MAE 214: ECONOMIC STRATEGY FOR BUSINESS LECTURE 1 INTRODUCTION: STRATEGY AND ECONOMICS 1 Strategy and Economics 1. The objective of this unit is to study and analyze strategy primarily from the perspective of eco- nomics: (a) Gaining a better understanding of how rms compete and organize themselves (b) Developing a more secure foundation for making good strategic decisions 2. Economic models feature the following four crucial elements: (a) Decision makers. Who are the active players? (b) Goals. What are the decision makers trying to accomplish? Are they prot maximizing, or do they have nonpecuniary interests? (c) Choices. What actions are under consideration? What are the strategic variables? What is the time horizon over which decisions can be made? 1
Transcript
MAE 214: ECONOMIC STRATEGY FOR BUSINESS
LECTURE 1
INTRODUCTION: STRATEGY AND ECONOMICS
1 Strategy and Economics
1. The objective of this unit is to study and analyze strategy primarily from the perspective of eco-nomics:
(a) Gaining a better understanding of how firms compete and organize themselves
(b) Developing a more secure foundation for making good strategic decisions
2. Economic models feature the following four crucial elements:
(a) Decision makers. Who are the active players?
(b) Goals. What are the decision makers trying to accomplish? Are they profit maximizing, ordo they have nonpecuniary interests?
(c) Choices. What actions are under consideration? What are the strategic variables? What isthe time horizon over which decisions can be made?
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(d) Relationship between choices and outcomes. What is the mechanism by which spe-cific decisions translate into specific outcomes? Is the mechanism complicated by uncertaintyregarding such factors as taste, technology, or the choices of other decision makers?
2 Main Topics
1. Economic Foundations of Strategy
(a) Cost and Revenue Functions
(b) Profit Maximization
(c) Pricing and Output Decisions
(d) Game Theory
2. Boundaries of the Firm
(a) Historical Perspective
(b) Horizontal Boundaries of the FirmCase Study: International Steel Market
(c) The Vertical Boundaries of the FirmCase Study: Australia’s Chicken Meat Industry
(d) Integration and Its AlternativesPepsi, Disney and Pixar, and KFC
3. Market and Competitive Analysis
(a) Market Structure and CompetitionCase Study: Retail Petrol Market in AustraliaCase Study: Airbus and Boeing
(b) Entry and ExitVictoria Taxi Industry
(c) Dynamic CompetitionTarget, Bunnings, Tesla
(d) Industry AnalysisCase Study: Australia’s Banking Industry
4. Strategy Dynamics
(a) Strategic PositioningCase Study: U.S. Airline IndustryQantas, Virgin, and the Dark Knight
(b) Sustaining Competitive AdvantageCase Study: Coke and PepsiCase Study: FedEx and UPS
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5. Internal Organization
(a) Performance Measurement and IncentivesAustralia’s Sugar Industry
3 Pricing and Output Decisions
1. Profit-maximization Hypothesis. The firm’s ultimate objective is to maximize profits
2. A firm’s profit equals its revenues minus costs.
3. Mathematically, we haveΠ(Q) = TR(Q)− TC(Q)
Q : the output
Π(Q) : firm’s profit function
TR(Q) : total revenue function
TC(Q) : total cost function
4. Profit maximization is an important concept in understanding the formation of business strategies
5. It could help a firm to make a better decision in several dimensions:
(a) Whether to take a specific marketing strategy or not
(b) When to expand the production capacity
(c) When to trigger a price war with competitors
(d) How to make a trade-off between long-term benefits and short-term losses
4 Cost Functions
1. The Total Cost Function. TC(Q) represents the relationship between a firm’s total costs andthe total amount of output it produces in a given time period, denoted by Q. The following figureshows a graph of a total cost function. For each level of output the firm might produce, the graphassociates a unique level of total cost. The total cost function is an effi ciency relationship in thatit shows the lowest possible total cost the firm would incur to produce a level of output, given thefirm’s technological capabilities and the prices of factors of production, such as labor and capital.
