1

ECONOMICS 3200BLecture 2Ch. 1, 2, 3

September 17, 2013

2

Introduction

• Decision making– Objectives – Information – Constraints– Trade-offs– Time horizons

• Role of self interest, aka “greed”• Scarcity• Distributional issues – equity, fairness

– The 1%ers

3

Introduction

Decision making– Forward looking: Information requirements and

uncertainty– Time horizon: short run vs. long run

– Adam Smith: individuals pursuing their own self interest will collectively produce the greatest good Greed is good, Economics 101

• Importance of incentives: individuals motivated by personal well-being

4

Introduction

Decision making• Constrained optimization

– Constraints• Character, history, skills, risk tolerance• Competitors’ strategies• Time• Resource constraints – short-run/long run (i.e. availability of

resources, quality)• Laws, regulations• Others – directors, investors, competitors, creditors (loan

covenants), contracts

5

Introduction

• Economic paradigms:– Perfect competition – many firms, homogeneous products

– Monopoly – one firm (seller)

– Contestable

– Monopsony – one firm (buyer)

– Oligopoly – small numbers

– Monopolistic competition – many, heterogeneous products

6

Introduction

• Problem: Competition

• Passive/active?

• Rivalry – “the goal of competition is to kill your competitors”– Compare to concept of competition in perfect competition model

• Michael Porter: Determinants of rivalry– Concentration and balance (Herfindahl-Hirschman index, concentration

ratios) – facilitate collusive behavior, deter entry, dominant firm

– Threat of entry, exit barriers

– Product differentiation – brand identity, switching costs, reputation

– Informational complexity

– Intermittent overcapacity – airlines, steel

– Bargaining power of buyers

– Industry growth

7

Introduction

• Are suppliers/competitors (including potential entrants) equally well-informed?– Perfect information?

– Role of Internet, role of social networks, B2B, B2C

– Implications for stability of entry/exit process

– Implications for innovation

8

Introduction

• Michael Porter: Competitive strategy– Establish profitable and sustainable position factoring in

bargaining power of suppliers and buyers, threat of entry, threat of substitutes, intensity of rivalry

• Strategies for achieving competitive advantage– Cost leadership

– Differentiation– Niche

• Role of management and luck– Gamblers’ ruin and industry concentration

9

Introduction

• Sustainability of competitive advantage– Barriers to imitation not insurmountable, thus firm

must create moving target by investing to continually improve position

– Well executed offensive strategy best defense against attack by challenger

– Role remains for defensive strategy – increase structural barriers to entry, increase probability of retaliation; retaliate when entry attempted

– Deeper pockets– Risk-taking vs. risk aversion – role of regulations, fear

of liabilities

10

Introduction

• Problem: Market definition

• Identification of buyers, sellers – potential entrants, potential sources of supply

• Geographic scope

– Local, regional, national, international

– Trade barriers, information

• What constitutes a substitute product?– Cross-price elasticities – measurement, critical values

– MR>0: elastic range of demand curve, thus high degree of substitutability with products that are not included in market

– Substitutability over time – alternative energy sources

11

Introduction

• Entry barriers – ease, speed of entry– Entry by outsiders (who are they?); entry by insiders– Height, perception of entry barriers – reputation,

economies of scale/scope, learning curves, access to distribution networks, switching costs, firm specific capital (patents, trade secrets, management skills, location)

– Strategic behavior of incumbents – entry accommodation or deterrence

• Time period for defining markets – time required for adjustments in buyer/seller behavior in response to certain size price change

12

Introduction

• Problem: Information• What do buyers know about availabilities, prices, quality?

– Search costs– Uncertainties re. quality – signals by firms for quality (advertising,

warranties, investments in creating brand names)– Limited search enhances market power of each firm– Impact of Internet – search sites

• What do suppliers know about technologies (product, production), consumer tastes, price elasticity, number and location of buyers, number and competencies of rivals, cost structures of rivals, strategies of rivals– Role of B2B – impact on relative bargaining advantages

• What do potential entrants know?– Impact of Internet

13

Introduction

Competition• Schumpeter

– “This process of creative destruction is the essential fact about capitalism. Every piece of business strategy must be seen in its role in the perennial gale of creative destruction.”

• Bob Crandall– “Kill your competitor”

• Porter– Competitive advantage

14

Introduction

• Among 50 wealthiest: Carlos Slim (#1), Bill Gates (#2), Amancio Oretga (#3), Li Ka-shing (#8), Bernard Arnault (#10), Stefan Persson (#12), Michael Bloomberg (#13), Jeff Bezos(#19), Larry Page & Sergey Brin (#20 and 21), Mukesh Ambani (#22), Carl Icahn (#26), Alberto Gonzalez (#32), Mikhail Fridman (#41), Lakshmi Mittal (#41), Aliko Dangote (#42), Mark Zuckerberg (#66)

15

Introduction

• Theory: If, then– If perfect competition, then P=MC

– If monopoly, then, P>AC

– If no entry barriers and zero exit costs, then markets contestable and P=AC

– If economies of scale to Q0 and diseconomies of scale beyond Q0 , then AC curve is U-shaped

– If oligopoly, then ???

