Summary Economics 1 2011

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Economics for business by David Begg and Damian ward (3rd

edition) chapters

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Chapter 1: Economics for business.

1.1; What is economics?

Economics is the social science that analyzes the production, the distribution and consumption of

goods and services. It studies how individuals, firms, governments and economies deal with the

problem of infinite wants and finite resources.

Factors of production are the resources needed to make goods and services,: land, labor, capital and

enterprise.

- Land is where raw materials come from (e.g. oil, gas, base metals, wood etc.).

- Labor is the ability to work.

- Capital is composed by all the elements which take part in the production process (e.g. machinery,

computers, offices, buildings etc.).

- Enterprise is what brings land, labor and capital together and organizes them into business units

that produce goods and services with the objective of making a profit.

The production possibility frontier (PPF) is an important illustrative tool, showing the maximum

number of products that can be produced by an economy with a given amount of resources.

Figure 1 - PPF

The PPF shows how resources are finite. The maximum production possibility for a give country is

limited, and choices have to be made in order to decide what and how much to produce (How many

cars and how many computers for example). At any point on the PPF curve, the country is employing

all of its resources to produce the best mix of goods and services to fit its needs. At point X not all the

Computers

Cars

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A

B

75

25

75 25

C

50

50

X

Y

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resources are employed, thus there is a margin of improvement in terms of total output. Point Y

represents a level of output which is not available yet but which might be achieved in the future

(when more resources will be available).

Opportunity costs are the benefits foregone from choosing the next best alternative.

As noticeable in figure 1, the country will have to choose whether to produce more computers or

cars. In case it produces more cars, the opportunity cost will consist in the foregone benefit of

producing more computers instead. Ideally we try, when making decisions, to make the opportunity

cost as low as possible.

Macroeconomics is the study of how the whole economy works (e.g. at national level or the whole

market for one product/service), while microeconomics is the study of how individuals make

economic decisions within an economy. Macroeconomics deals with the performance, structure,

behaviour and decision making of the whole economy. Microeconomics is concerned with how

households and firms make decisions to allocate their limited resources.

In a planned economy the government is the major owner of all the factors of production and

decides how resources are allocated.

In a market economy private individuals own the majority of the economic factors of production and

the government plays no role in allocating the resources, which is done by the market itself without

regulation.

Most of the times is a mix of both (for example the healthcare system might be government based

while the production of groceries will be decided by the firms in the groceries industry). In a mixed

economy, the government and the private sector jointly solve economic problems.

Market economies rely on a very quick and efficient communication of information that occurs

through prices. Therefore the price system solves the problem of what should be produced and what

not and the quantities.

Gross domestic product (GDP) is a measure of overall economic activity within an economy.

A way of measuring the planned side of an economy is to examine the size of government

expenditure as a percentage of GDP.

1.2; Why study economics for business?

The focus of economics is on the functioning of markets, and markets are very important for firms.

First of all because the marketplace is where businesses sell their products and therefore where they

make profits. Second, the market influences the costs of businesses: land, labour, capital and

enterprise are all purchased through markets.

Governments can also intervene in the markets, usually in order to benefit the whole society.

Governments can either seek to boost revenues when the firms operate in the interest of the public

or reduce them (increase costs) when the firms operates against the interests of society.

Firms don’t only operate within their regional or national environment, but rather in a very complex

and massive global macroeconomic system. It’s therefore important that businesses, in order to be

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successful, understand how macroeconomic events and global change will impact on their current

and future operations.

1.3; Appendix: the economist’s approach.

Economists think about the world in terms of models or theories, stripping out the complexity of the

real world in favour of a simple analysis of the central issues.

Models or theories are frameworks for organizing how we think about an economic problem.

Positive economics studies objective or scientific explanations of how the economy works.

Normative economics offers recommendations based on personal value judgments.

Thus positive economics statements rely upon data and facts, while normative economics

statements are people’s opinion, and thus subjective statements.

Diagrams provide a visual indication of the relationship between two variables. Variables can have

either a positive or a negative relationship, the former meaning their values increase and decrease

together, while with the latter the two variables move in opposite directions (with an increase in one

there will be a decrease in the other one).

The equation of a straight line is Y = a + bX.

A quadratic is generally specified as Y = a + bX + cX²

The gradient is a measure of the slope of a line.

One method of measuring the gradient of a line is to calculate the ratio between ΔY / ΔX (the change

of Y divided by the change of X).

Another method involves the use of a simple mathematical function called differentiation.

Differentiation is a means of understanding the gradient. The rule consist in Xⁿ = nXⁿ¯¹.

For example: 4 + X³ = 3X² (all the constants become 0).

It’s important to business because if we want to discover the level of production that leads to

minimum costs per unit, then we need a mathematical equation which links production and costs,

differentiate, set to zero and solve to find the ideal level of production.

Economists use two different types of data: time series and cross-sectional.

Time series data are the measurements of one variable at different points in time.

Cross-sectional data are the measurements of one variable at the same point in time but across

different individuals.

Panel data combines cross-sectional and time series data.

A percentage measures the change in a variable as a fraction of 100.

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Since percentages measure the rate of change in a variable, we need both the original and the new

value of the variable to do so, with the help of the following formula:

[(New value – Original value) / Original value] x 100

For example, a company’s share price was 2$ in 2008 and 6$ in 2010. The percentage change will be

[(6-2)/2]x100 = 200, thus the share price increased by 200%.

Index numbers are used to transform a data series into a series with a base value of 100.

Why do we use index numbers? First because having a base value of 100, it is very easy to calculate

the percentage change in the variable over time. Also, it’s very easy to make averages.

The Retail Price Index is, for example, the average of many individual product price indices.

Economists use two different ways to calculate averages: the arithmetic and the geometric means.

Arithmetic means sum all the values and divides them by the number of values, creating an error

when measuring growth since when doing so the base value changes all the time. This error can be

avoided using the geometric mean.

For example:

Obserevations Arithmetic mean Geometric mean

2,2 (2+2)/2 = 2 (2x2)¹‘² = 2

2,3,4 (2+3+4)/3 = 3 (2x3x4)¹‘³ = 2.88

The percentage increase between 3 and 4 is not the same as the percentage increase between 2 and

3, therefore arithmetic mean shows an error when calculating growth.

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Chapter 2: Consumers in the marketplace.

2.1; Business problem: what is the best price?

The best price is determined by the firm’s objectives, usually one of the following:

• Maximise profits

• Maximise market share

• Maximise total revenues

Though also non-commercial objectives are possible, such as improving the environment or being a

socially responsible employer, these are the most common ones. It is generally not possible to for a

firm to choose more than one of these objectives (they’re often in conflict with each other).

2.2; Introducing demand curves.

In attempting to understand consumer’s behaviour, economists use a very simple construct known

as the demand curve.

The demand curve illustrates the relationship between price and quantity demanded of a particular

product. The slope of the demand curve Qd is negative (downward sloping).

Figure 1 – Demand curve

2.3; Factors influencing demand.

The demand curve shows a negative relationship between price and quantity demanded, but the

willingness of consumers to purchase a certain product is affected by more factors than just price.

