organizations, And The Role Of Knowledge Examples include the search and negotiation of prices in a market, legal disputes over contracts, monitoring employees, and so on. c. What effect does the existence of contracting costs have on market economies? Contracting costs imply that markets are not always the best way to organize economic activities. Sometimes the creation of firms can lower contracting costs. Therefore, in most market economies, you see both market transactions as well as nonmarket transactions that occur within firms. Sometimes contracting costs are reduced by organizing transactions within firms. 311. If markets are so wonderful, why do firms exist? Firms exist because of the contracting costs associated with markets. For example, the presence of firms can reduce the number of transactions between customers and factors of production from n x m to n + m. Another example is the contracting cost associated with firm-specific assets. Including the asset in a firm can be preferable to outsourcing (using the market) to reduce hold-up costs. 312. In certain professional sports, team owners "own" the players. Owners can sell or trade players to another team. However, players are not free to negotiate with other team owners on their own behalf. The team owners initially obtain the rights to players through an annual draft that is used to allocate new players among the teams in the league. They can also obtain the rights to players by purchasing them from another team. Players do not like this process and often argue that they should be free to negotiate with all teams in the sporting league. In this case, they would be free to play for the team that offers the most desirable contract. Owners argue that this change in rights would have a negative effect on the distribution of talent across teams. In particular, they argue that all the good players would end up on rich, media-center teams such as New York or Los Angeles (because these teams could afford to pay higher salaries). The inequity of players across teams would make the sport less interesting to fans and thus destroy the league. Do you think the owners' argument is correct? Explain. 3-7 Chapter 03 - Markets, Organizations, And The Role Of Knowledge Absent contracting costs, the assignment of players to teams is not likely to be greatly influenced by who has the property right to decide where the player plays (the Coase theorem). Rather both the owners and the players will have incentives to have players play at locations where they create the most value. For instance, suppose the Minnesota team has the right to a player who is more highly valued in Los Angeles. The owner of the Minnesota team will have the incentive to sell the player to Los Angeles. If the player can decide where to play, he is likely to go to Los Angeles because they will offer him more money. What does vary between the two ownership systems is the distribution of wealth. The owners are better off under the current system and thus have incentives to argue on its behalf. New York and Los Angeles are likely to have strong teams under either system. However, the argument that they will get all the good players is unlikely to be valid. Once these teams have a sufficient number of stars, the marginal value of additional stars is likely to be lower for the big-market teams than for small-market teams which have fewer star players. 313. The guide at the Washington Monument tells your 10-year-old nephew, "Enjoy the monument. As a citizen you are one of its owners." Your nephew asks you if that is true. What do you say? The nephew owns the monument only in a very limited sense. He does not have a private property right that allows him to decide on the use of the monument. Also he cannot sell his claim. 314. Locust Hill Golf Club is a private country club. It charges an initiation fee of $23,000. When members quit the club, they receive no refund on their initiation fees. They simply lose their membership. Salt Lake Country Club is also a private golf course. At this club, members join by buying a membership certificate from a member who is leaving the club. The price of the membership is determined by supply and demand. Suppose that both clubs are considering installing a watering system. In each case, the watering system is expected to enhance the quality of the golf course significantly. To finance these systems, members would pay a special assessment of $2,000 per year for the next 3 years. The proposals will be voted on by the memberships. Do you think that the membership is more likely to vote in favor of the proposal at Locust Hill or for the one at Salt Lake Country Club? Explain. 3-8 Chapter 03 - Markets, Organizations, And The Role Of Knowledge At Locust Hill the members do not have an alienable property right. If they pay for the improvement they must play the course to get any benefits. Members who expect to leave the club in the near future (older members and people who are more likely to be transferred in their jobs) are less likely to support the proposal. They bear the full costs (assuming they will be there three years) and receive limited benefits. At the Salt Lake club, members leaving the club can sell their memberships. They will favor the new investment as long as the increase in the value of the membership is greater than the investment costs (it is a positive net present value project). Thus the members at the Salt Lake Country Club are more likely to approve the proposal. 315. Critically evaluate the advice of the Providence Consulting Group, which recommended to your company: That you analyze all the business divisions in your company. Rank them on growth potential. Sell all the low-growth units and invest the money in the high-growth units. Make sure not to sell the high-growth units. This advice does not make economic sense. Basic economics says that you should sell if and only if the unit is more valuable to someone else than to you (i.e., they are willing to pay a higher price than it is worth to you). Selling low growth units will decrease value if the price is lower than the value to your firm. Value is also wasted if you keep high-growth units that are more valuable to some other firm. As I discussed in class, this was a major conceptual problem with strategic planning in the 1970s. 316. Suppose that the U.S. government begins charging a $1 sales tax to all consumers for each dress shirt they buy. a. What is likely to happen to the price (not including the tax) and quantity demanded of dress shirts? Show using supply and demand graphs. 3-9 Chapter 03 - Markets, Organizations, And The Role Of Knowledge The price is likely to fall and the quantity demanded is likely to decrease: b. What is likely to happen to the demand for sport shirts (not taxed) and undershirts (which are worn primarily with dress shirts)? Explain. The demand for sports shirts is likely to increase since they are likely to be a substitute for dress shirts. Recall that if the price of a substitute increases the demand for the product increases (positive cross elasticity). The demand for undershirts, however, is likely to decline since they are a complement to dress shirts (negative cross elasticity). 317. Title-loan firms offer high-interest loans (the interest rate can exceed 200 percent per year) to high-risk customers. The title of a car is often used as collateral. If the borrower defaults on the loan, the company can repossess the car. Recently, the financial press has reported stories of poor people who have had their cars repossessed by title lending companies. Legislation is being proposed in some states to make this lending practice illegal. A proponent of the law made the following argument. The market for loans is very competitive given all of the banks, savings and loans, and finance companies. Outlawing title lending will make poor people better off. It will motivate the lending companies to provide loans with less onerous terms. Thus low income people and people with bad credit histories will be able to obtain credit on more favorable terms. Do you agree with this argument? Explain. The persons statement does not make sense. If the market for loans is competitive (as he states), loan companies would not be making abnormal profits on loans. Thus if the high interest rate loans are disallowed companies are unlikely to offer loans to the high-risk customers. Assuming these people know what is in their own best interest they will be worse off because they wont be able to borrow money that they otherwise would borrow. 3-10 Chapter 03 - Markets, Organizations, And The Role Of Knowledge 3-18. Suppose that annual demand in the U.S. market for ice cream cones can be expressed as QD = 800 + .2I - 100P, where QD is the number of cones demanded in millions of cones, I equals average monthly income in dollars, and P is price in dollars per cone. Supply can be expressed as QS = 200 + 150P (with the same units for quantity and price). a. Graph the demand and supply curves for ice cream cones, assuming that average monthly income is $2,000, and solve for the equilibrium price and quantity. When income is 2,000, the demand curve is QD = 800 + .2(2000) 100P = 1200 100P. Thus, the x intercept is 1200. The y-intercept will be at the point where QD = 0. Solving this for P, we get 0 = 1200 100P 1200 = 100P P=12 Supply does not depend on income, so it will just be a straight line which intersects the x-axis at 200 and has a positive slope of 1/150. Graphing these two lines, we get: To solve for the equilibrium price, we set the right-hand-sides of the two equations equal and solve for P: 1200 100P = 200 + 150P 1000 = 250P P=4 We plug this value for P into one of the original equations to solve for Q: QS = 200 + 150(4) QS = 200 + 600 QS = 800 3-11 Chapter 03 - Markets, Organizations, And The Role Of Knowledge These two quantities define the intersection point of the supply and demand graphs as indicated in the figure. b. Now assume that average monthly income drops to $750 and supply is unchanged. Draw the new demand curve on the same graph as used in (a) above and solve for the new equilibrium price and quantity. How would you describe the shift in demand intuitively? The change in income does not shift the supply curve. The demand curve has the same slope, but the intercept on the x-axis has changed to 800 + .2(750) = 950. The intercept on the y-axis will now occur where: 0 = 950 100P 100P = 950 P = 9.5 Adding this new demand curve to the above graph, we get: Price 12 $2000 9.5 200 950 1200 The new equilibrium price and quantity are determined in the same way as in part (a). First, we set the two equations equal and solve for P: 950 100P = 200 + 150P 750 = 250P P=3 Then we plug this into either original equation to get Q: Q = 200 + 150(3) = 650 The shift in demand is a parallel shift downward. This implies that fewer units are demanded at each price, but the rate of change in quantity as price changes is the same. 3-12 Chapter 03 - Markets, Organizations, And The Role Of Knowledge 3-19. The rent control agency of Rochester has found that aggregate demand is P = 500 5QD. Quantity, QD, is measured in thousands of apartments. Price, P, equals the monthly rental rate in dollars. The citys board of realtors acknowledges that this is a good demand estimate and has shown that supply can be expressed as P = 5QS. a. If the agency and the board are right about demand and supply, respectively, what is the free-market price? How many apartments are rented? We solve for the equilibrium price and quantity by setting the demand and supply equations equal to one another and solving for Q: 500 5Q = 5Q 500 = 10Q Q = 50 Then we solve for P by plugging this value of Q into either equation: P = 5 (50) = $250 So, the free market price is $250 per month and the number of apartments rented is 50,000. b. If we assume an average of 3 persons per apartment, what is the expected change in city population if the agency sets a maximum average monthly rent of $100 and all those who cannot find an apartment leave the city? If the monthly rent is capped at $100, demand will exceed supply. To show the effect of this, we can graph the demand and supply functions. The demand function has a y-intercept of P = 500. Its x-intercept is found by setting P = 0 and solving for Q as follows: 0 = 500 5Q Q = 100 The supply curve will intercept both axes at zero and have a positive slope of 5. 3-13 Chapter 03 - Markets, Organizations, And The Role Of Knowledge The free market price and quantity correspond to the intersection of the two curves. With a price ceiling of $100, the amount supplied would be found by setting P = 100 and solving the supply equation for Q as follows: 100 = 5Q Q = 20 To find the amount demanded, we do the same with the demand equation: 100 = 500 5Q 5Q= 400 Q = 80 These points are noted on the graph. Since apartment owners will only supply 20,000 apartments, 50,000 20,000 = 30,000 apartments that were supplied at the market price of $250 will no longer be supplied. Thus, since we are assuming 3 persons per apartment, 30,000 3 = 90,000 people who had apartments in a free market will no longer be able to find an apartment, and will leave the city. Thus the total change in city population is a decrease of 90,000 people. 3-20. Assume that before the ice storm of 2003, the weekly demand and supply for ice in the Rochester Metro Area were given by the following equations: Dpre: P = 100 Q Spre: S = 5 + 0.5Q 3-14 Chapter 03 - Markets, Organizations, And The Role Of Knowledge a. Draw a graph representing the Rochester ice market before the storm and label it carefully. What was the equilibrium price for the Rochester ice market before the storm? And the total quantity of ice traded? The following graph represents the market for ice in the Rochester Metro Area before the ice storm. The quantity demanded is equal to the quantity supplied at the market clearing price (i.e. the market is in equilibrium). In order to compute the equilibrium it suffices to equate the aggregate demand pre-storm to the aggregate supply pre-storm, as follows: 100 Q* = 5 + 0.5Q* and solve for Q*. The solution to the previous equation is Q*=63.33, as shown in the figure. The corresponding market clearing price is P*=$36.37, which is obtained by plugging Q* into either the demand or the supply equation. Price $100 Spre 36.37 Dpre $5 0 Quantity 63.33 100 3-15 Chapter 03 - Markets, Organizations, And The Role Of Knowledge b. As a result of the ice storm, electricity went out in the Rochester area. The demand for ice increased due to the lack of electricity to power refrigerators. The lack of power also caused the supply to decrease. Ice producers were still able to produce some ice using electric generators. Other ice had to be imported from other areas with power. The relevant post storm equations are the following: Dpost: P = 110 - Q Spost: P = 10 + 2Q Draw a graph representing the Rochester ice market after the storm and label it carefully. What is the new equilibrium price? What is the quantity? The following graph represents the market for ice in the Rochester Metro Area before the ice storm. Following the same approach described in the previous answer it is possible to compute the equilibrium Q and P. In the aftermath of the ice storm, Q*=33.33 and P*=$76.67. Price Spost $110 76.67 Dpost $10 Quantity 0 c. 33.3 110 An open-ad on a local newspaper, commenting on the dramatic increase in price of ice following the storm, stated: 3-16 Chapter 03 - Markets, Organizations, And The Role Of Knowledge Obviously, avarice and greed won out over decency and morality as ice-vendors took advantage of the ice storm to increase prices and gauge their loyal customers. Do you agree with this statement? Explain. The statement ignores the fact that the equilibrium quantity and price prevailing in a competitive market are the result of market forces. In particular, as a result of the storm, producers have to face a higher marginal cost of production (thus the shift of the supply) and consumers demand for ice increased (thus the shift of the demand), which in turn resulted in higher prices. If the prevailing price was any different from the one derived in the previous answer, the market would not be in equilibrium: that is the quantity supplied would not be equal to the quantity demanded. In particular, if the prevailing price after the storm remains at the same pre-storm level, the quantity supplied would fall short of the quantity demanded. Thus, some customer willing to buy at that price would not be able to purchase the quantity desired. 3-21. Suppose the supply and demand for wheat is given by: Supply: Qs = 1800 + 240P Demand: Qd = 2550 + 10I 266P, Where P = the price per bushel of wheat and I = income. The current value of I is 100. a. Find the current equilibrium price and quantity of wheat sold in the market place. [1800 + 240P] = [3550 266P] P = $3.46/bu Q = 2,630 b. Find the equilibrium price and quantity if income increases to 150. [1800 + 240P] = [4050 266P] P = $4.44/bu Q = 2,866 3-17 Chapter 03 - Markets, Organizations, And The Role Of Knowledge c. Show the change in equilibrium using a standard supply and demand graph. Make sure to label the axes and the curves. The graph does not need to be to scale. Just illustrate in a general way what is going on. 3-22. Assume that the demand curve for sporting guns is described by QD =100 2 p and the supply is described by Q =20+ p (Q & Q are in millions, p is in $) S a. D S Compute the competitive equilibrium price and quantity. Draw a graph of supply and demand curve and label it correctly. Compute the total value created in the market for sporting guns (hint: total value = consumer surplus + producer surplus). Q = 100 2 p Q = 20 + p 20 + p =100 2 p p = 40 Q = 20 + p Q = 20 D S 3-18 Chapter 03 - Markets, Organizations, And The Role Of Knowledge PS = 2020 = 200; CS = 1020 = 100; SW = PS + CS = 300 or SW =3020 = 300; b. Suppose that the government views sporting guns as a luxury product and taxes the consumers $6 for each sporting gun they buy. Solve the new competitive equilibrium. What losses do consumers of sporting guns incur as a result of the tax? What losses, if any, do the producers of sporting guns incur? Government tax has an effect on the demand curve. The demand curve moves inward (towards the direction of southwest) and can be described by Q = 100 2( p + 6) = 88 2 p . D Q = 88 2 p Q =20 + p 20 + p = 88 2 p p = 36 Q =20 + p Q =16 D CS= (44-36) 6=64. PS= 36-20) 6=128. So change in CS = 64-100=-36(loss); Change in PS=128-200=-72(loss). 3-23. Suppose there has been a storm in Nebraska that has destroyed part of the corn crop in the field. The demand curve for corn has not changed. As a result, the market clearing prices and quantities before and after the storm are: Pb = 50, Qb = 2000; Pa = 100, Qa = 1500. (The subscripts a and b refer to after the storm and before the storm.) a. Assume a linear demand curve for corn, i.e. P = + Q. Calculate , with the provided information, and draw the demand curve with P on the y-axis and Q on the x-axis. Label the intercept and the slope on the graph. 3-19 Chapter 03 - Markets, Organizations, And The Role Of Knowledge First, solve for , . = slope = (100-50)/(1500-2000) = -0.1. 100=0.1(1500) > = 250. b. The supply curve for the period after the storm is P = (1/15) Q, and it is parallel to the supply curve before the storm. Is the supply curve before the storm above or below that after the storm? Calculate the slope and the intercept of the supply curve before the storm. Draw both supply curves on a new graph with P on the yaxis and Q on the x-axis. Add the demand curve (calculated in part a) to the graph. The two supply curves have the same slopes. So, 50 = x + (1/15) (2000), from which solve for the intercept of the supply curve before the storm, i.e. x= -83.33. c. Suppose consumers care only about corn consumption and apple consumption (they live in a two-good world). How would the change in the price of corn affect the budget constraint of the typical consumer? Show graphically. How would the change in relative prices affect the typical consumers consumption of corn versus apples? Is this result consistent with your observation from the demand and supply framework (i.e. an increase in price of corn is associated with a decrease in the equilibrium quantity)? Explain. 3-20 Chapter 03 - Markets, Organizations, And The Role Of Knowledge The dashed line is the budget after the price change, while the solid line is before the price change. The change in relative prices would work to motivate a decrease in the amount of corn consumed and increase the amount of apples consumed by the individual. This is consistent with the conclusion from the supply and demand framework where the increase in price was associated with a decline in corn consumption. 