1 Economic Concepts For Strategy Besanko, Dranove, and Shanley Primer Chapter

2 Agenda Strategy Defined Review the Concepts Related to Costs Profitability, Revenue, and Demand Pricing and Output Decisions Game Theory

3 Perspective 1 of Strategy Taken From Besanko “the determination of the basic long- term goals and objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary for carrying out these goals.” –Alfred Chandler

4 Perspective 2 of Strategy Taken From Besanko “the pattern of objectives, purposes or goals, and the major policies and plans for achieving these goals, stated in such a way as to define what business the company is in or should be in and the kind of company it is or should be.” –Kenneth Andrews

5 Perspective 3 of Strategy Taken From Besanko “what determines the framework of a firm’s business activities and provides guidelines for coordinating activities so that the firm can cope with and influence the changing environment. Strategy articulates the firm’s preferred environment and the type of organization it is striving to become.” –Hiroyuki Itami

6 Key Points of Strategy Strategy focuses on long-term goals and objectives. Strategy develops action plans. In essence, strategy can be defined as the action plans that move the company towards its long-term goals and objectives within a particular environment.

7 Benchmarking Versus Principles Benchmarking is where you examine how successful companies operate and attempt to imitate them. It assumes that the keys to success can be measured and are knowable. Principles, as related to strategy, are a set of guidelines that work across time in many differing environments.

8 Besanko’s Framework for Strategy Boundaries of the firm What should the firm do and how large should it be? Market and competitive analysis What is the nature of the markets and the interaction between firms?

9 Besanko’s Framework for Strategy Cont. Position and dynamics How and on what basis does the firm compete? Internal organization How should the firm be internally organized and managed?

10 Total Cost Function The total cost function is the summation of all fixed (including sunk) and variable costs. It is usually represented as the following: TC(Q) = VC(Q) + FC(Q) Where VC(Q) denotes the variable costs Where FC(Q) denotes the fixed costs

11 Graphical Depiction of the Total Cost Function TC(Q) Total Cost Output (Q)

12 Variable and Fixed Costs A variable cost is a cost that is zero if no production occurs. A fixed cost is a cost that exists whether production occurs or not. Fixed costs can be broken down further into sunk costs. There tends to be more fixed costs in the short-run compared to the long-run.

13 Sunk Costs A sunk cost is a cost that cannot be recovered. A sunk cost is always considered a fixed cost, but a fixed cost does not necessarily imply being sunk. Sunk costs can have a significant impact on how you choose strategies.

14 Strategy and the Cost Function The types of strategies you have as a firm can be dictated by your present and future cost functions. Why?

15 Average and Marginal Costs Average cost can be defined as the total cost divided by output. Marginal cost is the change in total cost divided by the change in output.

16 Relationship Between Average and Marginal Cost If marginal cost is below average cost then average cost is decreasing. When average and marginal cost are equal, then marginal cost is at a minimum. When marginal cost is above average cost, the average costs are increasing

17 Graphical Depiction of Average and Marginal Costs $ Q MC AC

18 Long-Run Average Cost Curve The long-run average cost curve can be defined as the envelope of all possible short-run average cost curves. By envelope we mean the minimum amount that can occur given a particular level of output.

19 Scale of Economics When examining the long-run average cost curve, the economics of scale examines what happens to average cost as output is increased. There are three general types of scale: Economies of scale Minimum efficient scale Diseconomies of scale

20 Economies of Scale Economies of scale are said to exist when by increasing output, the long-run average costs decrease. This implies that AC(Q 1 ) > AC(Q 2 ) when Q 1 < Q 2 and you move from Q 1 to Q 2.

21 Minimum Efficient Scale Minimum efficient scale is said to exist when by increasing output, the long-run average costs does not change. This implies that AC(Q 1 ) = AC(Q 2 ) when Q 1 < Q 2 and you move from Q 1 to Q 2.

22 Diseconomies of Scale Diseconomies of scale are said to exist when by increasing output, the long-run average costs increase. This implies that AC(Q 1 ) < AC(Q 2 ) when Q 1 < Q 2 and you move from Q 1 to Q 2.