These alternative factors are divided by economists in four broad categories:

• Price of substitutes and complements

• Consumer income

• Tastes and preferences

• Price expectations

Q

P

0

€10

€5

5 10

Qd

As the price falls, consumers are

willing to demand greater amounts

of the good and vice versa.

Qd1

15

Qd2

20

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Substitutes are rival products competing in the same marketplace (e.g., rice and pasta).

Complements are products that purchased jointly (e.g., cars and petrol).

To understand the effect of income upon demand, distinction between normal and inferior goods

has to be made.

Normal goods are demanded more when consumer’s income increases and less when income falls.

Inferior goods are demanded more when income level fall and demanded less when income rises.

Tastes and preferences reflect consumer’s attitudes towards a particular product. Over time these

tastes and preferences are likely to change.

Advertising plays a very important role in demand theory.

First, it provides consumers with information about the products, making them aware that a new

product is on the market, with its special features. Demand usually increases only just because

buyers know the nature and availability of the product.

Second, advertising is also about trying to change consumer’s tastes and preferences. Accordingly,

advertising is also about informing the consumer about what they should buy.

Whether advertising is providing information or developing consumers’ tastes and preferences

(desires), the overriding aim is to shift the demand curve from Qd to Qd2 (as in figure 1).

In terms of demand curves, if we expect to prices to fall in the future, then demand today will be

reduced as people is willing to delay the purchase in order to save money. This will shift demand

back to Qd2 (as in figure 1). Also opposite price expectations are possible, with prices believed to rise

in the future leading to anticipated purchase (moving the demand curve to the right).

Price expectations are beliefs about how prices in the future will differ from prices today.

The law of demand states that, ceteris paribus (all other things being equal), if the price of a product

falls, more will be demanded.

Some consumers prefer products that have an element of exclusivity, and high prices ensure

exclusivity along with signalling that the product is special. Therefore high prices sometimes attract a

special group of consumers, shifting the demand curve to the right. These product are usually said to

be status symbols.

But everyone has limited resources, so the curve will be still downwards sloping.

2.4; Measuring the responsiveness of demand.

Businesses need to know the impact of price changes on the quantity demanded.

Elasticity is a measure of the responsiveness of demand to a change price.

The elasticity of a product is determined by a number of factors:

• Number of substitutes

• Time

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• Definition of the market

As the number of substitutes increases, the more elastic will be demand.

In the early periods of a new market, demand tends to be inelastic (due to fewer competitors and

substitutes), but in the long term, as more products enter the market, demand is likely to become

more elastic.

In markets where the similarity between products is higher than in others, demand will be more

elastic (it’s easier for consumers to switch to another and similar product).

Mathematically economists can measure elasticity using the following formulae:

• ε= %ΔD/%ΔP (percentage change in quantity demanded / percentage change in price)

• ε= (ΔD/ ΔP) x (P/D)

The value of ε for elasticity will lie between zero and infinity (0 < ε < ∞).

ΔD/ ΔP Elasticity value (ε) Type of demand

0 0 Perfectly inelastic

0.5 < 1 Inelastic

1 = 1 Unit elastic

2 > 1 Elastic

Infinitely large = ∞ Perfectly elastic

When demand is perfectly inelastic, quantity demanded will not be affected by any change in price.

When demand is perfectly elastic, any change in price will hugely affect quantity demanded.

When demand is unit elastic, quantity demanded will change equally to the change in price.

2.5; Income and cross-price elasticity.

Income elasticity measures the responsiveness of demand to a change in income.

Cross-price elasticity measures the responsiveness of demand to a change in the price of a substitute

or complement.

Figure 2 Figure 3 Figure 2 = perfectly

inelastic demand [ε=0]

Figure 3 = perfectly

elastic demand [ε=∞]

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Income elasticity (Yε) = %ΔD/%ΔY

If Yε < 1 the product is described as income inelastic, demand will change slower that the

income does, while if Yε > 1 then the product is income elastic, and demand will change at a

faster rate than income.

Cross-price elasticity (XYε) = %ΔDx/%ΔPy

If products X and Y are substitutes or rivals, then, as the price of Y increases the demand for X will

increase, so XYε lies between zero and +∞.

If X and Y are complements, then, as the price of Y increases, quantity demanded for X will decrease.

XYε lies between zero and -∞.

2.6; Business application: Pricing strategies I – exploiting elasticity’s.

A rather simple approach to pricing is to simply take the cost of producing the product and add a

mark-up. This system is called cost-plus pricing. The benefits of this approach lie in it being simple,

you only need to know how much profit you want to add on the production expenses. Though, it fails

to take into account the consumer’s willingness or unwillingness to buy the product.

The best pricing method comprehends the understanding and utilization of price elasticity of

demand.

Total revenue is price multiplied by number of units sold.

If demand is elastic, then dropping prices will raise total revenues; if demand is inelastic, price should

be raised in order to increase total revenues.

Changing the price involves the development of new pricing plans and the communication of price

changes to retailers of the product. As a result, change can be costly and not always offset by

improvements in revenues. Change can also represent a risk, since competitors could react to your

price changes. Furthermore you may not fully understand the price elasticity of your product and

therefore make a mistake when repricing it.

If we wish to target unit elasticity (that’s where revenues can be maximised), we need a measure of

how far our current pricing is from this best price. To find the best price we need to gather data that

will enable the demand curve for our product to be plotted and mathematically modelled.

Once we have a demand curve, we can see the relationship between price and quantity and measure

the elasticity of demand at various prices.

Data is difficult to find and retailers are not willing to change prices just for the sake of experimenting

and gathering data, therefore the job is usually given to market research companies. These will

scanner data from large selections of retailers such as supermarkets across vast areas. For each price

at which the product is sold, the market researchers also note down how many units of the product

are sold at the tills.

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By using econometrics, trend lines can be drew and analysed, providing information about the price

elasticity of demand. Knowing that unit elasticity is what we are looking for, we will be able to move

in that direction from the actual position along the curve.

Successful products go through four phases of the product life cycle: introduction, growth, maturity

and decline. Unsuccessful products usually don’t pass the introduction phase.

At each stage there is a different competitive environment and thus elasticities of demand.

In the introduction stage an innovative product is likely to be unique and face few, if any,

competitors. Therefore demand will be price inelastic, as the early adopters aren’t able to switch to

another company or product easily. Firms could therefore set higher prices.

In the growth phase competition increases, as companies that witnessed the success of the product

in the introduction stage want to enter the market as well. Elasticity of demand rises and therefore

prices start to decrease.

To gain a dominant position in the marker prices should be cut, giving preference to increased

market share rather than to maximise profits.

At the maturity stage of the market competition is usually fierce, leading to higher price elasticity of

demand. This is a reasonable base for aiming at sales maximisation strategies. High price elasticity

means having little control over pricing, as competitive pressures force the price down.

As the product enters the decline part of its life cycle, competition becomes lighter as companies exit

a market where consumers are doing the same. Elasticity of demand will become more inelastic,

which along with greater price stability will allow higher prices to be set.

Therefore, throughout the product life cycle the pricing strategy has to be reactive to the changing

competitive nature of the market.

