Chapter 1

Overview of
Business Economics

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
Learning objectives
1. Summarize how goals, constraints, incentives, and market rivalry affect
economic decisions.
2. Distinguish economic versus accounting profits and costs.
3. Explain the role of profits in a market economy.
4. Apply the five forces framework to analyze the sustainability of an
industry’s profits.
5. Apply present value analysis to make decisions and value assets.
6. Apply marginal analysis to determine the optimal level of a managerial
control variable.
7. Identify and apply six principles of effective managerial decision making.

2
 HEADLINE

On Tuesday software giant Amcott posted a year-end operating loss of $3.5

million. Reportedly, $1.7 million of the loss stemmed from its foreign language
division. With short-term interest rates at 7 percent, Amcott decided to use $20
million of its retained earnings to purchase three-year rights to Magicword, a
software package that converts generic word processor files saved as French
text into English. First-year sales revenue from the software was $7 million, but
thereafter sales were halted pending a copyright infringement suit filed by
Foreign, Inc. Amcott lost the suit and paid damages of $1.7 million. Industry
insiders say that the copyright violation pertained to “a very small component
of Magicword.” Ralph, the Amcott manager who was fired over the incident,
was quoted as saying, “I’m a scapegoat for the attorneys [at Amcott] who
didn’t do their homework before buying the rights to Magicword. I projected
annual sales of $7 million per year for three years. My sales forecasts were
right on target.” Do you know why Ralph was fired?
3
 TERMS
◎ Manager
○ A person who directs resources to achieve a stated goal
◎ Economics
◎ The science of making decisions in the presence of scarce
resources.
◎ Managerial economics
○ The study of how to direct scarce resources in the way that most
efficiently achieves a managerial goal. (Michael R. Baye,
Managerial Economics and Business Strategy, 6th edition,
McGrawHill/Irwin, p.25)

5
 MANAGERIAL ECONOMICS
A host of decisions to succeed as a manager:
1. Should you purchase components from other manufacturers or produce them
within your own firm?
2. Should you specialize in making one type of computer or produce several different
types?
3. How many computers should you produce, and at what price should you sell them?
4. How many employees should you hire, and how should you compensate them?
5. How will the actions of rival computer firms affect your decisions?

6
 ECONOMIC VS. ACCOUNTING PROFITS

◎ Accounting Profits
○ Total revenue (sales) minus dollar cost of producing
goods or services.
○ Reported on the firm’s income statement
◎ Economic Profits
○ Accounting profit minus total opportunity cost

7
BUSINESS ENVIRONMENT

8
 OPPORTUNITY COST
◎ Accounting Costs: The explicit costs of the resources needed to
produce goods or services and reported on the firm’s income
Statement
◎ Opportunity Cost: The cost of the explicit and implicit resources
that are foregone when a decision is made.
○ Implicit costs are very hard to measure →managers often overlook them
○ Ex: what does it cost you to read a book?
○ Suppose you own a building in New York that you use to run a small pizzeria.
Food supplies are your only accounting costs. At the end of the year, your
accountant informs you that these costs were $20,000 and that your revenues
were $100,000. Thus, your accounting profits are $80,000. Economic profits?
◎ Economic Profits: Total revenue minus total opportunity cost.

9
 SUBJECTS OF MANAGERIAL ECONOMICS
◎ Managerial Economics is concerned with economic
issues and problems related to business organization,
management, and strategy.
◎ Issues and problems include: an explanation of why
firms emerge and exist; why they expand: horizontally
and vertically; the role of entrepreneurs and
entrepreneurship; the significance of organizational
structure; the relationship of firms with the employees,
the providers of capital, the customers, the government;
the interactions between firms and the business
environment.
10
 THE ECONOMICS OF EFFECTIVE MANAGEMENT

An effective manager must:

1. Identify goals and constraints
2. Recognize the nature and importance of profits
3. Understand incentives
4. Understand markets
5. Recognize the time value of money,
6. Use marginal analysis.

11
 IDENTIFY GOALS AND CONSTRAINTS

◎ It is required to have a well-defined goal: achieving

different goals entails making different decisions.
○ Different units within a firm may be given different goals
◉ E.g.: marketing department maximizes sales or market share
◉ Financial group might focus on earnings growth or risk-reduction
strategies
◎ Decision maker faces constraints that affect the ability to
achieve a goal
○ Constraints are an artifact of scarcity

12
 “
“It is not out of the benevolence of the
butcher, the brewer, or the
baker, that we expect our dinner, but from
their regard to their own interest.”
Source: Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776.

13
 PROFITS AS A SIGNAL

◎ Profits signal to resource holders where resources are

most highly valued by society.
○ Resources will flow into industries that are most highly
valued by society
◉ The Five Forces Framework and Industry Profitability

14
 TIME VALUE OF MONEY
◎ Problem 1-1:
The manager of Automated Products is contemplating the purchase of a
new machine that will cost $300,000 and has a useful life of five years.
The machine will yield (year-end) cost reductions to Automated
Products of $50,000 in year 1, $60,000 in year 2, $75,000 in year 3, and
$90,000 in years 4 and 5. What is the present value of the cost savings of
the machine if the interest rate is 8 percent? Should the manager
purchase the machine?

15
THE FIVE FORCES FRAMEWORK

16
PRESENT VALUE OF INDEFINITELY LIVED ASSETS

17
 PRESENT VALUE OF FIRM

18
The examination of the costs and benefits of
a marginal (small) change in the production
of goods

19
 USE MARGINAL (INCREMENTAL) ANALYSIS

◎ Control Variable Examples:

○ Output
○ Price
○ Product Quality
○ Advertising
○ R&D.
◎ Basic Managerial Question: How much of the control
variable should be used to maximize net benefits?

20
DISCRETE DECISIONS

21
 NET BENEFITS

◎ Net Benefits = Total Benefits - Total Costs

◎ Profits = Revenue - Costs

22
 TERMS

◎ Marginal (incremental) benefit: The change in total

benefits arising from a change in the managerial
control variable Q.
◎ Marginal (incremental) cost (MC): The change in
total costs arising from a change in the managerial
control variable Q.
◎ Marginal net benefits: The change in net benefits that
arise from a one-unit change in Q
MNB = MB − MC
23
 “
Marginal Principle
To maximize net benefits, the manager should increase the managerial control
variable up to the point where marginal benefits equal marginal costs. This
level of the managerial control variable corresponds to the level at which
marginal net benefits are zero; nothing more can be gained by further changes
in that variable.

zz 24
 MARGINAL PRINCIPLE
◎ To maximize net benefits, the managerial control variable
should be increased up to the point where: MB = MC
◎ MB > MC means the last unit of the control variable
increased benefits more than it increased costs.
◎ MB < MC means the last unit of the control variable
increased costs more than it increased benefits.

25
MARGINAL PRINCIPLE

26
DISCRETE DECISIONS

27
CONTINUOUS DECISIONS

28
 MARGINAL BENEFIT (MB)

29
 DEMONSTRATION PROBLEM
◎ An engineering firm recently conducted a study to
determine its benefit and cost structure. The results of
the study are as follows:
B (Y) = 300Y − 6 Y 2
C (Y) = 4 Y 2
◎ The manager has been asked to determine the
maximum level of net benefits and the level of Y that
will yield that result.

30
 INCREMENTAL DECISIONS

◎ Sometimes managers are faced with proposals that

require a simple thumbs-up or thumbs-down decision
(yes-or-no decisions)
◎ Adopt project when incremental revenues exceed
incremental costs
◎ Incremental revenues: The additional revenues that
stem from a yes-or-no decision.
◎ Incremental costs: The additional costs that stem
from a yes-or-no decision.

