1. Slide 1 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Applications of Cost Theory Topics in this Chapter include: Estimation of Cost Functions using regressions »Short run -- various methods including polynomial functions such as cubic or quadratic functions »Long run -- various methods including Engineering cost techniques Survivor techniques Linear Break-Even Analysis and Operating Leverage Business Risk and Risk Assessment

2. Slide 2 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Estimating Cost Functions Firms want to know what their costs are now, what their costs will be, and what they would be at different output levels. Costs issues involve the type of cost (fixed, variable, average, etc.) and issues of time depreciation. »Items often depreciate with use »Items can also depreciate with passage of time Because prices of inputs change with inflation, must consider deflating or detrending cost data.

3. Slide 3 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Short Run Cost-Output Relationships Typically use TIME SERIES data for a plant or for firm, regression estimation is possible. Typically use a functional form that “fits” the presumed shape. SRTC is often CUBIC SRTC = a+bQ+cQ 2 +dQ 3 STAC is often QUADRATIC SRAC = a+bQ+cQ 2 quadratic is U-shaped or arch shaped. cubic is S-shaped or backward S-shaped

4. Slide 4 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Empirical Cost-Output Polynomial: In Theory Short run cost functions can be represented by a cubic relationship TC = a + bQ + cQ 2 + dQ 3 From this we can find ATC (average total cost) ATC = TC/Q = a/Q + b + cQ + dQ 2 We can also find MC (marginal cost) MC = dTC/dQ = b + 2cQ + 3dQ 2 Notice that both ATC and MC are U-Shaped as represented by quadratic equations (to the power of 2) Notice also that if “d” is insignificant, the form is even simpler as the last term is zero in each of the above examples

5. Slide 5 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Estimating Short Run Cost Functions: In Practice Example: TIME SERIES data of total cost Cubic Total Cost (to the power of three) TC = C 0 + C 1 Q + C 2 Q 2 + C 3 Q 3 Time Series Data: TC Q Q 2 Q 3 900 20 400 8,000 800 15225 3,375 834 19361 6,859  Predictor Coeff Std Err T-value Constant 1000 800 1.25 Q 50 20 2.5 Q-squared -10 2.5 -4.0 Q-cubed 2 1 2.0 R-square =.91 Adj R-square =.90 N = 35 Regression Output:

6. Slide 6 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PROBLEMS: 1. Write the cost regression as an equation. 2. Find the AC function. What is MC at Q=10? 3. Find the MC function. What is MC at Q=10? 1. TC = 1000 + 50 Q - 10 Q 2 + 2 Q 3 (1.25) (2.5) (4) (2) 2.AC = 1000/Q + 50 - 10 Q + 2 Q 2 3.MC = 50 - 20 Q + 6 Q 2 t-values in the parentheses NOTE: Total cost is S-shaped Average cost is U-shaped And even MC is U-shaped Find AC at Q=10. AC = 1000/10 + 50 – 10(10) + 2(10) 2 = 250 Find MC at Q=10. MC = 50 – 20 (10) + 6 (10) 2 = 100 = 450

7. Slide 7 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Estimating LR Cost Relationships Use a CROSS SECTION of firms »SR costs usually uses a time series Assume that firms are near their lowest average cost for each output A quadratic curve of a cross section of ACs for various firms can be used. Q AC LRAC

8. Slide 8 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Economies of Scope in Banking Economies of scope occur when producing two or more products jointly by one firm is less than the cost of producing them separately. Banking offers economies of scope through offering people who can help customers with checking, savings, credit cards, mortgages, car loans, trust accounts, and many other services. Banks are expanding into other fields, including brokerage, insurance, bill paying, foreign exchange hedging, and other services expanding economies of scope. Work by Jeffry Clark used a logarithmic cost function such as: Ln TC = a + b Ln Consumer Lending + c Ln Mortgage Lending He found evidence for Economies of Scope in banking up to about $100 million in assets.

9. Slide 9 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Engineering Cost Approach Engineering Cost Techniques offer an alternative to fitting lines through historical data points using regression analysis. It uses knowledge about the efficiency of machinery. Some processes have pronounced economies of scale, whereas other processes (including the costs of raw materials) do not have economies of scale. Size and volume are mathematically related, leading to engineering relationships. Large warehouses tend to be cheaper than small ones per cubic foot of space.