23 Short-Run Average Costs for Differing Firms Cost per unit Q LRAC SRAC 1 SRAC 2 SRAC 3 SRAC 4 SRAC 5

24 A Possible LRAC $/per unit Y LRAC AB Note: The section of output between A and B is known as the minimum efficient scale.

25 Profit There are two ways to define profits. In general, profit is defined as total revenue minus total costs.  = TR - TC The two ways of defining profits are: Accounting Profit Economic Profit

26 Accounting and Economic Profit Accounting profit can be defined as sales revenue minus accounting costs. Accounting costs do not usually take into account opportunity costs. Economic profit can be defined as sales revenue minus economic costs. Economic costs are equal to accounting costs plus all opportunity costs.

27 Present Value When you want to know what the value of something in the future is worth to you today, you can use the idea of present value. Present value takes a value in the future and converts it to what it is worth to you today.

28 Present Value Cont.

29 Net Present Value When you want to know what the value of a set of income streams is worth to you today, you can use the idea of net present value. Net present value takes a set of income streams in the future and converts it to what it is worth to you today.

30 Net Present Value Cont.

31 Demand Function The demand function is a function that gives the relationship between quantity demanded and all the variables that affect that quantity demanded. The demand function usually examines the relationship between price and quantity. The Law of Demand states that there is an inverse relationship between price and quantity demanded holding all other variables fixed.

32 Price Elasticity of Demand This measures the sensitivity of quantity demanded due to a change in price.

33 Price Elasticity of Demand Cont. When  > 1, then demand is said to be elastic. When  = 1, then demand is said to be unitary elastic. When  < 1, then demand is said to be inelastic.

34 Price Elasticity of Demand Cont. There is a relationship between revenue, elasticity, and price. When  > 1, then revenue can be increased by decreasing price. When  < 1, then revenue can be increased by increasing price. When  = 1, then revenue is maximized for the given price.

35 Causes of Price Sensitivity The commodity is consider homogeneous or near homogenous to its rival products. The price of the product is a large proportion of the buyer’s expenditure. The product is an input of a very elastic product.

36 Causes of Price Insensitivity Very few or no substitute products. A substitute product is much more costly. There are incentives that reduce the effective price of the product. The product is a complementary product to a product that is highly inelastic.

37 Total and Marginal Revenue Total revenue is defined as price times quantity where price is a function of quantity. TR = P(Q)*Q Marginal Revenue is the change in total revenue due to a change in quantity.

38 Relationship Between Elasticity and Marginal Revenue When demand is elastic, i.e.,  > 1, then marginal revenue is positive when quantity is increased. When demand is elastic, i.e.,  < 1, then marginal revenue is negative when quantity is increased.

39 Pricing and Output Decisions Change in profit (  ) can be defined as the change in quantity times the difference between marginal revenue and marginal cost, i.e.,  = (MR-MC)*  Q. When MR > MC, the firm can increase profits by decreasing price and selling more. When MR < MC, the firm can increase profits by increasing price and selling less. When MR = MC, the firm cannot increase profits.

40 Price Elasticity and the Output Decision The following relationships can be derived: MR – MC > 0, when PCM > 1 / . MR – MC < 0, when PCM < 1 / . Where PCM, the percentage contribution margin, is defined as (P – c) / P. P is the price of the product. c is the marginal cost.

41 Price Elasticity and the Output Decision Cont. When the percentage contribution margin is greater than the reciprocal of the price elasticity of demand, then prices should be decreased to increase profitability. When the percentage contribution margin is less than the reciprocal of the price elasticity of demand, then prices should be increased to increase profitability.

42 Game Theory Game theory is the study of a set of tools that can be used to analyze decision-making by a set of players who interact with each other through a set of strategies.