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2. Some examples of total cost function: TC(Q) = 2Q; TC(Q) = 3Q+ 10; TC(Q) = Q+ 5 (practice:draw each TC curve)
3. The total cost function has two components: fixed costs and variable costs. Variable costs, such asdirect labor and commissions to salespeople, increase as output increases. On the other hand, fixedcosts, such as general and administrative expenses and property taxes, remain constant as outputincreases.
4. Average Cost Function. The average cost function AC(Q) = TC(Q)/Q describes how the firm’saverage or per-unit-of-output costs vary with the amount of output it produces.
5. Examples of average cost function: AC(Q) = 2; AC(Q) = 3 + 10/Q; AC(Q) = 1 + 5/Q (try todraw each AC curve)
6. If total costs were directly proportional to output —for example, if they were given by a formula,such as TC(Q) = 5Q or TC(Q) = 37000Q, or more generally, by TC(q) = cQ, where c is a constant—then average cost would be a constant. This is because
AC(Q) =cQ
Q= c.
Often, however, average cost will vary with output. It may rise, fall, or remain constant as outputgoes up. When average cost decreases as output increases, there are economies of scale. Whenaverage cost increases as output increases, there are diseconomies of scale. When average costremains unchanged with respect to output, we have constant returns to scale.
4Qdescribes the rate of change of total cost with respect to output; that is, the cost of producing oneadditional unit of output.
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8. For example, suppose when Q = 100 units, TC = 400, 000, and when Q = 150, TC = 500, 000.Then 4Q = 150−100 = 50, andMC = (500, 000−400, 000)/50 = 2, 000. Thus, total cost increasesat a rate of 2,000 per unit of output when output increases over the range 100 to 150 units.
10. Businesses frequently treat average cost and marginal cost as if they were identical, and use averagecost when making decisions that should be based on marginal cost. But average cost is generallydifferent from marginal cost. The exception is when total costs vary in direct proportion to output,TC(Q) = cQ. In that case,
MC(Q) =c(Q+4Q)− cQ
4Q = c,
which, of course, is also average cost.
11. A more general relationship between average and marginal cost.
(a) When average cost is decreasing in output, marginal cost is less than average cost
(b) When average cost is increasing in output, marginal cost is greater than average cost
(c) When average cost is constant or at a minimum point, marginal cost is equal to average cost
12. These relationships follow from the mathematical properties of average and marginal cost, but theyare also intuitive. If the average of a group of things (costs of manufacturing cellular phones, test
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scores, or whatever) increases when one more thing (one more phone, one more test) is added tothe group, then it must be because the value of the most recently added thing —the “marginal”—is greater than the average. Conversely, if the average falls, it must be because the marginal is lessthan the average.
5 Revenue Functions
1. The demand function describes the relationship between the quantity of product that the firm isable to sell and all the variables that influence that quantity.
2. Price is the main factor that determines the demand of a product. Factors that affect the demandfor a product besides the price:
(i) Income
(ii) Substitutes and Complements (the prices of related products)
Example 1: Lyft Lowers Prices In Latest Rideshare War With Rival Uber
3. Of special interest is the relationship between quantity and price. To focus on this importantrelationship, imagine that all the other variables that influence the quantity demanded remainfixed, and consider how the quantity demanded would change as the price changes. The demandcurve P (q) shows the quantity of a product that consumers will purchase at different prices.
The demand curve is downward sloping: the lower the price, the greater the quantity demanded;the higher the price, the smaller the quantity demanded. This inverse relationship is called the lawof demand.
4. Total Revenue Function. The total revenue function TR(q) = P (Q)∗Q describes the relationshipbetween total revenue and output. In other words, it indicates how the firm’s sales revenues varyas a function of how much product it sells.
5. Marginal Revenue Function. The marginal revenue function MR(Q) = ∂TR(Q)∂Q or MR(Q) =
TR(Q+4Q)−TR(Q)4Q describes the rate of change of total revenue with respect to output.