2.7; Business application: Pricing strategies II – extracting consumer surplus.

Consumer surplus is the difference between the price charged for a product and the maximum price

that the consumer would have been willing to pay.

Consumer surpluses represent a benefit for consumers, but also missed profits for businesses.

Price discrimination is the act of charging different prices to different consumers for an identical good

or service.

For price discrimination to be successful three elements must exist:

• The firm must have control over prices, thus an inelastic demand (having price-setting

power)

• The firm must be able to distinguish the different groups of consumers that are willing to

pay different prices

• The resale of the good must be prohibited

There are three different types/degrees of price discrimination.

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Under first-degree price discrimination each consumer is charged exactly what they are willing to pay

for the good/service. It is very unlikely to happen because none is ever going to pay what he would

be able to. Also quite complicated to manage. The most used application of this method is selling

through biddings.

The second-degree price discrimination consists instead in charging consumers different prices based

on the amount of quantity purchased. Usually there is a fixed cost plus a variable cost that will

depend on the amount purchased. For example telephone subscriptions. Consumers that are willing

to spend more will buy at a higher fixed cost but receiving lower variable costs, while people that is

not willing to pay as much will get the cheaper base cost but with higher variable costs.

Third-degree price discrimination is when different groups of consumers are charged different prices.

For example business class seats in flights. Another example could be the pay per view television

subscriptions. Starting from a basis package of certain channels, the more channels you want the

more you pay (e.g., sport channels, movie channels etcetera). This technique is called product de-

bundling.

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Chapter 3: Firms in the marketplace

3.1; Business problem; managing fixed and variable costs.

Fixed costs are constant, they remain the same whatever the level of output.

Variable costs change or vary with the amount of production or demand.

The biggest problem of fixed costs is not that they cost huge amounts of money, but that the nature

of the cost does not change with the output and revenues. Variable costs have the advantage that

they can easily be changed in relation to the revenues/production/demand.

3.2; The short and long run.

The short run is a period of time of production is fixed, we tend to assume that capital is fixed and

labor is variable. If demand changes in the short run, a company can easily employ or fire people to

manage that demand, but if they need to expand because of the growing demand they cannot easily

build a new office, therefore capital is fixed in the short run. But labor could also be fixed in the short

run if a company works with contracts, like professional football players; they signed a 5-year

contract so their labor is rather fixed than variable.

The long run is a period of time when all factors of production are variable. We cannot really give a

definition of how long the long run is, because it depends very much on the industry. In the internet

industry the long run may be a week, while in the airplane manufacturing industry the long run may

be ten years.

3.3; The nature of productivity and costs in the short run.

Productivity in the short run.

In assessing productivity, we need to distinguish between total product and marginal product. Total

product is the total output produced by a firm’s workers. Marginal product is the addition to total

product after employing one more unit of factor input (labor). Marginal always means ‘one more’.

See table 3.1 on page 56 to get a good understanding of total product and marginal product.

Task specialization helps to raise productivity because the total process is broken down into separate

components, each worker then specializes in one task and becomes an expert in that task.

The law of diminishing returns states that, as more of a variable factor of production, usually labor,

is added to a fixed factor of production, usually capital, then at some point the returns to the variable

factor will diminish. In other words; over-resourcing of capital (putting four people behind one cash

desk) does not raise productivity/marginal product.

Costs in the short run.

In the short run, we have three types of costs; variable costs, fixed costs and total costs. Variable

costs are costs associated with the use of variable factors of production, such as labor. Fixed costs

are associated with the employment of fixed factors of production, like capital. Total costs are simply

fixed costs plus variable costs.

Average costs.

We measure the costs per unit using average costs. To calculate the average costs we have to divide

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the total costs by the number of units produced. You can subcategorize this by doing it for the

variable and fixed costs.

To calculate the marginal costs we have to divide the change in total costs by the change in output.

If we make graphs with the lines of average costs and marginal costs, it should be noted that the

marginal cost curve cuts through the minimum points of the average total and average variable cost

curves. This is a mathematical relationship which is difficult to explain.

3.4; Output decisions in the short run.

The price you sell your products for should always be related to your fixed and variable costs. If your

price is lower than the average fixed costs but higher than the average variable costs you could still

produce and sell and try to cover as much as possible of your fixed costs with the ‘profit’ you made

on the average variable costs. But if your price is lower than both average costs you shouldn’t

produce. If a company produces one more unit and the firm can receive a price that is equal to or

greater than the marginal cost, then it can break even or earn a profit on the last unit.

3.5; Cost inefficiency.

We only looked at the cost curve this far, but this does not give a clear view on how firms operate

because one firm may be way more efficient than another firm. Cost inefficiencies lead to

competitive disadvantages, so operating as near to the cost curve as possible is the best thing to do

for companies.

3.6; The nature of productivity and costs in the long run.

In the long run, both capital and labor are variable. Therefore, the law of diminishing returns does

not determine the productivity of a firm in the long run. This is simply because there is no fixed

capital in the long run to constrain productivity growth. So, in the long run, productivity and capital

must be driven by something else; returns to scale. Increasing returns to scale exist when output

grows at a faster rate than inputs. And the other way around of course. Constant returns to scale

exist when inputs and outputs grow at the same rate.

Economies of scale: production techniques.

Economies of scale exist for a number of reasons. The greater the scale of operations/production, the

more specialization is needed by workers, and the production uses mass-production techniques.

Therefore, as firms change their level of scale, they also change their production process and long-

run costs fall.

Indivisibilities.

This is about not being able to separate your fixed costs. E.g. if you have a jumbo jet that can carry

400 passengers, but you only find 300 passengers you cannot chop off the back of the plane to cut

your costs. Increasing your scale by buying another plane which flies from the end point to a new

point may give you the 100 passengers because they want to fly from the start point to the end point

via the middle point. This is nothing more than spreading fixed costs.

Geometric relationships.

Volume is a measure of storage capacity. So, if you decide to create a tank to brew beer, and we

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decide to double the volume of the tank, the material needed will not double in size. It becomes

proportionately cheaper to build larger tanks than it does to build smaller tanks.

Diseconomies of scale.

Long-run average costs will eventually begin to rise because, as companies increase in size, they

become more difficult to control and co-ordinate. More managerial input is required to run the

business.

Competitive issues.

The lowest point on the long-run average total cost curve is defined as the minimum efficient scale.

This is the output level at which long-run costs are at a minimum. The closer you are to the point of

minimum efficient scale, the more competitive your operation is. In order to take advantage of this

sort of economies of scale, a company might merge with another company. The new company will be

bigger than the two separate parts and economies of scale can be realized.

3.7; Business application; linking pricing with cost structures.

In every example given so far, fixed costs are a major component of total costs. We know that

volume is crucial when fixed costs are high, because additional volume helps to spread the fixed

costs over additional units of output. This lowers cost per unit sold, which ultimately lowers prices.

From the demand theory we know that we can generate higher demand at lower prices.

3.8; Business application; footballers as sweaty assets.

A common business term for making your fixed inputs work harder is ‘to sweat the assets’.

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Chapter 4: Markets in action

4.1: Business problem: picking a winner.