10. Slide 10 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Survivor Technique The Survivor Technique examines what size of firms are tending to succeed over time, and what sizes are declining. This is a sort of Darwinian survival test for firm size. Presently many banks are merging, leading one to conclude that small size offers disadvantages at this time. Dry cleaners are not particularly growing in average size, however.

11. Slide 11 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Break-even Analysis We can have multiple B/E (break-even) points with non-linear costs & revenues. If linear total cost and total revenue: »TR = PQ »TC = F + VQ where V is Average Variable Cost F is Fixed Cost Q is Output cost-volume-profit analysis Total Cost Total Revenue B/E Q Figure 9.5

12. Slide 12 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Break-even Quantity: Q B/E At break-even: TR = TC »So, PQ = F + VQ Q b = F / ( P - V) = F/CM »where contribution margin is: CM = ( P - V) PROBLEM: As a garage contractor, find Q B/E if: P = $9,000 per garage V = $7,000 per garage & F = $40,000 per year

13. Slide 13 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Amount of sales revenues that breaks even PQ b = P[F/(P-V)] = F / [ 1 - V/P ] Break-even Sales Volume Variable Cost Ratio Ex: At Q = 20, B/E Sales Volume is $9,00020 = $180,000 Sales Volume Answer: Q = 40,000/(2,000)= 40/2 = 20 garages at the break-even point.

14. Slide 14 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Target Profit Output l Quantity needed to attain a target profit If  is the target profit, Q target  = [ F +  ] / (P-v) Suppose want to attain $50,000 profit, then, Q target  = ($40,000 + $50,000)/$2,000 = $90,000/$2,000 = 45 garages

15. Slide 15 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Contribution Analysis Another variation is to find if added sales through a ad campaign or new product is justified. It looks at the incremental contributions and incremental additions to cost. Do the project if: »Added Contribution > Added Cost »(P – v)  Q >  Direct Fixed Cost »When this inequality holds, the project adds more to revenues than it adds to cost. Sometimes the assumptions do not hold 1.Costs may be semi-variable 2.Many times firms sell multiple products or small, medium, and large varieties 3.There is uncertainty as to the P, V, and F in the problem 4.Inconsistency in the planning horizon Limitations of B/E & Contribution Analysis

16. Slide 16 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Degree of Operating Leverage or Operating Profit Elasticity DOL = E  »sensitivity of operating profit (EBIT) to changes in output Operating  = TR-TC = (P-v)Q - F Hence, DOL =  Q(Q/  ) = (P-v)(Q/  ) = (P-v)Q / [(P-v)Q - F] A measure of the importance of Fixed Cost or Business Risk to fluctuations in output

17. Slide 17 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Suppose the Contractor Builds 45 Garages, what is the D.O.L? DOL = (9000-7000) 45. {(9000-7000)45 - 40000} = 90,000 / 50,000 = 1.8 A 1% INCREASE in Q  1.8% INCREASE in operating profit. At the break-even point, DOL is INFINITE. »A small change in Q increase EBIT by astronomically large percentage rates

18. Slide 18 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Break-Even Analysis and Risk Assessment One approach to risk, is the probability of losing money. Let Q b be the breakeven quantity, and Q is the expected quantity produced. z is the number of standard deviations away from the mean z = (Q b - Q )/  68% of the time within 1 standard deviation 95% of the time within 2 standard deviations 99% of the time within 3 standard deviations Problem: If the breakeven quantity is 5,000, and the expected number produced is 6,000, what is the chance of losing money if the standard deviation is 500? Answer: z =(5000 – 6000)/500 = -2. There is less than 2.5% chance of losing money. Using table B.1, the exact answer is.0228 or 2.28% chance of losing money. ^

19. Slide 19 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Prices, Output, and Strategy: Pure Competition and Monopolistic Competition Pure competition is a standard against which other market structures are compared. In it, there are many firms and the product is perfectly undifferentiated.  There are industries where are many firm, but the products or service are heterogeneous or differentiated. Monopolistic competition is when there are many firms, but the product or service is differentiated.  This brand competition may involve advertising campaigns and large promotional expenditures to stress often minor distinctions among products

