Read chapters 16, 17 and 18 from the attached book and then type a two page paper regarding what you thought was the most important concept(s), method(s), term(s), and/or any other thing that you felt was worthy of your understanding.  Define and describe what you thought was worthy of your understanding in half a page, and then explain why you felt it was important, how you will use it, and/or how important it is in managerial economics.  

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Australia • Brazil • Mexico • Singapore • United Kingdom • United States
fifth edition
Managerial
economics
A P R o B L e m s o LV i n G A P P Ro Ac h
luke M. Froeb
Vanderbilt University
Mikhael Shor
University of Connecticut
Brian T. McCann
Vanderbilt University
Michael r. Ward
University of Texas, Arlington
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Library of Congress Control Number: 2017947785
ISBN: 978-1-337-10666-5
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Managerial Economics, Fifth Edition
Luke M. Froeb, Brian T. McCann,
Mikhael Shor, Michael R. Ward
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In loving memory of Lisa, and for our families: Donna,
David, Jake, Halley, Scott, Chris, Leslie, Jacob, Eliana,
Cindy, Alex, and Chris
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v
Preface: Teaching Students to Solve Problems xiii
SECTION I Problem Solving and Decision Making 1
1 Introduction: What This Book Is About 3
2 The One Lesson of Business 15
3 Benefits, Costs, and Decisions 25
4 Extent (How Much) Decisions 37
5 Investment Decisions: Look Ahead and Reason Back 49
SECTION II Pricing, Costs, and Profits 65
6 Simple Pricing 67
7 Economies of Scale and Scope 83
8 Understanding Markets and Industry Changes 95
9 Market Structure and Long-Run Equilibrium 113
10 Strategy: The Quest to Keep Profit from Eroding 125
11 Foreign Exchange, Trade, and Bubbles 137
SECTION III Pricing for Greater Profit 151
12 More Realistic and Complex Pricing 153
13 Direct Price Discrimination 163
14 Indirect Price Discrimination 171
SECTION IV Strategic Decision Making 183
15 Strategic Games 185
16 Bargaining 205
SECTION V Uncertainty 215
17 Making Decisions with Uncertainty 217
18 Auctions 233
19 The Problem of Adverse Selection 243
20 The Problem of Moral Hazard 255
BrieF COnTenTS
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vi BRIEF CONTENTS
SECTION VI Organizational Design 267
21 Getting Employees to Work in the Firm’s Best Interests 269
22 Getting Divisions to Work in the Firm’s Best Interests 283
23 Managing Vertical Relationships 295
SECTION VII Wrapping Up 307
24 Test Yourself 309
Epilogue: Can Those Who Teach, Do? 315
Glossary 317
Index 325
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vii
Preface: Teaching Students to Solve Problems xiii
SECTION I Problem Solving and Decision Making 1
CHAPTER 1 INTRODUCTION: WHAT THIS BOOk IS ABOUT 3
1.1 Using Economics to Solve Problems 3
1.2 Problem-Solving Principles 4
1.3 Test Yourself 6
1.4 Ethics and Economics 7
1.5 Economics in Job Interviews 9
Summary & Homework Problems 11
End Notes 13
CHAPTER 2 THE ONE LESSON Of BUSINESS 15
2.1 Capitalism and Wealth 16
2.2 Does the Government Create Wealth? 17
2.3 How Economics Is Useful to Business 18
2.4 Wealth Creation in Organizations 21
Summary & Homework Problems 21
End Notes 23
CHAPTER 3 BENEfITS, COSTS, AND DECISIONS 25
3.1 Background: Variable, Fixed, and Total Costs 26
3.2 Background: Accounting versus Economic Profit 27
3.3 Costs Are What You Give Up 29
3.4 Sunk-Cost Fallacy 30
3.5 Hidden-Cost Fallacy 32
3.6 A Final Warning 32
Summary & Homework Problems 33
End Notes 36
CHAPTER 4 ExTENT (HOW MUCH) DECISIONS 37
4.1 Fixed Costs Are Irrelevant to an Extent Decision 38
4.2 Marginal Analysis 39
4.3 Deciding between Two Alternatives 40
COnTenTS
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CONTENTSviii
4.4 Incentive Pay 43
4.5 Tie Pay to Performance Measures That Reflect Effort 44
4.6 Is Incentive Pay Unfair? 45
Summary & Homework Problems 46
End Notes 48
CHAPTER 5 INVESTMENT DECISIONS: LOOk AHEAD AND REASON BACk 49
5.1 Compounding and Discounting 49
5.2 How to Determine Whether Investments Are Profitable 51
5.3 Break-Even Analysis 53
5.4 Choosing the Right Manufacturing Technology 55
5.5 Shut-Down Decisions and Break-Even Prices 56
5.6 Sunk Costs and Post-Investment Hold-Up 57
Summary & Homework Problems 60
End Notes 62
SECTION II Pricing, Costs, and Profits 65
CHAPTER 6 SIMPLE PRICING 67
6.1 Background: Consumer Values and Demand Curves 68
6.2 Marginal Analysis of Pricing 70
6.3 Price Elasticity and Marginal Revenue 72
6.4 What Makes Demand More Elastic? 75
6.5 Forecasting Demand Using Elasticity 76
6.6 Stay-Even Analysis, Pricing, and Elasticity 77
6.7 Cost-Based Pricing 78
Summary & Homework Problems 78
End Notes 81
CHAPTER 7 ECONOMIES Of SCALE AND SCOPE 83
7.1 Increasing Marginal Cost 84
7.2 Economies of Scale 86
7.3 Learning Curves 87
7.4 Economies of Scope 89
7.5 Diseconomies of Scope 90
Summary & Homework Problems 91
End Notes 94
CHAPTER 8 UNDERSTANDING MARkETS AND INDUSTRy CHANGES 95
8.1 Which Industry or Market? 95
8.2 Shifts in Demand 96
8.3 Shifts in Supply 98
8.4 Market Equilibrium 99
8.5 Predicting Industry Changes Using Supply and Demand 100
8.6 Explaining Industry Changes Using Supply and Demand 103
8.7 Prices Convey Valuable Information 104
8.8 Market Making 106
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CONTENTS ix
Summary & Homework Problems 108
End Notes 111
CHAPTER 9 MARkET STRUCTURE AND LONG-RUN EqUILIBRIUM 113
9.1 Competitive Industries 114
9.2 The Indifference Principle 116
9.3 Monopoly 120
Summary & Homework Problems 121
End Notes 123
CHAPTER 10 STRATEGy: THE qUEST TO kEEP PROfIT fROM ERODING 125
10.1 A Simple View of Strategy 126
10.2 Sources of Economic Profit 128
10.3 The Three Basic Strategies 132
Summary & Homework Problems 134
End Notes 136
CHAPTER 11 fOREIGN ExCHANGE, TRADE, AND BUBBLES 137
11.1 The Market for Foreign Exchange 138
11.2 The Effects of a Currency Devaluation 140
11.3 Bubbles 142
11.4 How Can We Recognize Bubbles? 144
11.5 Purchasing Power Parity 146
Summary & Homework Problems 147
End Notes 149
SECTION III Pricing for Greater Profit 151
CHAPTER 12 MORE REALISTIC AND COMPLEx PRICING 153
12.1 Pricing Commonly Owned Products 154
12.2 Revenue or Yield Management 155
12.3 Advertising and Promotional Pricing 157
12.4 Psychological Pricing 158
Summary & Homework Problems 160
End Notes 162
CHAPTER 13 DIRECT PRICE DISCRIMINATION 163
13.1 Why (Price) Discriminate? 164
13.2 Direct Price Discrimination 166
13.3 Robinson-Patman Act 167
13.4 Implementing Price Discrimination 168
13.5 Only Schmucks Pay Retail 169
Summary & Homework Problems 169
End Notes 170
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CONTENTSx
CHAPTER 14 INDIRECT PRICE DISCRIMINATION 171
14.1 Indirect Price Discrimination 172
14.2 Volume Discounts as Discrimination 176
14.3 Bundling Different Goods Together 177
Summary & Homework Problems 178
End Notes 181
SECTION IV Strategic Decision Making 183
CHAPTER 15 STRATEGIC GAMES 185
15.1 Sequential-Move Games 186
15.2 Simultaneous-Move Games 188
15.3 Prisoners’ Dilemma 190
15.4 Other Games 195
Summary & Homework Problems 199
End Notes 202
CHAPTER 16 BARGAINING 205
16.1 Strategic View of Bargaining 206
16.2 Nonstrategic View of Bargaining 208
16.3 Conclusion 210
Summary & Homework Problems 211
End Note 214
SECTION V Uncertainty 215
CHAPTER 17 MAkING DECISIONS WITH UNCERTAINTy 217
17.1 Random Variables and Probability 218
17.2 Uncertainty in Pricing 222
17.3 Data-Driven Decision Making 223
17.4 Minimizing Expected Error Costs 226
17.5 Risk versus Uncertainty 227
Summary & Homework Problems 228
End Notes 231
CHAPTER 18 AUCTIONS 233
18.1 Oral Auctions 234
18.2 Second-Price Auctions 235
18.3 First-Price Auctions 236
18.4 Bid Rigging 236
18.5 Common-Value Auctions 238
Summary & Homework Problems 240
End Notes 242
CHAPTER 19 THE PROBLEM Of ADVERSE SELECTION 243
19.1 Insurance and Risk 243
19.2 Anticipating Adverse Selection 244
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CONTENTS xi
19.3 Screening 246
19.4 Signaling 249
19.5 Adverse Selection and Internet Sales 250
Summary & Homework Problems 251
End Notes 253
CHAPTER 20 THE PRoblEm of moRAl HAzARd 255
20.1 Introduction 255
20.2 Insurance 256
20.3 Moral Hazard versus Adverse Selection 257
20.4 Shirking 258
20.5 Moral Hazard in Lending 260
20.6 Moral Hazard and the 2008 Financial Crisis 261
Summary & Homework Problems 262
End Notes 265
SECTIoN VI organizational design 267
CHAPTER 21 GETTING EmPloyEES To WoRk IN THE fIRm’S bEST INTERESTS 269
21.1 Principal–Agent Relationships 270
21.2 Controlling Incentive Conflict 271
21.3 Marketing versus Sales 273
21.4 Franchising 274
21.5 A Framework for Diagnosing and Solving Problems 275
Summary & Homework Problems 278
End Notes 281
CHAPTER 22 GETTING dIVISIoNS To WoRk IN THE fIRm’S bEST INTERESTS 283
22.1 Incentive Conflict between Divisions 283
22.2 Transfer Pricing 285
22.3 Organizational Alternatives 287
22.4 Budget Games: Paying People to Lie 289
Summary & Homework Problems 291
End Notes 294
CHAPTER 23 mANAGING VERTICAl RElATIoNSHIPS 295
23.1 How Vertical Relationships Increase Profit 296
23.2 Double Marginalization 297
23.3 Incentive Conflicts between Retailers and Manufacturers 297
23.4 Price Discrimination 299
23.5 Antitrust Risks 300
23.6 Do Buy a Customer or Supplier Simply Because It Is Profitable 301
Summary & Homework Problems 302
End Notes 304
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CONTENTSxii
SECTION VII Wrapping Up 307
CHAPTER 24 TEST yOURSELf 309
24.1 Should You Keep Frequent Flyer Points for Yourself? 309
24.2 Should You Lay Off Employees in Need? 310
24.3 Manufacturer Hiring 310
24.4 American Airlines 311
24.5 Law Firm Pricing 311
24.6 Should You Give Rejected Food to Hungry Servers? 312
24.7 Managing Interest-Rate Risk at Banks 313
24.8 What You Should Have Learned 313
Epilogue: Can Those Who Teach, Do? 315
Glossary 317
Index 325
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xiii
teaching students to solve Problems1
by Luke Froeb
When I started teaching MBA students, I taught economics as I had learned
it, using models and public policy applications. My students complained so
much that the dean took me out to the proverbial woodshed and gave me
an ultimatum, “improve customer satisfaction or else.” With the help of some
disgruntled students who later became teaching assistants, I was able to turn
the course around.
The problem I faced can be easily described using the language of eco-
nomics: the supply of business education (professors are trained to provide
abstract theory) is not closely matched to demand (students want practical
knowledge). This mismatch is found throughout academia, but it is perhaps
most acute in a business school. Business students expect a return on a fairly
sizable investment and want to learn material with immediate and obvious
value.
One implication of the mismatch is that teaching economics in the usual
way—with models and public policy applications—is not likely to satisfy stu-
dent demand. In this book, we use what we call a “problem-solving pedagogy”
to teach microeconomic principles to business students. We begin each chapter
with a business problem, like the fixed-cost fallacy, and then give students just
enough analytic structure to understand the cause of the problem and how to
fix it.
Teaching students to solve real business problems, rather than learn models,
satisfies student demand in an obvious way. Our approach also allows stu-
dents to absorb the lessons of economics without as much of the analytical
“overhead” as a model-based pedagogy. This is an advantage, especially in a
terminal or stand-alone course, like those typically taught in a business school.
To see this, ask yourself which of the following ideas is more likely to stay
with a student after the class is over: the fixed-cost fallacy or that the partial
derivative of profit with respect to price is independent of fixed costs.
eleMenTS OF a PrOBleM-SOlving PedagOgy
Our problem-solving pedagogy has three elements.
PreFaCe
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xiv PREFaCE
1. Begin with a Business Problem
Beginning with a real-world business problem puts the particular ahead of the
abstract and motivates the material in a straightforward way. We use narrow,
focused problems whose solutions require students to use the analytical tools
of interest.
2. Teach Students to view inefficiency as an Opportunity
The second element of our pedagogy turns the traditional focus of benefit–
cost analysis on its head. Instead of teaching students to spot and eliminate
inefficiency, for example, by changing public policy, we teach them to view
each underemployed asset as a money-making opportunity.
3. Use economics to implement Solutions
After you find an underemployed asset, moving it to a higher-valued use is
often hard to do, particularly when the inefficiency occurs within an organi-
zation. The third element of our pedagogy addresses the problem of incentive
alignment: how to design organizations where employees have enough infor-
mation to make profitable decisions and the incentive to do so.
Again, we use the tools of economics to address the problem of implemen-
tation. If people act rationally, optimally, and self-interestedly, then mistakes
have only one of two causes: either people lack the information necessary to
make good decisions or they lack the incentive to do so. This immediately sug-
gests a problem-solving algorithm; ask:
1. Who is making the bad decision?
2. Do they have enough information to make a good decision?
3. Do they have the incentive to do so?
Answers to these three questions will point to the source of the problem
and suggest one of three potential solutions:
1. Let someone else make the decision, someone with better information or
incentives
2. Give more information to the current decision maker
3. Change the current decision maker’s incentives
The book begins by showing students how to use this algorithm,
and subsequent chapters illustrate its use in a variety of contexts, for
example, extent decisions, investments, pricing, bargaining, principal–agent
relationships, and uncertain environments.
USing The BOOk
The book is designed to be read cover-to-cover as it is short, concise, and
accessible to anyone who can read and think clearly. The pedagogy is built
around business problems, so the book is most effective for those with some
work experience. Its relatively short length makes it reasonably easy to cus-
tomize with ancillary material.
The authors use the text in full-time MBA programs, executive MBA
programs (weekends), healthcare management executive programs (one night
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xvPREFaCE
a week), and nondegree executive education. However, some of our biggest
customers use the book in online business classes at both the graduate and
undergraduate levels.
In the degree programs, we supplement the material in the book with
online interactive programs like Cengage’s MindTap. Complete Blackboard
courses, including syllabi, quizzes, homework, slides, videos to complement
each chapter, and links to supplementary material, can be downloaded from
the Cengage website. Our ManagerialEcon.com blog is a good source of new
business applications for each of the chapters.
In this fifth edition, we have updated and improved the presentation and ped-
agogy of the book. The biggest substantive change is to Chapter 17, where we
present the decomposition of an observed difference between two groups into a
treatment effect + selection bias. Michael Ward has been using this in his classes at
University of Texas at Arlington, and rewrote the chapter to include it. We are also
beginning work to add interactive “activities” to the electronic text in MindTap,
Cengage’s new learning platform. These activities help comprehension, especially
for weaker students. In addition, we continue to rewrite and update the supple-
mentary material: videos, worked video problems, and the test bank. In addition
to the other updates throughout the text, Chapter 24 has two new sections.
We wish to acknowledge numerous classes of MBA, executive MBA, non-
degree executive education, and healthcare management students, without
whom none of this would have been possible—or necessary. Many of our for-
mer students will recognize stories from their companies in the book. Most of
the stories in the book are from students and are for teaching purposes only.
Thanks to everyone who contributed, knowingly or not, to the book. Professor
Froeb owes intellectual debts to former colleagues at the U.S. Department of
Justice (among them, Cindy Alexander, Tim Brennan, Ken Heyer, Kevin James,
Bruce Kobayahsi, and Greg Werden); to former colleagues at the Federal Trade
Commission (among them, James Cooper, Pauline Ippolito, Tim Muris, Dan
O’Brien, Maureen Ohlhausen, Paul Pautler, Mike Vita, and Steven Tenn); to
colleagues at Vanderbilt (among them, Germain Boer, Jim Bradford, Bill Christie,
Mark Cohen, Myeong Chang, Craig Lewis, Rick Oliver, David Parsley, David
Rados, Steven Tschantz, David Scheffman, and Bart Victor); and to numerous
friends and colleagues who offered suggestions, problems, and anecdotes for
the book (among them, Lily Alberts, Olafur Arnarson, Raj Asirvatham, Bert
Bailey, Justin Bailey, Pat Bajari, Molly Bash, Sarah Berhalter, Roger Brinner,
the Honorable Jim Cooper, Matthew Dixon Cowles, Abie Del Favero, Kelsey
Duggan, Vince Durnan, Marjorie Eastman, Tony Farwell, Keri Floyd, Josh Gapp,
Brock Hardisty, Trent Holbrook, Jeff and Jenny Hubbard, Brad Jenkins, Dan
Kessler, Bev Landstreet [B5], Bert Mathews, Christine Milner, Jim Overdahl, Craig
Perry, Rich Peoples, Annaji Pervajie, Jason Rawlins, Mike Saint, David Shayne,
Jon Shayne, Bill Shughart, Doug Tice, Whitney Tilson, and Susan Woodward).
We owe intellectual and pedagogical debts to Armen Alchian and William Allen3;
Henry Hazlitt4; Shlomo Maital5; John MacMillan6; Steven Landsburg7; Ivan Png8;
Victor Tabbush9; Michael Jensen and William Meckling10; and James Brickley,
Clifford Smith, and Jerold Zimmerman.11 Special thanks to everyone who guided
us through the publishing process, including Molly Umbarger, Christopher Rader,
and Jason Fremder.
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xvi
end nOTeS
PREFaCE
1. Much of the material is taken from Luke
M. Froeb and James C. Ward, “Teaching
Managerial Economics with Problems
Instead of Models,” in The International
Handbook on Teaching and Learning
Economics, eds. Gail Hoyt and KimMarie
McGoldrick (Northampton, MA: Edward
Elgar Publishing, 2012).
2. Armen Alchian and William Allen,
Exchange and Production, 3rd ed.
(Belmont, CA: Wadsworth, 1983).
3. Henry Hazlitt, Economics in One Lesson
(New York: Crown, 1979).
4. Shlomo Maital, Executive Economics: Ten
Essential Tools for Managers (New York:
Free Press, 1994).
5. John McMillan, Games, Strategies, and
Managers (Oxford: Oxford University
Press, 1992).
6. Steven Landsburg, The Armchair Economist:
Economics and Everyday Life (New York:
Free Press, 1993).
7. Ivan Png, Managerial Economics (Maiden,
MA: Blackwell, 1998).
8. http://www.mbaprimer.com
9. Michael Jensen and William Meckling,
A Theory of the Firm: Governance,
Residual Claims and Organizational
Forms (Cambridge, MA: Harvard
University Press, 2000).
10. James Brickley, Clifford Smith, and Jerold
Zimmerman, Managerial Economics and
Organizational Architecture (Chicago:
Irwin, 1997).
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1
1 Introduction: What This Book Is About
2 The One Lesson of Business
3 Benefits, Costs, and Decisions
4 Extent (How Much) Decisions
5 Investment Decisions: Look Ahead and Reason
Back
Problem Solving and
Decision Making
1Section
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3
1
In 1992, a junior geologist was preparing a bid recommendation for an oil
tract in the Gulf of Mexico. She suspected that the tract contained a large
accumulation of oil because her company, Oil Ventures International (OVI),
had an adjacent tract with several productive wells. Since no competitors had
neighboring tracts, none of them suspected a large accumulation of oil. Be-
cause of this, she thought that the tract could be won relatively cheaply and
recommended a bid of $5 million. Surprisingly, OVI’s senior management ig-
nored the recommendation and submitted a bid of $21 million. OVI won the
tract over the next-highest bid of $750,000.
If the board of directors asked you to review the bidding procedures at
OVI, how would you proceed? Where would you begin your investigation?
What questions would you ask?
You’d find it difficult to gather information from those closest to the bid-
ding. Senior management would be suspicious and uncooperative because no
one likes to be singled out for bidding $20 million more than was necessary.
Likewise, our junior geologist would be reluctant to criticize her superiors.
You might be able to rely on your experience—provided that you had run into
a similar problem. But without experience, or when facing novel problems,
you would have to rely on your analytic ability.
This book is designed to show you how to complete an assignment like
this.
1.1 Using Economics to Solve Problems
Solving a problem like OVI’s requires two steps: first, figure out what’s caus-
ing the problem; and second, how to fix it. In this case, you would want to
know whether the $21 million bid was too high at the time it was made, not
just in retrospect. If the bid was too aggressive, then you’d have to figure out
why the senior managers overbid and how to make sure they don’t do it again.
Introduction: What This
Book Is About
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SECTION I • Problem Solving and Decision Making 4
Both steps require that you predict how people behave in different cir-
cumstances, and this is where the economic content of the book comes in. The
one thing that unites economists is their use of the rational-actor paradigm.
Simply put, it says that people act rationally, optimally, and self-interestedly.
The paradigm not only helps you figure out why people behave the way they
do but also suggests ways to get them to change. To change behavior, you have
to change self-interest, and you do that by changing incentives.
Incentives are created by rewarding good performance with, for exam-
ple, a commission on sales or a bonus based on profitability. The performance
evaluation metric (revenue, cost, profit, or return on investment, ROI) is sepa-
rate from the reward structure (commission, bonus, raise, or promotion), but
they work together to create an incentive to behave a certain way.
To illustrate, let’s go back to OVI’s story and try to find the source of
the problem. After her company won the auction, our geologist increased the
company’s oil reserves by the amount of oil estimated to be in the tract. But
when the company drilled a well, it was essentially “dry,” so the acquisition
did little to increase the size of the company’s oil reserves. Using the informa-
tion from the newly drilled well, our geologist updated the reservoir map and
reduced the estimated reserves to where they was before OVI won the tract.
Senior management rejected the lower estimate and directed the geologist
to “do what she could” to increase the size of the estimated reserves. So, she
revised the reservoir map again, adding “additional” (not real) reserves to the
company’s asset base. The reason behind this behavior became clear when,
several months later, OVI’s senior managers resigned, collecting bonuses tied
to the increase in oil reserves that had accumulated during their tenure.
The incentive created by the bonus plan explains both the overbidding and
overestimated reserves as rational, self-interested responses to the incentive
created by the bonus. Senior managers overbid because they were rewarded
for acquiring reserves, regardless of the price. Their ability to manipulate the
reserve estimate made it difficult for shareholders and their representatives on
the board of directors to spot the mistake.
To fix this problem, you would have to find a way to better align manag-
ers’ incentives with the company’s goals, perhaps by rewarding management
for increasing profitability, not just for acquiring reserves. This is not as easy as
it sounds because it is typically hard to measure an employee’s contribution to
company profitability. You can do this subjectively, with annual performance
reviews, or objectively, using company earnings or stock price appreciation
as performance metrics. But each of these performance measures can create
problems, as we’ll see in later chapters.
1.2 Problem-Solving Principles
This story illustrates our problem-solving methodology. First, we reduced the
problem (overbidding) to a bad decision by someone at the firm (senior man-
agement) by asking:
Q1: Who made the bad decision?
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ChaPTEr 1 • Introduction: What This Book Is about 5
Once we know the “who,” we can use economics to figure out the “why.”
If people behave rationally, optimally, and self-interestedly, a bad decision oc-
curs for one of two reasons: either (i) decision makers do not have enough
information to make a good decision or (ii) they lack the incentive to do so.
This suggests that we can isolate the source of almost any problem by asking
two more questions:
Q2: Did the decision maker have enough information to make a good
decision?
Q3: Did the decision maker have the incentive to make a good decision?
Answers to these three questions not only point to the source of the prob-
lem but also suggest ways to fix it.
S1: Let someone else—someone with better information or better incentives—
make the decision,
S2: Give more information to the current decision maker, or
S3: Change the current decision makers’ incentives (the performance evalua-
tion metric or the reward scheme).
In OVI’s case, we see that (Q1) senior management made the bad decision
to overbid; (Q2) they had enough information to make a good bid, but (Q3)
they didn’t have the incentive to do so. One potential fix (S3) is to change
the incentives of senior management so that they are rewarded for increasing
profitability instead of oil reserves.
When reading about various business mistakes in the chapters that follow,
you should ask yourself these three questions to see if you can find the cause
of each problem, and a solution. By the time you finish the book, the analysis
should become second nature.
Here are some practical tips that will help you develop problem-solving
skills:
*Think about the problem from the organization’s point of view. Avoid
the temptation to think about the problem from the employee’s point of
view because you will miss the fundamental problem of goal alignment:
how does the organization give employees enough information to make
good decisions and the incentive to do so?
*Think about the organizational design. Once you identify a bad deci-
sion, avoid the temptation to solve the problem by simply reversing the
decision. Instead, think about why the bad decision was made and how
to make sure that similar mistakes won’t be made in the future.
*What is the trade-off? Your solution may solve the problem you identify,
but it may cause other problems. In this case, changing the incentives of
senior management by giving them limited stock (that they cannot sell
for five years) may solve the overbidding problem, but it may also makes
their performance dependent on external factors like the global macro-
economy, which are clearly beyond their control. Subject your solution
to the same analysis. Ask the same three questions that allowed you to
identify the initial problem.
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SECTION I • Problem Solving and Decision Making 6
*Don’t define the problem as the lack of your solution. This kind of think-
ing may cause you to miss the best solution. For example, if you define
a problem as “the lack of centralized purchasing,” then the solution will
be “centralized purchasing” regardless of whether that is the best option.
Instead, define the problem as “high acquisition cost,” and then examine
“centralized purchasing” versus “decentralized purchasing” (or some other
alternative) as potential solutions to the problem.
*Avoid jargon because most people misuse it. Force yourself to spell out
what exactly you mean in simple language. It will help you think clearly
and communicate precisely. As Einstein said, “If you can’t explain it
simply, you don’t understand it well enough.” In addition, almost every
scam is “sold” using jargon. If you use jargon, experienced listeners will
instinctively mistrust you and your analysis.
1.3 Test Yourself
In 2006, an investigative news program sent a TV reporter with a perfectly
good car into a garage owned by National Auto Repair (NAR). The reporter
came out with a new muffler and transmission—and a bill for over $8,000.
After the story was aired on national TV, consumers began avoiding NAR,
and profit plunged. What is the problem, and how do you fix it?
Let’s run the problem through our problem-solving algorithm:
Q1: Who made the bad decision?
The NAR mechanic recommended unnecessary repairs.
Q2: Did the decision maker have enough information to make a good decision?
Yes, in fact, the mechanic is the only one with enough information to
know whether repairs are necessary.
Q3: Did the decision maker have the incentive to make a good decision?
No, the mechanic receives bonuses or commissions tied to the amount of
repair work, which rewards the mechanic for making needless repairs.
Although answers to the three questions clearly point to the source of the
problem, solving it proved much more difficult. NAR tried two different solu-
tions, but both failed.
First, the company reorganized into two divisions: one responsible for rec-
ommending repairs and the other responsible for doing them. Those who rec-
ommended repairs were paid a flat salary, but those who did the repairs were
paid based on the amount of work they did.
PAUSE HERE AND TRY TO FIGURE OUT WHY THIS CHANGE DID
NOT SOLVE THE PROBLEM.
Mechanics in the two divisions began colluding. In exchange for recom-
mending unnecessary repairs, the service mechanic shared his incentive pay
with the recommending mechanic. The unnecessary repairs continued.
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ChaPTEr 1 • Introduction: What This Book Is about 7
NAR then went back to single mechanic who both recommended and per-
formed repairs, but replaced the incentive pay with a flat salary. Although this
removed the incentive to do unnecessary repairs, it also removed the incentive
to work hard, resulting in what economists call “shirking.” Since mechanics
made the same amount of money regardless of whether they recommended
and performed repairs, they ignored all but the most obvious problems.
Figuring out which solution is most profitable involves weighing the trade-
offs associated with various solutions. For example, before implementing the
two-division solution, NAR management should have asked whether the new
decision maker had enough information to make good decisions, as well as the
incentive to do so. The answer could have alerted NAR management to the
potential for collusion between the recommending mechanic and the repairing
mechanic. Similarly, this kind of analysis would have identified shirking by the
mechanics as a cost of the flat-salary solution.
With the benefit of hindsight, I would have suggested a third potential
solution: keep the original organizational design, but use an additional per-
formance metric, based on reports provided by “secret shoppers” who bring
good cars into the garage to test whether the mechanics order unnecessary
repairs. If so, fire or penalize the mechanics who recommend unnecessary re-
pairs. Secret shoppers are used successfully in other contexts, for example, in
restaurants to measure service quality. By measuring and rewarding quality,
restaurant chains are able to protect the value of a brand as a signal of quality.
Similarly, using secret shoppers may have been able to protect the value of
NAR’s brand as a signal of reliable service.
1.4 Ethics and Economics
Using the rational-actor paradigm in this way—to change behavior by chang-
ing incentives—makes some students uncomfortable because it seems to deny
the altruism, affection, and personal ethics that motivate most people. These
students resist learning the rational-actor paradigm because they think it im-
plicitly endorses self-interested behavior, as if the primary purpose of econom-
ics were to teach students to behave rationally, optimally, and selfishly.
These students would probably agree with a Washington Post editorial,
“When It Comes to Ethics, B-Schools Get an F,”1 which blames business
schools in general, and economists in particular, for the ethical lapses at FIFA,
Goldman Sachs, and other organizations.
A subtle but damaging factor in this is the dominance of economists
at business schools. Although there is no evidence that economists are
personally less ethical than members of other disciplines, approaching the
world through the dollar sign does make people more cynical.
What these students and the author, a former Harvard ethics professor,
do not understand is that to control unethical behavior, we first have to un-
derstand why it occurs. When we analyze problems like the one at OVI, we’re
not encouraging students to behave opportunistically. Rather, we’re teaching
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SECTION I • Problem Solving and Decision Making 8
them to anticipate opportunistic behavior and to design organizations that are
less susceptible to it. Remember, the rational-actor paradigm is only a tool for
analyzing behavior, not advice on how to live your life.
It is also important to realize that these kinds of debates are often de-
bates about value systems. Deontologists judge actions as good or ethical by
whether they conform to a set of principles, like the Ten Commandments or
the Golden Rule. Consequentialists, on the other hand, judge actions by their
consequences. If the consequences of an action are good, then the action is
deemed to be good or moral. We illustrate these contrasting value systems
with a story about price gouging.2
When Notre Dame entered the 2006 season as one of the top-ranked
football teams in the country, demand for local hotels during home games
rose dramatically. In response, local hotels raised room rates. According to the
Wall Street Journal, the Hampton Inn charged $400 a night on football week-
ends for a room that cost only $129 on non football days. Rates climbed even
higher for games against top-ranked foes. For the game against the University
of Michigan, the South Bend Marriott charged $649 per night—$500 more
than its normal weekend rate of $149.
On a campus founded by priests of the Congregation of Holy Cross,
where many students dedicate a year after graduation to working with the
underprivileged, these high prices caused alarm. The Wall Street Journal quotes
Professor Joe Holt, a former priest who teaches ethics in the school’s executive
MBA program, “It is an ‘act of moral abdication’ for businesses to pretend
they have no choice but to charge as much as they can based on supply and
demand.” The article further reports Mr. Holt’s intention to use the example
of rising hotel rates on football weekends for a case study in his class on the
integration of business and values.
Deontologists like Professor Holt would object on principle to the prac-
tice of raising prices in times of shortage.3 We might label this the Spider Man
Principle: with great power comes great responsibility. The laws of capitalism
allow corporations to amass significant power; in turn, society should demand
a high level of responsibility from corporations. In this case, while property
rights give a hotel the option of increasing prices, possession of these rights
does not relieve the hotel of its obligation to be concerned about the conse-
quences of its choices. A simple beneficence argument might suggest that keep-
ing prices low would be better for consumers.
Economics, on the other hand, gives us a consequentialist understanding
of the practice by comparing high prices to the implied alternative. An econ-
omist would show that if prices do not rise, the consequence would be excess
demand for hotel rooms. Would-be guests would find their rooms rationed,
perhaps on a first-come, first-served basis. More likely, arbitrageurs would set
up a black market, by making early reservations, and then “selling” their reser-
vations to customers willing to pay the market-clearing price. Not only would
consumers end up paying the same price, but these “arbs” would make money
that would have otherwise gone to the hotel. Without the ability to earn addi-
tional profit during times of scarcity, hotels would have less incentive to build
additional rooms, which would make the long-run problems even worse!
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ChaPTEr 1 • Introduction: What This Book Is about 9
Versions of this debate—between those who criticize business on ethical
grounds and those who are trying to make money—have been going on in
this country since its founding. Although a full treatment of the ethical di-
mensions of business is beyond the scope of this book, many disagreements
are really about whether morality should be defined by deontology or conse-
quentialism. Once you realize that a debate is really a debate between value
systems, it becomes much easier to understand opposing points of view, and to
reach compromise with your adversaries. For example, if the government were
considering price-gouging laws that made it illegal to raise prices on football
weekends, a solution might involve donation of some of the profits earned on
football weekends to a local charity. This might assuage the concerns of those
who ascribe to the Spider Man principle.
As a footnote to this story, when someone offered our former priest
$1,500 for his apartment on home-game weekends, he took the offer and now
spends his weekends in Chicago. Apparently, his principles became too costly
for him.
1.5 Economics in Job Inter views
If this well-reasoned introduction doesn’t motivate you to learn econom-
ics, read the following interview questions—all from real interviews of
students. These questions should awaken interest in the material for those of
you who think economics is merely an obstacle between you and a six-figure
salary.
——-Original Message——-
From: “Student A”
Sent: Friday, January 2, 2009, 3:57 PM
Subject: Economics Interview Questions
I had an interview a few weeks ago where I was told that
the position paid a very low base and was mostly incen-
tive compensation. I responded that I understood he was
simply “screening out” low productivity candidates
[NOTE: low productivity candidates would not earn very much under a sys-
tem of incentive compensation, and so would be less likely to accept a job
with strong incentive compensation].
I “signaled” back to him that this compensation struc-
ture was acceptable to me, as I was confident in my abil-
ities to produce value for the company, and for me.
[Note: “Signaling” and “screening” are both solutions to the problem of adverse
selection, the topic of Chapter 19.]
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SECTION I • Problem Solving and Decision Making 10
——-Original Message——-
From: “Student B”
Sent: Tuesday, January 18, 2000, 1:22 PM
Subject: Economics Interview Questions
I got a question from Compaq last year for a market-
ing internship position that partially dealt with sunk
costs. It was a “true” case question where the inter-
viewer used the Internet to pull up the actual products
as he asked the question, “I am the product manager for
the new X type server with these great features. It is to
be launched next month at a cost of $5,500. Dell launched
its new Y-type server last week; it has the same features
(and even a few more) for a cost of $4,500. To date, Com-
paq has put over $2.5 million in the development process
for this server, and as such my manager is expecting
above-normal returns for the investment.
My question to you is “what advice would you give to me on
how to approach the launch of the product, that is, do I go
ahead with it at the current price, if at all, even though
Dell has a better product out that is less expensive, not
forgetting the fact that I have spent all the development
money and my boss expects me to report a super return?”
I laughed at the question because it was the very first
thing we spoke about in the interview, catching me off-
guard a bit. He wanted to see if I got caught worry-
ing about all the development costs in giving advice to
scrap the launch or continue ahead as planned. (I’m not
an idiot and could see that coming a mile away … thanks
to economics, right? ! ! !)
[NOTE: the interviewer was testing Student B to see whether he would com-
mit the “sunk-cost fallacy,” covered in Chapter 3.]
——-Original Message——-
From: “Student C”
Sent: Tuesday, January 18, 2000, 1:37 PM
Subject: Economics Interview Questions
I got questions regarding transfer price within entities
of a company.
What prices could be used and why.
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Chapter 1 • Introduction: What this Book Is about 11
[NOTE: the problem of transfer pricing is one of the most common sources of
conflict between divisions and is covered in Chapters 22 and 23.]
——-Original Message——-
From: “Student D”
Sent: Tuesday, January 18, 2000 1:28 PM
Subject: Economics Interview Questions
You are a basketball coach with five seconds on the
clock, and you are losing by two points. You have the
ball and can take only one more shot (there is no chance
of a rebound). There is a 70% chance of making a two-
pointer, which would send the game into overtime with
each team having an equal chance of winning. There is
only a 40% chance of making a three-pointer (winning if
made). Should you shoot the two- or the three-point shot?
[NOTE: This is an example of decision making under uncertainty, the subject
of Chapter 17. For those of you who cannot wait, the answer is take the three-
point shot because it results a higher probability of winning, 40%, as opposed
to 35% = (70%) × (50%) for a two-point shot.]
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
• Problem solving requires two steps:
(i) figure out why people are making mis-
takes and then (ii) figure out how to pre-
vent future ones.
• The rational-actor paradigm is a model of
behavior that which assumes that people act
rationally, optimally, and self-interestedly,
that is, they respond to incentives.
• Incentives have two pieces: (i) a way of
measuring performance and (ii) a compen-
sation scheme to reward good (or punish
bad) performance.
• A well-designed organization is one in
which employee incentives are aligned with
organizational goals. By this we mean that
employees have (i) enough information to
make good decisions and (ii) the incentive
to do so.
• You can analyze any problem by asking
three questions:
Q1: Who made the bad decision?
Q2: Does the decision maker have enough
information to make a good decision?
Q3: Does the decision maker have the in-
centive to make a good decision?
• Answers to these questions will suggest one
of three solutions:
S1: Let someone else make the decision,
someone with better information or
incentives.
S2: Give the decision maker more
information.
S3: Change the decision maker’s incentives.
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SECTION I • Problem Solving and Decision Making 12
Multiple-Choice Questions
1. Why might performance compensation
caps be bad?
a. Different pay rates promote dissent.
b. Compensation caps can discourage
employees from being productive after
the cap.
c. Compensation caps can discourage
employees from being productive
before the cap.
d. Both b and c.
2. What is a possible consequence of a perfor-
mance compensation reward scheme?
a. It creates productive incentives.
b. It creates harmful incentives.
c. Both a and b.
d. Neither a nor b.
3. Which of the following is NOT one of the
three problem-solving principles laid out in
Chapter 1?
a. Under whose jurisdiction is the
problem?
b. Who is making the bad decision?
c. Does the decision maker have enough
information to make a good decision?
d. Does the decision maker have the
incentive to make a good decision?
4. Why might it be bad for hotels to not
charge higher prices when rooms are in
higher demand?
a. Arbitrageurs might establish a black
market by reserving rooms and then
selling the reservations to customers.
b. Rooms may be rationed.
c. Without the profit from these high
demand times, hotels would have less
of an incentive to build or expand,
making the long-run scarcity problem
even worse.
d. All of the above.
5. The rational-actor paradigm assumes that
people do NOT
a. act rationally.
b. use rules of thumb.
c. act optimally.
d. act self-interestedly.
6. The problem-solving framework analyzes
firm problems
a. from the organization’s point of view.
b. from the manager’s point of view.
c. from the worker’s point of view.
d. from society’s point of view.
7. Why might welfare for low-income
households reduce the propensity to
work?
a. It will not.
b. It reduces the incentive to work.
c. It is unfair.
d. It encourages jealousy.
8. Why might a “bonus cap” for executives be
a bad policy for the company?
a. It isn’t. Executives shouldn’t make
more than a certain amount.
b. It would sow discontent.
c. It would encourage shirking after the
executives reached the cap.
d. The cap could be set too high, so
executives may work too hard and
not reach it.
9. What might happen if a car dealership
is awarded a bonus by the manufacturer
for selling a certain number of its cars
monthly, but the dealership is just short of
that quota near the end of the month?
a. It may sell the remaining cars at huge
discounts to hit the quota.
b. It creates an incentive to sell cars from
different manufacturers.
c. It would ruin the relationship between
the dealer and the manufacturer.
d. Potential buyers will lose buying
power at the dealer.
10. Why might a supermarket advertise low
prices on certain high-profile items and sell
them at a loss?
a. It is a way for companies to be
charitable.
b. The store will sell other groceries
to the same customers, often at a
markup.
c. It would not.
d. This reduces the incentives of trade.
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ChaPTEr 1 • Introduction: What This Book Is about 13
Individual Problems
1-1 Goal Alignment at a Small Manufacturing
Concern
The owners of a small manufacturing concern
have hired a vice president to run the company
with the expectation that he will buy the com-
pany after five years. Compensation of the new
vice president is a flat salary plus 75% of the
first $150,000 profit, and then 10% of profit
over $150,000. Purchase price for the company
is set at 4.5 times earnings (profit), computed as
average annual profitability over the next five
years.
a. Plot the annual compensation of the vice
president as a function of annual profit.
b. Assume the company will be worth $10
million in five years. Plot the profit of buy-
ing the company as a function of annual
profit.
1-2 Goal Alignment at a Small Manufacturing Con-
cern (cont.)
Does this contract align the incentives of the
new vice president with the profitability goals
of the owners?
1-3 Goal Alignment at a Small Manufacturing
Concern (cont.)
Redesign the contract to better align the incen-
tives of the new vice president with the profit-
ability goals of the owners.
1-4 Goal Alignment at New York City Schools
A total of 1,800 New York City teachers who
lost their jobs earlier this year have yet to apply
for another job despite the fact that there are
1,200 openings. Why not?
1-5 Goal Alignment between Airlines and Flight
Crews
Planes frequently push back from the gate on
time, but then wait 2 feet away from the gate
until it is time to queue up for take-off. This
increases fuel consumption, and increases the
time that passengers must sit in a cramped
plane awaiting take-off. Why does this happen?
1-6 Goal Alignment between Hospitals and the Brit-
ish Government
In 2008, the Labour Party in Britain promised
that patients would have to wait for no more
than four hours to be seen in an emergency
room. The National Health Service started re-
warding hospitals that met this goal. What do
you think happened? (HINT: It was not good.)
Group Problems
G1-1 Goal Alignment with Your Company
Are your incentives aligned with the goals
of your company? If not, identify a problem
caused by goal misalignment. Suggest a change
that would address the problem. Compute the
profit consequences of the change.
G1-2 Contracts at Your Company
Identify a contract between your company and
a supplier or customer. Does it align the incen-
tives of the parties? If not, suggest a change that
would address the problem. Compute the profit
consequences of the change.
1. Amitai Etzioni, “When It Comes to Ethics,
B-Schools Get an F,” Washington Post,
August 4, 2002.
2. Ilan Brat, “Notre Dame Football Introduces
Its Fans to Inflationary Spiral,” Wall Street
Journal, September 7, 2006.
3. We thank Bart Victor for his enumeration of
these objections.
END NOTES
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15
2
In the spring of 2011, Rick Ruzzamenti of Riverside, California, decided to
donate his kidney to an organization set up to match donors and recipients.
His selfless act set off a domino chain of 60 operations involving 17 hospitals
in 11 different states.1 Donors, unable to help their loved ones because of
incompatible antibodies, donated kidneys to others who donated to others,
and so on, until the chain ended six months later in Chicago.
The good news is that 30 people received new kidneys and escaped the
living hell of dialysis. The bad news is that this complex barter system is the
only legal way for Americans to get kidneys.2 It is so inefficient that only
17,000 of the 90,000 people on waiting lists received kidneys last year.
To understand how complex and cumbersome this process is, imagine trying
to use it to find a new apartment. Suppose you wanted to move from Detroit to
Nashville. You would first try to find someone moving in the opposite direction,
from Nashville to Detroit. Failing that, you might try to find a three-way trade:
find someone moving from Nashville to Los Angeles, and another person moving
from Los Angeles to Detroit. Then swap the first apartment for the second, the
second for the third, and the third for the first. Finding a matched set of trades
that have the desired moving times, locations, and types of apartments causes the
same kinds of compatibility problems that trading kidneys does.
There are two common, but very different, reactions to this kind of
inefficiency. Economists see it as a threat, and something to be eliminated, for
example, by replacing this complex barter system with a simple market.
Businesspeople, on the other hand, see this kind of inefficiency as an
opportunity to make money. In this case, a creative entrepreneur could borrow
$100 million at 20% interest, buy a hospital ship, anchor it in international
waters, set up a database to match donors to recipients, broker sales, and fly
in experienced transplant teams. If she charges $200,000 and earns 10% on
each transaction, the break-even quantity is just 1,000 transplants each year.
This represents only 1% of the potential demand in the United States alone.
The One Lesson of
Business
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16 SECTION I • Problem Solving and Decision Making
The goal of this chapter is to show you how to exploit inefficiency as
an opportunity to make money. Students who’ve had some economics
training will find that they have a slight head start, but learning how to turn
inefficiency into opportunity requires as much creativity and imagination as
analytic ability.
2.1 Capitalism and Wealth
To identify money-making opportunities, like those in the kidney market, we
first have to understand how wealth is created and destroyed.
Wealth is created when assets move from lower- to higher-valued uses.
An individual’s value for a good or a service is measured as the amount
of money he or she is willing to pay for it.3 To “value” a good means that you
want it and can pay for it.4
If we adopt the linguistic convention that buyers are male and the sellers
are female, we say that a buyer’s “value” for an item is how much he will
pay for it, his “top dollar.” Likewise, a seller won’t accept less than her value,
“cost,” or “bottom line.”
The biggest advantage of capitalism is that it creates wealth by letting
people follow their self-interest.5 A buyer willingly buys if the price is below
his value, and a seller sells for the same selfish reason. Both buyer and seller
gain; otherwise, they would not transact.
Voluntary transactions create wealth.
Suppose that a buyer values a house at $240,000 and a seller at $200,000.
If they can agree on a price—say, $210,000—they both gain. In this case, the
seller sells at a price that is $10,000 higher than her bottom line and the buyer
buys at a price that is $30,000 below his top dollar.
Formally, the difference between the agreed-on price and the seller’s value
is called seller surplus. Likewise, buyer surplus is the buyer’s value minus the
price. The total surplus or gains from trade created by the transaction is the
sum of buyer and seller surplus ($40,000), the difference between the buyer’s
top dollar and the seller’s bottom line.
To see how well you understand the wealth-creating process, try to
identify the assets moving to higher-valued uses in the following examples:
• Factory owners purchase labor from workers, borrow capital from in-
vestors, and sell manufactured products to consumers. In essence, factory
owners are intermediaries who move labor and capital from lower-valued
to higher-valued uses, determined by consumers’ willingness to pay for
the labor and capital embodied in manufactured products.
• AIDS patients sometimes sell their life insurance policies to investors at
a discount of 50% or more. The transaction allows patients to collect
money from investors, who must wait until the patient dies to collect
from the insurance company. This transaction moves money across time,
from investors (who are willing to wait) to AIDS patients (who want the
money now).
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Chapter 2 • the One Lesson of Business 17
• Rover.com is an online service to match dog owners to dog walkers, pet
sitters, and overnight boarders. Since its founding in 2011, Rover has
become the largest marketplace for pet-sitting services, with over 65,000
registered sitters.
• When consumers purchase insurance, they pay an insurance company to
assume risk for them. In this context, you can think of risk as a “bad,”
the opposite of a “good,” moving from a consumer who wants to get rid
of it to an insurance company willing to assume it for a fee.
• In video games like Diablo III or World of Warcraft, thousands of people in
less-developed countries spend time playing the games to acquire “currency”
that can be used to acquire add-ons. These “gold farmers” sell the currency
to other players for cash on Web sites outside of the game environment.
Here’s a final example that is not so obvious. In 2004, a private equity con-
sortium purchased Mervyn’s, a department store located in the western United
States. It sold off the real estate on which the stores were located, and the
new owners set store rents at market rates. As a consequence, rent payments
doubled and the 59-year-old retailer went out of business, throwing 30,000
employees out of work.
PAUSE FOR A MOMENT AND TRY TO FIGURE WHY THIS
TRANSACTION CREATED WEALTH.
The private equity group unbundled Mervyn’s land-owning activity from
its retail activity. Once Mervyn’s stores had to pay market rents, it became
clear that the retail activity was losing money because its costs were higher
than the value it produced. The economy, as a whole, is better off without
such money-losing ventures.
How do you create wealth? Which assets do you move to higher-valued uses?
We close this section with a warning against the idea that if one person
makes money, someone else must be losing out. This mistake is so common
that it even has a name, “the zero-sum fallacy.” Policy makers often invoke
the fallacy to justify limits on profitability, or prices, or trade. It is a fallacy be-
cause the voluntary nature of trade requires that both parties gain; otherwise,
the transaction would not occur.
2.2 Does the Government Create Wealth?
Governments play a critical role in the wealth-creating process by enforcing
property rights and contracts—legal mechanisms that facilitate voluntary
transactions.6 By making sure that buyers and sellers can keep the gains from
trade, our legal system makes trade more likely, which contributes to Ameri-
ca’s enormous wealth-creating ability.7
Conversely, the absence of property rights contributes to poverty. The
reasons are simple: without private property and contract enforcement,
wealth-creating transactions are less likely to occur.8 Ironically, many poor
countries survive largely on the wealth created in the so-called underground, or
black-market economy, where transactions are hidden from the government.
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18 SECTION I • Problem Solving and Decision Making
Secure property rights are also associated with measures of environmen-
tal quality and human well-being. In nations where property rights are well
protected, more people have access to safe drinking water and sewage treat-
ment and they live about 20 years longer.9 If you give people ownership to their
property, they have an incentive to take care of it, invest in it, and keep it clean.
2.3 How Economics Is Useful to Business
Economics can be used by business people to spot money-making opportuni-
ties (assets in lower-valued uses). To see this, we begin with “efficiency,” one of
the most useful ideas in economics.
An economy is efficient if all assets are employed in their highest-valued uses.
Economists are obsessed with efficiency. They search for assets in lower-
valued uses and then suggest public policies to move them to higher-valued
ones. A good policy facilitates the movement of assets to higher-valued uses;
and a bad policy prevents assets from moving or, worse, moves assets to lower-
valued uses.
Determining whether a policy is good or bad requires analyzing all of its
effects—the unintended as well as the intended effects. Using this idea, Henry
Hazlitt reduced all of economics into a single lesson:10
The one lesson of economics: The art of economics consists in looking
not merely at the immediate but at the longer effects of any act or policy;
it consists of tracing the consequences of that policy not merely for one
group but for all groups.11
For example, recent proposals to prevent lenders from foreclosing on
houses helps the delinquent homeowners, but it also hurts lenders. If lenders
cannot foreclose on bad loans, this raises the cost of making loans, which, in
turn, hurts prospective home buyers.
Determining whether the policy is good or bad requires that we look not
only at the happy faces of the family that gets to stay in a foreclosed home,
but also at the sad faces of the family that can no longer afford to buy a house
because the cost of borrowing has gone up. The trick to “seeing” these indirect
effects is to look at incentives. In this chapter, we apply the rational actor par-
adigm to the problem of finding money making opportunities.
Making money is simple in principle—find an asset employed in lower-
valued use, buy it, and sell it to someone who places a higher value on it.
The one lesson of business: the art of business consists of identifying
assets in low-valued uses and devising ways to profitably move them to
higher-valued ones.
In other words, each underemployed asset represents a potential
wealth-creating transaction. The art of business is to identify these transac-
tions and find ways to profitably consummate them.
For example, once the government banned kidney sales, it simultaneously
created an incentive to try to circumvent the ban. Buying a hospital ship and
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Chapter 2 • the One Lesson of Business 19
sailing to international waters is just one solution. According to recent re-
search, there is a thriving illegal or “black market” for kidneys in the United
States. For about $150,000, organ brokers will connect wealthy buyers with
poor foreign donors, who receive a few thousand dollars and the chance
to visit an American city. Once there, transplants are performed at “bro-
ker-friendly” hospitals with surgeons who are either complicit in the scheme
or willing to turn a blind eye. Kidney brokers often hire clergy to accompany
their clients into the hospital to ensure that the process goes smoothly.12
Anything that impedes asset movement destroys potential wealth. We dis-
cuss three such impediments: taxes, subsidies, and price controls. These regu-
lations create inefficiency which also means opportunity.
Taxes
The government collects taxes out of the total surplus created by a transac-
tion. If the tax is larger than the surplus, the transaction will not take place. In
our housing example, if a sales tax is 25%, for instance, as in Italy, the tax will
be at least $50,000 because the price has to be at least $200,000, the seller’s
bottom line. Since the tax is more than the surplus created by the transaction,
the buyer and seller cannot find a mutually agreeable price that lets them pay
the tax.13
The one lesson of economics tells us that the intended effect of a tax is to
raise revenue for the government, but the unintended consequence of a tax is
that it deters some wealth-creating transactions.
The one lesson of business tells us that these unconsummated transac-
tions represent money-making opportunities. For example, in 1983, Sweden
imposed a 1% “turnover” (sales) tax on stock sales on the Swedish Stock Ex-
change. Before the tax, large institutional investors paid commissions that av-
eraged 25 basis points (0.25%). The turnover tax, by itself, was four times the
size of the old trading costs, and it fell most heavily on these big institutional
investors.
After the tax was imposed, institutional traders began trading shares on
the London and New York Stock Exchanges, and the number of transactions
on the Swedish Stock Exchange fell by 40%. Smart brokers recognized this
opportunity and profited by moving their trades to London and New York.
The Swedish government finally removed the turnover tax in 1990, but the
Swedish Stock Exchange has never regained its former vitality.
Subsidies
The opposite of a tax is a subsidy. By encouraging low-value consumers to buy
or high-value sellers to sell, subsidies destroy wealth by moving assets from
higher- to lower-valued uses—in exactly the wrong direction.
For example, government policies designed to extend credit to low-in-
come Americans increased homeownership from 64% to 69% of the popula-
tion. Many of these recipients, like Victor Ramirez, were able to afford houses
only due to the subsidies. Mr. Ramirez says. “I was a student making $17,000
a year, my wife was between jobs. In retrospect, how in hell did we qualify?”14
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20 SECTION I • Problem Solving and Decision Making
He qualified due to government subsidies. We know that these subsidies
destroy wealth because, without them, the money would have been spent dif-
ferently. A simple test will tell us whether the subsidy is inefficient: offer each
potential homeowner a payment equal to the amount of the subsidy. If they
would rather spend the money on something other than a home, then there is
a higher-valued use for the money.
The same logic can be used to identify ways to profit from inefficiency. To
see this, let’s look at health insurance that fully subsidizes visits to the doctor.
If you get a cold, you go to the doctor, who charges the insurance company
$200 for your care. This subsidy destroys wealth if you would rather self-
medicate and keep the $200.
Employers who recognize this are starting to offer insurance that requires
a large deductible or copayment. These fees stop low-value doctor visits and
dramatically reduce the cost of insurance. Employers can either keep the
money or use it to raise workers’ wages (by the amount they save on insur-
ance) to attract better workers. These high-deductible policies are becoming
more popular with companies like Whole Foods Market that have recognized
the inefficiency.
Price Controls
A price control is a regulation that allows trade only at certain prices.
There are two types of price controls: price ceilings, which outlaw trade at
prices above the ceiling, and price floors, which outlaw trade at prices below
the floor. The prohibition on buying and selling kidneys is a form of price
ceiling. Americans are allowed to buy and sell kidneys—but only at a price of
zero.
Price floors above the buyer’s top dollar or price ceilings below a seller’s
bottom line deter wealth-creating transactions.15 In our kidney example,
potential kidney sellers are deterred from selling because they can do so only
at a price of zero.
To see how to profit from this kind of inefficiency, we turn to the case
of taxis, which are regulated with a fixed price. This functions like a price
ceiling when you need to get you to the outer reaches of your metropolitan
area because the fixed fares won’t let taxis recover the cost of return trip. In
addition, taxis are often poorly maintained because regulated fares don’t allow
taxis to charge for better quality. Finally, taxis have a well-deserved reputation
for recklessness because there is no way for taxis to increase earnings except
by increasing volume, which they do by driving from place to place as fast as
possible.