Volatility (fluctuations) in prices makes financial planning very difficult for business owners, they

never know whether it is the right time to invest because of the changing environment. This problem

is not just limited to investing, the wage or price at which you hire employees also depends on the

market (demand and supply). Greater supply will increase competition and prices will fall, while

higher demand by firms will lead to higher wages. Predicting what market prices are going to do can

lead to a competitive advantage.

4.2: Bringing demand and supply together.

A supply curve depicts a positive relationship between the price of a product and the firm’s

willingness to supply the product. It has a positive slope; which is logical because the higher the

price, the more you would be willing to supply. If a firm wishes to maximize its profits, then it has to

be willing to supply additional units of output if the price it receives is greater than, or at least equal

to, the marginal cost.

Factors that lead to a shift in supply are;

- More firms entering the market, which logically increases industry output and therefore the supply

curve moves to the right. If firms close down the curve moves to the left because of less industry

output.

- If costs of labor, or other inputs, increase, profits must fall. As profits decrease, firms will be less

willing to supply and so the supply curve will move to the left. When prices of inputs fall, making

profits will be easier so more firms will be willing to supply and the supply curve moves to the right.

- If a new technology is invented that enables firms to be more productive, then their costs will fall.

This makes profits increase and firms are willing to supply more, therefore the supply curve moves to

the right.

Market equilibrium.

Where demand and supply meet is known as the market equilibrium. This occurs at the price where

consumers’ willingness to demand is exactly equal to firms’ willingness to supply. Any other

combination of price and quantity that are not the equilibrium values are described as market

disequilibria. If the market is in disequilibrium, then negotiations and resulting price changes will

push the market towards its equilibrium position

4.3: Changes in supply and demand.

Demands shifts to the right (increasing demand) is caused by:

- For a normal good when income increases, for an inferior good when income decreases.

- Following an increase in the price of a substitute.

- Following a reduction in the price of a complement.

- When tastes and preferences for this good improve.

Demand shifts to the left (decreasing demand) is caused by:

- For a normal good when income falls, for an inferior good when income rises.

- Following a decrease in the price of a substitute.

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- Following an increase in the price of a complement.

- When tastes and preferences for this good deteriorate (become worse).

Another important issue in changing demand are price expectations, these relate to views on future

prices. If prices are going to rise in the future, then you will bring forward your consumption.

Supply shifts to the right (increasing supply) is caused by:

- If more firms enter the market.

- If the costs of inputs, such as labor and raw materials, becomes cheaper.

- If technological developments bring about productivity gains.

Increased competition should lead to a drop in prices and more consumers taking up the product

because of the lower prices.

Supply shifts to the left (decreasing supply) is caused by:

- If firms exit the market.

- If the costs of inputs become expensive.

Elasticity and changes in the equilibrium.

Under inelastic supply we should expect that supply will not react strongly to a change in the price.

Although prices may rice a lot, supply doesn’t rise that much. By making the product scarce, or by

engineering inelastic supply, the price in the market will rise. When demand is elastic, the increase in

supply brings about a small change in the price. A small change in price means a big change in supply.

The lesson learned from this is: if faced with inelastic demand for your product, do not increase your

production capacity and thereby increase supply, because the price will drop quicker than output

increases and your total revenues will fall. However, if you are faced with elastic demand, do consider

increasing your capacity and supplying more to the market, as output grows at a faster rate than the

declining price and so total revenues will rise.

4.4: Disequilibrium analysis.

When supply exceeds demand, the market is said to be running a surplus. More is supplied than

demanded. The only way to sell the excess stock is to begin discounting the price until everything is

sold. The more unnecessary stock, the bigger the discount rates. The opposite situation is called a

market shortage, in this case demand is bigger than the supply. Two responses are likely: firms may

recognize the high demand for their products and raise the price or consumers may begin to bid up

the price in order to gain access to the product.

4.5: Pooling and separating equilibrium.

A separated equilibrium is where a market splits into two clearly identifiable sub-markets with

separate supply and demand. This is not really a realistic example. Pooling equilibrium is a more

realistic situation, this is a market where demand and supply for good and poor products pool into

one demand and one supply. Good products cannot be differentiated from bad goods.

Gresham’s law states that an increasing supply of bad products will drive out good products because

good products are more expensive to make. In order to solve this problem good-product-suppliers

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need to find a way of creating a separating equilibrium. The way to achieve this is to do something

that bad-goods-suppliers cannot do, like a 12-month warranty.

4.6: Business application: marketing pop concerts – a case of avoiding the equilibrium price.

For certain ‘luxury’ or ‘very-demanded’ products the equilibrium price is not good. Take the example

of a concert, if tickets are sold at the equilibrium price, it will only be just a sellout. If you then lower

the price, more people will demand the tickets and therefore the concert will be sold out in a matter

of hours. The importance of a sellout concert will be evidenced by the positive media attention. So

selling for lower prices raises demand which makes a concert seems extremely demanded. This helps

to reinforce the image of the celebrity in many ways; merchandising, CD’s and media attention.

4.7: Business application: labor markets.

Input markets are where factor inputs, such as land, labor, capital or entrepreneurship are traded.

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Chapter 5: Market structure and firm performance.

5.1; Business problem; where can you make profits?

The answer is simple: in any market where consumers are willing to pay a price that exceeds your

costs.

Demand is elastic: if one shop drops its prices, students will flock to this shop.

Demand is inelastic: whether a shop lowers or raises its prices, students will keep buying at that

shop.

5.2; Profit maximization.

Average revenue: the average price charged by the firm and is equal to the total revenue/quantity

demanded: (PQ)/Q.

Marginal revenue: is the change in revenue from selling one more unit.

Profit maximization: the output level at which the firm generates the highest profit.

Marginal profit: the profit made on the last unit and is equal to the marginal revenue (MC=MR)

minus the marginal cost.

If MC=MR, than MR-MC has to be 0.The firm maximizes profit when marginal profit = 0. When MR >

MC, the firm is making a marginal profit. When, MR < MC they make a marginal loss.

If demand increases for a product, the marginal revenue curve will shift to the right. This is because

when the market price increases at all output levels, the firm will receive a higher price for each

additional unit of output. In contrast, if demand for the product fell, then the marginal revenue curve

would shift to the left. With lower marginal revenues, the profit maximizing output would be

reduced.

5.3; The spectrum of market structures.

Perfect competition: a highly competitive competitive marketplace.

Monopoly: a marketplace supplied by only one competitor, so no competition exists.

Imperfect competition: a highly competitive where firms may use product differentiation.

Oligopoly: a market that consists of a small number of large players.

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Market structure: the economist’s general title for the major competitive structures of a particular

marketplace.

Perfect competition:

- Many buyers and sellers

- Firms have no market power

- Homogeneous products

- No barriers to exit* or entry

- Perfect information

* Exit barriers make exit from a market by existing competitors difficult.

Perfect competition is characterised by a set price. The curve will show two strokes crossing each

other somewhere in the middle.

Pricetaker: a firm who accepts the market price.

Accounting profits: are revenues less raw material costs, wages and depreciation.

Differences between accountant’s view and economist’s view see figure 5.10 page 107.