31
 INCREMENTAL DECISIONS

To illustrate, imagine that you

are the CEO of Slick Drilling
Inc. and you must decide
whether or not to drill for
crude oil around the Twin
Lakes area in Michigan. You
are relatively certain there are
10,000 barrels of crude oil at
this location. An accountant
working for you prepared the
information in the Table
below to help you decide
whether or not to adopt the
new project
32
On Tuesday software giant Amcott posted a year-end operating loss of
$3.5 million. Reportedly, $1.7 million of the loss stemmed from its foreign
language division. With short-term interest rates at 7 percent, Amcott
decided to use $20 million of its retained earnings to purchase three-year
rights to Magicword, a software package that converts generic word
processor files saved as French text into English. First-year sales revenue
from the software was $7 million, but thereafter sales were halted pending
a copyright infringement suit filed by Foreign, Inc. Amcott lost the suit and
paid damages of $1.7 million. Industry insiders say that the copyright
violation pertained to “a very small component of Magicword.” Ralph, the
Amcott manager who was fired over the incident, was quoted as saying,
“I’m a scapegoat for the attorneys [at Amcott] who didn’t do their
homework before buying the rights to Magicword. I projected annual sales
of $7 million per year for three years. My sales forecasts were right on
target.” Do you know why Ralph was fired?
33
Summary
1. Summarize how goals, constraints, incentives, and market rivalry affect
economic decisions.
2. Distinguish economic versus accounting profits and costs.
3. Explain the role of profits in a market economy.
4. Apply the five forces framework to analyze the sustainability of an
industry’s profits.
5. Apply present value analysis to make decisions and value assets.
6. Apply marginal analysis to determine the optimal level of a managerial
control variable.
7. Identify and apply six principles of effective managerial decision making.

34
 MARGINAL COST (MC)

35
Chapter 2
DEMAND ANALYSIS,
ESTIMATION AND
FORECASTING

Presenter: Vo Hoang Kim An

Foreign Trade University – Ho Chi Minh City – Vietnam
1.
Demand Analysis
By using elasticity of demand

37
 Price Elasticity of Demand (E)

◎ Measures responsiveness or sensitivity of consumers

to changes in the price of a good

◎ P & Q are inversely related by the law of demand so

E is always negative
○ The larger the absolute value of E, the more
sensitive buyers are to a change in price

6-38
RELATIVELY ELASTIC
As price changes, there is a
LARGE change in quantity
demanded for a good or service
40
RELATIVELY INELASTIC
As price changes, there is a
SMALL change in quantity
demanded for a good or service
UNIT ELASTICITY
As price changes, quantity
demand for a good or service
will change by the same amount
 Price Elasticity of Demand (E)

Elasticity Responsiveness ⏐E⏐

Elastic
Unitary Elastic
Inelastic

6-43
 Calculating Price Elasticity of Demand
◎ Price elasticity can be calculated by multiplying the
slope of demand (ΔQ/ΔP) times the ratio of price to
quantity (P/Q)

◎ Given Q = a + bP where b = ΔQ/ΔP

6-44
 Group discussion

◎ What is the relationship between elasticity

of demand and total revenue? Please give
examples.

6-45
 Price Elasticity & Total Revenue

Elastic Unitary elastic Inelastic

Quantity-effect No dominant effect Price-effect dominates
dominates

Price rises TR falls No change in TR TR rises

Price falls TR rises No change in TR TR falls

6-46
 Price Elasticity & Total Revenue
The manager at Borderline Video Emporium faces the demand curve
for Blu-ray DVD discs shown in Figure 6.1. Predict and calculate the
change in total revenue in below instances:
1. At the current price of $18 per DVD Borderline can sell 600 DVDs
each week. The manager can lower price to $16 per DVD and increase
sales to 800 DVDs per week. Over the interval a to b on demand curve
D the price elasticity is equal to -2.43.
2. Now suppose the manager at Borderline is charging just $9 per
compact disc and sells 1,500 DVDs per week (see Panel B). The
manager can lower price to $7 per disc and increase sales to 1,700
DVDs per week. Over the interval c to d on demand curve D, the
elasticity of demand equals -0.50.
○ From those results, what do you infer?
6-47
Price Elasticity & Total Revenue

6-48
 Marginal Revenue
◎ Marginal revenue (MR) is the change in total revenue
per unit change in output
◎ Since MR measures the rate of change in total revenue
as quantity changes, MR is the slope of the total
revenue (TR) curve

6-49
 Marginal Revenue & Price Elasticity

◎ For all demand & marginal revenue curves, the

relation between marginal revenue, price, & elasticity
can be expressed as

6-50
 MR, TR, & Price Elasticity

Marginal Price elasticity of

Total revenue
revenue demand

TR increases Elastic (⏐E⏐> 1)

Elastic
MR > 0 as Q increases
(⏐E⏐> 1)
(P decreases)

Unit Unit
elastic (⏐E⏐= 1)
elastic
MR = 0 TR is maximized
(⏐E⏐= 1)
TR decreases as Inelastic (⏐E⏐< 1)
Inelastic
MR < 0 Q increases (⏐E⏐< 1)
(P decreases) 6-51
2.
Demand Estimation
and Forcasting
By using regression and statistical
knowlede
52
 Empirical Demand Functions
◎ Demand equations derived from actual market data
◎ Useful in making pricing & production decisions
◎ In linear form, an empirical demand function can be
specified as

7-53
 Example: Estimating the Demand for a Pizza Firm

Specify price-setting firm’s demand function

Q = a + bP + cM + dPAl + ePBMac
Where:
◎ Q = sales of pizza at Checkers Pizza
◎ P = price of a pizza at Checkers Pizza
◎ M = average annual household income in Westbury
◎ PAl = price of a pizza at Al’s Pizza Oven
◎ PBMac = price of a Big Mac at McDonald’s

6-54
Example: Estimating the Demand for a Pizza Firm

6-55
Example: Estimating the Demand for a Pizza Firm

◎ Test the significance of estimated slope parameters?

◎ Is the model as the whole significant?
◎ Calculate the estimated demand elasticity at values
of P, M, PAl, and PBmac where P = 9.05, M = 26,614, PAl =
10.12, and PBMac = 1.15. Q=355,6944
◎ Explain the result?

6-56
 Time-Series Forecasts

◎ A time-series model shows how a time-ordered

sequence of observations on a variable is generated
◎ Simplest form is linear trend forecasting
○ Sales in each time period (Qt ) are assumed to be linearly
related to time (t)

7-57
 Linear Trend Forecasting

○ If b > 0, sales are increasing over time

○ If b < 0, sales are decreasing over time
○ If b = 0, sales are constant over time

7-58
Forecasting Sales for Terminator Pest Control

7-59
 Direct Methods of Demand Estimation
◎ Consumer interviews
○ Range from stopping shoppers to speak with them to
administering detailed questionnaires
○ Potential problems
◉ Selection of a representative sample, which is a sample (usually
random) having characteristics that accurately reflect the population
as a whole
◉ Response bias, which is the difference between responses given by an
individual to a hypothetical question and the action the individual
takes when the situation actually occurs
◉ Inability of the respondent to answer accurately

7-60
 Direct Methods of Demand Estimation

◎ Market studies & experiments

○ Market studies attempt to hold everything
constant during the study except the price of the
good
○ Lab experiments use volunteers to simulate actual
buying conditions
○ Field experiments observe actual behavior of
consumers

7-61
Chapter 3
Production and cost analysis;
The organization of a firm

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
 “
Part 1.
Production and cost analysis

63
 Basic Concepts of Production Theory
◎ Inputs are considered variable or fixed depending on how
readily their usage can be changed
◎ Variable input
○ An input for which the level of usage may be changed quite readily
◎ Fixed input
○ An input for which the level of usage cannot readily be changed and
which must be paid even if no output is produced
◎ Quasi-fixed input
○ An input employed in a fixed amount for any positive level of output
that need not be paid if output is zero

8-64
 Basic Concepts of Production Theory

◎ Short run
○ At least one input is fixed
○ All changes in output achieved by changing usage
of variable inputs
◎ Long run
○ All inputs are variable
○ Output changed by varying usage of all inputs

8-65
 Short Run Production

◎ In the short run, capital is fixed

○ Only changes in the variable labor input can
change the level of output
◎ Short run production function

8-66
1.
Production and Cost in
the Short Run

67
 Average & Marginal Products

◎ Average product of labor

○ AP = Q/L
◎ Marginal product of labor
○ MP = ΔQ/ΔL
◎ When AP reaches it maximum:
○ AP = MP
◎ Law of diminishing marginal product
○ As usage of a variable input increases, a point is
reached beyond which its marginal product decreases

8-68
Total, Average & Marginal Product
Curves
o Increasing marginal returns:
Range of input usage over
which marginal product
increases
o Decreasing (diminishing)
marginal returns: Range of
input usage over which
marginal product declines.
o Negative marginal returns:
Range of input usage over
which marginal product is
negative.