3-21 Chapter 04 - Demand CHAPTER 4 DEMAND CHAPTER SUMMARY This chapter builds on a brief introduction in the previous chapter by providing a more detailed analysis of product demand. The chapter covers demand functions and demand curves. It introduces elasticities and the properties of linear demand curves. The relation between total revenue and price is examined. The chapter also provides a brief introduction to network effects, the product-attribute model, product life cycles, and demand estimation. An appendix covers point elasticities, marginal revenue for linear demand curves, and log-linear demand curves. CHAPTER OUTLINE DEMAND FUNCTIONS DEMAND CURVES Law of Demand Managerial Application: Learning the Law of Demand the Hard Way Elasticity of Demand Managerial Application: Increased Foregin Competition and Demand Elasticities Calculating Price Elasticities Price Changes and Total Revenue Determinants of Price Elasticities Academic Application: Price Elasticities Managerial Application: Demand Elasticities and Airline Pricing Linear Demand Curves Total Revenue Marginal Revenue Profit Maximization OTHER FACTORS THAT INFLUENCE DEMAND Prices of Related Products Complements versus Substitutes Managerial Application: Complementarity between Computer Hardware and Software Managerial Application: Derived Demand Cross Elasticities Academic Application: Estimates of Cross Elasticities Income Normal versus Inferior Goods Managerial Application: Russian Cola Wars 4-1 Chapter 04 - Demand Income Elasticities Academic Application: Estimates of Income Elasticities Managerial Application: A Pampered Dog Loses His Stylist Other Variables INDUSTRY VERSUS FIRM DEMAND Industry Demand Curves Defining Industry and Market Area Managerial Application: 9/11 Causes Massive Shifts in Demand Curves Managerial Application: Store Layout Affects Demand Managerial Application: Demand Elasticity for Gasoline NETWORK EFFECTS Managerial Application: eBay and Network Effects PRODUCT ATTRIBUTES Managerial Application: Understanding What Consumers Want PRODUCT LIFE CYCLES Managerial Application: First-Mover Advantages and Financial Innovation DEMAND ESTIMATION Interviews Managerial Application: Using Technology to Assess Demand Price Experimentation Statistical Analysis Academic Application: On Estimating Demand Curves for Common Stocks Omission of Important Variables Multicollinearity Identification Problem Implications SUMMARY APPENDIX: DEMAND Point Elasticities Marginal Revenue for Linear Demand Curves Marginal Revenue and Demand Elasticity Log-Linear Demand Functions 4-2 Chapter 04 - Demand TEACHING THE CHAPTER This chapter reiterates the fundamentals of demand. In upper level courses that require students to complete a managerial economics or intermediate microeconomics course as a prerequisite, extensive coverage might not be as necessary, however it is essential for students to know the basic concepts in the chapter since they relate to material covered in later chapters. For example, the properties of linear demand curves are relevant in Chapters 17 (transfer pricing) and 19 (vertical integration and outsourcing). There are numerous Managerial Applications within the chapter that are used to illustrate key concepts (such as the relationship between elasticity and changes in revenue due to price changes) that can be used to generate class discussion of the topics rather than relying on lecturing. If students have only a limited economics background, the quantitative analysis will be new, however the tools are not too advanced so most students should not struggle with learning them. The Self-Evaluation Problems review the quantitative concepts presented in the chapter and provide a good way to determine whether students fully understand the concepts. There are numerous Review Questions at the end of the chapter that cover both the concepts and the quantitative tools of the chapter. Students might find these questions difficult if they have not worked through the Self-Evaluation Problems first. Instructors will likely want to review some of these questions to ensure students understand the material before assigning the Analyzing Managerial Decisions scenarios. There are three Analyzing Managerial Decisions scenarios presented in this chapter. The first, Setting Tuition and Financial Aid at Ursinus College, asks student to evaluate whether demand for a college education adheres to the law of demand. Students are presented an apparent violation of the law of demand and asked to determine if this explanation seems plausible. The second, Demand Curve for an Indian Electronics Product, is a quantitative analysis that asks students to derive the equation for the firms demand curve and to determine whether demand is elastic or inelastic at the prices referenced. Using this information, students are then asked to analyze whether the current price maximizes the bonus that can be earned under the compensation plan and whether the individual goals are aligned with the firms profit maximization goal. This question is a good precursor of the material that will be presented later in the text. The third scenario, Personal Video Recorders is a more comprehensive scenario that asks students to analyze how advertising might be affected by the use of digital video recorders. This scenario includes a quantitative analysis. (See the Solutions Manual for the answers to these problems). 4-3 Chapter 04 - Demand REVIEW QUESTIONS 41. What is the difference between a demand function and a demand curve? A demand function is a mathematical representation of the relation between the quantity demanded of a product and all factors that influence this demand. A demand curve pictures how many units will be purchased at each possible price, holding all other factors fixed. 42. How will each of the following affect the position of the demand curve for videocassette recorders (VCRs)? a. An increase in the price of VCR tapes. An increase in the price of VCR tapes will shift the demand curve for video recorders to the left (demand will decrease since the price of a complement has increased). b. A decrease in the price of VCRs. A decrease in the price of VCRs does not shift the position of the demand curve. Rather it results in an increase in the quantity demanded (movement along the curve). c. An increase in per capita income. An increase in personal income is likely to shift the demand curve for VCRs to the right (VCRs are probably normal goods). d. A decrease in the price of movie tickets. The decline in movie ticket prices might shift the demand for VCRs to the left (demand will decrease if movies and VCRs are substitutes). 43. If the demand for a product is inelastic, what will happen to total revenue if price is increased? Explain. The total revenue will increase. When demand is inelastic, a given percentage increase in price corresponds to a smaller percentage decrease in quantity demanded. Thus total revenue, which is equal to price times quantity, must increase. 4-4 Chapter 04 - Demand 44. What sign are the cross elasticities for substitute products? Explain. The cross elasticities between substitutes are positive. Cross elasticities measure the percentage change in the quantity demanded for a good given a percentage change in the price of another good. When the price of a good increases, the demand for substitute products increase. 45. Distinguish between normal and inferior goods. The demand for normal goods increases with income, while the demand for inferior goods decreases with income. 4-6. Is it true that a normal good must have an income elasticity that is more than one? Explain. No being a normal good means that the quantity demanded of the good increases with income. Therefore, the income elasticity simply has to be positive (> 0). 4-7. Suppose that the price of Product A falls from $20 to $15. In response, the quantity demanded of A increases from 100 to 120 units. The quantity demanded for Product B increases from 200 to 300. Calculate the arc cross elasticity between Product B and Product A. Is B a substitute or complement for A? Explain. Does Product A follow the law of demand? Explain. Cross Elasticity between B and A = (300-200)/($15-$20) [($20+$15)/2/]/[(300+200)/2] = -2.33. The two products are complements since they have a negative cross elasticity. An increase (decrease) the price of product A causes a decrease (increase) in the demand for B. The law of demand says that the quantity demanded for a good increases as its own price falls. This is true in the example for product A. 48. How can cross elasticities be used to help define the relevant firms in an industry? Firms with high positive cross elasticities are strong substitutes and thus might be considered to be competing in the same industry. 49. Suppose the price of heating oil increases significantly. Discuss the likely shortrun and long-run effects. 4-5 Chapter 04 - Demand An increase in the price of heating oil is likely to decrease the quantity demanded for heating oil (people buy less at higher prices). The long-run effects are likely to be larger than the short-run effects for a permanent increase in the price. Over the long-run, people will invest in more efficient heating equipment or equipment that uses natural gas or electricity; they will insulate their homes better, and so on. These actions will further decrease the demand for heating oil. 410. The Alexander Machine Tool Company faces a linear demand curve. Currently, it is selling at a price and quantity where its demand elasticity is 1.5. Consultants have suggested that the company expand output because it is facing an elastic demand curve. Do you agree with this recommendation? The elastic demand implies that total revenue will increase with an expansion in output (which must be sold at a lower price). However, this does not mean that Alexander Machine Tool should necessarily expand output. Alexander wants to maximize profits. Whether or not expansion is sensible depends on not only what happens to revenue, but also what happens to cost. There is not enough information in the problem to tell whether Alexander should increase output. Profit maximization is discussed in more detail in chapters 5 and 6. 411. For three years in a row, income among consumers has increased. Alexander Machine Tool has had sales increases in each of these three years. Does Alexander Machine Tool produce inferior or normal goods? Forecasts predict that income will continue to rise in the future. Should Alexander Machine Tool anticipate that demand for its products will continue to rise? Explain. The increase in sales might have been motivated by factors other than the increase in income (other factors have not been held constant). Therefore, it is not clear whether Alexander is producing an inferior or normal good. Without a more careful analysis, Alexander should be careful in forecasting that sales will increase with the expected increase in income. 412. The cross elasticity between product A and product B is 10. Do you think that product A is likely to face an elastic or inelastic demand curve? Explain. The cross elasticity of 10 suggests that B is a strong substitute for A. Thus, As demand curve is likely to be relatively elastic. If A increases its price, it is likely to loose sales to B. 4-6 Chapter 04 - Demand 413. Vijay Bhattacharya is interested in estimating the industry demand curve for a particular product. He has gathered data on historical prices and quantities sold in the industry. He knows that the industry supply curve has been stable over the entire period. He is considering estimating a regression between price and quantity and using the result as an estimate of the demand curve. Do you think this technique will result in a good estimate of the demand curve? Explain. The regression will not produce a good estimate of the demand curve due to the identification problem. The data on price and quantity are equilibrium combinations observed in the marketplace; they reflect the positions of both the supply and demand curves. Given that the supply curve has been stable, changes in price and quantity over the period reflect shifts in the demand curve. In this case, the regression is likely to generate a better estimate of the supply curve than the current demand curve. 414. Maria Tejada, a civil engineer uses data on population trends to forecast the use of a particular highway. Her forecasts indicate severe road congestion by the year 2010. She suggests building a new road. Comment on this approach. This demand forecast is likely to be based on current costs people face in using the highway (tolls, waiting times, and so forth). As highway use increases, the increased congestion will motivate some people not to use the road during busy time periods. For instance, they might drive to work early or take the train. These types of adjustments are likely to lower congestion during peak hours below what is forecast. Also the government might encourage more efficient use of the highway by appropriate tolls, and so forth. Tolls will help to internalize some of the increased waiting time that a commuter imposes on other commuters and thus will decrease the demand for road use. These types of actions might be preferred to building more highways. 415. Alexander Machine Tool faces the demand curve: P = $70 0.001Q. What price and quantity maximize total revenue? What is the price elasticity at this point? Total revenue is maximized at the midpoint of a linear demand curve. In this example, the quantity and price at the midpoint would be 35,000 and $35. The price elasticity at this point is one (unitary elasticity). 416. Studies indicate that the income elasticity of demand for servants in the United States exceeds 1. Nevertheless, the number of servants has been decreasing during the last 75 years, while incomes have risen significantly. How can these facts be reconciled? 4-7 Chapter 04 - Demand Factors other than income were not constant over the past 75 years. For example, increases in the prices of servants and decreases in the price of substitutes (for example, washing machines, microwave ovens, and vacuum cleaners) would explain why demand for servants has declined even though incomes have risen. 417. Prior to a price increase, the price and quantity demanded for a product were $10 and 100, respectively. After the price increase, they were $12 and 90. a. Calculate the arc elasticity of demand. Using equation 4.5 in the book, the arc elasticity is .579. b. Is the demand elastic or inelastic over this region? Demand is inelastic (elasticity is less than 1). c. What happened to total revenue? Total revenue increased ($1,000 to $1,080). 418. Define marginal revenue. Explain why marginal revenue is less than price when demand curves slope downward. Marginal revenue is the change in total revenue given a unitary change in price. Marginal revenue is less than price, when demand curves slope downward, because the price has to be lowered to increase sales. When quantity expands, all units must be sold at a lower price. 4-19. In 1991, Rochester, New York, had a serious ice storm. Electric power was out in houses for days. The demand for power generators increased dramatically. Yet the local merchants did not increase their prices, even though they could have sold the units for substantially higher prices. Why do you think the merchants adopted this policy? The analysis in chapter 4 suggests that the merchants would have increased the price. Given the inelastic demand, the merchants could have increased their profits by increasing the price of the generators. The analysis in the chapter, however, focuses on a single period. The merchants might not have wanted to take advantage of the situation because it would have made customers angry and less likely to patronize them in the future. 4-8 Chapter 04 - Demand 420. Seven teenagers, four boys and three girls, were given $200 each to go on a shopping spree. An advertising agency, which specializes in youth markets, gave the teens the money. An account executive accompanied the teens while they were shopping. Not only did the agency want to learn what they bought, but also what they talked about to see what was on their minds. Its not so much to stay in tune with trends, because trends are elusive. Its more whats really happening with teens and whats important to them. 1 a. Discuss the trade-offs between sample size (7 teens), cost, and reliability of what is learned from this experiment. Increasing the sample size would cost more. First, each additional teenager would be given $200. More importantly, the agency might have to add account executives to work with the teens. If not, the amount of detailed information that could be collected would decrease. Increasing the sample size provides a broader set of teenagers and is more likely to provide more general and accurate information about teen preferences. Collecting detailed information, however, is expensive. Thus, there is a tradeoff between cost and reliability. b. An agent accompanied the teens while they were shopping. Why didnt the ad agency avoid this expense and just look at what the teens bought? The agency wanted to understand the thought process that the teenagers went through in selecting their purchases. For example, what alternatives did they consider? What were the most important factors that led to the purchase decision, and so on? Knowing this type of information is potentially important in making advertising, new product, and other marketing decisions. 421. Southwest Airlines estimates the short-run price elasticity of business fares to be 2 and the long-run elasticity to be 5. Is ticket demand more elastic in the short-run or long-run? Does this seem reasonable? Explain. Fares are more elastic in the long run. Suppose Southwest raises prices. In the short-run some travelers will switch to other airlines. However, corporate contracts and frequent flyer miles will cause some people to stay with Southwest. 1 Teens Track Retail Trends for Ad Agency, Democrat and Chronicle (September 5, 1999), 1E. 4-9 Chapter 04 - Demand In the longer run, businesses may switch to alternative forms of transportation, conduct more meetings by phone, or arrange more trips farther in advance to get lower fares. They may also acquire corporate jets. 4-22. Gasoline prices increased substantially in 2004 and 2005. What adjustments did people make to minimize the long-term effects of this price increase? People made a variety of adjustments. For example, some purchased new, more fuel-efficient cars. Some invested in solar driven or hybrid vehicles. Others moved closer to work or other primary destinations. 4-23. Assume that demand for product A can be expressed as QA = 500 5PA + 3PB and demand for product B can be expressed as QB = 300 2PB + PA. Currently, market prices and quantities for these goods are PA = 5, PB = 2, QA = 481, and QB = 301. a. Suppose the price of product B increases to 3. What happens to the quantity demanded of both products? The quantity demanded for product A increases from 481 to 484, while the quantity demanded for product B falls from 301 to 299. b. Calculate the arc cross-elasticity between product A and product B using prices for product B of 2 and 3. The arc cross-elasticity calculated between the two points implied by prices for good B of 2 and 3 is: [(484 481)/(481 + 484)/2] / [(3 - 2)/(2 + 3)/2] = .00621/.04 = .016 c. Are these goods substitutes or complements? The two goods are substitutes: when the price of one good rises by a percent, the quantity demanded of the other good increases (in this case by less than one percent). 4-24. The Zenvox Television Company faces a demand function for its products which can be expressed as Q = 4000 P + 0.5I, where Q is the number of televisions, P is the price per television, and I is average monthly income. Average monthly income is currently equal to $2,000. Answer the following questions. 4-10 Chapter 04 - Demand a. Graph the demand curve (sometimes called the inverse demand curve) faced by Zenvox at the current income level. Be sure to label this and all graphs you draw carefully. On the same graph, depict marginal revenue. At what price and quantity is Zenvoxs total revenue maximized? What is the marginal revenue at this point? Show the calculation. Reversing the demand function to get P on the left-hand side, we get P = 4,000 Q + .5I. Plugging the stated value for income ($2,000) into the righthand side, we get the inverse demand curve for this income level as P = 5,000 Q. This is plotted with quantity on the x-axis and price on the y-axis, as a straight line with a y-intercept of 5,000 and a slope of -1. The x-intercept will equal 5,000. Total revenue (for this value of I) will be TR = PQ = (5,000 Q)Q = 5,000Q Q2. Marginal revenue is given by MR = 5,000 2Q. This will be graphed as a straight line with y-intercept of 5,000 and a slope of -2. The x-intercept will be 2,500. The following graph depicts both curves: Since the demand curve is linear, the point at which total revenue is maximized is at the midpoint, which corresponds to a price of $2,500 and quantity of 2,500. Total revenue at this point is $6,250,000. Marginal revenue is equal to zero at this point: MR = 5,000 2Q = 5000 2(2500) = 0. b. What is the price elasticity of Zenvoxs demand function at the price and quantity derived in part (a)? Explain what this value means in words. 4-11 Chapter 04 - Demand The price elasticity at the midpoint of a linear demand curve is 1. In words, this value means that a one percent increase (decrease) in price is met with a one percent decrease (increase) in quantity demanded. c. Why might Zenvox choose to produce at a price and quantity different than that derived in part (a)? Companies seek to maximize profits, which is generally different than maximizing total revenue. The company will take into account thecosts it faces in determining its optimal price and quantity. 4-25. According to an article in Forbes (March 2001) teen cigarette smoking declined significantly between 1975 and 2000. The most dramatic decline occurred in the years 19751981. Since then teen smoking has increased in some years and declined in others. Between 1975 and 1981 there was a slight decrease in the price of cigarettes. Thus the dramatic decline in smoking is not attributable to an increase in cigarette prices. One theory is that the significant increase in gasoline prices over this period motivated many teens not to smoke. a. Discuss how a rise in gasoline prices might affect the demand for cigarettes among teens. One way to answer the question is to focus on the standard effects in our analysis of consumer behavior in a two-good world: A rise in the price of gasoline holding the price of cigarettes constant will have two effects: teens will tend to substitute away from consuming gasoline to consuming cigarettes as cigarettes become relatively cheaper than they used to be (substitution effect), and teens will face a lower real income due to the increase in gasoline prices (income effect). The total effect on cigarette consumption will be uncertain, but if gasoline is a large enough expenditure for teens the income effect may dominate and cause lower consumption of cigarettes. Another acceptable method of answering the question is as follows: Cigarettes and gasoline might be complementary products (e.g., people tend to smoke when they drive). In this case, a rise in gasoline prices would result in a decline in the demand for cigarettes (teenagers drive less and smoke less). Also teenagers may spend a higher proportion of their budget on gasoline with higher gasoline prices. Thus there is less money left to spend on other goods such as cigarettes. 4-12 Chapter 04 - Demand b. Suppose there are two goods in the world, cigarettes and gasoline. Draw a figure that shows how an increase in gasoline prices can result in a decline in both gasoline and cigarette consumption. Use the standard consumer behavior graph with budget lines and indifference curves. Be sure to label your figure appropriately. Gallons of Gas In the above figure, suppose the initial budget line, before the gas price increase, is Budget Line 1, and the gas price increase causes the line to shift to the position of Budget Line 2. The optimal consumption bundle shifts from A to B, which has lower consumption of both goods. c. In the late 1990s the price of cigarettes increased from $2.50 per pack to $3.25 per pack. In one community during this time period, the number of packs of cigarettes consumed by teenagers fell from 10,000 to 9,000. Assume that everything except cigarette prices remained the same. Calculate the arc price elasticity among teens between these price points. The arc price elasticity is abs(-1000/.75)(2.875/9500)=.4035. d. Calculate the total expenditures on cigarettes by teens in part (c) both before and after the price increase. Did total revenue increase or fall? Discuss how this answer is implied by the arc elasticity that you calculated in part (c). Before price change: 2.5010,000=25,000 After price change: 3.259,000=29,250 Total revenue increased. This is implied by the arc elasticity because when elasticity is less than one, an increase in price increases total revenue. When elasticity is less than one, a 1 percent increase in price leads to a less than 1 percent decrease in total quantity, so total revenue, which is price times quantity, increases. 