Economic profits: are revenues less the costs of all factors of production.

Normal economic profits: are equal to the average rate of return which can be gained in the

economy.

Supernormal profits: are financial returns greater than normal profits.

The market equilibrium (The state of equilibrium that exists when the opposing market forces of

demand and supply exactly offset each other and there is no inherent tendency for change. Once

achieved, a market equilibrium persists unless or until it is disrupted by an outside force. A market

Market structures

Imperfect competition

Financial and commodity

markets

Perfect Competition

Small service sectors, bars, restaurants

Oligopoly

Supermarkets and banking

Monopoly

Microsoft and the Beckhams

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equilibrium is indicated by equilibrium price and equilibrium quantity.) can be influenced by entry

and exit of competitors in the market or by change in demand.

Productive efficiency: means that the firm is operating at the minimum point on its long-run average

cost curve. Moreover, in long-run equilibrium the firm is charging a price that is equal to the marginal

cost. This means that the firm is also allocatively efficient.

Allocative efficiency: occurs when price equals marginal cost, or P = MC.

5.5; Monopoly.

The UK competition authorities define a monopoly to exist if one firm controls more than 25 per cent

of the market.

Monopolies tend to exist because of barriers to entry. An high entry barrier can be caused by licences

or patents.

A natural monopoly: exists if scale economies lead to only one firm in the market: the produce

enough to fulfil the total needs in a market.

Creative destruction: occurs when a new entrant outcompetes incumbent companies by virtue of

being innovative.

Rent-seeking behaviour: the pursuit of supernormal profits. An economic rents is a payment in

excess of the minimum price at which a good or service will be supplied.

See table 5.4, page 116 for the key comparisons of perfect competition and monopoly.

5.6; Business application; understanding the forces of competition.

The five forces of Porter model is strongly related to perfect competition. For every force a manager

need to assess the following:

Bargaining power of suppliers:

- Number of suppliers

- Differentiation of outputs

- Ratio of input supply price to the output price

Bargaining power of customers:

- Number of buyers

- Number of substitutes available to buyers

- Price sensitivity of buyers

Threat of entry:

- Existence of entry barriers

- Capital entry requirements

- Access to distribution

- Threat of retaliation

Threat of substitutes:

- Price of substitutes

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- Differentiation of substitutes

Strategy and rivalry:

- Number of firms

- Exit barriers

- Rate of industry growth

If a company has a weak understanding, or lack of control over its competitive forces, then profits

will plummet. In contrast, if the firm can understand and manage the forces of competition that it

faces, then it has a better change of becoming monopoly.

5.7; Business application; oops we’re in the wrong box – the case of the airline industry.

Figure 5.19 on page 119.

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Chapter 6: Strategic rivalry.

6.1; Business problem; will rivals always compete?

strategic interdependence: exists when the actions of one firm will have implications for its rivals.

Oligopoly: a marketplace with a small number of large players such as banking, supermarkets and the

media.

Monopolistic competition: a highly competitive market where firms may use product differentiation.

For the most part it is the same as perfect competition except for the existence of product

differentiation. There are many examples of monopolistic competition and the all must relate to

differentiation in some form or other. Bars can be differentiated by location, or thing they sell. Shops

can be differentiated by distance, papers has to be sold in local shops, while people would drive an

hour to get food.

The monopolistic long-run equilibrium has some important features. First, the tangency equilibrium

results in average costs being above minimum average costs.

tangency equilibrium: occurs when the firm’s average revenue line just touches the firm’s average

total cost line.

In comparison with perfect competition, long-run equilibrium in monopolistic competition does not

result in firms operating at minimum average total costs. Therefore, monopolistic competition is not

productively efficient.

In long-run equilibrium, firms in monopolistic competition have some monopoly power because price

exceeds marginal costs. In perfect competition, freedom of entry and exit ensures that in long-run

equilibrium price, average cost and marginal cost are equal. There is no market power in perfect

competition. Firms in perfect competition are indifferent between serving a new customer and

turning them away. This is because the revenue from one more sale is always higher than the costs.

(P > MC).

Characteristics of monopolistic competition:

- product differentiation

- few opportunities for economies of scale

- zero economic profits

- yet, some power over pricing

6.3; Oligopoly theory.

An oligopoly is a market with a small number of large players. Unlike in perfect competition, each

firm has a significant share of the total market and therefore faces a downward-sloping demand

curve for its products. Firms in oligopolies are price-setters as opposed to price takes. Oligopolies are

often referred to as highly concentrated industries, implying that competition is concentrated in a

small number of competitors. A simple measure of concentration is the N-firm concentration ratio,

which is a measure of the total market share attributed to the N largest firms.

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N-firm concentration ratio (CR): a measure of the industry output controlled by the industry’s N

largest firms. So, the percentage of the market, owned by the N largest firms. For example: jumbo

(17%), albert heijn (23%) and super de boer (18%)are the 3 largest firms in the market, then the

three-firm concentration ratio is: 58%.

Entry barriers: represent an obstacle to a firm’s ability to enter a industry.

The costs for a firm can be exogenously or endogenously determined. Our natural entry barriers are

concerned with exogenous costs: means external, outside. These costs are outside the control of a

firm. This doesn’t mean that these costs are uncontrollable; rather, the firm does not influence the

price of labour, machines, raw materials and the production technology used. The level of costs

associated with a particular industry, as we saw with monopolies, can create an entry barrier.

In order to enter and compete in a industry its essential to build up a plant that is at least as big as

the MES (minimum efficient scale). For example, if we have 50 million customers and the MES is 10

million units per year, then we might reasonably expect 50m/10m = 5 firms in the market. If we

consider supermarkets, it is easy to see why natural entry barriers may exist. The big players in the

supermarket industry have in excess of 500 stores each. So the MES must be around 500 stores. So, it

is the natural, or exogenous, cost characteristics, coupled with the market size that leads to a natural

entry barrier and the creation of an oligopoly.

What happens if the MES it not very big compared with the market size? Entry is easier and aids

competition. Consider the case of soft drink manufactures. If you wish to enter the soft drinks

market, then you need to buy a bottling plant, a factory to house in and a warehouse and maybe

some trucks. These costs won’t exceed the 5million. This is for many companies not a huge amount

of money. So, the MES is not big and, therefore the entry barrier into the market is limited. So, as a

firm inside the market, how do you prevent entry? Easy; you change the cost characteristics of the

industry and make the MES bigger, or, as the economist would say, you endogenize the cost

function. If costs are endogenized, the firms inside the industry have strategically influenced the

level and nature of costs.

Sunk cost: is an expenditure that cannot be regained when exiting the market.

Contestable market: a market where firms can enter and exit the market freely. This exists when

there are no sunk costs.

6.4; Oligopoly theory: competition among the big ones.

A cartel is when all companies in a oligopoly co-operate and act as one monopolist, as this generates

the highest level of profits. Collusion is likely to fail when there is:

- a large number of firms

- product differentiation

- instability in demand and costs

6.5; Competition among rivals.

A kinked demand curve shows that price rises will not be matched by rivals, but price reductions will

be. That’s why this curve is often used to explain the pricing behaviour of competing petrol stations.