– If heterogeneous product, then monopolistic competition

– If economic profits, then entry occurs

16

Introduction

• Common shortcomings– Time: short run vs. long run

– Market/industry boundaries

– Competitive behavior – competitive strategies, competitive advantage

– First entrant• Tipping point

• Networks

– Evolution of technology• Disruptive technologies

17

Introduction

• Problem: Many paths to the “if”, thus many paths for “then”

• Example: Monopoly– How was monopoly created?

• Government, natural monopoly, successful strategies, superior management, luck

– Entry barriers created as part of process?• Depends on how monopoly created

– Strategies to sustain monopoly?• Rent seeking – public vs. private sector

• Sustainability

18

Introduction

Decision making– Adam Smith: individuals pursuing their own self

interest will collectively produce the greatest good Greed is good (Gordon Gekko, “Wall Street I”), Economics 101

– Margin Call: You succeed by being fist, being smartest or cheating

• Importance of incentives: individuals motivated by personal well-being

• Politicians – Quebec municipal governments; Africa • Sub-prime loan markets, Madoff and Ponzi, derivatives –

CDS, traders – bond vigilantes• What about altruism – George Clooney, Angelina Jolie, Mat

Damon?• Giving pledge initiative – Gates and Buffett

19

Introduction

• Time horizon– Longer the time horizon – fewer constraints,

more uncertainty• Temporal interdependence among decisions made

at different points in time

• Increasing complexity

– Shorter time horizon• Tradeoffs

• Rash behavior

• Susceptibility to herd mentality – safety in numbers

20

Introduction

Markets and players– What is a market? What is capitalism?– Reliance on markets – role of uncertainty, number of

competitors – Rules and regulations: role of governments

• Ex ante vs. ex post rule making – political risk• Ability to influence rule makers

– Market boundaries: Who’s in, who’s out?• Who’s waiting to get in?• Are the boundaries shifting?• Geographic/product?

21

Introduction

Teams

• Creation of clubs/teams – tribalism – Reinforce early success

– Limit competition among members

– Economies of scale

– Solution to imperfect information, absence of trust

– Enhance benefits for all members

– Exclusionary

• Language, race, religion, culture, nationality, socio-economic

22

Introduction

Firms• Organization that transforms inputs into outputs• Collection of people working as team• Existence of firms

– Limited liability – raising capital

– What does a “firm” maximize?

– Who makes the key decisions and why?• Separation of ownership and control

– How is accountability managed within the firm?

– How are they/how should they be organized?

23

Introduction

• From here to there– Defining here

– Choosing among all possible theres

– Choosing the path to get there• Options created/foregone along each path

• How long to get there along each path

– What if “there” chosen proves to be the wrong one?• How do you find out?

– Role of milestones and contingency planning

– Leadership

24

Introduction

• Risks– Margin for error: PV/I

– Confidence in data and analysis

– Size of bet

25

Firms

• What is a firm?– Legal structure – corporations, partnerships, sole

proprietorships

• Ownership of a firm– Private, public, government, not-for-profit

– Potash/Air Canada/Petro-Canada/CNR all started as Crown Corporations; privatized

– Is government ownership needed? Consider Hydro One, OPG, TTC, LCBO, CMHC, GTAA, AECL, CDIC, Canada Post, EDC, Via Rail

• Objectives of a firm

• Advantages of a firm

• Organization and governance of firms

26

Existence of Firms

• Technological• Transactions costs• Contractual

27

Existence of Firms

Technological• Team production• Economies of scale – specialization through scale, learning

by doing; comparative advantage in use of resources; larger number of production technologies available; indivisibilities

• Q(X10) + Q(X20) < Q(X10, X20)• Lower cost to meter/monitor team members internally

within firm than externally via the market• Economies of massed reserves through ownership of assets

– Insurance against machine breakdowns– Diversification across markets to reduce peak-load capacities– Indivisibilities/synergies in overhead functions: sales, marketing,

finance, engineering, legal, research, distribution• Economies of scope

28

Existence of Firms

Technological• Need to supervise/monitor/meter

– Supervisor measures efforts, determines rewards

– Bounded rationality limits scope of control

– Rules for compensation – subjectivity, favoritism

– Who monitors the monitor?

• Compensation to motivate employees– Seniority systems

– Vested pensions – less important because of systemic deficits with defined benefit plans

– Performance-based bonuses

29

Existence of Firms

Technological• Limits because of diseconomies of scale

– Shirking – free riding: benefits of leisure accrue to individual, costs of leisure (reduced effort) shared by all members of team

– Monitoring and metering costs to minimize shirking– Difficulty in measuring individual effort/contribution– Bounded rationality, noise in transmission of

information– Hierarchical organization structure –

“guard”/unproductive labor– Boredom and specialization– Motivation – risk aversion

30

Existence of Firms

Value Chain and Internalization

Primary Activities:• Raw materials Inbound Logistics Operations (Manufacturing)

Outbound Logistics Marketing After-Sale Service

• Operations can be sub-divided into – Fabrication of Materials Production of Parts Sub-assembly

Final Assembly

• For service activities, the value chain would look different

31

Existence of Firms

Value Chain and InternalizationSupport Services, which overlay the Primary

Activities:• Firm Infrastructure – finance, planning, legal

• Human Resource Management

• Technology Development

• Procurement