Uber is an alternative to taxis that makes money, in part, by exploiting
these regulatory inefficiencies. Flexible pricing and consumer ratings give Uber
drivers an incentive to go to distant destinations, to clean their cars, and to
drive safely.16
Beyond avoiding the inefficiency created by taxi regulation, Uber’s suc-
cess is also due to: (i) a more efficient driver–passenger matching technology;
(ii) larger scale, which supports faster matches; and (iii) surge pricing, which
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Chapter 2 • the One Lesson of Business 21
allows it to more closely match supply with demand throughout the day. The
surge pricing can be thought of as a way around inefficiency of fixed fares
mandated by regulation.17
2.4 Wealth Creation in Organizations
Companies can be thought of as collections of transactions, from buying raw
materials like capital and labor to selling finished goods and services. In a suc-
cessful company, these transactions move assets to higher-valued uses and thus
make money for the company.
As we saw from the story of the oil company in the introductory chapter, a
firm’s organizational design influences decision making within the firm. Some
designs encourage profitable decision making; others do not. A poorly designed
company will consummate unprofitable transactions or fail to consummate
profitable ones.
The reasons for this are analogous to the wealth-destroying effects of
government policies: organizations impose “taxes,” “subsidies,” and “price
controls” within their companies that either deter profitable transactions or
encourage unprofitable ones. For example, overbidding at the oil company
was caused by a “subsidy” paid to management for acquiring oil reserves.
Senior management responded to the subsidy by acquiring reserves, regardless
of the price. One solution to the problem was to eliminate the subsidy.
The analogy between the market-level problems created by taxes, subsi-
dies, and price controls and the organization-level problems of goal alignment
suggests is that we are using the same economic tools to analyze both types of
problems. The target of the analysis changes—from markets to organizations—
but the principles are the same.
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
• Voluntary transactions create wealth by
moving assets from lower- to higher-valued
uses.
• Anything that impedes the movement of
assets to higher-valued uses, like taxes, sub-
sidies, or price controls, destroys wealth.
• Efficiency means that each asset is
employed in its highest-valued use. Each
inefficiency implies a money-making
opportunity.
• The art of business consists of finding an
asset in lower-valued use and devising ways
to profitably move it to higher-valued one.
• A company can be thought of as a series of
transactions. A well-designed organization
rewards employees who identify and con-
summate profitable transactions or who
stop unprofitable ones.
Multiple-Choice Questions
1. An individual’s value for a good or service is
a. the amount of money he or she used to
pay for a good.
b. the amount of money he or she is will-
ing to pay for it.
c. the amount of money he or she has to
spend on goods.
d. None of the above.
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22 SECTION I • Problem Solving and Decision Making
2. The biggest advantage of capitalism is that
a. it allows the market to self-regulate.
b. it allows a person to follow his
self-interest.
c. it allows voluntary transactions, which
create wealth.
d. All of the above.
3. Wealth-creating transactions are more
likely to occur
a. with private property rights.
b. with strong contract enforcement.
c. with black markets.
d. All of the above.
4. Which of these actions creates value?
a. Buying a struggling firm and selling off
its assets for more than the purchase
price
b. A baseball slugger drawing paying fans
into the ballpark
c. A student increasing his decision-
making ability with an MBA
d. All of the above
5. Which of the following are examples of a
price floor?
a. Minimum wages
b. Rent controls in New York
c. Both a and b
d. None of the above
6. A price ceiling
a. is a government-set maximum price.
b. is an implicit tax on producers and an
implicit subsidy to consumers.
c. will create a surplus.
d. causes an increase in consumer and
producer surplus.
7. Taxes
a. impede the movement of assets to
higher-valued uses.
b. reduce incentives to work.
c. decrease the number of wealth-creating
transactions.
d. All of the above.
8. A consumer values a car at $20,000 and
it costs a producer $15,000 to make the
same car. If the transaction is completed at
$18,000, the transaction will generate
a. no surplus.
b. $5,000 worth of seller surplus and
unknown amount of buyer surplus.
c. $2,000 worth of buyer surplus and
$3,000 of seller surplus.
d. $3,000 worth of buyer surplus and
unknown amount of seller surplus.
9. A consumer values a car at $525,000 and
a seller values the same car at $485,000.
If sales tax is 8% and is levied on the
seller, then the seller’s bottom-line price is
(rounded to the nearest thousand)
a. $527,000.
b. $524,000.
c. $525,000.
d. $500,000.
10. Voluntary transactions
a. always produce gains for both parties.
b. produce gains for at least one party.
c. always increase wealth for everyone.
d. are inefficient.
Individual Problems
2-1 Airline Delays
How will commercial airlines respond to the
threat of new $27,500 fines for keeping passen-
gers on the tarmac for more than three hours?
What inefficiency will this create?
2-2 Selling Used Cars
I recently sold my used car. If no new produc-
tion occurred for this transaction, how could it
have created value?
2-3 Flood Insurance
The U.S. government subsidizes flood insurance
because those who want to buy it live in the
flood plain and cannot get it at reasonable rates.
What inefficiency does this subsidy create?
2-4 France’s Labor Unions Force Early Closing Times
In 2013, France’s labor unions won a case
against Sephora to prevent the retailer from
staying open late and forcing its workers to
work “antisocial hours.” The cosmetics store
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Chapter 2 • the One Lesson of Business 23
does about 20% of its business after 9 P.M.,
and the 50 sales staff who work the late shift
are paid an hourly rate that is 25% higher than
the day shift. Many of them were students or
part-time workers, who were put out of work
by these new laws. Identify the inefficiency, and
figure out a way to profit from it.
2-5 Kraft and Cadbury
When Kraft recently bid $16.7 billion for Cad-
bury, Cadbury’s market value rose, but Kraft’s
market value fell by more. What does this tell
you about the value-creating potential of the
deal?
2-6 Price of Breast Reconstruction versus Breast
Augmentation
Two similar surgeries, breast reconstruction
and breast augmentation, have different prices.
Breast augmentation is cosmetic surgery not
covered by health insurance. Patients who want
the surgery must pay for it themselves. Breast
reconstruction following breast removal due
to cancer is covered by insurance. The price
for one of the surgeries has increased by about
10% each year since 1995, whereas the other
has increased by only 2% per year. Which of
the surgeries has the lower inflation rate? Why?
Group Problems
G2-1 One Lesson of Business
Identify an unconsummated wealth-creating
transaction (or a wealth-destroying one) cre-
ated by some tax, subsidy, price control, or
other government policy, and then figure out
how to profitably consummate it (or deter it).
Estimate how much profit you would earn by
consummating (or deterring) it.
G2-2 One Lesson of Business (within an
Organization)
Identify an unconsummated wealth-creating
transaction (or a wealth-destroying one) within
your organization, and figure out how to prof-
itably consummate it (or deter it). Estimate how
much profit you would earn by consummating
it (or deterring) it.
1. See Kevin Sack, “60 Lives, 30 Kidneys, All
Linked,” New York Times, February 18,
2012.
2. See Sally Satel and Mark J. Perry, “More
Kidney Donors Are Needed to Meet a Rising
Demand,” Washington Post, March 7, 2010.
3. An individual’s value for a good or service is
measured as the amount of money he or she
is willing to pay for it. It is the ability-to-pay
component of value that is behind most cri-
tiques of capitalism. Unless you have enough
money to purchase an item, you do not
value it.
But other theories of value have even bigger
problems. For example, under Communism,
a labor theory of value is used. Value de-
pends on how much labor produced it. This
definition (the amount of labor embodied in
the good), if used to guide decisions, could
lead to situations where goods are produced
that nobody wants. The defining tenet of
Communism is “from each according to his
ability; to each according to his need.” Com-
munism is bad at creating wealth because
it allocates goods according to “needs,” not
“wants,” and because it’s tough to gauge
how much people need goods. Individuals
have great incentive to claim they are “need-
ier” than they really are. In the political
arena, groups compete for government funds
by claiming they are the “neediest.” Econo-
mists dislike the word need because it is so
often used to manipulate others into giving
away something. Listen to news reports
about proposed government spending cuts.
Most often those affected claim they “need”
EnD nOTES
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24 SECTION I • Problem Solving and Decision Making
the programs targeted for elimination. That
sounds better than saying they “want” the
programs. The definitions of value differ be-
cause Communism and Socialism are more
concerned with the distribution of wealth
than with the creation of wealth, which
is capitalism’s greatest concern. In other
words, capitalism is concerned with making
the proverbial “pie” as large as possible,
while Socialism and Communism are con-
cerned more about how to slice up that pie.
4. This is the idea behind the French phrase
laissez-faire (leave them alone).
5. “The only proper functions of a government
are: the police, to protect you from crimi-
nals; the army, to protect you from foreign
invaders; and the courts, to protect your
property and contracts from breach or fraud
by others, to settle disputes by rational
rules, according to objective law.” Ayn Rand,
Atlas Shrugged (New York: Random House,
1957), 977.
6. Tom Bethell, The Noblest Triumph: Prop-
erty and Prosperity through the Ages (New
York: St. Martin’s Press, 1995).
7. “The inherent vice of capitalism is the
unequal sharing of blessings; the inherent
virtue of socialism is the equal sharing of
miseries” (Winston Churchill).
8. Seth Norton, “Property Rights, the Environ-
ment, and Economic Well-Being,” in Who
Owns the Environment? ed. Peter J. Hill and
Roger E. Meiners (Lanham, MD: Rowman
and Littlefield, 1998).
9. Henry Hazlitt, Economics in One Lesson
(New York: Crown, 1979).
10. For chilling examples of the unintended
consequences of government policy, read
Jagdish Bhagwati’s book, In Defense of
Globalization (New York: Oxford Univer-
sity Press, 2004). In 1993, for example, the
U.S. Congress seemed likely to pass Senator
Tom Harkin’s Child Labor Deterrence Act,
which would have banned imports of tex-
tiles made by child workers. Anticipating
its passage, the Bangladeshi textile industry
dismissed 50,000 children from factories.
Many of these children ended up as prosti-
tutes. Ironically, the bill, which was designed
to help children, had the opposite effect.
11. Jeneen Interlandi, “Not Just Urban Leg-
end,” Newsweek, January, 19, 2009.
12. With a 25% tax, the seller receives 75%
of the sales price. If the tax is levied on the
seller, her bottom-line price increases to
$266,667 5 $200,000 / (0.75), which is
above the buyer’s top dollar of $240,000.
If the tax is levied on the buyer, his top dol-
lar decreases to $192,000, which is below
the seller’s bottom line.
13. David Streitfeld and Gretchen Morgenson,
“Building Flawed American Dreams,” New
York Times, October 18, 2008.
14. Price floors below a seller’s bottom-line
and price ceilings above a buyer’s top dol-
lar have no effect.
15. Megan Mcardle, “Why You Can’t Get a
Taxi,” The Atlantic, May 2012.
16. Judd Cramer and Alan B. Krueger, “Dis-
ruptive Change in the Taxi Business: The
Case of Uber,” American Economic Review
106, no. 5 (2016): 177–182. 
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25
3
Big Coal Power Company burns two types of coal from the Southern Powder
River Basin in Wyoming: high-energy 8,800 coal and low-energy 8,400 coal.
The numbers refer to the amount of energy contained in one pound of coal,
for example, 8,400 Btu/lb. Power plants crush the coal, and then burn it to
produce electricity.
The 8,400 coal generates about 5% less electricity per ton than 8,800
coal, so when the price of 8,400 fell 20% below the price of 8,800 coal, the
plant manager did the obvious thing and switched to the lower-price coal.
Not only did this reduce the average cost of electricity but it also increased
the manager’s compensation because his performance evaluation was based
on the average cost of electricity (cost/Btu). Unfortunately, however, the move
also reduced company profit.
Because the conveyor belts and crushers were already at capacity, the
manager was unable to increase the tonnage going through the plant. Elec-
tricity output fell by 5%, the difference between the amount of electricity pro-
duced by the two different coals, and the parent company had to replace the
lost electricity with higher-cost natural gas. Company profit fell by $5 million,
computed as the cost of replacing the lost electricity with natural gas, minus
the savings from using lower-price 8,400 coal.
Even though mistakes like this seem obvious in retrospect, spotting them
before they occur can be very difficult. The goal of this chapter is to show you
how to use benefit-cost analysis not only to spot mistakes but also to identify
profitable decisions that should have been made instead.
Benefits, Costs,
and Decisions
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SECTION I • Problem Solving and Decision Making26
3.1 Background: Variable, Fixed, and Total Costs
Knowing how costs vary with output allows you to compute the costs associ-
ated with the consequence of a decision that changes output.
Variable costs vary with output, but fixed costs do not.
To illustrate, suppose that you are the manager of a new candy fac-
tory. To produce candy, you build a factory, purchase ingredients, and
hire employees. Suppose your factory’s capital costs are $1 million/year
(e.g., a $10 million factory and a 10% cost of capital), employees can be
hired for $50,000 each and ingredients cost $0.50/candy bar. If you decide
to produce 1,000 candy bars in a year, you need to hire 10 employees, but
if you decide to produce 2,000 bars, you need 20 employees. For 1,000
bars, your production costs would be $1,500,500—$1 million for the fac-
tory, $500,000 in employee costs, and $500 in ingredient costs. For 2,000
bars, your production costs would be $2,001,000—$1 million for the fac-
tory, $1 million in employee costs, and $1,000 in ingredient costs (a total of
1,001,000 in variable costs).
Notice that labor costs and ingredient costs vary with output, but fac-
tory capital costs are $1 million regardless of how much you produce. We
say that labor costs and ingredient costs are variable, while the capital cost
is fixed. The distinction is important for decisions on how much to produce
and sell.
To illustrate the relationships among these costs, we plot them against
output in Figure 3.2. For output levels of zero, both fixed and total costs are
greater than zero. Total and variable costs both increase with output, and vari-
able costs appear as the difference between the total cost curve and the fixed
cost line.1
FIGURE 3.2 Cost Curves
P
ro
d
u
ct
io
n
C
o
st
s
Output Level
Variable Costs
Fixed Costs
Total Costs
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ChaptER 3 • Benefits, Costs, and Decisions 27
3.2 Background: Accounting versus Economic Profit
We now leave our fictitious candy manufacturer to talk about a real one. In
1990, Cadbury India offered its employees free housing in company-owned
flats (apartments) to offset the high cost of living in Bombay (now Mum-
bai). In 1991, when Cadbury added low-interest housing loans to its bene-
fits package, employees took advantage of this incentive and purchased their
own homes, leaving the company flats empty. The empty flats remained on the
company’s balance sheet for the next six years.
In 1997, Cadbury adopted Economic Value Added (EVA®), a financial
performance metric trademarked by Stern Stewart & Co. The main difference
between ordinary accounting profit and EVA® is that EVA® includes a capital
charge of 15%, representing the return that Cadbury could have made if it
had invested the capital tied up in the apartments.
By charging each division within a firm for the amount of capital it
uses, EVA® gives division managers an incentive to incur capital expendi-
tures only if they earn more than they cost, for example, by giving divi-
sion managers an incentive to reduce capital expenditures if they earn less
than 15%.
After adopting EVA®, Cadbury India’s annual EVA® dropped by £600,000
(15% cost of capital times the £4,000,000 capital tied up in the apartments).2
In response, senior managers decided to sell the unused apartments as they
were earning less than the company’s cost of capital.
If the Cadbury managers had a good sense of their factories’ variable,
fixed, and total costs, why were they holding on to the company-owned
flats?
To answer this question, we recognize another important distinction: the
difference between accounting costs and what economists call “economic
costs.” The difference is especially important to big decisions about whether
to buy or sell assets. For these decisions, you have to figure out what else you
could do with the money if you decide to sell an asset. We measure the cost
of using capital on any project by the returns we could get from investing it
elsewhere, which accounting costs do not do.
Table 3.1 presents a recent annual income statement for Cadbury.3 The
firm sold over £6 billion in goods for the year, and after subtracting various
expenses, it ended up with a profit of £431 million, which represents a return
of approximately 6.4% on sales. Expense categories include items such as the
following:
• Costs paid to its suppliers for product ingredients
• General operating expenses, such as salaries to factory managers and
marketing expenses
• Depreciation expenses related to investments in buildings and
equipment
• Interest payments on borrowed funds
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SECTION I • Problem Solving and Decision Making28
TABLE 3.1
Cadbury Income Statement (amounts in millions of pounds)
Net Sales £6,738
    Cost of Sales £3,020
Gross Profit £3,718
    Operating Expenses
        Selling, General, and Administrative Expenses £2,654
        Depreciation and Amortization £215
        Total Operating Expenses £2,869
Operating Income £849
    Other Income (Expense)
        Net Interest £(226)
        Other Income £(3)
        Total Other Income (Expense) £(229)
Earnings before Provision for Income Taxes £620
    Provision for Income Taxes £(189)
Net Earnings £431
These types of expenses are the accounting costs of the business.
Economists, however, are interested in all the relevant costs of decisions,
including the implicit costs that do not show up in the accounting statements.
For an example of an implicit cost, look at the income statement again. Notice
that it lists payments to one class of capital providers of the company (debt
holders). Interest is the cost that creditors charge for the use of their capi-
tal. But creditors are not the only providers of capital. Stockholders provide
equity, just as bondholders provide debt. Yet the income statement reflects no
charge for equity even though this is an important consideration for invest-
ment decisions.
Suppose that Cadbury receives £4 billion in equity financing. If these
equity holders expect an annual return of 12% on their money (£480 million),
we would subtract this amount from the £431 million in net earnings to
get a better idea of the economic profit of the business, −£49 million.
Negative economic profit means that the firm is earning less than shareholders
expect.
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Chapter 3 • Benefits, Costs, and Decisions 29
Had Cadbury shareholders expected only a 10.77% rate of return, the
economic return would have been close to zero, and investors would have
been satisfied. However, given that they expected a 12% return, they “lost”
money in this investment, relative to what they could have earned elsewhere.
In practical terms, a firm may show an accounting profit while experienc-
ing an economic loss. The two amounts are not the same because economic
profit recognizes both explicit and implicit costs of capital. A failure to con-
sider these hidden or implicit costs is why the Cadbury India managers con-
tinued to hold on to flats. By adopting EVA®, the firm made visible the hidden
cost of equity, and the mangers sold the abandoned flats.
In general, managers should consider all the benefits and costs of a deci-
sion. To show you how to do this, we introduce what economists call “oppor-
tunity costs.”
3.3 Costs Are What You Give Up
When deciding between two alternatives, you obviously want to choose the
one that returns the highest profit. Accordingly, we define the “opportunity
cost” of one alternative as the forgone opportunity to earn profit from the
other.
With this definition, costs imply decision-making rules, and vice versa.
If the benefit of the first alternative is larger than its cost—the profit of the
second alternative—then choose the first. Otherwise, choose the second. This
link is made explicit in Figure 3.3, showing a decision where the profit of A is
greater than the cost of A (the profit of B).
The opportunity cost of an alternative is what you give up to pursue it.
Henceforth, when we use the term cost, we are referring to opportu-
nity cost. Because costs depend on what you give up, and this depends on
FIGUre 3.3 Opportunity Cost
Manager
Profit of A Profit of B (Opp’t Cost of A)
A B
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SECTION I • Problem Solving and Decision Making30
the decision that you are trying to make, costs and decisions are inherently
linked.
To illustrate the link, consider the company’s decision to hold onto the
company-owned flats and earn, say, 2%. The opportunity cost of the decision
is the forgone opportunity to invest capital in the company’s other operations
and earn a .12% return.
3.4 Sunk-Cost Fallacy
The general rule for making decisions is simple.
Consider all costs and benefits that vary with the consequence of a decision
(If you miss some, that is the hidden-cost fallacy.)
But consider only costs and benefits that vary with the consequence of the
decision. (If you take account of irrelevant costs or benefits, that is the
sunk- or fixed-cost fallacy.)
These are the relevant costs and benefits of a decision.
In this section and the next, we examine these two mistakes in more
detail.
One of the most frequent causes of the sunk-cost fallacy is the “overhead”
allocated to various activities within a company. Because overhead does not
vary with most business decisions, it should not influence them. Look back at
the income statement in Table 3.1. Overhead costs appear in the line item of
Selling, General, and Administrative Expenses. An example of such an overhead
expense would be costs associated with the corporate headquarters staff or with
the sales force. These costs are considered fixed because output can be increased
without the need to increase the corporate staff, like the CFO or CEO.
For example, suppose that you are in charge of a new products division
and are considering launching a product that you will be able to distribute
through your existing sales force, without incurring extra expenses. However,
if you launch the new product, your division will be forced to pay for a portion
of the sales force. If this “overhead” charge is big enough to deter an otherwise
profitable product launch, then you commit the sunk-cost fallacy. Overhead
expenses are analogous to a “tax” on launching a new product. In this case,
the tax deters a profitable product launch, a wealth-creating transaction.
Depreciation4 is another common cause of the sunk-cost fallacy. To see
how this causes problems, consider a washing machine plant that is consider-
ing outsourcing its plastic agitators rather than making them internally as had
been done for several years. The firm received a bid of $0.70 per unit from a
trusted supplier and compared the bid to its internal production costs of $1.00
per unit, consisting of $0.60 for material, $0.20 for labor, $0.10 for deprecia-
tion, and $0.10 for other overhead.
The costs of depreciation and overhead5 are not relevant to an out-
sourcing decision because the firm incurs these costs regardless of whether
it decides to outsource. The relevant cost of internal production is $0.80,
and the relevant cost of outsourcing is $0.70. Multiply the cost difference
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ChaptER 3 • Benefits, Costs, and Decisions 31
by one million agitators/year, and the firms would save $100,000 if it
outsourced the part.
In this case, identifying the right decision was easier than implementing
it. Six years earlier, the plant had incurred $1 million worth of tooling costs
to make molds for the agitators. Following accounting principles, the cost of
the tooling was recorded as an “asset” on the plant’s balance sheet. Each year,
the accountants charged the plant $100,000/year for using this asset, which
was expected to last for 10 years. After the first year, the value of the asset
had shrunk to $900,000; after the second, $800,000; and so on. This is called
“straight-line depreciation.”
Six years after incurring the tooling expense, there was still $400,000
worth of undepreciated capital left on the company’s balance sheet. Accoun-
tants told the manager that if he decided to outsource the agitator, these
“assets” would become “worthless,” and the manager would be forced to take
a charge6 against his division’s profitability. The $400,000 charge would pre-
vent him from reaching his performance goal, and he would have to forgo
his bonus. Since the accounting profit was $400,000 lower with outsourcing,
the manager decided not to outsource even though outsourcing would have
increased company profitability.
The company’s incentive compensation scheme that rewarded managers
for increasing accounting profit gave the plant manager an incentive to com-
mit the sunk-cost fallacy. This leads to an important lesson:
Accounting profit does not necessarily correspond to economic profit.
In other words, the accounting costs do not necessarily correspond to the rel-
evant costs of a decision. In this case, rewarding employees for increasing account-
ing profit led to a decision (not outsourcing) that reduced economic profit.
If you remember the discussion in Chapter 1, a question should immedi-
ately occur to you: “How can the company better align the incentives of the
plant manager with the profitability goals of the parent company?”
The right answer involves a trade-off: if we allow the plant manager to
ignore the sunk-tooling costs, he will make the right outsourcing decision.
However, in the future, such a policy tells the manager that he can make sunk-
cost investments without worrying about whether they will turn out to be
profitable.
On the other hand, if we punish the plant manager for making the bad
investment (which is what the accounting performance metric does), then we
create incentives for him to forgo profitable outsourcing, that is, to commit
the sunk-cost fallacy.
We see a similar tradeoff in the pharmaceutical industry, where drug devel-
opment programs are very difficult to stop once they get started, and in soft-
ware development, where companies continue to develop software in-house,
even after cheaper and better alternatives become available on the market.
In these industries, the employee who can most easily recognize the mistake
is often the one who originally made it. Fixing these problems is difficult
because the employee with the best information about when to stop develop-
ment often lacks the incentive to do so.
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SECTION I • Problem Solving and Decision Making32
3.5 Hidden-Cost Fallacy
The second mistake you can make is to ignore hidden costs.
The hidden-cost fallacy occurs when you ignore relevant costs, those costs that
do vary with the consequences of your decision.
As a simple example of this, consider a football game. You buy a ticket for
$20, but at game time, scalpers are selling tickets for $50 because your team is
playing its cross-state rival who has legions of fans willing to pay over $50 to
go to the game. Even though you do not value the tickets at $50 (indeed—you
value them for much less), you go anyway because you think “These tickets
cost me only $20.”
By going to the game, you give up the opportunity to scalp the tickets
and earn $50, so the opportunity cost of going to the game is $50. Unless you
place a value on going to the game that is as at least $50, then yours is not the
highest-valued use for the ticket. In this case, you are sitting on an unconsum-
mated wealth-creating transaction. Instead, scalp the tickets and stay home!
The example in the introduction also illustrates the hidden-cost fallacy.
There, the plant manager did not consider the hidden cost of replacing the
lost electricity from the decision to switch to the lower-priced, but also lower-
energy coal.
In fact, the subprime mortgage crisis of 2008 can be traced to a failure to
recognize the hidden costs of loans made by dubious lenders, like Long Beach
Financial, owned by Washington Mutual (now bankrupt).
Long Beach Financial was moving money out the door as fast as it could, few
questions asked, in loans built to self-destruct. It specialized in asking homeowners
with bad credit and no proof of income to put no money down and defer interest
payments for as long as possible. In Bakersfield, California, a strawberry picker
with an income of $14,000 and no English was lent every penny he needed to buy
a house for $720,000.7
The credit-rating agencies did not recognize the hidden cost of these very
risky loans. As a consequence, Long Beach Financial was able to package and
sell these risky loans to Wall Street investors, like Lehman Brothers, who went
bankrupt when the loans eventually defaulted.
3.6 A Final Warning
The mistakes in this chapter may seem obvious, but they were all made by
sophisticated and experienced managers in some of the best-run companies
in the world. It is not much of a stretch to predict that you will make some
of the same mistakes, and for the same reasons: either you will lack the infor-
mation necessary to make a good decision or you won’t have the incentive to
do so.
When you find yourself struggling with a decision, remember two
things: first, recognize the relevant benefits and costs of the decision.
This is sometimes hard to do because it is easy to get lost in the data.
Decision-makers are easily distracted by irrelevant numbers, and often
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ChaptER 3 • Benefits, Costs, and Decisions 33
forget why they are analyzing the numbers. They forget the most important
lesson of this chapter, that costs are defined by the decisions you are trying
to make. When this happens, take a step back and ask “What decision am
I trying to make?”
If you begin with the costs, you will always get confused; but if you begin with
the decision, you will never get confused.
Second, consider the consequences of the decision from your organiza-
tion’s point of view. Like the washing machine plant manager in this chapter,
you may find yourself penalized for doing what’s best for the organization.
Given the number and types of decisions that managers have to make, it is
impossible to design compensation schemes that perfectly align managers’
incentives with the organization’s goals for each decision. When this happens,
and it almost certainly will, consider putting the company’s interests ahead
of your own. Good supervisors will recognize these sacrifices and try to find
ways to reward you.
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
• Costs are associated with decisions.
• The opportunity cost of an alternative is
the profit you give up to pursue it.
• Consider all costs and benefits that vary
with the consequences of a decision and
only costs and benefits that vary with the
consequences of a decision. These are the
relevant costs and relevant benefits of a
decision.
• Fixed costs do not vary with the amount
of output. Variable costs change as output
changes. Decisions that change output
change only variable costs.
• Accounting profit does not necessarily
correspond to economic profit.
• The fixed-cost fallacy or sunk-cost fallacy
means that you consider irrelevant costs.
A common fixed-cost fallacy is to let
overhead or depreciation costs influence
short-run decisions.
• The hidden-cost fallacy occurs when
you ignore relevant costs. A common
hidden-cost fallacy is to ignore the
opportunity cost of capital when
making investment or shutdown
decisions.
• If you begin by looking at the costs, you
will always get confused; if you begin with
the decision you are considering, you will
never get confused.
Multiple-Choice Questions
1. A business owner makes 1,000 items a
day. Each day she contributes eight hours
to produce those items. If hired, elsewhere
she could have earned $250 an hour. The
item sells for $15 each. Production does
not stop during weekends. If the explicit
costs total $150,000 for 30 days, the firm’s
accounting profit for the month equals
a. $300,000.
b. $60,000.
c. $450,000.
d. $240,000.
2. If a firm is earning negative economic
profits, it implies
a. that the firm’s accounting profits are zero.
b. that the firm’s accounting profits are
positive.
c. that the firm’s accounting profits are
negative.
d. that more information is needed to
determine accounting profits.
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SECTION I • Problem Solving and Decision Making34
3. Opportunity costs arise due to
a. resource scarcity.
b. lack of alternatives.
c. limited wants.
d. abundance of resources.
4. After graduating from college, Jim had
three choices, listed in order of preference:
(1) move to Florida from Philadelphia,
(2) work in a car dealership in Philadelphia,
or (3) play soccer for a minor league in
Philadelphia. His opportunity cost of
moving to Florida includes
a. the benefits he could have received
from playing soccer.
b. the income he could have earned at the
car dealership.
c. both a and b.
d. cannot be determined from the given
information.
5. Economic Value Added helps firms avoid
the hidden-cost fallacy
a. by ignoring the opportunity costs of
using capital.
b. by differentiating between sunk and
fixed costs.
c. by taking all capital costs into account,
including the cost of equity.
d. none of the above.
6. The fixed-cost fallacy occurs when
a. a firm considers irrelevant costs.
b. a firm ignores relevant costs.
c. a firm considers overhead or depreciation
costs to make short-run decisions.
d. both a and c.
7. Mr. D’s Barbeque of Pickwick, TN, produces
10,000 dry-rubbed rib slabs per year.
Annually Mr. D’s fixed costs are $50,000. The
average variable cost per slab is a constant
$2. The average total cost per slab then is
a. $7.
b. $2.
c. $5.
d. impossible to determine.
8. All the following are examples of variable
costs, except
a. hourly labor costs.
b. cost of raw materials.
c. accounting fees.
d. electricity cost.
9. The U.S. government bought 112,000
acres of land in southeastern Colorado
in 1968 for $17,500,000. The cost of
using this land today exclusively for the
reintroduction of the black-tailed
prairie dog
a. is zero, because they already own the
land.
b. is zero, because the land represents a
sunk cost.
c. is equal to the market value of the
land.
d. is equal to the total dollar value the
land would yield if used for farming
and ranching.
10. When a firm ignores the opportunity cost
of capital when making investment or
shutdown decisions, this is a case of
a. fixed-cost fallacy.
b. sunk-cost fallacy.
c. hidden-cost fallacy.
d. none of the above.
Individual Problems
3-1 Concert Opportunity Cost
Yo u w o n a f r e e t i c k e t t o s e e a B r u c e
Springsteen concert (assume the ticket has no
resale value). U2 has a concert the same night,
and this represents your next-best alternative
activity. Tickets to the U2 concert cost $80,
and on any particular day, you would be
willing to pay up to $100 to see this band.
Assume that there are no additional costs of
seeing either show. Based on the information
presented here, what is the opportunity cost
of seeing Bruce Springsteen?
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ChaptER 3 • Benefits, Costs, and Decisions 35
3-2 Concert Opportunity Cost 2
You were able to purchase two tickets to an
upcoming concert for $100 apiece when the
concert was first announced three months ago.
Recently, you saw that StubHub was listing
similar seats for $225 apiece. What does it cost
you to attend the concert?
3-3 Housing Bubble
Because of the housing bubble, many houses
are now selling for much less than their sell-
ing price just two to three years ago. There
is evidence that homeowners with virtually
identical houses tend to ask for more if they
paid more for the house. What fallacy are
they making?
3-4 Opportunity Cost
The expression “3/10, net 45” means that the
customers receive a 3% discount if they pay
within 10 days; otherwise, they must pay in
full within 45 days. What would the seller’s
cost of capital have to be in order for the dis-
count to be cost justified? (Hint: Opportunity
Cost)
3-5 Starbucks
Starbucks is hoping to make use of its excess
restaurant capacity in the evenings by experi-
menting with selling beer and wine. It specu-
lates that the only additional costs are hiring
more of the same sort of workers to cover
the additional hours and costs of the new line
of beverages. What hidden costs might emerge?
3-6 Dropping University Courses
Students doing poorly in courses often consider
dropping the courses. Many universities will
offer a refund before a certain date. Should this
affect a student’s drop decision?
3-7 Business Costs
A business incurs the following costs per unit:
labor $125/unit, materials $45/unit, and rent
$250,000/month. If the firm produces 1,000,000
units a month. Calculate the following:
a. Total variable costs
b. Total fixed costs
c. Total costs
Group Problems
G3-1 Fixed-Cost Fallacy
Describe a decision made by your company that
involved costs that should have been ignored.
Why did your company make the decision?
What should it have done? Compute the profit
consequences of the change.
G3-2 Hidden-Cost Fallacy
Describe a decision that you or your company
made that involved opportunity costs that
should have been considered. Why did your
company make the decision? What should it
have done? Compute the profit consequences of
the change.
G3-3 Hidden Cost of Capital
Does your company charge your division for
the capital that it uses? If not, does this lead
to bad decisions? What can be done to fix the
problem? Compute the profit consequences of
the change.
G3-4 Sunk Cost of Depreciation or Fixed Cost
of Overhead
Does your company make decisions based on
depreciation or overhead? If so, does this lead
to bad decisions? What can be done to fix the
problem? Compute the profit consequences of
the change.
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SECTION I • Problem Solving and Decision Making36
1. Note that the shape of the total cost curve
is not a straight line as it would have been
if we graphed the costs of the candy factory.
The reason: per unit variable costs often
drop with increasing output—a topic we
will discuss in later chapters.
2. We do not know the actual size of the
charges—they should be viewed as
illustrative.
3. Adapted from the Cadbury Schweppes PLC
2004 Annual Report. Note that this income
statement is for worldwide Cadbury opera-
tions, not just for the Bombay Division, and
is presented for a general illustration of eco-
nomic versus accounting costs.
4. Depreciation is an accounting methodology
to allocate the costs of capital equipment
to the years over the lifetime of the capital
equipment.
5. Labor would not be considered a fixed cost
unless the company would keep the workers
on payroll regardless of whether the part
was produced internally or externally.
6. Taking a “charge” against profitability
means that accounting profit would be
reduced by the amount of the charge—in
this case, $400,000.
7. Michael Lewis and David Einhorn, “The
End of the Financial World as We Know It,”
New York Times, January 3, 2009.
END NOTES
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37
4
In 2016, Georgetown Public Media was trying to decide how to allocate its
$120,000 marketing budget across three radio stations.
89.3 WPGL News wanted the budget allocated by audience size. As it is
larger than the other two stations, this would give it $60,000: (1) to host
panels on topical issues to increase the diversity of its audience and (2) to
advertise on buses to reach people where they are listening—in their cars.
However, over the past three years, WPGL expenses have risen, and last
year they were 40% above revenue.
91.9 WPGK, the independent station (blues, jazz, world music, and
Americana), surveyed its listeners and found that they have a passion for
live music. Consequently, WPGK wants $40,000: (1) to host a backstage
tent at a local music festival where it can do livestream interviews with
musicians and (2) to add dates to its successful Winter Wednesday con-
cert series.
90.5 WPOL Classical has the smallest audience of the three, but wants
$60,000 in order to collaborate with WPGK Radio on joint marketing
events to attract a new and more diverse audience. A recent national
study showed tremendous potential for growth because young nonwhite
consumers said they love classical music, but had never heard of their
local public radio station. In addition, a $10,000 marketing expenditure
last year caused a 15% increase in membership.
QUESTION: Obviously, the sum of the three requests is bigger than the
advertising budget (60 1 40 1 60 . 120). If you were in charge, how would
you allocate the money?
Extent (How Much)
Decisions
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SECTION I • Problem Solving and Decision Making38
ANSWER: First, you have to figure out what you are trying to accom-
plish. In the case of nonprofit organizations, there is usually a tension between
maximizing profit and using the money to “do good.” But in this case, there
is no conflict because increasing audience size (doing good) also maximizes
profit because 15% of new listeners will become members and donate $140 to
the organization.
The second step is to figure out where a dollar of advertising will have the
biggest impact. The poll results suggest if you could somehow inform young
nonwhite listeners about the classical station, they would become listeners. In
addition, the effects of WPOL marketing efforts last year suggest that increases
in the advertising budget would increase audience size.
Finally, if we want to fully fund the classical station, should you reduce
the news advertising budget? The fact that the news station is losing
money is irrelevant. We are concerned only with increasing audience size,
as each new listener has the same 15% probability of becoming a member.
As is common in decisions like this, there is no good evidence on whether
allocating less money to news station advertising would affect its audience
size.
In this case, Georgetown Public Media decided to fully fund the requests
of the alternative and classical stations, and gave only $20,000 to the news sta-
tion. Based on this allocation, it expects 9,280 new listeners, who are expected
to contribute $194,880 to the organization.
The purpose of this chapter is to show you how to make extent decisions
like this one.
4.1 Fixed Costs Are Irrelevant to an Extent Decision
In 2005, Memorial Hospital’s chief executive officer (CEO) conducted perfor-
mance reviews of the hospital’s departments. As part of this review process,
the chief of obstetrics proposed increasing the number of babies being deliv-
ered by his department. The CEO examined the department’s financial state-
ments and found that the average cost (AC) of deliveries ($5000) was above
average revenue ($4300). He asked what seemed like a reasonable question,
“Why would we want to do more of something that is losing $700 every time
we do it?”
As you should now recognize, the CEO is committing the fixed-cost fal-
lacy. As we learned in Chapter 3, the relevant costs and benefits of this extent
decision (“how many babies should the hospital deliver”) are those that vary
with the consequences of the decision.
Fixed costs are irrelevant to an extent decision.
If the CEO had started with a question like “Should we increase output
from 500 to 501 deliveries?” he might have avoided the mistake. The answer
depends only on the extra or marginal cost of another delivery, $3000. This is
the relevant cost of an extent decision.
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Chapter 4 • extent (how Much) Decisions 39
4.2 Marginal Analysis
To analyze extent decisions, we break down the decision into small steps and
compute the costs and benefits of taking another step. If the benefits of taking
another step are greater than the costs, then take another step. Otherwise, step
backward.
We call this marginal analysis. To illustrate, we use it to answer the question,
“Should I sell more?” where marginal analysis applies to both costs and revenues.
Marginal cost (MC) is the additional cost incurred by producing and sell-
ing one more unit.
Marginal revenue (MR) is the additional revenue gained from selling one
more unit.
If the benefit of selling another unit (MR) is bigger than the MC, then sell
another unit.
Sell more if MR . MC; sell less if MR , MC. If MR 5 MC, you are sell-
ing the right amount (maximizing profit).
Marginal analysis works for any extent decision, like whether to change
the level of advertising, the quality of service, the size of your staff, or the
number of parking spaces to lease. The same principle applies to each deci-
sion—do more if MR . MC, and do less if MR , MC.
Note that marginal analysis points you in the right direction, but it does
not tell you how far to go. The reason for this is that MC typically rises, and
MR falls, with additional steps. So after taking a step, you have to recompute
MC and MR to see whether further steps are warranted.
To illustrate how to use marginal analysis, let’s return to Georgetown
Public Media’s problem.
First, let’s try to estimate the MR of adding another listener. From the
information in the story, the MR of adding another listener can be computed
as the probability of becoming a member times the revenue expected from
each member, 15% 3 $140 5 $21. This is a crude estimate (some listeners
may donate more), but it is the only information we have.
As is often the case, even if you have good information about MR or MC,
information about the other is harder to come by. In this example, we have
only a little bit of information about the MC of adding listeners, from the
classical station, when last year’s $10,000 increase in advertising led to a 15%
increase in listeners. If this 15% represents 2,000 new listeners, then the MC
of adding a classical station listener is $5/listener, computed as $10,000/2,000,
sometimes called customer acquisition cost.
Because MR . MC or $21 > $5, marginal analysis tells you to increase
classical advertising, but it doesn’t tell you how far to go. Rather, you have to
get there by taking steps. In this case, you might double last year’s budget and
measure the effect.
To see how to do this, look at the following excel spreadsheet (derived
from fictitious data). In the first two rows, you can see that doubling the
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SECTION I • Problem Solving and Decision Making40
budget increases the number of listeners from 2,000 to 3,386 and the profit
from $32,000 to $51,112. Profits are computed in the last column as $21
times the number of customers minus the cost of the advertising. Note also
that the customer acquisition cost (the MC of adding a new listener) increases
from $5 to $10. Keep increasing advertising, as long as the MC of adding a
listener is less than $21.
Advertising MR MC Listeners Profit
$10,000 $21 $5.00 2000 $32,000
$20,000 $21 $10.00 3386 $51,112
$40,000 $21 $20.00 4773 $60,224
$42,000 $21 $21.00 4870 $60,274
$44,000 $21 $22.00 4963 $60,227
From the table, you can see that the optimal level of advertising is $42,000,
where the MC of acquiring a customer ($21) is equal to the MR of acquiring
a customer. If you advertise more than this, the number of listeners increases,
but profit falls because MC is higher than MR. Note also that as the adver-
tising level increases, its effectiveness drops. This is reflected in the increasing
MC of acquiring another customer, which is typical of many extent decisions.
You pick the low-hanging fruit first (where the MC is low), and then you
move to the more costly, higher-hanging fruit (where the MC is higher).
Typically, MR falls, and MC rises, the more you do.
For another application, suppose you are trying to decide when to cut
down a tract of trees. As you know by now, always begin your analysis with
a question, “Should I harvest the trees now or wait a year?” Because this is an
extent decision, break the decision into steps, where a step is a year. Suppose
further that the trees are worth $100 today and are growing at an 8% rate.
Next year, they will be worth $108.
If you harvest the trees today you would earn, say $100, from selling the
timber. If your investments earn 5%, after a year, you would have $105. On
the other hand, if you let the trees grow, and the trees are growing at an 8%
rate, after a year you would have timber worth $108. Don’t harvest.
In general, if the trees grow faster than your investments you earn more by
letting them grow. As trees grow older, their growth rate will eventually fall below
what you can make by investing your money. At this point, harvest the trees.
4.3 Deciding between Two Alternatives
Managers often have to decide between competing strategies to achieve the
same end. To see how to use marginal analysis in this setting, let’s return to
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Chapter 4 • extent (how Much) Decisions 41
the problem facing Georgetown Public Media. Imagine that the manager has
$100,000 to split between the news and classical stations.
This question defines the relevant costs: the opportunity cost of spend-
ing one more dollar on advertising for the classical station is the forgone
opportunity to spend that dollar on advertising for the news station. To
increase profit, increase spending on whichever medium has a higher mar-
ginal impact and “pay” for the increase by reducing spending on the other.
To do this, compute the marginal customer acquisition cost for both alter-
natives, and then shift spending toward the cheaper one. This will increase
profit even if you don’t know the benefit of acquiring a customer. All you
need to know is whether shifting dollars increases the total number of
customers.
In the following table, we vary the amount going to the classical sta-
tion. In the first row, with only $10,000 going to classical advertising, we
see that the MC of adding a listener is $5. In contrast, the MC of adding
a news listener is $67.50. Since it is cheaper to add customers by adver-
tising on the classical station, increase the budget to the classical station
and pay for it by reducing spending on news. In the second row, after
shifting $10,000 to classical advertising, we see that the total number of
listeners (last column) increases. Keep shifting dollars from news to clas-
sical, until you find the advertising split that maximizes the number of
listeners.
The optimal advertising split is $60,000 going to classical and $40,000
going to news. At this split, the MC of adding consumers is the same for each
medium, and the audience size is maximized (8,240). Although shifting more
than this increases the number of classical listeners, the increase is not enough
to offset the decline in news listeners.
Classical News Total
Advertising # Listeners MC Advertising # Listeners MC # Listeners
$10,000 3,386 $5.00 $90,000 3,430 $67.50 6,816
$20,000 4,197 $10.00 $80,000 3,273 $60.00 7,470
$30,000 4,773 $15.00 $70,000 3,095 $52.50 7,867
$40,000 5,219 $20.00 $60,000 2,889 $45.00 8,108
$50,000 5,584 $25.00 $50,000 2,646 $37.50 8,229
$60,000 5,892 $30.00 $40,000 2,348 $30.00 8,240
$70,000 6,159 $35.00 $30,000 1,965 $22.50 8,124
$80,000 6,394 $40.00 $20,000 1,424 $15.00 7,819
$90,000 6,605 $45.00 $10,000 500 $7.50 7,105
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SECTION I • Problem Solving and Decision Making42
Of course, it is very rare to have this kind of detailed information about a
marginal change. Typically, you will have only the kind of information avail-
able to Georgetown Public Media. To gain more information about the effec-
tiveness of your advertising, you might want to increase classical advertising
and measure the gain in listeners. Then reduce news advertising, and measure
the loss in listeners. By changing the advertising levels separately, you may be
able measure the marginal effectiveness of advertising expenditures on each
station.
With advertising, there may also be subtle measurement issues. For exam-
ple, some psychological models of advertising suggest that for fewer than four
exposures, advertising has no effect on decisions. The marginal effectiveness
of that fourth exposure is thus very large, but the average effectiveness of the
entire advertising budget would be much lower.
For another application of marginal analysis, let’s figure out how to reduce
costs at a Fortune 50 company that produces textile products at various man-
ufacturing plants in Latin America. The plants operate as cost centers, meaning
that plant managers are rewarded for reducing costs of production. To evalu-
ate the performance of its plants, the firm measures production using standard
absorbed hours (SAH). For each garment produced, the firm computes the time
required to complete each step in the manufacturing process. Complex gar-
ments like overalls require more time and thus are assigned a higher SAH (15
minutes) than simple garments like T-shirts (2 minutes). The output of a factory
is thus measured in SAH, and each factory is evaluated based on how much it
costs to get one hour’s worth of production in terms of cost per SAH.
Obviously, measuring output in this way allows managers to identify
lower-cost factories. Suppose that a factory in the Yucatan, Mexico operates at
$20/SAH, and a factory in the Dominican Republic operates at $30/SAH. As
a manager, do you think you could save $10/SAH by shifting production from
the Dominican Republic to the Yucatan?
Before answering this question, you might want to remember the big
lesson of Chapter 3, that costs are defined by the decision you are trying to
make. Here you are trying to decide whether to shift output from one factory
to another. If the costs used to compute cost per SAH include overhead that
cannot be avoided, then you won’t save on overhead as you shift production—
overhead is irrelevant for this extent decision. So, first you must adjust the
cost per SAH to exclude fixed costs, lest you commit the fixed-cost fallacy.
Second, make sure that cost per SAH is a good proxy for MC. To check
whether this is so, make sure that when you reduce output in the Dominican
Republic, you really are avoiding close to $30/SAH, and make sure that you
are incurring only about $20/SAH as you shift production to the Yucatan. If
this is not correct, then cost per SAH is a poor proxy for MC.
If you are convinced that $10 per SAH is a reasonable proxy for difference
in MCs between the two factories, you can make money by shifting produc-
tion. And, as above, marginal analysis tells you what direction to go (shift pro-
duction to the factory with the lower MC), but it doesn’t tell you how far to go.
Decide how far to go by taking a step and then re-measuring MC to determine
whether to take another step.
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Chapter 4 • extent (how Much) Decisions 43
In this example, the company shifted some production, but not as much as
the managers wanted because they needed to maintain good working relation-
ships with politicians in the Dominican Republic who would have been upset
if too many local workers lost jobs (another hidden cost!).
4.4 Incentive Pay
How hard to work is an extent decision, so marginal analysis can be used to
design incentives to encourage hard work. To illustrate this idea, suppose you
are a landowner evaluating two different bids for harvesting a tract of timber
containing 100 trees. One bid is for $150 per tree, and the other bid is for
$15,000 for the right to harvest all the trees. Which bid should you accept?
Although both bids have the same face value, they have dramatically dif-
ferent effects on the logger’s incentives. If you charge a fixed fee of $15,000
for the right to harvest all the trees, the logger treats the price paid to the
landowner as a fixed or sunk cost. He should, by the reasoning in Chapter 3,
ignore that cost when deciding how many trees to cut down. In other words,
under the fixed-fee contract, the marginal payment to the landowner of cut-
ting down another tree is zero. This gives the logger an incentive to cut down
trees as long as the value of each tree is greater than the cost of harvesting it.
Under this contract, the logger will end up cutting down all the trees that are
profitable to cut down.
On the other hand, if you charge the logger a royalty rate of $150 per tree,
the logger will cut down only those trees that can generate profit greater than
$150. If the forest is a mix of pine worth $200 per tree and fir worth $100
per tree, the logger will harvest only the pine and leave the fir.1 Consequently,
the landowner will receive less money under a royalty contract. The incentive
effect of a royalty rate is analogous to that of a sales tax because it deters
some wealth-creating transactions, that is, the fir trees are not harvested.2
The same idea can be applied to the problem of motivating salespeople.
To see this, suppose you are considering two different compensation schemes.
One is based on a 10% commission rate, where the salesperson earns 10%
on sales she makes. The other pays a 5% commission rate plus a $50,000 per
year flat salary. Each year, you expect salespeople to sell about 100 units at a
price of $10,000 per unit. Which compensation scheme should you use?
As in our logging example, the two payment schemes have the same face
value but dramatically different effects on incentives. If you pay a 10% com-
mission, the marginal benefit to the salesperson of making another sale is
$1,000. If you pay a 5% commission, the marginal benefit is only $500. If
some sales are relatively easy to make (i.e., the salesperson gives up less than
$500 worth of time and effort to make them), and some sales are relatively
difficult to make (i.e., they require at least $800 worth of effort), then only the
easy sales will be made under the 5% commission. Both the easy and difficult
sales will be made under the 10% commission. The $50,000 salary is fixed
with respect to sales effort, and so does not affect behavior.
In essence, the sales force responds to the smaller marginal benefit of selling
with less effort, which we call shirking. This kind of shirking is analogous to the
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SECTION I • Problem Solving and Decision Making44
decision of the logger to harvest only the high-profit trees when he pays a royalty
rate for each tree harvested. The logger responds negatively to the high marginal
cost of logging just as the salesperson responds negatively to the low marginal
benefit of selling. To induce higher effort, use incentives that reduce marginal
cost or increase marginal benefit. Fixed cost or benefit does not affect effort.3
4.5 Tie Pay to Performance Measures That Reflect Effor t
Measuring performance is a critical part of any organization, as the following
story illustrates. In 1997, a 50-year-old chief operating officer (COO) with a
bachelor’s degree in journalism and a law degree managed a consulting firm
with 10 account executives. The COO was in charge of keeping clients happy
and ensuring that the account executives were working in the best interests of
the company. The COO earned a flat salary of $75,000.
After taking classes in human resources, economics, and accounting, the
CEO recognized that the usual accounting profits were not motivating the
COO to work harder. He sat down with his COO, and together they designed
a new metric. All revenues counted toward the COO’s “profit” goal. But only
the expenses that the COO controlled directly—like compensation and office
expenses—were “charged” against his profit metric. All overhead items, like
rent, were placed in another budget because the COO could not control them;
that is, they were “fixed” with respect to his effort.
The CEO and the COO both agreed that, without much effort, the COO
could earn4 $150,000 each quarter. But earning more would take extraordi-
nary effort. To motivate the COO, they agreed on an incentive compensation
scheme that paid the COO one-third of each dollar that the company earned
above $150,000.
After making the change, the COO’s compensation jumped to $177,000—
an increase of 136%—but the firm’s revenues also jumped from $720,000
to $1,251,000—an increase of 74%. A good economy certainly contributed
to the increase, but the compensation plan also helped. Revenue increased
because the COO pushed hard to make and exceed earnings goals and, for the
first time, he worried about expenses. For example, he attempted to contain
costs by asking why phone bills were so high.
Along with changing the COO’s compensation scheme, the CEO also
moved to a system of incentive pay for the account representatives. This
had equally dramatic effects on the account representatives—except for one
employee who was going through a divorce. The incentive pay scheme did
little to increase his marginal incentives because half of everything he earned
went to his estranged wife. In other words, the marginal benefit of extra
work for this employee was half as much as that of other employees, and he
responded by working less hard.
Although the benefits of incentive pay seem clear, it is not a panacea—
especially in cases where it is difficult to measure performance. For example, if
you reward software programmers for finding and fixing “bugs” in software,
you also create an incentive for the same programmers to deliberately produce
bugs so they can be found later on. Research has found that incentive schemes
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Chapter 4 • extent (how Much) Decisions 45
are most effective when “effort matters, there is little intrinsic desire to do the
job, and money boosts the recipient’s social status.”5
On a related note, recognize that it is virtually impossible to measure and
reward all the different tasks and activities you want an employee to perform.
This is especially true of managers, who typically have a wide scope of respon-
sibility. For them, do not put too much faith in monetary incentives alone. Rec-
ognize that the success of an organization often depends on managers who exert
effort above and beyond the incentives set up for them. Firms should let these
managers know that they are appreciated, and promote and reward them as
best it can.
4.6 Is Incentive Pay Unfair?
Incentive pay generates inequality simply because more productive workers
or those who work harder get paid more. Some employees and managers will
resist even well-designed incentive pay schemes because they consider them
“unfair.” Moreover, incentive pay typically exposes workers to risk beyond
their control. For example, even if they work hard, salespeople compensated
on sales commission earn less if the macro economy does poorly.
However, these criticisms of incentive pay make the mistake of confusing
procedural fairness (everyone has the same opportunity) with outcome fair-
ness (everyone has the same outcome). If you adopt incentive pay, you get
higher productivity (procedural fairness) but also greater inequality (outcome
unfairness).
The reluctance of people to accept this trade-off can make it difficult
for firms to increase productivity. For example, Spain’s policy of finiquito
whereby firms have to pay fired workers 1.5 months of salary for every year
worked makes it difficult to motivate long-time employees. The severance
pay starts looking so good that long-term employees start trying to get fired.
One employee with 17 years’ experience speculated in a blog post, “How
hard should I really be working?”6 These kinds of policies are making it very
difficult for the southern European countries to grow their way out of the
recession.
But countries aren’t the only ones who resist incentive pay. Consider this
reaction from a “faculty” member in the “corporate learning center” of a
Fortune 50 company to a suggestion that his company adopt an incentive
compensation plan:
Forfeiting our most recently espoused values of equal ownership in Firm
X’s success is not the answer. I fear that we will be attempting to compete
for employees interested in a class-oriented system of compensation.
From where I sit, this is the last thing a corporation needing vast,
systemic, team-oriented change should be trying to do to compete in
the global marketplace. Many folks know I am a staunch opponent of
incentive plans, and I often quote Alfie Kohn (1993), whose research
shows that rewards punish. Saying “If you do this, you’ll get that” differs
little from saying “Do this or this will happen to you.” Incentives are
controlling.
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SECTION I • Problem Solving and Decision Making46
However, another aspect of the punishment is much more evident in
this change of policy: “Not receiving a reward one expects to receive is
also indistinguishable from being punished.” Just ask all those who don’t
receive the bonuses they were previously entitled to how they feel about
it. The incentive pay policy is overt in its support of class separation over
collective team participation. It ignores the premises of modern systems
thinking and reverts to the mechanistic theories of Descartes and Newton
for justification. A typical business school text from the 1950s would
have suggested instituting such an aristocratic policy.
This company has since been acquired.
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
• Do not confuse average and marginal costs.
• Average cost (AC) is total cost (fixed and
variable) divided by total units produced.
The fixed cost portion of AC is irrelevant to
an extent decision.
• Marginal cost (MC) is the additional cost
incurred by producing and selling one more
unit.
• Marginal revenue (MR) is the additional
revenue gained from selling one more unit.
• MR and MC are the relevant costs of
an extent decision, like selling. Sell more
if MR . MC; sell less if MR , MC.
If MR 5 MC, you are selling the right
amount (maximizing profit).
• An incentive compensation scheme that
increases MR or reduces MC will increase
effort. Fixed fees have no effects on effort.
• A good incentive compensation scheme
links pay to performance measures that
reflect effort.
Multiple-Choice Questions
1. When economists speak of “marginal,”
they mean
a. opportunity.
b. scarcity.
c. incremental.
d. unimportant.
2. Managers undertake an investment
only if
a. marginal benefits of the investment are
greater than zero.
b. MCs of the investment are greater
than marginal benefits of the
investment.
c. marginal benefits are greater than
MCs.
d. investment decisions do not depend on
marginal analysis.
3. A firm produces 500 units per week. It
hires 20 full-time workers (40 hours/
week) at an hourly wage of $15. Raw
materials are ordered weekly, and they
cost $10 for every unit produced. The
weekly cost of the rent payment for the
factory is $2,250. How do the overall
costs break down?
a. Total variable cost is $17,000; total
fixed cost is $2,250; and total cost is
$19,250.
b. Total variable cost is $12,000; total
fixed cost is $7,250; and total cost is
$19,250.
c. Total variable cost is $5,000; total
fixed cost is $14,250; and total cost is
$19,250.
d. Total variable cost is $5,000; total
fixed cost is $2,250; and total cost is
$7,250.