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Since car drivers can always drive on to the next filling station, each petrol station has a number of

nearby competitors. If one increases the prices, then the rest will hold prices to attract drivers. The

demand curve has a different shape above and below the current market prices:

1. The firm raises its price, rivals will keep their prices constant. The firm will, therefore, lose

customers when it raises prices. As a result, demand above the current market price is elastic.

2. In contrast, if a firm reduces its prices, all rivals will match the price reduction. The firm will not

gain more demand by reducing prices. Demand below the current market price is therefore inelastic.

6.6; Game theory.

The game theory seeks to understand whether strategic interaction will lead to competition or co-

operation between rivals.

To understand why competing, rather than co-operating, with a rival is preferable we need to

understand the importance of the nash equilibrium. The nash equilibrium occurs when each player

does what is best for themselves, given what their rivals may do in response.

A dominant strategy is a player’s best respond, whatever its rival decides. In a single-period game,

the game is only played once. In a repeated game, the game is played a number of times.

A credible commitment or threat has to be one that is optimal to carry out.

6.7; Game theory extensions: reaction functions.

Residual demand is equal to the market demand less the amount produced by the firm’s rivals.

In a Cournot model each firm threats its rival’s output as a given.

A reaction function shows that a firm’s profitmaximizing output varies with the output decision of its

rival.

A first-mover advantage ensures that the firm which makes its strategic decision first gains a

profitable advantage over its rivals.

A Stackelberg model is similar to the output approach of Cournot, but firms do not make strategic

decision simultaneously.

6.8; Auction theory.

There are four types of auction formats: the English auction (bids begin low and are increased

incrementally until no other bidder is willing to raise the bid. The Dutch auction (prices start high and

are gradually reduced until a bidder accepts the price and wins the auction). The first price sealed-bid

auction (bidders must submit a single bid, usually in writing). Second-price sealed-bid auction (a

variation on the first price sealed-bid auction. Again, bids are submitted in writing, but the highest

bidder pays the price of the second highest bid.

Private values means each bidder has a private, subjective, value of an item’s worth.

Common values means the value of the item is identical for all bidders, but each bidder may form a

different assessment of the item’s worth.

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The revenue equivalence theorem states that under private values each auction format will

generate the same level of revenue for the seller.

The winner’s curse is where a winning bid exceeds the true value of the sold item.

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Chapter 7: Growth strategies.

7.1; Business problem: how should companies grow?

Different types of growth:

1. Organic growth – The simple growth over time. In a market with rapidly expanding demand,

organic growth can be very sustainable. But strong competition can reduce growth, competition can

cut prices and volumes.

2. Horizontal growth – Merging two similar companies is referred to as horizontal growth, thus

occurs when a company develops or grows activities at the same stage of the production process.

Advantages can be increased sales, achievement of economics of scales and decreased operation

costs.

Diversification – The expansion of variety by product and geography would be considered

diversification . There is a difference between unrelated and related diversification. The separation of

those two can be very difficult; a supermarket operating in groceries, food, electronics and banks can

appear unrelated, but can equally be considered as different aspects of the retail market. Growing in

diversified way can mean an offset of risks as non-food sales may grow more than food sales.

3. Vertical growth – Means taking over the vertical chains of production. The chain consist of

sourcing, producing and distributing. A company might prefer vertical integration for the reason of

having more control on the value chain (quality, security).

7.2; Reasons for growth.

If a firm is a profit maximize, growth can be pursuit for revenue or costs improvements.

7.3 Horizontal growth.

Horizontal growth can occur in different ways for example: organic growth by buying more assets

(airline buying more airplanes). A firm can also consider acquisition and merger.

In either case, the company grows by merging its activities with those of an existing operator.

Merger: Generally involves 2 companies agreeing by mutual consent to merge their existing

operations.

Acquisition: Involves one firm purchasing another firm, This might occur by mutual consent or in a

hostile takeover, where the manager might try to resist the takeover.

Horizontal growth and revenue

In Chapter 2 elasticity of demand was examined. We can state that in case of inelasticity, dropping

prices will not lead to an incline in revenue, but raising prices do. In a case of elastic, dropping prices

rather than rising prices will lead to increased revenue.

Reducing competition

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In the case of merger and acquisition, at least 1 competitor will disappear, so competition will be

reduced. This leads to a reduction of substitutes, so likely the elasticity of demand is reduced as well.

Leaving less chance of price wars. If we now also consider perfect competition, oligopoly and

monopoly, we can reinforce the arguments above. Under perfect competition with a large number of

competitors, prices and profits are lowest. Under monopoly, prices and profits are highest. Under

oligopoly, consolidation in the industry can lead to greater cooperation to reduce competition and

even to the forming of cartels.

Exploiting market growth

The incentives from revenue and horizontal growth emanates from two main sources: first, a

reduction in the number of competitors and, therefore reducing elasticity, making price raises easier

and price wars less likely and second, to take advantage of customer growth opportunities in the

market.

Horizontal growth and costs

First, it is said that merger/acquisition leads to a reduction of long-run average costs and benefit

from economies of scale; As two companies come together you only need one CEO, one department

for Marketing and so on. This is called the principle of Rationalization. However, it is possible that a

firm becomes too big which leads to diseconomies of scale, problems of control and co-ordination.

This leads to reduced productivity, which in turn leads to increased long-run average costs.

Second, an alternative cost reason for horizontal expansion is the benefit to be had from the learning

curve. The learning curve says: ‘As cumulative output increases, average cost fall’. For an example of

the learning curve, see page 158 of the book.

7.4 Vertical growth.

Location benefits

For the steel industry for example melting plants are often located near steel rollers. Rolling steel

means it has to be heated, steel still heated from the melting process, can be more easily processed

then if they had to be cooled down, transported and heated again for being processed.

Problems from monopoly

It is possible that materials might be supplies by a monopoly. In which the price of materials is high.

A simple solution is to buy the supplier.

Transaction costs

Transaction costs are the costs associated with organizing the transaction of goods or services. If a

contract is established for the supply of goods or services, time of negotiating and lawyers

establishing the actual contract are both listed as transaction costs. Economist highlight a number of

factors that are likely to lead to higher transaction costs, these factors are all related to the degree to

which the contract or agreement can be declared complete. Under a complete contract, all of the

aspects of the contractual arrangement are fully specified.

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Aspects of a contract

Complexity - Is an obvious factor. For example sand is an uncomplicated product whilst lecturing is

complicated. As the product becomes more complex, the more incomplete the contract becomes. As

the contract becomes more incomplete, the higher are the cost of transaction

Uncertainty – Also affect the ability to write a complete contract. In the case of a bag of sand, the

certainty is high, for example in changing situations (changing weather) the bag remains the same.

Whilst a lecturer can be subjected to changing theory.

Monitoring – The more simple and certain the contract is, the more easy it is to monitor the

contract. Again compare the bag of sand and the lecturer. The delivery of a bag of sand is easy,

assessing whether the lecturer did a good job is less easy.

Enforcement – In the case of an incomplete contract it is more difficult to enforce.

Nexus of contracts – Is a collection of interrelated contractual relationships, where the firm

represents a nexus/central point, at which all these interrelated contractual relationships are

managed in the pursuit of profit.