43 Tools Used in Game Theory Matrix Form of a Game Dominant Strategy Dominated Strategy Nash Equilibrium Game Trees Subgame Perfection

44 Matrix Form of the Game The matrix form of a game represents the strategies and payoff of those strategies in a matrix. The key components of this is the players, the strategies, and the payoffs of the strategies. The matrix form is a useful tool when the players of the game must move simultaneously.

45 Matrix Form of the Game Cont. Player 2 Strategy 1Strategy 2 Player 1 Strategy 1 (Player 1 payoff, Player 2 payoff) Strategy 2 (Player 1 payoff, Player 2 payoff)

46 Matrix Form Example Suppose there were two producers of hogs, Farmer A and Farmer B. Assume that there are two strategies that each farmer can do: be large or be small. If each farmer chooses the same size, they will split the demand for there product evenly.

47 Matrix Form Example Cont. If both producers are small, then the market is worth $100. If both producers are large, then the market is worth $80. If one chooses to be large and the other chooses to be small, then the market is worth $90. When one farmer is small and the other is large, the large producer obtains 2/3 of the market leaving the rest to the small farmer.

48 Matrix Form Example Cont. Players: Farmer A, Farmer B Strategies: Large, Small Payoffs: Large, Large implies (40, 40) Large, Small implies (60, 30) Small, Small implies (50, 50) Small, Large implies (30, 60)

49 Matrix Form Example Farmer B LargeSmall Farmer A Large (40, 40)(60, 30) Small (30, 60)(50, 50)

50 Dominant and Dominated Strategies Dominant Strategy Given a set of strategies, a dominant strategy is one that is better than all other strategies in that set. Dominated Strategy Given a set of strategies, a dominated strategy is one that is worse than all other strategies in that set.

51 Nash Equilibrium A Nash Equilibrium is said to occur when given the strategies of the other players are held constant, there is no incentive for a player to change his strategy to get a higher payoff. In essence, a Nash Equilibrium occurs when all players in the game do not want to change their strategies given the other players’ strategies.

52 Nash Equilibrium Cont. A Nash Equilibrium will be in a Dominant Strategy. A Nash Equilibrium will never be in a dominated strategy.

53 Matrix Form Example with Nash Equilibrium Farmer B LargeSmall Farmer A Large (40, 40) Nash Equilibrium (60, 30) Small (30, 60)(50, 50)

54 Prisoners’ Dilemma A Prisoners’ Dilemma occurs when all parties through noncooperative strategies obtain a less than optimal solution due to their self interest. In the previous example, the Nash Equilibrium occurred at a sub-optimal solution for the game where both farmers chose large. They both would have been better off by choosing small.

55 Game Trees A Game Tree is a way of representing a sequential move game. There are four components to a Game Tree. Players Payoffs Nodes A node represents a position within the game. Actions An action is a move that moves from one node to the next.

56 Representation of Game Tree Player 1 Player 2 Action 1 Action 2 Action 3 Action 4 Action 5 Action 6 Player 1 Payoff, Player 2 Payoff

57 Game Tree Representation Using Previous Example Assuming Farmer A Moves First Farmer A Farmer B Large Small Large Small Large Small 40, 40 60, 30 30, 60 50, 50

58 Subgame Perfection When working with a Game Tree, an important equilibrium concept is the Subgame Perfect Nash Equilibrium (SPNE). A SPNE is said to exist if “each player chooses an optimal action at each stage in the game that it might conceivably reach and believes that all other players will behave in the same way.” (Besanko)

59 Subgame Perfection Cont. Subgame Perfection can be found by using a method called the fold-back method. In the fold-back method, you start at the end of the tree and work your way back to find the best strategies for each node.

60 Subgame Perfection Example 2 Farmer A Farmer B Large Medium Small Large Medium Small Large Medium Small 50, 50 65, , 60 SPNE Large Medium Small 55, 65 90, , 70 60, , , 110

61 Subgame Perfection Example 2 The SPNE is where Farmer A becomes large and Farmer B becomes small. This gives a payoff of 100 to Farmer A and a payoff of 60 to Farmer B. If this was a simultaneous move game, what would the outcome had been?