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Chapter 4 • extent (how Much) Decisions 47
4. Total costs increase from $1,500 to $1,800
when a firm increases output from 40 to
50 units. Which of the following is true if
MC is constant?
a. FC 5 $100
b. FC 5 $200
c. FC 5 $300
d. FC 5 $400
5. A manager of a clothing firm is deciding
whether to add another factory in addition
to one already in production. The manager
would compare
a. the total benefits gained from the two
factories to the total costs of running
the two factories.
b. the incremental benefit expected from
the second factory to the total costs of
running the two factories.
c. the incremental benefit expected from
the second factory to the cost of the
second factory.
d. the total benefits gained from the two
factories to the incremental costs of
running the two factories.
6. A firm is thinking of hiring an additional
worker to their organization who can
increase total productivity by 100 units a
week. The cost of hiring him is $1,500 per
week. If the price of each unit is $12,
a. the MR of hiring the worker is $1,500.
b. the MC of hiring the worker is $1,200.
c. the firm should not hire the worker
since MR , MC.
d. all of the above.
7. A retailer has to pay $9 per hour to hire
13 workers. If the retailer only needs to hire
12 workers, a wage rate of $7 per hour is suf-
ficient. What is the MC of the 13th worker?
a. $117
b. $9
c. $33
d. $84
8. If a firm’s AC is rising, then
a. MC is less than AC.
b. MC is rising.
c. MC is greater than AC.
d. the firm is making an economic profit.
9. A company is producing 15,000 units. At
this output level, MR is $22, and the MC
is $18. The firm sells each unit for $48
and average total cost is $40. What can we
conclude from this information?
a. The company is making a loss.
b. The company needs to cut
production.
c. The company needs to increase
production.
d. Not enough information is provided.
10. Food Fanatics caters meals where its cost
of producing an extra meal is $25. Each of
its meals sells for $20. At this rate, what
should the company do?
a. Produce more meals and increase its
profit.
b. Produce fewer meals and increase its
profit.
c. Not change production.
d. None of the above.
Individual Problems
4-1 Extent versus Discrete Problems
Identify which of the following are extent
decisions.
a. Decide whether to expand an existing
product into a new region.
b. What discount should be given on
products during the upcoming holiday
sale?
c. Should the advertising budget be changed
for the upcoming year?
d. Should you develop a new product for an
existing product line?
4-2 Game Day Shuttle Service
You run a game day shuttle service for parking
services for the local ball club. Your costs for
different customer loads are 1: $30, 2: $32, 3:
$35, 4: $38, 5: $42, 6: $48, 7: $57, and 8: $68.
What are your MCs for each customer load
level? What is the AC? If you are compensated
$10 per ride, what customer load would you
want?
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SECTION I • Problem Solving and Decision Making48
4-3 Paid for Grades
Children in poor neighborhoods have bleak
outlooks on life and do not see much gain to
studying. A recent experiment is paying chil-
dren in poor neighborhoods $100 for each “A”
they earn in a six-week grade reporting cycle.
How does this affect the children’s behavior?
4-4 Supplier Bids
Your company is contemplating bidding on an
RFP (request for proposal) for 100,000 units
of a specialized part. Why might the amount
be more than the requesting company actually
wants?
4-5 Processing Insurance Claims
Your insurance firm processes claims through
its newer, larger, high-tech facility and its older,
smaller, low-tech facility. Each month, the
high-tech facility handles 10,000 claims, incurs
$100,000 in fixed costs and $100,000 in vari-
able costs. Each month, the low-tech facility
handles 2,000 claims, incurs $16,000 in fixed
costs and $24,000 in variable costs. If you
anticipate a decrease in the number of claims,
where will you lay off workers?
4-6 Copier Company
A copier company wants to expand production.
It currently has 20 workers who share eight
copiers. Two months ago, the firm added two
copiers, and output increased by 100,000 pages
per day. One month ago, it added five workers,
and productivity also increased by 50,000 pages
per day. Copiers cost about twice as much as
workers. Would you recommend it hire another
employee or buy another copier?
Group Problems
G4-1 Extent Decision
Describe an extent decision made by your com-
pany. Compute the MC and marginal benefit of
the decision. Was the right decision reached? If
not, what would you do differently? Compute
the profit consequences of the change.
G4-2 Contracts
Does your firm use royalty rate contracts or
fixed-fee contracts? Describe the incentive
effects of the contracts. Should you change the
contract from one to the other? Compute the
profit consequences of changing the contract.
1. Alternatively, if the trees differ in their har-
vesting costs (some are near a logging road,
and some are not), the logger will cut down
only those trees that yield a profit of at least
$150.
2. Recall that we noted in Chapter 2 that
when a sales tax is larger than the surplus
of a transaction, it deters that transaction.
Similarly, when the royalty rate is larger
than the surplus here, it deters the wealth-
creating transaction (the harvesting of the
fir tree).
3. The point of discussing these different com-
pensation schemes is not to argue that one
or the other is the optimal design but rather
to simply note that incentives will affect
behavior.
4. Earnings refers to company profit.
5. Tyler Cowen, Discover Your Inner Econo-
mist: Use Incentives to Fall in Love, Survive
Your Next Meeting, and Motivate Your
Dentist (New York: Dutton, 2007).
6. http://www.lostinsantcugat.com/2010/01/
nonperformance-incentive-pay.html.
EnD nOTES
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49
5
In the summer of 2007, Bert Mathews was contemplating the purchase of a
48-unit apartment building in downtown Nashville. The building was 95%
occupied and generated $500,000 in annual profit. His investors were expect-
ing a 15% return, and the bank had offered to loan him 80% of the purchase
price at a rate of 5.5% interest. He computed his weighted average cost of
capital or WACC as 0.2 3 (15%) 1 0.8 3 (5.5%) 5 7.4%. Mr. Mathews
used his cost of capital to figure out how much he could afford to pay for the
property, and still earn enough to satisfy his investors. The answer was $6.75
million, computed as $500,000/($6.75 million) 5 7.4%. In other words, if he
paid $6.75 million and earned $500,000 each year, he could pay his investors
15% on their invested capital.
Even though the owner was willing to sell at this price, Mr. Mathews
decided not to purchase because he was worried about the deteriorating hous-
ing market and the rising number of mortgage defaults. This turned out to
be a good decision. A year later, the building’s occupancy rate fell to 90%,
which reduced annual profit to $450,000. In addition, lending standards had
tightened considerably. Now, the bank was willing to lend only 65% of the
purchase price, and at the higher rate of 7.5%. This raised Mr. Mathews’ cost
of capital to 10.125% 5 0.35 3 (15%) 1 0.65 3 (7.5%), which reduced the
value that he placed on the property. If he was going to earn 10.125%, the
most he could afford to pay for the property was $4.4 million, computed as
$450,000/($4.4 million) 5 10.125%, which the owners rejected as too low.
This story illustrates the effect of the financial crisis on the real estate
market, but more importantly for our purposes, the relevant costs and benefits
of investment decisions, the topic of this chapter.
5.1 Compounding and Discounting
All investment decisions involve a trade-off between current sacrifice and
future gain. Before investing, you need to know whether the future benefits
Investment Decisions: Look
Ahead and Reason Back
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SECTION I • Problem Solving and Decision Making50
are more than the current costs. Discounting is a tool that allows you to figure
this out.
The easiest way to understand discounting is to first consider its opposite,
compounding,
(Future value, one period in the future) 5 (Present value) 3 (1 1 r)
where r is the rate of return. If, for example, you invest $1 today at a 10%
rate, then you would expect to have $1.10 in one year. After two years, $1
becomes $1.21 5 $1.10 3 (1.10); after three years, $1.33; and so on. The gen-
eral formula for compounding is
(Future value, k periods in the future) 5 (Present value) 3 (1 1 r)k
In the following table, we use the above formula to compute the time that
it takes an investment to double in value, when left to grow, as in a savings
account. We see that higher the interest rates cause money to double in a
shorter period of time. In fact, we see that the interest rate multiplied by the
time it takes to double equals about 72 (last column). This is the so-called rule
of 721
If you invest at a rate of return r, divide 72 by r to get the number of
years it takes to double your money.
As you can see from the entries in the “Future Value” column this is not
an exact formula, but rather an approximation.
Current Value Interest Rate Years Future Value Rate*Time
$100 2.00% 36.0 $204 72
$100 4.00% 18.0 $203 72
$100 6.00% 12.0 $201 72
$100 7.20% 10.0 $200 72
$100 10.00% 7.2 $199 72
$100 12.00% 6.0 $197 72
$100 15.00% 5.0 $201 75
Discounting is the inverse of compounding and is defined by the formula,
(Present value) = (future value, k periods in the future) / (1 1 r)k
So, for example, at a 10% discount rate, $1 next year is worth only $1/
(1.1) 5 $0.91 today, $1 two years in the future is worth only $0.83 5 $1/(1.1)2
today, and $1 three years in the future is worth only 0.75 5 $1/(1.1)3 today.
For an example of how to use discounting, we turn to the problem of pen-
sions. Like most U.S. cities, Nashville uses discounting to decide how much
to save today to fund its future pension obligations. For a pension that pays
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Chapter 5 • Investment Decisions: Look ahead and reason Back 51
out $100,000 in 20 years, Nashville must save $20,485 5 $100,000/(1.0825)20
today, using an 8.25% discount rate. If the city invests the $20,485 and earns
8.25%, the savings will compound and be worth $100,000 in 20 years. If, how-
ever, the investments earn less than 8.25% (in fact they have done much worse),
then the city will not have saved enough when the future finally gets here.
Of course, a more realistic discount rate, say 6.5%, would mean much
higher current savings, $28,3805$100,000/(1.065)20 to fund the same future
pension. But higher savings means less current spending, and current spend-
ing is politically popular. This explains why many politicians prefer higher
discount rates,2 and why most public pensions are underfunded, by 25% on
average.
In the following table, we compute how much more the California State
Pension Fund (Calpers) must save if it were to reduce its discount rate from
7.5% to 2.56%, the risk-free rate of return.3
Future Value Rate Years Present Value
$100 7.50% 20.0 $24
$100 6.50% 20.0 $28
$100 5.50% 20.0 $34
$100 4.50% 20.0 $41
$100 3.50% 20.0 $50
$100 2.56% 20.0 $60
We see that as the discount rate falls from 7.5% to the risk-free rate of 2.56%,
the amount that the pension fund must save increases from $24 to $60, an
increase of more than 150%. But even more reasonable discount rates, like
5.5%, would require $34, an increase of 42% over what Calpers is currently
saving.
5.2 How to Determine Whether Investments Are Profitable
We are now in a position to use discounting to determine whether an invest-
ment is profitable. The rule is simple: discount and add up the future benefits
of an investment, and compare them to the current cost of the investment. If
the difference is positive (called the “net present value”), then the investment
earns more than the cost of capital. This intuition can be formalized into a
general decision rule, called the NPV rule.
If the net present value of the sum of all discounted cash flows is larger
than zero, then the project earns more than the cost of capital.
To see how this works, consider the returns on two different projects.
The first returns $1,200,000 at the end of year 1, and the second returns
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SECTION I • Problem Solving and Decision Making52
$1,200,000 at the end of year 2. The company would obviously prefer to get
money more quickly (if only so that it can invest it and earn more). Intuitively,
it makes sense that the first project is more attractive than the second. Projects
that return dollars sooner have higher rates of return, all else being equal.
Most projects, however, are more difficult to compare. We illustrate two
such projects in Table 5.1. Both projects require an initial investment of $100.
Project 1 returns $115 at the end of the first year, whereas Project 2 returns
$60 at the end of the first year and $60 at the end of the second. The compa-
ny’s cost of capital is 14%. To determine whether the investments are prof-
itable, we discount all future inflows and outflows to the present so we can
compare them to the initial investment.
TABLE 5.1
NPV Example
Project 1 Project 2
Year Cash Flow Present Value Cash Flow Present Value
0 2100.00 2100.00 2100.00 2100.00
1 60.00 52.63 115.00 100.88
2 60.00 46.17 0.00 0.00
Net Value 20.00 21.20 15.00 0.88
To compute the present value, cash payouts after year one are divided by
1.14; and payouts after year two are divided by (1.14)2. Looking at the “Net
Value” of the two projects in Table 5.1, it’s clear that Project 2 earns more
than the cost of capital while Project 1 does not.
The NPV rule illustrates the link between “economic profit” introduced in
Chapter 3 and investment decisions. Projects with positive NPV create economic
profit because they earn more than the company’s opportunity cost of capital (i.e.,
the company earns profit above what is required to pay its investors and its debt
service). The positive NPV of Project 2 means that Project 2’s return is higher than
14%, and the negative NPV of Project 1 means that its return is lower than 14%.
We see that projects earning accounting profit (like project one) do not necessarily
earn economic profit.
A close cousin of NPV analysis is the internal rate of return (IRR).
IRR is the discount rate that sets NPV equal to zero.
To see how this works, consider a project that requires an upfront pay-
ment of $2,000 (now), but pays back $500/year for the next five years.
We compute the NPV of this project in the following table for an inves-
tor with a 5% cost of capital and see that it has a positive NPV of $164.74.
According to the NPV theorem, this project earns economic profit because it
earns more than the 5% cost of capital.
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Chapter 5 • Investment Decisions: Look ahead and reason Back 53
Project
Cost of Capital 5.00%
Year Cash Flow Present Value
0 22,000.00 22,000.00
1 500.00 476.19
2 500.00 453.51
3 500.00 431.92
4 500.00 411.35
5 500.00 391.76
Net Value 164.74
To find the IRR, we increase the discount rate, until the NPV falls to zero.
Project
Internal Rate of Return (IRR) = 7.93%
Year Cash Flow Present Value
0 22,000.00 22,000.00
1 500.00 463.26
2 500.00 429.23
3 500.00 397.69
4 500.00 368.47
5 500.00 341.40
Net Value 0.04
At a discount rate of 7.93%, the NPV is only $0.04, very close to zero. We
say that the IRR of this project is 7.93%. If our cost of capital is less than this,
for example, 5%, we would invest in the project.
Note that the IRR and NPV give the same answer to this problem, but
IRR can be harder to interpret than NPV analysis. When in doubt, use NPV.
5.3 Break-Even Analysis
In your finance classes, you will learn that NPV analysis is the “correct” way
to evaluate investment decisions. A positive NPV is both a necessary and a suf-
ficient condition for an investment to be profitable. However, after doing NPV
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SECTION I • Problem Solving and Decision Making54
analysis in a variety of circumstances, you will begin to develop shortcuts and
rules of thumb, like payback periods, that give you similar answers. This is
potentially dangerous. When using shortcuts, make sure that you understand
the context in which the shortcut is being used and that it gives the same
answer as NPV analysis.
One of the most popular shortcuts is break-even analysis. Break-
even analysis can give you the wrong answer as it ignores the time value
of money. However, break-even analysis is easy to do and it generates sim-
ple, intuitive answers. To illustrate, let’s examine an entry decision. Instead
of asking whether entry is profitable, break-even analysis asks an easier
question, “Can I sell enough to break even?” If you can sell more than the
break-even quantity, then entry is profitable; otherwise, entry is unprofitable.
To compute the break-even quantity, we have to distinguish between mar-
ginal cost (MC), which varies with quantity, and fixed cost (F), which doesn’t.
Imagine that you incur a fixed cost to enter an industry and a constant4 per-
unit MC when you begin production. You will find that most of your invest-
ment decisions can be analyzed using this very simple cost structure.
The break-even quantity is Q 5 F/(P 2 MC),
where F is annual fixed cost, P is price, and MC is marginal cost.
The break-even quantity is the quantity that will lead to zero profit.5 The
logic behind the calculation is simple. Each unit sold earns the contribution
margin (P 2 MC), so named because this is the amount that one sale contrib-
utes to profit. You have to sell at least the break-even quantity to earn enough
to cover fixed costs. If you sell more than the break-even quantity, you have
earned more than enough to cover your fixed costs, or to earn a profit.
For example, consider Nissan’s 2008 redesign of its Titan pickup truck.
The Titan had only two years left on its eight-year product life cycle, and Nis-
san had to decide whether to redesign it. Complicating the decision was a
weakening demand for U.S. trucks, with sales predicted to fall from 1.3 mil-
lion in 2008 to only 400,000 trucks per year by 2011.
Nissan managers used a rough break-even calculation to evaluate their
investment alternatives. It would cost $400 million to design and build a new
truck from the bottom up. At a 15% cost of capital,6 the investment would
cost Nissan about $60 million per year. As it earned only $1,500 per truck,
Nissan would have to sell at least 40,000 trucks each year to break even. With
only a 3% share of the U.S. market, however, Nissan predicted they would sell
only 12,000 Titan trucks each year, not enough to break even.
The other option was to pay Chrysler to build the new Titan for Nissan.
Chrysler had just made a big investment in updating its Dodge Ram pickup and
had enough spare capacity on its Mexican assembly line. If Nissan used the Dodge
Ram as the base platform for the new Titan, the required investment to build the
new model would fall from $400 million to only $80 million. However, the mar-
gin would also fall to $1,250 per truck because Dodge charged a price that was
above the MC of building the trucks. This would reduce the annual capital cost
to only $12 million, which makes the break-even quantity only 9,600 trucks. In
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Chapter 5 • Investment Decisions: Look ahead and reason Back 55
the following table, we illustrate this break-even analysis and see that Nissan sells
enough to break even on the Dodge platform, but not on its own platform.
Platform Nissan Dodge
Cost of Capital 15% 15%
Capital $400,000,000 $80,000,000
Margin (P 2 MC) $1,500 $1,250
Break-Even Sales 40,000 9,600
Predicted Sales 12,000 12,000
Outsourcing the Titan to Chrysler would have made economic sense, but in
early 2009, the companies issued a joint statement indefinitely postponing the
project due to “declining economic conditions.”
5.4 Choosing the Right Manufacturing Technology
In 1986, John Deere was building a capital-intensive factory to produce large,
four-wheel-drive farm tractors when the price of wheat dropped dramatically.
Demand for these tractors also fell because they’re used exclusively for har-
vesting wheat. In response, John Deere stopped construction of its factory and
attempted to purchase Versatile, a Canadian company that assembled tractors
in a big garage using off-the-shelf components.
We can characterize John Deere’s decision as abandoning their capital-
intensive factory, characterized by big fixed cost but small MC, in favor of
Versatile’s technology, characterized by small fixed cost but big MC. Did John
Deere make the right decision?
As you should now begin to realize, the answer is “it depends.” In this
case, it depends on how much John Deere expected to sell. Suppose that the
capital-intensive technology had fixed costs of $100 and MCs of $10, whereas
Versatile’s technology had fixed costs of $50 but MCs of $20. (Note: We’re
deliberately choosing easy-to-work-with numbers so that we can illustrate the
general point.) To answer the question, we compute the break-even quantity—
the quantity at which John Deere is indifferent between the two technologies.
In the following table, we see that for a quantity of five units, the total
costs of the two manufacturing technologies are the same.
  In-House Versatile
Quantity 5 5
Fixed Costs/Year $100 $50
Marginal Cost $10 $20
Total Cost $150 $150
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SECTION I • Problem Solving and Decision Making56
If John Deere expects to sell more than five units, it should choose the
low-marginal-cost technology; and for less than five units, they should choose
the low-fixed-cost technology.
In this case, John Deere decided to acquire Versatile because projected demand
was low. However, the antitrust division of the U.S. Department of Justice chal-
lenged the acquisition as anticompetitive7 because John Deere and Versatile were
two of just four firms that sold large four-wheel-drive tractors in North America.
We end this section with a warning to avoid a very common business
mistake:
Do not use break-even analysis to justify higher prices or greater output.
Managers sometimes reason that they must raise price to cover fixed costs.
Similarly, managers sometimes reason that since average fixed costs decline
with quantity, they must sell as much as they can to reduce average cost. Both
lines of reasoning are flawed because, as you know, pricing and production
are extent decisions that require marginal analysis, not break-even analysis.
Remember, if you start your analysis by looking at costs you will always get
confused. Instead, start your analysis by asking a question. For an extent decision,
like how high to price or how much to produce, fixed or sunk costs are irrelevant
because they do not vary with the consequence of the decision. For an investment
decision, fixed or sunk costs are relevant because they haven’t yet been incurred.
5.5 Shut-Down Decisions and Break-Even Prices
To study shut-down decisions, we work with break-even prices rather than
quantities. If you shut down, you lose your revenue, but you get back your
avoidable cost. If revenue is less than avoidable cost, or equivalently, if price is
less than average avoidable cost,8 then shut down.
The break-even price is the average avoidable cost per unit.9
The only hard part in applying break-even analysis is deciding which costs are
avoidable. For that, we use the Cost Taxonomy, shown in Figure 5.1.10
To illustrate how to use the taxonomy, consider the following problem.
Fixed cost is $100/year, MC is $5/year, and you’re producing 100 units per
year. How low can price go before it is profitable to shut down?
Again, the answer is “it depends.” In this case, it depends on which costs
are avoidable. To make this concrete, think of the fixed cost as a one-year
renewable lease and the MC as the cost of production. MC varies with how
much you produce so it is avoidable. But until the lease comes up for renewal,
it is unavoidable, so you ignore it when deciding whether to shut down.
In the short run, only MC is avoidable, so the shut-down price is $5. In
the long run, fixed cost becomes avoidable, so it becomes relevant to the shut-
down decision. In the long run, the shut-down price includes average fixed
cost and rises to $6.11 As more costs become avoidable, the shut-down price
increases to reflect this.
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Chapter 5 • Investment Decisions: Look ahead and reason Back 57
5.6 Sunk Costs and Post-Investment Hold-Up
By 2000, Mobil Oil (now ExxonMobil) was the leading supplier of industrial
lubricants12 in the United States. It achieved that position—and a 13% mar-
ket share—by bundling engineering services with its high-quality lubricants.
With twice as many field engineers as its next-largest competitor, Mobil was
able to offer custom-designed lubrication programs to complement sales of its
lubricants.
One of Mobil’s largest customers was TVA, a regional producer of electric
power whose annual consumption of lubricants exceeded one million gallons.
Early in 2000, Mobil conducted a three-month engineering audit of TVA. This
audit included employee training, equipment inspections, and, for each piece
of TVA equipment, repair, service, and lubricant recommendations.
TVA made the recommended repairs, but then it gave the lubricant rec-
ommendation list to a Mobil competitor that offered lubricants at lower
prices. When Mobil failed to match the lower prices, they lost the contract and
their three-month investment. Mobil and its managers forgot a basic business
maxim.
Before investing, look ahead and reason back.
Economics is often called the “dismal science,” partly because of its dark
view of human nature. However, this dark view of human nature can pro-
tect you against what economists call post-investment hold-up. Sunk costs
are unavoidable, even in the long run, so after you incur them, you become
vulnerable to post-investment hold-up. In this case, Mobil made the invest-
ment in consulting services expecting that they could recoup the investment
through their pricing. However, TVA “held them up” by buying lubricants
from another vendor.
FIGUre 5.1 Cost Taxonomy
Costs
Avoidable
Costs
Unavoidable
or “Sunk” Costs
Variable Costs
(avoidable in short run)
Fixed Costs
(avoidable in long run)
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SECTION I • Problem Solving and Decision Making58
Let’s look more generally at the problem of post-investment hold-up by
rewriting profit as a function of the difference between price and average cost.
Profit 5 Rev 2 Cost 5 Q* P 2 Q* (Cost / Q) 5 Q* (P 2 AC)
If “Cost” includes all your costs, including your opportunity cost of
capital, then you are just breaking even (earning zero profit) when P 5 AC.
If price falls below AC, then you are losing money.
To see how this affects investment decisions, imagine that you are advising a
regional commercial printer, who is negotiating with a magazine, like National
Geographic. For the magazine, using a regional printer reduces shipping costs.
But to print a high-quality magazine, the printer must buy a $12 million roto-
gravure printing press. For the sake of clarity, we assume that the press has no
resale value and the firm has no capital cost (it can borrow money and pay no
interest). Suppose that the MC of printing a single copy is $2 and the printer
expects to print one million copies per year over a two-year period.
In the following table, we compute the average cost of printing the maga-
zine over the length of the contract.
RFP
Year Quantity Sunk Cost Variable Cost ($2/Unit)
0 $12,000,000
1 1,000,000 $2,000,000
2 1,000,000 $2,000,000
Total 2,000,000 $12,000,000 $4,000,000
Average $6 $2
Average Cost $8
In the above table, we see that $8 is the average cost of printing magazines
over the length of the contract. This is the break-even price for the printer and
represents her bottom line in negotiations with the magazine. Before they are
incurred, sunk costs are relevant to the negotiation.
QUESTION: Now suppose that the magazine accepts your offer of $8/
unit and immediately hands you a purchase order for $8,000,000, for the
first-year production. Do you accept the purchase order?
If you said “Yes,” you have just been held up. Since the $12M cost of the
printer is sunk, the magazine can decide to reduce its second-year price to only
$2, and you would have no option but to accept it. Instead, you should instead
refuse the purchase order at that price.
If the printer anticipates hold-up, it will be reluctant to deal with the mag-
azine. When this happens, hold-up becomes a problem not just for the poten-
tial victim but also for the potential perpetrator. The one lesson of business
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Chapter 5 • Investment Decisions: Look ahead and reason Back 59
is to figure out how to profitably consummate the transaction between the
printer and the magazine.
If possible, the printer will negotiate a contract that penalizes the maga-
zine should it decide to hold them up. With the assurance of a contract, the
printer may feel confident enough to incur sunk costs. But contracts are often
difficult and costly to enforce. A better solution might be to make the maga-
zine purchase the printing press and then lease it to the printer. In this case, the
magazine no longer poses a hold-up threat to the printer because the printer
has incurred no sunk costs.13
Note that if the cost of the printing press is fixed, meaning that it can
be recovered by selling the machine, then hold-up is not a problem. If the
magazine tries to renegotiate a price less than average cost, the printer will
refuse the business, sell the press, and recover its entire investment. Hold-up
can occur only if costs are sunk.
In general, many investments are vulnerable to hold-up. Anytime that
one party makes a specific investment—one that is sunk or lacks value out-
side of a trading relationship—the party can be held up by its trading part-
ner. If one party anticipates that she is at risk of being held up, she will be
reluctant to make relationship-specific investments, or demand costly safe-
guards, including compensation in the form of better terms from her trading
partner. This gives both parties an incentive to adopt contracts or organiza-
tional forms, such as investments in reputation or merger, to reduce the risk
of hold-up. The goal is to ensure that each party has both the incentive to
make relationship-specific investments and to trade after these investments
have been made.
Contracts should encourage both investment and trade.
For example, marriages are vulnerable to the same type of post-investment
opportunism that plagues commercial relationships. Parties invest time, energy,
and money in a marriage, the kinds of investments that differentiate marriages
from more casual relationships, which can be thought of as spot-market trans-
actions. These investments are valuable to the marriage parties but are largely
specific, in that they have a much lower value outside the relationship. The
marriage contract penalizes post-investment hold-up (i.e., divorce), and this
makes couples willing to invest more in the marriage.14
We close the chapter with the story of an economist and his fiancée who
were receiving premarital counseling from a priest before he would marry
them. The priest’s first question to the couple was “Why do you want to get
married?” The economist’s fiancée answered, “Because I love him and want
to spend the rest of my life with him.” As you might imagine, the economist
had a different answer, “Because long-term contracts induce higher levels of
relationship-specific investment.”
A year later, trying hard to find the right words to express how he felt
about his wife, he wrote an anniversary e-mail—using a cursive font—
declaring that his “relationship-specific investment was earning an above-
average rate of return.”
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SECTION I • Problem Solving and Decision Making60
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
• All investment decisions involve a trade-off
between current sacrifice and future gain.
Before investing, you need to know whether
the future benefits are bigger than the cur-
rent costs. Discounting allows you to figure
this out.
• Companies, like individuals, have different
discount rates, determined by their cost of
capital. They invest only in projects that
earn a return higher than the cost of capital.
• The NPV rule states that if the net pres-
ent value of the net cash flows from an
investment are positive, the project earns
economic profit (the investment earns more
than the cost of capital).
• Although NPV is the correct way to ana-
lyze investments, not all companies use it.
Instead, they use a variety of shortcuts like
pay-back period as they are often easier to
do and more intuitive.
• Break-even quantity is equal to fixed cost
divided by the contribution margin. If you
expect to sell more than the break-even quan-
tity, then your investment will be profitable.
• Avoidable costs can be recovered by shut-
ting down. If the benefits of shutting down
(you get back your avoidable costs) are
larger than the costs (you give up your
revenue), then shut down. The break-even
price is average avoidable cost.
• If you incur sunk costs, you are vulnera-
ble to post-investment hold-up. Anticipate
hold-up and choose contracts or organiza-
tional forms that give each party both the
incentive to make sunk-cost investments and
to trade after these investments are made.
Multiple-Choice Questions
1. Which of the following will increase the
break-even quantity?
a. A decrease in overall fixed costs
b. A decrease in the marginal costs
c. A decrease in the price level
d. An increase in price level
2. The higher the discount rates,
a. the more value individuals place on
future dollars.
b. the more value individuals place on
current dollars.
c. the more investments will take place.
d. does not affect the investment strategy
3. Assume a firm has the following cost and
revenue characteristics at its current level
of output: price 5 $10.00, average variable
cost 5 $8.00, and average fixed cost 5
$4.00. This firm is
a. incurring a loss of $2.00 per unit and
should shut down.
b. realizing only a normal profit.
c. realizing an economic profit of $2.00
per unit.
d. incurring a loss per unit of $2.00 but
should continue to operate in the short
run.
4. Sarah’s Machinery Company is deciding
to dump its current technology A for a
new technology B with smaller fixed costs
but bigger MCs. The current technology
has fixed costs of $500 and MCs of $50,
whereas the new technology has fixed costs
of $250 and MCs of $100. At what quan-
tity is Sarah’s Machinery Company indif-
ferent between two technologies?
a. 5
b. 6
c. 7
d. 8
5. What is the net present value of a project
that requires a $100 investment today and
returns $50 at the end of the first year and
$80 at the end of the second year? Assume
a discount rate of 10%.
a. $10.52
b. $11.57
c. $18.18
d. $30.00
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Chapter 5 • Investment Decisions: Look ahead and reason Back 61
6. You expect to sell 500 cell phones a month,
which have an MC of $50. If your fixed
costs are $5,000 per month, what is the
break-even price?
a. $10
b. $50
c. $60
d. $100
7. You are considering opening a new busi-
ness to sell dartboards. You estimate
that your manufacturing equipment will
cost $100,000, facility updates will cost
$250,000, and on average, it will cost you
$80 (in labor and material) to produce a
board. If you can sell dartboards for $100
each, what is your break-even quantity?
a. 1,000
b. 3,500
c. 4,375
d. 17,500
8. If GDP is expected to increase at a steady
rate of 3% per year, how many years
would it take for living standards to
double?
a. 10
b. 20
c. 24
d. 30
9. Break-even quantity is a point where
a. the level of profit is maximized.
b. the level of cost is minimized.
c. only variable costs are covered.
d. there are zero profits.
10. In the short run, a firm’s decision to shut
down should not take into consideration
a. avoidable costs.
b. variable costs.
c. fixed costs.
d. MCs.
Individual Problems
5-1 George’s T-Shirt Shop
George’s T-Shirt Shop produces 5,000 cus-
tom-printed T-shirts per month. George’s fixed
costs are $15,000 per month. The MC per
T-shirt is a constant $4. What is his break-even
price? What would be George’s break-even
price if he were to sell 50% more shirts?
5-2 Net Present Value
Suppose an initial investment of $100 will return
$50/year for three years (assume the $50 is
received each year at the end of the year). Is this a
profitable investment if the discount rate is 20%?
5-3 Doctor’s Human Capital
Probably the most important source of capital is
human capital. For example, most medical doc-
tors spend years learning to practice medicine.
Doctors are willing to make large investments
in their human capital because they expect to be
compensated for doing so when they begin work.
In Canada, the government nationalized the
health-care system and reduced doctors’ compen-
sation. Is this a form of post-investment hold-up?
5-4 Solar Panel Installation
A university spent $1.8 million to install solar
panels atop a parking garage. These panels will
have a capacity of 500 kW, have a life expec-
tancy of 20 years and suppose the discount rate
is 10%.
a. If electricity can be purchased for costs of
$0.10 per kWh, how many hours per year
will the solar panels have to operate to
make this project break even?
b. If efficient systems operate for 2,400 hours
per year, would the project break even?
c. The university is seeking a grant to cover
capital costs. How big of a grant would
make this project worthwhile (to the
university)?
5-5 Toy Trucks
Last year, a toy manufacturer introduced a
new toy truck that was a huge success. The
company invested $2.5 million for a plastic
injection-molding machine (which can be sold for
$2.0 million) and $100,000 in plastic injection
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SECTION I • Problem Solving and Decision Making62
molds specifically for the toy (not valuable to
anyone else). Labor and the cost of materials
necessary to make each truck are about $3.
This year, a competitor has developed a similar
toy that has significantly reduced demand for
the toy truck. Now, the original manufacturer
is deciding whether it should continue produc-
tion of the toy truck. If the estimated demand is
100,000 trucks, what is the break-even price for
the toy truck? Should the company shut down?
5-6 Running a Hotel during a Recession
In early 2008, you purchased and remodeled a
120-room hotel to handle the increased number
of conventions coming to town. By mid-2008, it
became apparent that the recession would kill
the demand for conventions. Now, you forecast
that you will only be able to sell 20,000 room-
nights that cost on average $50 per room per
night to service. You spent $20 million on the
hotel in 2008, and your cost of capital is 10%.
The current going price to sell the hotel is $15
million. What is your break-even price?
5-7 Short Run versus Long Run
A firm sells 1,000 units per week. It charges
$70 per unit, the average variable costs are $25,
and the average costs are $65.
a. What should the firm do in the short run?
Why?
b. What should the firm do in the long run?
Why?
c. At what price would the firm consider
shutting down in the short run?
d. At what price would the firm consider
shutting down in the long run?
Group Problems
G5-1 Shut-Down Decision
Describe a shut-down decision your company
has made. Compute the opportunity costs and
benefits of the decision (using break-even anal-
ysis if appropriate). Did your company make
the right decision? If not, what would you do
differently? Compute the profit consequences
of the decision.
G5-2 Investment Decision
Describe an investment decision your company
has made. Compute the opportunity costs and
benefits of the decision. Did your company
make the right decision? If not, what would
you do differently? Compute the NPV of the
investment.
G5-3 Post-Investment Hold-Up
Describe an investment or potential investment
your company (or one of your suppliers or
customers) has made that is subject to post-in-
vestment hold-up. What could or does your
company do to solve the hold-up problem and
ensure the investment gets made? Compute the
profit consequences of the solution.
1. The rule of 72 applies in most situations.
There is also a rule of 69 for continuous
compounding of interest. Neither is precise
enough for actual contracts and should only
be used for on-the-spot mental calculations.
2. If voters were perfectly rational, they would
recognize that most cities are not saving
enough to fund their future pension obliga-
tions. That they don’t seem to care enough
about the future has long been recognized
by psychologists, who have named this
“hyperbolic discounting.” In other words,
they place too much weight on the present
and not enough weight on the future. Busi-
nesses, like politicians, take advantage of
this irrationality by, for example, offering
a low “teaser” price and raising price in
the future, or by offering a low price on a
END NOTES
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Chapter 5 • Investment Decisions: Look ahead and reason Back 63
consumer durable, like a pod-coffee maker,
and then charging a high price on the con-
sumables, like the pod. Hyperbolic discount-
ing implies that when deciding whether to
purchase the pod-coffee “system,” consum-
ers place too much weight on the “current”
low price of the machine, and discount too
heavily the “future” high price of the pods.
By shifting most of the price to the future,
where consumers discount them too heavily,
the company can increase demand for the
system.
3. http://www.nytimes.com/2016/09/18/
business/dealbook/a-sour-surprise-for-
public-pensions-two-sets-of-books.html.
4. In later chapters, we will analyze situations
in which marginal costs are not constant.
5. 0 5 Profit
0 5 Revenue 2 Total Costs
0 5 Revenue 2 Variable Costs 2 Fixed Costs
0 5 (P 3 Q) 2 (MC 3 Q) 2 F
0 5 Q(P 2 MC) 2 F
F 5 Q(P 2 MC)
F/(P 2 MC) 5 Q
Q 5 F/(P 2 MC).
6. If you invest in an asset that loses its value
after some period (like designing a new
model truck that will become obsolete after
eight years), you can adjust your cost of
capital to account for the finite life of the
investment by using what is known as a
Debt constant 5 r/(12(1/(11r)^n)), where r
is the cost of capital and n is the number of
years before the investment loses its value.
For example, if the investment loses its value
after eight years, then the debt constant is
approximately 15% for a 5% cost of capital.
7. This was the first big case for one naive
but enthusiastic young economist.
8. Profit 5 Revenue 2 Cost
5 (P 3 Q) 2 (AC 3 Q), where AC 5
Average Cost 5 (Total Cost)/Q. Note that
if price is less than average cost, profit will
be negative.
9. Revenue , Avoidable cost 4
Revenue/Q , (Avoidable Cost)/Q 4
Price , (Avg. Avoidable Cost)
10. Ivan Png, Managerial Economics (Maiden,
MA: Blackwell, 1998).
11. Average Avoidable Cost 5 (Fixed Cost 1
Average Avoidable Cost 3 Q) IQ 5
($100 1 $5 3 100)/100 5 $6.
12. Industrial lubricants are very costly to pro-
duce. One 55-gallon barrel of oil yields just
two quarts of lubricant.
13. However, now the magazine can be held up
by the printer and may be reluctant to buy
the machine unless the printer can reassure
the magazine that it will not be held up.
14. The weakening of the marriage contract
in the United States (reduced penalties for
post-investment hold-up) allows a test of
this contractual view of marriage. Fol-
lowing the change, we would expect less
relationship-specific investment, like the
investment in children. Corresponding to
the weakening of the contract, women are
having fewer children and having them
later in life, when it is easier to drop in and
out of the labor market. They act as if they
are responding rationally to the increased
risk of post-investment hold-up.
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65
6 Simple Pricing
7 Economies of Scale and Scope
8 Understanding Markets and Industry Changes
9 Market Structure and Long-Run Equilibrium
10 Strategy: The Quest to Keep Profit from Eroding
11 Foreign Exchange, Trade, and Bubbles
Pricing, Costs, and Profits
2SECTION
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67
In 1968, Mattel introduced the inexpensive and wildly popular Hot Wheels
line of toy cars. Forty years and four billion cars later, the suggested retail price
of the classic Hot Wheels car had never budged above $1 even as production
costs continued to climb, squeezing margins. Eventually, some interns working
for Mattel suggested that they double both the wholesale price and suggested
retail price of the cars.
Initially, Mattel executives balked, fearing that a price increase could dev-
astate sales. Eventually, Mattel did increase its prices slightly to test the waters
and evaluate the wisdom of price adjustments. Shortly following the move,
Mattel reported one of its most successful quarters, with revenues unchanged
from a year earlier but profits rising by 20%.1
Pricing is a powerful but oft-neglected tool. We all know that Profit 5 (P 2
AC) 3 Q, but many businesses seem to focus on Q or AC and forget about P.
Think about companies you’ve worked for—I suspect they spent most of their
time thinking about how to sell more or how to reduce costs and not much
time thinking about how to raise price. This is a mistake. According to Roger
Brinner, Chief Economist at The Parthenon Group, most companies can make
money simply by raising price.2 Theory suggests that he is correct. For a com-
pany with a pretax profit margin of 8.6% (the average for the S&P 500, in-
cluding fixed costs), quantity would have to increase by 4% to have the same
profit effect as a 1% increase in price.
In this chapter, we consider “simple pricing,” the case of a single firm,
selling a single product, at a single price. Although this kind of pricing is rare
because most firms sell multiple products, at different prices, and in competi-
tion with rivals, it is important to understand simple pricing before moving on
to pricing in more complex settings. In addition, the simple pricing model has
become part of the business vernacular, and it is important to understand it
if you are to communicate well. In this chapter, we introduce demand curves,
show you how to use marginal analysis to choose the most profitable price.
We finish by showing how firms price in practice.
Simple Pricing6
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SECTION II • Pricing, Costs, and Profits68
6.1 Background: Consumer Values and Demand Cur ves
Let’s consider a simplified relationship between price and quantity purchased
by a single consumer, using some good, like a slice of pizza.
Suppose consumers are pretty much the same, and that they value the first
slice at $5, the second at $4, the third at $3, and so on. This is the marginal
value. Knowing the value that consumers place on each subsequent slice allows
us to construct Table 6.1, which shows the marginal value and total value for
the various quantities. For the first slice, the total and marginal values are the
same, both equal to $5. For the second slice, the marginal value is $4, while
the total value of consuming two slices is $9 5 $5 1 $4. For the third slice, the
marginal value is $3, and the total value is $12 5 $5 1 $4 1 $3, and so on.
Table 6.1
Pizza Value Table
Slices Purchased Marginal Value ($) Total Value ($)
1
2
3
4
5
5
4
3
2
1
5
9
12
14
15
The consumer uses marginal analysis to decide how much to consume
because it is an extent decision. If the marginal value of consuming another
unit is above the price, the consumer consumes another unit. For example, at a
price of $5, the consumer purchases only one slice because the second slice has
a value ($4) that is below the price.
At a price of $4, the consumer purchases two slices; at a price of $3, three
slices; at a price of $2, four slices; and at a price of $1, five slices. The con-
sumer’s decision of how much to buy at each price is a demand curve, listed in
Table 6.2.
Table 6.2
Pizza Demand Schedule
Slice Price ($) Slices Purchased
5
4
3
2
1
1
2
3
4
5
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ChaPTEr 6 • Simple Pricing 69
A demand curve tells you how much consumers will purchase at a given
price.
It is easy to see from Table 6.2 that the consumer purchases more as price
falls, which is called the first law of demand. This makes intuitive sense. Con-
sider the value you, a hungry consumer, receive from the first slice of pizza—it
is likely to be substantial. The additional value you receive from eating the sec-
ond slice is a bit less, and by the time you have eaten four slices, the additional
value of the fifth is fairly small. The marginal, or additional, value of consum-
ing each subsequent slice diminishes the more you consume.
In Table 6.3, we show how much surplus consumers get at each price. At
a price of $5, there is no surplus as the consumer pays a price exactly equal to
his total value. But as price declines, consumer surplus, the difference between
total value and amount paid, increases. Note that the additional value of
consuming the last slice is only $1.
Table 6.3
Pizza Consumer Surplus
Price ($) Slices Purchased Total Amount Paid ($) Total Value ($) Surplus ($)
5
4
3
2
1
1
2
3
4
5
5
8
9
8
5
5
9
12
14
15
0
1
3
6
10
To describe the buying behavior of a group of consumers, we add up all
the individual demand curves to get an aggregate demand curve. The simplest
way to show this is to consider the case where each consumer wants only a
single item (i.e., the marginal value of a second unit is zero). To construct a
demand curve that describes the behavior of seven buyers, we simply arrange
the buyers by what they are willing to pay (e.g., $7, $6, $5, $4, $3, $2, and
$1). At a price of $7, one buyer will purchase;3 at a price of $6, two buyers
will purchase; at $5, three buyers; and so on. At a price of $1, all seven
buyers will purchase the good. An aggregate or market demand curve is the
relationship between the price and the number of purchases made by this
group of consumers. In Figure 6.1, we plot this demand curve.
Note that price—the independent variable—is on the “wrong” axis.
There are good reasons for this that will become apparent, but for now, just
accept that economists like to do things a little differently. Note also that
economists have special jargon describing the response of demand to price.
We say that as price decreases, “quantity demanded” increases. If something
other than price causes an increase in demand, we instead say that the
“demand shifts” to the right, or “demand increases,” such that consumers
purchase more at the same price. We’ll discuss factors that shift demand in a
later chapter.
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SECTION II • Pricing, Costs, and Profits70
To determine the quantity demanded at each price using the demand
curve, look for the quantity on the horizontal axis corresponding to a price on
the vertical axis. At a price of $6, buyers demand two units; at a price of $5,
three units; and so on. As price falls, quantity demanded increases.
6.2 Marginal Analysis of Pricing
Demand curves present sellers with a dilemma. Sellers can raise price and sell
fewer units, but earn more on each unit sold. Or they can reduce price and sell
more, but earn less on each unit sold. This trade-off is at the heart of pricing
decisions.
We use demand curves to change the pricing decision (“what price
should I charge”) into a quantity decision (“how much should I sell?”)
that we already know how to solve. If marginal revenue (MR) is greater
than marginal cost (MC), 4 sell more, and you do this by reducing
price. Reduce price (sell more) if MR . MC. Increase price (sell less) if
MR , MC.
To see how to use marginal analysis to increase profit, examine Table 6.4.
The columns list the Price, Quantity, Revenue, MR, MC, and total Profit for
a simple demand curve. Suppose that the product costs $1.50 to make. At
a price of $7, one consumer would purchase, so revenue would be $7. Cost
would be $1.50, so profit on the first sale would be $5.50.
FIgurE 6.1 Demand Curve
$0.00
$2.00
$4.00
$6.00
$8.00
0 2 4 6 8
Quantity
P
ri
ce
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ChaPTEr 6 • Simple Pricing 71
Table 6.4
Optimal Price
Price ($) Quantity Revenue ($) MR ($) MC ($) Profit ($)
7 1 7 7 1.50 5.50
6 2 12 5 1.50 9.00
5 3 15 3 1.50 10.50
4 4 16 1 1.50 10.00
3 5 15 21 1.50 7.50
2 6 12 23 1.50 3.00
1 7 7 25 1.50 23.50
If we sell a second unit, we have to reduce price to $6, and revenue
increases from $7 to $12. We say that the MR of the second unit is $5. This is
bigger than the MC of the second unit, so it pays to sell the second unit. In the
last column, we see that profit increases from $5.50 to $9.00.
If we sell a third unit, we have to reduce price to $5, and revenue increases
from $12 to $15. The MR of the third unit is $3, which is bigger than the MC
of the third unit, so it pays to sell the third unit. In the last column, we see that
profit increases from $9.00 to $10.50.
So far, all these changes have been profitable because MR has been greater
than the MC. We earned $5.50 on the first unit, $3.50 on the second unit, and
$1.50 on the third unit. These marginal profits sum to a total profit of $10.50,
as indicated in the last column of Table 6.4.
However, if we sell a fourth unit, total profit decreases because the MR is
only $1, which is less than the $1.50 MC. Selling three units, at a price of $5 is
“optimal” because it makes the most profit.
After going through your analysis to compute the optimal price, suppose
your boss looks at you and says, “This is the stupidest thing I’ve ever seen!
Since the price is $5, and the cost of producing another good is only $1.50,
we’re leaving money on the table.” What do you tell her?
Your boss has confused average revenue or price with marginal
revenue. They’re easy to confuse. Here’s why. As long as price is greater
than average cost, it appears that an increase in quantity would increase
profit.5 However, this reasoning is incorrect because you cannot sell more
without reducing the price on all goods, and not just on the extra units
your boss wants to sell.
Tell your boss that you are already making all profitable sales—those for
which MR exceeds MC. Marginal analysis, not average analysis, tells you
where to price or, equivalently, how many units to sell.
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SECTION II • Pricing, Costs, and Profits72
6.3 Price Elasticity and Marginal Revenue
Unfortunately, you’re never going to see a demand curve like the one in
Figure 6.1. In general, it is very difficult to get information about demand at
prices away from the current price. In fact, if anyone—particularly an eco-
nomic consultant—ever tries to show you a complete demand curve, don’t
trust it; the consultant probably has only a very rough estimate as to what
demand looks like away from current prices.
At this point you may be shaking your head and wondering why you have
to learn about things you will never see. Table 6.4 shows us that we don’t need
the entire demand curve to know how to price—all we need is information on
MR and MC. If MR . MC, reduce price; if MR , MC, increase price. As we
saw earlier, marginal analysis points you in the right direction, but it doesn’t
tell you how far to go. You get to the best price by taking steps and then by
re-computing MR and MC to see whether you should take another step.
So how do we estimate MR? The answer involves measuring quantity
responses to past price changes, essentially “experimenting” with price
changes, or surveying potential consumers to see how much they would buy
in response to a price change. If you do get useful information about demand
away from the current price, it’s likely to be about the price elasticity of de-
mand, which we denote by e.
e 5 %DQuantity Demanded 4 %DPrice
where %D means “percentage change in.” Price elasticity measures how sen-
sitive demand is to a change in price. A demand curve for which quantity
changes more than price is said to be elastic, or sensitive to price; and a de-
mand curve for which quantity changes less than price is said to be inelastic,
or insensitive to price.
If |e| . 1, demand is elastic; if |e| , 1, demand is inelastic.
Since price and quantity move in opposite directions—as price goes up,
quantity goes down, and vice versa—price elasticity is always negative (the
first law of demand requires it); that is, e , 0. Because it is negative, many
people will just drop the negative sign. To avoid confusion, we will usually
refer to elasticity using its absolute value, denoted by |e|.
To show how to estimate elasticity, consider this 1999 “experiment” at
MidSouth, a medium-sized retail grocery store. The store’s managers decreased
the price of three-liter Coke (diet, caffeine-free, and classic) from $1.79 to
$1.50 because they wanted to match a price offered at a nearby Walmart. In
response to the price drop, the quantity sold doubled, from 210 to 420 units
per week.
To compute elasticity, simply take the percentage quantity increase and
divide it by the percentage price decrease. Some confusion inevitably occurs
because we can compute percentage changes in several different ways, depend-
ing on whether we divide the changes by their initial or final values. Usually,
the best estimate comes from dividing by the midpoint of price (P
1
1 P
2
)/2 and
the midpoint of quantity (Q
1
1 Q
2
)/2.6
06665_ch06_ptg01_065-082.indd 72 8/9/17 8:21 PM
Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

ChaPTEr 6 • Simple Pricing 73
e 5 [(Q
1
2 Q
2
) 4 (Q
1
1 Q
2
)] 4 [(P
1
2 P
2
) 4 (P
1
1 P
2
)]
In the three-liter Coke example, the calculation works like this:
23.8 5 [(210

2 420) 4 (210

1 420)] 4 [(1.79 2 1.50) 4 (1.79 1 1.50)]
In this case, the estimated price elasticity is 23.8, indicating an elastic
demand, where a 1% decrease in price of three-liter Coke leads to a 3.8%
increase in quantity.7 The change in revenue associated with the change is
($1.50

3 420) 2 ($1.79

3 210) 5 $630 2 $375.90 5 $254.10
This experiment illustrates the relationship between elasticity and revenue,
for an elastic demand, a decrease in price leads to an increase in revenue.