4-13 Chapter 04 - Demand 4-26. In an article appearing in the Dow Jones News Service on February 5th, 2004, the agency cites Saudi Arabias concern about the production of oil by the OPEC cartel. Assume the current daily demand for OPECs oil is given by the following equation: P = 50 0.001Q where P is the price per barrel (ppb) and Q is the quantity of barrels sold daily (in thousands). Moreover, suppose the marginal cost of producing a barrel is constant at zero. a. Would it surprise you to learn that OPECs declared objective is to sell 25 million barrels a day for an average price of $25 per barrel? Why or why not? Explain. You may use a graph to support your argument. Price per barrel It is not surprising that the OPECs declared objective is to sell 25MM barrels a day for an average price of $25 per barrel. As the picture above shows, this quantity maximizes the OPECs total revenue from the production of oil, given the demand curve in the question. More importantly, given that MC=0, it also maximizes OPECs profit from selling oil. 4-14 Chapter 04 - Demand In particular, the total revenue function for the OPECs oil is: TR= P*Q or TR = (50 0.001Q)Q or TR = 50Q 0.001Q2 The corresponding Marginal Revenue curve is (notice: MR has the same intercept and twice the slope of the original inverse demand curve, as pointed out in class): MR=50 20.001Q = 50 0.002Q As explained in class, profit is at the maximum when MR=MC. Thus, by explicitly solving the previous condition one obtains the Q that maximizes profit. Given that MC=0 by assumption, the condition reduces to the following: MR = 0 or 50 0.002Q = 0 The solution to the previous equation is Q = 25,000. For this quantity, OPEC can charge (at most) P= $25. b. Assume that after OPECs meeting this week, the new demand for OPEC oil will be given by: P = 40 - .001Q. Would OPECs stated objective (25 million barrels at an overall price of $25) be attainable after this change? Explain. Assume OPEC ignores the demand shift. Whats the maximum price per barrel they can charge if they decide to keep producing 25 million barrels per day? What is the profit in this case? As the figure below shows the OPECs declared objective is not feasible after the demand change. If OPEC wants to charge $25 per barrel, it will have to cut back production to 15MM barrels per day. If OPEC wants to keep selling 25MM barrels per day after the demand change, it will have to lower the price per barrel to $15 per barrel. In this latter case, the OPECs profit is going to be $375,000,000 per day. 4-15 Chapter 04 - Demand Price per barrel c. Now suppose that OPEC recognizes that demand has changed (as in (b)) and wants to maximize profits. What is the daily quantity they should supply? At what price? What is the profit in this case? What is the price elasticity of demand at this price/quantity combination? Explain. The objective of selling 25MM barrels per day is not optimal after the demand shift. Indeed, after the change takes place, the optimal daily quantity is 20MM barrels, which should be sold at a price of $20 per barrel as shown in the picture. The optimal price/quantity combination is obtained following the same steps shown in the answer to part (a). The daily profit corresponding to this price/quantity combination is $400,000,000, which is higher than the profit OPEC would earn if it kept production at 25MM barrels per day ($375,000,000 from part (b) of the question). The price elasticity of demand is equal to 1. This is because the MC of production is constant at zero and, thus, profit maximization is equivalent to revenue maximization. As described in class, if a firm is to maximize total revenue, it should choose the price/quantity combination such that the price elasticity of demand is equal to 1. 4-16 Chapter 04 - Demand 4-27. As a result of strikes in Canada the world price of nickel rose by 20 percent in December. Over the same period, the quantity demanded of nickel decreased from 10,000,000 to 8,500,000 pounds worldwide. The world price of nickel was 70 cents per pound before the strikes. a. Show graphically the effect of Canadian strikes on the market for nickel. Price per pound b. Given the information above, whats the price elasticity of the world demand for nickel over the relevant price range? The formula for the arc-elasticity is the following: P(Q) = | [Q/(Q1+Q2)/2 ]/[ P/(P1+P2)/2 ] | Substituting the figures given in the question in the previous formula gives: P(Q) = | [-1,500,000 / 9,250,000]/[ 0.14 / 0.77 ] | = 0.891892 c. Did the total expenditure for nickel increase, decrease, or remain constant after the strikes? How is this consistent with your answers to parts (a) and (b)? Explain clearly and concisely. The total expenditure for nickel increased from $7,000,000 (0.7*10,000,000) before to $7,140,000 (0.84*8,500,000) after the strikes. This is consistent with the elasticity of demand being less than one over the relevant price range (i.e. demand being inelastic). As discussed in class, in the inelastic portion of the demand (<1), total revenue/expenditure increases as the price increases. 4-28. Assume the demand curve for gasoline is given by the following equation: 4-17 Chapter 04 - Demand P = 10 0.0005 Q, where P is the price per gallon and Q is the quantity of gasoline in gallons. Assume that the only supplier of gasoline in the region is General Gasoline Co. and that the marginal cost of production is constant at zero. a. If the company is currently charging $4 a gallon, is it maximizing profit? If so, prove it. If not, find out the price that maximizes its profit, and compare the profits at the two prices. MR = 100 2 0.005Q MR = MC = 0, solve for Q* = 10,000. Substitute this into the demand curve and get the price, P* = 100 0.005(10,000) = $50. This is less than the $60 the company is charging now. Profit with $60 can be calculated as the following. First get the quantity in equilibrium. $60 = 100 0.005 Q. Q = 8000. Profit is then $60 (8000) = $480,000. Profit with $50 is $50(10,000) = $500,000 > $480,000. Setting prices to be $50 is indeed more profitable than setting the price to be $50. b. Discuss the likely effect of the introduction of a fuel-efficient car in the region, i.e. what would happen to the equilibrium quantity. Show the changes on a graph that displays (you dont need to show actual numbers) General Gasolines pricing solution and explain. Fuel efficient cars will decrease the demand for gasoline. The dashed lines are the demand curve and MR curve after the introduction of the fuel efficient car (which reflects a decrease in the demand for gasoline). The profit-maximizing quantity would be the intersection of the MR curve with the x-axis, which is the MC curve. The quantity in equilibrium is lower than that before. 4-29. The accompanying chart presents data on the price of fuel oil, the quantity demanded of fuel oil, and the quantity demanded for insulation. 4-18 Chapter 04 - Demand Fuel Oil Price per gallon Quantity demanded (Millions of gallons) $3.00 100 $5.00 90 $7.00 60 Insulation Quantity demanded (Millions of tons) 30 35 40 a. Calculate the price elasticity (arc-elasticity) of demand for fuel oil as its price rises from 30 cents to 50 cents; from 50 cents to 70 cents. Calculate the change in total revenue in the two cases. Explain how the changes in revenue relate to your estimated elasticities. = 0.2105 for price change from 30 cents to 50 cents =1.2 for price change from 50 cents to 70 cents Total revenue increases (decreases) with a price increase when demand is inelastic (elastic). This is what happens here. Revenue increases in the first case ($3,000 to $4,500) and falls in the second case ($4,500 to $4,200). b. Calculate the arc cross-elasticity of demand for insulation as the price of fuel oil rises from 50 cents to 70 cents. Are fuel oil and insulation substitutes or complements? Explain. Q = 0.2 > 0, fuel oil and insulation are substitutes since the crosselasticity is greater than zero. Higher fuel oil prices lead to an increase in demand (and consumption) for insulation. PI fuel 4-30. Japan has 4,350 miles of expressway all toll roads. In fact, the tolls are so high that many drivers avoid using expressways. A typical 3 hour expressway trip can cost $47. A new $12 billion bridge over Tokyo Bay that takes 10 minutes and costs $25 rarely is busy. One driver prefers snaking along Tokyos city streets for hours to save $32 in tolls. 2 Assume that the daily demand curve for a particular stretch of expressway is: P = 800 yen - .16 Q. 2 J. Singer (2003), Lonesome Highways: In Japan, Big Tolls Drive Cars Away, Wall Street Journal (September 15), A1 and A15. 4-19 Chapter 04 - Demand a. At what price-quantity point does this demand curve have a price elasticity of one? With a linear demand curve, unitary price elasticity occurs at the midpoint of the demand curve. Recall, this is the point where marginal revenue equals zero. To derive the MR curve, take twice the negative slope, MR = 800 yen - .32 Q = 0 .32 Q = 800 Q = 2500 P = 800 -.16 (2500) P = 400 yen Alternatively, you can derive the midpoint of the demand curve by taking half the intercept (800 yen), or P = 800/2 = 400 and solve for Q when P = 400 = 800 -.16 Q. In this case, we get .16 Q = 400, or Q = 2500. b. Assume the government wishes to maximize its revenues from the expressway, what price should it set? And how much revenue does it generate at this price? Maximum revenue occurs at unitary price elasticity, P= 400 yen and Q = 2500 cars. Total Revenue = P Q = 1,000,000 yen per day c. Suppose that traffic engineers have determined that the efficient utilization of this particular toll road is 4,000 cars per day. This traffic level represents an optimum tradeoff between congestion (with its associated reduction in speeds and increase in accidents) between expressways and surface roads. If 4,000 cars per day is the socially efficient utilization of the toll road, what price should be set on the toll road? And how much revenue is collected by the government? If 4,000 cars per day is the socially efficient utilization of the expressway, then the price should be: P = 800 yen - .16 (4000) P = 160 yen Revenue = P Q = 640,000 yen d. Which price, the one in part b, or the one in part (a) would you expect the government to set? 4-20 Chapter 04 - Demand If the expressway users are organized and have their own special interest lobby, they might put pressure on the government to lower the tolls. On the other hand, government officials looking to reduce budget constraints would like to keep the tolls high, probably closer to the price in part (b), than in part (c). 4-21 Chapter 05 - Production And Cost CHAPTER 5 PRODUCTION AND COST CHAPTER SUMMARY This chapter presents a basic economic analysis of production and cost. Primary topics include production functions, optimal input choice, cost, and profit maximization. The chapter also provides an introduction to cost estimation and factor demand curves. The chapter includes a short case study (Rich Manufacturing). An appendix derives the factor-balance equation. CHAPTER OUTLINE PRODUCTION FUNCTIONS Returns to Scale Managerial Application: Increasing Returns to Scale at Volkswagen Returns to a Factor Managerial Application: Studying for an Examthe Law of Diminishing Returns Managerial Application: Basebals Batting Averages CHOICE OF INPUTS Production Isoquants Managerial Application: Substitution of Inputs in Home Building Isocost Line Managerial Application: General Motors is Shanghaied Cost Minimization Changes in Input Prices Academic Application: Minimum Wage Laws COSTS Cost Curves Managerial Application: Job Seekers Use Internet Production Functions and Cost Curves Managerial Application: Industry Responds to Higher Metals Prices Opportunity Costs Short Run Versus Long Run Fixed and Variable Costs Short-Run Cost Curves Long-Run Cost Curves Managerial Application: DeLorean Automobiles Managerial Application: Public Utilities 5-1 Chapter 05 - Production And Cost Minimum Efficient Scale Managerial Application: Size Doesnt Always Matter Learning Curves Academic Application: Economies of Scale and Learning Effects in the Chemical Processing Industry Economies of Scope Managerial Application: Economies of Scale and Scope in Apartment Management Managerial Application: Economies of Scale and Scope in DSP Production PROFIT MAXIMIZATION FACTOR DEMAND CURVES Managerial Application: China Becomes the Worlds Smokestack Managerial Application: Hog Producers React to Increase in Corn Prices Managerial Application: Demand for Labor Falls Following 9/11 Terrorist Attacks COST ESTIMATION SUMMARY APPENDIX: THE FACTOR-BALANCE EQUATION Slope of an Isoquant Factor-Balance Equation TEACHING THE CHAPTER Chapter 5 reviews the basics of production and costs. Although most students will likely have been exposed to the concepts of short-run and long-run costs of production in previous courses, the graphical and quantitative analysis using isoquants and isocost lines may be new for some students. Students typically grasp these concepts more quickly than the consumer choice tools presented in chapter 2, however, instructors will want to review the key concepts and several quantitative examples to be sure students understand the material. In particular, returns to scale are given extensive coverage in the chapter and students are less likely to be familiar with these concepts. Instructors will need to spend varying amounts of time on this chapter based on the backgrounds of the students in the course and the goals of the course. There are numerous Self-Evaluation Problems and Review Questions that can be assigned to determine whether students understand the concepts and quantitative tools presented in the chapter. Instructors will likely want to review several of these questions before assigning the Analyzing Managerial Decisions scenarios. There are also numerous Managerial Applications that have non-technical examples of the concepts that can be used to generate class discussion. 5-2 Chapter 05 - Production And Cost There are three Analyzing Managerial Decisions scenarios presented in this chapter. The first, Choosing the Mix of People and Machines to Ticket Airline Customers, is a quantitative scenario asking students to calculate and graph the costs of production. The problem then also asks students consider what other factors should be considered before making a decision about the optimal mix of inputs. In the second scenario, Developing Economies of Scale for Malaysias Proton Holdings, students must apply the concept of economies of scale and determine what actions the company needs to take to achieve economies of scale. The third scenario, Rich Manufacturing, asks students to evaluate how a manager should respond to a price increase that results from a pricing policy of cost-plus pricing. Students are asked to consider both short run and long run implications. (See the Solutions Manual for the answers to these problems). REVIEW QUESTIONS 51. Distinguish between returns to scale and returns to a factor. Returns to scale refers to the relation between output and a proportional variation of all inputs taken together. Returns to a factor refers to the relation between output and the variation in only one input, holding all other inputs fixed. 52. Your company currently uses steel and aluminum in a production process. Steel costs $.50 per pound, and aluminum costs $1.00 per pound. Suppose the government imposes a tax of $.25 per pound on all metals. What affect will this have on your optimal input mix? Show using isoquants and isocost lines. It is likely to shift the optimal mix toward using more aluminum. The $0.25 per pound tax is a larger percentage tax on steel. Thus, the price of steel has increased relative to the price of aluminum. The graphic analysis is similar to Figure 5.7. The original isocost line has a slope of -.5/1 = -.5. The slope of the isocost line after the tax is -(.5+.25)/(1+.25) = -.6. The optimal input mix to produce any given quantity of output now uses more aluminum and less steel. Note: The chapter concentrates on the substitution effect and does not go into detail about scale effects. In a more in-depth analysis, one would consider changes in the scale of output that also might accompany an increase in input prices. 53. Your company currently uses steel and aluminum in a production process. Steel costs $.50 per pound, and aluminum costs $1.00 per pound. Suppose that inflation doubles the price of both inputs. What affect will this have on your optimal input mix? Show using isoquants and isocost lines. 5-3 Chapter 05 - Production And Cost If inflation has the same percentage effect on both inputs, there is no change in relative prices. Thus, there is no change in the optimal input mix to produce any given output. A graphical picture such as Figure 5.7 remains unchanged. 54. Is the "long-run" same the calendar time for all firms? Explain. No. The short run is the operating period during which at least one input is fixed in supply. In the long run, no inputs are fixed. These definitions are not based on calendar time. Rather, the length of each period depends on how long it takes the firm to vary all inputs. This time can vary across firms. 55. You want to estimate the cost of materials used to produce a particular product. According to accounting reports, you initially paid $50 for the materials that are necessary to produce each unit. Is $50 a good estimate of your current production costs? Explain. The historical cost is not necessarily a good estimate of current production cost. The relevant cost is the current opportunity cost of the materials. 56. Suppose that average cost is minimized at 50 units and equals $1. What is marginal cost at this output level? It is $1. Marginal equals average when the average is at a minimum. 57. What is the difference between economies of scale and economies of scope? Economies of scale involve efficiencies from producing higher volumes of a given product, while economies of scope involve cost savings that result from joint production. 58. What is the difference between economies of scale and learning effects? Economies of scale imply reductions in average cost as the quantity being produced in the production period increases. Learning effects imply a shift in the entire average cost curve (the average cost for producing a given quantity in a production period decreases with cumulative volume). 59. Suppose that you can sell as much of a product as you want at $100 per unit. Your marginal cost is: MC = 2Q. Your fixed cost is $50. What is the optimal output level? What is the optimal output, if your fixed cost is $60? 5-4 Chapter 05 - Production And Cost Setting the marginal revenue of $100 equal to the marginal cost, yields an optimal output of 50 units. The optimal output does not depend on the fixed cost. In either case, it makes sense to continue to operate and the optimal output is 50. 510. Discuss two problems that arise in estimating cost curves. Statistical problems, such as omitted-variables problems (discussed in chapter 4) can arise in cost estimation. Among the most common problems in cost estimation are difficulties in obtaining data on the relevant costs. Accounting costs are often poor estimates of the opportunity costs of resources. 511. Suppose that the marginal product of labor is: MP = 100 L, where L is the number of workers hired. You can sell the product in the marketplace for $50 per unit and the wage rate for labor is $100. How many workers should you hire? You want to hire workers up to the point where the marginal revenue product equals the wage rate. The marginal revenue product in this example is $50 MP = 5000 - 50L. Setting this expression equal to $100 and solving for L indicates that it is optimal to hire 98 workers. The 98th worker brings $100 of incremental revenue into the firm. This figure equals the marginal cost of the employee ($100). 512. Textbook writers typically receive a simple percentage of total revenue generated from book sales. The publisher bears all the production costs and chooses the output level. Suppose the retail price of a book is fixed at $50. The author receives $10 per copy, and the firm receives $40 per copy. The firm is interested in maximizing its own profits. Will the author be happy with the book company's output choice? Does the selected output maximize the joint profits (for both the author and company) from the book? 5-5 Chapter 05 - Production And Cost The author will not be happy with the companys output choice. The author wants to maximize the number of copies sold (he does not care about the costs of production). Alternatively, the publisher will want to produce an output where its marginal revenue of $40 equals its marginal cost of production. Thus, under the current contract, the author would prefer a higher output than the publisher. The selected output does not maximize joint profits. To maximize joint profits, the output should be selected where the marginal revenue for both the author and the publisher of $50 is equal to the marginal cost. From the standpoint of joint profit maximization, the publisher selects too low a level of output. This is because the publisher bears all the incremental cost, but only receives a fraction of the incremental revenue. 513. Suppose your company produces one product and that you are currently at an output level where your price elasticity is 0.5. Are you at the optimal output level for profit maximization? How can you tell? No you are not producing an optimal output. Profit maximization cannot occur at a point where the price elasticity is less than 1 (demand is inelastic). Total revenue will increase if output is reduced. Total costs will also decrease. Therefore, profits will rise with a reduction in output (over some range). 514. Semiconductor chips are used to store information in electronic products, such as personal computers. One of the early leaders in the production of these chips was Texas Instruments (TI). During the early period in the development of this industry, TI made the decision to price its semiconductors substantially below its production costs. This decision increased sales, but resulted in near-term reductions in profits. Explain why TI might have made this decision. TI might have wanted to increase sales and thus its cumulative production to obtain a reduction in production costs through learning effects. These learning effects might give TI a competitive advantage over competitors and thus increase future profits. 5-6 Chapter 05 - Production And Cost 515. The AFL-CIO has been a steadfast proponent of increasing the minimum wage. Offer at least two reasons why they might lobby for such increases. One reason is that they might simply be in favor of increasing wages for some minimum wage workers. This support might increase union support among labor and result in future union growth. A second reason is that they favor the increase because it increases the price of low cost non-unionized labor. Increasing the price of this input substitute will increase the demand for higher priced/skilled unionized labor. 516. Mountain Springs Water Company produces bottled water. Internal consultants estimate the companys production function to be Q = 300L2K, where Q is the number of bottles of water produced each week, L is the hours of labor per week, and K is the number of machine hours per week. Each machine can operate 100 hours a week. Labor costs $20/hour, and each machine costs $1000 per week. a. Suppose the firm has 20 machines and is producing its current output using an optimal K/L ratio. How many people does Mountain Springs employ? Assume each person works 40 hours a week. At optimum: M PL = w MPK r 600LK = 20 300L2 10 2K= 2 L K=L If the firm has 20 machines, K= 2000 hours/week 2000 = L L = 2000 hours/week L = 50 people b. Recent technological advancements have caused machine prices to drop. Mountain Springs can now lease each machine for $800 a week. How will this affect the optimal K/L ratio (i.e., will the optimal K/L ratio be smaller or larger)? Show why. 2K = 20 L 8 K=5 L4 5-7 Chapter 05 - Production And Cost Previously Mountain Springs had a K/L ratio of 1. Now, it has increased to 5/4. Thus, the decrease in the price of capital caused the optimal K/L ratio to increase. 