Transaction costs and vertical growth

When will a firm grow or shrink along its vertical axis? The firm will grow when it needs to reduce its

transaction costs by making use of its hierarchy or managerial structure to control its transactions.

On the other side firms will shrink when it beliefs that it is possible to use the market to reduce

transaction costs.

Vertical growth: strategic considerations

An important transaction problem is the hold-up problem, which is the renegotiation of contracts

and is linked to asset specificity. A specific asset has a specific use; a general asset has many uses.

7.5 Diversified growth.

Diversification involves a company expanding into related or unrelated markets.

This may occur for a number of reasons, but a strong costs reason centres on the concept of

economies of scope. Which is said to exist if the costs of producing two or more outputs jointly is less

than the costs of producing the outputs separately. Cost (A) + Cost (B) > Cost (A+B)

Diversification and risk reduction

Diversification can reduce a company’s exposure to risk. By being active in more than 1 market, the

risks are spread in case of threats of new entrants, recession or falling back sales. On the other hand

the profit of a company will rise if one of the markets its being active in faces fall of costs or

increased sales. In order for this to be true the various operations must form a diversified portfolio of

business activities, which means it contains a mix of uncorrelated business operations.

7.6 Evidence on mergers.

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To examine how mergers of all types improve firm-level performance, economist have used a variety

of techniques. These techniques have included stock market studies, financial ratio analysis and case

studies. Stock market studies investigate whether shareholders from the buying firm or the acquired

target firm gain most. Most commonly acquired forms gain most. Financial and accounting examine

merger activity within similar industry. Case studies examines specific mergers and look for firm-

specific example of merger benefits.

7.7 Business application: horizontal growth by merger.

Merger is attractive in times of recession as well as in a growing economy. In a recession firms hope

to benefit from economies of scale and be more cost-efficient. Whilst in a situation of a growing

economy firms see options to merge as a means of exploiting growth while achieving economies of

scale.

7.8 Business application: vertical growth – moving with the value.

A common feature of business firms is change. The consequence of changes is that the value added

in each stage of the vertical chain of production also changes. As costs fall, or revenues rise, then one

part of the value chain becomes more valuable. Similarly as costs rise, or revenues fall, then another

part of the value chain becomes less valuable.

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Chapter 8: Governing business.

8.1 Business problem: managing managers.

Within all of us there is an element of Homer Simpson (actually stated in the book!). We appear to do

a lot but often have more willingness to do little. Recognizable are frequent coffee breaks, toilet

visits or even pub visits in work time! This is called the principal-agent problem. Basically a principal is

a person who hires an agent to undertake work on their behalf. Principal can suffer from 2 profound

problems; the interests of the agents and the principal differs and principals can have difficulties

monitoring the agents work. The principal expects when he hires the agent that the agent will, as he

has promised, increase profit. If he does not, moral hazard-type behaviour is the case. This occurs

when someone agrees to undertake a certain set of actions but then, once a contractual

arrangement has been agreed, behaves in a different manner. The costs of this behaviour are more

generally termed as agency costs, meaning it reflects reductions in value to principals from using

agents to undertake work on their behalf.

8.2 Profit maximization and the separation of ownership from control.

Earlier it was stated that firms are profit maximizers, trying to bring MC (marginal costs) and MR

(marginal revenue) into an equilibrium. But this is very complex since raw materials prices change,

companies are likely to sell more than 1 product and output prices could change. So, they are never

sure what ‘the’ maximum profit is. Aside from this practical problems of trying to equate MC and MR,

there are strong reasons why a firm might pursue objectives different than profit maximization.

Crucially it is often the case that the individuals who manage a firm are different from the individuals

who own the firm. Separation of ownership from control exists where the shareholders, who own

the company, are a different set of individuals from the managers that control the business on a day-

to-day basis.

Managerial objectives

Economist have proposed a number of alternative theories relating to the objectives that managers

might pursue.

Consumption of perquisites

So, rather than work hard for the company’s owners, managers would rather indulge themselves in

the purchase of expensive cars, jets and lavish expense accounts that can be used to dine clients (and

friends). So managers try to express dominance and success.

Sales maximization

An alternative hypothesis recognizes that the measurement of profit can be subjective. How much

will the firm decide to depreciate its assets and what provision for bad debts will it charge to the

profit and loss statement this year? So managers might decide the maximize sales. Often mistaken is

that people think that profit increases as revenue increases, this is not true giving the fact of

diseconomies of scale and the law of diminishing returns.

Growth maximization

The final hypothesis is that managers will seek to maximize growth, rather than profit. It is no

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surprise that the pay of top directors is linked to the size of the company. Other intentions can be

having an competitive advantage, economies of scale and increased power over pricing.

Behavioural theories

Behavioural theories of the firm are based on how individuals actually behave inside firms.

Goal setting

Organizations are complex environments represented by a mixture of interest groups, including

managers, workers, consumers and trade unions. Even within managers there are sub-groups such as

marketing managers, account managers and production managers. If for instance the marketing

manager gets to the top of the company, extra money will flow to the marketing department. So

different people represent different goals.

Target setting

Regardless of which goals or objectives predominate, the complexity of the environment will mean

that measures and targets are difficult to set. How much should sales increase? 10% or 20%. It has to

determined what is realistic. And set a maximum level of growth and a acceptable level of growth.

Herbert Simons invented the concepts of satisficing, which is the attainment of acceptable levels of

performance. For example 10% growth is acceptable and 20% is maximum. But the establishment of

the maximum growth is difficult, it could be 20%, 25% or even 50%. And, failure to meet a goal

creates tension between the group who sets the goal and the people pursuing them, so it’s maybe

better to set a realistic goal. Thus, separation of ownership from control provide managers with the

incentive to pursue any of the above objectives.

8.3 Principal – agent theory.

Agency costs between managers and shareholders

If 1 person owns a company he is manager but also shareholder. If the firm would generate 100.000

euro in profit, but the owner decides to buy a 30.000 car for the money. The owner still receives

70.000 + 30.000 = 100.00. But when he decides to sell half of the companies stake because the

company has grown, this changes. The profit is 100.000 and the owner buys the car of 30.000 that

means that both the original owner and the new stakeholder can only divide 70.000 among them.

This means that the new stakeholder does not receives 50.000 but 35.000. Compare this the original

owner who still receives the car, he receives 30.000 + 35.000 = 65.000. Therefore, the value of a

share in the company is 35.000 and not 50.000. The reduction in the company’s value from

employing an agent to manage the company is an example of an agency cost. The agency cost in this

example is 50.000 – 35.000 = 15.000. This arises from the fact that the original owner his different

interest than the new shareholder and because the original owner is not monitored. So, it is possible

to use the company’s money to satisfy the owners interest at the expense of the remaining owner.