6. Price Elasticity of Demand. Look at a firm that is considering a price increase. The firmunderstands that according to the law of demand, the increase in price will result in the loss ofsome sales. This may be acceptable if the loss in sales is not too large. If sales do not suffer much,the firm may actually increase its sales revenue when it raises its price. The shape of the demandcurve can strongly affect the success of the firm’s pricing strategy. The concept of the price elasticityof demand summarizes this effect by measuring the sensitivity of quantity demanded to price. Theprice elasticity of demand, commonly denoted by η, is the percentage change in quantity broughtabout by a 1 percent change in price. The formula is
η = −4Q/Q04p/p0,
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where 4Q = Q1 −Q0 and 4p = p1 − p0.
7. Example. Suppose price is initially $5, and the corresponding quantity demanded is 1,000 units. Ifthe price rises to $5.75, the quantity demanded would fall to 800 units. Then
η =800−100010005.75−55
=−0.2
0.15= 1.33.
8. Example: Price elasticity of demand for tobacco products
9. Suppose management believed η = 0.75. If it comtemplated a 3 percent increase in price, then itshould expect a 3 ∗ 0.75 = 2.25 percent drop in the quantity demanded as a result of the priceincrease.
10. If η is less than 1, we say that demand is inelastic. If η is greater than 1, we say that demand iselastic.
11. Relationship between MR and η. The following relationship between MR and η holds:
MR(Q) = p(Q)(1− 1
η).
When demand is elastic, so that η > 1, it follows that MR > 0. In this case, the increase in outputbrought about by a reduction in price will raise total sales revenues. When demand is inelastic, sothat η < 1, it follows that MR < 0. Here, the increase in output brought about by a reduction inprice will lower total sales revenues.
12. Example. If η = 0.75, and the current price p = 15, then marginal revenueMR = 15∗(1−1/0.75) =−5.
6 Profit Maximization Condition
1. To maximize the profit, the firm chooses output Q such that
3. This simple but important equation could help us solve many questions
(a) When to adjust prices in response to changes of business environment
(b) How to adjust to the optimal price level
(c) How the price should change in response to the change of cost structure
(d) How consumer sensitivity in price affects a firm’s pricing strategy
(e) When a new, similar product is introduced, how should a firm change its pricing strategy
4. When MR(Q) 6= MC(Q), the profit is not maximized, and the firm needs to adjust its pricingstrategy.
5. MR(Q) > MC(Q) =⇒ produce more =⇒ the firm should decrease price. On the other hand, whenMR(Q) < MC(Q) =⇒ produce less =⇒ the firm should increase price.
6. A big question is: to determine whether the profit is maximized, the firm needs to know whetherMR(Q) = MC(Q). MC(Q) can be easily estimated from the firm’s cost data. To estimateMR(Q),the firm needs to know the elasticity of demand. But how?
1. In many markets there are only a small number of firms. For example, Asahi, Kirin, Sapporo, andSuntory account for well over 90 percent of sales in the Japanese beer market. In the market forcommercial aircraft, there are essentially only two producers: Airbus and Boeing. In these “smallnumbers”situations, a key part of making strategic decisions —pricing, investment in new facilities,and so forth —is anticipating how rivals may react.
2. How does a firm rationally anticipate how its rivals may react? A penetrating approach is to attemptto “get inside the minds”of its rivals, figure out what is in their self-interest, and then maximizeaccordingly. However, your rivals’optimal choices will often depend on their expectations of whatyou intend to do, which in turn, depend on their assessments of your assessments about them. Howcan one sensibly analyze decision making with this circularity?
3. Game theory is a branch of mathematics and economics that provides powerful tools in analyzingstrategic interactions among firms.
4. The first game theory textbook was published in 1944. The main solution concept in game theory,Nash equilibrium, was formalized by John Nash in 1950. 50 years later in 1994, John Nash got aNobel prize in Economics for his contributions in game theory. The movie "A Beautiful Mind" is a2001 American biographical drama film based on the life of John Nash.