517. The Workerbee Company employs 100 high school graduates and 50 college graduates at respective wages of $10 and $20. The total product for high school graduates is 1000 + 100QH, whereas the total product for college graduates is 5000 + 50QC. QH = the number of high school graduates, while QC = the number of college graduates. Is the company hiring the optimal amount of each type of worker? If not, has it hired too many high school or too many college graduates? Explain. No, the MP/Input price ratios for high school and college graduates is as follows: 100/10 = 10 and 50/20 = 2.5. Thus high school graduates yield 10 units per dollar, while the college graduates yield 2.5 units per dollar (on the margin). The company should fire college graduates and hire high school graduates. 5-18. Q 0 1 2 3 4 5 6 7 8 9 TC TFC TVC 500 MC 80 60 50 60 75 95 120 150 185 5-8 AC AFC AVC Chapter 05 - Production And Cost a. Complete the above table. Q 0 1 2 3 4 5 6 7 8 9 TC 420 500 560 610 670 745 840 960 1110 1295 TFC 420 420 420 420 420 420 420 420 420 420 TVC 0 80 140 190 250 325 420 540 690 875 MC NA 80 60 50 60 75 95 120 150 185 AC NA 500 285 203 169 149 140 137 139 144 AFC NA 420 210 140 105 84 70 60 53 47 AVC NA 80 70 63 63 65 70 77 86 97 b. Graph TC, TFC, TVC, MC, AC, AFC, and AVC against Q. The graphs for TC, TFC, and TVC can be included on the same figure. AC, AFC, and AVC should be on a separate graph since they are dollars/unit (versus total dollars). 5-19. Suppose the Jones Manufacturing Company produces a single product. At its current input mix the marginal product of labor is 10 and the marginal product of capital is 20. The per unit price of labor and capital are $5 and $10, respectively. Is the Jones Company using an optimal mix of labor and capital to produce its current output? If not, should it use more capital or labor? Explain. The company is using the optimal mix of labor and capital to produce its current output. At an optimal input mix the marginal-product-to-price ratios are equal for all inputs. This condition implies that you cannot gain by spending less on one input and more on another (the marginal output per dollar is the same for all inputs). In this problem the ratios for both inputs is 2 units/dollar. 5-9 Chapter 05 - Production And Cost 5-20. Suppose the production function of PowerGuns Co. is given by Q = 25LK where Q is the quantity of guns produced in the month, L is the number of workers employed, and K is the number of machines used in the production. The monthly wage rate is $3,000 per worker and the monthly rental rate for a machine is $6,000. Currently PowerGuns Co. employs 25 workers and 40 machines. Assume perfect divisibility of labor and machines. a. What is the current average product of labor for PowerGuns Co.? What is the current marginal product of machines? (Assume 1 unit increase in machines.) The current input mix is L=25 and K=40, so the current output level is Q = 25 25 40 = 25000 AP(L) = Q/L = 25000/25 = 1000 To compute the marginal product of machine, we keep the employment of labor constant, L=25, and increase K by 1 unit, so K=41 and compute the new output level, Q = 25 25 41 = 25625 , thereby the marginal product of machine, MP(K) 25625 25000 = 625. b. Does PowerGuns production function display increasing, decreasing, or constant returns to scale? Explain. The production function displays increasing returns to scale. For example, if PowerGuns double the employment of both labor and machines, i.e., L=50, K=80, we have the new output level Q = 2550 80 =100000 , which is four times as large as the original output. c. What is the total cost of the current production of PowerGuns in a month? What is the average cost to produce a shooting gun? Assuming the number of machines does not change, what is the marginal cost of producing one additional gun? TC = $3000 25 + $6000 40 = $315,000 AC = TC/Q = $315000/25000 = $12.6 5-10 Chapter 05 - Production And Cost To compute the marginal cost, we solve this equation for the new level of labor employment (K is fixed), 25000 + 1 = 25 L 40, we get L = 25.001. So the marginal cost of producing one additional gun is, MC = 0.001 $3000 = $3.00. d. What is the law of diminishing returns? Does this production display this characteristic? Explain. Law of diminishing returns states that the marginal product of a variable factor will eventually decline as the use of the factor is increased also called the law of diminishing marginal product. No, it does not display the characteristics. For example, hold L fixed at 25. The marginal product of K is always 25L = 625 (i.e., for each unit increase in K, Q increases by 625 units). 5-21. Assume Kodaks production function for digital cameras is given by Q = 100(L0.7K0.3), where L and K are the number of workers and machines employed in a month, respectively, and Q is the monthly output. Moreover, assume the monthly wage per worker is $3,000 and the monthly rental rate per machine is $2,000. NOTE: Given the production function, the marginal product functions are MPL = 70(L-0.3K0.3) and MPK = 30(L0.7K-0.7). a. If Kodak needs to supply 60,000 units of cameras per month, how many workers and machines should it optimally employ? Kodak should minimize the total cost of producing the 60,000 cameras, given the production function and input prices. Therefore, it should employ a labor-to-capital ratio such that the following condition holds: MPK / MPL = wK / wL or (30L0.7K-0.7) / (70L-0.3K0.3 ) = 2000 / 3000 When solved for the optimal L/K ratio, the equation yields: 9L=14K, or L=(14/9)*K. The optimal input ratio together with the production target produces a system of two equations in two unknowns (K and L), which has a unique solution. That is: 5-11 Chapter 05 - Production And Cost L=(14/9) K and 60,000 =100(L0.7K0.3) Solving the system using standard techniques yields the optimal quantity of K and L; Kodak should employ L* = 685.04 and K* = 440.38. b. What are the total cost and average cost of producing the quantity given in (a)? The total cost of producing any quantity Q is obtained by using the following accounting equation: TC(Q) = wK K(Q) + wL L(Q). Substituting the data in the question for wK and wL, and those in the previous answer for L(Q) and K(Q), one obtains the total cost of producing 60,000 digital cameras when the optimal K/L ratio is employed: TC = 2000 440.38 + 3000 685.04 = $2,935,880 The average cost of production is simply equal to the total cost divided by the total output. Thus, the average cost for each camera is: AC = $2,935,880/60,000 = $48.93 5-22. For simplicity, throughout this problem, assume labor (L), capital (K), and quantity produced (Q) can be infinitely divided that is, it is fine to hire 3.3 workers, rent 4.7 machines, and/or produce 134.2 units. Answer the following questions, assuming the production function for DurableTires Corp. is Q=L1/3K1/2, where Q is the quantity of tires produced, L is the number of workers employed, and K is the number of machines rented. 5-12 Chapter 05 - Production And Cost a. What is the quantity of tires produced when the company employs 64 workers and 36 machines? When K=36 and L=64, Q=24: 641/3 361/2 = 24 b. What are the average product of labor (L) and the average product of machines (K) when the input mix is the one given above? Clearly and concisely, please explain how you would interpret these numbers. The average product of labor is (24 / 64) = 0.375; the average product of capital is (24/36) = 0.667. Average product of a factor is equal to the total product divided by the number of units of the input considered. The average product of labor (capital) is the average output generated by one unit of labor (capital). c. Continue to assume the input mix given above: What is the marginal product of labor (L), if the number of workers is increased by 1 unit? What is the marginal product of capital (K), if the number of machines is increased by 1 unit, instead? Clearly and concisely, please explain how you would interpret these numbers. The marginal product of a input is the change in total output associated with a one unit change in that input, holding other inputs fixed. L= 64+1; K =36; Q = 24.124; Marginal product of Labor is 24.124 24 =0.124 L= 64; K =36+1; Q = 24.331; Marginal product of Capital is 24.331 24 =0.331 An additional unit of labor (capital) increases production by 0.124 (0.331) units. d. Does DurableTires production function display increasing, decreasing, or constant returns to scale? Explain. Would your answer change, if the production function were Q=L1/2K1/2? How? Explain. If we increase all the inputs by one percent: L=64.64; K=36.36. Output increases to 24.199, which represents a 0.83 percent increase from the original output of 24 units. Thus, output increases less then proportionally when all the inputs are increased by the same proportion, which implies that the production function displays decreasing returns to scale. 5-13 Chapter 05 - Production And Cost If production function were Q = L1/2K1/2, then L= 64 and K = 36 results in Q = 48; and L= 64.64 and K = 36.36 results in Q = 48.48, which corresponds to a 1 percent increase in output. Therefore, the production function in this case (Q = L1/2K1/2) displays constant returns to scale, as output increases proportionally when all the inputs are increased by the same proportion. e. Does DurableTires production function display increasing, decreasing, or constant returns to labor? Explain. Would your answer change, if the production function were Q=L1/2K1/2? How? Explain. If we increase labor input by 1 percent, L= 64.64 and K = 36 results in Q = 24.08, which represents a 0.33 percent increase in output. Thus, the production function displays decreasing returns to scale to labor, since output increases less than proportionally as we increase the use of labor. If the production function were Q = L1/2K1/2, L= 64 and K = 36 results in Q = 48, while L= 64.64 and K = 36 results in Q = 48.24 which represents a 0.50 percent increase in output. Therefore, in this case also, the production function (Q = L1/2K1/2) displays decreasing returns to labor. 5-23. Answer the following questions, continuing to assume the production function for DurableTires Corp. is Q=L1/3K1/2, where Q is the quantity of tires produced, L is the number of workers employed, and K is the number of machines rented. Moreover, assume the wage per unit of labor (wL) is $50 and the rental price per machine is $200 (wK). a. What is the total cost of producing the quantity of tires you found in your answer to question (5-23)? And the average cost? Assuming the number of machines rented does not change, what is the marginal cost of producing one additional tire? Given that wL = $50 and wK = $200, the Total Cost of producing 24 units of output is (6450)+(36200) = $10,400. The Average Cost is (10,400/24=) $433.33. For the calculation of Marginal Cost it is assumed that K cannot be immediately changed (K=36). To increase production by one unit, Q = 24+1, given K = 36 and Q = L1/3*K1/2, L must increase to 72.34. Then, the Total Cost becomes ((72.3450)+(36200) =) $10,817. Thus, the Marginal Cost of producing one additional unit is (10,817 - 10,400 =) $417. 5-14 Chapter 05 - Production And Cost b. Given the production function above, the marginal product of labor and the marginal product of capital are MPL= 1/3(L-2/3K1/2) and MPK=1/2(L1/3K-1/2), respectively. Given the wage and rental rate above, is DurableTires Corp. adopting an optimal input mix to produce the quantity of tires found in question (5-23a)? If yes, why? If not, why not, and how could DurableTires Corp. save money producing that same quantity of tires? Explain. In order to achieve cost minimization, a company has to choose the input mix such that the slope of the isoquant is equal to the slope of the isocost line. That is: -MPL / MPK = - PL / PK where, given the production function and the input prices, MPL / MPK = 0.125 / 0.333 = 0.375 PL / PK = 50 / 200 = 0.25 In order to increase profitability for an output of 24 units, one needs to determine the optimal quantity of K and L that, given Q = L1/3K1/2, will yield Q = 24. Then, using the optimal (L,K) combination, and given that wL = $50, and wK = $200, one can calculate the minimum cost of production for 24 units of output. When we plot L and K quantities against cost of production (see graph below) we see that cost of production decrease along the arrows indicated in the graph. The minimum total cost is achieved when L=81.6 and K=30.6. You can get this by solving L and K from the two equations (1) MPL / MPK = 0.25 = PL / PK and (2) 24 = L1/3*K1/2. Intuitively, the ratio of the MPK and MPL was too big, increasing the denominator and decrease the numerator would make the ratio approach 0.25. Doing so implies employing more L and less K. The total cost of producing 24 units with this input mix is $10,203, which is less than the $10,400 calculated earlier, when the company employs L=64 and K= 36. Notice that using (L,K) = ( 81.6 , 30.6 ): 5-15 Chapter 05 - Production And Cost MPK = 0.390 MPL = 0.098 MPL/MPK = 0.25 = PL/PK c. What happens to the optimal input mix you found in question (5-23) if the government introduces a tax that raises the cost of labor to $150 per worker? Explain. After a tax on labor is introduced, workers become relatively more expensive. Thus, for the same output level, the company will shift toward an input mix that is relatively more capital intensive than the original one. 5-16 Chapter 05 - Production And Cost L 5-24. Assume DurableTires Corp. faces the following demand curve, P=250 0.1Q. If DurableTires marginal cost is constant at $35, how many tires should it produce in order to maximize its profits? Whats DurableTires profit in this case? Should the elasticity of demand be greater, equal, or less than 1 at the profit-maximizing price and quantity? Explain (hint: you may use a graph to support your argument). The demand is P = 250 0.1* Q, and the marginal cost is MC = $35. Thus: TR = Q(250 0.1 Q) And MR = 250 20.1Q. For profit maximization, a firm needs to ensure that MR = MC. That is: 250 20.1Q = 35 Q = 1,075 The firm should charge P=$142.5 for this quantity. And the profit will be: 5-17 Chapter 05 - Production And Cost Profit = (142.5 35)1,075=$115,562.5 Because this is the profit maximizing quantity for a firm having a positive marginal cost, the elasticity of demand should be greater than 1. See next graph. Price $250 $142.5 $35 MC 0 MR 2,500 5-18 Quantity Chapter 06 - Market Structure CHAPTER 6 MARKET STRUCTURE CHAPTER SUMMARY This chapter presents an economic analysis of market structure. It starts with perfect competition as a benchmark. Potential barriers to entry, that might limit competition, are examined. Subsequently, the chapter analyzes monopoly, monopolistic competition, and oligopoly. The chapter provides a brief introduction to elementary game theory. (Chapter 9 provides a more comprehensive treatment of game theory.) CHAPTER OUTLINE MARKETS COMPETITIVE MARKETS Firm Supply Short-Run Supply Decisions Long-Run Supply Decisions Competitive Equilibrium Strategic Considerations Managerial Application: Entry in Low Carb Food Superior Firms Academic Application: Phantom Freight BARRIERS TO ENTRY Incumbent Reactions Specific Assets Scale Economies Reputation Effects Excess Capacity Historical Application: Excess Capacity at ALCOA Managerial Application: Entry in Consumer Electronics Incumbent Advantages Precommitment Contracts Licenses and Patents Learning-Curve Effects Pioneering Brand Advantages Exit Costs Managerial Application: Government Restrictions on Exit MONOPOLY Profit Maximization Unexploited Gains from Trade 6-1 Chapter 06 - Market Structure MONOPOLISTIC COMPETITION Managerial Application: Monopolistic Competition in Golf Balls OLIGOPOLY Nash Equilibrium Output Competition Price Competition Managerial Application: Price Wars Empirical Evidence Cooperation and the Prisoners Dilemma Prisoners Dilemma Cartels Managerial Application: Collusion in the Lysine Industry SUMMARY TEACHING THE CHAPTER Chapter 6 focuses on market structure, a concept that students must understand so they can properly assess the business environment, which is an important component of the analysis presented in later chapters of the text. There are several key concepts in this chapter that will be referred to throughout the book. Most of the material in this chapter is likely to be review, so instructors can determine the appropriate mix of class discussion and problem solving that is needed for their students and the goals of the course. The basics of game theory are presented in this chapter using the prisoners dilemma. The Self-Evaluation Problems are graphical and quantitative in nature, serving as a good review of the tools presented in the chapter. The Review Questions provide a good review of the characteristics of market structure and other main concepts in the chapter. There are several questions that provide additional review of the quantitative and analytical concepts presented in the chapter and a few questions that review the concept of a Nash Equilibrium, which is covered more fully in Chapter 9. There are three Analyzing Managerial Decisions scenarios presented in this chapter. The first, United Airlines, asks students to evaluate the costs of production and determine which costs are most relevant in determining whether the airline should continue to run a particular flight. The second, Pricing and Investment Decisions, is a quantitative scenario that asks students to determine the profit-maximizing output for a good and to consider how short-run capacity constraints might affect their choice of output. Students are also asked to consider how they might behave in the long-run in this industry. The third scenario Entry Decision asks students to evaluate how they would behave as a Cournot competitor including determining whether there a first-mover advantage exists in the market. (See the Solutions Manual for the answers to these problems). 6-2 Chapter 06 - Market Structure REVIEW QUESTIONS Note: Questions 6-2, 6-7, and 6-8 require knowledge about the relation between the area under the marginal cost curve and total costs. This relation is not examined in detail in the book. An instructor should review this relation in class before assigning these problems. 61. What four basic conditions characterize a competitive market? 62. A large number of either actual or potential buyers and sellers. Product homogeneity. Rapid dissemination of accurate information at low cost. Free entry and exit in the market. The short-run marginal cost of the Ohio Bag Company is 2Q. Price is $100. The company operates in a competitive industry. Currently, the company is producing 40 units per period. What is the optimal short-run output? Calculate the profits that Ohio Bag is losing through suboptimal output. The optimal short-run output is where marginal cost = marginal revenue (in this case price). Therefore, the optimal output is 50 units. Current profits are TR - TC = $4,000 - $1,600 = $2,400. Note: assuming no fixed costs, total costs are equal to the area under the marginal cost curve (area = 1/2BH). Profits with optimal output = $5,000 - $2,500 = $2,500. The firm is forgoing $100 through suboptimal output choice. 63. Should a company ever produce an output if the managers know it will lose money over the period? Explain. The firm should operate in the short run, as long as it obtains enough revenue to cover its variable costs. Revenue in excess of variable costs helps to cover fixed costs (which are incurred even if the firm does not operate). 6-3 Chapter 06 - Market Structure 64. What are economic profits? Does a firm in a competitive industry earn long-run economic profits? Explain. Economic profits are abnormal profits (profits above what it takes to entice investment in the industry). Firms in a competitive industry can earn economic profits in the short run. The existence of economic profits will attract entry into the industry. Thus, firms are unlikely to earn economic profits over a long time period. Even in relatively competitive industries, however, there are firms that do exceptionally well over long time periods, for example by being the low-cost producer or having some particular advantage relative to competitors, such as location. These are inframarginal rents (not monopoly rents). The excess returns often do not go to the owner of the enterprise, but rather to the factor input that produces the particular advantage. We discuss these issues in greater detail in Chapter 8. 65. The Johnson Oil Company has just hired the best manager in the industry. Should the owners of the company anticipate economic profits? Explain. No. The excess returns are likely to go to the manager. The managers salary will be bid up by other firms who want the managers services. 66. A Michigan Court ruled in the 1990s that General Motors did not have the right to close a particular Michigan plant and lay people off. Do you think this ruling benefited the people of Michigan? Explain. It might have benefited some Michigan people in the short run (for example, the employees at the plant). Over the long run, the ruling might have significant negative effects. In particular, companies will be less likely to invest in new plants in the state if they think that they will not be free to close them should the plants prove to be unprofitable. This reduction in investment can hurt people in the state (for example, by providing less future employment and a lower tax base). 67. The Suji Corporation has a monopoly in a particular chemical market. The industry demand curve is P = 1,000 5Q. Marginal cost is 3Q. What is Suji's profit-maximizing output and price? Calculate the corresponding profits. The optimal output of 76.92 is found by setting MR = MC: 1000 - 10Q = 3Q. The corresponding price of $615.40 is found from the demand curve. The profits are TR - TC = $47,336.57 - $8,875.03 = $38,461.54. Note: we are assuming that there are no fixed costs. Thus, total cost is the area under the marginal cost curve. 6-4 Chapter 06 - Market Structure 68. Assume the industry demand for a product is: P = 1,000 - 20Q. Assume that the marginal cost of product is $10 per unit. a. What price and output will occur under pure competition? What price and output will occur under pure monopoly (assume one price is charged to all customers)? Price equals marginal cost under pure competition. Thus, price = $10 and quantity = 49.5. The monopolist will set marginal revenue (1000 - 40Q) equal to marginal cost. The corresponding price and quantity are $505 and 24.75. b. Draw a graph that shows the lost gains from trade that result from having a monopoly. The graph is the same as in Figure 6.5 (except that a different demand curve is used). 69. In 1981, the United States negotiated an agreement with the Japanese. The agreement called for Japanese auto firms to limit exports to the United States. The Japanese government was charged with helping make sure the agreement was met by Japanese firms. Were the Japanese firms necessarily hurt by this limited ability to export? Explain. No. The limit on exports might have helped to support a higher price for Japanese automobiles in the United States. The governments might be viewed as helping the Japanese firms to support a cartel to limit quantity and increase price (that is, to reach the monopoly solution). 