In general, we can express the revenue change as the sum of quantity and price
changes:8
%DRevenue < %DQuantity 1 %DPrice If quantity increases by more than price decreases (which it does for elastic demand), then revenue increases, and vice versa. The results in Tables 6.5 and 6.6 summarize the relationship. Table 6.5 For Elastic Demand Price increase S Revenue decrease Price decrease S Revenue increase Table 6.6 For Inelastic Demand Price increase S Revenue increase Price decrease S Revenue decrease To illustrate the relationship between price, revenue, and elasticity, let’s look at former mayor Marion Barry’s tax increase on gasoline sales in the District of Columbia (DC). Before the tax was put into law, DC gas station owners argued against it, predicting that the 6% price increase would reduce quantity by 40%. Essentially, gas station owners were arguing that the price elasticity of demand for gasoline sold in the District was 26.7 5 40% 4 6%. Because of this very elastic demand, the gas station owners predicted that a tax increase would cause gasoline revenue, and the taxes collected out of rev- enue, to decline. In fact, after the tax was levied, quantity fell by 38%, very close to what gas station owners had predicted. More importantly, tax revenue fell, as would be predicted by the top row of Table 6.5. 06665_ch06_ptg01_065-082.indd 73 8/9/17 8:21 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits74 The exact numerical relationship between MR (change in revenue) and elasticity is MR 5 P(121/|e|).9 We can use this formula to express the marginal analysis rule using price elasticity and margins place of MR and MC: MR . MC implies that (P 2 MC)/P . 1/|e| This expression has an intuitive interpretation. The left side of the expres- sion is the current margin (P 2 MC) ∕ P, whereas the right side is the desired margin, which is the inverse elasticity, 1/|e|. If the current margin is greater than the desired margin, reduce price because MR . MC. Intuitively, the more elastic demand becomes (1/|e| becomes smaller), the less you can profitably raise price because you will lose too many customers. For example, after MidSouth Grocery reduced the price of three-liter Coke to $1.50, its actual margin was 2.7%, which is much less than the de- sired margin of 26%51/|3.8|. In other words, the price was much too low according to our simple model of pricing (one product, one firm, one price). Ordinarily, a profit-maximizing store manager would raise the price in such a situation. In this case, however, the managers were using three-liter Coke as a loss leader, deliberately pricing too low as a way to attract customers to the store. Why? Because they hoped that customers would spend money on other items once they got there. Our simple pricing model does not take account of the effect of a low Coke price on sales of other products. We will discuss this, and other more complex pricing strategies, in later chapters. To see how to use elasticity to set price, consider the following spreadsheet. The first two columns represent a demand curve, with price determining how much quantity is sold. In the third column, we compute the price elasticity. In the first row, at a price of $4.8, quantity is 7.0, and elasticity is 21.4. The actual margin is 0.46, and the desired margin is 0.71 5 1/(1.4). Since the actual margin is less than the desired margin, produce less, and you do this by increasing price. In the second row, price goes up to $5.0, the actual margin increases to 0.48, and the desired margin decreases to 0.59 because demand becomes more elastic. At a price of 5.2, we see that profit is maximized at $16, and the desired margin (0.5) is equal to the actual margin. At the optimal price of 6.2 and a 50% margin, it is easy to compute MC (MC 5 2.6). Price ($) Quantity Elasticity (P 2 MC)/P 1/|Elas| Profit ($) 4.8 7.0 21.4 0.46 0.71 15.50 5.0 6.6 21.7 0.48 0.59 15.88 5.2 6.2 22.0 0.50 0.50 16.00 5.4 5.7 22.3 0.52 0.43 15.88 5.6 5.2 22.7 0.54 0.37 15.52 5.8 4.7 23.1 0.55 0.32 14.96 6.0 4.2 23.5 0.57 0.29 14.22 06665_ch06_ptg01_065-082.indd 74 8/9/17 8:21 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChaPTEr 6 • Simple Pricing 75 6.4 What Makes Demand More Elastic? Given the importance of price elasticity to pricing—the more elastic is demand, the lower is the profit-maximizing price—it’s worthwhile to understand what makes demand more or less elastic. In this section, we list five factors that affect demand elasticity and optimal pricing. Products with close substitutes have more elastic demand. Consumers respond to a price increase by switching to their next-best alternative. If their next-best alternative is a very close substitute, then it doesn’t take much of a price increase to induce them to switch. This is why revenues fell when Mayor Barry raised the price of gasoline by 6%. Since DC has many commuters, they began purchasing gasoline near their homes in Virginia and Maryland, close substitutes for gasoline in DC. In a similar vein, we see that individual brands, such as Nike, have closer substitutes (other brands) than do aggregate product categories, like running shoes. This leads to our next factor. Demand for an individual brand is more elastic than industry aggregate demand. As a rough estimate, brand price elasticity is approximately equal to industry price elasticity divided by the brand share. For example, if the elasticity of demand for all running shoes is 20.4%, and the market share of Nike running shoes is 20%, price elasticity of demand for Nike running shoes is 20.4/(0.20) 5 22. Using our optimal pricing formula, this would give Nike a desired margin of 50%. If you search the Internet, you’ll find industry price elasticity estimates that you can combine with market share estimates to get an estimate of brand elasticity. And you can use this estimate to gain a general idea of whether your brand price is too high or too low. Products with many complements have less elastic demand. Individual products that are consumed as part of a larger bundle of com- plementary goods—say, computers, operating systems, and the applications that run on them—have less elastic demand. One of the reasons that iPhones have such a low price elasticity of demand (and such a high margin) is due to the number of applications (apps) that run on them. If the price of an iPhone in- creases, you are less likely to substitute to another product, due to the comple- mentary apps. Another factor affecting elasticity is time. Given more time, consumers are more responsive to price changes. They have more time to find substitutes when price goes up and more time to find new uses for a good when price goes down. This leads to our fourth factor: In the long run, demand curves become more elastic. This phenomenon could also be explained by the speed at which price information is disseminated. As time passes, information about a new price becomes more widely known, so more consumers react to the change. 06665_ch06_ptg01_065-082.indd 75 8/9/17 8:21 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits76 As an example, consider automatic teller machine (ATM) fees. In 1997, a bank in Evanston, Indiana, ran an experiment to determine the elasticity of de- mand for ATMs with respect to ATM fees. At a selected number of ATMs, the bank raised user fees from $1.50 to $2.00. When informed of the fee increase, users typically completed the current transaction (the short run) but avoided the higher-priced ATMs in the future (the long run). Our final factor relates elasticity to the price level. As price increases, con- sumers find more alternatives to the good whose price has gone up. And with more substitutes, demand becomes more elastic. As price increases, demand becomes more elastic. For example, high-fructose corn syrup (HFCS) is a caloric sweetener used in soft drinks. For this application, sugar is a perfect substitute for HFCS. However, import quotas and price supports have raised the U.S. price of sugar to about twice that of HFCS. All soft drink bottlers have switched to HFCS from sugar. Because bottlers have no close substitutes for low-priced HFCS, its demand is less elastic. But if the price of HFCS were to rise to that of sugar, sugar would become a perfect substitute for HFCS. In other words, demand for high-priced HFCS becomes very elastic as it approaches the price of sugar. As a strategy, many firms would like to make demand for their products less elastic (less sensitive to price). One way to do this is to create a brand identity that makes consumers less sensitive to price. A good example of this is Harley Davidson whose motorcycle brand has become synonymous with free- dom, individualism, and the American Way. To build and maintain the brand the firm supports user groups (H.O.G., Harley Owners’ Group) and sponsors motorcycle rallies (e.g., in Sturgis). 6.5 Forecasting Demand Using Elasticity We can also use elasticity as a forecasting tool. With an elasticity and a percent- age change in price, you can predict the corresponding change in quantity:10 %DQuantity < e(%DPrice) For example, if the price elasticity of demand is 22, and price goes up by 10%, then quantity is forecast to decrease by 20%. Remember that price is only one of many factors that affect demand. Income, prices of substitutes and complements, advertising, and tastes all affect demand. To measure the effects of these other variables on demand, we define a factor elasticity of demand: Factor elasticity of demand 5 (%DQuantity Demanded) 4 %DFactor Factors can be anything that affects demand, such as temperature, other prices, or incomes. For example, demand for bottled water, iced tea, and car- bonated soft drinks is strongly influenced by temperature. If the temperature elasticity of demand for beverages is 0.25, then a 1% increase in temperature will lead to a 0.25% increase in quantity demanded. Income elasticity of demand measures the change in demand arising from changes in income. Positive income elasticity means that the good is normal; that 06665_ch06_ptg01_065-082.indd 76 8/9/17 8:21 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChaPTEr 6 • Simple Pricing 77 is, as income increases, demand increases. Negative income elasticity means that the good is inferior; that is, as income increases, demand declines. The decreasing incomes associated with the financial crisis of 2008 provided a number of ex- amples of inferior goods. Although most retailers saw dramatic sales declines in 2008, Walmart’s sales increased. Sales of Spam, a low-priced meat product, shot up in 2008, leading Hormel to add a second shift at its Minnesota factory. Cross-price elasticity of demand for Good A with respect to the price of Good B measures the change in quantity demanded for A caused by a change in the price of B. A positive cross-price elasticity means that Good B is a sub- stitute for Good A: as the price of a substitute increases, demand increases. Negative cross-price elasticity means that Good B is a complement to Good A: as the price of a complement increases, demand decreases. Comput- ers, for example, are complements to operating systems that run on them. We can trace part of Microsoft’s initial success with its DOS operating system to its strategy of licensing DOS to competing computer manufacturers. That strategy helped keep the price of computers low, which stimulated demand for Microsoft’s operating system. We can estimate factor elasticities by using a formula analogous to the estimated price elasticity formula, and we can use factor elasticities to forecast or predict changes over time or even changes from one geographic area to another. Suppose you’re trying to compare the year-to-year performance of one of your regional salespeople over a period in which income grew by 3%. If demand for your products has an income elasticity of 2, you would expect quantity to increase by 6%. You don’t want to reward the salesperson for increases in quantity that are largely unrelated to her effort. A performance measure more closely related to effort would subtract 6% from the actual growth because that is the growth related to income, and not to sales effort. 6.6 Stay-Even Analysis, Pricing, and Elasticity Stay-even analysis is a simple two-step procedure that tells you whether a given price increase, for example, 5%, will be profitable. 1. In the first step, you compute how much quantity you can afford to lose before the price increase becomes unprofitable. This “stay-even quantity” is a simple function of the size of the price increase and the contribution margin, %DQ5%DP/(%DP 1 margin), where margin 5 (P 2 MC)/P.11 2. In the second step, you predict how much quantity will go down if you raise price by the given amount. The decision rule is simple: If the predicted quantity is less than the stay-even quantity, then the price increase will likely be profitable, and vice versa. The analysis gives you a quick answer to the question of whether changing price is profitable. It uses the same information as does the marginal analysis of Section 6.4, but it does so in a simpler, intuitive way. 06665_ch06_ptg01_065-082.indd 77 8/9/17 8:21 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits78 SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • Individual demand describes how many units an individual will purchase at a given price. • Aggregate demand, or market demand, is the total number of units that will be pur- chased by a group of consumers at a given price. • Pricing is an extent decision. Reduce price (increase quantity) if MR . MC. Increase price (reduce quantity) if MR , MC. The optimal price is where MR 5 MC. • Price elasticity of demand, e 5 (%change in quantity demanded) 4 (%change in price) 1. Estimated price elasticity 5 [(Q 1 2 Q 2 ) / (Q 1 1 Q 2 )] 4 [(P 1 2 P 2 ) / (P 1 1 P 2 )] is used to estimate demand elasticity from a price and quantity change. 2. If |e| . 1, demand is elastic; if |e| , 1, demand is inelastic. To illustrate, let’s go back to the Mattel’s pricing question from the beginning of this chapter: should they double the price of their Hot Wheels cars? Imagine that it costs Mattel $0.50 to manufacture, package, and distribute a car, which it currently sells to retailers for $0.75. If Mattel were to double the wholesale price to $1.50, the margin would increase fourfold from $0.25 to $1.00. This means that Mattel could lose three-fourths of its customers and still earn the same profit that it earned prior to the price increase. Thus, Mattel’s stay-even quantity for a 100% increase in price is a 75% decrease in quantity. Since quantity fell by much less than 75%, the price increase was profitable. 6.7 Cost-Based Pricing Our expressions for optimal pricing, MR5MC or (P2MC)/P51/|elasticity| use information about consumer demand and a firm’s cost structure to find the optimal price. Yet, many companies set prices based only on costs, ignoring demand entirely. For example, cost-plus pricing arrives at a price by adding a fixed dollar margin to the cost of each product, while mark-up pricing multiplies the cost by a fixed number greater than 1. It doesn’t take much analysis to see that ignoring consumer demand leads to suboptimal pricing—just imagine cost- based pricing applied to diamonds, wine, movie tickets, or bottled water. Without comparing costs to demand, we cannot know if goods are priced optimally. To understand why cost-based pricing persists, we apply the second question in our problem-solving paradigm: does the decision maker have enough information to make a good decision? In one survey of managers, most reported that they are well informed about their own costs, but less than half reported being well informed about demand.12 Part of the reason for this is historical accident. Tax compliance required firms to have cost accountants, and since these cost data were there anyway, pricing managers used them. A firm that takes its profitability (and pricing) seriously needs a “demand accounting” (market research) division, too. 06665_ch06_ptg01_065-082.indd 78 8/9/17 8:21 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChaPTEr 6 • Simple Pricing 79 • %DRevenue < %DPrice 1 %DQuantity • Elastic demand (|e| . l): Quantity changes more than price. DRevenue Price c Price T 2 1 • Inelastic demand (|e| , 1): Quantity changes less than price. DRevenue Price T Price c 2 1 • MR . MC implies that (P 2 MC) / P . l/|e|; that is, the more elastic is demand, the lower the optimal price. • Five factors affect elasticity: 1. Products with close substitutes have more elastic demand. 2. Products with many complements have less elastic demand. 3. Demand for brands is more elastic than industry demand. 4. In the long run, demand becomes more elastic. 5. As price increases, demand becomes more elastic. • Income elasticity, cross-price elasticity, and advertising elasticity are measures of how changes in these other factors affect demand. • It is possible to use elasticity to forecast changes in demand: %DQuantity 5 (Factor elasticity)(%DFactor). • Stay-even analysis can be used to determine the quantity change required to offset a price change. The stay-even quantity is %DQ 5 %DP/(%DP 1 margin). A proposed price increase is profitable if the predicted quantity loss is less than the stay- even quantity. Multiple-Choice Questions 1. Jim has estimated elasticity of demand for gasoline to be 20.7 in the short run and 21.8 in the long run. A decrease in taxes on gasoline would a. lower tax revenue in both the short and long run. b. raise tax revenue in both the short and long run. c. raise tax revenue in the short run but lower tax revenue in the long run. d. lower tax revenue in the short run but raise tax revenue in the long run. 2. Its lunch time, you are hungry and would like to have some pizza. By the law of diminishing marginal value, a. you would pay more for your first slice of pizza than your second. b. you would pay more for your second slice of pizza than your first. c. you would pay an equal amount of money for both the slices since they are identical. d. none of the above. 3. Jim recently graduated from college. His income increased tremendously from $5,000 a year to $60,000 a year. Jim decided that instead of renting he will buy a house. This implies that a. houses are normal goods for Jim. b. houses are inferior goods for Jim. c. renting and owning are complementary for Jim. d. need information on the price of houses. 4. Which of the following goods has a negative income elasticity of demand? a. Cars b. Items from Dollar stores c. Shoes d. Bread 06665_ch06_ptg01_065-082.indd 79 8/9/17 8:21 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits80 5. An economist estimated the cross-price elasticity for peanut butter and jelly to be 1.5. Based on this information, we know the goods are a. inferior goods. b. complements. c. inelastic. d. substitutes. 6. Christine has purchased five bananas and is considering the purchase of a sixth. It is likely she will purchase the sixth banana if a. the marginal value she gets from the sixth banana is lower than its price. b. the marginal benefit of the sixth banana exceeds the price. c. the average value of the sixth banana exceeds the price. d. the total personal value of six bananas exceeds the total expenditure to purchase six bananas. 7. Buyers consider Marlboro cigarettes and Budweiser beer to be complements. If Marlboro just increased its prices, what would you expect to occur in the Budweiser market? a. Demand would rise, and Budweiser would reduce price. b. Demand would fall, and Budweiser would reduce price. c. Demand would fall, and Budweiser would increase price. d. Demand would rise, and Budweiser would increase supply. 8. Which of the following is the reason for the existence of consumer surplus? a. Consumers can purchase goods that they “want” in addition to what they “need.” b. Consumers can occasionally purchase products for less than their production cost. c. Some consumers receive temporary discounts that result in below-market prices. d. Some consumers are willing to pay more than the price. 9. A bakery currently sells chocolate chip cookies at a price of $16/dozen. The MC is $8/dozen. The cookies are becoming more popular with customers, and so the bakery owner is considering raising the price to $20/dozen. What percentage of customers must be retained to ensure that the price increase is profitable? a. 28.0% b. 33.3% c. 66.6% d. 72.0% 10. Suppose your firm adopts a technology that allows you to increase your output by 15%. If the elasticity of demand is 23, how should you adjust price if you want to sell all of your output? a. 5% lower b. 0.5% lower c. 15% higher d. 15% lower Individual Problems 6-1 Elasticity of T-shirt Sales George has been selling 5,000 T-shirts per month for $8.50. When he increased the price to $9.50, he sold only 4,000 T-shirts. What is the demand elasticity? If his MC is $4 per shirt, what is his desired markup and what is his initial actual markup? Was raising the price profitable? 6-2 Increasing Movie Ticket Prices To conduct an experiment, AMC increased movie ticket prices from $9.00 to $10.00 and measured the change in ticket sales. Using the data over the following month, they concluded that the increase was profitable. However, over the subsequent months, they changed their minds and discontinued the experiment. How did the timing affect their conclusion about the profitability of increasing prices? 6-3 Promotional Pricing An end-of-aisle price promotion changes the price elasticity of a good from 22 to 23. 06665_ch06_ptg01_065-082.indd 80 8/9/17 8:21 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChaPTEr 6 • Simple Pricing 81 If the normal price is $10, what should the promotional price be? 6-4 Bar Nuts Why do bars offer free peanuts? Group Problems G6-1 Pricing Describe a pricing decision your company has made. Was it optimal? If not, why not? How would you adjust price? Compute the profit consequences of the change. 1. Matt Townsend, “Mattel Surges Most Since 2009 as Prices Fuel Profit,” Bloomberg, July 17, 2012, www.bloomberg.com/ news/2012-07-17/mattel-surges-most-since- 2009-as-prices-fuel-profit.html. 2. See Roger Brinner, “Pricing: The Neglected Orphan,” Parthenon Perspectives. 3. Don’t get distracted by the fact that at a price of $6, the buyer is being charged a price exactly equal to his or her value and is thus earning no surplus. At a price of $6, the buyer is exactly indifferent between buying and not buying. This is a result of using whole numbers to describe prices and values. For convenience, imagine that the value is a fraction above the price, so that the buyer will purchase. 4. Marginal profit 5 MR 2 MC and is the extra profit from selling one more unit. 5. Profit 5 Revenue 2 Cost 5 Q*(P 2 AC), where AC is average cost. 6. In computing the midpoints, we use the formulas (Q 1 1Q 2 )/2 and (P 1 1 P 2 )/2. Since 2 divides both denominator and numerator, the formula simplifies, as here. 7. Note that if we used the initial price and quantity to compute the percentage changes, the calculation would be [(210 2 420) ∕ 210] ∕ [($1.79 2 $1.50) ∕ $1.79] or 2 100% / 16.2%; that is, 2 6.2. 8. This is a first-order approximation and will work well for small changes. The approximation does not work well for large changes. 9. MR 5 DRevenue/DQ 5 D(PQ)/DQ 5 (DPQ 1 DQP)/DQ 5 P(1 2 1/|e|). The symbol D means “change in.” 10. This is a first-order approximation and will work well for small changes. The approximation does not work well for large changes. 11. This is just one of many equivalent formulas. The important thing to note is that any stay-even formula ensures that the profit before and after the price change is the same. 12. Robert J. Doan and Hermann Simon, Power Pricing (New York: Simon & Schuster, 1996). END NOTES 06665_ch06_ptg01_065-082.indd 81 8/9/17 8:21 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 06665_ch06_ptg01_065-082.indd 82 8/9/17 8:21 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 83 7 In 1906, three entrepreneurs launched the French Battery Company in Madison, Wisconsin. The company’s early growth was driven by the demand for radio batteries, and its most successful product was the Ray-O-Vac bat- tery, leading the firm to change its name to Rayovac in 1930. Over the next 60 years, it grew to become one of the top three battery producers in the United States along with Duracell and Energizer. In 1996, the company was acquired by the Thomas H. Lee Company, a Boston-based private equity firm. After making an initial public offering the fol- lowing year, the company took advantage of easy credit availability to expand via acquisition. It purchased battery manufacturers such as BRISCO GmbH, ROV Limited, VARTA AG, Direct Power Plus, and Ningbo Baowang in order to take advantage of “efficiencies and economies of scale.” Company managers ex- pected that as they produced more of the same good, average costs would fall. In 2003, Rayovac purchased Remington Products (electric razors); in 2005, it purchased United Industries Corporation (lawn and garden care, household insect control, and pet supplies) and Tetra Holding GmbH, a Ger- man supplier of fish and aquatic supplies. To reflect its position as a provider of a broad portfolio of products, the company changed its name to Spectrum Brands in 2005. Managers often justified the company’s expansions into these new areas with claims of cost savings. For example, as part of its acquisition of United Industries, Spectrum’s managers anticipated “that there would be synergies, better performance, and all that.” As is often the case, it is much eas- ier to describe synergies than it is to capture them, and although it’s not clear whether this was the case for Spectrum, the company declared bankruptcy in 2009.1 Since emerging from bankruptcy, Spectrum has delivered impressive performance, and it has continued to pursue synergies via acquisitions of busi- nesses like the Hardware & Home Improvement Group of Stanley Black & Decker in 2012 and Armored AutoGroup in 2015. In this chapter, we examine the two types of synergies described in the above story, economies of scale and scope, and show you how to exploit them. Economies of Scale and Scope 06665_ch07_ptg01_083-094.indd 83 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits84 This is especially important if your company is following a cost leadership strategy, but managers should always be looking for ways to cut costs, regard- less of whether it is the company’s primary strategy. A reduction in average cost translates to an immediate increase in profit (recall that Profit 5 (Price 2 Average Cost)*Quantity). If marginal cost (MC) goes down as well, you get an “extra” increase in profit from the increase in output; remember that if MC falls below marginal revenue (MR), it becomes profitable to increase output. Many business decisions, like break-even analysis, can be made using very simple characterizations of cost (like a fixed cost plus a constant per-unit cost). With economies of scale or scope, however, decision making may require more complex (and realistic) cost functions. In this section, we will examine decision making in the presence of economies of scale and scope. 7.1 Increasing Marginal Cost Most firms will eventually face increasing average costs as they try to increase output. The firm finds that each extra unit of output requires more inputs to produce than previous units, an outcome described as the law of diminishing marginal returns. The law of diminishing marginal returns states that as you try to expand output, your marginal productivity (the extra output associated with ex- tra inputs) eventually declines. Diminishing marginal returns occur for a variety of reasons, among them are the difficulty of monitoring and motivating larger workforces, the increas- ing complexity of larger systems, or the fixed nature of some factors. In pop- ular jargon, these are known as “bottlenecks.” Bottlenecks often arise when more workers, or any variable input, must share a fixed amount of a comple- mentary input. When productivity falls from bottlenecks, costs increase. Diminishing marginal productivity implies increasing marginal cost. If more inputs are needed to produce each extra unit of output, then the cost of producing these extra units—the marginal cost—must increase. And once the marginal cost rises above the average cost, the average will rise as well. Say, for example, the average cost to produce the first 100 units of a product is $50 per unit. If the marginal cost of the 101st unit is more than $50, overall average cost will increase. Increasing marginal costs eventually lead to increasing average costs. Just as a baseball player’s season batting average will rise if his game bat- ting average is above his season batting average, so too does average cost rise if marginal cost is above the average. In Figure 7.1, the rising average cost of production implies that marginal cost is above average cost. In the presence of fixed costs, increasing marginal cost gives you a U-shaped average cost curve (shown in Figure 7.2). The curve initially falls due to the presence of fixed costs, but then it rises due to increasing marginal costs. 06665_ch07_ptg01_083-094.indd 84 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 7 • economies of Scale and Scope 85 Knowing what your average costs look like will help you make better decisions. Here’s a famous example. In 1955, Akio Morita brought his newly invented $29.95 transistor radio to New York. He shopped it around, and after turning down an original equipment manufacturer (OEM) deal from Bulova, he eventually found a retailer that would sell it under his “Sony” brand name. The problem was that the retailer had a chain of around 150 stores and wanted to buy 100,000 radios, 10 times more than Mr. Morita’s capacity. Mr. Morita turned the offer down. He knew that he would lose money pro- ducing 100,000 units because increasing output would require hiring and training more workers and an expansion of facilities, raising his average cost or break-even price. After being turned down, the retailer agreed to settle for 10,000 units at the lowest unit price, and the rest is history. The Sony brand radios became C o st Output Marginal Cost Area of Increasing Marginal Costs (diminishing marginal returns) C o st Output Marginal Cost Average Total Cost Figure 7.2 U-Shaped Average Cost Curve Figure 7.1 Diminishing Marginal Returns 06665_ch07_ptg01_083-094.indd 85 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits86 very popular, and the company evolved into the giant electronics firm it is today. The moral of the story is know what your costs look like—otherwise, you could end up making unprofitable deals. In this case, using a more realis- tic cost function, Morita was able to compute his break-even prices, allowing him to bargain effectively with the retail chain.2 7.2 Economies of Scale The law of diminishing marginal returns is primarily a short-run phenomenon arising from the fixity of at least one factor of production, like capital or plant size. In the long run, however, you can increase the size of the plant, hire more workers, buy more machines, and remove production bottlenecks. In other words, your “fixed” costs become “variable” in the long run. If long-run average costs are constant with respect to output, then you have constant returns to scale. If long-run average costs rise with output, you have decreasing returns to scale or diseconomies of scale. If long-run average costs fall with output, you have increasing returns to scale or economies of scale. Economies of scale can result from a variety of areas. Larger firms can benefit more from capital equipment like machinery: average costs decrease as volume increases and fixed costs are unchanged. Larger firms may also benefit from purchasing economies if they receive discounts for buying in larger quan- tities. Average costs associated with shared administrative services can also fall as output increases. Economies of scale have had a dramatic effect on the structure of the poultry industry in the United States.3 In 1967, a total of 2.6 billion chickens and turkeys were processed in the United States. By 1992, that number had in- creased to nearly seven billion. Despite this large increase, the number of pro- cessing facilities dropped from 215 to 174. The share of shipments of plants with over 400 employees grew from 29% to 88% for chicken production and from 16% to 83% for turkey production over the same period. The shift in the structure of the industry was due largely to changes in technology, which reduced costs of processing poultry in larger plants. Taking advantage of economies of scale is also critical in ocean shipping. The Maersk McKinney Moller entered service in July of 2013 with the larg- est cargo capacity of any container ship in the world. The ship is over 1,300 feet long and has a cargo capacity of over 18,000 TEU containers (TEU is the acronym for a 20-foot equivalent unit, which is a stackable, 20-foot-long cargo container.) The enormous size of the ship reflects the value of economies of scale in this industry. On a standard shipping route, the daily operating expenses (in dollars per TEU) for a 2,000 TEU capacity ship are about $20. Increasing the capacity of that ship to 14,000 TEU, however, cuts the daily operating expenses per TEU to just over $12.4 06665_ch07_ptg01_083-094.indd 86 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 7 • economies of Scale and Scope 87 It is important to realize, however, that the same factors (i.e., the fixity of some input) that cause diminishing marginal returns in the short run can also cause decreasing returns to scale in the long run. Often, the managerial structure of the company does not scale beyond a certain point. Management is an important input into the production processes. As the company grows, so do the problems of coordination, control, and monitoring. Managers often behave as if they have a fixed amount of decision-making capability, so giving them more decisions often leads to managerial bottlenecks that raise costs. Knowing whether your long-run costs exhibit constant, decreasing, or in- creasing returns to scale can help you make better long-run decisions. If your long-run costs exhibit increasing returns to scale, securing big orders allows you to reduce average costs. 7.3 Learning Cur ves Learning curves are characteristic of many processes. As you produce more, you learn from the experience, and this experience helps you produce future units at a lower cost. Learning curves mean that current production lowers future costs, which has important strategic consequences. Here the maxim “Look ahead and reason back” is particularly important. For example, every time an airplane manufacturer doubles production, marginal cost decreases by 20%. If the first plane costs $100 million, then the second will cost $80 million, the fourth will cost $64 million, the eighth will cost $51.2 million, and so on. In Table 7.1, we illustrate such a learning curve. Note that marginal cost is below average cost at all levels of production beyond the first plane, indicating economies of scale.5 TABLE 7.1 Airplane Manufacturing Costs Quantity Marginal Cost ($M) Total Cost ($M) Average Cost ($M) 1 100.0 100.0 100.0 2 80.0 180.0 90.0 3 70.2 250.2 83.4 4 64.0 314.2 78.6 5 59.6 373.8 74.8 6 56.2 429.9 71.7 7 53.4 483.4 69.1 8 51.2 534.6 66.8 9 49.3 583.9 64.9 10 47.7 631.5 63.2 06665_ch07_ptg01_083-094.indd 87 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits88 To see how learning curves affect decision making, put yourself in American Airlines’ place during negotiations with Boeing to purchase air- planes. From Boeing’s point of view, a big order from the world’s largest air- line would allow it to “walk down its learning curve,” as shown in Figure 7.3, and reduce the costs of future production. However, American knows that its order will allow Boeing to reduce costs for future sales and wants to capture some of Boeing’s increased profit. If American knew exactly how many planes Boeing would make over the lifetime of the airplane, it could offer a price at Boeing’s average cost. For example, if Boeing expected to produce eight units, American could offer $66.8 million per plane, and Boeing would break even on the order over the lifetime of the model. But if the lifetime production is not known, then American must pursue other strategies. For example, American could ask for “kickbacks” on sales of future Boeing planes; however, this request may vio- late European or U.S. antitrust laws. Alternatively, since stock prices reflect future earnings, American could ask for a percentage of the increase in Boe- ing’s stock market value following announcement of the deal; such a request would be equivalent to buying call options to purchase Boeing stock before beginning negotiations. When Boeing’s stock value increased because of the order, the value of the call options would also increase. These strategies may violate securities laws on insider trading, so be sure to get legal advice before trying something like this. Instead, American offered to purchase planes exclusively from Boeing over the next 30 years in exchange for a very favorable price. By offering exclusiv- ity, American guaranteed Boeing a big chunk of demand that would lower 0.0 40.0 20.0 80.0 60.0 100.0 120.0 0 864 10 Quantity $ M 2 Marginal Cost ($M) Average Cost ($M) Figure 7.3 Airplane Manufacturing Learning Curve 06665_ch07_ptg01_083-094.indd 88 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 7 • economies of Scale and Scope 89 costs. Boeing was willing to give American a very good deal in exchange for such a guarantee. As a strange footnote to this story, in 1998, Boeing tried to acquire rival McDonnell-Douglas. The European Commission antitrust authority objected because Boeing’s large European competitor, Airbus, objected to the long-term exclusive contracts as anticompetitive. Airbus claimed Boeing’s exclusive con- tracts prevented it from competing for American’s business. To complete its purchase of McDonnell-Douglas, Boeing agreed not to enforce its exclusive contracts with American, leaving American free to purchase from Airbus if it so chose. 7.4 Economies of Scope Gibson Guitar traditionally used rosewood for fingerboards on its less expensive Epiphone guitars and reserved ebony for its high-end Gibson brand. Both rosewood and ebony are excellent tone woods, but ebony is preferred for its distinct sound and pure black appearance. A significant number of ebony fingerboard blanks are rejected for use on the Gibson brand guitars because carving of the fingerboard reveals brown streaks in the otherwise pure black wood. The percentage of fingerboards rejected has increased steadily over the past 10 years as the world supply of streak-free ebony has shrunk. Gibson Guitar began installing these streaked blanks on its lower-end instruments. The buyers perceive the streaked ebony fingerboard as an upgrade over rosewood. Its ability to use discarded ebony in its Epiphone guitars gives Gibson both a cost and quality advantage over rivals that produce only high- end or only low-end instruments. In this case, we say there are economies of scope between production of high-end and low-end guitars. If the cost of producing two products jointly is less than the cost of pro- ducing those two products separately—that is, Cost(Q 1 , Q 2 ) , Cost(Q 1 ) 1 Cost(Q 2 ) —then there are economies of scope between the two products. Obviously, you want to exploit economies of scope by producing both Q 1 and Q 2 . This is a major cause of mergers. For example, about eight years ago, we saw a consolidation in the food distribution business. Companies like Kraft, Sara Lee, and ConAgra sell a variety of meat products, hot dogs, sau- sage, and lunchmeats because they can derive economies of scope by distribut- ing these products together. Once you set up a distribution network, you can easily pump more products through the network without incurring additional costs. These low costs put pressure on their competitors, in particular, a regional breakfast sausage manufacturer in 1997. This manufacturer used 18 trucks and a single distribution center that served retail customers located in 21 southern and Midwestern states. Unfortunately, the demand for breakfast sau- sage is seasonal, with a peak in November and December. During the heavy 06665_ch07_ptg01_083-094.indd 89 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits90 winter months, the manufacturer had to pay outside carriers a premium to handle excess product, but for the other eight months, half of its trucking fleet sat idle. Because the firm sold only a single product—breakfast sausage—it could not exploit the scope economies associated with distributing a full product line. The manufacturer had several choices. It could have acquired other com- panies to have a full product line to distribute. It could have sold out to one of the larger, full-line companies, like ConAgra. Such a company could exploit the scope economies associated with distribution, thus placing a higher value on the firm. Or it could have outsourced its distribution function. Several regional and nationwide distribution companies distribute a variety of food products, and these companies could take advantage of scope economies by distributing a full portfolio of meat products. Our sausage maker eventually decided to outsource its distribution. How- ever, after it sold its trucking fleet, it was held up by the distributor. Outsourc- ing was a good idea, but poorly executed. 7.5 Diseconomies of Scope Production can also exhibit diseconomies of scope if the cost of producing two products together is higher than the cost of producing them separately. In this case, you reduce costs by paring down the product line. AnimalSnax Inc. makes pet food on extruder lines in 23 plants. This manufacturer has a variety of customers, from large retailers like Walmart to small mom-and- pop pet stores. Currently, the firm produces 2,500 different products, or stock-keeping units (SKUs), using 200 different formulas. All customers pay about the same price per ton. Recently, however, some of the large customers have demanded price concessions. These requests worry the firm because of the so-called 80–20 rule: accord- ing to this rule of thumb, 80% of a firm’s profit comes from around 20% of its customers. Because big customers (the 20%) order in bulk, the manufac- turer can set up its extruders for long production runs. These big orders are much more profitable than smaller orders because all orders require the same setup time regardless of the amount produced and packaged. To reduce the costs associated with smaller orders, AnimalSnax reduced the variety of its product offerings to 70 SKUs, using only 13 different formu- las. The firm also began offering price discounts for larger orders. Although some smaller customers were upset about being forced to use new formulas, most were willing to switch. This allowed the company to consolidate small orders into large ones to reduce setup costs. Typical savings for one extruder line are illustrated in Figure 7.4. Under the new approach, the same amount of pet food that had been produced in one eight-hour shift could now be produced in just six hours. This dramatic increase in productivity (25%) also allowed the company to close several of its 23 plants. 06665_ch07_ptg01_083-094.indd 90 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 7 • economies of Scale and Scope 91 H o u rs U se d Product Mix Old 10 8 6 4 2 0 New Run Time Setup Time Figure 7.4 Pet Food Extruder Line Operation Times SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • The law of diminishing marginal returns states that as you increase output, your marginal productivity (the extra output associated with extra inputs) eventually declines. • Increasing marginal costs eventually cause increasing average costs and make it more difficult to compute break-even prices. When negotiating contracts, it is important to know what your cost curves look like; otherwise, you could agree to unprofitable deals. • If average cost falls with output, then you have increasing returns to scale. In this case you want to focus your strategy on securing sales that enable you to realize lower costs. Alternatively, if you offer suppliers big orders that allow them to realize economies of scale, try to share in their profit by demanding lower prices. • If your average costs are constant with respect to output, then you have constant returns to scale. If average costs rise with output, you have decreasing returns to scale or diseconomies of scale. • Learning curves mean that current produc- tion lowers future costs. It’s important to look over the life cycle of a product when working with products characterized by learning curves. • If the cost of producing two outputs jointly is less than the cost of producing them separately—that is, Cost(Q 1 , Q 2 ) , Cost(Q 1 ) 1 Cost(Q 2 ) —then there are economies of scope between the two products. This can be an important source of competitive advantage and can shape acquisition strategy. Multiple-Choice Questions 1. Microsoft found that instead of producing a DVD player and a gaming system separately, it is cheaper to incorporate DVD playing capabilities in its new version of the gaming system. Microsoft is taking advantage of a. economies of scale. b. learning curve. c. economies of scope. d. decreasing marginal costs. 06665_ch07_ptg01_083-094.indd 91 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits92 2. As a golf club production company pro- duces more clubs, the average total cost of each club produced decreases. This is because a. total fixed costs are decreasing as more clubs are produced. b. average variable cost is decreasing as more clubs are produced. c. there are scale economies. d. total variable cost is decreasing as more clubs are produced. 3. Average costs curves initially fall a. due to declining average fixed costs. b. due to rising average fixed costs. c. due to declining accounting costs. d. due to rising marginal costs. 4. What might you reasonably expect of an industry in which firms tend to have econ- omies of scale? a. Exceptional competition among firms b. A large number of firms c. Highly diversified firms d. A small number of firms 5. A security system company’s total produc- tion costs depend on the number of sys- tems produced according to the following equation: Total Costs 5 $20,000,000 1 $4,000* quantityproduced. Given these data, which of the following is a false statement? a. There are economies of scale. b. There are fixed costs associated with this business. c. There are diseconomies of scale. d. A firm that produces a larger output has a cost advantage over a smaller firm. 6. Following are the costs to produce Prod- uct A, Product B, and Products A and B together. Which of the following exhibits economies of scope? a. 100, 150, 240 b. 100, 150, 250 c. 100, 150, 260 d. All of the above 7. According to the law of diminishing mar- ginal returns, marginal returns a. diminish always prior to increasing. b. diminish constantly. c. diminish never. d. diminish eventually. 8. It costs a firm $90 per unit to produce product A and $70 per unit to produce product B individually. If the firm can produce both products together at $175 per unit of products A and B, this exhibits signs of a. economies of scale. b. economies of scope. c. diseconomies of scale. d. diseconomies of scope. 9. A company faces the following costs at the respective production levels in addition to its fixed costs of $50,000: Quantity Marginal Cost ($) Sale Price ($) Marginal Return ($) 1 10,000 20,000 10,000 2 11,000 20,000 9,000 3 12,000 20,000 8,000 4 13,000 20,000 7,000 5 14,000 20,000 6,000 10. How would you describe the returns to scale for this company? a. Increasing b. Decreasing c. Constant d. Marginal 11. Once marginal cost rises above the average cost, a. average costs will increase. b. average costs are unaffected. c. average costs will decrease. d. none of the above. 06665_ch07_ptg01_083-094.indd 92 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 7 • economies of Scale and Scope 93 Individual Problems 7.1 Scale and Scope What is the difference between economies of scale and economies of scope? 7.2 Brand Extensions Suppose Nike’s managers were considering expanding into producing sports beverages. Why might the company decide to do this under the Nike brand name? 7.3 Rangers’ T-Shirts The variety of Riverside Ranger logo T-shirts includes 12 different designs. Setup between designs takes one hour (and $18,000), and, after setting up, you can produce 1,000 units of a particular design per hour (at a cost of $8,000). Does this production exhibit scale economies or scope economies? 7.4 Average and Marginal Costs Describe the change in average costs and the relationship between marginal and average costs under the following three conditions as quantities produced increase: Average Cost Marginal Cost versus Average Cost Constant returns to scale Rising Falling Flat Higher Lower Equal Decreasing returns to scale Rising Falling Flat Higher Lower Equal Increasing returns to scale Rising Falling Flat Higher Lower Equal 7.5 Learning Curves Suppose you have a production technology that can be characterized by a learning curve. Every time you increase production by one unit, your costs decrease by $6. The first unit costs you $64 to produce. If you receive a request for pro- posal (RFP) on a project for four units, what is your break-even price? Suppose that if you get the contract, you estimate that you can win another project for two more units. Now what is your break-even price for those two units? 7.6 Multiconcept Restaurants Are a Growing Trend A multiconcept restaurant incorporates two or more restaurants, typically chains, under one roof. Sharing facilities reduces costs of both real estate and labor. The multiconcept restaurants typically offer a limited menu, compared with full-sized, stand-alone restaurants. For example, KMAC operates a combination Kentucky Fried Chicken (KFC)/Taco Bell restaurant. The food preparation areas are separate, but orders are taken at shared point-of-sale (POS) stations. If Taco Bell and KFC share facilities, they reduce fixed costs by 30%; however, sales in joint facilities are 20% lower than sales in two separate facilities. What do these numbers imply for the decision of when to open a shared facility versus two separate facilities? Group Problems G7-1 Economies of Scale Describe an activity, process, or product of your company that exhibits economies or disecono- mies of scale. Describe the source of the scale economy. How could your organization exploit the scale economy or diseconomy? Compute the profit consequences of the advice. G7-2 Learning Curves Describe an activity or process or product of your company characterized by learning curves. Describe the source of the learning curve. How could your organization exploit the learning curve? Compute the profit consequences of the advice. G7-3 Economies of Scope Describe two activities inside your organization, or one inside and one outside your organiza- tion, that exhibit economies (or diseconomies) of scope. Describe the source of the scope econ- omies. How could your organization exploit the scope economy or diseconomy? Compute the profit consequences of the advice. 06665_ch07_ptg01_083-094.indd 93 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits94 1. For more on Spectrum Brands’ difficulties, see Elizabeth Woyke and David Henry, “The Buyout Boom’s Dark Side,” Business Week, August 13, 2007. 2. Akio Morita with Edwin M. Reingold and Mitsuko Shimomura, Made in Japan: Akio Morita and Sony (New York: Penguin, 1988). 3. Michael Ollinger, James M. McDonald, and Milton Madison. “Technological Change and Economies of Scale in U.S. Poultry Pro- cessing,” American Journal of Agricultural Economics 87 (February 2005): 116–129. 4. Shipping costs from Jean-Paul Rodrigue, Claude Comtois, and Brian Slack, eds., The Geography of Transport Systems, 3rd ed. (London: Routledge, 2013). 5. Formula for marginal cost: 100*0.8^ (Log (# planes)/Log (2)). END NOTES 06665_ch07_ptg01_083-094.indd 94 8/10/17 4:55 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 95 8 In 1997, the portable electric generator industry was a mildly profitable but not particularly exciting industry. For over a decade, sales of portable electric generators had been pretty stable with average annual growth of around 2%. But all this changed dramatically as the year 2000 (Y2K) approached. Many consumers were afraid that the power grid would collapse because the computer programs that controlled it would not be able to adapt to the change from 1999 to 2000. Anticipating a big increase in demand for portable generators, managers at Akers, MacMillan, and Parlow (AMP) implemented a Y2K strategy that involved doubling production capacity. Other firms in the industry made similar investments. In 1999, demand for portable generators boomed as expected; industry shipments increased by 87%, and prices increased by 21%. But the following year was a bust. Demand fell back to 1998 levels, and prices tumbled to below the 1998 level. Industry profit dropped dramatically, along with capacity uti- lization rates. AMP’s Y2K strategy to increase production capacity turned out to be a big mistake. Along with half the firms in the industry, it declared bank- ruptcy in 2000. AMP’s managers would have benefited from a better understanding of the changes affecting its industry. In particular, everything that happened to AMP was predictable. If AMP’s managers had been able to forecast and interpret these industry-level changes, the topic of this chapter, they would have been able to survive and even prosper. In this chapter, we show you how to do this using aggregate demand and aggregate supply curves. 8.1 Which Industr y or Market? In Chapter 6, we showed you how to set a single price if you are a single firm, selling a single product, facing a group of consumers whose behavior can be described by a demand curve. This is often referred to as a “monopoly” model of pricing because it involves only a single firm. In this chapter, we show you Understanding Markets and Industry Changes 06665_ch08_ptg01_095-112.indd 95 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits96 how prices are determined in an industry where many sellers and many buyers come together in a “market” setting, a situation referred to as “perfect com- petition” because sellers must compete with one another in order to sell to buyers. We characterize the behavior of sellers with what is called a “supply curve” in much the same way that we characterized the behavior of buyers with a demand curve. One note of caution before we begin the chapter: do not use demand and supply analysis to describe changes facing an individual firm. For example, it makes no sense to talk about the “demand and supply of iPhones” because there is only one seller of iPhones. Rather you use demand and supply to talk about the changes in the overall smart phone industry. Before you begin analyzing an industry, you must carefully consider what you want to learn from the analysis. Perhaps you want to forecast future changes or to understand past ones. In our example, you might want to know, “Why did the price for portable generators in the United States increase in 1999 and decrease in 2000?” Usually the question will suggest a particular market definition. The current question suggests that you should examine the annual market for portable generators in the United States. Notice that this market has a time (annual), a product (portable generators), and a geographic (the United States) dimension. Different questions will suggest different mar- kets to study. Although this point may seem obvious, people often overlook it. Avoid confusion by first defining your market or industry. Demand and supply analysis is especially important if your firm’s success or profitability is closely linked to the profitability of your primary industry. If you know how the industry is going to change, it will help you recognize opportunities. For example, many towns are changing zoning laws to make it more difficult to build apartments. This has led some entrepreneurs to antici- pate a reduction in future supply that will drive up the price of apartments. To position themselves to take advantage of these changes, they are building new apartments or buying and renovating existing ones. 8.2 Shifts in Demand As we’ve seen, changes in price lead to changes in quantity demanded. In an example from Chapter 6, we showed that when we increase price from $6 to $7, one fewer consumer decides to purchase, so quantity demanded decreases from two units to one unit. This change is called a movement along the demand curve. But price is only one factor that affects demand. In general, it helps to catalog the factors that affect demand into controllable and uncontrollable factors. A controllable factor is something that affects demand that a company can control. Price, advertising, warranties, product quality, distribution speed, service quality, and prices of substitute or complementary products also owned by the company are all examples of controllable factors. 06665_ch08_ptg01_095-112.indd 96 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 8 • Understanding Markets and Industr y Changes 97 A firm can manipulate controllable factors to increase demand for its products. Here’s a famous business example. In the late 1970s, Microsoft developed the DOS operating system to control IBM personal comput- ers. Demand for the DOS operating system depended not only on its own price but also on the price and availability of the computers that ran it, as well as on the applications that ran under it, like spreadsheets and word processors. To increase demand for its DOS operating system, Microsoft manipulated the following controllable factors: • Microsoft licensed its operating system to other computer manufacturers. The resulting competition between IBM and these new licensees lowered the price of computers—a complementary product. • Microsoft developed its own versions of word processing and spreadsheet software—Word and Excel—two important complementary products in almost any office. • Microsoft kept the price for its DOS product relatively low. As more consumers purchased DOS computers, more companies made applica- tions that ran on DOS computers, increasing future demand for DOS software. In contrast, uncontrollable factors include things like income, weather, interest rates, and prices of substitute and complementary products owned by other companies. And as is illustrated by the story in the introduction, expec- tations of future changes can also affect current demand. Consumer expec- tation of a massive power outage in 2000 was an uncontrollable factor that affected 1999 demand for portable electric generators. An uncontrollable factor is something that affects demand that a com- pany cannot control. Even though you may not be able to control a factor affecting demand, you need to understand how it affects the industry in which you compete because it can affect your own profitability. This requires that you learn how to manipulate demand and supply curves, our next topic. Because we only have two variables on our demand graph—price and quantity—the only way to represent a change in a third variable is with a shift of the demand curve. For example, if the price of a substitute product increases, then industry demand for a product will increase. We represent this as a rightward shift in the demand curve, as shown in Figure 8.1. In this case, at every price, demand shifts rightward, or increases, by four units. At a price of $8.00, for example, quantity demanded is nine units compared to five previously. Another way to look at this is from the per- spective of quantity demanded. For example, seven units were previously demanded at a price of $6.00; this quantity is now associated with a price of $10.00. In contrast to this increase in demand, a decrease in a substitute’s price would decrease demand, shifting the curve leftward where fewer units are demanded at each price. 06665_ch08_ptg01_095-112.indd 97 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits98 8.3 Shifts in Supply Supply curves describe the behavior of a group of sellers and tell you how much will be sold at a given price. The construction of supply curves is similar to that of demand curves; we arrange sellers by the prices at which they are willing to sell. Every person willing to sell at or below the given price “supplies” product to the market. For example, suppose we have nine sellers, with values of {$4, $5, $6, $7, $8, $9, $10, $11, $12}; at a price of $4, one seller would be willing to sell; at a price of $5, two sellers; and so on, until, at a price of $12, all nine sellers would be willing to sell. This supply curve describes the aggregate behavior of these nine sellers. Note that a supply curve requires competition among sellers. As we saw in Chapter 4, a single firm will produce where MR 5 MC. In contrast, multiple firms facing competition will behave as if they produce where P 2 MC. In this case, price will determine how much is supplied to the market: high prices lead to lots of supply and low prices to smaller supply. Supply curves differ from demand curves in one very important way: Supply curves slope upward; that is, the higher the price, the higher the quantity supplied. In other words, at higher prices, more suppliers are willing to sell. We plot our aggregate supply curve in Figure 8.2. As with demand curves, we plot supply curves with price on the vertical axis and quantity on the horizontal axis. Also, like demand curves, supply FIgUre 8.1 Demand Increase $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 $14.00 0 2 4 6 8 10 12 14 Quantity P ri ce New Demand Demand 06665_ch08_ptg01_095-112.indd 98 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 8 • Understanding Markets and Industr y Changes 99 curves shift when a variable other than price changes. Entry or exit of firms along with changes in costs, technology, and capacity will all result in a shift of the supply curve. Consider the effect of increased costs. How would that shift the supply curve? Think about an individual seller first—if that producer now has to pay more to produce the same quantity, he or she will require a higher price to cover those increased costs. If other sellers are situated sim- ilarly, the aggregate supply curve will decrease, or shift upward (and to the left). This means that higher prices are necessary to induce sellers to supply the same quantities. Alternatively, you could say that a smaller quantity will be made available at the previous price. 8.4 Market Equilibrium Market equilibrium is the price at which quantity supplied equals quan- tity demanded. In other words, at the equilibrium price, the numbers of buyers and sellers are equal, so there’s no pressure for prices to change. That’s why we call it an “equilibrium.” You can see an illustration of market equilibrium in Figure 8.3, where, at a price of $8, five units are demanded and five units supplied. To understand why this is an equilibrium, consider what happens at prices higher or lower than $8. For example, at a price of $11, the quantity demanded (2) is less than the quantity supplied (8), meaning that eight sellers are trying to sell to only two buyers. The sellers will compete with one another by offering to sell at a lower price. We say that excess supply exerts downward pressure on price. $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 $14.00 0 2 4 6 8 10 Quantity P ri ce FIgUre 8.2 Supply Curve 06665_ch08_ptg01_095-112.indd 99 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits100 At a price of $6, the quantity demanded (7) is greater than the quan- tity supplied (3)—seven buyers are chasing just three sellers, a case of excess demand. In this case, we say that excess demand exerts upward pressure on price. Only at a price of $8 are the numbers of buyers and sellers equal, exert- ing no pressure on price to change. This is why we call $8 an equilibrium price. At the equilibrium price, only buyers with values of $8 and above buy, and only sellers with values $8 and below sell. No one else wants to buy or sell. In market equilibrium, there are no unconsummated wealth-creating transactions. Another way of thinking about this is that the market has identified the high-value buyers and the low-value sellers, brought them together, and set a price at which they can exchange goods. The market moves goods from lower- to higher-valued uses and thus creates wealth. Economists often personify market forces by saying that the market works with an “invisible hand.”1 RIDDLE: How many economists does it take to change a light bulb? ANSWER: None. The market will do it. 8.5 Predicting Industr y Changes Using Supply and Demand We can use supply and demand curves to describe changes that occur at the industry level. In Table 8.1 and Figure 8.4, we begin with a simple example of how an increase in demand changes price and quantity. This increase in demand could arise from an increase in income, a decrease in the price of a complement, or an increase in price of a substitute. $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 $14.00 0 2 4 6 8 10 Quantity P ri ce Supply Demand FIgUre 8.3 Market Equilibrium 06665_ch08_ptg01_095-112.indd 100 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 8 • Understanding Markets and Industr y Changes 101 TABLE 8.1 Market Equilibrium Analysis Price ($) Demand Supply New Demand 12 1 9 5 11 2 8 6 Equilibrium 2 10 3 7 7 9 4 6 8 Equilibrium 1 8 5 5 9 7 6 4 10 6 7 3 11 5 8 2 12 4 9 1 13 We see the initial equilibrium of $8, where quantity demanded equals quantity supplied (5 units) in the first three columns of Table 8.1, as indicated by the shaded numbers in the fifth row. After the demand shift, the new equi- librium is $10, where quantity demanded equals quantity supplied (7 units). The shaded numbers in columns 1, 3, and 4 of the third row show this new equilibrium. Again, the mechanism driving price to the new equilibrium is competition among buyers to buy and competition among sellers to sell. At the old price of $8, $0 $5 $10 $15 0 10 15 Quantity P ri ce 5 Demand Supply New Demand FIgUre 8.4 Market Equilibrium Following Demand Shift 06665_ch08_ptg01_095-112.indd 101 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits102 there is excess demand—more buyers than sellers. This imbalance puts upward pressure on price until it settles at the new equilibrium price of $10. Notice that price increases from $8 to $10, while quantity increases from 5 to 7 units. To illustrate the usefulness of demand and supply, let’s return to the changes in the electric generator industry that occurred around 1999. Using demand-supply analysis, we can explain exactly what happened. We can see this analysis in Figure 8.5. In the graph, we see the change from 1998 to 1999 as the change from the initial equilibrium of A to a new equilibrium of B (denoted A S B) after both demand and supply increased. Supply shifted outward as firms invested in capacity increases, while demand increased due to anticipation of power out- ages. Because price increased by 21%, we know that the increase in demand must have been bigger than the increase in supply. Both shifts contributed to the quantity increase of 87%. In 2000, when demand returned to its 1998 level (denoted B S C), prices dropped below the 1998 level, but quantity stayed above the 1998 level because of the supply increase. Although it is relatively easy to predict these kinds of qualitative changes, predicting exact quantitative changes is much more difficult. For accurate quantitative predictions, you’d need information about the exact magnitudes of the supply and demand shifts, and information about the slopes of the supply and demand curves, information that is very hard to get. In fact, you should be very suspicious of consultants who claim they can provide accurate quantitative forecasts because it is difficult to pre- cisely estimate the parameters necessary to construct a forecast. Nevertheless, we can learn a lot from simple qualitative analysis. AMP’s managers should have been able to predict the general movement in price and quantity A S B S C, as shown in Figure 8.5; and they could have taken steps 0 200 400 600 800 1,000 1,200 1,400 0 500 1,000 1,500 2,000 Unit Sales (000s) $ /U n it ( In d u st ry A ve ra g e) 1998 1999 2000 BA C 1998 Demand 1999 Demand 1998 Supply 1999 Supply FIgUre 8.5 Demand-Supply in U.S. Generator Business 06665_ch08_ptg01_095-112.indd 102 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 8 • Understanding Markets and Industr y Changes 103 to prepare for the changes. For example, because the demand shift was tempo- rary, they could have hired temporary workers, or even outsourced the extra production, instead of investing in their own capacity expansion. Alternatively, like John Deere’s managers in Chapter 5, they could have chosen a low-fixed- cost technology, thereby better positioning themselves to make money once price dropped below its 1998 levels. 8.6 Explaining Industr y Changes Using Supply and Demand The preceding analysis has asked you to predict what happens to price and quantity following increases or decreases in supply and demand, or both. This kind of analysis is relatively simple, as there are only four changes that can occur: an increase or decrease in supply and an increase or decrease in demand. A slightly more difficult, but still very useful, analysis involves using supply and demand to explain industry changes. You look at a change in price and quantity, and then describe what must have happened to either supply and demand or both. For example, the price of soybeans increased by 50% from mid-2007 to early 2008. From what we’ve learned so far, you should know that an increase in price could have been driven by an increase in demand, a decrease in sup- ply, or both. In this case, both factors appear to have been influencing price. Demand has increased thanks to rising world population and incomes. Supply has contracted because many farmers decided to switch production to substi- tute products, like corn, that can be turned into biofuels. Both an increase in demand and a decrease in supply caused the dramatic price increase. Let’s test our understanding of the analysis thus far. Try to explain the increase in the quantity of mobile phones and the decline in price over the past decade using shifts in the demand or supply curves. -------TAKE A MOMENT AND TRY TO COME UP WITH THE ANSWER------- To answer this question, you have to explain two points in time. On a graph, the initial point has a high price and small quantity. The final point has low price and large quantity. You can explain these data with a simple increase (rightward shift) in the supply curve. In Figure 8.6, as supply increases, the equilibrium price falls from P 0 to P 1 and the equilibrium quantity increases from Q 0 to Q 1 .2 We end this section by asking you to explain a very significant increase in price and decline in the quantity of short-term commercial loans that occurred during September 2008. These short-term loans are used by virtually every major business to balance the inflows of revenue with the outflows of costs and are behind many major transactions. In what follows we are going to talk about the 30-day U.S. commercial loan market, where the “price” of a loan is the annualized interest rate on the loan, for instance, 0.5%. In the second week of September 2008, the quantity of these loans declined dramatically, and the price (interest rate) on these loans shot up from 3% to 5%. 06665_ch08_ptg01_095-112.indd 103 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits104 These changes spooked Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, and they were characterized as a “freeze” in the mar- ket for short-term lending. What could have accounted for these changes? -------TAKE A MOMENT AND TRY TO COME UP WITH THE ANSWER------- The changes could be explained by a simple decrease in the supply of loans. In fact, following the bankruptcy of Lehman Brothers, the troubles at Fannie Mae and Freddie Mac, and the first bailout of AIG, commercial lenders became increasingly worried that borrowers would not be able to repay these loans. In other words, lenders became less willing to lend, and the resulting decrease in supply caused both an increase in the price of borrowing (the interest rate) and a decline in the amount of lending. As a footnote to this story, the Federal Reserve guaranteed these short-run financial transactions to remove the fear of default, which increased supply, and the interest rates came back down. Many students report that demand and supply analysis is especially useful in job interviews as it gives them a way to show off their analytical expertise by explaining industry changes. 