8-69
 Phases of
Marginal Returns
As the usage of an input increases, marginal product
initially increases (increasing marginal returns), then
begins to decline (decreasing marginal returns), and
eventually becomes negative (negative marginal
returns).

70
The Role of the Manager in the
Production Process

8-71
 Profit-Maximizing Input
Usage
To maximize profits, a manager should use inputs at levels at
which the marginal benefit equals the marginal cost. More
specifically, when the cost of each additional unit of labor is w,
the manager should continue to employ labor up to the point
where VMPL = w in the range of diminishing marginal product

72
 Short Run Production Costs

◎ Total variable cost (TVC)

○ Total amount paid for variable inputs
○ Increases as output increases
◎ Total fixed cost (TFC)
○ Total amount paid for fixed inputs
○ Does not vary with output
◎ Total cost (TC)
○ TC = TVC + TFC
8-73
 Short-Run Total Cost Schedules

Output (Q) Total fixed cost Total variable Total Cost

(TFC) cost (TVC) (TC=TFC+TVC)
0 $6,000 $ 0 $ 6,000
100 6,000 4,000 10,000
6,000 12,000
200 6,000
9,000 15,000
300 6,000
14,000 20,000
400 6,000
22,000 28,000
500 6,000 34,000 40,000
600 6,000

8-74
Total Cost Curves

8-75
 Average Costs
•

8-76
 Short Run Marginal Cost

◎ Short run marginal cost (SMC) measures

rate of change in total cost (TC) as output
varies

8-77
 Average & Marginal Cost Schedules

Output Average Average Average total Short-run

(Q) fixed cost variable cost cost marginal cost
(AFC=TFC/ (AVC=TVC/Q) (ATC=TC/Q= (SMC=ΔTC/ΔQ)
Q) AFC+AVC)

0 -- -- -- --
100 $60 $40 $100 $40

200 30 30 60 20
20 30 50 30
300
15 35 50 50
400
12 44 56 80
500 10 56.7 66.7 120
600

8-78
Average & Marginal Cost Curves

8-79
Short Run Average & Marginal Cost
Curves

8-80
 Short Run Cost Curve Relations

◎ AFC decreases continuously as output

increases
○ Equal to vertical distance between ATC & AVC
◎ AVC is U-shaped
○ Equals SMC at AVC’s minimum
◎ ATC is U-shaped
○ Equals SMC at ATC’s minimum

8-81
 Short Run Cost Curve Relations

◎ SMC is U-shaped
○ Intersects AVC & ATC at their minimum points
○ Lies below AVC & ATC when AVC & ATC are
falling
○ Lies above AVC & ATC when AVC & ATC are
rising

8-82
Relations Between Short-Run Costs & Production

8-83
Relations Between Short-Run Costs & Production

◎ In the case of a single variable input, short-run

costs are related to the production function by
two relations

8-84
Short-Run Production & Cost Relations

8-85
 Relations Between Short-Run Costs &
Production
◎ When marginal product (average product) is increasing,
marginal cost (average cost) is decreasing
◎ When marginal product (average product) is decreasing,
marginal cost (average variable cost) is increasing
◎ When marginal product = average product at maximum AP,
marginal cost = average variable cost at minimum AVC

8-86
 Summary of Short-Run Empirical
Production Functions
Short-run cubic
production equations

Total product

Average product of labor

Marginal product of labor

Diminishing marginal
returns
Restrictions on
parameters
10-
 Summary of Short-Run Empirical Cost
Functions
Short-run cubic
cost equations

Total variable cost

Average variable cost

Marginal cost
Average variable cost
reaches minimum at
Restrictions on
parameters
10-
 Sunk cost
A cost that is forever lost
after it has been paid.

89
 Fixed and Sunk Costs
Considering this illustration problem:
◎ ACME Coal paid $5,000 to lease a railcar from the Reading
Railroad. Under the terms of the lease, $1,000 of this payment is
refundable if the railcar is returned within two days of signing the
lease.
1. Upon signing the lease and paying $5,000, how large are ACME’s
fixed costs? Its sunk costs?
2. One day after signing the lease, ACME realizes that it has no use for
the railcar. A farmer has a bumper crop of corn and has offered to
sublease the railcar from ACME at a price of $4,500. Should ACME
accept the farmer’s offer?

8-90
Exercise 1

8-91
Exercise 1

a. What are the estimated total, average, and marginal product

functions?
b. Are the parameters of the correct sign, and are they significant
at the 1 percent level?
c. At what level of labor usage is average product at its maximum?
Assume that the wage rate for labor (w) is $200.
d. What is output when average product is at its maximum?

8-92
Exercise 2

8-93
Exercise 2
a. Do the parameter estimates have the correct signs? Are they
statistically significant at the 5 percent level of significance?
b. b. At what level of output do you estimate average variable cost
reaches its minimum value?
c. What is the estimated marginal cost curve?
d. What is the estimated marginal cost when output is 700 units?
e. What is the estimated average variable cost curve?
f. What is the estimated average variable cost when output is 700
units?

8-94
Typical Isoquants

9-95
2.
Production and Cost in
the Long Run

96
 Marginal Rate of Technical Substitution

◎ The MRTS is the slope of an isoquant & measures the

rate at which the two inputs can be substituted for one
another while maintaining a constant level of output

9-97
 Marginal Rate of Technical Substitution

◎ The MRTS can also be expressed as the ratio of two

marginal products:

9-98
 Isocost Curves

•
○ Represents amount of capital that may be purchased if zero labor is
purchased
9-99
Isocost Curves

9-
Optimal Input Combination to Minimize Cost
for Given Output

9-
 Optimal Combination of Inputs

◎ Minimize total cost of producing Q by choosing the input

combination on the isoquant for which Q is just tangent to
isocost curve
◎ Two slopes are equal in equilibrium
◎ Implies marginal product per dollar spent on last unit of
each input is the same

9-
 DEMONSTRATION PROBLEM

Terry’s Lawn Service rents five small push mowers and two
large riding mowers to cut the lawns of neighborhood
households. The marginal product of a small push mower is 3
lawns per day, and the marginal product of a large riding
mower is 6 lawns per day. The rental price of a small push
mower is $10 per day, whereas the rental price of a large riding
mower is $25 per day. Is Terry’s Lawn Service utilizing small
push mowers and large riding mowers in a cost-minimizing
manner?