610. Compare the industry output and price in a Cournot versus a competitive equilibrium. Do firms earn economic profits in the Cournot model? Does economic theory predict that firms always earn economic profits in oligopolistic industries? Explain. What does the empirical evidence indicate? Output is lower and price is higher in the Cournot equilibrium. Firms earn economic profits in the Cournot equilibrium (unless the number of firms is large). Economic theory does not predict that firms will always earn economic profits in oligopolistic industries. For example, if the firms compete on price rather than quantity), the result can be the competitive outcome and no economic profits are earned. The empirical evidence indicates that firms in some oligopolistic industries earn economic profits. 6-5 Chapter 06 - Market Structure A Nash equilibrium is a set of actions (or strategies) such that each player is doing the best it can given the actions of its opponents. A joint confession is the Nash equilibrium in the prisoners dilemma. Given one person confesses, it is in the interests of the other party to confess as well (indeed, confession is a dominant strategy it is in a players interest to confess no matter what the other player does.) 6-12. Candak Corporation produces professional quality digital cameras. The market for professional digital cameras is monopolistically competitive. Assume that the inverse demand curve faced by Candak (given its competitors prices) can be expressed as P = 5,000 - .2Q and Candaks total costs can be expressed as TC = 20,000,000 + .05Q2. Answer the following questions. a. What price and quantity will Candak choose? To find the optimal price and quantity, we set marginal revenue equal to marginal cost. Marginal revenue equals 5000 - .4Q (the derivative of total revenue) and marginal cost equals .1Q (the derivative of total cost). Setting these equal and solving for Q yields: 5000 - .4Q = .1Q .5Q = 5000 Q = 10,000 Plugging this quantity into the demand curve gives us the price as follows: P = 5000 - .2(10,000) P = $3,000 b. Is this likely to be a long-run equilibrium for Candak Corporation? Whyor why not? If not, what is likely to happen in the market for professional digital cameras, and how will it affect Candak? Since the market is monopolistically competitive, this will not be a long-run equilibrium. To see this, first note that Candaks average cost at the equilibrium point above can be expressed as: 20,000,000/Q + .05Q = 2000 + 500 = $2500 Since price ($3000) is above average cost, the firm is making a positive economic profit. Since entry is possible in a monopolistically competitive market, these profits will attract entry by other firms. This will reduce demand for Candaks products (shift its demand curve to the left). In the long run, Candak should be expected to produce at a point where price equals (long run) average cost and there is no economic profit. 6-6 Chapter 06 - Market Structure 613. Will a monopolist ever choose to produce on the inelastic portion of its demand curve? Explain. No. If a monopolist is producing on the inelastic portion of its demand curve, it can increase revenue by increasing price. The corresponding decrease in quantity also implies that costs will decrease. Recall that with a linear demand curve, marginal revenue equals zero at the midpoint of the demand curve, which is also the point at which total revenue is maximized and the elasticity of demand is equal to 1. Since marginal cost will not be negative, the point at which marginal revenue equals marginal cost must occur at or to the left of this point (since marginal revenue is decreasing in quantity). It is also true that the elasticity of demand is always greater than 1 to the left of this point. 6-7 Chapter 07 - Pricing With Market Power CHAPTER 7 PRICING WITH MARKET POWER CHAPTER SUMMARY This chapter extends the analysis in previous chapters to examine pricing decisions in greater detail. It starts by reviewing the benchmark case of charging one price to all customers. It then examines more sophisticated pricing policies that can be used to increase profits. CHAPTER OUTLINE PRICING OBJECTIVE BENCHMARK CASE: SINGLE PRICE PER UNIT Profit Maximization Relevant Costs Price Sensitivity Estimating the Profit-Maximizing Price Linear Approximation Cost-Plus Pricing Markup Pricing On the Importance of Assumptions Potential for Higher Profits Managerial ApplicationParker Hannifin Increases Profits by Adopting and Economically Sound Pricing Policy Managerial ApplicationMicrosofts Market Power and Pricing HOMOGENEOUS CONSUMER DEMANDS Block Pricing Managerial ApplicationBlock Pricing at Hickey-Freeman Two-Part Tariffs PRICE DISCRIMINATION HETEROGENEOUS CONSUMER DEMANDS Managerial ApplicationTwo-Part Pricing for Capital Goods Managerial ApplicationAs Cigarette Prices Soar, A Gray Market Booms Exploiting Information about Individual Demands Personalized Pricing Managerial ApplicationTuition Pricing Group Pricing Managerial ApplicationVirtual Vineyards Managerial ApplicationPricing of Books Using Information about the Distribution of Demands Menu Pricing Coupons and Rebates Managerial ApplicationHarry Potter: An Example of Price Discrimination 7-1 Chapter 07 - Pricing With Market Power BUNDLING Managerial ApplicationBudling Videogames OTHER CONCERNS Multiperiod Considerations Future Demand Managerial ApplicationEarly Use of the Free Sample Managerial ApplicationApple Apologizes for Its Pricing of iPhones Future Costs Storable Products Strategic Interaction Legal Issues Managerial ApplicationMarket Segmentation Managerial ApplicationApple Settles Antitrust Case by Lowering iTune Prices in Britain IMPLEMENTING A PRICING STRATEGY SUMMARY TEACHING THE CHAPTER A popular teaching tool is to ask students to discuss during class several examples of alternative pricing schemes they encounter and then discuss the characteristics of these goods, and their markets, that allow for such pricing schemes to exist. This exercise provides a good opportunity to relate back to the material earlier in the text on the topic of demand and elasticity. The Managerial Applications throughout the chapter are also good discussion starters. This chapter presents many topics that are usually of interest to students. Students often recognize that the single-price model presented in chapter 6 does not apply for many of the goods they purchase so they are typically interested in understanding how alternative pricing schemes can be implemented. The material is relatively straightforward, however, some students might struggle with the mathematical examples in the text. Instructors will want to spend more or less time on this content based on the relevance to their particular course and their students backgrounds. The Self-Evaluation Problems or the Review Questions, both located at the end of the chapter, could be assigned as a group exercise during class to determine whether students understand the material (particularly the mathematical questions), or could be covered during class by the instructor. There are three Analyzing Managerial Decisions scenarios in this chapter. The first, Profit Potential for a Microbrewery, asks students to calculate the profit-maximizing price when only a single price is charged to all customers and then asks students to consider alternative pricing policies that might increase profits. This scenario is a relatively straight-forward application of microeconomic theory, particularly for students with prior coursework in intermediate microeconomics or managerial economics. 7-2 Chapter 07 - Pricing With Market Power The second scenario, Cell Phone Pricing, focuses on implementing a pricing scheme when the seller is unable to distinguish high demand customers from relatively low demand customers. The goal is to have customers self-select into the appropriate monthly cell phone plan. This problem is more complex than the first scenario, so instructors may want to cover a problem of this type in class or assign such a problem as a group assignment. The final scenario, iTunes Music Pricing, is a comprehensive problem asking students to consider many of the key concepts in the chapter. Students are asked to consider not only what pricing schemes might currently be offered but also to consider how the strategy might change in the future. (See the Solutions Manual for the answers to these problems). REVIEW QUESTIONS 71. Macrosoft is a new producer of word processing software. Recently it announced it is giving away its product to the first 100,000 customers. Using the concepts from this chapter, explain why this might be an optimal policy. There are often network externalities for software products--demand is higher when there are more users. Given that people exchange documents, it is advantageous to use compatible software. Therefore, Macrosoft might be giving the product away to create a large base of users to increase future demand. With higher demand it will be able to charge higher prices. It is also expensive for a person to change software programs (having to learn new commands, etc.). The company may be trying to encourage people to switch so that they will be locked in when it comes to purchasing new editions. Users will be willing to pay a somewhat higher price for the new edition rather than switching to a new product because of the switching costs. 72. The local space museum has hired you to assist them in setting admission prices. The museums managers recognize that there are two distinct demand curves for admission. One demand curve applies to people ages 12 to 64, whereas the other is for children and senior citizens. The two demand curves are: PA = 9.6 0.08QA PCS = 4 0.05QCS, where PA is the adult price, PCS is the child/senior citizen price, QA is the adult quantity, and QCS is the child/senior citizen quantity. Crowding is not a problem at the museum, so managers consider marginal cost to be zero. 7-3 Chapter 07 - Pricing With Market Power a. What price should they charge to each group to maximize profits? Adults Children/Senior Citizens 9.6 - .16QA = 0 4 .1QCS = 0 QA = 60 QCS = 40 PA = 9.6 0.08 60 PCS = 4 0.05 40 PA= $4.8 PCS = $2 Set MR = MC Find Price b. How many adults will visit the museum? How many children and senior citizens? 60 adults 40 children and senior citizens c. What are the museums profits? Profits = TR TC = 4.8 60 + 2 40 - 0 = $368 73. Textbook publishers have traditionally produced both United States and international editions of most leading textbooks. The United States version typically sells at a higher price than the international edition. (a) Discuss why publishers use this pricing plan. (b) Discuss how the Internet might affect the ability of companies to implement this type of policy. a. The demand for textbooks in certain foreign markets is more elastic than in the Untied States (i.e., consumers are more price sensitive). The policy is likely a form of price discrimination (group pricing). b. The internet potentially makes it more likely that books sold outside of the United States will be resold in the United States, thus making it more difficult to sustain price differentials (consider the example of cigarettes in the text). A necessary condition for price discrimination is the ability to limit resale among consumers. 7-4 Chapter 07 - Pricing With Market Power 74. Suppose in Table 7.2 (Product Bundling) that the professional user values Expedia Streets at $15 rather than $30. Keep all other valuations the same. Discuss how this change affects the optimal pricing strategy. In this case there are no gains from bundling. The sum of the minimum reservation price is the same as the minimum reservation price for the bundle. To sell both products to both types of users you can either set the prices at $15 and $10 for Streets and Planner respectively, or price the bundle at $25. Profits are the same in either case. 75. Explain why perfect personalized pricing is typically more profitable than menu pricing. Why then do companies use menu pricing? In the limit, personalized pricing extracts the maximum profit from each consumer. With menu pricing, typically some of the consumers obtain surplus. If the firm tries to extract the maximum surplus from each customer by pricing menu options in a particular way, some of the consumers are likely to be able to select different options to obtain surplus. This ability to self-select from the menu typically makes it impossible to extract all consumer surplus. 76. In the example in this chapter, the linear approximation method produced the profit-maximizing price, whereas the markup pricing rule did not. Does this imply that the linear rule is always better than the markup rule? Explain. In the example, the underlying demand curve was linear. Thus, the linear approximation method worked well (perfectly). If the demand curve is highly nonlinear the technique will not work well. If the demand curve is isoelastic (or if the current elasticity is close to that at the optimal price), the markup pricing rule will dominate. 77. Why do companies grant discounts to senior citizens and students? Presumably, it is a form of price discrimination. Senior citizens and students are likely to have more elastic demand for products than the average consumer. Thus, it can be optimal to charge them a lower price, while charging other customers a higher price. Note that the other customers are not subsidizing senior citizens and students. All customers are paying at least marginal cost for the product. 7-5 Chapter 07 - Pricing With Market Power 78. You own a theater with 200 seats. The demand for seats is Q = 300 100P. You are charging $1.25 per ticket and selling tickets to 175 people. Your costs are fixed and do not depend on the number of people attending. Should you cut your price to fill the theater? Explain. What other pricing policies might you use to increase your profits? Revenue is maximized at the point where marginal revenue equals zero. In this problem, MR = 3 - .02Q. Thus, it is optimal to sell 150 tickets at a price of $1.50 a ticket. This policy produces $225 in revenue. The current policy produces $218.75 in revenue. The theater might be able to increase revenue through price discrimination. For example, it might price tickets to the general public at $1.50. It could then entice other people who are not willing to pay the $1.50 through policies such as senior citizen or student discounts. 79. The Snow City Ski Resort caters to both out-of-town skiers and local skiers. The demand for ski tickets for each market segment is independent of the other market segments. The marginal cost of servicing a skier of either type is $10. Suppose the demand curves for the two market segments are: Out of town: Qo = 600 - 10P Local: Ql = 600 - 20P a. If the resort charges one price to all skiers, what is the profit-maximizing price? Calculate how many lift tickets will be sold to each group. What is the total profit? Add the two demand curves together to get the total demand curve: Q = 1200 - 30P. Note: at prices above $30 the local customers will not buy any tickets and so the total demand curve for prices above $30 is simply the out-of-town demand curve. Rearrange the demand curve so that price is on the left side of the equation. The optimal number of tickets sold is found by setting marginal revenue (40 .0333Q) equal to marginal cost ($10). Price can be found by substituting this quantity into the demand curve. The optimal quantity is 450 tickets (100 local; 350 nonlocal), price = $25, and profits = $6,750. b. Which market segment has the highest price elasticity at this outcome? The local skiers have more elastic demand. The point elasticity for the localskier market is 5 versus .714 for the out-of-town market. Note: point elasticities are covered in the appendix to chapter 4; the student could also calculate arc elasticities. 7-6 Chapter 07 - Pricing With Market Power c. If the company sells tickets at different prices to the two market segments, what is the optimal price and quantity for each segment? What are the total profits for the resort? To answer this question the student would solve for the optimal quantity in each market by setting marginal revenue in the market equal to marginal cost. Prices are found by substituting these quantities into the relevant demand curves. Profits are found by subtracting the total costs ($10 the number of tickets sold) from total revenue (collected from both markets). Snow City should charge $35 to out-of-town skiers and sell 250 tickets. The price and quantity for local skiers are $20 and 200 tickets. Total profits are $8,250. d. What techniques might the resort use to implement such a pricing policy? What must the resort guard against, if the pricing policy is to work effectively? Snow City might implement the pricing policy by selling tickets to local customers at locations that are not frequented by out-of-town skiers (for example, local super markets). Other techniques also might be feasible. Snow City must guard against resale between local and out-of-town skiers. For example, they might want to make the tickets nontransferable and require an ID. Also, Snow City must worry about out-of-town skiers finding out about the price difference and hence going to the locations that sell discount tickets. To guard against this possibility, Snow City might want only to sell the discount tickets off season when the out-of-towners are not around. 710. All consumers have identical demand for a product. Each person's demand curve is P = 30 2Q. The marginal cost of production is $2. Devise a two-part tariff that will exhaust all consumer surplus. The company could charge marginal cost of $2 and an up-front fee equal to the consumer surplus. At a $2 price, the quantity sold is 14. Consumer surplus is equal to the area of the triangle below the demand curve, but above marginal cost (see Figure 7.5). The resulting up-front charge is $196. 711. Xerox sells both copiers and a toner for their copiers. While customers are not required to buy Xerox toner, most do because specified machines use toner only for that machine. The Xerox toner and machines are closely designed and nonXerox toner in Xerox machines produces inferior copies. Evaluate the statement: Xerox makes 75 percent of its profits selling toner and 25 percent of its profits selling machines. 7-7 Chapter 07 - Pricing With Market Power Presumably Xerox is pricing the two products to maximize total profits. Given the joint nature of the products it is difficult to allocate profits meaningfully between the two products. For example, the toner might be priced above cost to extract additional profits from heavy users who might value Xerox copy machines (which are of relatively high quality) highly. This might be better than simply charging a higher price for copy machines to all buyers. The profits, however, are related to the demand for the copy machines (not just the toner). 712. Some tennis clubs charge an up-front fee to join and a per-hour charge for court time. Others do not charge a membership fee but charge a higher per-hour fee for court time. Consider clubs in two different locations. One is located in a suburban area where the residents tend to be of similar age, income, and occupation. The other is in the city with a more diverse population. Which of the locations is more likely to charge a membership fee? Explain. Two-part pricing is most likely to be optimal when consumers are relatively homogeneous. In this case, the up-front fee will be used to extract the consumer surplus. If demands are heterogeneous, setting a high up-front fee will extract surplus from some customers but discourage potential customers with lower valuations from purchasing the product. Thus, you might expect to see the two-part pricing at the suburban location with a more heterogeneous customer base. 713. Consider three firms: a shoe store at the mall, an automobile dealership, a house painting firm. a. Which firm would you expect to engage in the most price discrimination? Why? House painting firms are in a fairly good position to price discriminate. The product cannot be resold among consumers. The painter has an opportunity to observe the prospective buyer and make an assessment about the willingness to pay before quoting a price. It can be expensive for the buyer to obtain additional quotes (in terms of time). Automobile dealers also are able to judge the willingness to pay before negotiating the final deal. Cars, however, are becoming more of a commodity and it is becoming easier to comparison shop. The typical shoe store quotes a price to all customers and while it can engage in menu pricing, personalized pricing is more difficult. Cars and shoes also can be resold among consumers. b. How has the internet changed the pricing policies of these businesses? 7-8 Chapter 07 - Pricing With Market Power The internet is unlikely to have a large impact on the ability of house painters to price discriminate. However, it could make it easier for the consumer to identify potential painters to make competitive quotes. The internet makes it relatively easy to obtain detailed cost estimates on cars and to obtain prices from a variety of dealers. These factors have made price discrimination more difficult for automobiles. An internet store specializing in shoes has the technology to make certain price options available to consumers based on purchase histories, etc. This might increase the ability to price discriminate. On the other hand it can make it easier to comparison shop, thus limiting market power. 