8.7 Prices Convey Valuable Information Markets play a significant role in collecting and transmitting information between buyers and sellers. In a sense, prices are the primary mechanism that market participants use to communicate with one another. Buyers signal their willingness to pay, and sellers signal their willingness to sell, with prices. To illustrate how this communication occurs, let’s examine the changes that occurred when a pipeline carrying gasoline to Phoenix broke.3 The break could have been disastrous because Arizona has no refineries of its own; it receives gasoline primarily through two pipelines. One of these pipelines starts in El Paso and supplies gasoline from refineries in Texas and New Mexico. Upon entering Arizona, that pipeline travels first to terminals in Tucson and then to terminals in Phoenix. FIgUre 8.6 Demand-Supply Shifts in the Mobile Phone Industry Q0 Q1 P1 P0 Initial Supply Final Supply 06665_ch08_ptg01_095-112.indd 104 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 8 • Understanding Markets and Industr y Changes 105 On July 30, 2003, the Tucson-to-Phoenix section of the pipeline from El Paso ruptured, closing that section of the line from August 8 to August 23, when partial service resumed. Using supply-demand analysis, you should now be able to analyze what happened in the daily market for gasoline in Phoenix. Following a decrease in supply to Phoenix, the price should go up and quantity should go down. Indeed, the Phoenix price went from less than $1.60 to over $2.10 per gallon. What is less obvious is why the Tucson price also increased as shown in Figure 8.7. Given the location of the pipeline break, it would seem that Tucson should now have an excess supply, which would reduce Tucson prices. Instead, Tucson prices increased from about $1.60 to $1.80 per gallon. What happened? The tank wagon owners who normally deliver gas from the Tucson terminal to Tucson gas stations discovered that delivering gas to Phoenix was more profitable than delivering it to Tucson. Tucson and Phoenix tank wagons waited for as much as six hours at the terminal in Tucson to buy gasoline to deliver to Phoenix. The high prices in Phoenix conveyed informa- tion to sellers in Tucson that it was more profitable to sell in Phoenix. So, the supply actually decreased in Tucson—resulting in a price increase in that city. Next time you hear a politician complaining about the “high price of gas,” tell her that without those high prices, consumers would consume too much, and suppliers would supply too little. If politicians set prices instead of markets, prices would not convey the information that provides incentives FIgUre 8.7 Phoenix and Tucson Gas Prices 100 120 140 160 180 200 220 7/ 1/ 20 03 7/ 8/ 20 03 7/ 15 /2 00 3 7/ 22 /2 00 3 7/ 29 /2 00 3 8/ 5/ 20 03 8/ 12 /2 00 3 8/ 19 /2 00 3 8/ 26 /2 00 3 9/ 2/ 20 03 9/ 9/ 20 03 9/ 16 /2 00 3 9/ 23 /2 00 3 9/ 30 /2 00 3 P ri ce ( ce n ts p er g al lo n ) Tucson-to-Phoenix line ruptures (7/30) Service on Tucson-to-Phoenix line suspended (8/8) Tucson-to-Phoenix bypass begins service (8/24) Phoenix-Mesa, AZ Tucson, AZ 06665_ch08_ptg01_095-112.indd 105 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits106 for buyers to conserve and for sellers to increase supply. Without higher prices, shortages would occur, and gasoline would not move from lower- to higher-valued uses. A similar situation occurred in Nashville in 2016 when a gas pipeline burst in Alabama. Anticipating a shortage, drivers flocked to gas stations to fill up, and prices rose. In response, tank wagon owners increased deliveries to the Nashville market. Tennessee Governor Bill Haslam also stepped in with an attempt to help the situation. But, rather than calling for price controls, he took another approach, issuing State of Tennessee Executive Order No. 56 that declared a temporary state of emergency. This declaration meant that reg- ulations limiting the number of hours for commercial truck drivers delivering fuel were suspended during the emergency conditions. The information conveyed by prices is especially important in financial markets, where each market participant possesses a little piece of information about the prospects for a traded security. By trading, they reveal their informa- tion to the market. For example, the price of a stock is a good predictor of the discounted flow of profit that will accrue to the stockholder. Likewise, prices of S&P futures are good predictors of the future level of the S&P 500 stock market index, and foreign exchange futures are good predictors of future exchange rates. The information contained in these prices has obvious uses to companies and individuals trying to make decisions based on an uncertain future. In fact, market prices are so good at forecasting the future that companies like Hewlett Packard, Eli Lilly, and Microsoft are setting up internal markets to help forecast demand for their products.4 They set up automated trading platforms and let employees buy and sell contracts that pay off according to how much the company will earn or sell in the future. The prices of the con- tracts tend to be much more accurate predictors than traditional forecasting methods and are being used to plan production. The accuracy of these prices in forecasting future sales can also help firms design compensation schemes for salespeople; for example, salespeople could be rewarded for increasing sales above the forecast quantity. 8.8 Market Making In the supply-demand analyses in this chapter, we’ve been ignoring the costs of making a market. Buyers and sellers don’t simply appear in a trading pit and begin transacting with one another. Instead, someone has to incur costs to identify high-value buyers and low-value sellers, bring them together, and devise ways of profitably facilitating transactions among them. The econo- mies of Chicago, New York, London, and Tokyo depend largely on the profit earned from making markets. These profits are the “costs” of making a mar- ket that, when significant, can prevent prices from moving to equalize demand and supply. In this section, we show exactly how a “market maker” makes a market— by buying low and selling high. Consider a market maker facing the demand and supply curves shown in Figure 8.8: nine buyers have values {$12, $11, 06665_ch08_ptg01_095-112.indd 106 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 8 • Understanding Markets and Industr y Changes 107 $10, $9, $8, $7, $6, $5, $4}, and nine sellers are willing to sell at the same prices. If there were only a single (monopoly) market maker, how much would she offer the sellers (the bid), and how much would she charge the buyers (the ask)? How many transactions would occur? If the market maker does not want to be left in either a long (holding inven- tory) or short (owing inventory) position, then she has to pick prices (the bid and the ask) that equalize quantity supplied and quantity demanded. Note that if the market maker bought and sold at the competitive price ($8), she would earn zero profit. To earn profit, the market maker must buy low (at the bid) and sell high (at the ask). For example, if the market maker were going to engage in, say, three transactions, she would offer sellers $6 (from the supply curve, we see that three sellers will sell if the price is at least $6) and charge buyers $10 (from the demand curve, we see that three buyers are willing to pay at least $10). Consequently, there are five obvious bid-ask price combinations:5 • Buy at $4 and sell at $12 (one transaction). • Buy at $5 and sell at $11 (two transactions). • Buy at $6 and sell at $10 (three transactions). • Buy at $7 and sell at $9 (four transactions). • Buy at $8 and sell at $8 (five transactions). Note that the market maker faces a familiar trade-off. She can consum- mate fewer transactions but earn more on each transaction; or she can con- summate more transactions but earn less on each transaction. In Table 8.2, we calculate the optimal bid-ask spread for the market maker: either buy at $6 and sell at $10, or buy at $5 and sell at $11. Both earn profit of $12. FIgUre 8.8 Market-Making Supply and Demand Curves $0.00 $2.00 $1.00 $4.00 $3.00 $6.00 $5.00 $8.00 $7.00 $10.00 $9.00 $12.00 $11.00 $13.00 0 1 2 3 4 5 6 7 8 9 10 Quantity P ri ce Supply Demand 06665_ch08_ptg01_095-112.indd 107 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits108 TABLE 8.2 Optimal Spread in Market Making Bid ($) Ask ($) Quantity Profit ($) 8 7 6 5 4 8 9 10 11 12 5 4 3 2 1 0 8 12 12 8 Now suppose that competition among several market makers forces the bid-ask spread—the price of a transaction—down to the costs of market mak- ing, which we suppose to be $2 per transaction. Now what is the competitive bid and ask? In this case, each market maker would buy at $7 and sell at $9. Those offering worse prices wouldn’t make any sales, and those offering better prices wouldn’t cover costs. In this case, competition forces price down to cost, thereby raising the number of transactions from three to four. SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • A market has a product, geographic, and time dimension. Define the market before using supply-demand analysis. • Market demand describes buyer behavior; market supply describes seller behavior in a competitive market. • If price changes, quantity demanded increases or decreases (represented by a movement along the demand curve). • If a factor other than price (like income) changes, we say that demand curve increases or decreases (a shift of the demand curve). • Supply curves describe the behavior of sellers and tell you how much will be sold at a given price. • Market equilibrium is the price at which quantity supplied equals quantity demanded. If price is above the equilibrium price, there are too many sellers, forcing price down, and vice versa. • Prices convey valuable information; high prices tell buyers to conserve and sellers to increase supply. • Making a market is costly, and competition between market makers forces the bid- ask spread down to the costs of making a market. If the costs of making a market are large, then the equilibrium price may be better viewed as a spread rather than a single price. Multiple-Choice Questions 1. Changes in prices of a good causes a. movement along the demand curve. b. movement along the supply curve. c. no movement along either curve. d. both a and b. 06665_ch08_ptg01_095-112.indd 108 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 8 • Understanding Markets and Industr y Changes 109 2. If the market for a certain product experi- ences an increase in supply and a decrease in demand, which of the following results is expected to occur? a. Both the equilibrium price and the equilibrium quantity could rise or fall. b. The equilibrium price would rise, and the equilibrium quantity could rise or fall. c. The equilibrium price would fall, and the equilibrium quantity could rise or fall. d. The equilibrium price would fall, and the equilibrium quantity would fall. 3. When demand for a product falls, which of the following events would you not neces- sarily expect to occur? a. A decrease in the quantity of the prod- uct supplied b. A decrease in its price c. A decrease in the supply of the product d. A leftward shift of the demand curve 4. Suppose a recent and widely circulated medical article has reported new benefits of cycling for exercise. Simultaneously, the price of the parts needed to make bikes falls. If the change in supply is greater than the change in demand, the price will ________________ and the quantity will ________________. a. rise, rise b. rise, fall c. fall, rise d. fall, fall 5. Suppose there are nine sellers and nine buyers, each willing to buy or sell one unit of a good, with values {$10, $9, $8, $7, $6, $5, $4, $3, $2}. Assuming there are no transactions costs, what is the equilibrium price in this market? a. $5 b. $6 c. $7 d. $8 6. If the government imposes a price floor at $9 (i.e., price must be $9 or higher) in the above market, how many goods will be traded? a. Five b. Four c. Three d. Two 7. Say the average price of a new home in Lampard City is $160,000. The local government has just passed new licensing requirements for housing contractors. Based on possible shifts in demand or supply and assuming that the licensing changes don’t affect the quality of new houses, which of the following is a reasonable prediction for the average price of a new home in the future? a. $140,000 b. $150,000 c. $160,000 d. $170,000 8. Suppose a new employer is also relocating to Lampard City and will be attracting many new people who will want to buy new houses. Assume that the change in licensing requirements mentioned in Ques- tion 7 occurs at the same time. What do you think will happen to the equilibrium quantity of new homes bought and sold in Lampard City? a. It will decrease substantially. b. It will decrease but not by much. c. It will increase. d. Not enough information. 9. The price of peanuts increases. At the same time, we see the price of jelly (which is often consumed with peanut butter) rise. How does this affect the market for peanut butter? a. The demand curve will shift to the left; the supply curve will shift to the left. b. The demand curve will shift to the left; the supply curve will shift to the right. c. The demand curve will shift to the right; the supply curve will shift to the left. d. The demand curve will shift to the right; the supply curve will shift to the right. 06665_ch08_ptg01_095-112.indd 109 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits110 10. Holding other factors constant, a decrease in the tax for producing coffee causes a. the supply curve to shift to the left, causing the prices of coffee to rise. b. the supply curve to shift to the right, causing the prices of coffee to rise. c. the supply curve to shift to the left, causing the prices of coffee to fall. d. the supply curve to shift to the right, causing the prices of coffee to fall. Individual Problems 8.1 Widget Market The widget market is competitive and includes no transaction costs. Five suppliers are willing to sell one widget at the following prices: $30, $29, $20, $16, and $12. Five buyers are will- ing to buy one widget at the following prices: $10, $12, $20, $24, and $29. What is the equi- librium price and quantity in a competitive market? 8.2 Cotton Prices The “A” index is a proxy for the world price of cotton. From January to October of 2010, the price reflected by the “A” index increased about 80%. Provide two separate explanations for this price increase using shifts in supply or demand. What one piece of information would allow you to decide which of the two is a better explanation? 8.3 Hand Sanitizer Due to the H1N1 flu outbreak, the demand for hand sanitizer has tripled. Should Johnson & Johnson increase production of their Purell hand sanitizer? Should it invest in doubling production capacity? 8.4 Chocolate Candy Bars Market a. In the accompanying diagram (which rep- resents the market for chocolate candy bars), the initial equilibrium is at the intersection of S 1 and D 1 . Circle the new equilibrium if there is an increase in cocoa prices. b. In the same diagram, the initial equilibrium is at the intersection of S 1 and D 1 . Circle the new equilibrium if there is rapid eco- nomic growth. Graph for Problem 8-4 Chocolate Candy Bars Market P ri ce Quantity S2 S1 S3 D3 D1D2 8.5 Demand Shifts Indicate whether the following changes would cause a shift in the demand curve for Product A and, if so, the direction of the shift. Change Demand Curve Shift? Direction of Shift? Increase in price of complementary product Yes No Increase Decrease N/A Increase in the price of the Product A Yes No Increase Decrease N/A Launch of effective advertising cam- paign for Product A Yes No Increase Decrease N/A 8.6 Valentine’s Day On Valentine’s Day, the price of roses increases by more than the price of greeting cards. Why? (Hint: Consider what makes roses and cards different and how that difference might affect supply’s responsiveness to price.) 06665_ch08_ptg01_095-112.indd 110 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 8 • Understanding Markets and Industr y Changes 111 1. Credit for the invisible hand metaphor goes to Adam Smith and his renowned The Wealth of Nations. 2. Note that an increase in demand could explain the increase in quantity but not the decrease in price. 3. Federal Trade Commission, Gasoline Price Changes: The Dynamic of Supply, Demand, and Competition (Washington, DC: U.S. Government Printing Office, 2005). 4. Barbara Kiviat, “The End of Management?” Time, July 12, 2004, “Inside Business” section. 5. Note that it makes sense to make this mar- ket only for five transactions or fewer. For quantities greater than this, the demand curve lies below the supply curve. So to complete seven transactions, for example, the market maker would have to offer sellers $10 (see the supply curve) and charge buyers $6 (see the demand curve) for a net loss of $4 per transaction. EnD nOTES Group Problem G8-1 Supply and Demand Using shifts in supply and demand curves, describe a change in the industry in which your firm operates. The change may arise from a change in costs, entry/exit of firms, a change in consumer tastes, a change in the macroeco- nomy, a change in interest rates, or a change in exchange rates. Label the axes, and state the geographic, product, and time dimensions of the demand and supply curves you are drawing. Explain what happened to industry price and quantity by making specific references to the demand and supply curves. If more than one change occurred, then decompose the change into smaller pieces so that your explanation has a step-by-step character to it. (Hint and warn- ing: Demand and supply curves are used at the industry level, not at the firm level.) Describe how your company could profitably use the analysis. 06665_ch08_ptg01_095-112.indd 111 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 06665_ch08_ptg01_095-112.indd 112 8/10/17 4:57 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 113 9 Jim Collins’s book Good to Great has sold over four million copies since it was published in 2001, making it one of the most successful business advice books of all time. It has been translated into 35 languages and has appeared on the best-seller lists of the New York Times, Wall Street Journal, and Business Week. Collins and his research team examined over 1,000 established companies and found 11 companies that made the jump from average or below-average performance to great results. From the experiences of these 11 “good-to-great” companies, Collins created a list of general management principles that he argued would help other companies make similar leaps. Anyone familiar with the 2008 mortgage crisis should easily recognize one of the good-to-great companies, Fannie Mae. Shares of Fannie Mae were valued at around $70 per share in mid-2001, the year Collins’s book was pub- lished. By 2009, government regulators had seized the company, and its shares were trading below $1. Another one of the companies, Circuit City, declared bankruptcy in 2008 and was liquidated. Overall, none of the 11 good-to- great companies outperformed the market over the years following the book’s publication. So where did the analysis go wrong? The book ran into two serious problems. The first was to confuse correla- tion with causation. Just because you observe successful firms behaving in a particular way does not mean that the behavior caused the success. We will return to this theme in Chapter 17 when we examine decision making under uncertainty. Until we do, beware of consultants peddling “best practices” of successful firms. The second problem of Good to Great was to ignore the long-run forces that tend to erode profit. It’s incredibly difficult to sustain great performance. High profit draws attention to the value that a firm creates, and customers, suppliers, competitors, substitutes, and new entrants will try to capture some of the values. How and why this occurs is the topic of this chapter. Market Structure and Long-Run Equilibrium 06665_ch09_ptg01_113-124.indd 113 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits114 In contrast to Chapter 8, where we analyzed short-run industry-level changes within a single market or industry, in this chapter, we analyze how changes in one industry affect other industries. In particular, the ability of cap- ital and labor to move between two industries implies that the prices and prof- its of one industry are related to prices and profits in another. 9.1 Competitive Industries To understand the relationship between industries, we first consider the extreme case of a perfectly competitive industry where: • firms produce a product or service with very close substitutes, meaning demand is very elastic; • firms have many rivals and no cost advantages; • the industry has no entry or exit barriers. The demand curve for the output of a perfectly competitive firm is flat (perfectly elastic). A competitive firm cannot affect price, so there is little a competitive firm can do except react to industry price. If price is above mar- ginal cost (MC), it sells more; if price is below MC, it sells less. In sum, a competitive firm’s fortunes are closely tied to those of the industry in which it competes. No industry is “perfectly” competitive because it is a theoretical bench- mark, although several industries, such as formal stock exchanges or agricul- tural commodities, come close. We use the benchmark because it helps us see the long-run forces that determine long-run industry performance. Here’s an example. Suppose industry demand suddenly increases for a product in a competitive industry. From Chapter 8, you should know that price goes up following the increase in demand. At the higher price, firms in the industry earn above-average profit—but only for a while. This “for a while” is the period that economists call the “short run.” Above-average profit lasts only for a while because profit attracts capital to the industry; existing firms expand capacity, or new entrants come into the industry. This increases industry supply, which leads to a decrease in price. Entry and capacity expan- sion continue, and price keeps falling until firms in the industry are no longer earning above-average profit. At this point, capital stops flowing into the in- dustry, and we say that the industry has reached long-run equilibrium. The length of the short run depends on how quickly assets can move into or out of the industry. It could be as short as a few seconds in highly liquid financial markets or as long as several years in industries where it takes a lot of time and effort to move assets. In the long run, no competitive industry earns more than an average rate of return. If it does, firms will enter the industry or expand, increasing supply until the profit rate returns to average. To a business student trying to make money, this seems like terrible news. But it’s not all bad news: In the long run, no competitive industry can earn less than an average rate of 06665_ch09_ptg01_113-124.indd 114 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 9 • Market Structure and Long-run equilibrium 115 return. If it does, firms will exit the industry or reduce capacity, decreasing supply until the profit rate returns to average. A competitive firm can earn positive or negative economic profit in the short run but only until entry or exit occurs. In the long run, competitive firms earn only an average rate of return. When firms are in long-run equilibrium, economic profit is zero (includ- ing the opportunity cost of capital), firms break even, and price equals average cost. Recall that profit is equal to (P 2 AC)*Q; so if price equals average cost, and cost includes a capital charge for the opportunity cost of capital, there’s no reason for capital to move because it cannot earn a higher rate of return elsewhere. Competitive industries will experience demand and supply shocks that result in short-run price increases and decreases, but economic profit tends to revert to zero. Another way to say this is that profit exhibits mean rever- sion where the mean is zero economic profit. According to reported estimates, profit moves back toward an average rate of return at a speed of about 38% per year.1 For example, if profit is 20% above the mean one year, it will be only 12.4% above the mean in the following year.2 A separate analysis of more than 700 business units found that 90% of both above-average and below- average profitability differentials disappeared over a 10-year period. Return on investment, as shown in Figure 9.1, revealed a strong tendency to revert to the mean level of approximately 20% for both over- and underperformers. Be careful not to confuse short- and long-run analysis. If we are analyz- ing an increase in demand in an industry, price and quantity will increase in Figure 9.1 Mean Reversion of Profitability (ROI, Return on Investment) 10 0 20 30 40 1 9 10 Year R O I ( % ) 2 3 4 5 6 7 8 06665_ch09_ptg01_113-124.indd 115 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits116 the short run, and firms will earn above-average profit. In the long run, these above-average profits will attract new assets into the industry, which will in- crease supply until profits fall back to the average. Make sure to distinguish between the short run and the long run. For example, do not say things like “demand creates its own supply.” Instead, analyze the changes more precisely by separating them into short- and long-run changes. 9.2 The Indifference Principle We have begun to see the role of entry and exit, or asset mobility, as the ma- jor competitive force driving profit to zero (remember that economic profit includes a cost of capital, so economic profit is normally zero). Positive profit attracts entry, and negative profit leads to exit. The ability of assets to move from lower- to higher-valued uses is the force that moves an industry toward long-run equilibrium. Such asset mobility leads to what Steven Landsburg3 calls the indifference principle: If an asset is mobile, then in long-run equilibrium, the asset will be in- different about where it is used; that is, it will make the same profit no matter where it goes. Labor and capital are generally highly mobile assets. They flow into an in- dustry when profits are high and out of an industry when profits are negative. Once this long-run equilibrium is reached, capital is indifferent about where it goes because it earns the same return (its opportunity cost) regardless of the industry. To show you how the forces of asset mobility link markets together, let’s apply long-run equilibrium analysis to the problem of deciding where to live. Suppose that San Diego, California, is more attractive than Nashville, Tennes- see. What do you think will happen? If labor is mobile, people will move from Nashville to San Diego. This migration will increase the demand for housing in San Diego, driving up San Diego house prices while simultaneously reducing demand (and prices) for Nashville houses. The process will continue until the higher price of housing makes San Diego just as unattractive as Nashville. At that point, migration will stop, and we say that the two cities are in long-run equilibrium. Both places are now equally attractive, meaning consumers are indifferent between them. The lower housing costs in Nashville compensate Nashvillians for the less attractive living conditions like the hot and humid summers. Wages also adjust to restore equilibrium. The indifference principle tells us that in long-run equilibrium, all professions should be equally attractive, pro- vided labor is mobile. If school teaching is more attractive than truck driving, for example, some truck drivers will become school teachers, increasing supply and reducing the wage for school teachers, but decreasing supply and increas- ing the wage for truck drivers. When all professions are equally attractive, the migration stops, and the wages stop moving. It may take a long time for entry to move wages to an equilibrium level, especially in professions that require a long period of training. In these industries, the long run might be very long. 06665_ch09_ptg01_113-124.indd 116 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 9 • Market Structure and Long-run equilibrium 117 Once equilibrium is reached, differences in wages, called compensating wage differentials, reflect differences in the inherent attractiveness of various professions. Why do embalmers make almost 20% more than rehabilitation counselors?4 Assuming the two industries are in long-run equilibrium, the higher wages com- pensate embalmers for working in a relatively unattractive profession. In the same way that lower-cost housing compensates Nashvillians for living in Nashville, embalmers’ higher wages compensate them for working with dead bodies. As demand and supply shocks change price in one industry, region, or profession, assets move in and out of industries, regions, and professions, until a new equilibrium is reached. In this way, the forces of competition allocate re- sources to where they are most highly valued and allow our economy to adapt rapidly to shocks. One of the concerns following the housing meltdown in the late 2000s was its potential impact on labor mobility. In previous recessions, there was a relatively rapid migration from locations where the jobs were disappearing (e.g., the Rust Belt) to areas where they were being created (e.g., the Sun Belt). But this time, the decline in housing values made it difficult for people to move (unless they walked away from their mortgages) because they were reluctant to sell houses at a loss. This reduced the flexibility of the U.S. economy and slowed down the adjustment to a new long-run equilibrium. We can apply the same long-run analysis to gain insight into some funda- mental relationships in finance. We start with the common sense observation that investors prefer higher returns and lower risk. If one investment earns the same return as another but is less risky, investors will move capital from the more risky investment to the less risky investment and bid up the price of the less risky investment. The higher price decreases its expected rate of return5—its expected price change—until the higher-risk investment is just as attractive as the less risky investment. In equilibrium, the risky investment will earn a higher rate of return to compensate investors for bearing risk. We can illustrate this relationship with a simple example. Suppose that two stocks are trading at the same $100 price. Research analysts tell us that in a year, the first stock will increase in value to $120 with probability 0.5 or maintain its current value of $100 with probability 0.5. The expected price of the stock next year is $110, and the expected return is 10%. Likewise, a simi- larly priced second stock will increase in value to $130 with probability 0.5 or decrease in value to $90 with probability 0.5. Although the second stock has the same expected price ($110) and expected return (10%), it is more risky because the return has a higher variance (next year value of $90 or $130). In- vestors will sell the risky stock and buy the less risky stock. This increases the price of the first stock, reducing its expected return; it also decreases the price of the second stock, increasing its expected return. The higher return on a risky stock is called a risk premium, and this pre- mium is analogous to a compensating wage differential. Just as higher wages compensate embalmers for preserving cadavers, higher expected rates of re- turn compensate investors for bearing risk. In equilibrium, differences in the rate of return reflect differences in the riskiness of an investment. 06665_ch09_ptg01_113-124.indd 117 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits118 We can see this relationship in Figure 9.2, which plots the Chicago Board Options Exchange Volatility Index (VIX) against the price of the S&P 500 stock index. The VIX measures the implied riskiness of the index, as com- puted from options prices. From the fall of 2008 to the spring of 2009, the stock market declined by about 50% while the VIX increased by about 100%. Whatever was making stocks more volatile was also reducing the stock prices, thereby increasing expected returns in order to compensate investors for bear- ing more risk. In other words, investors had to be offered lower prices in order to be willing to take on the added risk. Since government bonds are thought to be risk-free, investors often benchmark expected stock returns against the returns from holding govern- ment bonds. Over the last 50 years in the United States, annual bond returns have averaged 6.97%, whereas annual stock returns have averaged 11.29%. The difference is a risk premium that compensates investors for holding risky stocks. The historical equity risk premium (of stocks over bonds) has varied over the last 50 years as shown in Figure 9.3.6 If you can predict how risk changes, you can make a lot of money by antic- ipating asset price changes. In late 2006, for example, risk premia became very small. Not only was the difference between expected returns on stocks versus bonds small; so were the differences between expected returns on low- versus high-quality stocks and between emerging market debt versus U.S. debt. Small spreads between risky and less risky assets meant either that the world had be- come less risky or that investors were simply ignoring risk in search of higher returns. In hindsight, it looks like risk was being ignored. If you had been smart enough to recognize this, you would have moved out of risky assets and into less risky assets, like bonds. When risk returned in late 2007, the stock market began a 50% decline, and you would have earned a lot of money. Figure 9.2 Stock Volatility and Returns Fe b- 08 M ar -0 8 Ap r-0 8 M ay -0 8 Ju n- 08 Ju l-0 8 Au g- 08 Se p- 08 Oc t-0 8 No v- 08 De c- 08 Ja n- 09 Fe b- 09 M ar -0 9 –60 –40 –20 0 20 40 60 80 100 120 140 C h an g e si n ce Ja n 2 0 0 8 ( % ) VIX S&P 06665_ch09_ptg01_113-124.indd 118 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 9 • Market Structure and Long-run equilibrium 119 You also could have made a lot of money using a similar approach with European debt. Figure 9.4 shows the yields on 10-year government bonds for Greece and Germany since 1997. In late 1997, yields on Greek bonds were over 10% compared to the yields of around 5% for German bonds. This spread disappeared in 2002, with yields of around 5% in both countries, when Greece joined the European Union. In 2008, the risk premium began to reap- pear. Yields on Greek bonds eventually reached nearly 30% in February 2012, whereas German yields fell to under 2%. If you can anticipate changes in risk premia like this, you can make money. A prescient “risk-off” trade would have been to short Greek debt and buy German debt in 2007, and sell in 2012. Figure 9.3 Historical Equity Risk Premium 0 1 2 3 4 5 6 7 8 9 10 19 60 19 65 19 70 19 75 19 80 19 85 19 90 19 95 20 00 20 05 20 10 P er ce n ta g e Figure 9.4 Yields on 10-Year Government Bonds 0 5 10 15 20 25 30 35 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 P er ce n ta g e Greece Germany 06665_ch09_ptg01_113-124.indd 119 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits120 Conversely, a prescient “risk-on” trade would have been to buy Greek debt and short German debt in 1997, and sell in 2001.7 In fact, today’s volatile stock market has given rise to a new jargon, the so- called risk-on and risk-off investing, where investors attempt to profit by in- creasing their risk exposure when they expect favorable macro developments, and decreasing it when they foresee unfavorable developments. This can be easily understood as an application of the idea of long-run equilibrium. For example, if you expect a reduction (or increase) in the risk that the European Union will dissolve, it makes sense to buy (or sell) assets with exposure to this risk. 9.3 Monopoly If competitive firms live in the worst of all possible economic worlds, monopoly firms live in the best. Monopolies have attributes that protect them from the forces of competition. • Monopolies produce a product or service with no close substitutes. • Monopolies have no rivals. • Barriers to entry prevent other firms from entering the industry. An example of a monopoly firm is a biotechnology company that de- velops and then patents a new variety of crop plant without any substitutes. Without rivals and with patent protection preventing others from entering, the firm will enjoy a period of protection from the forces of competition. Unlike a competitive firm, a monopoly firm8 can earn positive profit— an above-average rate of return—for a relatively long time. This profit is a reward for doing something unique, innovative, or creative—something that gives the firm less elastic demand. But even monopolies are not permanently protected from the forces of entry and imitation. No barrier to entry lasts forever. Eventually other firms develop substitutes or invent new products that compete with the monopoly’s products and erode monopoly profit. The main difference between a compet- itive firm and a monopoly is the length of time that a firm can earn above- average profit. In the long run, even monopoly profit is driven to zero. To see why this is so, recall from Chapter 6 that a firm will price at the point where (P 2 MC)/ P 5 1/ |elasticity|. In the very long run, the forces of entry and imitation (the development of close substitutes) make the monopo- list’s demand more elastic. The elastic demand will push price down toward marginal cost and will eventually drive economic profit to zero. Here is a well-known example from the portable music player industry. In October 2001, Apple released the company’s first portable music player, the iPod. The iPod’s stylish design, straightforward user interface, and gener- ous storage space gave Apple a unique, user-friendly product. The elasticity of demand for the iPod was very low, and the margins for the product were very high. Over the next several years, however, rivals like SanDisk, Samsung, and 06665_ch09_ptg01_113-124.indd 120 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 9 • Market Structure and Long-run equilibrium 121 Microsoft released competing music players. The development of these rival products made demand for iPods more elastic. The higher elasticity reduced the iPod’s price-cost margin, and Apple’s profit eroded. Of course, Apple didn’t stand still. Its managers keep improving the product, keeping it innovative and different from rival products—in a word, unique. The fact that Apple is still making iPods is testament to the company’s ability to innovate. SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • A firm in a competitive industry can earn positive or negative profit in the short run until entry or exit occurs. In the long run, competitive firms earn only an average rate of return. • Profit exhibits mean reversion or “regres- sion toward the mean.” • If an asset is mobile, then in equilibrium the asset will be indifferent about where it is used (i.e., it will make the same profit no matter where it goes). This implies that unattractive jobs will pay compensating wage differentials, and risky investments will pay compensating risk differentials (or a risk premium). • The difference between stock returns and bond yields is a compensating risk pre- mium. When risk premia become too small, some investors view this as a time to get out of risky assets because the market may be ignoring risk in pursuit of higher returns. • Monopoly firms can earn positive profit for a longer period of time than competitive firms, but entry of competing firms and im- itation eventually erode their profit as well. Multiple-Choice Questions 1. In the long run, which of the following outcomes is most likely for a firm? a. Zero accounting profits but positive economic profits b. Zero accounting profits c. Positive accounting profits and positive economic profits d. Zero economic profits but positive ac- counting profits 2. At the individual firm level, which of the following types of firms faces a down- ward-sloping demand curve? a. Both a perfectly competitive firm and a monopoly firm b. Neither a perfectly competitive firm nor a monopoly firm c. A perfectly competitive firm but not a monopoly firm d. A monopoly firm but not a perfectly competitive firm 3. Which of the following types of firms are guaranteed to make positive economic profit? a. Both a perfectly competitive firm and a monopoly b. Neither a perfectly competitive firm nor a monopoly c. A perfectly competitive firm but not a monopoly d. A monopoly but not a perfectly com- petitive firm 4. What is the main difference between a competitive firm and a monopoly firm? a. The number of customers served by the firm. b. Monopoly firms are more efficient and therefore have lower costs. c. Monopoly firms can generally earn positive profits over a longer period of time. d. Monopoly firms enjoy government protection from competition. 06665_ch09_ptg01_113-124.indd 121 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 122 SECTION II • Pricing, Costs, and Profits 5. Which of the following products is clos- est to operating in a perfectly competitive industry? a. Nike shoes b. Cotton c. Perdue Chicken d. Restaurants 6. A firm in a perfectly competitive market (a price taker) faces what type of demand curve? a. Unit elastic b. Perfectly inelastic c. Perfectly elastic d. None of the above 7. A competitive firm’s profit-maximizing price is $15. At MC 5 MR, the output is 100 units. At this level of production, aver- age total costs are $12. The firm’s profits are a. $300 in the short run and long run. b. $300 in the short run and zero in the long run. c. $500 in the short run and long run. d. $500 in the short run and zero in the long run. 8. What would happen to revenues if a firm in a perfectly competitive industry raised price? a. They would increase. b. They would increase but profit would decrease. c. They would increase along with profit. d. They would fall to zero. 9. If a firm in a perfectly competitive industry is experiencing average revenues greater than average costs, in the long run a. some firms will leave the industry and price will rise. b. some firms will enter the industry and price will rise. c. some firms will leave the industry and price will fall. d. some firms will enter the industry and price will fall. 10. A sudden decrease in the market demand in a competitive industry leads to a. losses in the short run and average profits in the long run. b. above-average profits in the short run and average profits in the long run. c. new firms being attracted to the industry. d. demand creating supply. Individual Problems 9-1 Faculty Housing Benefits At a university faculty meeting in 2012, a pro- posal was made to increase the housing benefits for new faculty to keep pace with the high cost of housing. What will likely be the long-run ef- fect of this proposal? (Hint: Think indifference principle.) 9-2 Snacks, Beer, and Marijuana Snack food vendors and beer distributors earn some monopoly profits in their local markets but see them slowly erode from various new substitutes. When California voted on legal- izing marijuana, which side would you think that California beer distributors were on? What about snack food venders? Why? 9-3 Entry and Elasticity Suppose that new entry decreased your demand elasticity from 22 to 23 (made demand more elastic). By how much should you adjust your price of $10? 9-4 Competitive Industries Relative to managers in more monopolistic industries, are managers in more competitive industries more likely to spend their time on re- ducing costs or on pricing strategies? 06665_ch09_ptg01_113-124.indd 122 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 9 • Market Structure and Long-run equilibrium 123 9-5 Economic Profit Describe the difference in economic profit be- tween a competitive firm and a monopolist in both the short and long run. Which should take longer to reach the long-run equilibrium? 9-6 Economics versus Business Describe an important difference in the way an economist and a businessperson might view a monopoly. Group Problem G9-1 Compensating Wage Differential Give an example of a compensating wage differential, a risk premium, or some kind of long-run equilibrium price difference your company faces. How can your company profit- ably exploit this difference? 1. Eugene Fama and Kenneth French, “Fore- casting Profitability and Earnings,” Journal of Business, April 2000. 2. Profitability at time t 1 l 5 Profitability at time t 2 (0.38 3 Profitability at time t); 12.4% 5 20% 2 7.6%. 3. Steven Landsburg, The Armchair Economist: Economics and Everyday Life (New York: Free Press, 1993). 4. Median salary of embalmers equals $40,410, and median salary of rehabilita- tion counselors equals $34,390 according to May 2015 National Occupational Employ- ment and Wage Estimates from the Bureau of Labor Statistics. 5. The percentage return on an investment that is held for one period is equal to (P t11 2 P t )/P t , where P t is the initial price of the investment. P t11 is the expected price in the next period, so the difference is the ex- pected return. If the current price increases (i.e., P t increases), then the expected return decreases. 6. Adapted from information provided by Aswath Damodaran at http://www.stern. nyu.edu/~adamodar/pc/datasets/histretSP.xls. 7. Example inspired by Don Marron at http:// dmarron.com/2011/12/21/the-most-imporant -economic-chart-of-the-year/. 8. In contrast to price takers (competitive firms), monopoly firms are price search- ers. These firms face a downward-sloping demand curve; as price increases, quantity sold drops and vice versa. A price searcher “searches” for the optimal price–quantity combination. EnD nOTES 06665_ch09_ptg01_113-124.indd 123 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 06665_ch09_ptg01_113-124.indd 124 8/9/17 8:30 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 125 10 In 1971, three partners opened a coffee shop in Seattle’s Pike Place Market. Two of the partners wanted to name the store after the ship Pequod from Moby Dick, but the third disagreed. Eventually they agreed to name the store after the Pequod’s first mate. The company enjoyed mild growth until 1988 when the partners agreed to sell the company to their former director of retail operations and marketing. Over the following 20-plus years, that director has overseen the expansion of the company to over 23,000 worldwide stores as of 2015 and revenues of over $19 billion. And in case you haven’t put it all together yet—Starbuck was the first mate on the Pequod and that former di- rector of retail operations is Howard Schultz, who recently stepped down as CEO of the world’s largest coffee retailer, Starbucks. What has been the key to the company’s success? According to Schultz:1 “Starbucks is the quintessential experience brand and the experience comes to life by our people. The only competitive advantage we have is the relation- ship we have with our people and the relationship they have built with our customers.” The ability to create this unique experience draws on distinctive capabilities the company has developed in both producing high-quality cof- fee and establishing a relationship-oriented culture among its employees and customers. In a 2012 study of U.S. consumer sentiments expressed through social media outlets, Starbucks was ranked as the most loved restaurant- related brand,2 and the company generated over $3.6 billion in 2015 operating income despite operating in a very competitive industry. Succeeding in the face of competition requires that you first find a way to create an advantage and then figure out how to protect that advantage. How important is creating and sustaining advantage? Here’s how one financial col- umnist summarized the view of one of the most respected investors of our time: Warren Buffett was once asked what is the most important thing he looks for when evaluating a company. Without hesitation, he replied, “Sustainable competitive advantage.” Strategy: The Quest to Keep Profit from Eroding 06665_ch10_ptg01_125-136.indd 125 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits126 I agree. While valuation matters, it is the future growth and prosperity of the company underlying a stock, not its current price that is most im- portant. A company’s prosperity, in turn, is driven by how powerful and enduring its competitive advantages are. Powerful competitive advantages (obvious examples are Coke’s brand and Microsoft’s control of the personal computer operating system) create a moat around a business such that it can keep competitors at bay and reap extraordinary growth and profit. Like Buffett, I seek to identify—and then hopefully purchase at an attractive price—the rare companies with wide, deep moats that are getting wider and deeper over time. When a company is able to achieve this, its shareholders can be well rewarded for decades. Take a look at some of the big pharmaceutical companies for great examples of this.… It is extremely difficult for a company to be able to sustain, much less expand, its moat over time. Moats are rarely enduring for many reasons: high profit[s] can lead to complacency and are almost certain to attract competitors, and new technologies, customer preferences, and ways of doing business emerge. Numerous studies confirm that there is a very powerful trend of regression toward the mean for high-return-on-capital companies. In short, the fierce competitiveness of our capitalist system is generally wonderful for consumers and the country as a whole, but bad news for companies that seek to make extraordinary profit over long pe- riods of time.3 In Chapter 9, we discussed how the forces of competition tend to erode high profit; in this chapter, we show you what to do about it. This material will help you formulate long-run strategies to slow your firm’s competitive erosion of profit; it will help you figure out how to build a moat around your company so that you can sustain profitability. We’ll also evaluate Buffett’s in- vestment strategy. 10.1 A Simple View of Strategy From Chapter 9, you should know that firms would rather be monopolists than competitors. In fact, if you hire management consultants, they should advise you to figure out how to become a monopolist (assuming they’re worth the money you are paying them). To keep one step ahead of the forces that erode profit, firms develop strategies. And although there are lots of different definitions of strategy, they all generally tend to emphasize the importance of gaining sustainable competitive advantage. For example, in the 2013 book Playing to Win, co-author A.G. Lafley, the former CEO of Procter & Gamble, defined strategy as “an integrated set of choices that uniquely positions the firm in its industry so as to create sustainable advantage.” Firms have a com- petitive advantage when they can (a) deliver the same product or service ben- efits as their competitors but at a lower cost or (b) deliver superior product or 06665_ch10_ptg01_125-136.indd 126 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 10 • Strategy: the Quest to Keep profit from eroding 127 service benefits at a similar cost. Firms with a competitive advantage are able to earn positive economic profits. In some respects, strategy is very simple. Figure 10.1 shows the allo- cation of economic value for a particular product. The height of the col- umn represents the total value of the product where value is the maximum amount a buyer is willing and able to pay for the product. That total value gets divided among the different players. Cost represents how much value is captured by suppliers. The difference between the price you charge and your cost is profit, and the difference between value and price is surplus captured by the consumer. Here’s a simple example. Say a representative consumer values the product at $400, it’s priced at $300, and it costs $200 per unit to produce. The box between $300 and $200 (price minus cost) represents $100 of profit to the firm. Consumer surplus is also $100 ($400 less $300). This simple diagram communicates several important ideas in strategy. First, it highlights that both value creation and value capture are critical. The starting point to strategy is producing a product that a consumer is willing and able to pay for. But, you also have to be able to capture some of that value for yourself as profit. Strategy is ultimately about how to increase the size of the profit box. The box gets bigger if the firm can lower its costs or raise its price. At a very high level, it’s really that simple. Strategy is about raising price or reducing cost. Really successful firms manage to do both. Extremely successful firms like Starbucks do it over a long period of time, reflecting a sustainable competitive advantage. Customer Value = $400 (maximum willingness to pay) Cost per unit = $200 Price per unit = $300 CONSUMER SURPLUS COST PROFIT Figure 10.1 Allocation of Value 06665_ch10_ptg01_125-136.indd 127 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits128 10.2 Sources of Economic Profit So what are the keys to competitive advantage and generating sustainable eco- nomic profit? Two schools of thought offer differing points of view. The first— the industrial organization (IO) economics perspective—locates the source of advantage at the industry level. The second—the resource-based view (RBV)— locates it at the individual firm level. The Industry (External) View The IO perspective focuses on the industry. According to Michael Porter, “The essence of this paradigm is that a firm’s performance in the marketplace de- pends critically on the characteristics of the industry environment in which it competes.”4 Certain industries are more attractive than other industries be- cause of their structural characteristics. Companies in those industries possess market power, which allows them to keep prices above the competitive level and to earn economic profit. Industry structure includes factors such as bar- riers to entry, product differentiation among firms, and the number and size distribution of firms. For example, industries with high barriers to entry are more attractive because competitors find it more difficult to enter the industry and drive profit down to competitive levels; firms in industries with differenti- ated products have less elastic demand and therefore higher profit; and indus- tries with a small number of firms of different sizes are less likely to compete vigorously. If industry structure is the most important determinant of long-run prof- itability, then the key to generating economic profit is to operate in the right industry. According to Michael Porter’s Five Forces model,5 the best industries are characterized by • low buyer power, • low supplier power, • low threat of entry (high barriers to entry), • low threat from substitutes, and • low levels of rivalry between existing firms. A key first step in applying the Five Forces model is defining what ex- actly we mean by “industry.” An industry is a group of firms producing products that are close substitutes to each other to serve a market. It’s im- portant to realize that firms often operate in multiple industries. So, the analysis may need to be done on a product-by-product basis for multiprod- uct companies. Industry analysis and the Five Forces model is largely about which play- ers capture the value in an industry. Just because you are in an industry that creates value doesn’t mean that you are going to capture it. Suppliers, industry rivals, and buyers all want to capture value too: suppliers want to charge as much as possible, and buyers want to pay as little as possible. The Five Forces model helps you think about how much of the industry value your firm is likely to capture given the characteristics of the industry. It all depends on the strength of the forces. Let’s start with supplier power. 06665_ch10_ptg01_125-136.indd 128 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 10 • Strategy: the Quest to Keep profit from eroding 129 Suppliers can charge higher prices (and capture more of the industry value) when they have greater power. They are the providers of any input to the product or service. Examples include labor, capital, and providers of raw/ partially finished materials. Supplier power tends to be higher when the inputs they provide are critical inputs or highly differentiated. Concentration among suppliers also contributes to supplier power because a firm will have fewer bargaining options. Even if many suppliers exist, power may still be high if there are significant costs to switching between suppliers. The story on buyer power is similar. If buyers are concentrated (consider if your firm were an automotive supplier and your buyers were the major auto manufacturers) or if it is easy for buyers to switch from firm to firm, buyer power will tend to be higher. More power means these buyers will find it easier to capture value (e.g., by bargaining hard to pay a lower price), taking value away from your firm. Threats from potential entrants are another important force to consider. As we discussed in Chapter 9, economic profits tend to draw new entrants. These entrants will quickly erode the profit of an industry unless barriers pre- vent or slow their entry. Examples of entry barriers include government pro- tection (e.g., patents or licensing requirements), proprietary products, strong brands, high capital requirements for entry, and lower costs driven by econo- mies of scale. Substitute products can still erode a firm’s ability to capture value even if barriers to entry are high. If close substitutes to a product are available and buyers find it inexpensive to switch to them, it will be hard for a firm to build and maintain high profits. The final force concerns the rivalry among existing firms, the force most directly related to our typical view of “competition.” If a large number of sim- ilarly situated firms compete in an industry with high fixed costs and slow industry growth, rivalry is likely to be quite high. Rivalry also tends to be higher when products are not very well differentiated and buyers find it easy to switch back and forth. The wide differences in profitability across industries in Figure 10.2 sup- port the IO view.6 The most profitable industry, pharmaceuticals, exhibits rel- atively high barriers to entry, arising from significant investments in personnel and technology; moreover, successful products enjoy extended periods of pat- ent protection (legal barriers to entry). Overall, the IO view suggests that the way to earn economic profits is to choose an attractive industry and then develop the resources that will allow you to successfully compete in the industry. But, what about managers who don’t have the luxury of choosing a new industry? The tools of industry analy- sis can still be helpful. First, move beyond a historical analysis of your industry to think about how the five forces might change in the future. Second, and more importantly, think about what actions you can take to make your current industry position more attractive. For example, how can you reduce supplier power? One answer is to increase rivalry among your suppliers. For example, you could do this by using an online procurement auction to purchase raw ma- terials and semifinished inputs. Auctions are the topic of Chapter 17. Steps that 06665_ch10_ptg01_125-136.indd 129 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits130 you take to decrease rivalry with your competitors, reduce buyer power, and build entry barriers will all help improve the attractiveness of your industry position. It’s also important to realize the limitations of tools like the Five Forces. First, this view focuses on value capture—it doesn’t really provide any insight into how value gets created in the industry. Second, this view portrays an in- dustry as a zero-sum game; that is, the way you get a bigger piece of the pie is to take it from one of the other participants in the industry. Although this is one way to view competition (and one that is often correct), companies can also work with other industry participants to try to build a larger pie. With a larger pie, everyone’s slice grows bigger. Cooperative efforts with rivals, buy- ers, and suppliers feature prominently in a book by Adam Brandenburger and Barry Nalebuff called Coopetition (cooperative competition). The authors remind us that to look beyond the threats to firm profitability, emphasized by Porter’s Five Forces analysis, to opportunities for cooperation that can en- hance firm and industry profitability. Annabelle Gawer and Michael A. Cusumano offer a similar idea for think- ing about strategy in industries like telecommunications where success re- quires creating an “ecosystem” of complementary products.7 A company must first decide whether to pursue a “product” or a “platform” strategy; a “prod- uct” is proprietary and controlled by one company, whereas a “platform” needs a set of complementary innovations to reach its full potential. One of the biggest mistakes a company can make is to pursue a product strategy and Figure 10.2 Profitability Differences between Industries 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% Ph ar m ac eu tic al s Pr ep ac ka ge d So ftw ar e Se m ico nd uc to rs W om en ’s Cl ot hi ng S to re s De nt al E qu ip m en t Ea tin g Pl ac es Dr ug S to re s Pe tro le um /N at ur al G as Ra ce Tr ac k O pe ra tio ns Tr uc ki ng E xc ep t L oc al En gi ne er in g Se rv ice s Co m pu te r S ys te m D es ig n Ca bl e T V Se rv ice M ot or V eh icl es Ai rli ne s 06665_ch10_ptg01_125-136.indd 130 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 10 • Strategy: the Quest to Keep profit from eroding 131 fail to recognize the platform value of their product. The best example of this is perhaps the Macintosh computer, which, due to its early technological lead, could have become the dominant platform for personal computing. Instead they priced high, failed to encourage complementary innovation, and let Mic- rosoft become the dominant platform. The Resource (Internal) View If industry structure told the whole story about strategy, we wouldn’t expect to find performance differences across firms within industries. These differ- ences do exist, however, and the resource-based view (RBV) gained favor in the 1990s as an explanation for these inter-firm differences. The RBV explains that individual firms may exhibit sustained performance advantages due to their superior resources, where resources are defined as “the tangible and intangible assets firms use to conceive of and implement their strategies.”8 Resources can be tangible like equipment, real estate, and financial capital as well as intangible like brand, knowledge, and organizational culture. Two primary assumptions underlie the RBV: resource heterogeneity and resource immobility. The RBV views firms as possessing different bundles of resources that are immobile (the resources resist transfer or copying). These immobile resources are the sources of differential performance within an industry. Given the differences in resources across firms, the RBV9 provides further guidance on when these resources may lead to superior performance, where superior performance is defined as the firm’s ability to earn above-average profit. If a resource is both valuable and rare, it can generate at least a tem- porary competitive advantage over rivals. A valuable resource must allow a business to conceive of and implement strategies that improve its efficiency or effectiveness. Examples include resources that let a firm operate at lower costs than its rivals or charge higher prices to its customers. For a resource to be rare, it must not be simultaneously available to a large number of competitors. Resources that generate temporary competitive advantage do not nec- essarily lead to a sustainable competitive advantage. For such resources to deliver a sustainable advantage, they must be difficult to substitute for or imi- tate. Otherwise, any advantages that those resources deliver will be competed away. Imitation and substitution both erode firm profit. In the first, a compet- itor matches the resource by exactly duplicating it; in the second, a competi- tor matches the resources by deploying a different but strategically equivalent resource. We can list several conditions that make resources hard to imitate (inimitability): 1. Resources that flow from a firm’s unique historical conditions will be difficult for competitors to match. 2. If the link between resources and advantage is unclear, then competitors will have a hard time trying to recreate the particular resources that deliver the advantage. 3. If a resource is socially complex (e.g., organizational culture), rivals will find it difficult to duplicate the resource. 06665_ch10_ptg01_125-136.indd 131 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits132 Be wary of any advice you read that claims to identify critical resources or capabilities that successful companies have to develop in order to gain a com- petitive advantage. You should be skeptical of such advice for two reasons. First, explanations such as these often mistakenly conclude a causal relation- ship when only a correlation exists. Remember the Good to Great companies that we mentioned in Chapter 9. They all had five management principles in common that supposedly drove their success. Their subsequent less-than-great performance raises serious doubts about whether these “best practices” caused their prior superior performance. The second reason you should question such advice has to do with the nature of competition in general. Publicly available knowledge is not going to help you create a competitive advantage. Let’s say an author discovers that having a chief managerial economics officer (CMEO) in your company always leads to a competitive advantage in companies and publishes this advice in a new book. You read the book and decide to hire a CMEO for your business and no competitive advantage follows. What happened? Well, your competi- tor probably read about the CMEO “secret” as well and hired one, too. Now that everyone knows about it, no advantage is possible. Competitive advan- tage flows from having something that competitors can’t easily duplicate, such as an extremely valuable brand like Starbucks. You’re not likely to find these on the shelves of your local bookstore. Nor are you likely to get it from a con- sultant who is selling the same advice that he or she sells to your competitors. 10.3 The Three Basic Strategies A firm looking to generate superior economic performance, given its industry and resource base, has three basic strategies it can follow to keep one step ahead of the forces of competition: 1. cost reduction, 2. product differentiation, or 3. reduction in competitive intensity. Most strategies fall into one of these three categories. The first strategy, cost reduction, is pretty self-explanatory. Low-cost strategies are usually found in industries where products are not particularly differentiated and price com- petition tends to be fierce. Walmart and Southwest are two famous examples of companies that have been very successful in developing low-cost strategies. Note, however, that cost reductions generate increases in long-run profitabil- ity only if the cost reduction is difficult to imitate. If others can easily du- plicate your actions, cost reduction will not give you sustainable competitive advantage. The third strategy, reducing competitive intensity, is also self-evident. If you can reduce the level of competition within an industry and keep new com- petitors from entering, you may be able to slow the erosion of profitability. (In the chapter on strategic interaction, we’ll use game theory to develop strate- gies that reduce the intensity of competition.) One easy way to reduce rivalry is to ask the government to do it for you. This is what the bookselling industry 06665_ch10_ptg01_125-136.indd 132 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 10 • Strategy: the Quest to Keep profit from eroding 133 in Germany does. Discounting of new books by German booksellers is illegal, essentially making price competition a crime. U.S. washing machine manufac- turers have benefited from regulation as well. A 2000 Department of Energy regulation banned the sale of low-priced washing machines under the guise of increasing energy efficiency. Who were the biggest supporters of the ban? It was not the consumers, who by a margin of six-to-one preferred to purchase lower-priced machines. It was the washing machine manufacturers—because now they would be able to sell expensive “front-loading” models at an average price of $240 more than the banned machines.10 We can interpret the second strategy, product differentiation, as a reduc- tion in the elasticity of demand for the product. Less-elastic demand leads to an increase in price because the optimal margin of price over marginal cost is related to the elasticity of demand; that is, (P 2 MC)/ P 5 1/ |e|. When your product is effectively differentiated from other products, demand is less elas- tic, leading to a higher margin of price over marginal cost. Starbucks is an excellent example of a company that has successfully pursued a differentiation strategy for over 40 years. And they have pursued differentiation in both the product (coffee) and the overall experience as well. Another successful example of a product differentiation strategy is Perdue Chicken. Frank Perdue took an essentially homogeneous product—chicken— and turned it into a branded product, Perdue Chicken. He did this by exer- cising quality control over the entire supply chain, from the feed to the final product. Consumers perceive his branded chickens to be of higher quality. Thus, they have less-elastic demand, allowing Perdue to charge a higher price. Economies of scale (cost reduction) also have played a part in Perdue’s success. Prelude Lobster’s11 managers tried a product differentiation strategy simi- lar to Perdue’s. Although they advertised their superior after-catch handling of the lobsters, customers correctly perceived that, for lobsters, unlike chicken, the supply chain is largely uncontrollable. Prelude was eventually forced out of business by lower-cost competitors who did not advertise. With the benefit of hindsight, it is easy to identify successful strategies (and the reasons for their success) or failed strategies (and the reason for their failures). It’s much more difficult to identify successful or failed strategies be- fore they succeed or fail. But this is what you have to do in order to invest successfully, or to build successful strategies. To illustrate the importance of this idea, let’s return to the wisdom of in- vesting in companies with a sustainable competitive advantage. This strategy leads to sustained, above-average profitability for the company, but remember that the stock price also determines the return from investing. If the stock price is high relative to its discounted future earnings, the investment is a bad one, regardless of whether the company has a sustainable competitive advantage. Warren Buffett, for instance, makes money by acquiring companies whose potential future earnings are high relative to their current stock price. He then helps develop strategies to help them realize their high potential earnings by cre- ating a sustainable competitive advantage. He doesn’t make money simply by investing in companies with a current competitive advantage. Instead, his success is due to his ability to help these companies craft successful long-run strategies. 06665_ch10_ptg01_125-136.indd 133 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 134 SECTION II • Pricing, Costs, and Profits SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • Strategy is simple—to increase perfor- mance, figure out a way to increase P (price) or reduce C (cost). • The industrial organization (IO) economics perspective assumes that the industry struc- ture is the most important determinant of long-run profitability. • The Five Forces model is a framework for analyzing the attractiveness of an industry. Attractive industries have low supplier power, low buyer power, low threat of entry, low threat of substitutes, and low rivalry. • According to the resource-based view (RBV), individual firms may exhibit sus- tained performance advantages because of their superior resources. To be the source of sustainable competitive advantage, those resources should be valuable, rare, and dif- ficult to imitate/substitute. • Strategy is the art of matching the resources and capabilities of a firm to the opportu- nities and risks in its external environment for the purpose of developing a sustainable competitive advantage. • Be wary of any advice you read that claims to identify critical resources or capabilities that successful companies have to develop in order to gain a competitive advantage. • To stay one step ahead of the forces of competition, a firm can adopt one of three basic strategies: cost reduction, product differentiation, or reduction in the intensity of competition. Multiple-Choice Questions 1. An industry is defined as a. a group of firms producing the exact same products and services. b. firms producing items that sell through the same distribution channels. c. firms that have the same resources and capabilities. d. a group of firms producing products that are close substitutes. 