8-
 Long-Run Costs

◎ Long-run total cost (LTC) for a given level

of output is given by:
LTC = wL* + rK*
◎ Where w & r are prices of labor & capital, respectively

9-
 Long-Run Costs
◎ Long-run average cost (LAC) measures the cost per unit
of output when production can be adjusted so that the
optimal amount of each input is employed
○ LAC is U-shaped
○ Falling LAC indicates economies of scale
○ Rising LAC indicates diseconomies of scale

9-
 Long-Run Costs
◎ Long-run marginal cost (LMC) measures the rate of
change in long-run total cost as output changes along
expansion path
○ LMC is U-shaped
○ LMC lies below LAC when LAC is falling
○ LMC lies above LAC when LAC is rising
○ LMC = LAC at the minimum value of LAC

9-
Long-Run Average & Marginal Cost

9-
 INSIDE BUSINESS
In industries with economies of scale, firms that produce greater levels of output produce at lower
average costs and thus gain a potential competitive advantage over rivals. Recently, two
international businesses pursued such strategies to enhance their bottom line.
Japan’s Matsushita Plasma Display Panel Company, Ltd., invested $835 million to build the world’s
largest plant for producing plasma display panels. The factory—a joint venture between Panasonic
and Toray Industries—had the capacity to produce 250,000 panels per month by the late 2000s. This
strategy was implemented in response to rising global demand for plasma display panels, and a
desire on the part of the company to gain a competitive advantage over rivals in this increasingly
competitive industry.
An automaker in India—Maruti Udyog Ltd.—produced tangible evidence that economies of scale
are important in business decisions. It enjoyed a 271 percent increase in net profits in the mid-
2000s, thanks to its ability to exploit these economies. The increase was spawned by a 30 percent
increase in sales volume that permitted the firm to spread its sizable fixed costs over greater
output. Importantly, the company’s reduction in average costs due to economies of scale was more
than enough to offset the higher costs stemming from increases in the price of steel.
SOURCES: “Matsushita Plans Big Expansion of PDP Manufacturing,” IDG News Service, May 19, 2004; “MUL Gains from Cost-Saving Measures,” Sify India, May 18,
2004.
108
 “
Part 2.
The organization of a firm

109
110
 OVERVIEW
I. Methods of Procuring Inputs
○ Spot Exchange
○ Contracts
○ Vertical Integration
II. Optimal Procurement Input
III. Principal-Agent Problem
○ Owners-Managers
○ Managers-Workers

111
 Learning objectives
1. Discuss the economic trade-offs associated with obtaining inputs
through spot exchange, contract, or vertical integration.
2. Identify four types of specialized investments, and explain how each can
lead to costly bargaining, underinvestment, and/or a “hold-up problem.”
3. Explain the optimal manner of procuring different types of inputs.
4. Describe the principal–agent problem as it relates to owners and
managers.
5. Discuss three forces that owners can use to discipline managers.
6. Describe the principal–agent problem as it relates to managers and
workers.
7. Discuss four tools the manager can use to mitigate incentive problems in
8. the workplace.
112
1.
METHODS OF
PROCURING INPUTS
1. Spot exchange
2. Contract
3. Vertical integration
113
 METHODS OF PROCURING INPUTS

Consider the manager of a car rental company. One input

needed to produce output (rental cars) is automobile
servicing (tune-ups, oil changes, lube jobs, and the like).
The manager has three options:
1. Simply take the cars to a firm that services automobiles
and pay the market price for the services
2. Sign a contract with a firm that services automobiles
3. Create within the firm a division that services
automobiles
114
 METHODS OF PROCURING INPUTS

◎ Spot exchange: An informal relationship between a

buyer and seller in which neither party is obligated to
adhere to specific terms for exchange.
◎ Contract: A formal relationship between a buyer and
seller that obligates the buyer and seller to exchange at
terms specified in a legal document.
◎ Vertical integration: A situation where a firm produces
the inputs required to make its final product.

115
 SPOT EXCHANGE (AT ARM’S LENGTH )
◎ Definition: An informal relationship between a buyer
and seller in which neither party is obligated to adhere
to specific terms for exchange.
○ Occurs when autonomous parties exchange goods or services
with no explicit or implicit agreement that the relationship will
continue into the future.
◎ Examples: Purchasing at Coop Mart, staying at New World
hotel for a night.
◎ Advantage: the firm gets to specialize in doing what it
does best

116
 CONTRACTS
◎ Definition: A contract is a legal agreement which defines the
conditions of an exchange or series of exchanges.
○ A formal relationship between a buyer and seller that obligates the buyer
and seller to exchange at terms specified in a legal document
◎ Examples: Bank loan, futures contract, marriage, etc.
◎ Advantage: purchase “nonstandard” inputs
◎ Disadvantage: costly to write; it takes time, and often legal fee,
extremely difficult to cover all the contingencies that could occur
in the future

117
 VERTICAL INTEGRATION (VI)
Definition: it is the situation where a firm shuns other
suppliers and chooses to produce an input internally.
◎ It alters control structures. Hidden information and hidden action
problems are reduced.
◎ Repeated interactions improve trust and coordination
◎ The integrated firm has a common set of goals.
◎ But remember the problems with making
Advantage: no longer has to rely on other firms
Disadvantage: loses the gains in specialization, has to
manage the production of inputs and final product
→bureaucratic costs associated with a larger organization.
118
 PRACTICE
Determine whether the following transactions involve spot
exchange, a contract, or vertical integration:
1. Clone 1 PC is legally obligated to purchase 300 computer chips each
year for the next three years from AMI. The price paid in the first
year is $200 per chip, and the price rises during the second and
third years by the same percentage by which the wholesale price
index rises during those years.
2. Clone 2 PC purchased 300 computer chips from a firm that ran an
advertisement in the back of a computer magazine.
3. Clone 3 PC manufactures its own motherboards and computer
chips for its personal computers.

119
 TRANSACTION COSTS

◎ Definition: Transactions costs are costs associated with

acquiring an input that are in excess of the amount paid to
the input supplier (Coase, 1937).
◎ Obvious examples: Insurance, freight, damage, own time.
◎ Other important examples: cost of searching for a supplier
willing to sell a specific input, negotiations costs incl.
opportunity cost of time, legal costs, costs of maintaining
assets required to engage in the transactions.

120
 TRANSACTION COSTS

◎ Many transaction costs are obvious.

○ Ex: input supplier charges a price of $10 per unit but
requires you to furnish your own trucks and drivers to
pick up the input → transaction costs : the cost of the
trucks and the personnel needed to “deliver” the input
to your plant.
◎ Some important transaction costs are less obvious →
distinguish b/w transaction costs : specific to a particular
trading or general in nature → specialized investment.

121
 SPECIALIZED INVESTMENT
◎ Definition: A specialized investment (SI) is an expenditure that is
made to allow two parties to make exchanges, but has less value in
alternative uses.
→ Examples: to ascertain the quality of chips, Apple spend $100 on a machine that tests the
chips’ quality:
○ If the machine is useful only for testing chips from TSM → SI.
○ If the machine can be resold at its purchase price or used to test the quality of
bolts produced by Intel Corp→ not a SI
→ Examples: Insuring assets (life or crops) when taking out a loan, building trust with a
supplier/customer, quality control investments required to access international markets
(food, toys, etc.).
◎ Definition: A relationship-specific exchange is one that occurs when
both parties to the exchange have made specialized investments.
These investments are called relationship-specific investments (RSIs).
122
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

1. Site specificity
2. Physical asset specificity
3. Human asset
4. Dedication

123
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

◎ Site specificity: Here, assets are situated side-by-side.

○ Examples: Coal mines and power plants, grain elevators and
rail-spurs, processes in steel or wine production

◎ Physical asset specificity: Here, the physical/

engineering/chemical properties of the asset are tailored
to a given set of transactions.
○ Examples: Dyes and molds, some genetically modified
organisms, software products

124
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

◎ Human asset specificity: Here, the SI is human in nature.

○ Examples: Skill acquisitions, building trust
◎ Dedicated asset: is one that would be a complete write-
off if the transactions in question were cancelled.