7-14. Cellwave is a cellular phone company. Answer the following questions relating to its pricing policies: a. When Cellwave started out it sold to a group of homogenous retail customers. Each persons monthly demand for cell phone minutes was given by P = $2 .02Q, where P = the price per minute and Q = the quantity of minutes purchased each month. Cellwaves marginal cost is 10 cents per minute. Suppose that Cellwave charges a single per minute price to all customers (independent of the number of minutes they use each month). What is the profit-maximizing price? Depict this choice on a graph. On a per customer basis, what are the companys profit, consumer surplus, and the deadweight loss? Optimal quantity is where MR = MC: 2 - .04Q = .10; Q* = 47.5 minutes; P* = $1.05 per minute; Per customer basis: profit = ($1.05-.10) 47.5 = $45.125; Consumer surplus = 47.5 (2-1.05) = $22.56; DWL = (95 47.5) (1.05 -.10) =22.56; 7-9 Chapter 07 - Pricing With Market Power b. Suppose that Cellwave chooses to charge a two-part tariff (with a monthly fixed charge and a per minute rate) rather than a single per minute price. What twopart tariff extracts the entire consumer surplus? What are the companys profits (on a per customer basis)? How many minutes does each customer use per month? What is the deadweight loss? The optimal two-part tariff will charge 10 cents/minute (the marginal cost) and an upfront fee equal to the entire consumer surplus = (2-.10) 95 = $90.25. The profits are $90.25 per customer. Each consumer uses 95 minutes per month and there is no deadweight loss. c. After several years of operation, Cellwave developed a new group of business customers (in addition to its old customer base). The business customers had homogenous demands. Each of these customers monthly demand for cell phone minutes was given by P = $2 - .004Q. Graph the two demand curves for the two customer groups on the same figure along with the marginal cost. Suppose that Cellwave wants to menu price by offering two plans with different monthly fixed charges. Each plan would allow free calls up to some maximum limit of minutes per month. No calls are allowed beyond these maximums. Assume that Cellwave designs a plan that extracts all consumer surplus from the retail customers. Shade the area of the graph that shows how much consumer surplus must be given to each business customer to make the plan work. Explain why. Each business customer must get at least the area of the abc triangle as consumer surplus or he will not buy the high-end plan. This is the surplus that he would receive if he purchases the low end plan. If the high-end plan is priced too high, he will buy the low-end plan instead and the menu plan will not work. 7-10 Chapter 07 - Pricing With Market Power 7-15. The Hewl-Pact Company produces a popular printer than prints over 100 pages per minute. It recently announced that it was introducing a lower priced model of the printer that can print 30 pages per minute. While not revealed to the public, it turns out that it costs the company more to produce the lower priced product. The two models are identical except for a $20 internal part for the low-priced model that slows the printer from 100 to 30 pages per minute. Provide an economic explanation for why the company decided to produce a new lower priced, but more costly, model of the printer. 7-11 Chapter 08 - Economics Of Strategy: Creating And Capturing Value CHAPTER 8 ECONOMICS OF STRATEGY: CREATING AND CAPTURING VALUE CHAPTER SUMMARY This chapter is the first of two chapters on strategy. It concentrates on the basic ways firms can create and capture value. Chapter 9 uses game theory to study strategic interactions among a small number of identifiable rival firms. Chapter 8 presents a framework for discussing how firms create value. It also discusses the conditions under which a firm can capture value (either by having market power or, in certain cases, having superior factors of production). The economics of diversification are examined, and a framework for strategy formulation is presented. A mini-case (Wal-Mart.com) highlights some of the issues in the chapter and the answers for the associated discussion questions are included below. Most managerial economics books focus on a very limited set of decisions (for example, pricing, input selection and output), taking the market product, and its characteristics, as given; they also assume that a firm produces only one product. This chapter uses basic economic principles to analyze a broader set of corporate policies. CHAPTER OUTLINE STRATEGY VALUE CREATION Production and Producer Transaction Costs Managerial ApplicationDell Computers: Reducing Producer and Consumer Transaction Costs Consumer Transaction Costs Managerial ApplicationCreating Value: Reducing Consumer Waiting Time Managerial ApplicationReducing Consumer Transactions Costs: Kraft Lunchables Managerial ApplicationTerrorist Attacks Affect Value Creation in the Airline Industry Other Ways to Increase Demand Product Quality Price of Complements Historical ApplicationGiving Away Razors to Increase Demand for Blades Price of Substitutes Managerial ApplicationAirlines Restrict Cell Phone Use New Products and Services Managerial ApplicationTechnology and Value Cooperating to Increase Value Managerial ApplicationAdvanced Photo System 8-1 Chapter 08 - Economics Of Strategy: Creating And Capturing Value Converting Organizational Knowledge into Value Managerial ApplicationSonic Drive-Ins Convert Wetware to Software Opportunities to Create Value CAPTURING VALUE Market Power Entry Barriers Historical ApplicationCreating but Not Capturing Value: Eli Whitney Degree of Rivalry Managerial ApplicationCompetition and the Number of Competitors Threat of Substitutes Managerial ApplicationItalian Textiles and Chinese Competition Buyer and Supplier Power Managerial ApplicationSugar Prices Market Power and Strategy Superior Factors of Production Producer Surplus Captured by Superior Assets Second-Price Auctions Team Production Team Capabilities and Organizational Architecture Managerial ApplicationTeam Capabilities at Sharp Corporation Academic ApplicationFlexible Manufacturing and Team Capabilities A Partial Explanation for Wal-Marts Success Managerial ApplicationEconomic Profits without Market Power: A Summary of Key Concepts Managerial ApplicationWalmarts Strategy Proves Timely During the 2007 Holiday Season All Good Things Must End Managerial ApplicationNomura Securities Company: It Is Not Easy to Remake a Business Changing Fortunes Polaroids Success and Ultimate Failure to Capture Value ECONOMICS OF DIVERSIFICATION Benefits of Diversification Economies of Scope Managerial ApplicationWal-Mart Diversifies into the Traditional Grocery Store Business Promoting Complements Costs of Diversification Managerial ApplicationMcFocus at McDonalds Managerial ApplicationProposed Megamerger Collapses in the Drug Industry Management Implications A Faulty Reason to Diversify 8-2 Chapter 08 - Economics Of Strategy: Creating And Capturing Value When Does Diversification Create Value? Managerial Application: Philips Electronics Managerial Application: Diversification Problems at Xerox Who Captures the Gains from Diversification? STRATEGY FORMULATION Understanding Resources and Capabilities Understanding the Environment Managerial ApplicationFaulty Analysis at Kodak Combining Environmental and Internal Analyses Strategy and Organizational Architecture Managerial ApplicationStrategy at Microsoft Managerial ApplicationA Retail Success Story and Luck Academic ApplicationContemporary Approach to Strategy Can All Firms Capture Value? SUMMARY TEACHING THE CHAPTER This chapter is the first in the text to apply the basic tools of microeconomics beyond their traditional applications to illustrate how firms can create value. The chapter relies on the fundamental tools presented in the early chapters (e.g., supply and demand graphs, short-run cost curves, etc.). However, it also makes use of a graph of firms reaction curves which is a more advanced concept. Figure 8.1 is a versatile graph that can be used to illustrate the examples covered in the first section of the chapter on value creation. It would be useful to refer back to this figure when discussing ways to create value and ask students to explain why the curves would change as the textbook suggests. More than any other chapter, this chapter has a plethora of Managerial, Historical, and Academic Applications to illustrate the key points. Rather than lecturing on each of the concepts, these applications can be used to generate class discussion about the topics, which can then be covered more fully in lecture if there are remaining questions. They can also be used to encourage students to find other examples on their own of companies or industries that have had a similar experience. This chapter also refocuses on two important concepts that will be discussed later in the text: teams and organizational architecture. Several parts of this chapter can be reviewed later in the course once these concepts have been covered more fully in later chapters. The textbook authors have suggested a variety of cases that can be used in class to further discuss these concepts. 8-3 Chapter 08 - Economics Of Strategy: Creating And Capturing Value There are three Analyzing Managerial Decisions scenarios presented in this chapter. The first, Investing in a New Restaurant Concept, asks students to evaluate the market structure of the restaurant industry. Many of the relevant concepts are initially presented in Chapter 6, but the students should be sure to incorporate the additional insights they have gained from the material in this chapter. The second scenario, Leaving New York City for the Farmlands of Illinois, asks students to apply several different concepts from the chapter. First, they must identify the market structure of the market they wish to enter. Second, they must consider how they would create and capture value in order to be profitable. This scenario requires the students to fully understand the material to formulate their answer because they must consider how a variety of factors interact to determine the potential profitability of the investment. The final scenario, Walmart.com, provides a comprehensive example for students to work through that applies concepts from the entire chapter. This example would be useful as a group assignment that could also then be used for class discussion. The Self-Evaluation Problems at the end of the chapter will give students an opportunity to determine whether they understand the quantitative aspects of the chapter, while the Review Questions focus more on application of the concepts in the chapter. These Review Questions are quite thorough and could easily be used in class to generate class discussion. REVIEW QUESTIONS 81. Choose a company that markets computer products over the Internet (for example, through a web search). In what ways does the company create value? Is it likely to capture much of this value? Explain. The answer to this question depends on the example developed by the student. Internet companies often create value by reducing transaction costs. In discussing the potential to capture value, the student should focus on the effects of competition and whether this is likely to reduce the ability of the firm to capture profits. 82. Airbus and Boeing are two major producers of jumbo jets. Are these firms guaranteed to make high profits since there are only two large firms in the industry? Explain. No. Even if there are only two firms in the industry, they may compete vigorously to reduce prices and profits. This issue is discussed in more detail in chapter 6, and in particular in chapter 9 (on game theory). 8-4 Chapter 08 - Economics Of Strategy: Creating And Capturing Value 8-3. The Watts Brewing Company owns valuable water rights that allow it to produce better beer than competitors. The company sells its beer at a premium and reports a large profit each year. Is this firm necessarily making economic profits? Explain. No. Its advantage is that it owns a valuable but marketable asset. The firm may be only making normal profits given the opportunity cost of keeping the water rights itself rather than selling them to others in the marketplace. The company is more valuable because it owns the water rights. However, selling the rights to others might be the best way to capture this value. 84. What are team capabilities? Give examples of firms that appear to have them. Because of the interdependencies among workers and assets, the value of the inputs as a team can sometimes be greater than the simple sum of the values if each worker and asset were employed at its next best use across other firms. Thus, it is possible that the overall firm will be more valuable than the sum of its parts. We characterize such a firm as having team production capabilities. Sharp is an example from the book. Many other examples exist. 85. Sun Resorts has a hotel on a Caribbean Island. It recently spent money to lobby the government to build a better airport and expand air service. Why did they do this? Do you think that Sun Resorts cares about how many airlines will serve the island? Explain. Airline service is a complement for Sun Resorts. Cheaper air service to the island increases the demand for Sun Resorts. Thus, Sun Resorts wants better airport service and lower airfares. Lower fares are more likely to result if there are several airlines that compete in serving the island. These concerns are clearly important to Sun Resorts. 8-5 Chapter 08 - Economics Of Strategy: Creating And Capturing Value 86. Evaluate the following statement: Business is war. Never consort with the enemy. Cooperating with competitors can sometimes create value. An example is Kodak and Fuji cooperating to adopt a common standard for the Advanced Photo System. Managers should consider possible cooperation with suppliers, customers, regulators, competitors, etc. in thinking about ways to create value. Also, while certain practices are illegal in certain countries, firms can sometimes capture value by cooperating to increase monopoly power (e.g., forming a cartel). 87. The Long-Drive Golf Company manufactures a new line of golf clubs. The Cushion Bag Company makes a special golf bag that protects the delicate shifts on these clubs. The respective prices are Pc and Pb for the clubs and bags. The marginal cost for producing either product is 100. Demand for each product is Q = 1000 (Pc + Pb) when Pc + Pb is 1,000 or less, 0, otherwise How will the two companies price the products if they do not cooperate? What are the resulting quantities and profits? What are the prices, quantities, and profits if the two companies price cooperatively? Explain why there is a difference. In the noncooperative situation, each firm will take the other firms price as given. Demand for each firm is given by Pj = (1000 Pi*) Q, where Pi* is the expectation of the other firms price. Setting marginal revenue equal to marginal cost of 100 yields an optimal quantity for each firm of Q = 450 - .5 Pi*. Substituting the overall demand curve (Q = 1000 (Pj + Pi)) yields the following reaction curve for each firm: Pj = 550 0.5Pi. In equilibrium, both firms set the same price (since the problem is the same for both firms). The resulting prices are $367 each for the clubs and the bags. The firms sell 267 bags and 267 sets of clubs. Profits are $71,201 for each firm. Note that the answers might vary slightly due to rounding. If the firms price collectively, they will use the combined demand curve PT = 1000 Q, where PT is the combined prices of the two products. The marginal cost of producing the combination is 200. Setting marginal cost equal to marginal revenue yields a combined price of $600 (e.g., $300 for the bags and clubs, respectively). A total of 400 sets of clubs and bags are sold. The combined profits are $160,000, which is greater than the combined profits under independent pricing of $142,402. In the noncooperative situation each firm fails to consider the negative effect that raising its own price has on the other firms demand and profits. In cooperative pricing these cross effects are taken into account. This accounts for the difference in the outcome. 8-6 Chapter 08 - Economics Of Strategy: Creating And Capturing Value 88. One CEO justified the merger of his soft-drink company with a machine tool company in the following manner: This is a great merger. First the products are unrelated. Thus our companys earnings volatility is likely to decrease. Second, our management team has proved that we are better managers than the former management team of the tool company, and thus we are likely to discover new ways to create and capture value within the tool company. Evaluate this rationale. It is true that the merger might reduce earnings volatility. However, shareholders can diversify on their own by buying shares in the two companies. Thus, it is not obvious that the merger of the two companies creates value (which is likely to involve higher transaction costs than simply having investors buy the shares on their own). While the companys management team may be good in their industry, it is not obvious that they will have an advantage in competing in an unrelated industry. They are more likely to be able to exploit any special talents they have in a related business. 89. Pepsi produces Fritos and Lays potato chips in addition to its basic soft-drink products. Discuss potential ways that this business combination might increase value. There may be economies of scope, such as in jointly marketing the products through Pepsis marketing channels (they are related products and sold to many of the same customers). Also, the products are complements and Pepsi can take this into account in their pricing. 810. The Strippling Drug Company has just obtained an important patent for a new drug that increases male virtility and cures male pattern baldness at the same time. Does this imply that Strippling has a competitive advantage in producing the drug? Explain. No. It might be better off for the company to sell the patent to another company that has more experience and scale for producing the new drug. 8-7 Chapter 10 - Incentive Conflicts And Contracts CHAPTER 10 INCENTIVE CONFLICTS AND CONTRACTS CHAPTER SUMMARY This chapter provides an overview of incentive conflicts and contracting within firms. It begins by defining the firm as a focal point for a set of contracts. It then discusses the many incentive conflicts that exist between the parties that make up the firm. The role of contracts in reducing these conflicts is examined. The importance of asymmetric information in limiting the ability to solve these problems in a costless manner is stressed. Both postcontractual and precontractual information problems are examined. The role of implicit contracts and reputational concerns in reducing incentive conflicts is discussed. CHAPTER OUTLINE FIRMS Managerial ApplicationEnforceability of Implicit contracts INCENTIVE CONFLICTS IN FIRMS Owner-Manager Conflicts Choice of effort Perquisite taking Differential risk exposure Managerial ApplicationThe Spectrum of Organizations Differential horizons Overinvestment Other Conflicts Managerial ApplicationBuyer-Supplier Conflicts Managerial ApplicationExperimental Evidence on Free-Rider Problems Managerial ApplicationIncentive Conflicts throughout the World CONTROLLING INCENTIVE PROBLEMS THROUGH CONTRACTS Costless Contracting Managerial ApplicationJack Welchs Perquisites Costly Contracting and Asymmetric Information Managerial ApplicationAgency Problems with Owner-Managers Postcontractual Information Problems Agency Problems Managerial ApplicationPilots of Private Jets Example of Agency Costs Managerial ApplicationTechnology to Reduce Monitoring Costs Managerial ApplicationIncentive Problems between Firms and Their Law Firms Precontractual Information Problems Bargaining Failures Adverse Selection 10-1 Chapter 10 - Incentive Conflicts And Contracts Managerial ApplicationRising Health Care Costs Create Employee Conflict IMPLICIT CONTRACTS AND REPUTATIONAL CONCERNS Implicit Contracts Managerial ApplicationCokes Implicit Contract Reputational Concerns Managerial ApplicationCorporate Scandal Affects Personal Reputations INCENTIVES TO ECONOMIZE ON CONTRACTING COSTS Managerial ApplicationCan the SEC Reduce Contracting Costs? SUMMARY TEACHING THE CHAPTER The incentive problem is represented using the utility-maximization framework initially presented in Chapter 2. Although it is likely students will remember the material well enough to understand the presentation of the material as it relates to this chapter, some students may need a brief review. One of the key points of the chapter is that incentives matter and the goal of a contract is to design an incentive system that will result in desirable outcomes. A second key point is that although in many of the analyses presented thus far the firm is considered to be a single actor, in reality, the firms actions are the aggregation of many individual decisions made by the employees of the firm. Properly structured contracts are an important tool to align the actions of the actors with the best interest of the firm. There are two Analyzing Managerial Decisions scenarios presented in the chapter. The first, Opening a New Restaurant, asks students to consider the conflicts that might arise between the owner and the managers and how compensation might be structured to head off these conflicts. The second scenario, eBay.com, asks students to consider the conflicts that might arise in an online setting. Students should consider how the support services provided by eBay might limit the number of conflicts that arise. (See the Solutions Manual for the answers to these problems). The Self-Evaluation Problems reiterate the core concepts of the chapter and ask students to make use of their quantitative skills. In particular, the first problem asks students to determine the total agency costs and to divide these costs into the residual loss and outof-pocket costs, which could be particularly difficult for students and could be covered in class after that section of the lecture is presented. The Review Questions cover some of the core definitions but also ask students to apply the concepts of the chapter to understand how contracts might or might not alleviate conflicts. 10-2 Chapter 10 - Incentive Conflicts And Contracts REVIEW QUESTIONS 101. What is a firm? Economists have developed several different definitions of a firm. This book focuses on one particularly useful definition: The firm is a focal point for a set of contracts. 102. Give examples of incentive conflicts: a. Between shareholders and managers. Managers might want to invest in pet projects, rather than projects that increase shareholder value. They might also prefer to spend company resources for personal consumption rather than on productive investment projects. Many other examples are possible. b. Between coworkers on teams. One prominent example is the classic free-rider problem. Individually, team members can have incentives to shirk and hope that everyone else on the team works hard. 103. What is asymmetric information? How can it limit contracts from solving incentive conflicts? Asymmetric information means that all contracting parties do not share the same information. With symmetric information incentive conflicts would be relatively easy to solve. The contracting parties could agree to take certain actions and if they do not they can be heavily penalized. Asymmetric information, however, can make it difficult to ascertain whether or not a party has honored the terms of the contract. 104. Name the two parties involved in an agency relationship. Principal and agent. 10-3 Chapter 10 - Incentive Conflicts And Contracts 105. What potential problems exist in agency relationships? An agent agrees to act in the interests of the principal. However, the agent may subsequently act in his own self interest at the expense of the principal. For example, a real-estate agent has a legal obligation to represent the seller of a house. Nevertheless, the agent might provide confidential information to a prospective buyer (for example, the lowest price which the seller is willing to take) to speed the sale of the house and the receipt of the agents commissions. 106. Is it worthwhile for shareholders to seek to completely eliminate incentive problems with managers and directors through means such as monitoring? Why or why not? Generally no. It is optimal to incur out-of-pocket expenses to reduce agency problems only up to the point where the marginal reduction in the residual loss is equal to the marginal increase in out-of-pocket expenses. A firm might want to stop employees from taking company pencils home for personal use. However, the costs of completely eliminating this behavior are likely to be too high to justify. 