2. Attractive industries have all the following, except a. high supplier power. b. low buyer power. c. high entry barriers. d. low rivalry. 3. Which of the following is not an example of an entry barrier? a. Government protection through pat- ents or licensing requirements b. Strong brands c. Low capital requirements for entry d. Lower costs driven by economies of scale 4. Buyers have higher power when a. their suppliers sell a highly differenti- ated product. b. they are not a significant purchaser of their supplier’s output. c. switching costs are low. d. the buyer industry is highly fragmented (buyers are not concentrated). 5. Which of the following is not a factor that contributes to higher rivalry in an industry? a. Numerous competitors b. High fixed costs c. Fast industry growth d. Low switching costs for buyers 6. The concept that describes firms possessing different bundles of resources is a. resource heterogeneity. b. resource immobility. c. barriers to entry. d. imitability. 7. If a firm successfully adopts a product- differentiation strategy, the elasticity of demand for its products should a. increase. b. decrease. 06665_ch10_ptg01_125-136.indd 134 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 10 • Strategy: the Quest to Keep profit from eroding 135 c. become marginal. d. be unaffected. 8. When a resource or capability is valuable and rare, a firm may gain a a. sustainable competitive advantage. b. competitive parity. c. cost advantage. d. temporary competitive advantage. 9. Which of the following is critical for a firm adopting a long-term cost-reduction strategy? a. The firm must also differentiate its product or service. b. The strategy reduces costs by at least 10%. c. The strategy is focused on reducing internal production costs. d. The methods of achieving cost reduc- tions are difficult to imitate. 10. When a resource or capability is valuable, rare, hard to imitate, and nonsubstitutable, firms may gain a. a temporary competitive advantage. b. a complex competitive advantage. c. competitive parity. d. a sustainable competitive advantage. Individual Problems 10-1 High Rivalry For each category, indicate which condition is associated with higher rivalry among competitors. Number of firms High Low Fixed costs High Low Level of product differentiation High Low Industry growth High Low Buyer switching costs High Low 10-2 Increasing Customer Value To increase a company’s performance, a man- ager suggests that the company needs to in- crease the value of its product to customers. Describe three ways in which this advice might be incorrect (Hint: Think about what else might or might not change that affects profit.) 10-3 Intangible Resources Why might intangible resources like human capital and intellectual assets be a more likely source of sustainable competitive advantage than tangible resources? 10-4 Five Forces and the Airline Industry Examine the U.S. passenger airline industry us- ing the Five Forces model. Is this an attractive industry? Why or why not? 10-5 Smartphone Market The smartphone market has been dominated by Apple, but recently the Droid has been able to leverage Google’s information services into market gains while Blackberry, known for its se- cure business-oriented network, has attempted to become more attractive with a “friendlier” interface. At the same time, a number of less ca- pable fringe firms are emerging. How do these features fit into an industrial organization (IO) view of the market versus a resource-based view (RBV)? 10-6 Salons and Teeth Whitening Salon owners have recently started offering teeth whitening services to clients in addition to their more standard services. In a number of states, regulators have ordered the salon owners to stop, claiming that this service constitutes the practice of illegal dentistry. What group would you expect to be behind the state’s efforts to ban salons from providing teeth whitening ser- vices? Why? 06665_ch10_ptg01_125-136.indd 135 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 136 SECTION II • Pricing, Costs, and Profits Group Problems G10-1 Strategy What strategy is your company following (try to classify it into one of the three strategies in the text)? How is your strategy working—how long will it allow you to maintain a competitive advantage? G10-2 Resources What are your firm’s key resources and/or capabilities? How do these translate into a competitive advantage? 1. See http://www.forbes.com/sites/ carminegallo/2011/03/25/starbucks -ceo-lesson-in-communication-skills/. 2. See http://www.digitalcoco3.com/ brand-love-infographic/. 3. Whitney Tilson, “Boring Portfolio” column on the Motley Fool site, February 28, 2000, http://www.fool.com/ boringport/2000/boringport000228.htm. 4. Michael Porter, “The Contributions of In- dustrial Organization to Strategic Manage- ment,” Academy of Management Review 6 (1981): 609–620. 5. Michael Porter, Competitive Strategy (New York: Free Press, 1980). 6. Profitability measured by operating income divided by assets over the period 1988– 1995. Adapted from Pankaj Ghemawat and Jan W. Rivkin. “Creating Competitive Advantage.” Harvard Business School Back- ground Note 798-062, February 2006 (re- vised from original January 1998 version). 7. Anabelle Gawer and Michael A. Cusumano, “How Companies become Platform Lead- ers,” Sloan Management Review 49 (2008): 28–35. Michael Porter also recognizes the importance of considering complements in an industry, although he argues that the presence of complements is not necessarily bad or good for an industry. He suggests that complements affect industry profit- ability through the way they influence the other five forces. 8. Definition from Jay B. Barney and Asli M. Arikan, “The Resource-Based View: Origins and Implications,” in The Black- well Handbook of Strategic Management, edited by Michael A. Hitt, R. Edward Freeman, and Jeffrey S. Harrison (Oxford: Oxford University Press, 2001), 138. 9. For an overview of the resource-based view, see Jay Barney, “Firm Resources and Sustained Competitive Advantage,” Journal of Management 17 (1991): 99–120. The explanation contained here draws from that description. 10. For more on how companies use the legal and regulatory process to further their competitive strategies, see Richard Shell, Make the Rules or Your Rivals Will (New York: Crown Business, 2004). For more on regulation, see S. E. Dudley, Primer on Regulation (Mercatus Policy Series, George Mason University, November 2005), avail- able at http://mercatus.org/publication/ primer-regulation. 11. Harvard Business School case number 9-373-052, “Prelude Corp.” Harvard Business School case number 9-373-052, “Prelude Corp.” EnD nOTES 06665_ch10_ptg01_125-136.indd 136 8/9/17 8:31 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 137 11 When the business plan for the new Nissan Rogue was developed in September 2005, a dollar was worth 115 yen. At this exchange rate, the contribution margin for models sold in the United States was projected to be 18%. When the Rogue was launched 21 months later, the dollar had appreci- ated to 124 yen. For the U.S. division of Nissan, this was good news because the Rogue was produced in Japan, but sold in the United States. Consequently, the revenue they earned (in dollars) had gone up relative to the costs they incurred (in yen). The contribution margin jumped to 20%. We illustrate this change in Figure 11.1. As you can see in the figure, Nissan’s good fortune did not last long. In 2008, the dollar started falling in value. By June 2011, the dollar had fallen to 77 yen and this caused the Rogue’s margin to fall to 12%. At that time, Nissan had planned on increasing the “domestic content” of its vehicles sold in the United States. Greater domestic content means that costs, and profit, are affected less by exchange rate movements. Higher domestic content can also increase domestic demand by appealing to consumers who want to “Buy American.” But higher domestic content has costs, as well. One can imagine a Japanese company in Indiana paying an American worker $16/hour to assemble items that were manufactured in Mexico by a worker who makes only $4/hour. For equal amounts of work, this would imply an 80% domestic content, but also much higher costs. As of 2016, Nissan had made some progress toward in- creasing the domestic content of their cars, for example, their Frontier Truck had the highest domestic content in its class (50%). In this chapter, we show you (1) how exchange rates are determined and (2) how changes in exchange rates affect firms and consumers. We also tell you what little we know about “bubbles,” prices that are not determined by the usual forces of supply and demand. The bursting of an asset bubble can have a big effect on exchange rates, so we include bubbles in this chapter. Foreign Exchange, Trade, and Bubbles 06665_ch11_ptg01_137-150.indd 137 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits138 11.1 The Market for Foreign Exchange To illustrate exchange rate movements, we examine the curious case of Iceland. The story begins in 2001, when all three of Iceland’s recently privat- ized banks decided to enter the high-risk world of investment banking. They borrowed from other banks, and used the funds to buy Beverly Hills condos, British soccer teams, and Danish airlines. At that time, the prices of the assets they purchased were rising faster than the interest rates they were paying, so the banks made a lot of money. Buoyed by the belief that asset prices would keep rising, Iceland’s banks borrowed more and bought more. By 2006, the banks were finding it difficult to borrow from other banks, so they started borrowing through the Inter- net, mostly from depositors living in the United Kingdom. In just two years, the number of depositors lending money to Iceland’s banks outnumbered the entire population of Iceland and the amount they borrowed was bigger than Iceland’s entire national income. By 2008, some of the assets purchased by the banks began to decline in value. In response, the credit rating agencies downgraded the banks’ credit- worthiness, and foreign depositors rushed to withdraw their money. As depos- its came home to the UK, not only did the banking sector crash, but the krona plunged in value and prices of imported goods soared.1 Although these changes caused a lot of pain in Iceland, there is an upside to a weak currency—Iceland’s exports began looking a lot less expensive to foreign buyers. Exports (and tourism) increased, and employment eventually recovered. Figure 11.1 YEN/USD Exchange Rate 130.00 120.00 110.00 100.00 18% Margin 24% Margin 12% Margin U S D /J P Y 90.00 80.00 70.00 60.00 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 06665_ch11_ptg01_137-150.indd 138 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 11 • Foreign exchange, trade, and Bubbles 139 Greece had a similar crash, at about the same time, but its response has been very different. Because Greece does not have its own currency (it aban- doned the drachma when it joined the Eurozone in 2001), their exchange rate is “fixed” with respect to their major trading partners. Consequently, Greece’s exports still look expensive, and its economy has yet to recover. As of 2016, unemployment was still over 20% and national income was shrinking. To understand these changes, we begin with a simple question, “Why do people want to trade one currency for another?” To answer it, imagine that an Icelander wants to buy a Land Rover built in the United Kingdom. Before she can purchase an imported car, imagine that our Icelandic consumer must pay for the car in pounds. While not literally true (it could be anyone in the verti- cal supply chain, for example, the manufacturer, exporter, or local car dealer), the exposition is simpler if we pretend that the consumer exchanges krona (ISK) for pounds (GBP) and then buys the imported car herself. In words that should now be familiar, we say that the Icelander “demands” pounds in order to purchase British goods. Iceland’s aggregate demand for British pounds includes everyone in Iceland who wants to purchase British goods and services, or who wants to invest in Britain. To do so, they have to “sell” krona to “buy” pounds. Every time you see the word “sell,” think of supply, and every time you read the word “buy,” think of demand. On the other side of the transaction are those who want to “sell” pounds to “buy” krona. The “supply” of pounds includes everyone in Great Britain who wants to buy Icelandic goods and services or who wants to invest in Iceland. The market for foreign exchange brings together the demanders of pounds and the suppliers of pounds, and the equilibrium price is the exchange rate, or the price of a pound measured in krona.2 We plot the price of a pound measured in krona in Figure 11.2. The financial symbol for this exchange rate is GPB/ISK. We see that the price of a pound Figure 11.2 GBP/ISK Exchange Rate 220 200 180 160 140 120 100 2005 2006 2007 2008 2009 2010 2011 2012 G B P /I S K 06665_ch11_ptg01_137-150.indd 139 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits140 increased from 125 krona in 2008 to about 200 krona in 2012. We say that the pound appreciated, or that that krona depreciated. To figure out why these changes occurred, apply the tools of Chapter 8 to the market for foreign exchange. Here is how to do it. When UK deposi- tors withdrew their krona deposits, they sold krona to buy pounds. This rep- resented an increase in demand for pounds that made the price of a pound appreciate against the krona. Alternatively, we could analyze these movements by using the supply and demand for krona. The trick is realizing that supply of pounds (those who sell pounds to buy krona) is also demand for krona. Similarly, demand for pounds (those who sell krona to buy pounds) is also the supply of krona. And the price of a krona, measured in pounds, is the inverse of the price of a pound measured in krona. When the pound appreciated from 125 to 200 krona, we could also say that the krona depreciated from 0.008 pounds to about 0.005 pounds, or about half a penny. If this sounds complicated, it is. The difficult part is keeping track of your frame of reference. If you are looking at it from the point of view of pounds, it is a demand increase that leads to a pound appreciation, but if you are look- ing at it from the point of view of krona, it is a supply increase that leads to a krona depreciation. Since the pound appreciation is a krona depreciation, both frames give you the same answer. Now let’s test your understanding: try to figure out how a decrease in U.S. interest rates affects the exchange rate of the dollar against a foreign currency, like the yen. This is the kind of question you might get in a job interview at Nissan. To answer it, we use dollars as our frame of reference and start from first principles. A lower U.S. interest rate would make investing in the United States appear less attractive to a Japanese investor, who has to sell yen to buy dollars to invest in the United States. Consequently, a lower U.S. interest rate would decrease Japanese demand for U.S. dollars, which would make the dollar depreciate against the yen. Now analyze the behavior of a Japanese borrower. A lower U.S. interest rate makes the “carry trade” (borrow dollars from a U.S. bank and then sell dollars to buy yen to invest in Japan) look more attractive. This represents an increase in the supply of dollars (“selling” dollars), which makes the dollar depreciate against the foreign currency. Notice that we get the same answer regardless of whether we look at the foreign investors or foreign borrowers: lower U.S. interest rates will make U.S. investors look overseas for investments and U.S. borrowers look domestically for loans. Both lead to a depreciation of the dollar. 11.2 The Effects of a Currency Devaluation Now that we understand how exchange rates are determined, the next step is to figure out what effects they have on the real economy. We begin with the simple case of a good with 100% domestic content and examine the effects of currency devaluation on four groups: domestic consumers, domestic producers, foreign consumers, and foreign producers. 06665_ch11_ptg01_137-150.indd 140 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 11 • Foreign exchange, trade, and Bubbles 141 Golf courses may have close to 100% domestic content, so we are going to use them to illustrate the effect of a peso devaluation. After the devalua- tion, golf in Mexico looks less expensive to U.S. consumers and makes golf in the United States look more expensive to Mexican consumers. The net effect of a peso devaluation is a reduction demand for U.S. golf and increase in demand for Mexican golf. The supply of golf, with 100% domestic content, is unaffected. We represent these changes on the left side of Figure 11.3. As above, the key to understanding them is to keep track of your frame of reference. A peso devaluation increases the demand for golf in Mexico but does not affect sup- ply. As a result, the price of Mexican golf goes up, measured in pesos. The higher price helps Mexican golf course owners (producers) but hurts Mexican golfers (consumers). The peso devaluation (dollar appreciation) has the opposite effect in the United States. In general, a devaluation reduces U.S. demand and price, mea- sured in dollars. U.S. golfers (consumers) benefit but U.S. golf course owners (producers) are harmed. A currency devaluation helps domestic suppliers and foreign consumers but hurts domestic consumers and foreign suppliers. Things get more complicated when, as is common, firms do not produce items with 100% domestic content. In general, firms that export heavily also tend to import heavily. In this case, a currency devaluation will increase export demand but also reduce supply because it raises the cost of imported parts. What this means is that our simple message that currency devaluations benefit domestic firms and harm domestic consumers is muted to the extent that the domestic content falls below 100%. With this caveat, let’s return to the effects of an appreciation of the pound relative to the Iceland krona. First, it increased export demand, for example, Quantity P ri ce in P es o s Quantity P ri ce in D o ll ar s Supply of Golf in Tijuana New Demand Demand for Golf in Tijuana Supply of Golf in San Diego New Demand Demand for Golf in San Diego Figure 11.3 Demand-Supply Analysis of a Peso Devaluation 06665_ch11_ptg01_137-150.indd 141 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits142 for fish in Iceland. As a consequence, the domestic price of fish (in krona) went up. These changes helped Icelandic producers but hurt Icelandic consumers. Similarly, the appreciation of the pound decreased export demand for for- eign goods sent to Iceland, which caused a drop in the price of, for exam- ple, British cars (in pounds). These changes hurt British producers but helped British consumers. 11.3 Bubbles From 1980 to about 2008, the economies of the developed world experienced steady growth, low unemployment, and mild inflation. Things were so good, for so long, that this period has been called the “great moderation.” When it ended, it was sudden, dramatic, and unexpected. Very few economists predicted the crash, but since it happened, many of us have tried to come up with satisfactory explanations for it. With this chapter, we take a tentative step into the controversial area of bubble-ology, the study of prices not determined by the usual forces of demand and supply. Our explanation has to do with the self-fulfilling role of expectations. During the great moderation, people began to expect that things would con- tinue as they had for so long. To see how this could affect price, imagine that buyers and sellers see a price increase in one year and expect a similar price increase in the following year. If buyers expect a future price increase, they would accelerate buying to avoid it, just as sellers would delay selling to take advantage of it. We illus- trate these changes in Figure 11.4, which shows an increase in demand and a decrease in supply. Both changes tend to increase price. In other words, once people form expectations about future price increases, these expectations tend to become self-fulfilling. This is often what economists mean when they talk about “bubbles.” In addition, if buyers expect prices to increase faster than the interest rate, it makes sense to borrow and buy now in order to sell in the future. In fact, an increase in leverage, or borrowing, often accompanies bubbles. Q P D1 S2 S1 D2 Figure 11.4 Effects of Expectations on Demand and Supply 06665_ch11_ptg01_137-150.indd 142 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 11 • Foreign exchange, trade, and Bubbles 143 There are certain characteristics of bubbles that economists have documented.3 1. Bubbles emerge when investors disagree about the importance of big economic events. Because it is easier to place financial bets on higher prices, optimistic investors dominate. 2. Bubbles involve very large increases in trading volume. 3. Bubbles may continue even when many suspect a bubble. The bubble won’t pop, however, until a sufficient number of skeptical investors act simultaneously. So far, no one has figured out how to predict when this is likely to occur. To illustrate these phenomena, let’s look at the housing market in the United States. The increase in prices began in 1993 when the government enacted policies designed to encourage low-income homeowners to buy houses. The government reduced qualifications for home borrowing from government-sponsored lenders like Fannie Mae. This led to an increase in the supply of credit to would-be homeowners, and an increase in demand for houses, which lead to an increase in the rate of home ownership, as shown in Figure 11.5.4 This is the “big economic event” that started the bubble. Especially in areas where the supply was limited by strict zoning laws (e.g., East Coast, California, and Florida), prices increased dramatically. Because many market participants expected housing prices to continue to increase, they borrowed heavily to buy bigger and sometimes even second houses. The bankers who lent them money thought that the loans were “safe” because the price of the underlying asset had always gone up in the past. As a consequence, banks were willing to lend on very favorable terms.5 Figure 11.5 U.S. Home Ownership Rate 60 61 62 63 64 65 66 67 68 69 70 19 87 19 89 19 91 19 93 19 95 19 97 19 99 20 01 20 03 20 05 20 07 06665_ch11_ptg01_137-150.indd 143 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits144 11.4 How Can We Recognize Bubbles? In 2006, David Lereah, chief economist of the National Association of Realtors, published a book titled Are You Missing the Real Estate Boom? Why Home Values and Other Real Estate Investments Will Climb Through the End of the Decade—And How to Profit from Them. The book argued that the price increase was due to limits on supply (low inventories, zoning restrictions) and increases in demand (low mortgage rates, and favorable demographics caused by a big increase in retirees, who often buy second homes). Lereah predicted that the price increase would continue at least through the end of the decade. In contrast, Yale economist Robert Shiller warned of an irrational hous- ing bubble.6 He identified the bubble by comparing house prices to rents. From Chapter 9, we know that in long-run equilibrium, homeowners should be indifferent between buying and renting. For example, if the price of rent- ing becomes much less expensive than buying, we would expect that buyers would turn to renting which would reduce demand for owning and eventually bring the price down. In Figure 11.6, we plot the relationship between the cost of renting and the cost of owning a house, we see that owning became much more expensive than renting (70% more in 2006). We also see the dramatic decline in house prices beginning in 2006. So, Professor Shiller was right about house prices being too high, but he was a couple years early with his call. So why did the bubble pop? If you believe the bubble-ologists, it was because there were enough skeptical investors, like Professor Shiller, who started betting on house prices to fall. But the truth is that we don’t know. Without a more complete theory of bubbles, one would tell us when they were going to pop, it is impossible to test for the existence of bubbles. 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 Price-to-Rent Ratio (Q1 1997 = 1.0) Case-Schiller Home Price Index/Owner-Equivalent Rent Figure 11.6 Renting versus Owning 06665_ch11_ptg01_137-150.indd 144 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 11 • Foreign exchange, trade, and Bubbles 145 Interestingly, this was not Professor Shiller’s first good call on a price bubble. In 2000, he made what is perhaps the best prediction in stock market history when his book Irrational Exuberance was released at the same time that the “Internet” or “tech” bubble began to burst. He identified the bubble by looking at the long-run equilibrium relationship between stock prices and earnings or profit. If prices are rational, then they should equal the discounted flow of future earnings. Obviously, we cannot observe future earnings, so Professor Shiller plotted current stock prices against a 10-year trailing average of past earnings. In Figure 11.7, we update Professor Shiller’s analysis and plot the Price/ Earnings ratio of the S&P 500 index (and comparable predecessor indices) going back to 1882. The average of the ratio is about 16, which means that, on average, a stock’s price is about 16 times its trailing earnings. Equivalently, if you hold a typical stock for 16 years, earnings will just cover the purchase price, on average. So what do bubbles have to do with exchange rates? Looking at Shiller’s graph, we see that from 2003 to 2007, the stock market was over-valued, relative to its long-run average. In fact, there are only two other episodes in history where stock prices have been this high (1929 and 2000), relative to earnings. In both of these cases, prices crashed after reaching these heights. Shiller’s methodology also tells us that Icelandic banks began borrowing and investing at a time when asset prices (including house prices) were very Figure 11.7 Stock Price/Earnings Ratio 0 18 81 18 86 18 92 18 98 19 03 19 09 19 15 19 20 19 26 19 32 19 37 19 43 19 49 19 54 19 60 19 66 19 71 19 77 19 83 19 88 19 94 20 00 20 05 20 11 20 17 10 20 30 40 50 P /E Year Arithmetic Mean: 16.7 Geometric Mean: 15.5 Price/Earnings Ratio of U.S. Stocks, 1881–2017 (Using 10-Year, Inflation-Adjusted Earnings) 06665_ch11_ptg01_137-150.indd 145 8/10/17 5:22 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION II • Pricing, Costs, and Profits146 expensive. Once the asset prices began to come down, depositors lost faith in the banks’ ability to pay them back. When they withdrew their deposits, and sold krona to buy pounds, the krona depreciated relative to the pound, which hurt Icelandic consumers. If you look closely at the graph, you will also see that 2017 stock prices are as expensive as they were in 2007. This suggests to some that the stock market is over-valued, but others say that the valuation is justified given the very low discount (interest) rates. Remember that when you buy a stock, you receive the discounted flow of future profit. If the discount rate is very low, discounted future profits are bigger, which should drive up the price of the stock relative to its earnings. The difficulty of testing whether stocks are really over-valued (in a bubble) is why bubble-ology is so controversial. Besides, if someone really knew that a bubble were going to burst, he probably wouldn’t waste time telling you (they would trade on the information instead). And he certainly wouldn’t waste time writing textbooks. 11.5 Purchasing Power Parity So is there a similar long-run relationship that would tell us when a currency is over-valued? The answer is purchasing power parity, the idea that, in the long run, exchange rates and/or prices should adjust so that tradable goods cost the same no matter where you buy them. If they didn’t, exporters could make money by buying the good in one country and selling it in another. This is referred to as “arbitrage.” In July 2007, the Economist reported that a Big Mac cost $7.61 in Iceland, $3.41 in the United States, and only $1.45 in China. The theory of purchasing power parity says that arbitrage should push these prices together. The idea is that if goods are cheaper in China, exporters can buy them in China, ship them to the United States, and then sell them to U.S. consumers. To buy the Chinese goods, U.S. consumers would sell dollars to buy yuan, increasing demand for yuan, which would make the yuan appreciate relative to the dollar, which would increase the dollar price of a Big Mac purchased in China. In other words, the Economist’s “Big Mac Index”7 can tell you which currencies are over- or under-valued relative to the dollar. Now there are some problems with the theory linking these prices together. The obvious one is that Big Macs are not traded goods and cannot be shipped thousands of miles. However, many of the ingredients in a Big Mac are actively traded (so it may work) and, in 2007, the Big Mac Index was able to identify Iceland’s over-valued krona and China’s under-valued yuan. Both of those currencies have since moved in the direction that the index would have predicted. 06665_ch11_ptg01_137-150.indd 146 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 11 • Foreign exchange, trade, and Bubbles 147 SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • In the market for foreign exchange between England and Iceland, the supply of pounds includes everyone in Britain who wants to sell pounds to buy krona in order to buy Icelandic goods, or invest in Iceland. • The demand for pounds includes everyone in Iceland who wants to sell krona to buy pounds in order to buy British goods, or invest in Britain. • The demand for pounds is equal to the sup- ply of krona, and vice-versa. • Exchange rates are prices determined by supply and demand. An increase in demand for pounds or a decrease in supply of krona will appreciate the pound relative to the krona. • A decline in U.S. interest rates will induce foreign borrowers to borrow in dollars, sell the dollars to buy a foreign currency, and then invest in the foreign country (the so-called “carry trade”). Such an increase in the supply of dollars causes a dollar depreciation. • A decline in U.S. interest rates would have a similar effect on domestic investors who would look to international investments with higher rates of return. They would sell dollars to buy the foreign currency, and then invest in the foreign country. Such an increase in the supply of dollars causes a dollar depreciation. • Devaluations help domestic producers and foreign consumers, but hurt domestic con- sumers and foreign producers. • Expectations about the future play a role in price bubbles. If buyers expect a future price increase, they will accelerate their purchases to avoid it. Similarly, sellers will delay selling to take advantage of it. In this respect, the expectations become self-fulfilling. • You can potentially identify bubbles by using the “indifference principle” of Chapter 9 to tell you when market prices move away from their long-run equilibrium relationships. Multiple-Choice Questions 1. The intersection between demand for dollars and the supply of dollars is known as the a. inflation rate. b. exchange rate. c. price. d. quantity. 2. An individual in the United States wants to buy office equipment from England that costs 2,800 pounds. If the exchange rate is $1.92, how much will it cost in dollar terms? a. $2,800 b. $5,376 c. $1,458 d. Need more information 3. If the Chinese yuan devalues relative to the U.S. dollar, then a. U.S. producers will benefit; Chinese consumers will benefit. b. U.S. producers will benefit; Chinese consumers will be hurt. c. U.S. producers will be hurt; Chinese consumers will benefit. d. U.S. producers will be hurt; Chinese consumers will be hurt. 4. Following a peso appreciation relative to the dollar, which of the following results is expected to occur? a. Prices in the United States would rise, and prices in Mexico would rise. b. Prices in the United States would rise, and prices in Mexico would fall. c. Prices in the United States would fall, and prices in Mexico would rise. d. Prices in the United States would fall, and prices in Mexico would fall. 06665_ch11_ptg01_137-150.indd 147 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 148 SECTION II • Pricing, Costs, and Profits 5. Following a peso appreciation relative to the dollar, which of the following results is expected to occur? a. U.S. consumers would benefit, and Mexican producers would benefit. b. U.S. consumers would be hurt, and Mexican producers would benefit. c. U.S. consumers would benefit, and Mexican producers would be hurt. d. U.S. consumers would be hurt, and Mexican producers would be hurt. 6. Following an increase in Mexican interest rates relative to U.S. interest rates (which causes Mexican investors to borrow abroad to invest domestically), which of the following is expected to occur? a. The dollar would appreciate relative to the peso, and Mexican prices would increase. b. The dollar would appreciate relative to the peso, and Mexican prices would decrease. c. The dollar would depreciate relative to the peso, and Mexican prices would increase. d. The dollar would depreciate relative to the peso, and Mexican prices would decrease. 7. Following an increase in Mexican interest rates relative to U.S. interest rates, which caused U.S. investors to invest in Mexi- can bonds, which of the following would occur? a. The dollar would appreciate relative to the peso, and Mexican prices would increase. b. The dollar would depreciate relative to the peso, and Mexican prices would decrease. c. The dollar would depreciate relative to the peso, and Mexican prices would increase. d. The exchange rate would not be af- fected, and neither would Mexican prices. 8. In July 2014 the price of a Big Mac was $4.80 in the United States, while in China it was only $2.73 at market exchange rates. So the “raw” Big Mac index says that the yuan was under-valued by 43% at that time. How would domestic inflation in China affect the Big Mac Index? a. The Big Mac Index would indicate that the Chinese currency is less under-valued. b. The Big Mac Index would indicate that the Chinese currency is more under-valued. c. The Big Mac Index is not affected by inflation. d. The Big Mac Index would indicate that the Dollar is more under-valued. 9. If the U.S. economy strengthens, consumer incomes increase, and consumers buy more imported goods and services. How will this affect exchange rates? a. The dollar will appreciate relative to the yuan, and U.S. prices will increase. b. The dollar will appreciate relative to the yuan, and U.S. prices will decrease. c. The dollar will depreciate relative to the yuan, and U.S. prices will increase. d. The dollar will depreciate relative to the yuan, and U.S. prices will decrease. 10. If buyers expect future price increases, they will ____ their purchases to avoid it. Simi- larly, sellers will ____ selling to take advan- tage of it. a. accelerate; accelerate b. accelerate; delay c. delay; accelerate d. delay; delay Individual Problems 11-1 The Carry Trade In 2014, the euro was trading at $1.35 on the foreign exchange market. By 2015, the rate had fallen to $1.10, due to falling European interest rates. Explain the fall in the price of a euro using supply and demand curves, and in words. 06665_ch11_ptg01_137-150.indd 148 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 11 • Foreign exchange, trade, and Bubbles 149 11-2 Brexit Fears When Great Britain voted to leave the Euro- zone, the pound depreciated 17% against the dollar. It also raised fears that the Eurozone would fall apart. Explain how this fear would affect the euro/dollar exchange rate. 11-3 Effects of the Pound Devaluation on Tourism and Bank Profits Explain the effects of the pound devaluation on (1) imports and tourism to Great Britain and (2) profits of U.S. bank with European trading sub- sidiaries in London (which earn profit in pounds). 11-4 The Effects of a Pound Depreciation on Whirlpool Most of the appliances that Whirlpool sells in the UK, are built in the EU. What is the effect of a pound depreciation on Whirlpool’s profit margin. 11-3 Domestic Content Explain the effect of a dollar depreciation on domestic firms and domestic consumers for goods with less than 100% domestic content. 11-4 Dollar Devaluation How will a dollar devaluation affect businesses and consumers in the twin cities of El Paso, the United States, and Juarez, Mexico? 11-5 Effect of Expectations on the Exchange Rate If market participants expect the krona to ap- preciate relative to the dollar, what will happen? Group Problems G11-1 Exchange Rate Effects on Industry Using shifts in supply and demand curves, describe how a change in the exchange rate affected your industry. Label the axes, and state the geographic, product, and time dimensions of the demand and supply curves you are drawing. Explain what happened to industry price and quantity by making specific references to the demand and supply curves. How can you profit from future shifts in the exchange rate? How do you predict future changes in the exchange rate? G11-2 Exchange Rate Effects on Your Firm Describe how a change in the exchange rate affected your firm. Explain what happened to your price and quantity. How can you profit from future shifts in the exchange rate? How do you predict future changes in the exchange rate? 1. We are very grateful to Olafur Arnarson for his guidance and feedback on our discussion of the financial crisis in Iceland. We recom- mend his book on the subject to anyone who reads Icelandic. 2. To analyze these changes, we assume that there are only two countries (Iceland and Great Britain) trading goods and investing in each other’s countries. Trade is easier to explain with a two-country example, so we ignore trade that runs through third-party countries. 3. Justin Lahart, “Bernanke’s Bubble Labora- tory,” Wall Street Journal, May 16, 2008. 4. David Streitfeld and Gretchen Morgenson, “Building Flawed American Dreams,” New York Times, October 18, 2008, http://www.nytimes.com/2008/10/19/ business/19cisneros.html 5. Edward L. Glaeser, Joseph Gyourko, and Albert Saiz, “Housing Supply and Housing Bubbles,” NBER Working Paper 14193, July 2008, https://www.nber.org/papers/ w14193 6. Jonathan R. Laing, “The Bubble’s New Home,” Barron’s, June 20, 2005, http://www.barrons.com/articles/ SB111905372884363176 7. See “Big Mac Index,” The Economist, http://www.economist.com/content/ big-mac-index END NOTES 06665_ch11_ptg01_137-150.indd 149 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 06665_ch11_ptg01_137-150.indd 150 8/9/17 8:32 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 151 SECTION 12 More Realistic and Complex Pricing 13 Direct Price Discrimination 14 Indirect Price Discrimination Pricing for Greater Profit 3 06665_ch12_ptg01_151-162.indd 151 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 06665_ch12_ptg01_151-162.indd 152 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 153 In July of 2007, Scholastic Publishing released Harry Potter and the Deathly Hallows, the final installment of the smash Harry Potter book series, the best-selling book series in history. Sales expectations were high, as the previ- ous book in the series had sold over seven million copies in the first 24 hours. Scholastic set a suggested retail price of $34.99 and was rumored to be sell- ing the book to retailers at a wholesale price of $18.99, a margin of 45.7%.1 From Chapter 6, you would expect retailers to set the price somewhere above $18.99—specifically, at the point where the markup equals the inverse demand elasticity, (P 2 MC) / P 5 1/ | e |. Instead, Costco and Walmart offered the book for $18.18 and $17.87, respectively. Online retailer Amazon was even more aggressive. Those who preordered the book paid only $17.99, and also received a $5 gift certificate and free shipping. At this point, three potential conclusions about pricing might occur to you: (1) book retailers aren’t interested in maximizing profit; (2) we gave you bad advice with the (P 2 MC) / P 5 1/ | e | pricing rule; or (3) real-world pric- ing is more complex than we have let on. In fact, there are a lot of times when you want to move beyond the simple pricing rule of Chapter 6 because you can make more money by doing so. We have seen this kind of pricing before, when the grocery store in Chapter 6 put a low price on three-liter Coke to generate additional foot traffic. Whatever the grocery store lost on three-liter Coke, it made up in sales on other items. Amazon was following a similar tactic. By pricing low, Amazon sold over two million copies of The Deathly Hallows. Some buyers were new customers, who would purchase books from Amazon in the future, and some purchased additional items at the same time that they purchased The Deathly Hallows. In fact, Amazon estimated that about 1% of its $2.89  billion second-quarter revenue was due to this effect. 12 More Realistic and Complex Pricing 06665_ch12_ptg01_151-162.indd 153 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit154 Both the grocery store and the bookstore were pricing where MR , MC, or equivalently where (P 2 MC) / P , 1/ | e |. They did so because they were trying to maximize total profit, not profit on an individual product. In this chapter, we show you how to move beyond the simple, single- product analysis of Chapter 6 to more complex and realistic settings, like those involving commonly owned products. In fact, the MR 5 MC pricing rule applies only to a single-product firm setting a single price on a single product. In more complex settings, the rule may not apply. 12.1 Pricing Commonly Owned Products Commonly Owned Substitutes Commonly owned products add a level of complexity to pricing that we can easily understand by using marginal analysis. To see this, let’s examine the recently announced acquisition of SABMiller, the owner of Miller brands of beer, by Anheuser-Busch InBev, which owns the Budweiser brands. Many con- sumers consider Miller and Budweiser to be close substitutes. How would this acquisition change the pricing of the two brands? With just one brand, the pricing decision is simple. You trade-off the ben- efits of a lower price (more units sold) against the costs of a lower price (less earned on each unit). Marginal analysis balances these two effects and sug- gests a price at the point where MR 5 MC to maximize profit. Common ownership of two substitutes changes this simple pricing cal- culus. Now, an increase in the sales of one brand (through a price reduction) will “steal” some sales from the other. Before you owned the rival brand, you didn’t care where your additional sales came from, but now that you own both brands, you don’t want to steal sales from a brand that you already own. This is sometimes called “cannibalizing” the sales of one product with increased sales of the other. After the acquisition, you will find it profitable to eliminate such cannibalization. You do this by raising price on each brand. Formally, common ownership of two substitute products reduces the mar- ginal revenue of each product, since some of the revenue gain for one prod- uct comes at the expense of the other. With a single product, you price at MR 5 MC. After acquiring a substitute product, MR falls below MC. As a consequence, the post-acquisition firm finds it profitable to cut back output or, equivalently, increase price. We summarize this intuition in the following maxim: After acquiring a substitute good, raise price on both goods. Anticipating some pushback from the Antitrust Division of the U.S. Department of Justice, the merging parties agreed to sell the Miller brands in the United States to a rival, Molson Coors. Only with the assurances that Miller brands would stay under separate ownership did the Department of Justice allow the merger to go forward in July 2016. Another way to see why acquisitions raise price is to focus on the change in perspective that joint ownership confers. Your concern changes from earn- ing profit on an individual good to earning profit on both goods. Remember 06665_ch12_ptg01_151-162.indd 154 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChaPTEr 12 • More realistic and Complex Pricing 155 from Chapter 6 that aggregate demand (for both goods) is less elastic than the individual demands that comprise the aggregate. With less elastic demand, prices should increase. So far we haven’t said anything about which price to raise more; but here, again, marginal analysis can give us some guidance. Recall that the optimal price for a single product is set so that the margin is lower on more elastic products because consumers are more sensitive to the price of these products. If you could somehow switch these consumers to the higher-margin product, you’d increase profit. You can do this by raising the price on the low-margin good. After acquiring a substitute product, raise price on both goods, but raise price more on the more elastic (low-margin) product. As you raise price on the low-margin product, some consumers switch to the higher-margin substitute, thereby increasing profit. This tells you which direction to go (raise price on both and raise it more on the low-margin product), but it doesn’t tell you by how much. You get there by taking small steps. After raising price, recalculate MR and MC—or simply check to make sure that profit increases—to see if further change is profitable. After acquiring a substitute product, you can also try to reduce cannibal- ization by repositioning the products so that they don’t directly compete with each other—provided that repositioning isn’t too expensive. For example, post-merger, Anheuser-Busch InBev could reposition some of its larger port- folio as “craft” or “imported” beers so that they don’t directly compete with Budweiser. Commonly Owned Complements Common ownership of complementary products leads to the opposite advice. Suppose a concert venue purchases the profitable parking garage next to the venue. Before the purchase, both the parking garage and the concert venue set prices without considering the effect of their prices on each other’s demand. But after the acquisition, a price decrease at the concert venue will increase the number of customers at the concert venue and the parking garage. Com- mon ownership of the concert venue and parking garage increases MR at each because increasing sales of one product (by reducing price) increases demand for the other. When MR rises above MC, output should increase, or, equiva- lently, optimal price should fall. We summarize this intuition in the following maxim: After acquiring a complementary product, reduce price on both products to increase profit. 12.2 Revenue or Yield Management Products like cruise ships, parking lots, hotels, and stadiums have several characteristics that affect their pricing. First, the costs of building capacity are 06665_ch12_ptg01_151-162.indd 155 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit156 mostly fixed or sunk. Second, these costs are large relative to marginal costs. Third, firms in these industries typically face capacity constraints; that is, they can increase output only up to capacity, but no further. To understand how prices are set in these industries, let’s begin with the decision of how much capacity to build. This is an extent decision, so we use marginal analysis. The owners have an incentive to keep adding capacity (more parking spaces, more hotel rooms, more cruise ship cabins, more seats in a stadium) as long as long-run marginal revenue is greater than long-run marginal cost, LRMR . LRMC. The owners stop building additional capacity when LRMR 5 LRMC. Here, the term long-run marginal revenue refers to the expected additional revenue that another parking space, hotel room, ship cabin, or stadium seat would earn over the life of the capacity. Likewise, long- run marginal cost is the expected additional cost of building, maintaining, sell- ing, and using another unit of capacity over the life of the capacity. Once construction is finished, we know from Chapter 3 that we should ignore sunk or fixed costs when setting price to avoid committing the sunk- cost fallacy. The relevant costs and benefits of setting price are the short-run marginal revenue (MR) and short-run marginal cost (MC). Since short-run marginal cost is likely to be much smaller than long-run marginal cost, while short-run marginal revenue is likely to be close to long-run marginal revenue, you want to price to fill capacity, assuming that capacity was set correctly equating long-run marginal cost to long-run marginal revenue. This leads to the rather obvious advice: If MR . MC at capacity, then price to fill available capacity. Because MR . MC, the firm’s managers would like to reduce price in order to sell more, but cannot because the firm is limited by capacity. So the firm sells as much as it can, or prices to fill capacity. If demand is known, this is relatively easy to do. For example, to set price for a parking lot in a downtown business district, you look to see what time the lot fills up. If the lot fills up before 9 a.m., then raise price; if the lot is still empty at 9 a.m., then reduce price. If the lot fills up near 9 a.m., the price is just right. In contrast, if demand is hard to predict, pricing to fill capacity becomes much more difficult. For example, each time a cruise ship sails, no one knows what demand will be. To determine optimal price, the cruise line’s managers balance the costs of overpricing (lost profit on unfilled cabins) against the cost of underpricing (lower margins on filled cabins). In this case, an optimal price would minimize the expected costs of these two errors. If the lost profit from these two pricing errors is symmetric, then the firm should price so that expected (predicted) demand is just equal to capacity. We call this the “target price.” However, if the lost profit from over- pricing is less than the lost profit from underpricing, then the firm should overprice, or price above the target price, and vice versa. This will lead, on average, to more overpricing errors than underpricing errors, but the cost of these errors is lower. 06665_ch12_ptg01_151-162.indd 156 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChaPTEr 12 • More realistic and Complex Pricing 157 If the cost of overpricing (unused capacity) is smaller than the cost of underpricing (lower margins), then price higher than would fill capacity on average, and vice versa. The precise degree of underpricing or overpricing depends not only on these costs, but also on the probability of each type of error, which depends on what demand we think is likely to happen. We will illustrate this difference more clearly in Chapter 17 when we discuss pricing under uncertainty. Obviously, with better demand forecasts, you will make fewer errors, which will raise profit because the ship is filled as close to capacity as possible and at the best possible price. To better match demand to available capacity, cruise ship managers often adjust prices up until the time the ship sails. If it looks like capacity is going unused, they reduce price; and if it looks like capacity will be more than filled, they raise price. But charging different prices to passengers who purchase at different times raises other problems. First, a slew of websites (from Hopper and Cayole to Google Flights) now help consumers forecast future prices on flights and cruises. If consumers realize that they may get a lower price if they wait to purchase, then you create an incentive for them to wait. This makes it more difficult for airlines to match demand to capacity—the whole point of adjusting price. To eliminate the incentive to time purchases, many cruise- line managers reduce price only slightly or reduce price only by offering cabin upgrades, so that consumers don’t realize that they’re paying less. Second, if some passengers realize they paid more than their fellow passengers who booked at different times, they may become angry and demand a refund or disparage the cruise line to future customers. We discuss this phenomenon in a section of the chapter on price discrimination titled “Only Schmucks Pay Retail.” No one wants to be a schmuck. 12.3 Adver tising and Promotional Pricing In this section, we use marginal analysis to show you how to price in conjunc- tion with advertising or promotional expenditures. The most important thing to realize is that different types of promotional expenditures affect demand in different ways. For pricing, it is most important to know whether promotional expenditures make demand more or less price elastic.2 If promotional expenditures make demand more (less) price elastic, then you should reduce (increase) price when you promote the product. Consider the simplest kind of advertising—information about the price of your product relative to substitute products. Coupons, end-of-aisle displays in grocery stores, and weekly advertising inserts in the newspaper fall into this category. By focusing consumers on prices, you make them more sensitive to price differences, which makes demand more elastic. When you make demand more elastic, you want to reduce price to attract more customers. When you see this kind of promotion, you also typically see a reduction in the price of the promoted good. 06665_ch12_ptg01_151-162.indd 157 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit158 On the other hand, advertising designed to increase the attractiveness of the product makes demand less elastic. Advertising the product’s high quality or associating the product with a celebrity or desirable activity falls into this category. These promotional campaigns are trying to reduce the customer’s sensitivity to price. In this case, it makes sense to increase price. A final cautionary note about pricing and quality: a higher price may influence consumer perceptions about the quality of the product. If you know nothing else about the product except its high price, you may infer that it is of high quality. In this case, you’d want to price high to signal quality. Many wines are priced high for this reason. 12.4 Psychological Pricing Many pricing strategies are built on the assumption that consumers behave in a rational, calculating way. But, sometimes they don’t. Consider Coca-Cola’s failed attempt to have vending machines adjust price with the temperature. Because people are willing to pay more for a cold drink when it is hot, the Coca-Cola CEO pronounced that “it is fair that it [a can of Coke] should be more expensive” when heat drives up demand.3 A consumer outcry (and opportunistic advertising by rival Pepsi) led the company to reverse course. However, the CEO could have easily gained consumer acceptance by explain- ing that the vending machines will be providing discounts when colder tem- perature suppresses demand. Even though both statements—higher prices when temperatures are high and lower prices when temperatures are low—are equivalent, they are quite different, behaviorally. The relatively new field of behavioral economics adds psychological insights to standard economic models. Prospect theory, developed by Nobel Prize win- ner Daniel Kahneman and his long-time colleague Amos Tversky, identifies sev- eral behavioral regularities that are useful in formulating pricing strategy. First, people perceive how good a price is based on its distance from a “reference price.” A reference price is simply how much we expect something to cost, given the environment. For example, we might see $4 for a bottle of beer as both unreasonably expensive (at a grocery store) and reasonably cheap (at a restaurant). This means that altering a consumer’s price expecta- tion upward can have the same effect on demand as altering the actual price downward, though without sacrificing profit. For example, first presenting a consumer with higher-priced options can drive up price expectations and make later, lower-priced options appear less expensive in comparison. Managing price expectations is as important as managing price. Prospect theory implies that consumers are motivated not by the actual price level, but rather by a comparison of the price level to the reference price. The idea is that a consumer will perceive a “win,” and is more likely to buy, if the price is below the reference price. It follows that firms should try to “frame” decisions so that consumers perceive them as gains, not losses. By describing its policy as higher prices during warmer weather, Coca-Cola implicitly set a low reference price, during the colder weather. Instead, Coca-Cola should 06665_ch12_ptg01_151-162.indd 158 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChaPTEr 12 • More realistic and Complex Pricing 159 have emphasized the lower prices during cold weather, which would have set a higher reference price, during the warm weather. Similarly, retailers should focus on “cash discounts” rather than “credit card surcharges” and airlines on “discounts for not checking bags” rather than “checked bag fees.” A second behavioral insight is that multiple losses or multiple gains do not obey simple arithmetic. How would you feel if, on your way home today, you lost $20? Now imagine instead you lost $10 and then, minutes later, you lost another $10. Which of these scenarios made you feel worse? To most people, the two losses feel worse even though they amount to the same $20. Similarly, finding two $10 bills makes most people happier than finding one $20 bill. For most of us, losses and gains are superadditive (the happiness from $10 1 $10 is greater than the happiness from $20). This has clear implications for pricing: Integrate losses but separate gains. Let’s reverse the example involving losing $20. If I have to lose $20, I’d rather do it all at once than lose a little each step of the way. This is why you rarely see charges for “shipping and handling” quoted separately. This also may account for the popularity of all-inclusive vacations. On the other hand, consider the decision by some airlines in 2008 to begin charging passengers for snacks on flights. At first glance, it seems like a sensible strategy. With a snack charge, only those who really value a snack buy, and the rest of the passengers aren’t forced to subsidize their fellow passengers’ snacking habits with slightly higher fares. Unfortunately for these airlines, the average consumer did not view it this way. First, the charge was seen as a loss simply because it was new. Second, having passengers face these small charges on top of the ticket price made many feel nickel-and-dimed, with the result that some switched airlines. Also beware of consumer concerns with fairness. One reason Home Depot would rather face shortages than raise price for snow shovels when it snows is to not be perceived as “unfair.” Consumers often have a notion of what they believe to be fair behavior by sellers. If you cross this line, the reaction can be quite strong. You only need to recall the increase in gas prices in 2012 that led to outraged calls for price controls and “windfall profit” taxes from infuriated consumers (although nobody seemed to call for price supports and “insuffi- cient profit” subsidies when prices fell dramatically). Companies that want to set prices that could be viewed as “unfair” must come up with creative solutions to overcome this concern. One example comes from the music industry. Performers don’t want to be perceived as greedy, so they set concert prices well below the market-clearing price. For example, a 2013 Beyoncé concert sold out in seconds because tickets were priced as low as $47. Minutes later, a large number of tickets appeared on secondary sites, like Craigslist and StubHub, at prices of over $2,000 for fairly poor seats. The secondary market prices aren’t viewed as unfair because most people think that fans are reselling tickets. But often, the artists or promoters hold back a number of tickets from the initial sale and then resell them on the secondary market. The artist may share in the proceeds from these secondary sales but may avoid blame for the high prices.4 Of course, this works only as long as consumers don’t figure out what’s going on. 06665_ch12_ptg01_151-162.indd 159 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit160 SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • After acquiring a substitute product, • raise price on both products to reduce price competition between them. • raise price more on the low-margin (more price elastic) product. • reposition the products so that there is less substitutability between them. • After acquiring a complementary product, reduce price on both products to increase demand for both products. • If fixed costs are large relative to marginal costs, capacity is fixed, and MR . MC at capacity, then set price to fill available capacity. • If demand is hard to forecast and the costs of underpricing are smaller than the costs of overpricing, then underprice, on average, and vice versa. • If promotional expenditures make demand more elastic, then reduce price when you promote the product, and vice versa. • Psychological biases suggest being aware of price expectations and “framing” price changes as gains rather than as losses. Multiple-Choice Questions 1. After massive promotion of Rihanna’s lat- est music album, the producers reacted by raising prices for her albums. This implies that promotion expenditures made the album demand a. more elastic. b. unitary elastic. c. change due to psychological pricing. d. less elastic. 2. All of the following choices are examples of promoting a firm’s product, except a. celebrity endorsements. b. pricing. c. discount coupons. d. end-of-aisle displays. 3. A firm that acquires a substitute product can reduce cannibalization by a. doing nothing. b. repositioning a product so that it does not directly compete with the substitute. c. setting the same price on both products. d. lowering prices on the low-margin products. 4. A shoe-producing firm decides to acquire a firm that produces shoe laces. This implies that the firm’s aggregate demand (shoes 1 laces) will be a. less elastic than the individual demands. b. more elastic than the individual demands. c. equally elastic as the individual demands. d. none of the above. 5. After firm A producing one good acquired another firm B producing another good, it lowered the prices for both goods. One can conclude that the goods were a. substitutes. b. complements. c. not related. d. none of the above. 6. Firms tend to raise the price of their goods after acquiring a firm that sells a substitute good because a. they lose market power. b. there is an increase in the overall demand for their products. c. the aggregate demand for both goods is more elastic than the demand for the individual goods. d. the aggregate demand for both goods is less elastic than the demand for the individual goods. 7. For products like parking lots and hotels, costs of building capacity are mostly fixed 06665_ch12_ptg01_151-162.indd 160 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChaPTEr 12 • More realistic and Complex Pricing 161 or sunk and firms in this industry typically face capacity constraints. Therefore, a. if MR . MC at capacity, then the firms should price to fill capacity. b. if MR , MC at capacity, then the firms should price to fill capacity. c. if LRMR . LRMC at capacity, then the firms should price to fill capacity. d. if LRMR , LRMC at capacity, then the firms should price to fill capacity. 8. A firm started advertising its product and this changed the product’s elasticity from 22 to 21.5. If, prior to advertising, the firm charged $10, the firm should a. raise price from $10 to $15.00. b. reduce price from $10 to $6.67. c. raise price from $10 to $13.33. d. reduce price from $10 to $7.50. 9. After running a promotional campaign, the owners of a local hardware store decided to decrease the prices for the advertised prod- ucts sold in their store. One can infer that a. the promotional expenditures made the demand for the advertised products more elastic. b. the promotional expenditures made the demand for the advertised products less elastic. c. the promotional expenditures had no effect on the demand elasticity. d. the owners got it wrong. To cover the promotional expenses, they should have raised the prices. 10. On average, if demand is unknown and costs of underpricing are ____ than the costs of overpricing, then ____. a. smaller; overprice b. smaller; underprice c. larger; underprice d. none of the above Individual Problems 12-1 Parking Lot Optimization Suppose your elasticity of demand for your parking lot spaces is 22, and price is $8 per day. If your MC is zero, and your lot is 80% full at 9 a.m. over the last month, are you optimizing? 12-2 Parking at Cowboys Stadium What would efficient revenue management imply for the pricing of the Cowboys Stadium parking lot on typical game days? How about for the Super Bowl? How about for the many smaller events that fill less than half the lot? 12-3 Product Store Locations Some high-end retailers place their most expensive products right in the entryway of the store, where consumers will see them first, and place their more popular, better-selling items further back. Why? 12-4 Macintosh versus iPhone When the Macintosh computer was introduced in 1982, Apple made it difficult for third-party software developers to develop software for the platform. In contrast, Apple makes it relatively easy for third-party developers to make appli- cations that run on the iPhone. Compare and contrast these two strategies. 12-5 Concert Prices Concert prices have increased coincidentally with illegal downloading of music off the Inter- net. Why? 12-6 Radio Stations and Rock Concerts In 2005, Clear Channel (an owner of multiple popular radio stations) spun off concert pro- moter Live Nation into an independent com- pany. How would this affect prices for concert tickets or rates for radio programming? Group Problems G12-1 Pricing Commonly Owned Products Evaluate a pricing decision your company made involving commonly owned products. Was it optimal? If not, why not? How would you adjust price? Compute the profit consequences of this adjustment. 06665_ch12_ptg01_151-162.indd 161 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit162 G12-2 Yield or Revenue Management Evaluate a pricing decision your company made that involved a product or service with fixed capacity. Was price set optimally? If not, why not? How would you adjust price? Compute the profit consequences of the change. G12-3 Promotional Pricing Evaluate a pricing decision of your com- pany that coincided with a promotional or advertising campaign. Was price set optimally? If not, why not? How would you adjust price? Compute the profit consequences of the change. G12-4 Psychological Pricing Evaluate a pricing decision of your company based on psychological pricing. Was price set optimally? If not, why not? How would you adjust price? Compute the profit consequences of the change. 1. Story adapted from Joe Nocera, “Harry and the Strange Logic of Book Discounters,” New York Times, July 28, 2007, http://select. nytimes.com/2007/07/28/business/28nocera. html. 2. Luke M. Froeb, Steven Tenn, and Steven T. Tschantz, “Mergers When Firms Compete by Choosing Both Price and Promotion,” International Journal of Industrial Organization 28 (2010): 695–707. 3. Constance L. Hays, “Variable-Price Coke Machine Being Tested,” New York Times, October 28, 1999, C1. 4. Mark Hefflinger, “Top Artists ‘Scalping’ Own Tickets on Resale Sites,” Wall Street Journal, March 12, 2009. END NOTES 06665_ch12_ptg01_151-162.indd 162 8/9/17 8:34 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 163 Pricing Laptops Dell Inc. sells over 100,000 computer systems per day, more than one every second. The company sells to individual home users, to small businesses, and to every Fortune 100 company. Some of these customers are less price sensitive than others. If Dell could identify these customers and figure out a way to charge them higher prices, it could increase profit. Pricing Museum Tickets Once the home of Peter the Great, the enormous green-and-white Winter Palace in Saint Petersburg, Russia, now houses one of the world’s most famous art collections. Tourists who fly many miles to Saint Petersburg are unlikely to miss visiting the Hermitage Museum, home to three million works of art. Locals, on the other hand, are poorer than the international tourists who visit their country and have hundreds of other nearby options competing for their expenditures. Charging a single price for admission would require either charging tourists much less than the profit-maximizing price or making the museum prohibitively expensive for many locals. Potentially, both Dell and the Hermitage could benefit by charging differ- ent prices to different consumer groups. Dell could increase profit by charging lower prices to more price-sensitive home and small business users, while the Hermitage could increase profit by offering price discounts to locals. However, such discriminatory pricing is risky, and sometimes illegal. In this chapter, we discuss ways of profitably designing and implement- ing price discrimination schemes, in which sellers charge different prices to different consumers, not on the basis of differences in costs but, rather, on the differences in consumer demand. We move beyond the simple pricing of Chapter 6, where a single firm set a single (“uniform”) price on a single prod- uct by allowing a firm to set multiple prices for the same product. Direct Price Discrimination13 06665_ch13_ptg01_163-170.indd 163 8/9/17 8:35 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit164 13.1 Why (Price) Discriminate? To see how price discrimination increases profit, let’s look at the simple aggre- gate demand curve from Chapter 6 (Table 6.4), where seven consumers are willing to pay $7, $6, $5, $4, $3, $2, and $1 for a good that costs $1.50 to make. There, we saw that the profit-maximizing price is $5. At this price, the company sells three units. We calculate total profit ($10.50) as revenue ($15) minus cost ($4.50). At the optimal price of $5, low-value consumers—those willing to pay $4, $3, and $2—don’t purchase, even though they’re willing to pay more than the cost of producing the good. These three consumers represent unconsummated wealth-creating transactions. The one lesson of business tells us to find a way to profitably consummate these transactions. Suppose you could identify these customers because they live in a cer- tain part of town, because they are older, or because they have children. You could offer them a price reduction by sending discount coupons to residents who live in certain ZIP codes (as Victoria’s Secret has done with its catalogs), by offering discounts to senior citizens (as do many restaurants and grocery stores), or by offering discounts for families with children (as airlines do when allowing lap children to fly for free). To see how this would affect profit, we split the consumers into two different groups and compute the profit-maximizing prices for each group. We do this in Tables 13.1 and 13.2 for the high- and low-value consumers, respectively. In Table 13.1, we compute the profit-maximizing price for the TABLE 13.2 Optimal Price for Low-Value Consumers Price ($) Quantity Revenue ($) MR ($) MC ($) Total Profit ($) 4 1 4 4 1.50 2.50 3 2 6 2 1.50 3 2 3 6 0 1.50 1.50 1 4 4 (2) 1.50 (2) TABLE 13.1 Optimal Price for High-Value Consumers Price ($) Quantity Revenue ($) MR ($) MC ($) Total Profit ($) 7 1 7 7 1.50 5.50 6 2 12 5 1.50 9 5 3 15 3 1.50 10.50 06665_ch13_ptg01_163-170.indd 164 8/9/17 8:35 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 13 • Direct price Discrimination 165 high-value consumers. The profit-maximizing price is $5, the company sells three units, and total profit ($10.50) is revenue ($15) minus cost ($4.50), the same as computed in Table 6.4. In Table 13.2, we derive demand for low- value consumers by subtracting out the three units demanded by high-value consumers. If we could charge a separate price to the low-value consumers—those willing to pay $4, $3, $2, and $1—we would face a second demand curve, illustrated in Figure 13.1. We could price at $4 and sell one unit, price at $3 and sell two units, price at $2 and sell three units, or price at $1 and sell four units. Marginal analysis tells us to set a price of $3, sell two units to the low- value group, and earn an extra $3. This is the motivation for price discrimination: it allows a firm to sell items to low-value customers who otherwise would not purchase because the price is too high. Price discrimination is the practice of charging different prices to differ- ent buyers or groups of buyers based on differences in demand. For products with relatively low marginal costs or with less-elastic demand, like software, music, or pharmaceutical drugs, the gap between price and marginal cost is largest. For these products, price discrimination is most profitable because there are more consumers whose values are above the mar- ginal cost of production but below the profit-maximizing price. Charging lower prices to low-value consumers also means that you charge high-value customers higher prices, making the practice controversial. For example, drug manufacturers sell patented drugs, like Lipitor, Viagra, Zoloft, or Claritin, to different countries at different prices. Drugs sold in Canada and Mexico are less expensive than drugs sold in the United States, at least early in the life cycle of the drug. This has created incentives for U.S. con- sumers to drive to Mexico and Canada, buy drugs, and bring them back into $2.00 $3.00 $4.00 $5.00 0 1 2 3 4 Quantity P ri ce 5 $1.00 $0.00 Figure 13.1 Demand Curve for Low-Value Consumers 06665_ch13_ptg01_163-170.indd 165 8/9/17 8:35 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit166 the United States. It has also created incentives for pharmacies in Mexico and Canada to offer drugs for sale to U.S. consumers. This so-called drug reimpor- tation emerged as an issue in the 2016 U.S. presidential campaign. If we allow reimportation, what do you think will happen? We can use our simple example to figure this out. Think of the low-value consumers (those in Table 13.2) as foreign pharmacies. Drug reimportation means that they buy drugs at $3 and then resell them for $5 to U.S. consumers (the high-value group in Table 13.1). Once U.S. drug manufacturers realize that they are losing money by discriminating, they would go back to setting a uniform price of $5. The policy implication is that if we allow drug reimporta- tion, profits of U.S. drug manufacturers would fall, and foreign buyers would face higher prices. 