There are other types of specificities, and some investments

may express multiple forms

125
 USEFULNESS OF SIs

◎ SIs generally promote economic efficiency (increase the

welfare of society) in that they identify collaborations
between firms that reduce the cost of producing the
same amount of goods or increase the amount of goods
produced by the same level of resources or do a bit of
both (supply/demand graphs).
◎ They are probably good for the firms in question because
the firms would likely not make the investment
otherwise.
◎ Problems may arise because SIs create vulnerability.
126
 IMPLICATION OF SI

◎ Specialized investments increase transaction costs

because they lead to
(1) costly bargaining: no other supplier capable of providing the
desired input at a moment’s notice → no “market price” for the
input → bargaining process costly
(2) underinvestment: the level of the specialized investment often
is lower than the optimal level.
(3) opportunism: When a SI existed, buyer/seller attempt to
capitalize on the “sunk” nature of the investment by engaging in
opportunism

127
 IMPLICATION OF SI

(3) opportunism:
→ The “hold-up problem”: Once a firm makes a
specialized investment, the other party may attempt to
“rob” it of its investment by taking advantage of the
investment’s sunk nature.
→ This behavior make firms reluctant to engage in
relationship-specific investments in the first place
unless they can structure contracts to mitigate the hold-
up problem.

128
1.
OPTIMAL INPUT
PROCUREMENT
When to use each form of input
procurement?

129
 OPTIMAL INPUT PROCUREMENT

Spot exchange
Jiffyburger, a fast-food outlet, sells approximately 8,000 quarter-pound
hamburgers in a given week. To meet that demand, Jiffyburger needs
2,000 pounds of ground beef delivered to its premises every Monday
morning by 8:00 AM sharp.
1. As the manager of a Jiffyburger franchise, what problems would
you anticipate if you acquired ground beef using spot exchange?
2. As the manager of a firm that sells ground beef, what problems
would you anticipate if you were to supply meat to Jiffyburger
through spot exchange?

130
 SPOT EXCHANGE

◎ Used if there are no transaction costs and there are many

buyers and sellers in the input market
◎ Price is determined by the market price (intersection of
the supply and demand curves)
◎ Easily to change to suppliers that offer lower prices
◎ Disadvantages: result in high transaction costs due to
opportunism, bargaining costs, and underinvestment
when input requires substantial specialized investments

131
 CONTRACTS

◎ Overcome hold-up problem and the need to bargain over

price each time the input is to be purchased
◎ Can specify prices of the input before the parties make
specialized investments
◎ Reduces the incentive for either the buyer or the seller to
skimp on the specialized investments required for the
exchange
◎ How long should the contract last?

132
 CONTRACT LENGTH

◎ “Optimal” contract length: trade-off between the

marginal costs and marginal benefits of extending the
length of a contract.
◎ MC increases as contracts become longer
○ Contracts of long duration are more difficult to write because it
is harder to specify all contingencies, e.g., oil price rise, new
technology, etc; the less flexibility the firm has in choosing an
input supplier
◎ MB (avoided transaction costs of opportunism and
bargaining) vary with the length of the contract
○ For simplicity we can draw a flat MB curve
133
OPTIMAL CONTRACT LENGTH

134
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

135
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

136
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

137
 VERTICAL INTEGRATION
◎ Produce the input internally. Utilized when:
○ SIs generate transaction costs (due to opportunism, bargaining costs,
or underinvestment)
○ Product is extremely complex
○ The economic environment is plagued by uncertainty
◎ Advantage: mitigate transaction costs
◎ Disadvantages:
○ Managers must replace the discipline of the market with an internal
regulatory mechanism
○ The firm must bear the cost of setting up production facilities →firm no
longer specializes in doing what it does best
◎ VI should be undertaken only when spot exchange or contracts
have failed.
138
 OPTIMAL INPUT PROCUREMENT
Depend on the extent to which there is relationship-
specific exchange.

139
 EXAMPLE: GENERAL MOTOR AND FISHER BODY
◎ Early 20th century: specialized investments
were relatively unimportant → GM bought
the bodies for its cars using spot exchange
◎ Closed metal bodies for car manufacturing
→ high degree of physical-asset specificity
→ GM and Fisher Body signed a 10-year
contract
◎ Parties to engage in opportunism → GM
vertically integrated by purchasing Fisher
Body

140
 METHODS OF PROCURING INPUTS

◎ Spot Exchange
○ When the buyer and seller of an input meet,
exchange, and then go their separate ways.
◎ Contracts
○ A legal document that creates an extended
relationship between a buyer and a seller
◎ Vertical Integration
○ When a firm shuns other suppliers and chooses to
produce an input internally

141
 KEY FEATURES

◎ Spot Exchange
○ Specialization, avoids contracting costs, avoids costs of vertical
integration.
○ Possible “hold-up problem.”
◎ Contracts
○ Specialization, reduces opportunism, avoids skimping on
specialized investments
○ Costly in complex environments
◎ Vertical Integration
○ Reduces opportunism, avoids contracting costs
○ Lost specialization and may increase organizational costs

142
 THE PRINCIPAL-AGENT PROBLEM
◎ Occurs when the principal cannot observe the effort of the agent.
○ Example: Shareholders (principal) cannot observe the effort of the
manager (agent).
◎ The Problem: Principal cannot determine whether a bad outcome
was the result of the agent’s low effort or due to bad luck
◎ Manager’s must recognize the existence of the principal-agent
problem and devise plans to align the interests of workers with that
of the firm
◎ Shareholders must create plans to align the interest of the manager
with those of the shareholders.

143
144
Manager receive 10 percent of profits

145
 SOLVING THE PROBLEM BETWEEN OWNERS AND
MANAGERS

◎ Internal incentives
○ Incentive contracts
○ Stock options, year-end bonuses
◎ External incentives
○ Personal reputation.
○ Potential for takeover.

146
 SOLVING THE PROBLEM BETWEEN WORKERS AND
MANAGERS
◎ Profit sharing: Mechanism used to enhance workers’ efforts that
involves tying compensation to the underlying profitability of the
firm.
◎ Revenue sharing: Mechanism used to enhance workers’ efforts that
involves linking compensation to the underlying revenues of the
firm.
◎ Piece rates: depend on the output produced
◎ Time clocks and spot checks

147
 CONCLUSION

◎ The optimal method for acquiring inputs

depends on the nature of the transactions costs
and specialized nature of the inputs being
procured.
◎ To overcome the principal-agent problem,
principals must devise plans to align the agents’
interests with the principals.

148
Google Buys Motorola Mobility to Vertically Integrate In a bold move,
Google purchased Motorola Mobility—the recently spun-off cellular
arm of Motorola—for $12.5 billion. This move marks an attempt by
Google to vertically integrate into the smartphone hardware market.
Industry experts note that the purchase will allow Google to build
prototypes and advanced hardware devices that will help to point its
software business partners in the direction Google wants to go.
Google is banking on the increased coordination between its
software and Motorola’s hardware and the reduction in risks
associated with vertical integration outweighing the costs.
If you were a decision maker at Google, would you have
recommended vertical integration?

149
Chapter 4
The Nature of Industry

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
 INDUSTRY ANALYSIS
◎ Market Structure: Factors that affect managerial
decisions
○ Number and size of firms
○ Industry concentration
○ Technological and cost conditions
○ Demand conditions.
○ Ease of entry and exit

151
 INDUSTRY CONCENTRATION

152
NUMBER AND SIZE OF FIRM

153
 EXAMPLE
◎

154
155
 INTEGRATION AND MERGER ACTIVITY

◎ Vertical Integration.
○ Where various stages in the production of a single product
are carried out by one firm.
◎ Horizontal Integration.
○ The merging of the production of similar products into a
single firm
◎ Conglomerate Mergers
○ The integration of different product lines into a single firm

156
 PROS & CONS OF HORIZONTAL INTEGRATION

PROS CONS
◎ Lower costs → economics ◎ Destroyed value.
of scale / scope. ◎ Legal repercussions.
◎ Increased differentiation ◎ Reduced flexibility.
◎ Increased market power.
◎ Reduced competition.
◎ Access to new markets.