20. Slide 20 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Competitive Strategy Analysis Many industries are already competitive, but firms need to find ways to stay competitive Core Competencies – technology-based expertise or knowledge on which a firm can focus its strategy. Value Proposition – basis for customer willing to pay more than cost-covering prices »Find value in the value chain »Find value in network relationships

21. Slide 21 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Strategy Process Figure 10.1

22. Slide 22 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Generic Types of Strategies to Attain Sustainable Profits Product Differentiation Strategy »A strategy that relies upon differences in products or processes affecting perceived customer value. »For example, Coca-Cola or Nestlé Cost-based Strategies »A strategy that relies upon low-cost operations, marketing, or distribution. For example, Southwest Airlines & Dell Computers Information Technology Strategy »Use IT capabilities to distinguish yourself from others »For example, Allstate Insurance & GPS tracking to offer lower insurance rates to those who don’t drive their best cars to work

23. Slide 23 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Relevant Market Concept A market is a group of economic agents that interact in a buyer- seller relationship. The number and size of the buyers and sellers affect the nature of that relationship. A popular measure of concentration is the percentage of an industry comprised of the top 4 firms. Similarly, the market share held by the top 4 buyers is a popular measure of buyer concentration. The relationship among firms is affected by: a. the number of firms and their relative sizes. b. whether the product is differentiated or standardized. c. whether decisions by firms are independent or coordinated (collusion).

24. Slide 24 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Michael Porter’s Five Forces of Competitive Advantage The forces that determine competitive advantage are: 1.The Threat of Substitutes can be offset by brands, complementors, and special functions served by the product. 2.The Threat of Entry can be reduced by high fixed costs, scale economies, restriction of access to distribution channels, or product differentiation. 3.The Power of Buyers from the threat of concentration of buyers. 4.The Power of Suppliers for the threat when concentrated suppliers of key inputs affect profitability. 5.The Intensity of Rivalry impact profitability via market concentration, price competition tactics, exit barriers, ratio of FC to TC (cost fixity), and industry growth rates.

25. Slide 25 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Figure 10.2

26. Slide 26 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Break-even Sales Change Analysis The price-cost margin percentage (PCM) is defined as PCM = ( P – MC )/P. A price cut may help or hurt profitability depending on price elasticities and price cost margins. We can ask how much quantity must change after a price cut to breakeven (from before the price cut)? If we cut prices 10%, to breakeven, the percentage change in quantity (  Q/Q) must be large enough to satisfy the equation to breakeven: PCM / (PCM –.10) < (1 +  Q/Q ) The larger is the price-cost margin percentage, the smaller will be the necessary quantity response to justify cutting price.  If PCM is 80%, then.8/(.8-.1) = 1.14. Hence, a 10% cut in price must be offset by only a 14% increase in quantity to breakeven.  If PCM is only 20%, then.2/(.2-.1) = 2. Hence, a 10% cut in price must be offset by at least a 20% increase in quantity to breakeven. So with Hanes underwear and low PCM discourages discounting.

27. Slide 27 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. There is a continuum of market structures:  Pure Competition assumes: 1. a very large number of buyers and sellers 2.homogeneous product (standardized) 3.complete knowledge of all relevant market information 4.free entry and exit (no barriers) These assumptions imply several things about competitive markets, including price equals average cost in the long run. Pure Monopolistic Competition Competition Oligopoly Monopoly Best Worst

28. Slide 28 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Monopoly assumes: 1.Only one firm in the market area 2.Low cross price elasticity with other products. 3.No interdependence with other competitors. 4.Substantial entry barriers These assumptions imply that the monopoly price is well above marginal cost. Monopoly is discussed in full in Chapter 11.  Monopolistic competition assumes: 1.A large number of firms, some of which may be dominant in size 2.Differentiated products 3.Independent decision making by individual firms 4.Easy entry and exit These assumptions imply several things about monopolistic competition, including that the price in the long run is equal to average cost.