13.2 Direct Price Discrimination We can draw a distinction between direct and indirect price discrimination. Under direct price discrimination, we can identify members of the low-value group, charge them a lower price, and prevent them from reselling their low- er-priced goods to the higher-value group (arbitrage). Under indirect price dis- crimination, we cannot perfectly identify the two groups or cannot prevent arbitrage, so we must find indirect methods of setting different prices to the two different groups. This distinction will become clearer in Chapter 14 when we describe various methods of achieving indirect price discrimination. To discriminate directly, you must be able to identify different customer groups with different elasticities. Then, you set an optimal price for each group. Obviously, charge a lower price to the group with the more-elastic demand, and a higher price to the group with the less-elastic demand, accord- ing to the pricing formula we derived in Chapter 6. (P 1 2 MC 1 ) / P 1 5 1/ | elasticity 1 | and (P 2 2 MC 2 ) / P 2 5 1/ | elasticity 2 | Once you implement price discrimination, you create an incentive for members of the low-elasticity group to try to purchase at the lower prices offered to the high-elasticity group. If too many customers are able to do this, then they can make price discrimination unprofitable. Note that the marginal cost of selling to the two different groups can be different—that is, MC 1 Z MC 2 . But as long as the price elasticities differ, pric- ing is still going to be determined, in part, by differences in elasticity. For example, senior citizens often have more price-elastic demand for a variety of reasons (including lower incomes and a lower opportunity cost of time). As a result, older people often pay lower prices in movie theaters than do younger people. The theater managers are able to recognize a low-value customer by the age indicated on a driver’s license. They prevent arbitrage by making sure that those admitted on a senior citizen’s ticket do not resell their tickets to younger customers. 06665_ch13_ptg01_163-170.indd 166 8/9/17 8:35 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 13 • Direct price Discrimination 167 Of course, price discrimination need not be limited to just two groups. In the extreme, a firm could tailor prices to each consumer. For example, col- leges discriminate between students of different incomes and wealth levels. At America’s top universities, fewer than half of all undergraduates pay full price while a majority receive some degree of financial aid. To award scholarships, colleges do not need to identify groups with different elasticities. Instead, col- leges tailor prices to each student’s family income directly by examining tax returns and bank statements. For example, Harvard and Yale universities both announced that, for middle-class families, college education is priced at about 10% of annual income. 13.3 Robinson-Patman Act There is a tension in the law about the effects of price discrimination. On the one hand, if a firm offers an array of different prices to consumers, it consum- mates more transactions and thus creates more wealth. On the other hand, if it charges prices closer to what consumers are willing to pay for a good, it reduces consumer surplus (the difference between what consumers are willing to pay and what they have to pay). The Robinson-Patman Act is part of a group of laws collectively called the antitrust laws governing competition in the United States. Under the Robinson-Patman Act, it’s illegal to give or receive a price discount on a good sold to another business across state lines. This law does not cover services or sales to final consumers, though a number of states have laws that do. The U.S. Congress passed the Robinson-Patman Act in 1936 in response to complaints from small grocery stores facing competition from lower-cost competitors like A&P, the first grocery store chain. Sometimes called the Anti-Chain-Store Act, the Robinson-Patman Act tries to protect independent retailers from chain- store competition by preventing the chains from receiving supplier discounts. Small retailers have sued book publishers, large book retailers, large drugstore chains, Walmart, and other large retailers (together with their suppliers) for giving or receiving price discounts.1 There are two ways to defend yourself from a Robinson-Patman lawsuit: you can claim that the price discount was cost-justified or that the price discount was given to meet the competition. This leads to the following legal advice on how to comply with the antitrust laws: Charge all customers the same price, unless the cost of serving them var- ies. But feel free to cut price to any customer to meet the lower price of a competitor.2 Often, pricing that looks discriminatory (based on demand differences) results instead from the different costs of serving different consumers. Small drugstores, small grocery stores, and small bookstores pay higher prices than do large chains like Walmart at least in part because supplying big customers costs less. Big customers order full truckloads, reducing transportation costs; they also invest in information technology that reduces ordering and inventory costs and simplifies ordering, distribution, and sales. If the higher prices arise 06665_ch13_ptg01_163-170.indd 167 8/9/17 8:35 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit168 from the higher costs of serving small mom-and-pop shops, then the higher prices are not discriminatory. Antitrust economists have long recognized that the Robinson-Patman Act discourages discounting. If companies have to offer the same price to every customer, they are less likely to reduce price to their most price-elastic cus- tomers. Fortunately, many practices, such as offering promotional allowances to large retailers, are similar to discounts, making it relatively easy to comply with the law without risking the loss of your best customers. 13.4 Implementing Price Discrimination Now that we know how price discrimination works and how legal constraints limit the actual practice, we can discuss how to do it. We focus on the two price discrimination opportunities described in the introduction. Pricing Laptops How does Dell identify customers who are less price sensitive and charge them more? The company used to simply ask them. Until a few years ago, visitors of the company’s home page would select between shopping for Home, Home Office, Small & Medium Business, or Large Enterprise. Prices for identical products would vary depending on which category you click. In October 2012, you could have purchased a 2.6 GHz Dell Precision M6600 laptop for $3,208 as a large enterprise customer. If instead you clicked on “Home Office,” you could have bought the exact same laptop for 40% less. Offering these differ- ent prices to different customer groups allowed Dell to increase the overall profitability of selling computers. What’s a bit confusing is why large business customers didn’t simply order using the “Home Office” or “Small Business” links. Perhaps they eventually learned to do just that. In 2014, Dell seems to have suspended this practice. Pricing Museum Tickets Most mornings, there is a long line of customers outside the Hermitage Museum standing in front of a window signed “tickets.” Nearby, another line also proclaims tickets—but in Russian and at prices that are 75% less. While proof of citizenship is not required to obtain the “local” tickets, only those asking for tickets in unaccented Russian can get the lower prices. This creates incentives for arbitrage, and many locals have set up small enterprises that buy tickets at local prices and then resell them at a profit. To combat this, the museum staff monitors low-priced ticket holders upon entry into the museum. It has become a game for some foreign visitors to see if they can feign language and mannerisms to pass for a local. Very few succeed. Foreign tour operators have complained about the discriminatory nature of the pricing at the Hermitage, leading the Russian Travel Industry Union to petition for an end to discriminatory pricing. While the Hermitage initially agreed in 2010, it quickly backed out of the idea, noting that an end to such discriminatory pricing would only lead to everyone paying the higher price. 06665_ch13_ptg01_163-170.indd 168 8/9/17 8:35 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 13 • Direct price Discrimination 169 13.5 Only Schmucks Pay Retail Consumers don’t like knowing that they’re paying a higher price than other consumers. This is summed up in popular sayings like “Only schmucks pay retail.”3 If low-elasticity consumers know they’re being discriminated against, they may even refuse to purchase. A study of online pricing showed that when shoppers are asked whether they have any discount or coupon codes (thus revealing the existence of price discrimination), a large number of customers abandon their virtual shopping carts, which can make price discrimination unprofitable.4 So, if you’re price discriminating, it’s important to keep it a secret if you can. Otherwise, you may lose your high-value customers to rivals who don’t price discriminate (or who hide it better). SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • Price discrimination is the practice of charging different people or groups of people different prices based on differences in demand. Typically more people are served under price discrimination than under a uniform price. • Arbitrage can defeat a price discrimination scheme if enough of those who purchase at low prices resell to high-value consumers. This can force a seller to go back to a uniform price. • If a seller can identify two groups of consumers with different demand elasticities, and can prevent arbitrage between the groups, it can increase profit by charging a higher price to the low- elasticity group. • Direct price discrimination requires that you be able to identify members of the low-value group, charge them a lower price, and prevent them from reselling their lower-priced goods to the higher- value group. • It can be illegal for a business to price discriminate when selling goods to other businesses unless • price discounts are cost-justified, or • discounts are offered to meet competitors’ prices. • Price discrimination may outrage customers who discover that others are getting a better price. If you can, keep price discrimination a secret or make sure that customers see the discrimination as fair. Multiple-Choice Questions See the end of next chapter for multiple-choice questions. Individual Problems See the end of next chapter for individual home- work problems. Group Problems See the end of next chapter for group home- work problems. 06665_ch13_ptg01_163-170.indd 169 8/9/17 8:35 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit170 1. European and many other countries have laws with similar prohibitions to Robinson-Patman. 2. John H. Shenefield and Irwin M. Stelzer, “Common Sense Guidelines,” The Antitrust Laws: A Primer, 3rd ed. (Washington, DC: AEI Press, 1998), 123–126. 3. Schmuck (shmŭk) noun, slang: a clumsy or stupid person; an oaf. 4. Mikhael Shor and Richard L. Oliver, “Price Discrimination through Online Couponing: Impact on Purchase Intention and Profit- ability,” Journal of Economic Psychology 27 (2006): 423–440. END NOTES 06665_ch13_ptg01_163-170.indd 170 8/9/17 8:35 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 171 Express Lanes State Route 91 connects the residents of Riverside County, California, to their workplaces in nearby Orange County, on the other side of the Santa Ana Mountains. The freeway is one of the most congested in the United States. Two-hour commutes for a ten-mile stretch are not uncommon. In each direc- tion, drivers face a choice between at least four free public lanes and two tolled express lanes. The express lanes vary in price from around $1.50 in the middle of the night to over $10 on a Friday afternoon. You might suspect that the express lanes would be popular among impa- tient drivers. While somewhat true, the express lanes save only a few minutes on an average day. What they do offer is predictability, as delays on the free lanes can vary greatly from day to day. Motorists who value reliability pay the tolls, while those who can afford to be late every now and then don’t.1 The challenge is pricing the toll lanes just right—too high, and even high-value travelers will choose the free lanes; too low, and the “express” lanes will be too popular and congested, decreasing their value. Airline Travel Business travelers have less-elastic demand than do leisure travelers, both because they don’t pay for their own tickets and because they have fewer alternatives due to very specific time and geographic demands for a flight (“I have to be in Dallas, Texas, at 8:00 a.m. on Tuesday”). Unfortunately for airlines, business and leisure travelers are not easy to identify, making direct price discrimination difficult. Instead, airlines identify leisure travelers by their willingness to plan vacations months in advance. In contrast, business travel- ers often have to plan trips on very short notice. A ticket purchased a month in advance can often be had for less than half the price of one purchased closer to the flight. However, if too many business travelers take advantage of such advance-purchase discounts, they can render price discrimination unprofitable. Indirect Price Discrimination14 06665_ch14_ptg01_171-182.indd 171 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit172 For example, one manufacturing company found that its 60 regional managers purchased tickets for their biweekly travel just days before takeoff. By stan- dardizing its meeting dates (and purchasing tickets three weeks in advance), the company saved nearly half a million dollars in travel expenses. This, of course, means that the airline lost half a million dollars in revenues. 14.1 Indirect Price Discrimination When a seller cannot directly identify who has a low or high value, the seller can still discriminate by designing products or services that appeal to different consumer groups. For example, grocery stores use coupons to price discrim- inate. High-income shoppers are typically less price sensitive than are low- income consumers, at least for low-priced items. They have a high opportunity cost of time, which means they are less likely to clip coupons out of a news- paper or circulars. The grocery store essentially asks low-value consumers to identify themselves by their coupon-clipping behavior. This indirect price discrimination differs from the direct price discrimination of Chapter 13 because high-value customers could clip coupons if they wanted. If too many high-value customers (those with a low elasticity of demand) clip coupons, then the attempt at price discrimination becomes unprofitable. Unlike direct price discrimination, where the seller can identify different groups, indirect price discrimination requires identifying some feature that is correlated with value, and then designing products that differ along this fea- ture. The express lanes on State Route 91 differentiate consumer groups based on their value of reliability. Airlines differentiate business customers from leisure customers by their willingness to plan ahead. Software manufacturers discriminate between high-value and low-value consumers by designing different versions of software to appeal to each group. For example, Adobe used to license its flagship Photoshop product (the leading software for the graphic design industry) for about $300 per year while offer- ing its low-end product, Photoshop Elements, for about $100. Here, the threat is obvious—Adobe must design and price the two versions so that high-value professional editors prefer the full-featured version to the much cheaper version. Adobe did this by omitting some features essential for professional video editing from its low-end version. To make this concrete, let’s go through a numerical example. Suppose your marketing department does a survey (see Table 14.1) of potential users that reveals that commercial users are willing to pay $500 for a full-featured version, whereas home users are willing to pay only $175. This kind of hetero- geneity leaves you with the usual trade-off: you can price high ($500) but sell only to the high-value consumers, or price low ($175) and sell to both high- and low-value consumers. Assuming equal numbers of each type of consumer, the profitability of these two strategies is reported in the first two rows of Table 14.2. Now consider an indirect price discrimination strategy in which we offer both a full-featured version to commercial users and a disabled version to home users. The most we can charge the home users for the disabled version is 06665_ch14_ptg01_171-182.indd 172 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 14 • Indirect price Discrimination 173 $150. The difficult part of implementing indirect price discrimination is pric- ing the full-featured version to make sure that the high-value customers do not purchase the disabled, and cheaper, software. Note that if we tried to charge commercial users $500 for the full- featured version, none of them would buy it. This is because consumers will buy the version of the software that gives them more consumer surplus, or value minus price. The disabled version provides $50 of surplus ($200 [value] 2 $150 [price]), while the full-featured version provides $0 ($500 [value] 2 $500 [price]). But if we charge $150 for the disabled version and $449 for the full-featured version, high-value consumers gain more surplus by buy- ing the full-featured version ($51 5 $500 [value] 2 $449 [price]) than they do by buying the disabled version. You have to price the full-featured version low enough so commercial users get at least as much consumer surplus as they do from the disabled version. The effect of this price discrimination strategy is shown in the third row of Table 14.2. This example illustrates the threat of what marketers call cannibalization. You could charge $500 for the full-featured software if you did not offer a disabled version. But if you do offer a disabled version of a good, you have to be careful that you do not cannibalize sales of the high-priced version. Specif- ically, since our commercial users see the full-featured version as $300 better than the disabled version ($500 [value of full-featured version] 2 $200 [value of disabled version]), the difference in price between the two versions must be less than $300. TABLE 14.1 Demand for Software Software Version Home Users ($) Commercial Users ($) Full-featured version 175 500 Disabled version 150 200 TABLE 14.2 Potential Software Pricing Strategies Strategy Implementation Total Profit 1. Sell only to commercial users at a single high price. Price full-featured version at $500; do not sell home version. $500 2. Sell to all users at a single low price. Price full-featured version at $175. $175 1 $175 5 $350 3. Price discriminate: price high to the commercial users; price low to the home users. Price disabled version at $150; price full-featured version at $449. $150 1 $449 5 $599 06665_ch14_ptg01_171-182.indd 173 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit174 Price discrimination is not always profitable. Sometimes, it is better to offer only a single product as the risk of cannibalization is too great. Consider a slight change to our previous example, given in Table 14.3. The only differ- ence is that the commercial users now value even the disabled version highly. As before (Table 14.2), we can sell only to commercial users at a profit of $500, or to all users for a profit of $350. But what if we tried to sell two ver- sions? To attract the home users, the disabled version can be priced no higher than $150. This disabled version gives our commercial users $250 of surplus. Since our commercial user sees only a $100-value difference between the two versions, it cannot be priced higher than $249. But selling the home version at $150 and the commercial version at $249 provides lower profit than selling only the commercial version at $500. TABLE 14.3 Demand for Software Software Version Home Users ($) Commercial Users ($) Full-featured version 175 500 Disabled version 150 400 These examples show that indirect price discrimination is not only a pricing issue, but also a product design issue. We avoid cannibalization by making the lower-priced version as unattractive as possible to commercial users by disabling the features most important to them. For example, only the full- featured Photoshop supports CMYK colors. If you’re a home user, you probably don’t even know what that is. If you’re a professional graphic designer, you probably find CMYK indispensable. Recently, Adobe changed its versioning by dropping its consumer product entirely and instead licensing Photoshop to all customers for $10 per month. A $50 per month plan includes additional software and cloud storage. Effectively, the former full-featured product is now the “disabled” version. In one of the more infamous examples, IBM released the LaserPrinter E in May 1990, a lower-price alternative to its popular LaserPrinter. The Laser- Printer E printed at a speed of 5 pages per minute compared to 10 pages per minute for the higher-priced LaserPrinter. IBM actually added microchips to the LaserPrinter E (at an additional cost) to insert wait states to slow the print speed. This is known as a “damaged goods” strategy.2 Similarly, Microsoft sold both “server” and “client” versions of its Windows NT operating system at a price difference of $800. It was later revealed that two easily changed lines of code were responsible for the technical differences between the two products. HP Printers Hewlett-Packard uses a different strategy to sort consumers into high- and low-value groups. High-value consumers identify themselves by how many ink cartridges they buy. To charge higher prices to the high-value group, HP prices its printers close to marginal cost, but sells cartridges at a 50% margin. 06665_ch14_ptg01_171-182.indd 174 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 14 • Indirect price Discrimination 175 To make sure you understand how this works, let’s use a numerical exam- ple. In particular, suppose that HP’s low-value customers consume one car- tridge each year and are willing to pay $100 for printing services (printer plus one cartridge), and their high-value customers consume two cartridges each year and are willing to pay $200. What price should HP charge? We compute the revenue of two different pricing strategies in Table 14.4. In row 1, we compute the revenue from pricing printers at $50 and cartridges at $50. We see that low-value consumers would pay $100, whereas high-value consumers would pay $150. In row 2, we see that the firm could do better by giving away the printer and charging $100 for each cartridge. In this case, the low-value consumers pay $100 and the high-value consumers pay $200. This pricing strategy works only because the high-value consumers use more cartridges than low-value consumers. Since HP charges a relatively high price for the cartridges, high-value customers end up paying a higher margin on printing services (printer 1 cartridges) than do low-value consumers. This pricing strategy, termed metering, is used to sell razor blades at higher margins than razors, and famously for the marketing of Barbie products: you give away the dolls and sell the dresses with very high margins. High-value shavers use more razor blades (replacing them more frequently as they become dull), and high-value doll users purchase more Barbie outfits. Lower-value consumers buy fewer razors and fewer doll accessories. As we described in Chapter 9, profits that flow from successful price dis- crimination are likely to attract competition. In the case of printer manufac- turers, for example, the high markups on ink cartridges create profitable entry for toner refill kits. Printer manufacturers may be tempted to prevent rivals from selling lower-priced cartridges, say, by tying the sales of new cartridges to the sales of printers. But such ties can run afoul of the antitrust laws. Here is some advice from a former antitrust prosecutor:3 Do not tie the sale of one product to another. Such arrangements are only legal in a few rare instances—to ensure effective functioning of compli- cated equipment, to name one. But they are generally against the law. Instead, HP spends over $1 billion per year on ink research and develop- ment, in part to stay a step ahead of generic ink manufacturers. As an alter- nate strategy, companies like Epson and Canon rely on microchips affixed to their ink cartridges that prevent the use of generic cartridges and ink refills. TABLE 14.4 Pricing Strategies Low-Value Consumers $100 Value, 1 Cartridge ($) High-Value Consumers $200 Value, 2 Cartridges ($) Total Revenue ($) Strategy 1: $50 printer 1 $50 cartridge 100 150 250 Strategy 2: $0 printer 1 $ 100 cartridge 100 200 300 06665_ch14_ptg01_171-182.indd 175 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit176 14.2 Volume Discounts as Discrimination So far, we’ve been discussing ways of price discriminating between different customers—that is, setting different prices to different people or groups of people. Here, we consider the case of a single customer who demands more than one unit of a good. To price discriminate in this case, we have to find a way to set different prices for each unit consumed. Consider a single customer who’s willing to pay $7 for the first unit, $6 for the second, $5 for the third, and so on, as in our earlier demand curve example. If the price is set at $7, this consumer will purchase one unit; if the price is set at $6, two units; $5, three units; and so on. This is an individual demand curve. Note the difference between an individual and an aggregate demand curve. With an aggregate demand curve, each point represents a different consumer with a different value for a single unit of the good. For an individual demand curve, each point represents the value that a single consumer is willing to pay for an additional unit. Individual demand curves slope downward because the marginal value, the value placed on extra units, declines with each purchase. For example, a retailer who purchases from a manufacturer may find that the first few items are relatively easy to sell, but to sell more, she may have to lower the price, hold the item in inventory for a longer period of time, or spend money on pro- moting the item. All these activities reduce the value that the customer (here, the retailer) is willing to pay for additional units. If a seller is setting a single price, it doesn’t matter whether she faces an aggregate or an individual demand—the profit calculus is the same. She’ll sell all items where MR . MC. If we assume, as before, that marginal cost is $1.50, the profit-maximizing price $5. And, just as in the aggregate demand curve, we see units worth $4, $3, and $2 that are not purchased even though the consumer places a value on these extra units that are higher than the mar- ginal cost of producing them. These three extra units represent unconsum- mated wealth-creating transactions. The trick to profitably selling more is to find a way to sell additional units without dropping the prices of the earlier units. There are several ways to do this: • Offer volume discounts; for example, price the first good at $7, the second at $6, the third at $5, and so on. • Use two-part pricing, which is both a fixed price and a per-unit price. Charge a per-unit price low enough to consummate all wealth-creating transactions (set it at MC 5 $1.50), then bargain over how to split the resulting surplus. The consumer’s total value for six units is $27 (5 $7 1 $6 1 $5 1 $4 1 $3 1 $2), and six units cost just $9 (5 6 3 $1.50) to produce. Bargain over how to split the remaining surplus ($18 5 $27 2 $9) created by the transaction. This is the “fixed price” part of the transaction. 06665_ch14_ptg01_171-182.indd 176 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 14 • Indirect price Discrimination 177 • Bundle the goods. As we have just seen, the consumer’s total value for six units is $27. If you have enough bargaining power, you can capture the entire consumer surplus by pricing a bundle of six goods at just below $27. If not, then bargain over how to split it. This example illustrates a very important lesson for pricing: When bargaining with a customer, do not bargain over unit price; instead, bargain over the bundled price. First, figure out how much the consumer would demand if price were set at marginal cost; then bargain over the bundled price for this amount. This strategy ensures that you’re bargaining over how to split the largest possible pie. 14.3 Bundling Different Goods Together We can also use bundling in a slightly different context—when consumers have different demands for different items. Consider a movie theater with two groups of customers whose preferences for two films—a horror film and an adventure film—are different.4 The theater owners cannot engage in direct price discrimination because they cannot identify the movie preferences of particular consumers ahead of time. But they can bundle the films together in a double feature and accomplish the same thing. Suppose the theater has 100 potential customers: one half would be will- ing to pay $12 to see the horror film and $8 to see the adventure film; the other half would pay $8 to see the horror film and $12 to see the adventure film. If the theater sets the same price for each film, it faces the usual trade-off. It can sell each film to all 100 consumers at a price of $8, leading to a revenue of $800 per film, or it can sell each film to half of the moviegoers at a price of $12, leading to a revenue of $600 per film. In this case, pricing low is more profitable, so each film would be sold at a price of $8 and the theater owner would earn revenue of $1,600 on the two films. But look what happens when the theater bundles both films together in a double feature. Each customer values the bundle at $20, so the theater can sell to all 100 customers at the bundled price of $20 earning revenue of $2,000 on the two films. In this case, bundling makes customers more homogeneous (they’re will- ing to pay the same amount for the bundle), so the seller doesn’t have to reduce the price of the bundle to sell more tickets. Intuitively, bundling makes it easier for the theater to extract consumer surplus with a single price for the bundle. Bundled pricing5 allows a seller to extract more consumer surplus if will- ingness to pay for the bundle is more homogeneous than willingness to pay for the separate items in the bundle. For example, the bundling of channels allows cable TV providers to extract 65% more consumer surplus than if the chan- nels were priced separately.6 06665_ch14_ptg01_171-182.indd 177 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit178 SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • When a seller cannot identify low- and high-value consumers or cannot prevent arbitrage between two groups, it can still discriminate indirectly by design- ing products or services that appeal to groups with different price elasticities of demand. • If you offer a low-value product that is attractive to high-value consumers, you may cannibalize sales of your high-price product. • Metering is a type of indirect discrimina- tion that identifies high-value consumers by how intensely they use a product (e.g., by how many cartridges they buy). In this case, charge a big markup on the cartridges and a lower markup on the printer. • When pricing for an individual customer, do not bargain over unit price. Instead, you should • offer volume discounts; • use two-part pricing; or • offer a bundle containing a number of units. • Bundling different goods together can allow a seller to extract more consumer surplus if willingness to pay for the bundle is more homogeneous than willingness to pay for the separate items in the bundle. Multiple-Choice Questions 1. A software firm can offer a high-feature version of its software or a stripped-down low-feature version, each with similar pro- duction costs. Which of the following can- not be an optimal strategy? a. Offer only the high-feature version aimed only at a high-value market segment. b. Offer only the low-feature version aimed at all market segments. c. Offer both versions targeted to differ- ent value segments. d. Offer only the high-feature version aimed at all market segments. 2. Which of the following conditions must be satisfied for price discrimination to be successful? a. The seller must have a different prod- uct for each group of customers. b. The seller must be able to identify each customer as having a high or low value. c. The seller must be able to prevent arbi- trage between the two groups. d. None of the above. 3. Perfect price discrimination is when a firm can charge each customer exactly what they are willing to pay. In this case, a. the demand curve is very inelastic. b. the marginal revenue is the demand curve. c. the demand curve is very elastic. d. the marginal cost curve is the average cost curve. Use the following table to answer Ques- tions 4–6. Assume the cost of producing the goods is zero and that each consumer will purchase each good as long as the price is less than or equal to value. Consumer values are the entries in the following table. Consumer A ($) Consumer B ($) Good 1 2,300 2,800 Good 2 1,700 1,200 4. Suppose a monopolist only sold the goods separately. What price will the monopolist charge for good 1 to maximize revenues for good 1? a. $2,300 b. $2,800 06665_ch14_ptg01_171-182.indd 178 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 14 • Indirect price Discrimination 179 c. $1,200 d. $1,700 5. What is the total profit to the monopolist from selling the goods separately? a. $4,500 b. $6,300 c. $7,000 d. $6,000 6. What is a better pricing strategy for the monopolist? What is the resulting profit? a. Bundle the goods at $2,800; Profits 5 $5,600 b. Bundle the goods at $4,000; Profits 5 $8,000 c. Charge $2,800 for good 1 and charge $1,700 for good 2; Profits 5 $4,500 d. Charge $2,300 for good 1 and charge $1,200 for good 2; Profits 5 $7,000 7. Assume that the price elasticity of demand for movie theatres is 20.85 during all evening shows but for all afternoon shows the price elasticity of demand is 22.28. For the theater to maximize total revenue, it should a. charge the same price for both shows, holding other things constant. b. charge a higher price for the afternoon shows and lower price for the evening shows, holding other things constant. c. charge a lower price for the afternoon shows and higher price for the evening shows, holding other things constant. d. Need more information. 8. Arbitrage a. is the act of buying low in one market and selling high in another market. b. can force a seller to go back to uni- form pricing. c. can defeat direct price discrimination. d. All of the above. 9. Airlines attempt to charge a ________ price to business travelers compared to leisure travelers because business travelers have a ____________________ demand than leisure travelers. a. higher; more elastic b. higher; less elastic c. lower; more elastic d. lower; less elastic 10. Metering is a. a type of indirect price discrimination. b. a type of direct price discrimination. c. an evaluation of a product. d. an example of bundling. Individual Problems 14-1 Barbie Dolls and Accessories Why might Mattel set a much lower margin on its Barbie dolls than on the accessories for the dolls? 14-2 German Brothels German brothels recently began offering a monthly subscription service for multiple pur- chasers. If you wished to reduce the incidence of prostitution, would you consider this pricing plan to be a desirable change? 14-3 Selling Salsa Your family business produces a secret recipe salsa and distributes it through both smaller specialty stores and chain supermarkets. The chains have been demanding sizable discounts but you do not want to drop your prices to the specialty stores. When can you legally accom- modate the chains without losing profits from the specialty stores? 14-4 Microwave Ovens A manufacturer of microwaves has discovered that male shoppers, on average, have lower val- ues for microwave ovens than female shoppers. Additionally, male shoppers attribute almost no extra value to an auto-defrost feature, while female shoppers, on average, value the auto-defrost feature. There is little additional cost to incorporating an auto-defrost feature. The manufacturer is considering introducing two different models. The manufacturer has 06665_ch14_ptg01_171-182.indd 179 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION III • Pricing for Greater Profit180 determined that men value a simple microwave at $70 and one with auto-defrost at $80, while women value a simple microwave at $80 and one with auto-defrost at $150. If there is an equal number of men and women, what pricing strategy will yield the greatest revenue? What if women comprise the bulk of microwave shoppers? 14-5 Music Pricing The pricing model for iTunes has been to price songs individually. Instead, Spotify opted to offer unlimited song playing for a monthly fee. Would Spotify’s pricing model likely yield more profit than pricing songs individually? 14-6 Bundling At a student café, there are equal numbers of two types of customers with the following val- ues. The café owner cannot distinguish between the two types of students because many stu- dents without early classes arrive early anyway (i.e., she cannot directly price discriminate). Students with Early Classes ($) Students without Early Classes ($) Coffee 0.70 0.60 Banana 0.50 1.00 The marginal cost of coffee is $0.10. The marginal cost of a banana is $0.40. Is bundling more profitable than selling separately? If so, what price should be charged for the bundle? Group Problems G14-1 Price Discrimination Does your company price discriminate? Explain how the practice works (direct or indirect) and estimate the profit consequences of price discrimination relative to charging a single, uni- form price. If your company doesn’t currently price discriminate, are there opportunities to do so? How would you design the price discrimi- nation? Estimate the profit consequences. G14-2 Price Discrimination Data7 Collect a set of price quotes for no fewer than 30 airplane tickets. Examine how these price quotes change as you vary the tickets—one characteristic at a time. For instance, suppose you get a price quote for a ticket on United Airlines from Raleigh- Durham to Chicago, departing on May 17 and returning on May 19. Change the following characteristics, one at a time, and get a new price quote: • Change the time of departure within the same day. • Change the source of your quote (e.g., from Travelocity to the airline’s website). • Change the predeparture interval date (e.g., compare flights bought a couple of days in advance to months in advance). • Change the class of the ticket and travel restrictions. • Change the return date to include a Satur- day stay-over. • Change anything else you can think of. Make sure you get price quotes from air- ports where one airline has a dominant presence (e.g., Delta in Seattle) and a route presenting stiff competition from a “discount” carrier such as Frontier or JetBlue. Describe some of the important differences in pricing you observe. Are the pricing differ- ences consistent with the patterns of indirect or direct price discrimination, or are there other explanations? Original, novel, and thoughtful interpretations of the patterns you see in the data are particularly welcome. 06665_ch14_ptg01_171-182.indd 180 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 14 • Indirect price Discrimination 181 1. Kenneth A. Small, Clifford Winston, and Jia Yan, “Uncovering the Distribution of Motorists’ Preferences for Travel Time and Reliability,” Econometrica 73 (2005): 1367–1382. 2. Raymond J. Deneckere and R. Preston McAfee, “Damaged Goods,” Journal of Eco- nomics and Management Strategy 5 (1996): 149–174. 3. See John H. Shenefield and Irwin M. Stelzer, “Common Sense Guidelines,” in The Anti- trust Laws: A Primer, 3rd ed. (Washington, DC: AEI Press, 1998), 123–126. 4. Adapted from Hal R. Varian, “Sorting Out Bundling and Antitrust Law,” New York Times, July 26, 2001. 5. Bundling can be accomplished in different ways. Pure bundling describes a situation where the commodities in a bundle are not offered for sale separately, whereas mixed bundling refers to a pricing strategy where the bundled goods can also be purchased separately. 6. Gregory S. Crawford and Joseph Cullen, “Bundling, Product Choice, and Efficiency: Should Cable Television Networks Be Offered a la Carte?” Information Economics and Policy 19 (2007): 379–404. 7. Adapted from Pat Bajari’s economics class. END NOTES 06665_ch14_ptg01_171-182.indd 181 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 06665_ch14_ptg01_171-182.indd 182 8/9/17 8:37 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 183 SECTION 15 Strategic Games 16 Bargaining Strategic Decision Making 4 06665_ch15_ptg01_183-204.indd 183 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 06665_ch15_ptg01_183-204.indd 184 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 185 On the island of Bermuda, the Cooper & Sons chain of department stores has been in the same family since 1897. Its largest rival, Gibbons, has been in the hands of another family for nearly as long. Yet, a decade ago, business began to slip. Increasing competition from Internet retailers led revenues to decline by 30% in just a few years. Several competing department stores have shut their doors. In 2012, competition for the remaining dollars had become fierce. Cooper lowered its prices to try to steal some of Gibbons’ customers. Gibbons responded with price cuts of its own. Then Cooper cut prices even more and expanded its store hours. Short of starting a land war in Asia, few moves are as dumb as starting a price war with a close competitor. Each firm mistakenly believes that it can somehow “win” the war. When this doesn’t happen, they find themselves with low profits, consumers who have grown accustomed to low prices, and the problem of how to end hostilities. In October 2012, Gibbons announced that it would not be undercut. On its face, the announcement—“If you find a better price, we’ll match it”— seemed to promise even lower prices, but in fact, it ended the war. Cooper no longer had an incentive to undercut Gibbons’ prices because it couldn’t gain customers by doing so. Gibbons’ customers would stay with Gibbons and demand a price match instead. Quite counterintuitively, a price-matching announcement can end a price war. In this chapter, we show you how to use game theory to analyze situations like these, where the profit of one firm depends critically on the actions of others. Studying game theory will give you insight into not only where compe- tition with rivals is likely to lead, but also how to change the rules of the game to your advantage. This chapter can be thought of as a complement to Chapter 10, where we introduced three basic strategies for slowing profit erosion: (1) reducing costs, (2) differentiating your product, and (3) reducing competitive intensity. Strategic Games15 06665_ch15_ptg01_183-204.indd 185 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making186 Game theory will help you better understand the third strategy. The likely outcome of a game is a Nash equilibrium, named for John Nash, the mathematician (and Nobel laureate in economics) profiled in Sylvia Nasar’s 1998 book and the Academy Award-winning 2001 movie, A Beautiful Mind. A Nash equilibrium is a pair of strategies, one for each player, in which each strategy is a best response to the other. In equilibrium, each player is doing the best that he or she can given what the other player is doing. In what follows, we show how to compute equilib- ria in each type of game, and how to change the rules of the game to your advantage. In what follows, we distinguish between two different types of games: sequential-move games and simultaneous-move games. 15.1 Sequential-Move Games In sequential-move games, players take turns, and each player observes what his or her rival did before having to move. To compute the likely outcome of a sequential game, we look ahead and reason back, or predict what will happen tomorrow in response to each of our possible actions today. By anticipating how the other player will react tomorrow, we can accurately forecast the con- sequences of her own moves. We represent sequential games using the extensive or tree form of a game, familiar to anyone who has ever used a decision tree. Consider the simple two- move game illustrated in Figure 15.1. An entrant is deciding whether to enter an industry currently controlled by a single incumbent firm. Beginning on the bottom of the left branch of the tree, we see that entry can lead to two dif- ferent outcomes depending on how the incumbent reacts. The incumbent has two choices: accommodate entry or fight it. Accommodation (e.g., by keeping FIgurE 15.1 Entry Game 0, 10 Entrant Incumbent In Out Accommodate Fight 5, 5 –5, –5 06665_ch15_ptg01_183-204.indd 186 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTEr 15 • Strategic games 187 prices high) results in a payoff of $5 million for each firm, whereas fighting (e.g., by pricing low) results in a loss of $5 million for each firm. Initially, an entrant may fear entry because of the potential loss of $5 million. After all, a gamble between making $5 million and losing $5 million might not appeal to most firms. However, before deciding on a course of entry, the entrant should look forward and reason back. If the entrant decides to enter, the incumbent does better by accommodating. In Figure 15.2, we denote the best response of the incumbent by crossing out the suboptimal strategy. Once the entrant knows how the incumbent will react, she can compute the profit for both options. If she enters, the incumbent will accommodate, and the entrant earns $5 million. If she stays out, it doesn’t matter what the incumbent does—the entrant earns nothing. Comparing $5 million to $0, the entrant will enter. We denote the best strategy of the entrant in Figure 15.2 by crossing out the suboptimal strategy. What remains is the equilibrium path of the game, {In, Accommodate}, where each player is maximizing her payoff when taking the actions of subsequent players into account.1 The analysis doesn’t stop here, however. We don’t just want to figure out what’s likely to happen; we also want some guidance about how to change the game to our advantage. For example, in this game, if the incumbent could figure out how to deter entry, he could end up on the right branch of the tree and earn $10 million instead of $5 million. One way to deter entry is to threaten to fight (by slashing prices) if the entrant should enter. We diagram the threat by eliminating one of the branches of the tree in Figure 15.3. If the entrant believes the threat, she’ll stay out because entry, combined with an incumbent’s low price, would yield a loss of $5 million for the entrant. By eliminating one of his own options, the incum- bent has changed the equilibrium of the game to {Out, Fight}. This highlights one of the interesting conclusions of this type of analysis—you can make your- self better off by eliminating one of your options. FIgurE 15.2 Entry Accommodation 0, 10 Entrant Incumbent In Out Accommodate Fight 5, 5 –5, –5 06665_ch15_ptg01_183-204.indd 187 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making188 The difficult part for the incumbent is convincing the entrant it will price low following entry. Every incumbent would want to claim that he’ll fight entry, but this threat, on its own, isn’t credible. This is because fighting by pricing low is less profitable for the incumbent than pricing high if entry does occur. The incumbent is threatening to act against his own self-interest. To make a threat credible, you have to change the game. One way to do this is to promise customers that any competitive offer will be beaten by 10%. These promises are legally binding contracts in most jurisdictions. This would credibly signal to potential entrants that the incumbent will reduce its prices if they enter, which would hopefully deter entry. This is the whole point of studying game theory. Being able to compute the equilibrium tells you where you are likely to end up. But this depends on the payoffs and the rules of the game, neither of which is fixed. While games like Monopoly and checkers have rigid rules, the rules governing busi- ness interactions are often more flexible, often dictated by little more than history or inertia. After you compute the equilibrium, try to figure out if you can change it to your advantage. 15.2 Simultaneous-Move Games In simultaneous-move games, each player decides on her strategy before know- ing the decisions of other players. To analyze these games, we use the matrix or strategic form of a game. How to Find Nash Equilibria Consider the matrix in Table 15.1. The matrix represents a game between two parolees, Jesse and Frank, who are caught driving together shortly after a nearby bank robbery. The police suspect Jesse and Frank but have no direct evidence tying them to the crime. However, association with other felons is a FIgurE 15.3 Entry Deterrence with Commitment 0, 10 Entrant Incumbent In Out Fight –5, –5 06665_ch15_ptg01_183-204.indd 188 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTEr 15 • Strategic games 189 violation of parole, so the district attorney (DA) can send them both back to jail to serve the remaining sentences on their previous crimes. The DA puts the two parolees in separate cells and offers to go lighter on the one who confesses. Jesse (termed the row player because he selects rows of the matrix) has two strategies, Confess and Stay Mum. Frank chooses between the same strat- egies in the columns of the matrix. The payoff to each (reflecting the number of years in jail) is the two-element entry (row, column) in the corresponding cell. For example, if Jesse chooses “Confess” and Frank chooses “Stay Mum,” then Jesse’s payoff is 23 (three years in jail) and Frank’s payoff is 210. The game in Table 15.1 describes the three components of a game: the players, their available strategies, and the resulting payoffs. This particular game is about as simple as they come with just two players with two strat- egies each. To find Nash equilibria, we ask, “Are both players playing a best response to what their rivals are playing?” If so, you have found a pair of strategies that is a Nash equilibrium. Let’s start from Jesse’s perspective. For each of Frank’s possible strate- gies, select the row strategy that maximizes Jesse’s payoff. If Frank chooses the “Confess” column, Jesse’s best row response is to play “Confess,” earning a payoff of 25 which is better than his “Stay Mum” payoff of 210. To indicate this, we underline this payoff of 25. If Frank plays “Stay Mum,” Jesse’s best response is also to play “Stay Mum,” earning a payoff of 22. In general, you would continue through all the column player’s strategies underlining the best row response, as shown in Table 15.2. In more complex games, best responses might not be unique if two strategies have the same payoff. If two strategies are tied for best response, simply underline both. TABLE 15.1 Jesse and Frank Frank Confess Stay Mum Jesse Confess 25, 25 23, 210 Stay Mum 210, 23 22, 22 TABLE 15.2 Identifying the Row Player’s Best Responses Frank Confess Stay Mum Jesse Confess 25, 25 23, 210 Stay Mum 210, 23 22, 22 06665_ch15_ptg01_183-204.indd 189 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making190 We can do the same thing for Frank’s best column responses to each row. If Jesse plays “Confess,” Frank chooses “Confess” (because 25 is better than 210), and if Jesse plays “Stay Mum,” Frank chooses “Stay Mum.” This is depicted in Table 15.3. Recall that a pair of strategies is an equilibrium if both players are playing their best responses. Since we underlined best responses, an equilibrium occurs whenever both payoffs in a box are underlined. In this case, the game has two equilibria, {Confess, Confess} and {Stay Mum, Stay Mum}. The fact that there are two equilibria (including one in which both stay mum) is a problem for the DA. If she could, the DA would like to change the game to get Frank and Jesse to confess for sure. She does this by increasing the reward to confessing. The DA promises Jesse that if he confesses while Frank stays mum, she will let Jesse go free. She makes the same offer to Frank. Table 15.4 shows how this slight alteration in the payoffs changes the players’ best responses. TABLE 15.4 Prisoners’ Dilemma Frank Confess Stay Mum Jesse Confess 25, 25 0, 210 Stay Mum 210, 0 22, 22 Now there is only one equilibrium. Even if Jesse thinks Frank will stay mum, Jesse’s best response is still to confess.2 The only Nash equilibrium is in the upper-left corner, in which both players confess. 15.3 Prisoners’ Dilemma The situation depicted in Table 15.4 illustrates a tension between conflict (self-interest) and cooperation (group interest). If Frank and Jesse cooperate by both staying mum (lower right), the group would be better off. However, this is not an equilibrium. By following their self-interests, the players both confess and end up in the upper left box. TABLE 15.3 Identifying the Column Player’s Best Responses Frank Confess Stay Mum Jesse Confess 25, 25 23, 210 Stay Mum 210, 23 22, 22 06665_ch15_ptg01_183-204.indd 190 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTEr 15 • Strategic games 191 The prisoners’ dilemma is perhaps the oldest and most studied game in economics, and reflects many business situations. For example, the pricing dilemma in the introduction of this chapter and illustrated in Table 15.5 has the same logical structure as the prisoners’ dilemma. Even though Gibbons’ profits are higher than Cooper’s due to its larger size, both Cooper and Gibbons could make more money if both priced high, but both pricing high is not a Nash equilibrium. Cooper does better by pricing low regardless of what Gibbons does, and Gibbons does better by pricing low regardless of what Cooper does. The only Nash equilibrium is for both to price low, in the upper- left corner. Price Discrimination Dilemma You learned in Chapters 13 and 14 that you can often increase profit by price discriminating, provided different consumers have different demand elastici- ties and you can prevent arbitrage. But when you’re competing against other firms, price discrimination may provoke your rivals to retaliate in a way that could make you both worse off. If your rivals begin discriminating in reaction to your decision to discriminate, then everyone’s profit can fall below what it would have been had no one price discriminated. For example, firms often dis- criminate by offering discounts to customers based on where they live. Super- markets and pizza chains may target promotions to customers who live closer to rival stores.3 Companies often offer coupons at supermarket checkouts to customers who have purchased competing brands.4 In each of these attempts to price discriminate, we would expect rivals to react by offering lower prices to these targeted customers as well. The result is that equilibrium prices are lower than they would be without targeted discounts. In Table 15.6, we see an illustrative game involving two grocery stores. These stores (Kroger and Safeway) are considering whether to offer discount coupons to customers who live farther away—and closer to a competitor’s store. These customers have more elastic demand than customers living closer to the store. If just one grocery store offers such coupons, then its profit increases. However, if its competitor does the same thing, then all the stores wind up with about the same overall sale volume, but at lower prices. In equilibrium, both stores price discriminate, and both are worse off. Intuitively, with a uniform price, the stores compete vigorously for customers only on the boundaries of TABLE 15.5 Pricing Dilemma Gibbons Price Low Price High Cooper Price Low 100, 120 400, 0 Price High 0, 480 300, 360 06665_ch15_ptg01_183-204.indd 191 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making192 their market areas. When they discriminate, they compete vigorously for all customers, no matter where they live, and industry profit suffers. While nei- ther Kroger nor Safeway is a prisoner, they are nevertheless playing a prison- ers’ dilemma. Advertising Dilemma Table 15.7 exhibits an advertising dilemma that again has the same logical structure as the prisoners’ dilemma. Rival tobacco manufacturers R.J. Reynolds and Phillip Morris both used to advertise quite heavily on television. Cigarette advertising is predatory; it serves mainly to steal market share from rivals without increasing market size. Thus, both companies could make more money by not advertising, but the lower-right corner in Table 15.7 is not an equilibrium. If the rival doesn’t advertise, each firm can do better by advertising and stealing the rival’s customers. The only Nash equilibrium is for both to advertise and earn lower profits. TABLE 15.7 Advertising Dilemma Phillip Morris Advertise Don’t Advertise R.J. Reynolds Advertise 30, 30 50, 20 Don’t Advertise 20, 50 40, 40 When the government banned over-the-air cigarette advertising in the early 1970s, the profitability of the cigarette industry increased by nearly 40%.5 The ban moved the industry from the upper-left corner to the lower- right corner of the payoff matrix. Ordinarily, however, you can’t count on the government to help you out of a prisoners’ dilemma. Free-Riding Dilemma The game in Table 15.8 illustrates the strategic interdependence typical of an MBA study group. It’s also typical of the kinds of payoffs you’d expect in any group or team-based activity. Each player has the option of working hard or shirking. The benefit of working hard is that you raise your grade, but the TABLE 15.6 Oligopoly Price Discrimination Dilemma Kroger Price Discriminate Uniform Prices Safeway Price Discriminate 0, 0 4, 22 Uniform Prices 22, 4 2, 2 06665_ch15_ptg01_183-204.indd 192 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTEr 15 • Strategic games 193 downside is that you sacrifice leisure time. If both work, they will earn an A, if only one works, they earn a B, and if both shirk, they earn a C. To determine the Nash equilibrium of the game, you need to know how study group members rank various outcomes. Assume that students value lei- sure time more than a one-letter grade improvement, but less than a two-letter grade improvement. Thus, B1Leisure is better than an A which is better than a C1Leisure which is better than a B. Then, Sally’s best response to Joe shirking is to also shirk (C1Leisure is preferable to a B), and Sally’s best response to Joe working is again to shirk (B1Leisure is preferable to an A). Because Joe has the same preferences, the Nash equilibrium is {Shirk, Shirk}, where each player receives a C plus leisure time. This outcome is inefficient because students in the group would jointly prefer the A that comes from hard work. However, this outcome is not an equilibrium because once the other group members are working hard, the best response is to shirk. As in the other prisoners’ dilemma games, there is a tension between con- flict and cooperation. Successful study groups figure out how to manage this tension, and get out of the low-grade equilibrium. Getting Out of a Prisoners’ Dilemma The Nash equilibrium of a prisoners’ dilemma represents an unconsummated wealth-creating transaction between players. In the pricing dilemma, both players would like to price high. In the advertising dilemma, both would like to advertise less. In the free-riding game, both would like to work harder. However, none of these outcomes is a Nash equilibrium. The point of studying the prisoners’ dilemma is to learn to avoid these bad outcomes or, alternatively, to learn how to consummate these unconsum- mated wealth-creating transactions among players. The implication of the prisoners’ dilemma for a long-run strategy is clear: try to avoid games with the logical structure of a prisoners’ dilemma. Instead, work on developing long-run strategies that change the structure of the game to make your own payoffs less dependent on your rivals’ actions. If possible, try to differentiate your product or figure out a way to lower your costs. If you have no other option, try to reduce the intensity of competition with- out running afoul of the antitrust laws. For example, if Cooper and Gibbons can find a way to coordinate their pricing, they can get out of this dilemma. TABLE 15.8 Free-Riding Dilemma Joe Shirk Work Sally Shirk C1Leisure, C1Leisure B1Leisure, B Work B, B1Leisure A, A 06665_ch15_ptg01_183-204.indd 193 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making194 However, explicit price coordination is a violation of the antitrust laws, as summed up in the following advice from a former antitrust prosecutor: Do not discuss prices with your competitors. That is one of those black- and-white areas. The enforcement authorities can be counted on to bring a criminal prosecution if they learn that you have met with your com- petitors to fix prices or any other terms of sale. Jail time is increasingly common.6 Instead, Cooper and Gibbons department stores introduced price match- ing, reducing the strategic benefits of lowering prices. Effectively, this means that if either store charges low prices, both stores in effect do. The only way to improve payoffs is to have both stores charge higher prices. When Prisoners’ Dilemmas Are Repeated As a general matter, it is easier to get out of a prisoners’ dilemma when the game is repeated. For example, suppose our MBA group members were not just playing the free-riding game in Table 15.8 once, but, as is more likely, they were playing it over and over. With repeated games, you can condition your future behavior on your opponent’s past behavior with a trigger strategy. For example, both could agree to cooperate by working in each period, but adopt the following strategy: if my classmate worked last time, I will work too, but if my classmate shirked, it will trigger me to shirk from now on. Is this agreement a Nash equilibrium? By working, each player receives an A in each period, but without leisure time (the second best outcome of the four). If one of the players shirks, that player receives a higher payoff in that period. But the player knows that his colleague will shirk forever after, leading to a worse outcome. Thus, cooperating leads to the second-best outcome in each period. Cheating leads to a one-time gain followed by worse payoffs in all future periods. The comparison between these depends on the discount rate and on the expected length of the future relationship between MBA students. Low discount rates (where future payoffs are more valuable) and long rela- tionships both make cooperation more likely. Similarly, the hold-up problem between a supplier and a customer from Chapter 5 can be described as a prisoners’ dilemma in which both parties ben- efit from the transaction but one party cannot help himself from holding up the counter-party once relationship-specific costs are sunk. In a repeated-game context, the likelihood of hold-up is decreased because such an action sac- rifices the future value of the relationship. When cooperation is important, devise ways to make the interaction more like a repeated game to avoid “cheating.” To determine the best way to play a repeated prisoners’ dilemma, profes- sor of political science Robert Axelrod had a novel idea—he ran a tournament with a cash prize. He asked professors of political science, mathematics, psy- chology, computer science, and economics to submit strategies as programma- ble functions, and he then ran simulated tournaments among the programs. Axelrod was able to characterize the features of the strategies that earned the highest profit: 06665_ch15_ptg01_183-204.indd 194 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTEr 15 • Strategic games 195 • Be nice: Start by cooperating, and don’t strike first. • Be easily provoked: Respond immediately to rivals. • Be forgiving: Don’t try to punish other players too much if they defect from the cooperative outcome. • Don’t be envious: Focus on your own slice of the profit pie, not on your competitor’s. • Be clear: Make sure your competitors can easily interpret your actions. The tit-for-tat strategy—cooperating the first period and then doing what your opponent did last period—won the tournament. It exhibits all of the characteristics of a successful strategy. Tit-for-tat never strikes first and responds immediately to defection, but limits punishment to only a single period. It is focused on maximizing your own profit, and not on limiting your competitor’s profits. And finally, it is easily understood by rivals. 15.4 Other Games Game of Chicken In the classic game of chicken, two teenage boys—say, James and Dean—drive their cars straight toward each other. If both go straight, they crash and die. If one goes straight while the other swerves, the one who goes straight wins the praise of peers, whereas the one who swerves suffers the humiliation of “chickening out.” If both swerve, each suffers humiliation.7 Intuitively, you should realize that there are two equilibria to this game. If James goes straight and Dean swerves, then each player is doing the best he can, given what the other player is doing. James cannot improve his payoff by swerving and Dean cannot improve his by going straight (assuming death is worse than humiliation). In Table 15.9, we have attached numerical values to each of the outcomes, and you should verify for yourself that the game of chicken has two equilibria in the off-diagonal entries of the matrix. TABLE 15.9 Game of Chicken James Go Straight Swerve Dean Go Straight 210, 210 3, 0 Swerve 0, 3 0, 0 Now that we have analyzed the game and the likely outcomes, the next step is to figure out how to change the game to your advantage. Note that each party prefers one of the equilibria. This implies an obvious strategy: com- mit to a position, and make sure your rival understands your commitment. Coordination is important here so that the players don’t end up killing each other. 