157
 DOJ/FTC HORIZONTAL MERGER GUIDELINES

158
EXAMPLE

159
 TYPE OF MARKET STRUCTURE

◎ Economists have developed four primary models of

market structures: perfect competition, monopoly,
oligopoly, and monopolistic competition
◎ This system of market structure is based on two
dimensions:
○ The number of firms in the market (one, few, or
many)
○ Whether the goods offered are identical or
differentiated
160
TYPE OF MARKET STRUCTURE

This system of market

structure is based on two
dimensions:
• The number of firms in the
market (one, few, or many)
• Whether the goods offered
are identical or
differentiated
Differentiated goods are
goods that are different but
considered somewhat
substitutable by consumers
161
162
 PERFECT COMPETITION

◎ A price-taking producer is a producer whose actions

have no effect on the market price of the good it sells
◎ A price-taking consumer is a consumer whose actions
have no effect on the market price of the good he or
she buys
◎ A perfectly competitive market is a market in which
all market participants are price-takers
◎ A perfectly competitive industry is an industry in
which producers are price-takers.
163
 PERFECT COMPETITION
Two Necessary Conditions for Perfect Competition
1. For an industry to be perfectly competitive, it must contain
many producers, none of whom have a large market
share.
◉ A producer’s market share is the fraction of the total
industry output accounted for by that producer’s
output.
2. An industry can be perfectly competitive only if consumers
regard the products of all producers as equivalent.
○ A good is a standardized product, also known as a
commodity, when consumers regard the products of
different producers as the same good. 164
 PERFECT COMPETITION

Free entry and exit

◎ There is free entry and exit into and from an industry
when new producers can easily enter into or leave that
industry
◎ Free entry and exit ensure:
○ That the number of producers in an industry can
adjust to changing market conditions
○ That producers in an industry cannot artificially
keep other firms out.
165
 MONOPOLY

◎ A monopolist is a firm that is the only producer of a

good that has no close substitutes. An industry
controlled by a monopolist is known as a monopoly,
e.g. De Beers
◎ The ability of a monopolist to raise its price above the
competitive level by reducing output is known as
market power.
◎ What do monopolist do with this market power?

166
 MONOPOLY

Why do monopolies exist?

◎ A monopolist has market power and as a result will charge higher
prices and produce less output than a competitive industry. This
generates profit for the monopolist in the short run and long run
◎ Profits will not persist in the long run unless there is a barrier to
entry. This can take the form of:
○ Control of natural resources or inputs
○ Increasing returns to scale
○ Technological superiority
○ Government-created barriers including patents and
copyrights
167
 MONOPOLY

Disadvantages
◎ Exploitation of consumer – higher prices
◎ Potential for supply to be limited – less choice
◎ Potential for inefficiency – X-inefficiency – complacency over
controls on costs

168
 MONOPOLY

Advantages
◎ May be appropriate if natural monopoly
◎ Encourages R&D
◎ Encourages innovation
◎ Development of some products not likely without some
guarantee of monopoly in production
◎ Economies of scale can be gained – consumer may benefit

169
 OLIGOPOLY

◎ Oligopoly is a common market structure. It arises

from the same forces that lead to monopoly, except in
weaker form. It is an industry with only a small
number of producers. A producer in such an industry is
known as an oligopolist.
◎ When no one firm has a monopoly, but producers
nonetheless realize that they can affect market prices,
an industry is characterized by imperfect
competition.

170
 OLIGOPOLY
Is it an Oligopoly, or Not?
◎ According to Justice Department guidelines, an HHI
below 1,500 indicates a strongly competitive market,
between 1,500 and 2,500 indicates a somewhat
competitive market, and over 2,500 indicates an
oligopoly.
◎ In an industry with an HHI over 2,500, a merger that
results in a significant increase (about 200 points) in
the HHI will receive special scrutiny and is likely to be
disallowed.
Source: The United States Department of Justice, 2018
171
 OLIGOPOLY
The HHI for some oligopolistic industry
Industry HHI Largest firms
PC Operating systems 9,182 Microsoft, Linux

Wide-body aircraft 5,098 Boeing, Airbus

Diamond mining 2,338 De Beers, Alrosa, RioTinto

Automobiles 1,432 GM, Ford, Chrysler, Toyota, Honda, Nissan, VW

Buena Vista, Sony Pictures, 20th Century Fox, Warner Bros,

Movie distributor 1,096
Universal, Paramount, Lionsgate

Internet service provider 750 SBC, Comcast, AOL, Verizon, Road Runner,…

Retail grocers 321 Walmart, Kroger, Sears, Target, Costco, Walgreens,

Sources: Canadian Government; Diamond Facts 2006; www.w3counter.com; Planet retail; Autodata; Reuters; ISP Planet; Swivel. Data cover 2006-2007

172
 MONOPOLISTIC COMPETITION
Monopolistic competition is a market structure in which:
◎ There are many competing producers in an industry
◎ Each producer sells a differentiated product
◎ There is free entry into and exit from the industry in
the long run

173
 SUMMARY

Perfect
Monopolistic
Competition Oligopoly Monopoly
Competition

Large number of buyers Few sellers

MARKET and sellers Many sellers Homogeneous or
Single producer and seller
No close substitutes
Homogeneous product differentiated product
Differentiated product available
STRUCTURE Perfect substitutes
available
Close substitutes available
Interdependent decision-
making Impossible entry (pure
monopoly), or may face
S Free entry and exit
Relatively free entry and
exit
Substitutes may or may
not be available
threat of potential entrants
(contestable monopoly)
Perfect knowledge and Non-price competition in Very difficult entry and exit Usually regulated public
innovation the form of advertising and utilities (natural
Strategic pricing-output monopolies that produce
No advertising or product product innovation decision and marketing essential goods)
innovation effort

174
 SUMMARY
1. There are four main types of market structure based on the
number of firms in the industry and product differentiation:
perfect competition, monopoly, oligopoly, and monopolistic
competition
2. In a perfectly competitive market all producers are price-
taking producers and all consumers are price-taking
consumers – no one’s actions can influence the market price
3. There are two necessary conditions for a perfectly competitive
industry: there are many producers, none of whom have a large
market share, and the industry produces a standardized
product or commodity. A third condition is often satisfied as
well: free entry and exit into and from the industry.
175
 SUMMARY
4. A monopolist is a producer who is the sole supplier of a good
without close substitutes. An industry controlled by a
monopolist is a monopoly.
5. Many industries are oligopolies: there are only a few sellers. In
particular, a duopoly has only two sellers. Oligopolies exist for
more or less the same reasons that monopolies exist, but in
weaker form. They are characterized by imperfect competition:
firms compete but possess market power.
6. Monopolistic competition is a market structure in which there
are many competing producers, each producing a differentiated
product, and there is free entry and exit in the long run.

176
Chapter 5
Pricing, Advertising and Investment
policies in business

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
1.
Pricing policies

178
HEADLINE: Mickey Mouse Lets You Ride “for Free” at Disney World

Walt Disney World Theme Parks offer

visitors a wide variety of ticket choices.
The one thing these ticket options have in
common is that they entail a fixed
entrance fee and allow customers to take
as many rides as they want at no
additional charge. For instance, by
purchasing a 1-Day ticket for about $105,
a customer gains unlimited access to the
park of her choice for one day.
Wouldn’t Disney earn higher profits if it
charged visitors, say, $10.50, each time
they went on a ride?