29. Slide 29 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Oligopoly assumes: 1.Only a few firms in the market area 2.Products may be differentiated or undifferentiated 3.There is a large degree of interdependence with other competitors These assumptions imply several things about monopolies, including that the monopoly price is well above marginal cost. After going briefly over these four market structures, this chapter examines: » Pure Competition »Monopolistic Competition

30. Slide 30 CHARACTERISTICS OF DIFFERENT MARKET ORGANIZATIONS Although not every industry fits neatly into one of these categories, the categories do provide a useful and convenient framework for thinking about industry structure and behavior.

31. Slide 31 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Price-Output Determination Under Pure Competition Competitive firms attempt to maximize profits. Competitive firms cannot charge more than the market price of others, since their product is identical to all others. Hence, competitive firms are price takers. Total revenue, TR, is P·Q, where price is given. Therefore, marginal revenue, MR, is price, P. Profit (  ) is total revenue minus total cost, that is:  = TR - TC.

32. Slide 32 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Profit maximization implies that each firm produces an output where Price = Marginal Cost (P = MC). »To produce more than this quantity implies that P < MC, which is not the most profitable decision. »To produce less than where P=MC, implies that P > MC, and the firm could increase profits by expanding output. In short run, a competitive firm may earn economic profits. In long run, entry pushes price down to the minimum point of the average cost curve, so that economic profits are zero.

33. Slide 33 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A Competitive Market in the Short Run 1.If P = MC for each firm, then each firm is doing what it thinks maximizes profits. Firms are in equilibrium. 2.Equilibrium for the industry if: Demand equals Supply at the going price In this example, the firm is earning economic profits as P SR > AC. »When both (1) & (2) occur, the market is in a Competitive Equilibrium a firm the industry MC D   MC AC CAN EARN ECON PROFITS IN THE SHORT RUN P SR Q1Q1

34. Slide 34 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A Competitive Market in the Long Run Industries which have economics profits draw entry and shift the  MC 1 curve out to  MC 2 where there is no reason for more firms to enter or firms to exit the industry Price covers all cost, so in the LR, P=AC which means that Economic Profits are zero. a firm the industry MC D   MC 2 AC ZERO ECON PROFITS IN THE LONG RUN  MC 1 P LR entry

35. Slide 35 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Long Run Competitive Markets with external diseconomies of scale As demand rises for products, we find that inputs become more expensive. The rising cost is not due necessarily to the productivity of the firms, but higher prices for what they purchase. One example is the rising price for crude oil. As demand in the world increases, the marginal seller of oil is ever pricier. Figure 10.5 $/barrel for oil Quantity in million barrels per day D1 D2 Persian Gulf Oil Mexican Oil Brazilian Ethanol

36. Slide 36 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Long Run Equilibrium in an Increasing Cost Industry As demand shifts from D1 to D2, the price rises to P2 and the long run supply curve is upward rising. The cause is the upward shift in AC that firms experience.

37. Slide 37 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Price-Output Determination Under Monopolistic Competition Monopolistic Competition »MARKET STRUCTURE Many Firms and Many Buyers Easy Entry & Exit PRODUCT DIFFERENTIATION ! ! ! Historical Background »Joan Robinson “Economics of Imperfect Competition,” 1933 »Edward Chamberlin, “Theory of Monopolistic Competition,” 1933 Small Groups & Large Groups Product Differentiation Among Gas Stations

38. Slide 38 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Product Differentiation Differentiation occurs when consumers perceive that a product differs from its competition on any physical or nonphysical characteristic, including price. Examples: restaurants, dealer-owned gas stations, video rental stores, book & convenience stores, etc. Assumptions of the Model: »Large number of firms »Differentiated Product »Conditions of Cost and Demand are Similar »Easy Entry & Exit

39. Slide 39 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Basic Model of Monopolistic Competition In the Short Run »produce where MR= MC »price on the demand curve NOTICE: »P > MC »economic profits exist P > AC »there exists incentives for entry into this industry AC MC D MR PMPM QMQM SHORT RUN DIAGRAM

40. Slide 40 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Profits in the SR Induces Entry Entry in this industry “steals” customers. Demand curve shifts inward RESULTS »MR = MC (like monopoly) »P = AC (like competition) »Profits in LR are zero (like competition) »not at Least Cost Point of AC curve (like monopoly) AC D’ D LONG RUN DIAGRAM P Q MC MR

41. Slide 41 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Properties of Monopolistic Competition Inefficient Production »EXCESS CAPACITY not at least cost point of AC curve »Could Avoid Excess Capacity by JOINTLY PRODUCING at the same plant Kroger Salt & Morton Salt produced at the same plant Sears’ Kenmore and Whirlpool dishwashers are built at same factory. Does the expectation of zero profits in the future stifle innovation? Is there too much product differentiation?