107. What is adverse selection? Give an example. Adverse selection refers to the tendency of an individual with private information about something that affects a potential partners benefits to make offers that are detrimental to the trading partner. A common example is from the insurance industry. Prospective customers are more likely to know about their health than insurance companies. The customers who are most likely to purchase insurance at a given price are those who are most likely to use it. 108. How do reputational concerns aid in the enforcement of contracts? Individuals can find it in their interests to honor contracts and not engage in short-run opportunistic actions because they fear the loss of future business and profits from developing a bad reputation. 10-4 Chapter 10 - Incentive Conflicts And Contracts 109. Schmidt Brewing Company is family-owned and -operated. The family wants to raise some capital by selling 30 percent of the common stock to outside shareholders. The company has been profitable and the family indicates that it expects to pay high dividends to shareholders. The family will maintain 70 percent ownership of the common stock and continue to manage the firm. The rights of shareholders are specified in the company's corporate charter. The charter specifies such items as voting rights (procedures and items subject to a vote), meeting requirements, board size, rights to cash flows, and so on. Once adopted, a charter can only be changed by a vote of the shareholders. What types of provisions in the corporate charter of Schmidt Brewing might motivate minority shareholders to pay higher prices for the stock? Explain. Minority shareholders will be worried about being "frozen out" by the Schmidt family. For instance, the family might decide to pay no dividends but pay themselves high salaries in order to take money out of the firm. Minority shareholders can limit this problem by having certain provisions in the corporate charter. One desirable provision might be to have mandatory dividend payouts. Minority shareholders might also demand supermajority voting rules where major assets sales, investment decisions, and changes in the corporate charter have to be supported by at least 75 percent or more of the outstanding shares. 1010. Which of the following examples is an adverse-selection problem and which is an incentive problem? Explain why. In each case, give one method that the restaurant might use to reduce the problem. a. A restaurant decides to offer an all-you-can-eat buffet that is sold for a fixed price. The restaurant discovers that the customers for this buffet are not its usual clientele. Instead, the customers tend to have big appetites. The restaurant loses money on the buffet. Adverse Selection: A pre-contractual information problem. People seeing the buffet prices know how much they are likely to eat, but the restaurant does not. Consequently, the buffet price tends to attract people who will eat a lot of food. There are many potential ways to address this problem. For instance, the restaurant might raise the prices on the buffet to cover the costs of the largest eaters and then offer deals for other customers such as being able to fill a smaller plate for a lower price. b. A restaurant owner hires a manager who promises to work long hours. When the owner is out of town, the manager goes home early. This action results in lost profits for the firm. 10-5 Chapter 10 - Incentive Conflicts And Contracts Incentive Problem: Post-contractual information problem. The manager promises to work hard, but once the owner is not around to monitor her, she shirks. Potential solutions include: providing incentive compensation (for example, a profitsharing plan), and increased monitoring. 1011. In 1992 the state of California charged Sears Auto Centers with overcharging customers for unneeded or unperformed repairs. Sears agreed to a settlement that could cost as much as $20 million. Sears had compensated its salespeople with commissions based on total sales. Following the settlement, Sears dropped the commissions and went to a straight salary. Sears recently indicated that it is planning to reinstate commissions for salespeople in their Auto Centers. It even plans on paying commissions for selling customers brake jobs and wheel alignments. These two products were the core of the 1992 scandal. Sears says that it has taken steps to prevent a recurrence of past problems. In particular, the decision right to recommend repairs is granted to mechanics who are paid a straight salary. Sales consultants are paid commissions for selling repair services but are not authorized to recommend repairs. Under the old system that caused problems, these individuals diagnosed repair problems and sold the corresponding service to customers. Why do you think Sears wants to reinstall commissions for its salespeople? Do you think that the new safeguard that separates diagnosing problems from selling services will prevent a recurrence of past problems? Explain. Salespeople are likely to exert less effort on selling products if they are paid straight salaries than if they receive sales commissions. Sears Auto Centers probably wanted to reinstate commissions to increase the effort of their salespeople. Yet, there are still potential problems with the proposed safeguards. For instance, the salespeople might pressure the mechanics to recommend more repairs. The mechanics, in turn, might have incentives to respond to this pressure. They might be friends of the salespeople. They also might fear that the salespeople will be promoted to management positions and take it out on the mechanics if they did not help them earn higher incomes while they were salespeople. In rare cases, the salespeople might even offer financial bribes to the mechanics to make more recommendations for repairs. Also the customers deal with the salesperson, not the mechanic. The salespeople will have incentives to overstate/exaggerate the recommendations of the mechanics. 10-6 Chapter 10 - Incentive Conflicts And Contracts 1012. The Sonjan company currently purchases health insurance for all of its 1,000 employees. The company is considering adopting a flexible plan whereby employees either can have $2,000 in cash or purchase an insurance policy (which currently costs $1,000). Do you see any potential problems with the new plan? Explain. The plan represents an increase in payouts to employees. However, this increase in pay might be necessary to attract and retain qualified employees. The plan also gives the employees flexibility in choosing their own benefits. One potential problem with the plan, however, is adverse selection. The people who are least healthy are the most likely to purchase insurance. The insurance company will realize this incentive. Most likely, it will begin requiring medical exams for applicants. This action will increase the costs of providing insurance to employees. The insurance company might also increase prices because it realizes that it will have a less healthy pool to insure. A second problem with the plan is administrative costs. The company must incur costs to explain the plan to employees and operate a system that keeps track of each employees choice, etc. 10-7 Chapter 11 - Organizational Architecture CHAPTER 11 ORGANIZATIONAL ARCHITECTURE CHAPTER SUMMARY This chapter introduces the concept of organizational architecture. discussing the dual economic problems of: It begins by linking decision rights with knowledge, and motivating agents to make productive decisions based on their information. Markets solve this problem though a system of alienable private property rights. Within firms, the problem has to be addressed by management through the design of the organizational architecture. The three components of organizational architecture (decision-right assignment, performance-evaluation system, and reward system) are like three legs of a stool. They are complements and must be considered together. They also complement the less formal aspects of a firms corporate culture. If the management does not adopt a productive architecture the firm will suffer. Architecture is an important managerial tool that can be used at all levels in the organization. CHAPTER OUTLINE THE FUNDAMENTAL PROBLEM Architecture of Markets Academic ApplicationSpontaneous Creation of Markets: Evidence from Prisoner-of-War Camps Architecture within Firms Decision Rights Controls Managerial ApplicationOrganizational Architecture at Century 21 Tradeoffs ARCHITECTURAL DETERMINANTS Managerial ApplicationTechnology Changing the Energy Industry Managerial ApplicationNew Technology Provides Better Controls Changing Architecture Managerial ApplicationChanging Organizational Architecture at JCPenney Managerial ApplicationChanging Organizational Architecture Requires Careful Analysis Historical ApplicationChanging Organizations Too Frequently: Not a New Phenomenon 11-1 Chapter 11 - Organizational Architecture Interdependencies within the Organization Managerial ApplicationWhen the Legs of the Stool Dont Balance CORPORATE CULTURE Managerial ApplicationWal-Mart Sing-Alongs Helps Create A Culture Corporate Culture and Communication Corporate Culture and Employee Expectations A System of Complements Managerial ApplicationCorporate Culture at Mary Kay Cosmetics WHEN MANAGEMENT CHOOSES AN INAPPROPRIATE ARCHITECTURE Firing the Manager Market for Corporate Control Product Market Competition MANAGERIAL IMPLICATIONS Academic ApplicationMarmots and Grizzly Bears Managerial ApplicationQwerty versus Dvorak Evaluating Management Advice Benchmarking Managerial ApplicationBenchmarking the Lincoln Electric Company OVERVIEW OF PART 3 SUMMARY TEACHING THE CHAPTER One of the key points in this chapter is that the three legs of the organizational architecture stool must be balanced. This chapter builds on the foundation presented in chapter 10, which highlighted the way decisions are made by firms and why it is important that the actors within the firm have interests that are aligned with the interests of the firm. This chapter is different in that the focus is now on explaining the factors that affect whether the three legs are balanced for a particular firm, which are highlighted in figure 11.1. This figure should provide the foundation that students need to analyze cases and students should be encouraged to refer to this table when answering the questions in the chapter. If students struggle with using figure 11.1 on their own, they can refer to the Managerial Implications section of this chapter for a set of questions that will aid them in their analysis. This chapter has numerous applications that can be used to illustrate the key points. This chapter focuses on concepts and not quantitative analysis so students should be able to offer good discussion about these topics without much lecture. This chapter serves as an introduction to these concepts which are covered more fully in the next six chapters. 11-2 Chapter 11 - Organizational Architecture There are two Analyzing Managerial Decisions scenarios in this chapter. The first, Tipping in Restaurants, asks students to consider why waiters compensation is heavily dependent on tips. Students are also asked to consider why restaurants require a certain percentage tip for large parties. Students should consider the material from the previous chapter in formulating their answers. The second, Eastman Kodak, is more comprehensive in scope. Students should focus on explaining whether the three legs of the stool were balanced, since this is the approach introduced in the chapter. The textbook authors recommend an additional case, Nordstrom: Dissension in the Ranks? (A) (Harvard Business School Case #9-191-002), and have provided the following detailed description of how this case can be used in class. At the time of the case Nordstrom has experienced a long history of success. Its strategy and architecture appear to have worked well. In 1989, however, the company was engaged in a dispute with a labor union and several related lawsuits over its performance evaluation and reward systems. The relevant question is: Should Nordstrom make changes in its architecture? Figure 11.1 can be used to organize the discussion. A careful analysis suggests that, while Nordstrom had been successful, their system motivated violations of the Fair Labor Standards Act (the architecture did not fit the regulation box in Figure 11.1). These violations were exposing the firm to millions of dollars of potential liability that the labor union had private incentives to pursue (the union would like to stop Nordstrom from placing competitive pressures on other firms in the industry to mimic their commission oriented-system). Nordstrom should do something to address the issue. Yet, they must be careful not to make such radical changes as to destroy what made them great. This case can be updated by talking about what has subsequently happened to Nordstrom. The employees in Washington ultimately voted to withdraw from the union suggesting that most employees were not unhappy with the system. Nordstrom did make some minor changes in its system to help assure compliance with the law. However, the basic system remained intact. During 1999, Nordstrom had relatively bad stock price performance. They appeared to have lost their image as a trend-setter. Since 2000, however, Nordstrom has on average roughly tracked the S&P 500 (through April 2003). Starting in 2000 the company made some substantial changes in their management and organizational architecture. For example, Nordstroms centralized decisions on overall purchasing, advertising, etc. However, they have maintained local execution and selection. These developments are well summarized in Fashion Victim, Barrons (April 3, 2000, pp. 2022). This discussion can be tied back to Chapter 8 and the difficulty of maintaining an advantage in a competitive marketplace. (See the Solutions Manual for the answers to these problems). 11-3 Chapter 11 - Organizational Architecture REVIEW QUESTIONS 111. Describe the three aspects of organizational architecture? First is the assignment of decision rights; this assignment indicates who has authority to make particular decisions within the organization. Second is the performance-evaluation system; this system specifies the criteria that will be used to judge the performance of agents within the organization (for example, employees). Third is the reward system; this system specifies how compensation (and other rewards and punishments) will be distributed among agents within the firm. 112. What is a major difference between the architectures of markets and firms? The architecture in markets is created spontaneously with little conscious thought or human direction. Through market transactions, property rights are reassigned so that decision making and specific knowledge are linked. Private property rights provide strong incentives for productive actions they create powerful performance-evaluation and reward systems. Within firms, the architecture is created by management. 113. How might the softer elements of corporate culture help increase productivity in an organization? Give some examples of how managers might foster these elements to implement desired change in an organization. Softer elements in a firms corporate culture include such things as slogans, role models, corporate stories, and social gatherings. These features can be important in communicating the objectives of the firm to employees and other stakeholders. They can also serve to convey to employees the architecture of the firm (what decision rights employees have, what will receive positive evaluations, and rewards). Also, these features can be used to enhance employee expectations that other employees will behave in particular ways. As we show in the appendix to chapter 9, sometimes these expectations are important in fostering cooperation among employees. It is easy to give examples of how managers might use the softer elements to meet these objectives. For example, consider the case of Mary Kay Cosmetics, highlighted in a box in Chapter 11. 11-4 Chapter 11 - Organizational Architecture 114. Prominent management consultants sometimes argue that decision making in teams is usually more productive than decision making by individuals (important synergies arise when teams operate that are absent when individuals work by themselves). These consultants suggest that most companies have long failed to make proper use of teams. Their advice is that most firms should increase their use of teams significantly. Critique this advice. Managers should be skeptical of this type of advice. If firms have not used teams and continued to survive over a long time period, this suggests that the use of teams is not always productive. The principle of economic Darwinism suggests that competition long ago would have driven firms to use more teams if teams were always more productive. After all, teams are not a new idea. It is possible that the environment has changed in ways that make the use of teams more valuable for certain firms. However, this does not mean that all firms should use teams (it depends on the environment in which they operate). In the next chapter, we discuss the economics of teams in more detail. 11-5. Assume that some firms within the same industry are observed to be multidivisional whereas others are functionally organized. Assume further that all firms are about the same size and have existed for a long period of time in their current organizational structures. Is this observation inconsistent with the survival of the fittest concept discussed in class? Explain. No. Firms in the same industry can vary on dimensions other than size. For example, one firm might produce many products and optimally organize as a multi-divisional firm, while another firm might concentrate on fewer products and organize as functionally. 116. Evaluate the following argument: Management fads make no sense. One day its TQM. The next it is empowerment or business-process reengineering. There is no economic justification for these fads. Management are just like sheep following each other to the slaughter. 11-5 Chapter 11 - Organizational Architecture One can argue that this statement is not true. Changes in the business environment (technology, markets, and regulation) can promote a common demand for organizational changes among firms in a given environment. Consulting firms (and others) have incentives to provide help in making these changes and also to label them in a proprietary manner (e.g., EVA). The new products disappear as environments continue to change, as their usefulness wears out, as new products develop, etc. The pattern can produce what appears to be management fads. However, these fads can ultimately help to increase value if they are implemented correctly by the correct set of firms. 117. Some of the electric generating plants of the Tennessee Valley Authority are powered by coal. Coal is purchased by a separate procurement division and is transferred to the plants for use. Plant managers often complain that the coal is below grade and causes problems with plant maintenance and efficiency. What do you think is causing this problem? What changes would you make to help correct this problem? There is likely to be a problem with organizational architecture. The procurement people are likely to be incented to purchase coal at a low price. This motivates them to be less concerned about quality. Possible solutions involve changing the incentive system of the procurement division to focus more on quality. Alternatively, TVA might reassign decision rights to purchase coal to plant managers. (This might lose certain economies of scale in purchasing.) In either case, they must also worry about the other two legs of the stool. For example, if the procurement people are evaluated on quality, someone must be assigned the decision right to monitor this quality. Alternatively, if decision rights are changed (for example by moving the responsibility to purchase coal), it is likely that incentives will need to be changed as well. 11-6 Chapter 12 - Decision Rights: The Level Of Empowerment CHAPTER 12 DECISION RIGHTS: THE LEVEL OF EMPOWERMENT CHAPTER SUMMARY This is the first of two chapters on the assignment of decision rights. It considers the optimal assignment of a given decision right (such as the right to set the price of a product). It begins by considering whether the right should be centralized or decentralized. Then it examines where in a hierarchical level the decision right should be placed and whether the right should be granted to an individual or a team of workers. The chapter also introduces the important concepts of decision management, decision control, and influence costs. It provides a short case study and an appendix that analyzes the economics of collective decision making (for example, team decision making) in greater detail. CHAPTER OUTLINE ASSIGNING TASKS AND DECISION RIGHTS CENTRALIZATION VERSUS DECENTRALIZATION Benefits of Decentralization Effective Use of Local Knowledge Managerial Application: Improving Performance through DecentralizationThe Zebra Team Conservation of Management Time Training and Motiviation for Local Managers Managerial Application: Railroads Decentralize after Centralizing Costs of Decentralization Incentive Problems Coordination Costs and Failures Managerial Application: Technology Spurs Centralization in Financial Services Managerial Application: International Companies Blend Centralization and Decentralization Less Effective Use of Central Information Illustrating the Trade-offs Managerial Application: Local Content Rules and Decentralization Managerial Application: Not Everyone Likes Empowerment Management Implications Across Firms Managerial Application: Decentralization and the Global Supply Chain Recent Trends 12-1 Chapter 12 - Decision Rights: The Level Of Empowerment Managerial Application: Technology and BureaucracyCypress Semiconductors LATERAL DECISION-RIGHT ASSIGNMENT ASSIGNING DECISION RIGHTS TO TEAMS Managerial Application: Employing Teams to Assemble Knowledge Benefits of Team Decision Making Improved Use of Dispersed Specific Knowledge Employee Buy-In Costs of Team Decision Making Collective-Action Problems Free-Rider Problems Management Implications When Will Team Decision Making Work Best? Managerial Application: Monsanto Uses Two-Person Teams Optimal Team Size DECISION MANAGEMENT AND CONTROL Managerial Application: Team-Based OrganizationHallmark Greeting Cards Managerial Application: Investigating Sexual Harassment at Compuware Separation of Decision Management and Control Empowerment Managerial Application: Should CEO and Board Chair Be Separate? DECISION RIGHT ASSIGNMENT AND KNOWLEDGE CREATION INFLUENCE COSTS Historical Application: Separate Decision Management and ControlNot a New Idea Managerial Application: Influence Costs at Reynolds Tobacco SUMMARY APPENDIX: COLLECTIVE DECISION MAKING The Example of Majority Voting TEACHING THE CHAPTER It is important to remind students that this chapter focuses on only one of the legs of the stool, decision-right assignment. This chapter focuses on the level of empowerment of decision-making (whether these decision rights should be centralized or decentralized), where as the next chapter focuses on the bundling of tasks into jobs and subunits. Figure 12.1, and the related examples in the text, serve as a useful tool for illustrating the differences between the two dimensions of job design. 