179
 OVERVIEW
1. Basic pricing strategies
○ Perfect competition
○ Monopoly & Monopolistic Competition
○ Cournot Oligopoly
2. Strategic pricing for greater profits
○ Price Discrimination o Two-part pricing
○ Block Pricing o Commodity Bundling
3. Pricing strategies for special structure of cost and
demand structures
○ Peak-Load Pricing
○ Cross -Subsidies

180
 “
BASIC PRICING STRATEGIES

181
 PERFECT COMPETITION
S
Price (dollars)

Price (dollars)
P0
P0 D = MR

0 Q0 0 Quantity
Quantity Panel B – Demand curve facing
Panel A – Market a price-taker 183
 PERFECT COMPETITION

Short-run Output Decision

◎ AVC tells whether to produce
○ Shut down if price falls below minimum AVC
◎ SMC tells how much to produce
○ If P ≥ minimum AVC, produce output at which
P = SMC
◎ ATC tells how much profit/loss if produce
•
184
PERFECT COMPETITION

TotalProfit
revenue =$36 x 600
= $21,600 - $11,400
==$21,600
$10,200

Total cost = $19 x 600

= $11,400

185
 PERFECT COMPETITION

Profitcost
Total = $3,150
= $17 -x$5,100
300
== -$1,950
$5,100

Total revenue = $10.50 x 300

= $3,150

186
LONG-RUN PROFIT-MAXIMIZING EQUILIBRIUM

Profit = ($17 - $12) x 240

= $1,200

187
Short-Run Profit Maximization for Monopoly

188
Maximizing Profit at Aztec Electronics: An Example

◎ Aztec possesses market power via patents

◎ Sells advanced wireless stereo headphones
◎ Using time-series data over the ten-year time period
1994-2004, estimated demand function:
Q = 41.000 - 500P + 0,6M - 22,5Pr
○ Q: Output; P: Price of advanced wireless stereo
headphones; M: Consumer Income; Pr: Price of
signal tuning tool

189
Maximizing Profit at Aztec Electronics: An Example
◎ From a consulting firm, Aztec predicted consumer income
and price of signal tuning tool in 2002 are $45.000 and $800,
respectively.
◎ Aztec estimated their average variable cost function:
AVC = 28 - 0,005Q + 0,000001Q2
Requests:
◎ What is Aztec’s optimal decision in 2005, knowing that their
estimated fixed cost is $270.000?
◎ What is Aztec’s decision when the demand function
changes as a result of reduced consumer income?
P = 80 – 0,002Q 190
 Profit Maximization at Aztec Electronics

191
 A SIMPLE MARKUP RULE

◎ Homogeneous product Cournot industry, 3 firms.

◎ MC = $10.
◎ Elasticity of market demand = - ½.
◎ Determine the profit-maximizing price?
◎ EF = N EM = 3 × (-1/2) = -1.5.
◎ P = [EF/(1+ EF)] × MC.
◎ P = [-1.5/(1- 1.5] × $10.
◎ P = 3 × $10 = $30.

192
AN EXAMPLE

193
194
 MARKUP RULE FOR COURNOT OLIGOPOLY

195
 AN EXAMPLE
◎ Homogeneous product Cournot industry, 3 firms.
◎ MC = $10.
◎ Elasticity of market demand = - 1/2.
◎ Determine the profit-maximizing price?

14-
 BASIC PRICING
◎

197
 “
STRATEGIC PRICING FOR
GREATER PROFITS

198
 STRATEGIC PRICING FOR GREATER PROFITS
◎ Most models examined to this point involve a “single”
equilibrium price
◎ In reality, there are many different prices being
charged in the market
1. Price discrimination
2. Two-part pricing
3. Block pricing
4. Commodity bundling
199
 PRICE DISCRIMINATION
Price discrimination: The practice of charging
different prices to consumers for the same good
or service.
3 basic forms:
1. First-degree price discrimination
2. Second-degree price discrimination
3. Third-degree price discrimination
200
FIRST-DEGREE (PERFECT) PRICE DISCRIMINATION
◎ Every unit is sold for the
maximum price each consumer
is willing to pay
○ Allows the firm to capture entire
consumer surplus
◎ Difficulties
○ Requires precise knowledge about
every buyer’s demand for the good
○ Seller must negotiate a different
price for every unit sold to every
buyer
14-
 SECOND-DEGREE PRICE DISCRIMINATION
◎ Lower prices are offered for larger
quantities and buyers can self-select
the price by choosing how much to buy
◎ Given the posted schedule of prices,
consumers sort themselves according
to their willingness to pay for
alternative quantities of the good.
◎ The firm charges different prices to
different consumers, but does not need
to know specific characteristics of
individual consumers.
◎ Example: electric utilities
14-
AN EXAMPLE

You are a pricing analyst for QuantCrunch Corporation, a company that

recently spent $15,000 to develop a statistical software package. To date, you
only have one client. A recent internal study revealed that this client’s
demand for your software is Qd = 300 – 0.2P and that it would cost you $1,000
per unit to install and maintain software at this client’s site. The CEO of your
company recently asked you to construct a report that compares (1) the
profit that results from charging this client a single per-unit price with (2) the
profit that results from charging $1,450 for the first 10 units and $1,225 for
each additional unit of software purchased. Construct this report, including
in it a recommendation that would result in even higher profits.

14-
6-
 THIRD-DEGREE PRICE DISCRIMINATION

◎ If a firm sells in two markets, 1 & 2 (consumer

in different demographic groups)
○ Allocate output (sales) so MR1 = MR2
○ Optimal total output is that for which MRT = MC
◎ For profit-maximization, allocate sales of total
output so that
MRT = MC = MR1 = MR2

14-
 THIRD-DEGREE PRICE DISCRIMINATION

14-
 AN EXAMPLE
◎

14-
 THIRD-DEGREE PRICE DISCRIMINATION

Conditions for the pricing strategy to be effective

◎ Differences must exist in the elasticity of demand of
various consumers.
◎ The firm must have some means of identifying the
elasticity of demand by different groups of
consumers
◎ Consumers purchasing at lower prices cannot resell
their purchases to others.

14-
ALLOCATING SALES BETWEEN MARKETS

14-
CONSTRUCTING THE MARGINAL REVENUE CURVE

14-
PROFIT-MAXIMIZATION UNDER THIRD-DEGREE
PRICE DISCRIMINATION

14-
 TWO-PART PRICING
◎ Two-part pricing: Pricing strategy in which consumers
are charged a fixed fee for the right to purchase a product,
plus a per-unit charge for each unit purchased.
○ Example: Athletic club memberships.

14-
 “
Two-Part Pricing:
A firm can enhance profits by engaging in two-
part pricing: charge a per-unit price that equals
marginal cost, plus a fixed fee equal to the
consumer surplus each consumer receives at
this per-unit price.

213
 A NUMERICAL EXAMPLE
Assume that an individual’s inverse demand curve is given
by: P = 20 – 2Q, and the cost function is C(Q) = 2Q. The firm
seeks to find the optimal, profit-maximizing two-part pricing.
Find the optimal price and initiation fee for this product.

14-
 BLOCK PRICING
◎ Block pricing: Pricing
strategy in which
identical products are
packaged together in
order to enhance
profits by forcing
customers to make an
all-or-none decision to
purchase.
E.g. Paper, Six-packs of soda,
Different sized of cans of green
beans.
14-
 AN ALGEBRAIC EXAMPLE
◎ Typical consumer’s ◎ Optimal Quantity To
demand is P = 10 - 2Q Package: 4 Units
◎ C(Q) = 2Q
◎ Optimal number of
units in a package?
◎ Optimal package price?

14-
 AN ALGEBRAIC EXAMPLE
◎ Optimal Price for the ◎ Costs and Profits with
Package: $24 Block Pricing

14-
 “
Block Pricing: By packaging units of a
product and selling them as one package, the
firm earns more than by posting a simple per-
unit price. The profit-maximizing price on a
package is the total value the consumer
receives for the package.

218
 COMMODITY BUNDLING
◎ Commodity Bundling: The practice of bundling several
different products together and selling them at a single
“bundle price.”
○ E.g. Vacation packages, Computers and software, Film and
developing.