42. Slide 42 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Selling and Promotional Expenses Suppose that the price is determined outside of the model, as with liquor prices in some States. We will expand promotional activities until the extra profit associated with the activity equals the extra cost of the promotion. This decision rule for Optimal Advertising is when: Contribution Margin = Marginal Cost of Advertising or P – MC = k  A/  Q or expand advertising whenever (P – MC)(  Q/  A) > k where, contribution (P – MC) is the marginal profit contribution of an additional sale, and the marginal cost of advertising is ( k  A  Q).

43. Slide 43 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Example: Radio Advertising To sell one more unit of output will cost the price of the added message, k, divided by the marginal product of a dollar of advertising (  Q/  A). If a radio message costs $1000, and if that message yields 5 new items sold, then the marginal cost of advertising is $200, ($1000 /marginal product of advertising). If it costs $200 to sell one more car (MCA=$200), and if the contribution of another car sold is $300 to profits, then we should expand promotional expenses.

44. Slide 44 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Competitive Markets Under Asymmetric Information Used car: who knows what about it? The buyer or the seller? Asymmetric Information -- unequal or dissimilar knowledge among market participants. Incomplete Information -- uncertain knowledge of payoffs, choices, or types of opponents a market player faces.

45. Slide 45 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Search Goods versus Experience Goods Search goods are products or services whose quality is best detected through a market search. Experience goods are products and services whose quality is undetected when purchased. Warranties and firm reputations are used to assure quality. But if someone is selling his or her car, isn't it likely that the car is no good? Is it a lemon? »This is an explanation why used car prices are so much lower than new car prices. If one firm defrauds customers, how do the reputable firms signal that they are NOT like the fraudulent firm?

46. Slide 46 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Adverse Selection and the Notorious Firm Suppose that a firm may decide to produce a High Quality or Low Quality product, and the buyer may decide to offer a High Price or a Low Price. Since the firm fears that if it offers a High Quality product but that buyers only offer a Low Price, they only produce Low Quality products and receive Low Prices. This is the problem of adverse selection

47. Slide 47 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Notorious Firm Analysis Simultaneous decisions of buyer & seller A risk averse decision by the firm is to make a Low Quality product Best for the buyer is a low price, but a high quality good. Worst for the buyer is a high price but a low quality good. BUYER SELLER Hi Price Low Price High Quality Low Quality 130 70 150 90 Payoffs in the boxes are for the seller only We end in a trap of only poor quality goods at low prices.

48. Slide 48 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Solutions to the Problem of Adverse Selection Regulation (Disclosure Laws, Truth in Lending) Reliance Relationships are long term, mutually beneficial agreements, often informal. Brand names (a form of a “hostage” to quality) Nonredeployable assets are assets that have little value in another other use  Example: Dixie Cups made with paper-cup machinery which cannot be used for other purposes — if Dixie Cups leak, the company is in trouble

49. Slide 49 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Credible Commitments A credible commitment is a conditional strategy for establishing trust by promising to make the promise-giver worse off by violating that trust »such as a promise of product replacement if the product ever fails. Examples : 1.Dooney & Bourke promise life-time replacement of handbags 2.Other firms have sometime promised: If any of my products fail to work, I will pay the buyer three-times their purchase price in recompense! Clearly, this commitment makes the firm worse off if they sell shoddy goods. 3.Brand names are a “bond” or “hostage” lost if products fail to live up to promises.

50. Slide 50 © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Mechanisms for commitments Use of nonredeployable assets such as reputation. Once lost, a good reputation is hard to rebuild. Entering into alliance relationships which would fall apart if any party violated their commitments. using a "hostage mechanism" that is irreversible and irrevocable can deter breaking commitments. »Examples are "double your money back guarantees," and "most favored nation" clauses.