Agency costs between workers and managers

Agency costs do not only occur between managers and owners of the company, but also between

managers and workers. For example, if a manager hires shelf packers to work for him in a

supermarket there are two ways of payment. First, piece rates, let’s say 0.20 for every piece he puts

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on the shelf and second an hour rate of 5 per hour. The employer paid by the hour, can sit around

and do nothing, but still earn 5 euro, in contrast to the employer paid per piece. He needs to put at

least 25 products on the shelf in an hour to earn 5 euro an hour. So, paying per piece could be a way

to reduce agency costs. Piece rates is used when the output is easy to verify, like with car sellers,

they receive a commission for every car they sell. But how do you verify the output of a manager?

Monitoring workers, good communication, investment decisions and so on. How do you align the

owners interest with the managers interest? We need an alternative way to reduce agency costs.

Stock options could provide a solution to reducing agency costs.

8.4 Business application: Stock options and the reduction of agency costs.

In order to reduce agency costs, managers could offer the option of buying stocks in the future for a

price agreed in the past. So, if the managers performance is good and the price of a share raises the

manager can get I better price for his share, raising his income. But how effective are stock options as

a solution to agency costs?

1. If a manager owns 30.000 a year, he gets that salary whether the company performs well or not. If

he is offered stock options, he will earn 20.000 + stock options. So, if the company underperforms he

will lose money. Meaning the risk of stock options could be unattractive to managers.

2. The managers performance is linked to the share’s price, but what if the share price is influenced

by other things? Like the degree of competition or a policy by the government.

3. It could also be the case, the managers works hard but other managers not, so his effort does not

means extra pay because of the other managers.

4. A manager with stock options will only be interested in raising the company’s share price, but what

if shareholders want more than just a high share price?

5. Finally, managers behaviour should be verifiable, in some cases managers kept liabilities of the

balance sheet to inflate the share’s price and in other cases expenses were capitalized and reported

as assets, rather than sent to the profit and loss account as an expense. So, it seemed the company

was doing well and managers cashed in on stock option.

Therefore, performance contracts can help to resolve the principal-agent problem, but only if:

- workers accept the contracts; greater reward for higher risks

- there is a link between worker effort and the performance measures

- the performance can be co-ordinated across a number of objectives

- workers cannot unduly influence the measure

But owners have to be careful with rewards, as they can attract bad managers or bad media

attention

Performance pay and the public sector

A current trend is to introduce performance pay in the public sector. Paying care doctors a fixed

salary plus a performance element which is linked to a certain healthcare indices. The key, as with

performance contracts in the private sector, is to ensure that workers can respond to the incentives

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and do not divert the effort of employees away from other important value-adding activities. For

example, a dentist the extraction of a tooth attracts the same reward as a extensive root canal work.

The root canal work is more beneficial to the patient, but the extraction is more easy to perform for a

dentist. The important learning point is that markets, prices and incentives direct the allocation of

resources; and this is equally important in the private and public sectors.

8.5 regulation of businesses.

We have examined the governance of managers by shareholders. We will also show that , in other

ways, markets can act against the interest of consumers or even the public. Not surprisingly, the

interest of firms and wider society differ. Polluting the environment, rather than cleaning factory

emissions, is a cheap alternative for a profit maximizing firm. At the heart of most economists’

understanding is that an economy characterized by perfectly competitive markets is Pareto-efficient,

means that no one within an economy can be made better off without making some other people

worse off. Therefore, the wellbeing of society is at a maximum.

8.6 Externalities.

Externalities are the effects of consumption, or production, on third parties. If production, or

consumption, by one group improves the wellbeing of third parties, then a positive externality has

occurred. If it reduces the wellbeing of third parties it is a negative externality. The cost of a private

firm of producing a particular output is the marginal private cost, this includes cost of raw materials,

labour and machinery. MSC, marginal social cost, refer to the cost to society for producing one extra

good.

MSC > MPC: The equilibrium of the firm is with a bigger quantity and the society would want to

decrease the output. Which means the firm will choose a level of output that is greater than society

demands. The firm does not recognize the pollution costs

MSC < MPC: Society find it more desirable to produce more output than the company does.

MPB: Marginal private benefit, is the benefit to the individual from consuming one more unit of

output>

MSB: Marginal social benefit, is the benefit to society from the consumption of on more unit of

output

MPB > MSB: The optimal benefit for society is where MSP meets MSC, but in the case of MPB > MSB

implies that one individual benefits more from consumption than society demands.

MPB < MSB: Society gains more benefit than a private individual from consumption. Examples could

be education and vaccination.

8.7 Dealing with externalities.

Taxation and subsidy

The problem with an externality is that the pricing mechanism does not impose the costs, or benefits,

on the correct individuals. If a firm pollutes the environment, the whole of the society bear with that.

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So, a way has to be found to internalize the costs. A way of doing that is with extra taxation and that

works like this. The maximum profit of a firm, which pollutes, 2000 outputs. In this situation marginal

private benefit and marginal private cost are equal. A taxation means extra costs for firms, the height

of the taxation forced the firms price to rise and the demand to decrease. In such a way were

marginal social benefit and marginal social cost are in a equilibrium.

For example, cigarettes in the original situation cost 2 euro in equilibrium and the quantity was 50,

but after tax raises of 0,80 euro, the demand curve changed. Demand decreased.

Subsidies

Subsidies are payments made to producers, by the

government, which leads to a reduction in the market

price. This leads to a increase of demand. Basically, it is

the same like the previous example only reversed.

Subsidies are mend to increase output, taxation to decrease output.

8.8 Market power and competition policy.

Earlier we compared a monopoly with perfect competition and argued that in case of a monopoly

the price is higher and the output lower. Now, with the introduction of Pareto-efficiency, we show

that in society’s perspective, monopoly is not a desired market structure. To analyze this use figure

8.5 in your book on page 193, as I was unable to find an image representing this on the internet.

consumer surplus: The difference between the price consumers are willing to pay and the price

they actually pay

Producer surplus: The difference between the price a firm wants to sell its products for and the

price they actually sell at

Dead-weight loss: Loss of welfare to society resulting from the existence of monopoly

Creative destruction: Enables a firm to overcome the entry barriers of an existing monopoly. With

creative innovation destroying the existing monopoly

Competition policy

In the UK, the Director General of Fair trading supervises company behaviour and, where fit, can

refer individual companies to the Competition Commission, they investigate whether a monopoly, or

potential monopoly, significantly affects competition.

8.9 Business application: Carbon trading.

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Carbon dioxide, a greenhouse gas, is a by-product of burning fossil fuels such as oil and coal. Burning

fossil fuels for energy creates greenhouse gasses, so this is an example of a negative externality. The

marginal private cost of producing electricity does not reflect the full marginal cost, which also

includes the effect of environment pollution. Environmental and growth economist examine the

rising production of greenhouse gases using an environmentally-adapted Kuznet-curve. The

environmental Kuznet-curve shows an n-shaped relationship between the production of greenhouse

gases and GDP per capita. As an economy grows and GDP per capita rises, then a greater use of fossil

fuels production results in the rising production of detrimental greenhouse gases. Once an economy

reaches a certain size and affluence, then there is likely to be sufficient wealth and technical

expertise to address the use of fossil fuels and the generation of greenhouse gases. Therefore, in

advanced high GDP per capita economies the production of greenhouse gasses starts to decline. In

order to reduce greenhouse gases. The first is a license to pollute and the second is permits to emit

pollutants.