5. Formally speaking, game theory is the study of mathematical models of conflict and cooperationbetween intelligent rational decision-makers.
6. Be careful when applying game theory to make predictions =⇒ people may not be rational orintelligent... Watch the Name That Pasta game from MasterChef Season Four Episode 11 and youwill know what I am talking about. Or check "millionaire hot seat fails" on YouTube.
7. Consider an industry that consists of two firms, Alpha and Beta, that produce identical products.Each must decide whether to increase its production capacity in the upcoming year. The conse-quences of each firm’s choices are described in the table below. The first entry is Alpha’s annualeconomic profit; the second entry is Beta’s annual economic profit. Each firm will make its capacitydecision simultaneously and independently of the other firm.
Capacity Expansion Game
Firm BetaDo not expand Expand
Firm Alpha Do not expand $18, $18 $15, $20Expand $20, $15 $16, $16
8. To predict the likely outcome of games, game theorists use the concept of Nash equilibrium (NE):
Definition 1 A Nash equilibrium is a profile of strategies such that each player is doing the bestit can, given the strategies of the other players. In other words, at an equilibrium, no player wouldhave any incentive to change his/her strategy given the strategies by his/her opponents.1
9. In the capacity expansion game, the Nash equilibrium is a pair of strategies such that:
• Alpha’s strategy maximizes its profit, given Beta’s strategy• Beta’s strategy maximizes its profit, given Alpha’s strategy
1An explanation on how to find NE can be found here: https://www.youtube.com/watch?v=F_GFmjl6f4I
10. Hence, the Nash equilibrium is (Expand, Expand).
11. Check that the other three possible combinations are not equilibria.
12. We use Nash equilibrium to predict a plausible outcome of a game as it is a self-enforcing focal point :if each party expects the other party to choose its Nash equilibrium strategy, then both parties will,in fact, choose their Nash equilibirum strategies. At the Nash equilibrium, then, expectation equalsoutcome —expected behavior and actual behavior converge. So it is a stability concept (condition).
13. The Nash equilibrium does not necessarily correspond to the outcome that maximizes the aggre-gate profit of the players. Alpha and Beta would be collectively better off by refraining from theexpansion of their capacities. However, the rational pursuit of self-interest leads each party to takean action that is ultimately detrimental to their collective interest. This conflict between the col-lective interest and self-interest is often referred to as the Prisoners’Dilemma. The dilemma arisesbecause in pursuing its self-interest, each party imposes a cost on the other that it does not takeinto account. The prisoners’dilemma is a key feature of equilibrium pricing and output decisionsin oligopolistic industries.
14. To test your understanding on NE, watch the following bar scene from A Beautiful Mind
17. What is the Nash equilibrium in the modified capacity game?
18. Prisoner’s Dilemma
Two suspects in a crime are put into separate cells. If they both confess, each will be sentenced tofive years in prison. If only one of them confesses, he will be freed and used as a witness againstthe other, who will receive a sentence of 20 years. If neither confesses, they will both be convictedof a minor offense and spend one year in prison. What is a Nash equilibrium in this game?
20. Game of Chicken: the two players drive toward each other. Whichever veers (dove strategy) first,loses respect/esteem.
Two movies related to the Game of Chicken:
Rebel without a cause (1955): http://youtu.be/u7hZ9jKrwvo
Cry Baby (1990): http://youtu.be/fC0Y6OOXAvk
21. A payoff matrix of Chicken game
22. These examples assume that each party moves simultaneously. What if the players move sequen-tially? Say Firm Alpha moves first in the modified capacity game. Draw a game tree to describethis situation.
23. We use the concept of Subgame Perfect Nash Equilibrium (SPNE) to predict the outcome. In anSPNE, each player chooses an optimal action at each stage in the game that it might conceivablyreach and believes that all other players will behave in the same way.
24. In this sequential capacity expansion game, the SPNE is
Beta’s optimal strategy:
Small If Alpha chooses Do Not ExpandSmall If Alpha chooses Small