12-2 Chapter 12 - Decision Rights: The Level Of Empowerment The examples at the beginning of the chapter show a contrast between centralizing and decentralizing decision-making. It is important for students to recognize that there is no one-size-fits-all model for all firms. It would be useful to refer back to figure 11.1 to remind students of all of the factors that might lead to different decision-right assignments in firms. The Managerial Applications can be used as examples to show centralized versus decentralized decision-making rights, but students can also be asked to share examples from their own experience. They should also be able to offer discussion about working in teams and team capabilities. The final sections of the chapter move from a discussion about the level of empowerment to a more comprehensive discussion of what is means to have decision rights. What are decision-makers empowered to do and why does it matter who is empowered to make decision? The appendix extends the chapter by focusing on problems associated with group decision-making. This chapter briefly introduces some of the material from the public choice literature, such as problems with majority voting. The material in the appendix is not particularly technical in nature and would be useful for all students to review since they will likely find it very useful in answering the discussion questions for the Analyzing Managerial Decisions scenarios. There are two Analyzing Managerial Decisions scenarios presented in this chapter. The First, Teams at GM vs. Levi Strauss, asks students to consider why team production might work in one industry and not in another. The second scenario, Medford University, is more complex and asks students to consider not only why a team might be used in this scenario but also to consider the design of the team. (See the Solutions Manual for the answers to these problems). APPENDIX PROBLEMS 1. What factors should a manager consider when deciding on the composition of a team charged with making an important decision? The manager will want to consider the specific knowledge and skills of the potential team members. Sometimes, however, people with important information or skills should be left off a team if the agency costs of including them on the team are large. 2. Suppose the managers in the example in this appendix do not necessarily vote according to their preferences in each round of the voting. Rather, they might vote for a less preferred option in the first round to obtain a preferred outcome in the final round. Suppose that Patrick has agenda control. How should he manipulate the agenda to achieve his preferred outcome? 12-3 Chapter 12 - Decision Rights: The Level Of Empowerment The managers will vote according to their preferences in the second round (they have nothing to lose). In the first round, they will not vote according to their preferences if they anticipate that they can motivate a preferred outcome in the second round. Patrick wants to have A run against C in the final round. To achieve this outcome, he should run A versus B in the first round. If Maria is forward looking, she will vote for A over B in the first round. She prefers B to A, but will realize that B will lose to C in the final round. Therefore, she will vote for A in the first round since she prefers A to C. REVIEW QUESTIONS 12-1. Discuss the costs and benefits of decentralized decision making relative to centralized decision making. The costs of decentralized decision making are agency costs, coordination costs and failures, and less effective use of central information. The benefits of decentralization are more effective use of local knowledge, conservation of the time of top management, and training and motivation for local managers. 12-2. Mark Wilson, chief of personnel, has been instructed to increase the hiring of women at the Morton Cement Company. Mark will be evaluated by company president Josh Cohen on his success or failure in meeting this goal. Mark does not evaluate the performance of any of the division chiefs and each chief must approve all new division employees. Do you expect Mark to succeed in this endeavor? Why or why not? Explain your reasoning. Mark is likely to have trouble meeting his objectives. While he is evaluated and rewarded on meeting his goal, he is not assigned the relevant decision rights to help him accomplish it. Unless the division chiefs are aligned with Mark for some other reason (for example, they favor increasing the number of females in the organization), they have no direct incentives to listen to Marks requests. 12-3. Define the terms decision management and decision control. Under what circumstances might it be optimal to make one individual responsible for both decision management and decision control? What do you expect the ownership of common stock to look like in such a firm? Explain. decision management: the initiation and implementation of decisions. decision control: the ratification and monitoring of decisions. 12-4 Chapter 12 - Decision Rights: The Level Of Empowerment If the specific knowledge/information that is necessary for both decision management and decision control is vested in one agent it can be too costly to try and separate the two decision functions. When decision management and control are combined the agent is likely to be the primary residual claimant, otherwise, the resulting agency problems would be too great. 12-4. Jan van der Schmidt was the founder of a successful chain of restaurants located throughout Europe. He died unexpectedly at the age of 55. Jan was sole owner of the company's common stock and was known for being quite authoritarian. He personally made most of the company's personnel decisions. He also made most of the decisions on menu selection, food suppliers, and advertising programs. Employees throughout the firm are paid fixed salaries and were closely monitored by van der Schmidt. Jan's son, Karl, spent his youth driving BMWs around Holland and Germany at high speeds. He spent little time working with his father in the restaurant business. Nonetheless, Karl is smart and just received his MBA degree from a leading business school. Karl has decided to follow his father as the chief operating officer of the restaurant chain. What advice about organizational architecture for the company would you offer Karl now that he has taken over? Karl does not have the same level of specific knowledge to run the company as his father. Rather, the specific knowledge is likely to be held by other people throughout the company. Given this distribution of knowledge, Karl will probably have to decentralize decision rights. Decentralizing decision rights will require associated changes in the performance-evaluation and reward systems (so that the three legs of the stool balance). Karl will probably want to increase the emphasis on performance-based pay to motivate the newly empowered employees to make decisions that are in the best interest of the company. 12-5. Discuss the positive and negative effects of a university rule that would not allow professors to change a grade once recorded. The rule would reduce the influence costs that come from students asking for regrades, lobbying for grade changes, and so forth. The rule, however, might produce less accurate grading because there is no opportunity to correct even obvious errors. 12-5 Chapter 12 - Decision Rights: The Level Of Empowerment 12-6. Many companies have been experimenting with organizing their manufacturing around teams of employees. The employees are given decision rights on such things as how to organize the work and employee schedules. Often the employees are paid based on team output. Sometimes, this organizational arrangement has worked well. In other cases, it has not. Discuss the conditions under which you think that this type of team organization is most likely to succeed. Teams are most likely to be productive when the relevant specific knowledge for the decision is dispersed among individuals and where the costs of collective decision-making and controlling free-rider problems are low. 12-7. A leading business school currently uses study teams in the MBA program. Each team has five members. Some of the work in the first year is assigned to study teams and graded on a group basis. Discuss the trade-offs involved with enlarging student study groups in the MBA program from five people to six people. Increasing the team size from five to six will increase the amount of knowledge on the team. Thus, the teams will have more skills to complete projects. However, it is harder to control free-rider problems in larger groups. Also it can be more difficult for six people to reach consensus and coordinate their actions than five. 12-8. It is frequently argued that for empowerment to work, managers must let go of control and learn to live with decisions that are made by their subordinates. Evaluate this argument. In contrast to this argument, for empowerment to work managers should not relinquish all control. If a manager gives an employee both decision control and decision management rights for the same decision, the agency problems will be substantial. Managers must maintain some level of decision control (for example, monitoring). Employees can still be empowered by being given greater decision management rights (initiation and implementation rights). 12-9. It is sometimes argued that empowerment can be successful only if managers learn to live with decisions made by lower-level employees. Managers are to set clear boundaries within which employees can make decisions (for example, allowing a salesperson to set prices between $15,000 and $20,000). Managers should never overturn a decision if it is within the boundaries. Rather, good decision making should be encouraged through proper incentives and training. Do you agree that for empowerment to work, managers should always set clear boundaries and live with decisions within these boundaries? Explain. 12-6 Chapter 12 - Decision Rights: The Level Of Empowerment Boundary setting can be useful. However, it is not always possible to set clear boundaries. Some types of decisions are difficult to quantify. For example, you might ask an employee to initiate a potential solution to a production problem. Unfortunately, it might not be possible to clearly state the conditions under which you will ratify the employee's decision. If the decision is very important to the company, you probably will want to reserve the right to say no. Increasing the employee's initiation and implementation rights still increases the employee's level of decision authority (empowerment). 12-10. Several Fortune 100 companies have nominated members of the clergy to be members of their boards of directors. Discuss the advantages and disadvantages of such a proposal. Members of the clergy have incentives to maintain a reputation for honesty. They may also value this attribute highly in their utility functions. Therefore, they are potentially good monitors in that they are less likely to collude with top managers to take advantage of other stakeholders of the firm. A potential disadvantage with them serving on the board is that they might not have specific knowledge to make sound business decisions. Also there are potential incentive problems. For instance, they might favor donations to their religious institution over maximizing firm value. 12-11. An organizational consultant evaluates your division. She indicates that she does not like the divisional manager's top-down management style. She recommends setting up a board that consists of the divisional manager and his top 10 department managers. The consultant suggests that all major policy decisions be made by the board by a majority voting rule. She argues that this process will make for better use of information within the organization. She also argues that our political system is a democracy, which works well, and that the same concept could be applied beneficially within the corporation. Evaluate the recommendation. To answer this type of question, it is useful to consider both the information and incentive issues in changing the architecture. In terms of informational considerations, it is not obvious that department heads will have detailed information on the activities of other divisions. Thus, information costs are likely to rise under the proposal. In terms of incentive issues, it is not obvious that the managers will vote in a manner consistent with increasing firm value. Rather, the managers are likely to focus on their own self interest. For example, they might support the proposals of other managers, even if they are bad ideas, to help gain support for their own proposals. This type of decision-making process is likely to engender significant influence costs. The potential problems of majority voting are highlighted in the appendix to chapter 12. 12-7 Chapter 12 - Decision Rights: The Level Of Empowerment 12-12. The Colorado Symphony Orchestra (CSO) was formed after the Denver Symphony was no longer financially viable. CSOs corporate charter requires that it cannot have an operating deficit in any year. Revenues, donations, grants, and other income must equal or exceed operating expenses. CSO balances its budget each year by adjusting the musicians' salaries. For example, in 1999 the musicians were not paid for the last 2 weeks of the year. CSOs board of directors and executive management committees are composed of one-third each of musicians, full-time CSO staff, and community supporters of the CSO. In most organizations, it is unusual for labor to have representation on the board of directors and management committees. Explain why you would expect musicians to have seats on the CSO board and management committees. Whenever management holds residual claims, decision management need not be separated from decision control. CSOs residual claimants are the musicians. Therefore, the musicians hold substantial decision management and decision control rights by sitting on the board of directors and management committees. 1213. Recently a number of companies have adopted what is known as open-book management. Under this concept lower-level employees are given training to help them understand the companys financial statements and how their individual actions affect financial performance. They are given access to information previously known only to more senior management. They are also given detailed revenue and cost data as it relates to their jobs. For instance, one company gave delivery drivers information about the maintenance costs of the companys vans, whereas a building company gave employees detailed cost information on such items as a spoiled batch of glue. Why do you think this management trend is occurring now, rather than say 20 years ago? Does this policy fit with other changes that are occurring in organizations? Explain. Do you think all companies should open their books to lower-level employees? Explain. 12-8 Chapter 12 - Decision Rights: The Level Of Empowerment Open-book management complements the current trend toward decentralizing decision rights in firms. Technology, competition, and deregulation have motivated many firms to decentralize decision rights. Decentralization will work best if employees have specific knowledge to make productive decisions. They will gain some of this knowledge as a by-product of their jobs. Other knowledge has to be given to them. This is a primary function of open-book management. Twenty years ago, decision rights tended to be more centralized and it was less important to provide lower-level employees with detailed information about costs, revenues, profits, and so on. Computer technology and an improved quality of the work force also make it potentially less expensive to practice open-book management than in the past. As indicated, open-book management fits with decentralization, which in turn complements an increased emphasis on pay-for-performance plans. While open book management is appropriate for some firms, it is not appropriate for all firms. For some firms, it is not optimal to decentralize decision rights. In these firms, the benefits of open-book management are likely to be less than the costs. For example, if an employee is asked to perform the sole task of digging for coal, is it important that the employee understand the financial statements of the overall company? 1214. Microsofts Encarta is a multimedia encyclopedia on CD-ROM. It has nine different editions. Examples include editions in British English, American, German and Italian. The North American Version alone has 40 million words and 45,000 articles. Microsoft has delegated major editorial decisions to teams of local experts, mostly academics and specialists, who know their stuff. For example, a team of experts primarily from Italy have been given editorial decisions for the Italian edition. Encyclopedia Britannica uses a different policy. Its central staff has decision rights to assure a standard presentation is presented in all editions. Discuss the pluses and minuses of Microsofts policy relative to Encyclopedia Britannicas. Pluses of Microsoft policy: Local experts are more likely to be aware of facts pertaining to the local area. They are also more likely to know how to present the material in a readable way to local residents. They will also be aware of cultural issues (e.g., what the local people would find offensive, etc.). Microsoft did not always use this policy and had made a number of mistakes about boundaries, culture, etc. that had made people angry. For example, at one point the South Koreans were so upset about incorrect statements about Japanese dominance of Korea in the third and fourth centuries that a Korean newspaper called for a boycott on all Microsoft products. Essentially all these benefits relate to colocating decision rights with relevant knowledge. Doing so presumably has the potential to increase sales. 12-9 Chapter 12 - Decision Rights: The Level Of Empowerment Minuses of Microsoft Policy: There are likely to be inconsistencies across editions. For example, in the U.S. edition Alexander Graham Bell is credited with inventing the telephone. In the Italian edition, the credit goes to Antonio Meucci (an Italian-American). These types of inconsistencies and potential inaccuracies can potentially hurt the reputation of Encarta as an authoritative source of information. They are due to both coordination problems and agency problems. Local experts might have their own political and social agendas, and may have less than optimal incentives to worry about the overall value of Microsoft. Also, this type of decentralized decision making can be difficult to coordinate. The system might also be more costly because it does not take advantage of potential economies of scale from having one central staff. 1215. Blue Cross Blue Shield of Rochester is Rochesters largest health insurance provider. In exchange for the insurance premiums they pay, families insured by BCBS receive all their health care needs from a group of approximately 500 doctors approved by BCBS. (Families must choose their doctors from among these 500 doctors.) When a patient insured by BCBS visits a doctor for a consultation, the patient pays a small copayment (usually $10). The doctor is reimbursed for the difference between the cost of the consultation and the copayment by RCIPA Corp. RCIPA Corp. is a firm owned by the 500 doctors who are BCBS-approved. At the beginning of each fiscal year, BCBS and RCIPA agree on a total dollar amount that BCBS will pay to RCIPA for medical services provided to patients covered by BCBS. BCBS further agrees that this dollar amount will not be adjusted for higher- or lower-than-expected medical care required by BCBS patients. RCIPA in turn pays member doctors, based on a fee schedule, for the medical services they provide to BCBS-insured patients. If, at the end of the year, there is any money left over, it is distributed to RCIPA members. If there is not enough money to pay for all the services provided by the member doctors, then the shortfall is allocated among the member doctors who must contribute cash to make up the shortfall. Why do you think RCIPA serves as an intermediary between BCBS and the doctors who care for BCBSs clients? Why would BCBS risk paying too much for the medical care of their customers? Why would RCIPA and its members risk being underpaid for their services? Is one of the two parties forcing the other to agree to such an arrangement? If so, who is forcing whom? Why? 12-10 Chapter 12 - Decision Rights: The Level Of Empowerment In the absence of this arrangement between BCBS and RCIPA, doctors have incentives to provide more medical services than is optimal: They know that they will be reimbursed for all care provided, even though some of that care might cost more than the benefit conferred by it on the insured patient. If this were allowed to occur, BCBSs costs would increase, and hence the cost of health insurance would increase. Additionally, doctors may have incentives to less-than-optimal quality medical care: Some of the costs of poor quality care, in particular loss of reputation and possible government intervention, are borne by BCBS and the other member doctors, not by the doctor providing the sub-standard care. The agreement between BCBS and RCIPA to pre-specify the amount that the doctors association will be reimbursed for services provided reduces doctors incentives to provide services whose marginal cost is above its marginal benefit. If the doctors collectively provide too many services, RCIPA will eventually run out of money, and reimbursement will cease before the end of the year. There is still the free-rider problem: Any one doctor can attempt to get a bigger portion of the available pie of reimbursement funds by overproviding services. However, RCIPA has a council of doctors which oversees services provided by each of its members. If the council sees individual doctors over-providing, it can presumably take action to get those doctors to cease. It would be difficult for BCBS to provide this oversight function directly rather than indirectly through the doctors association. It is unlikely that either party is forcing the other party into this arrangement. Rather, the creation and use of RCIPA reduces total agency costs (higher out-of-pocket expenses, but lower residual loss), which increases the size of the pie to be distributed among the contracting parties. (In fact, the existence of an RCIPA-like organization is mandated by state law, but it is arguable that RCIPA would exist without the state mandate.) This is a good example of collocating decision rights with the knowledge necessary to optimally exercise those decision rights. Doctors, not insurance firms, know best what medical services to provide their clients. (The health care industry is one of those rare industries in which the customer that is, the patient knows less than the supplier about the quantity and quality of services required.) Unfortunately, doctors also know best what services to provide to make themselves better off, and there is a risk that doctors, if given complete decision rights over patient care, will order too much care. So some decision rights are vested in RCIPAs medical council. This council has more knowledge of appropriate patient care than do insurance companies, albeit less than the patients doctors. 12-11
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