14-
DEMONSTRATION PROBLEM

14-
 PRICING STRATEGIES FOR SPECIAL COST
AND DEMAND STRUCTURES

1. Peak-Load Pricing
2. Cross-subsidization

221
 PEAK-LOAD PRICING
◎ Peak-load Pricing:
Pricing strategy in
which higher prices
are charged during
peak hours than
during off-peak hours.

14-
 “
Peak-Load Pricing: When demand is higher
at some times of the day than at other times,
a firm may enhance profits by peak-load
pricing: charging a higher price during peak
times than is charged during off-peak times.

223
“

224
 CROSS-SUBSIDIES PRICING
◎ Principle: Whenever the demands for two products
produced by a firm are interrelated through costs or
demand, the firm may enhance profits by cross-
subsidization: selling one product at or below cost and
the other product above cost.
○ E.g.: Browser and server software, Drinks and meals at restaurants.

14-
EXAMPLE
◎ The demand for electricity is Q =5-P in peak periods and Q =4-2P
in off-peak periods. Both periods take up half of each day.
Variable cost is 0.25 per unit of output per period and capital cost
capacity are 0.75 per unit of capacity per day. Capacity costs are
sunk and cannot be adjusted between periods
◎ Find the optimal capacity, peak price and off-peak price

14-
 CONCLUSION
◎ First degree price discrimination, block pricing,
and two part pricing permit a firm to extract all
consumer surplus.
◎ Commodity bundling, second-degree and third
degree price discrimination permit a firm to
extract some (but not all) consumer surplus.
◎ Simple markup rules are the easiest to implement,
but leave consumers with the most surplus and
may result in double-marginalization.
◎ Different strategies require different information.
14-
 ANSWERING THE headLINE
Why does Disney World charge a cover fee for entering the
park and then let everyone who enters ride for free? The
answer lies in the ability to extract consumer surplus by
engaging in two-part pricing. In particular, the marginal
cost of an individual ride at an amusement park is close to
zero, as in Figure. If the average consumer has a demand
curve like the one in Figure, setting the monopoly price
would result in a price of $10.50 per ride. Since each
customer would go on five rides, the amusement park
would earn $52.50 per customer. (This ignores fixed costs,
which must be paid regardless of the pricing strategy.) But
this would leave the average consumer with $26.25 in
consumer surplus. By charging an entry fee of $105 but
pricing each ride at $0, each consumer rides an average of
10 rides and the park extracts all consumer surplus and
earns higher profits

14-
2.
Advertising policies in
business
1. Advertisement and its roles
2. Economic analysis of advertising in business

229
 ADVERTISEMENT
◎ Definition: expenditure undertaken by a firm to
promote the sales of its products or services.
○ E.g.: paid-for space in print, radio or television media;
promotional activity
◎ Advertising is intended to influence consumer
choice in favor of the advertiser’s product or
service.

14-
Graphical Analysis of Advertising

14-
 OPTIMAL ADVERTISING DECISIONS
◎ To maximize these profits, managers should advertise
up to the point where the incremental revenue from
advertising equals the incremental cost
○ Incremental cost of advertising: the dollar cost of the
resources needed to increase the level of advertising (e.g.:
fees paid for additional advertising space)
○ Incremental revenue: the extra revenue the firm gets as a
result of the advertising campaign.

14-
 OPTIMAL ADVERTISING DECISIONS
◎

14-
 DEMONSTRATION PROBLEM

Corpus Industries produces a product at constant

marginal cost that it sells in a monopolistically
competitive market. In an attempt to bolster profits, the
manager hired an economist to estimate the demand for
its product. She found that the demand for the firm’s
product is log-linear, with an own price elasticity of
demand of –10 and an advertising elasticity of demand of
0.2. To maximize profits, what fraction of revenues should
the firm spend on advertising?

14-
3.
Investment policy in
business
Investment appraisal in business
1. Investment with risk and uncertainty

235
 BASIC STEPS IN INVESTMENT APPRAISAL
1. Defining the objectives: decide the type of investment
projects.
○ Replacement investment: old equipment has to be replaced
○ Expansionary investment: firm expands its capacity to meet
growing demand
○ Other investments: health and safety or environmental
reasons.
2. Identifying options: consider the various ways in which
the objective might be met.
3. Identifying the costs, benefits, timing and uncertainties
of each option.
14-
 BASIC STEPS IN INVESTMENT APPRAISAL
4. Choosing the method of appraisal: discounted
cash flow techniques, internal rate of return,
payback or the accounting rate of return
5. Choosing the cost of capital: to choose a value to
represent the opportunity cost of the resources
6. Test of viability: whether projects are individually
worth while and ranked in order of merit.
7. Presenting the results: The present value of each
of the projects should be presented to the
decision makers
14-
 AN INVESTMENT EXAMPLE
◎ Step 1: An electricity supplier has decided to build
a new power station
◎ Step 2: The alternative technologies available
should be considered
◎ Step 3: Costs of undertaking each alternative
plan, variable costs of producing electricity,
expected revenues, anticipated life of the
project (25 years for a power station), costs in
closing the power station
○ Estimating the cash flows of a project: capital costs,
○ operating costs, revenues and decommissioning costs
14-
 AN INVESTMENT EXAMPLE
◎ Step 4: Choosing the method of appraisal:
○ Discounted cash flow techniques (NPV)
○ Internal Rate of Return (IRR)
○ Payback
○ Accounting rate of return

14-
 “
Rules to choose project
Discounted cash flow techniques (NPV):
1. Projects have positive NPV should all be undertaken
2. Projects having a negative NPV should be rejected
3. Projects have higher NPV should be preferred

240
14-
14-
 INTERNAL RATE OF RETURN (IRR)

◎ The rate of discount that makes the NPV of

the cash flow of a project equal to zero.
◎ Projects with higher IRR are preferred.

14-
 DEMONSTRATION PROBLEM
◎ According to the IRR method, which project if preferred?

14-
 PAYBACK METHOD

◎ Calculates the time in years or months that

projects have to run before they cover their
original capital outlay
◎ Criticisms:
○ It does not discount the cash flows.
○ It ignores all returns after the payback period

14-
RECOGNIZE THE TIME VALUE OF MONEY

246
 THE ACCOUNTING RATE OF RETURN

14-
NON-DISCOUNTING METHODS OF INVESTMENT APPRAISAL
◎ Payback method
◎ Accounting rate of return.

14-
 SUMMARY

◎ 4 methods of investment appraisal:

○ Discounting methods:
◉ Net present value (NPV)
◉ Internal rate of return (IRR)
○ Non-discounting methods:
◉ Payback method
◉ The accounting rate of return

14-
 PROJECTS RANKING AND CAPITAL RATIONING

14-
DEMONSTRATION PROBLEM

14-
 SUMMARY

1. Pricing strategies:
a) Basic pricing strategies
◉ Monopoly & Monopolistic Competition
◉ Cournot Oligopoly
b) Strategic pricing for greater profits
◉ Price Discrimination o Two-part pricing
◉ Block Pricing o Commodity Bundling
c) Pricing strategies for special structure of cost and
demand structures
◉ Peak-Load Pricing o Transfer Pricing
◉ Cross Subsidies

14-
 SUMMARY

14-
 SUMMARY

3. Methods of investment appraisal:

a) Discounting methods
◉ Net present value (NPV)
◉ Internal rate of return (IRR)
b) Non-discounting methods
◉ Payback method
◉ The accounting rate of return

14-
 PRACTICE
Using the following data for project A and B:
◎ Calculate the net present value for each project, assuming a cost of capital
of 15%.
◎ Calculate the internal rate of return for each project.
◎ Which project should the firm choose based on using net present value and the
internal rate of return?
◎ If the cost of capital were to increase to 20%, would project A or B be preferred?

14-