06665_ch15_ptg01_183-204.indd 195 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making196 Commitment changes what is essentially a simultaneous-move game into a sequential-move game. We illustrate this in Figure 15.4. The equilibrium is easy to compute. Dean does better by doing the opposite of whatever James does before him. So if James goes straight, Dean swerves, and vice versa. Once James knows what Dean is going to do, he sees that {Straight, Swerve} gives him a higher payoff than {Swerve, Straight}. The difficult part is convincing the other player that you are committed. One way to do this is to lock the steering wheel in place using an antitheft device, like the Club, and throw away the key. Make sure that the other player sees you do this. Otherwise, he may also commit to going straight, and you could both end up dead. The game of chicken has business applications as well. Table 15.10 rep- resents the choices faced by competing biotechnology companies who were developing hybrid (disease-resistant) grapes. Each company could afford to tailor the grape variety to only one country, either Italy or South Africa. Both prefer to be the sole entrant in a market, and both prefer Italy—a larger market—to South Africa. This game has the same logical structure as the game of chicken, with two equilibria: {South Africa, Italy} and {Italy, South Africa}. TABLE 15.10 Market Entry Game of Chicken Firm B Italy South Africa Firm A Italy 0, 0 100, 50 South Africa 50, 100 250, 250 FIgurE 15.4 First-Mover Advantage in a Game of Chicken James Dean Dean Straight Swerve Straight Swerve Straight Swerve –10, –10 0, 03, 0 0, 3 06665_ch15_ptg01_183-204.indd 196 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTEr 15 • Strategic games 197 If Firm A can move first or commit to going into Italy, it will force Firm B into South Africa. By moving first, Firm A turns the simultaneous-move game into a sequential-move game in which it “chooses” the favorable equilibrium. We graph this outcome in Figure 15.5. Dating Game The dating game shares the tension between group interest (cooperation) and self-interest (conflict) inherent in a prisoners’ dilemma. The game in Table 15.11 is about a couple with different interests—Sally likes ballet and Joe likes wrestling. But each likes the other’s company and would prefer attending events together. The two would be best served if Sally and Joe could agree to attend an event together (total payoff of 5), but neither coordination possibility—both attend the ballet or both attend wrestling match—is a Nash equilibrium. The only Nash equilibrium is the lower left, where Joe goes to the wrestling match and Sally goes to the ballet.8 This outcome is not opti- mal, however, since both enjoy spending time together. As in the prisoners’ dilemma, the idea is to find a way to change the rules of the game so both players can earn higher payoffs. TABLE 15.11 Dating Game Joe Wrestling Ballet Sally Wrestling 1, 4 0, 0 Ballet 2, 2 4, 1 FIgurE 15.5 Sequential Market Entry Firm A Firm B Firm B S. Africa Italy Italy S. Africa Italy S. Africa 50, 100 100, 50–50, –50 0, 0 06665_ch15_ptg01_183-204.indd 197 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making198 One easy way to increase the joint payoffs is to take turns by attending a different event together each week. This solution gives a higher group payoff (5) than the Nash equilibrium (4). Note the similarity of this solution to the repeated prisoners’ dilemma—if you repeat the game, you’ll find it relatively easy to figure a way out of the dilemma. The dating game also gives you a way to analyze the tension between divi- sions within a corporation. Suppose Chevrolet and Cadillac—two divisions of General Motors (GM)—receive a volume discount if they purchase tires from a single supplier. However, Chevrolet and Cadillac cannot agree on a com- mon supplier because each has its own preference: Chevrolet wants Good- year Tires, but Cadillac wants Michelin. This interdivision conflict negatively affects company-wide profit (see Table 15.12). We will return to this topic in Chapter 22, “Getting to Work in the Firm’s Best Interests.” TABLE 15.12 Corporate Division Dating Game Chevrolet Goodyear Tires Michelin Tires Cadillac Goodyear Tires 1, 4 0, 0 Michelin Tires 2, 2 4, 1 Interdivision conflict is more likely to arise when the parent company runs each division as a separate profit center. Finding a way to create cooperation for the good of the parent company is the management’s problem. In this case, GM might offer some kind of profit sharing or subsidization, such as Cadillac paying Chevrolet to use Michelin tires. Shirking/Monitoring Game We can consider the problem of how to manage workers efficiently as a game between an employer and an employee. Game theory helps us understand how best to manage self-interested employees. Consider the most basic situation: a self-interested employee would pre- fer to work less (shirk), but shirking is profitable only if his manager is not monitoring what he does. The manager wants the employee to work hard, but must incur costs to monitor the employee’s behavior. Table 15.13 represents the game. Try to find an equilibrium before reading on. TABLE 15.13 Shirking/Monitoring Game Employee Shirk Work Manager Monitor 21, 0 5, 5 Don’t Monitor 210, 10 10, 5 06665_ch15_ptg01_183-204.indd 198 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTEr 15 • Strategic games 199 If the manager monitors, then the employee does better by working. If the employee works, the manager does better by not spending resources on monitor- ing. But if the manager doesn’t monitor, then the employee does better by shirk- ing. But if the employee shirks, the manager prefers to monitor. And so on. This game has no “pure strategy” equilibrium (meaning that each player selects one of the two strategies and sticks to it), but it does have an equilibrium in “mixed” strategies in which players choose which strategies to play randomly. An easy way to understand the concept of mixed strategies is to think about a sports contest. Should an American football team run or pass? If the team always runs, the defense will always prepare a good run defense, and the same will happen if the team always passes. The best strategy is to mix between runs and passes to try to keep the defense guessing. The exact probability of running will vary from team to team, depending on its players’ abilities, and from game to game, depending on the abilities of rival players. The idea is to use the element of surprise to keep your opponent from taking advantage of your strategy. In the equilibrium of our monitoring/shirking game, managers randomly monitor employees’ behavior, and employees randomly shirk. As the manager’s goal is to affect the behavior of the employee, it turns out that the probability of monitoring depends on how much the employee gains by shirking, and the probability of shirking depends on how much it costs the employer to monitor the employee’s behavior. Now that we understand behavior in this game, let’s try to figure out how to change the outcome to our advantage. The employer can reduce shirking by combining monitoring with some incentive compensation. When the employer monitors and finds the employee is working hard, the employer can reward the employee with a bonus; or, equivalently, when the employer monitors and finds the employee is shirking, the employer can punish him with a fine, like demotion or dismissal. This combination of monitoring and incentive com- pensation can reduce the costs of controlling self-interested employees. We’ll return to this problem in Chapter 21 when we discuss aligning employee incentives with the goals of the firm. SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • In sequential-move games, players observe all prior decisions of the rival before decid- ing on a strategy. • In simultaneous-move games, players do not observe the rival’s decision before deciding on their own strategies. • A Nash equilibrium is a pair of strategies, one for each player, in which each strategy is a best response to the other. These repre- sent the likely outcomes of games. • When the rules of the game are flexible, change them to your advantage. • In sequential games, players can change the outcome by committing to a future course of action. Credible commitments are difficult to make because they may require players to threaten to act against their own self-interest. • In the prisoners’ dilemma, conflict and cooperation are in tension—self-interest leads the players to outcomes that no one likes. Studying the games can help you find a way to avoid these bad outcomes. 06665_ch15_ptg01_183-204.indd 199 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making200 • In repeated games, it is much easier to get out of bad situations. Here are some gen- eral rules of thumb: • Be nice: No first strikes. • Be easily provoked: Respond immedi- ately to rivals. • Be forgiving: Don’t try to punish other players too much. • Don’t be envious: Focus on your own slice of the profit pie, not on your competitor’s. • Be clear: Make sure your competitors can easily interpret your actions. Multiple-Choice Questions 1. The prisoners’ dilemma is an example of a. a sequential game. b. a simultaneous game. c. a shirking game. d. a dating game. 2. A Nash equilibrium a. is where one player maximizes his pay- off and the other doesn’t. b. is where each player maximizes his own payoff given the action of the other player. c. is where both players are maximizing their total payoff. d. is a unique prediction of the likely out- come of a game. Use the following to answer Questions 3–5: Consider the following information for a simultaneous-move game: two discount stores (megastore and superstore) are interested in expanding their market share through adver- tising. The following table depicts the profits of both stores with and without advertising. Payoffs for Megastore are in black. Superstore Advertise Don’t Advertise Megastore Advertise $95, $80 $305, $55 Don’t Advertise $65, $285 $165, $115 3. A Nash equilibrium is a. for Megastore to advertise and for Superstore to advertise. b. for Megastore to advertise and for Superstore not to advertise. c. for Megastore not to advertise and for Superstore to advertise. d. for Megastore not to advertise and for Superstore not to advertise. 4. When the stores reach the Nash equilib- rium, their profits will be a. Megastore $95 and Superstore $80. b. Megastore $305 and Superstore $55. c. Megastore $65 and Superstore $285. d. Megastore $165 and Superstore $115. 5. If collusion were not illegal, then it would be optimal a. for Megastore to advertise and for Superstore to advertise. b. for Megastore to advertise and for Superstore not to advertise. c. for Megastore not to advertise and for Superstore to advertise. d. for Megastore not to advertise and for Superstore not to advertise. 6. In a Nash equilibrium, a. players are always maximizing their joint profit. b. one player is always earning a higher profit than the other. c. players must be playing the game sequentially. d. None of the above. 7. In repeated games, all of the following make it easier to get out of bad situations except a. be nice, no first strikes. b. respond immediately to rivals. c. punish uncooperative players as much as you can. d. make sure your competitors can easily interpret your actions. Refer to the following strategic form game of price competition for Questions 8 and 9. 06665_ch15_ptg01_183-204.indd 200 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTEr 15 • Strategic games 201 Firm B Low Price High Price Firm A Low Price 0, 0 50, 210 High Price 210, 50 25, 25 8. If this game is played once, then a. firm A will charge a low price, and firm B will charge a low price. b. firm A will charge a high price, and firm B will charge a low price. c. firm A will charge a low price, and firm B will charge a high price. d. firm A will charge a high price, and firm B will charge a high price. 9. Suppose the game is infinitely repeated. What strategies will each firm likely utilize? a. Firm A will charge a low price, and firm B will charge a low price. b. Firm A will charge a high price, and firm B will charge a low price. c. Firm A will charge a low price, and firm B will charge a high price. d. Firm A will charge a high price, and firm B will charge a high price. 10. You, a real-estate developer, own a piece of land in Nassau, Bahamas, next to an equally sized piece of land owned by a competitor. Both of you have the choice of building a casino or a hotel. Your payoffs are as follows: You Casino Hotel Your Casino 3, 3 20, 5 Competitor Hotel 5, 20 2, 2 How much is it worth to you to get your casino building permit first? a. $2 million b. $3 million c. $15 million d. $17 million Individual Problems 15-1 To Vote or Not to Vote Mr. and Mrs. Ward typically vote oppositely in elections and so their votes “cancel each other out.” They each gain two units of utility from a vote for their positions (and lose two units of utility from a vote against their positions). However, the bother of actually voting costs each one unit of utility. Diagram a game in which they choose whether to vote or not to vote. 15-2 To Vote or Not to Vote Part II Suppose Mr. and Mrs. Ward agreed not to vote in tomorrow’s election. Would such an agree- ment improve utility? Would such an agreement be an equilibrium? 15-3 Compatibility Microsoft and a smaller rival often have to select from one of two competing technolo- gies. The rival always prefers to select the same technology as Microsoft (because compatibility is important), while Microsoft always wants to select a different technology from its rival. Describe the equilibrium of this game. 15-4 Salary Negotiation The following figure represents the potential outcomes of your first salary negotiation after graduation. Assuming that this is a sequential-move game with the employer moving first, indicate the most likely outcome. Does the ability to move first give the employer an advantage? If so, how? As the employee, is there anything you could do to realize a higher payoff? 15-5 Renegotiating Employment Contracts Every year, management and labor renegotiate a new employment contract by sending their proposals to an arbitrator who chooses the best proposal (effectively giving one side or the other $1 million). Each side can choose to hire, or not hire, an expensive labor lawyer (at a cost of 06665_ch15_ptg01_183-204.indd 201 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making202 $200,000) who is effective at preparing the pro- posal in the best light. If neither hires lawyers or if both hire lawyers, each side can expect to win about half the time. If only one side hires a lawyer, it can expect to win three-quarters of the time. 1. Diagram this simultaneous-move game. 2. What is the Nash equilibrium of the game? 3. Would the sides want to ban lawyers? 15-6 Entry Game with Withdrawal In the text, we considered a sequential-move game in which an entrant was considering entering an industry in competition with an incumbent firm (Figure 15.1). Consider now that the entrant, if fought, has the possibility of withdrawing from the industry (at a loss of 1 for the entrant and a gain of 8 for the incum- bent), or staying (at a loss of 5 for each player). What is the equilibrium of this game? Discuss if the entrant is better off with or without the ability to withdraw. Group Problem G15-1 Strategic Game Describe some interaction your company has with another entity (firms producing comple- mentary or substitute products, upstream sup- pliers, or downstream customers), or between internal divisions within your firm that can be described as a sequential or simultaneous game. Diagram the strategies, players, and compute payoffs as best you can. Compute the Nash equilibria. What can you do to change the rules of the game to your advantage? Compute the profit consequences of your advice. Employer Low Salary Offer High Salary Offer Employee Accepts Employee gets 100 Employer gets 75 Employee Accepts Employer gets 100 Employee gets 75 Employee Walks Employer gets 0 Employee gets 0 Employee Walks Employer gets 0 Employee gets 0 1. For sequential games, this is a specific type of Nash equilibrium called a subgame- perfect or rollback equilibrium. 2. When a player has the same best response to anything that other players might do, it is called a dominant strategy. Here, “Confess” is dominant for both Jesse and Frank. 3. Retail scanner data and company loyalty programs sometimes make such discrimi- nation possible. For a detailed analysis of these strategies, see Greg Shaffer and Z. John Zhang, “Competitive Coupon Target- ing,” Marketing Science 14 (1995): 395–416 and Greg Shaffer and Z. John Zhang, “Pay END NOTES 06665_ch15_ptg01_183-204.indd 202 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTEr 15 • Strategic games 203 to Switch or Pay to Stay: Preference-Based Price Discrimination in Markets with Switching Costs,” Journal of Economics and Management Strategy 9 (2000): 397–424. 4. Examples of these so-called pay-to-switch strategies include Coca-Cola’s giving a dis- count on Diet Coke to purchasers of Diet Pepsi and Chesebrough-Pond’s giving a dis- count on Mentadent Toothpaste to purchas- ers of PeroxiCare. See Ibid. 5. For more on how the advertising ban actu- ally benefitted the tobacco companies, see James L. Hamilton, “The Demand for Ciga- rettes: Advertising, the Health Scare, and the Cigarette Advertising Ban,” Review of Eco- nomics and Statistics 54 (1972): 401–411. 6. John H. Shenefield and Irwin M. Stelzer, “Common Sense Guidelines,” in The Anti- trust Laws: A Primer, 3rd ed. (Washington, DC: AEI Press, 1998), 123–126. 7. Actually, the classic version of the game of chicken involved two cars driving toward the edge of a cliff, with the winner being the one who jumped out of the car last. Our updated version preserves the cars as well as the drivers. 8. In an alternate version of the Dating Game, players’ preferences for one event over the other are not as strong as their preference to be together. In this case, the game has two equilibria in which both attend the same event. 06665_ch15_ptg01_183-204.indd 203 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 06665_ch15_ptg01_183-204.indd 204 8/9/17 8:38 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 205 In the summer of 2011, the owners of the National Basketball Association (NBA) were locked in negotiations with the players’ union over how to split revenue. The union wanted 57%, equal to its previous contract, but the own- ers were offering only 50%. Despite some concessions from the players’ union, the owners locked out the players, canceling the beginning of the season. After months of finger-pointing and legal threats, the players settled for what the owners had originally offered. In contrast to the players’ union, public sector employee unions have been able to bargain much more successfully. In places like California, with strong unions, public sector workers earn as much as 30% more than their private sector counterparts, by some estimates. In Central Falls, Rhode Island, the city workers were able to win retirement benefits so generous that they bank- rupted the city. A similar contrast appears in the bargaining over drug prices. Hospi- tals and health maintenance organizations (HMOs) are able to buy drugs at prices that are 10% to 40% less than drugstores pay. What accounts for these differences? In this chapter, we answer these questions from two different, but comple- mentary, points of view. We begin with a strategic view that characterizes bar- gaining as a formal game of chicken where the ability to commit to a position gives one player bargaining power over its rivals. The other view of bargaining begins with the observation that real nego- tiations rarely have rules like the ones that characterize formal games. Under this view of bargaining, it is the alternatives to agreement that determine the terms of agreement, regardless of the precise form of the negotiations. If you can increase your opponent’s gain to reaching agreement (or decrease your own), you make your opponent more eager to reach agreement, and this allows you to capture a bigger share of the proverbial pie. Bargaining16 06665_ch16_ptg01_205-214.indd 205 8/9/17 8:39 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making206 16.1 Strategic View of Bargaining In this section, we model bargaining as a game of chicken where the ability to commit to a position gives one player bargaining power over rivals. To make this concrete, imagine that a company’s managers are bargaining with a labor union over a fixed sum and that each player has just two possible strategies: bargain hard or accommodate. If both bargain hard, they’ll fail to reach a deal, and therefore each will earn nothing; if both accommodate, they split the gains from trade. If one player bargains hard and the other accommodates, the player who bargains hard takes 75% of the gains from agreement. In Table 16.1, we see that this game has the same logical structure as a game of chicken. If both players accommodate, they split the gains from trade (lower right), but this is not an equilibrium because either player can do better by bargaining hard. If both bargain hard, then each earns nothing (upper left), but this is not an equilibrium because either player can do better by accom- modating the other. The two equilibria, {Bargain Hard, Accommodate} in the upper-right quadrant and {Accommodate, Bargain Hard} in the lower-left quadrant, are where each party is playing optimally against its rival. TABLE 16.1 Labor Negotiation Game Management Bargain Hard Accommodate Union Bargain Hard 0, 0 75, 25 Accommodate 25, 75 50, 50 At this point, you should know what to expect in a game of chicken—both parties will try to steer the game to their preferred equilibrium by committing to a position. If you can convince your rival that you’re going to bargain hard, regardless of what your rival does, he will do better by accommodating, and you will get a bigger share of the gains from trade. To see the value of commitment, we examine the game as a sequential- move game where the party able to make a commitment gets to move first. In this case, imagine that the union makes either a generous offer or a low offer; and then management must either accept or reject the offer. If manage- ment accepts the offer, it earns what the union offered; if not, management locks out the union, and each party earns nothing. We diagram the offers and payoffs in Figure 16.1. To analyze the game, we begin at the second stage, and notice that the management does better by accepting whatever is offered in the first stage. Regardless of whether the union makes a generous offer or a low offer, accepting the offer gives manage- ment a higher payout than rejecting it. Realizing this, the union makes a low offer at the first stage and earns 75% instead of 25%. We identify the equilib- rium by putting two lines through all the suboptimal options in Figure 16.1. 06665_ch16_ptg01_205-214.indd 206 8/9/17 8:39 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 16 • Bargaining 207 This game illustrates a classic first-mover advantage—by moving first, or equivalently, by committing to bargain hard, the union can capture most of the gains from trade. By now you should be able to recognize that the simultaneous-move game is symmetric, which means that if management can commit to lock out the union if it receives a low offer, it can change the outcome of the game. If the union believes management’s threat, it will make a generous offer instead of a low one. As in the entry deterrence game in Chapter 15, by committing to a posi- tion, management changes the equilibrium of the game by eliminating an option. We illustrate the new equilibrium in Figure 16.2. Figure 16.1 Labor Negotiation Game with Union Commitment Union Management Management Low Offer Generous Offer Accept Accept Reject (lock out) Reject (lock out) 75, 25 0, 00, 0 25, 75 Figure 16.2 Labor Negotiation Game with Management Commitment to Lock Out Union Management Management Low Offer Generous Offer Accept Reject (lock out) Reject (lock out) 0, 00, 0 25, 75 06665_ch16_ptg01_205-214.indd 207 8/9/17 8:39 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making208 Although committing to a lockout sounds simple, it’s difficult for the man- agement to persuade the union that it will pursue an otherwise unprofitable strategy. If the threat is not believed by the union, management might actually have to carry through on the threat, leading to the following maxim: The best threat is one you never have to use. Lockouts (and strikes) occur because the union doesn’t believe manage- ment’s threat. In these cases, the only way for management to convince the union that it’s committed to a lockout is to actually lock the union out. To summarize: the strategic view of bargaining suggests that if you can commit to a position, you can capture a bigger share of the gains from agree- ment. But committing to a position is difficult because it requires you to act against your self-interest. If your rival doesn’t believe your commitment, she will test you and you may go through a period of no agreement. To see the practical implications of the strategic view, imagine that you are buying a new car. To get a better price, try to put the car dealer in a position where he is forced to either accept or reject your offer. First, figure out which car you want to buy and exactly which features you want. Then, do some research to find out what the dealer’s actual cost is and calculate a price where the dealer can make some, but not too much, money. Bring only one check, preferably a cashier’s check that cannot be modified, made out for a specific amount, and threaten to leave if the dealer says anything but “yes” to your offer. If the car dealer believes you, then your offer is likely to be accepted. 16.2 Nonstrategic View of Bargaining The games just described take a strategic view of bargaining, in which the outcome depends on who moves first and who can commit to a position. This dependence of the bargaining outcome on the precise rules of the bar- gaining game is a little disturbing because real-world bargaining rarely has such well-defined rules. To address this shortcoming, John Nash, the same mathematician responsible for the Nash equilibrium, proved that any rea- sonable bargaining outcome would split the gains from trade.1 We call this an “axiomatic” or “nonstrategic” view of bargaining because it does not depend on the rules of the bargaining game or whether players can commit to a position. To understand this result, imagine two players bargaining with each other. Without agreement, Player 1 earns D 1 and Player 2 earns D 2 . These are some- times called the players’ “outside options” or “disagreement values.” If they reach an agreement, they earn A. If the gains to trade are positive, that is, if A 2 (D 1 1 D 2 ) . 0, then they are split evenly by the parties. In this case, Player 1 receives D 1 1 (A 2 (D 1 1 D 2 )) / 2 5 (A 1 D 1 2 D 2 ) / 2, and Player 2 receives D 2 1 (A 2 (D 1 1 D 2 )) / 2 5 (A 1 D 2 2 D 1 ) / 2. 06665_ch16_ptg01_205-214.indd 208 8/9/17 8:39 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 16 • Bargaining 209 Notice that each player’s split depends not only on how much the agree- ment is worth (A), but also on the players’ outside options, or disagreement values (D 1 and D 2 ). Player 1 receives more if his outside option is better or if Player 2’s outside option is worse. This leads immediately to the following advice: To improve your own bargaining position, improve your outside option, or decrease that of your opponent. This nonstrategic view of bargaining tells you that if you can decrease your own gain to reaching agreement by improving your outside option, you become a tougher bargainer because you have less to gain by reaching agree- ment. For example, the best time to ask for a raise is when you already have an attractive offer from another company (D 1 is big). Because you have a good alternative, your gain to reaching agreement is small, which makes you less eager to reach agreement. Note the similarity of the disagreement value to the idea of opportunity cost. The cost of staying in your current job is the offer you give up if you stay. If you have a good alternative offer, the oppor- tunity cost of staying in your job is high, putting you in a stronger bargaining position. The result also tells us how bargaining is likely to change as circumstances change. Suppose, for example, that Player 1 receives a bonus B for reaching agreement. The total gain to reaching agreement has now risen from A to A 1 B. The nonstrategic view of bargaining tells us that this bonus will be split between the two parties. In essence, Player 1 “gives away” half of his bonus to Player 2. If you increase the first player’s gain to reaching an agree- ment, you make him more eager to reach agreement, and this puts him in a weaker bargaining position. Bonuses like this are similar to incentive compensation schemes that companies adopt to induce salespeople to increase sales. Offering salespeo- ple bonuses increases their eagerness to reach agreement with their customers, and this makes them weaker bargainers. So, if you give your salespeople an incentive like this, you can expect lower prices when they negotiate with cus- tomers. We will come back to this theme in Chapter 21 when we talk about how to align the incentives of salespeople—who typically prefer lower prices so they can make more sales—with the profitability goals of the company. To understand how advice gleaned from Nash’s bargaining outcome differs from advice gleaned from analyzing bargaining as a strategic game, let’s return to the union/management game. The strategic view of bargaining emphasized the role of commitment and timing in affecting the outcome of a game. For example, management’s commitment to lock out the union in the event of a low offer changes the equilibrium of the game. But strategies play no role in the nonstrategic view of bargaining. Only a strike that hurts man- agement more than it hurts the union can improve the bargaining position of labor. This is why strike threats are more common during seasonal peaks in demand, when it would hurt the firm more than it would hurt the union. By changing the alternatives to agreement for management (bigger loss during a strike), the union can increase management’s willingness to reach agreement. 06665_ch16_ptg01_205-214.indd 209 8/9/17 8:39 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making210 The next time you shop for a car, keep in mind that salespeople typically get paid commissions at the end of the month. So buying a car near the end of the month means that the salesperson earns an immediate commission. This immediacy raises the gain to reaching agreement (remember that current dollars are worth more than future dollars due to the time value of money), increasing the likelihood that you’ll receive a better offer. You can also shop for cars at unpopular times, like Black Friday or Christmas Eve, when demand is low. Look at it from the salesperson’s point of view: the cost of selling to you is the forgone opportunity to sell to someone else. If there is no one else around, the cost of selling to you is essentially zero; or equivalently, the sales- person’s outside alternative is very poor. Mergers or acquisitions of rivals can also strengthen your bargaining posi- tion. Suppose an insurance company is putting together a network of hospitals to serve its client base. The insurance company bargains with individual hospi- tals over whether to include them in the network and what price they’ll charge if included in the network. To get better prices, the insurance company threat- ens to exclude one hospital in favor of a nearby substitute hospital. But if the two hospitals merge and bargain together, the insurance company’s bargain- ing alternatives become much worse. If the insurance company fails to reach agreement with the merged hospitals, then its managers must go to the third- best alternative, which might be farther away from its client base. This would reduce the attractiveness—and profitability—of the network, and make the insurance company more eager to reach agreement with the merged hospital. To make this concrete, let’s use a numerical example. Suppose an insur- ance company can market its network to an employer for $100 per subscriber if the network contains one of two hospitals and for $120 if it contains both, but the insurance company cannot market the plan at all without at least one of the hospitals. The insurance company goes to the first hospital and tells them that they are likely to reach agreement with the second. This makes the gain from adding the hospital to its network that already has the other hospi- tal in it only $20. Under the nonstrategic view of bargaining, this $20 is evenly split between the hospital and the insurance company. The insurance company does the same thing to the second hospital. Thus, before a merger, the insur- ance company plays each hospital against the other, and each hospital gets only $10 for joining the network. Now suppose the two hospitals merge and bargain together. The insur- ance company can no longer threaten to drop one of the hospitals in favor of the other, so the gain from striking a bargain with the merged hospitals is the full $120, which is also evenly split in the Nash bargaining solution. The merger increases the total payment to the hospitals from $20 to $60. 16.3 Conclusion Let’s close this chapter by applying the nonstrategic view of bargaining to the different negotiations in the introduction. To do this, we focus on the outside alternatives of each of the parties. Let’s begin with the NBA lockout. If the play- ers don’t play, they lose not only their salaries (half of the revenue), but they also 06665_ch16_ptg01_205-214.indd 210 8/9/17 8:39 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 16 • Bargaining 211 lose a year of longevity (the average player plays for only five years). In con- trast, the owners lose only the contribution margin (half of the revenue minus the variable cost), which is much smaller than what the players lose. Because they have less to gain from reaching agreement, the owners were less eager to reach agreement, and this allowed them to get most of what they asked for. Public employee unions are particularly good bargainers because they help elect (and defeat) the politicians they bargain against. If a politician fails to reach agreement with the union, she knows that the union can help put her out of a job. This makes the politician more eager to reach agreement and a weaker bargainer. The end result is that public sector unions earn more than private sector workers who have to bargain against bosses whose compensa- tion is typically tied to the profitability of the company. Finally, let’s look at the bargaining between drug companies and two dif- ferent types of customers, retail drugstores and hospitals. Drugstores typically carry all the competing brands because this is what their customers want. If they fail to stock a drug, the customer will go to a competing drugstore that carries the drug. The drug store will lose not only the profit on sale of the drug, but also the profit on sales of other items that the customer would have bought when buying the drug. For this reason, drugstores are eager to reach agreement on all brands, so they don’t get very good prices. The greater bargaining power of hospitals is due to their ability to “steer” patients toward a particular drug. To do this, they use formularies, which limit the number of brands in each class. For example, they will carry only one nondrowsy allergy drug. This creates price competition among the nondrowsy allergy drug brands to get onto the formulary. As a result, hospitals are able to get better prices. In this chapter, we have described two different ways of thinking about bar- gaining. This raises the obvious question, which is better? The answer is that “it depends” on the particular setting in which you find yourself. If you can credi- bly commit to a position by, for example, making a take-it-or-leave-it offer, then go ahead. If, as is more likely, commitment is costly or not credible, then try to change the alternatives to agreement, as they determine the terms of agreement. SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • The strategic view of bargaining envisions bargaining as a game of chicken where the ability to commit to a position allows a player to capture the lion’s share of the gains from trade. • However, credible commitments are diffi- cult to make because they require players to commit to a course of action against their self-interest. • The nonstrategic view of bargaining does not focus on the explicit rules of the game to understand the likely outcome of the bargaining. Rather, it is the alternatives to agreement that determine the terms of any agreement. • Anything you can do to increase your opponent’s gains from reaching agreement or to decrease your own will improve your bargaining position. 06665_ch16_ptg01_205-214.indd 211 8/9/17 8:39 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making212 Multiple-Choice Questions 1. For threats or commitments to be effective, they must be a. irrational. b. profitable. c. credible. d. none of the above. 2. Fred and his employer both know that Fred can generate $200,000 of profit per year for his company. After negotiations, they agree that he will earn $110,000 in annual compensation. What does this imply for the value of his outside or next best alternative? a. $0 b. $5,000 c. $10,000 d. $20,000 3. How many pure strategy equilibria does the following game have? a. 0 b. 1 c. 2 d. 3 Labor Bargain Hard Be Nice Management Bargain Hard 0, 0 20, 10 Be Nice 12, 18 15, 15 4. In the game in Question 3, how much does Labor earn if they can move first? a. 10 b. 15 c. 18 d. 20 5. Consider a vendor–buyer relationship. Which of the following conditions would lead to the buyer having more bargaining power? a. Lots of substitutes for the vendor’s product are available. b. There are relatively few buyers and many vendors. c. It costs little for buyers to switch vendors. d. All of the above. 6. Consider bargaining in which each party increases its outside option by $10,000. Which of the following is a likely result. a. The chance of a deal increases. b. Each party’s share of the bargaining surplus increases by $10,000. c. The bargaining split remains the same. d. Each party share of the bargaining surplus increases by $5,000. 7. Pete and Lisa are entering into a bargaining situation in which Pete stands to gain up to $5,000 and Lisa stands to gain up to $1,000, provided they reach agreement. Who is likely to have the stronger bargaining position? a. Pete b. Lisa c. They will be equally effective. d. These potential gains will have no impact on bargaining. 8. George and KC have been working jobs that pay $60,000 and $30,000 per year, respectively. They are trying to decide whether to quit their jobs and jointly open up a taco stand on the beach, which they estimate can earn $150,000 per year. How will the taco stand proceeds be split? a. They won’t quit their jobs. b. George gets $90,000 and KC gets $60,000. c. George gets $75,000 and KC gets $75,000. d. George gets $100,000 and KC gets $50,000. 9. The game of chicken has a. a second-mover advantage. b. a first-mover advantage. c. no sequential-move advantage. d. potential sequential-move advantages, depending on the players. 06665_ch16_ptg01_205-214.indd 212 8/9/17 8:39 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 16 • Bargaining 213 10. Two hospitals are bargaining with an insurance company to get into its provider network. The insurance company can earn $100 if it puts one of the hospitals in its net- work and $200 if it puts both hospitals in its network. If both hospitals merge and bar- gain jointly, how much more will they earn? a. $0 b. $50 c. $100 d. $200 Individual Problems 16-1 Newspaper Bargaining Two equal-sized newspapers have an overlap in circulation of 10% (10% of the subscribers subscribe to both newspapers). Advertisers are willing to pay $10 to advertise in one newspa- per but only $19 to advertise in both, because they’re unwilling to pay twice to reach the same subscribers. What’s the likely bargaining negotiation outcome if the advertisers bargain by telling each newspaper that they’re going to reach an agreement with the other newspaper, so the gains to reaching agreement are only $9? Suppose the two newspapers merge. What is the likely post-merger bargaining outcome? 16-2 Airline Merger American Airlines and British Airways are pro- posing to merge. If British pilots and American pilots are represented by different unions, how would this merger affect airline costs? 16-3 House Closing You’ve entered into a contract to purchase a new house, and the closing is scheduled for the next week. It’s typical for some last-minute bargaining to occur at the closing table, where sellers often try to tack on extra fees. You have three options for the closing: (1) attend your- self, (2) send an attorney authorized to close only per the previously negotiated terms, or (3) presign all the closing documents per the cur- rent terms and not attend the closing. Which of these would be most advantageous from a bar- gaining position? 16-4 A City and Its Unions Robert G. Flanders Jr., the state-appointed receiver for Central Falls, RI, said his city’s dec- laration of bankruptcy had proved invaluable in helping it cut costs. Before the city declared bankruptcy, he said, he had found it impossi- ble to wring meaningful concessions out of the city’s unions and retirees who were being asked to give up roughly half of the pensions they had earned as the city ran out of cash. Why does bankruptcy give the city bargaining power against its unions? 16-5 Entering International Markets Your pharmaceutical firm is seeking to open up new international markets by partnering with various local distributors. The different distribu- tors within a country are stronger with different market segments (hospitals, retail pharmacies, etc.) but also have substantial overlap. a. In Egypt, you calculate that the annual value created by one distributor is $60 mil- lion per year, but would be $80 million if two distributors carried your product line. How much of the value can you expect to capture? b. Argentina also has two distributors with values similar to those in Egypt, but both are run by the government. How does this affect the amount you could capture? c. In Argentina, if you do not reach an agree- ment with the government distributors, you can set up a less efficient Internet-based distribution system that would generate $20 million in value to you. How does this affect the amount you could capture? 16-6 PBMs Pharmaceutical Benefits Managers or PBMs are intermediaries between upstream drug manu- facturers and downstream insurance compa- nies. They design formularies (list of drugs that 06665_ch16_ptg01_205-214.indd 213 8/9/17 8:39 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SECTION IV • Strategic Decision Making214 insurance will cover) and negotiate prices with drug companies. PBMs want a wider variety of drugs available to their insured populations, but at low prices. Suppose a PBM is negotiat- ing with two nondrowsy allergy drugs, Claritin and Allegra, for inclusion on the formulary. The “value” or “surplus” created by including one nondrowsy allergy drug on the formulary is $100, but the value of including a second drug is only $30. a. What’s the likely bargaining negotiation outcome if the PBM bargains by telling each drug company that they’re going to reach agreement with the other drug company? b. Now suppose the two drug companies merge. What is the likely post-merger bar- gaining outcome? Group Problem G16-1 Bargaining Describe some bargaining interaction your company has with another entity (firms pro- ducing complementary or substitute products, upstream suppliers, or downstream customers), or between internal divisions within your firm. Describe the bargaining as either a strategic or nonstrategic interaction. Compute payoffs as best you can. Compute the Nash equilibria (strategic) or the likely outcome (nonstrategic view). What can you do to change the bargain- ing to your advantage? Compute the profit con- sequences of your advice. 1. John Nash, “The Bargaining Problem,” Econometrica 18, no. 2 (1950): 155–162. END NOTE 06665_ch16_ptg01_205-214.indd 214 8/9/17 8:39 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 215 17 Making Decisions with Uncertainty 18 Auctions 19 The Problem of Adverse Selection 20 The Problem of Moral Hazard Uncertainty 5SECTION 06665_ch17_ptg01_215-232.indd 215 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 06665_ch17_ptg01_215-232.indd 216 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 217 XYZ makes money by designing and developing software. They start with a number of ideas, recommend the best ones based on market demand, dig deeper into a few, create products, launch them, and then hope their products succeed. Their design process is illustrated in Figure 17.1. At the “Recommend” phase, the marketing team provides revenue pro- jections for five candidate products. In the “Discover” phase, the technology “department” makes estimates of the cost and complexity for the best two of the five projects. The company has the capacity to develop only one product at a time, so it is critical that it picks the most profitable. In 2011, based on the data 17 Making Decisions with Uncertainty 50 IdeasBRAINSTORM RECOMMEND DISCOVER DEVELOP LAUNCH $ XYZ’s “Funnel” Approach Software Product Selection Method 5 Recommendations 2 Candidates 1 Product 0 or 1 Products Figure 17.1 XYZ Design Process 06665_ch17_ptg01_215-232.indd 217 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SeCTiON V • uncertainty218 presented in Table 17.1, the company decided to develop product A because it looked as if it was going to earn $300K more than product B. Table 17.1 XYZ Profit Projections Product A Product B Technology Complex Simple Projected revenue $1 million $600,000 Cost $200,000 $100,000 Profit $800,000 $500,000 Unfortunately, the product was scrapped prior to launch, which put the company into a financial hole and prompted a formal review of the deci- sion-making process by the board of directors. What the review discovered was a classic trade-off: more technically complex projects had higher potential revenue, but they were also more likely to be scrapped prior to launch, due to their inherent complexity. In fact, a review of last four years of data indicated that only 50% of the more complex products were launched, compared to a 75% launch rate for simpler products. This mistake could have easily been avoided had XYZ known how to make decisions in the face of uncertainty, the topic of this chapter. In what follows, we show you how to quantify uncertainty by replacing known quan- tities with random variables.1 17.1 Random Variables and Probability You’ll never have as much information as you want—especially when you’re faced with a significant decision. This means that you cannot simply compute the costs and benefits of a decision (as we did in Chapter 3) because costs or benefits will be uncertain. Instead, we use random variables to take account of what we don’t know. When we’re uncertain about what value a variable will take, we identify the situations in which it takes on different values, list the possible values, and assign a probability to each value. Usually, we are interested in expected values, or average outcomes, computed using a weighted average, where the weights are the probabilities. The mean or expected value of a random variable that can take on two values, {x 1 , x 2 }, with probabilities {p, 1 2 p}, is E[X] 5 p 3 x 1 1 (1 2 p) 3 x 2 . In general, the expected value of a random variable that can take on N values is E[X] 5 p 1 3 x 1 1 p 2 3 x 2 1 . . . 1 p N 3 x N where the probabilities sum to one. In this chapter, we will work with discrete random variables, which can assume only a limited number of values.2 06665_ch17_ptg01_215-232.indd 218 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTer 17 • Making Decisions with uncertainty 219 As a simple example of how to use random variables, suppose you go to a carnival and contemplate playing a game called the Wheel of Cash. The wheel looks like a simple roulette wheel, with three pie-like wedges. On each wedge is a number: $100, $75, and $5. If the cost to play is $50, should you take a chance on the game? First, note that you have three possible outcomes: $100, $75, and $5. If the wheel is fair—that is, if each outcome has an equal probability of occurring— then the expected value of playing the game is (1/3)($100)1(1/3)($75)1(1/3) ($5) 5 $60. So it looks like a really good deal. On average, you’ll earn $10 every time you play. But before playing, you should remember this maxim: If a deal seems too good to be true, it probably is. If players could really earn, on average, $10 each time they played, we’d expect to see a very long line of players eager to take their chances. Likewise, we’d expect to see the carnival losing money on the game. However, because this is an ongoing operation, we should recognize that it is probably not losing money. What’s more likely is that the wheel is not fair and that it lands on the $5 wedge more frequently than on the other two wedges. For example, if the wheel is twice as likely to land on the $5 than on the $75 or $100 wedges, then the expected value of playing is only (1/6)($100)1(1/6)($75)1(2/3)($5) 5 $32.50. On average, you lose (and the carnival earns) $17.50 every time you play. Now, let’s return to the decision facing our software development com- pany, XYZ. If the firm decides to develop the complex product (A), it incurs costs of $200K, and then have a 50% chance of launching, and receiving rev- enue of $1 million. If the firm decides to develop the simple product (B), it incurs costs of only $100K, and have a 75% chance of launching, but receiv- ing revenue of $600K. What should XYZ do? We diagram the consequences of the decision in Figure 17.2. (0.5) * $800K + (0.5) * –$200K =$300K (probability = 0.5) Firm = $800K (probability = 0.75) Firm = $500K (probability = 0.5) Firm = $200K (probability = 0.25) Firm = $100K (0.75) * $500K + (0.25) * –$100K =$350K Figure 17.2 Modeling an Uncertain Decision 06665_ch17_ptg01_215-232.indd 219 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SeCTiON V • uncertainty220 Look first at the left branch of the decision tree in Figure 17.2. If XYZ decides to develop product A, it doesn’t know whether the product will make it to the launch stage. If it is lucky, it will end up in the first box on the bottom row, and earn $800K (computed as $1,000K revenue minus $200K develop- ment cost). If it gets unlucky, the product will not be launched, and the firm will lose the $200K development cost. The firm quantifies its uncertainty by estimating a 50% probability of landing in the first box, and a 50% probabil- ity of landing in the second. The expected profit of launching product A is the weighted average of the profit in each box, or $300K. This is computed in the box labeled “Develop Product A.” Now look at the right branch of the decision tree in Figure 17.2. If XYZ decides to develop product B, it doesn’t know whether the product will make it to the launch stage. If it is lucky, it will end up in the third box on the bot- tom row, and earn $500K (computed as $600K revenue minus $100K devel- opment cost). If it gets unlucky, the product will not be launched, and the firm will lose the $100K development cost. The firm quantifies its uncertainty by estimating a 75% probability of landing in the third box, and a 25% proba- bility of landing in the fourth. The expected profit of launching product B is the weighted average of the profit in each box, or $350K. This is computed in the box labeled “Develop Product B.” Although more than $50K of expected profit separates the alternatives, you want to make sure that the firm has estimated probabilities precisely enough to distinguish between the two alternatives. Do not get lulled into a sense of false precision. A simple way to determine if your probabilities are precise enough is to see how different they would have to be to reverse the decision. If the proba- bility of a successful launch for product B were 67% instead of 75% or if the probability of a successful launch for product A were 55% instead of 50%, the decision would be reversed. If, XYZ Software has no more confidence in one set of probabilities than in the other, the decision is a wash. Thus, XYZ may want to gather more information—perhaps by surveying end users or consulting with outside software engineers in hopes of estimating the proba- bilities more precisely. This kind of analysis also clearly identifies the two separate risks that XYZ faces. Since the decision is so close, a next step might be to find a cre- ative way to avoid either possible risk. Perhaps the firm could find a better way to screen potential projects. For example, XYZ may be able to evaluate the software projects sooner, which may reduce the potential loss if they do not launch. For another example of how uncertainty could change the decision making, let’s return to the entry deterrence example in Chapter 15. Suppose that the potential entrant is uncertain about whether the incumbent will price low if it enters, and it quantifies this uncertainty by placing a 40% chance on a low price following entry. So the entrant faces a 60% chance of earning $5, but also a 40% chance of losing $5. The expected value of 06665_ch17_ptg01_215-232.indd 220 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTer 17 • Making Decisions with uncertainty 221 entering is (0.4)(2$5) 1 (0.6)($5) 5 $1.00. The expected value of staying out of the industry is $0. So the expected benefits are $1.00 larger than the expected costs. We illustrate this decision with a tree in Figure 17.3. We’ve seen that using random variables—and their associated probability distributions—rather than exact numbers to do benefit-cost analysis identifies sources of risks and points out ways to mitigate them. But we have another good reason for doing this kind of analysis: if things don’t turn out well, you have a good justification for making the wrong decision. By using a distri- bution that includes a worst-case scenario, you explicitly recognize the pos- sibility that things can turn out poorly. By presenting decision-makers with analyses that account for uncertainty, you allow them to distinguish between bad luck and bad decisions. To illustrate the final benefit of replacing exact numbers with random variables, let’s turn to another example. Suppose an associate invites you to invest in a new business venture. He gives you a prospectus that shows how much money you’ll make if you invest. The prospectus is based on estimates of cost and demand. How should you analyze the prospectus? Your associate has most likely given you a best-case scenario (low costs/ high demand). Add other scenarios (low costs/low demand, high costs/high demand, high costs/low demand), and assign probabilities to each scenario. The appropriate number of scenarios will depend on the specific applica- tion. Compute profit under each possible outcome, and calculate expected profit as the weighted sum of the possible outcomes. Almost certainly, your associate will do well under all scenarios; you, however, will do well under only a few. This analysis exposes an incentive conflict between you (the investor) and your associate. In this case, don’t invest unless you can better align his Figure 17.3 Entry Decision with Uncertainty (probability = 0.60) Entrant profit = $5 (probability = 0.40) Entrant profit = –$5 $0(0.60) $5 + (0.40) –$5 = $1.00 06665_ch17_ptg01_215-232.indd 221 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SeCTiON V • uncertainty222 incentives with your own. For example, suggest that he accept a payoff that rewards him only if the venture does well. If he declines, then most likely he doesn’t believe his own forecasts. This is a kind of adverse selection, a topic that we cover in Chapter 19. 17.2 Uncer tainty in Pricing If you don’t know your demand, you face uncertainty in pricing. One of the easiest ways to model uncertainty is to classify the number and type of poten- tial customers. Suppose you run a marketing survey and find you have two types of customers: high-value customers willing to pay $8 and low-value con- sumers willing to pay just $5. Your survey tells you that there are equal num- bers of high- and low-value customers. Obviously, you have two possible options: price high ($8) and sell only to the high-value group, or price low ($5) and sell to everyone. Which price should you choose? The answer is, “It depends.” In this case, it depends on your costs, which we’ll set at $3 per unit for illustrative purposes. We plot the decision tree in Figure 17.4. If you price high, you earn $8 2 $3 5 $5, provided you get a high-value customer. Since such sales happen only 50% of the time, the expected profit is $2.50. If you price low, you sell all the time, and you earn $5 2 $3 5 $2. So, price high and sell half as many goods, and earn an expected $0.50 more on each unit you sell. Note that with this high-price strategy, you’re left with unconsum- mated wealth-creating transactions—the low-value customer is willing to pay $5 for a good that costs you $3 to produce. To consummate these transactions, you may want to try price discrimination (see Chapters 13 and 14). Figure 17.4 Pricing Decision with Uncertainty (probability = 0.50) Profit = $5 (probability = 0.50) Profit = $0 (probability = 0.50) Profit = $2 (probability = 0.50) Profit = $2 (0.50) $5 + (0.50) $0 = $2.50 (0.50) $2 + (0.50) $2 = $2 06665_ch17_ptg01_215-232.indd 222 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTer 17 • Making Decisions with uncertainty 223 Price Discrimination If you can identify the two types of customers, set different prices for each group and prevent arbitrage between them, and then you can price discrimi- nate. Sell at a price of $8 to the high-value customers and at a price of $5 to the low-value customers. A common strategy can exploit observing low-value customers rejecting the high price and leave. Try to offer a discount of $3 before they exit the store. However, once your customers learn you’re discriminating, high-value customers will try to mimic the behavior or appearance of low-value custom- ers to get the lower prices. Figuring out how to correctly identify low- and high-value customers is critical for any price discrimination scheme. To see how identification matters, consider car salespeople. By making customers wait at the dealership before offering them a price discount, sales- people can identify low-value customers. The longer customers are willing to wait, the bigger the price discount they receive. This discrimination scheme works because the opportunity cost of time is higher for high-value customers. Only low-value customers are willing to wait for better offers. To defeat this kind of discrimination, try to mimic the behavior of low- value customers. If it’s too difficult for you, or if you’re too impatient, hire a negotiating agent who can bargain for you. According to a 1995 article3 in the American Economic Review, new- car salespeople tend to give worse offers (higher prices) to women and minority buyers. The article described a study employing “testers” who were given identical credit histories and bargaining scripts. The study found that women and minority testers received worse offers than their nonminority male counterparts. Surprisingly, these offers did not vary with the race or gender of the sales- person—minority and female salespeople discriminated against minority and female car buyers, just as their male and nonminority counterparts did. The article concluded that the discrimination did not arise from racial or gender bias but rather, race and gender helped identify the customer’s willingness to pay. This kind of “statistical” discrimination is profitable, but also illegal. Why, then, do salespeople think women and minority buyers are willing to pay more? It could be that nonminority men are better bargainers because they have better access to information about the costs of the car or perhaps they simply have a “taste” for bargaining. 17.3 Data-Driven Decision Making At the end of her workday, Amy, a young brand manager at Shoebuy.com, found herself in the elevator with the CEO. He asked about online sales of her brand. When Amy admitted that online sales were sluggish, the CEO sug- gested that displaying product reviews before product features might increase sales. When the elevator opened on the ground floor, Amy said that she had forgotten something and then went back to her office to run an experiment. She set up two sites, one with the product features before product reviews and one with the opposite. Every other online shopper was switched between 06665_ch17_ptg01_215-232.indd 223 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SeCTiON V • uncertainty224 the two sites. Within 24 hours, Amy had collected enough data to determine which display worked best. Three days later, she e-mailed the CEO to report the results of her experiment: putting the reviews in front of the features increased sales by 3%. Amy received a promotion by year’s end, and her “open mind” and “willingness to experiment” were mentioned in her performance review. Increasingly, firms are hiring “quants” to run experiments to resolve the uncertainty around business decisions. They answer questions like where best to site new facilities or close old ones, how high to set prices, or how to reduce employee turnover. Typically, these are questions about causality, like “Will doing X increase Y?” To answer them, data are collected on outcomes (like sales) from a group exposed to X, the “treatment group,” and those not exposed, the “control group.” In Amy’s case, the customers presented with the new design of product features before product reviews made up the treatment group. Ideally, estimating the casual effect of a treatment X on outcome Y would require us to observe the same group with and without the treatment. Strictly speaking, this is impossible. The same individual cannot be in both groups. Instead, a control group is constructed to be as close an approxima- tion to the treated group as possible. Good analyses are those that are able to construct good controls. The enemy of a good control is selection bias. Selection bias occurs when the treatment group differs systematically from the control group. When this occurs, some of measured effect is due to both the causal effect of the treat- ment (what we want to estimate) as well as “selection bias” (the underlying difference between the two groups). Unless the selection bias is negligible, our estimate could incorrectly suggest a bad decision. Observed effect 5 Treatment effect 1 Selection bias Different analytical tools have been developed to construct good controls for different contexts with the goal of eliminating selection bias. Ultimately, a manager will have to evaluate how well they work. The simplest technique is often the best. In the Shoebuy experiment above, assigning every other user coming to the site is a way to eliminate selection bias. Since there is no reason to think that consumers who arrive near each other differ in any systematic way, any differences between the groups would tend to wash out. Since there is no selection bias, the observed difference between the groups is due solely to the treatment effect. This is why random- ized experiments, in which the subjects of the experiment are assigned to the treatment group in a random or unbiased way, have come to be regarded as “the gold standard” in data analytics. Whenever possible, run simple randomized experiments to get unbiased estimates of the treatment effect. Increasingly, however, firms must use nonexperimental data on choices by consumers, employees, vendors, and so on. This push has led to the new job title of “data scientists” who might use “machine learning” to discern patterns in “big data.” No matter the size of the data or how it is processed, selection 06665_ch17_ptg01_215-232.indd 224 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTer 17 • Making Decisions with uncertainty 225 bias remains the biggest problem. Without an experiment, a control group has to be constructed after the fact. Because it is not randomized, it is possible for unexpected differences between the treatment and control groups to bias the results. For example, say Shoebuy is trying to decide whether displaying shoe fea- tures prominently affects sales. It might be tempting for Amy to try to esti- mate the benefit of displaying shoe features more prominently by comparing historical sales of shoes when features have been displayed to sales and when features have not been displayed. To see how selection bias could complicate inference, look at Table 17.2. Each row shows what would have happened if we could observe both treat- ment (features displayed prominently) and control conditions (features not displayed prominently). This is hypothetical because we don’t really know what would have happened to the treatment group if it was not treated or the control group if it was treated. The true display effect is $25,000 2 $9,000 5 $16,000 for the treated group versus $21,000 2 $24,000 5 2$4,000 for the untreated group. This difference in effects is probably because features are already displayed prominently where they are important (e.g., rub- ber sole for winter boots or cushioning for running shoes). For the other shoes, displaying these features merely clutters the marketing message and depresses sales. Amy compares what she does observe, the two diagonal values of $25,000 for the treated and $24,000 for the control to estimate a $1,000 effect. She concludes that displaying features does not help sales very much. The mar- keting department knows better and now looks suspiciously at any further analyses that Amy produces. Her estimate includes selection bias because the marketing department has already acted on information that Amy wants to test for. It is not uncommon for the analyst to be asked to confirm what the manager already knows and has acted on and this can result in selection bias. The better approach was to run the experiment that Amy ran at the beginning of this section. Table 17.2 Changing Display Formats Sales if Displayed ($) Sales if Not Displayed ($) Display Effect ($) Shoes with Features Displayed Prominently 25,000 9,000 16,000 Shoes without Features Displayed Prominently 21,000 24,000 24,000 Observed values in bold and unobserved values in gray. An additional problem with data analytics based on the flood of non- experimental data is researcher bias. Sometimes the analyst has the wrong 06665_ch17_ptg01_215-232.indd 225 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SeCTiON V • uncertainty226 incentives, for example, his or her compensation depends on a certain out- come. Since the comparison group is determined after the data are collected, the analyst has some discretion when deciding which observations belong in the comparison group and which do not. This may create a temptation to admit some selection bias into the analysis in order to generate the desired, but wrong, result. Instead of data driving the decisions, decisions are deter- mining which data are used. When this occurs, you might get severely biased results. For unbiased analyses, analysts should not be compensated based on the results they generate. 17.4 Minimizing Expected Error Costs Rather than making decisions that maximize expected profits (i.e., those whose expected benefits are bigger than their expected costs), it is some- times useful to think instead about minimizing expected “error costs.” This approach is useful when one of your alternatives would work well in one state of the world but not the other, and you are uncertain about which state of the world you are in. For example, XYZ’s vice president for new products must decide which products to bring to market and which to pull the plug on. For- mally, she wants to know whether the product launch will be profitable. She conducts cost and market research studies to assess the probability, p, that a product launch is profitable. We illustrate this decision in Table 17.3. The two alternatives are repre- sented by the two rows, and our uncertainty is represented by the columns. In other words, she can choose a row, but she doesn’t know which column she is in. If she decides to launch the product and it is profitable, then our column matches the row, and her error cost is zero. Likewise, if she kills the project and it is unprofitable, the column again matches the row. The two errors are repre- sented by the off-diagonal elements in the table: she can kill a profitable product (a “false positive” or “Type I error”) that has a cost of C I ; or she can launch an unprofitable product (a “false negative” or “Type II error”) with a cost of C II. Table 17.3 Error Costs of a Product Launch REALITY Profitable (Probability 5 p) Unprofitable (Probability 5 1 2 p) Expected Error Cost Decisions Launch product 0 C II (1 2 p) 3 C II Do not launch product C I 0 p 3 C I The optimal decision is to choose the row with the smaller expected error costs. If she launches the product, it could be unprofitable, resulting in 06665_ch17_ptg01_215-232.indd 226 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTer 17 • Making Decisions with uncertainty 227 expected error costs of (12p) 3 C II . If she kills the product, there is still a probability p that it would have been profitable and she caused an expected cost of p 3 (C I ). Therefore, launch the product if (12p) 3 C II , p × C I . She needs three pieces of information to make the decision: the size of the two error costs and the probability. Of these, there is often more uncertainty about the probability p. You can use a type of break-even analysis to determine how high p would have to be before a product launch is profitable. The probability that equates the two expected errors is P 5 C I / (C I 1 C II ). If p is above P, approve the project. But will our vice president for product introduction be too cautious? A failed product launch will become all too apparent to everyone, including her superiors. In contrast, a scrubbed product launch that would have been profitable is less apparent simply because we do not observe what did not happen. Since her career advancement is likely to be hindered by noticeable mistakes, she has an incentive to set too high of a value for P, or be too cau- tious, so as to avoid the types of mistakes that are most visible. Another way for her to avoid mistakes is to continue to gather information that will make her more certain that her estimate of p is above P (or below it). With more and better cost studies, focus groups, and pilot studies, she becomes more certain of making the right decision. The value of this information is that the firm will benefit from smaller decision error costs. The important trade-off is usually the cost of delay. Dawdling will cut into a finite product lifecycle or will allow another firm to enter first. Optimally, she would balance the value of more precise information with these costs of delay. However, the same factors that led her to set too high a standard could also lead her to require too much certainty. This type of analysis is also useful for balancing the risks of overpricing and underpricing errors, which we discussed in Chapter 12. Suppose that a cruise ship faces an uncertain demand. To model the benefits and costs of a pricing decision, consider two states of the world: high demand and low demand. If demand turns out to be high, it would be an error to underprice. If demand turns out to be low, overpricing is a mistake. Predict the probability of demand being high or low, and the costs of under- or overpricing mistakes. Pick the option that minimizes your expected error costs. 17.5 Risk versus Uncer tainty Our approach so far has described uncertainty as something that can be quantified using random variables; that is, you can list the possible outcomes and assign probabilities to each of those outcomes. Some scholars draw a distinction between “risk”—uncertainty that can be modeled with random variables—and “uncertainty,” which refers to outcomes that we cannot fore- see or whose probabilities we cannot estimate. In other words, uncertainty is a way of characterizing what we don’t know about the distribution of the random variables themselves.4 Understanding the difference between risk and uncertainty can be crit- ical. Risk can be quantified, priced, and traded. It can even be hedged with 06665_ch17_ptg01_215-232.indd 227 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SeCTiON V • uncertainty228 large pools of assets. Uncertainty, in contrast, is much more difficult to deal with. And, mistaking risk for uncertainty can have devastating consequences because it leads to overconfidence. At least part of blame for the recent financial crisis can be laid at the feet of bankers who mistakenly thought they were hedging the risk associated with complex financial instruments like collateralized debt obligations (CDOs). This mistaken assumption came from statistical models of risk, constructed from random variables, and tested on data from a period without any extreme events.5 When the financial crisis hit, it was an outcome far outside the predic- tions of most statistical models, and the banks found that their hedges could not prevent them from insolvency. So, how do you deal with uncertainty? Gathering more or better information is often a good place to start. Some companies have turned to prediction markets to help them try to quantify uncertain situations.6 For example, retailer Best Buy uses dispersed sets of nonexperts to predict a variety of outcomes like holiday sales rates. Google also uses internal prediction markets mostly focused on demand and usage forecasting. Prediction markets gather information from a wide group of people in order to try to turn uncertainty into risk. Despite our best efforts, we can never be sure that the models we use to quantify risk are the right ones. In other words, uncertainty is something that we cannot eliminate. Consequently, it makes sense to design organizations that can adapt to it—by keeping your options open as long as possible. We leave you with a piece of advice from an organization that is designed to succeed in the most uncertain of environments. The Warfighting manual of the U.S. Marines advises us to design flexible, decentralized, organizations to succeed in this “intrinsically unpredictable” environment: Because we can never eliminate uncertainty, we must learn to fight effec- tively despite it. We can do this by developing simple, flexible plans; plan- ning for likely contingencies; developing standing operating procedures; and fostering initiative among subordinates. SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • When you’re uncertain about the costs or benefits of a decision, assign a simple prob- ability distribution to the variable and com- pute expected costs and benefits. • When customers have unknown values, you face a familiar trade-off: price high and sell only to high-value customers, or price low and sell to all customers. • If you can identify high-value and low- value customers, you can price discriminate and avoid the trade-off. To avoid being discriminated against, high-value customers will try to mimic the behavior and appear- ance of low-value customers. • Decisions are increasingly being driven by data analytics. When possible run random- ized experiments. Otherwise, consider how systematic differences between the control and treatment group might generate selec- tion bias that limits the usefulness of the analysis. 06665_ch17_ptg01_215-232.indd 228 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 ChapTer 17 • Making Decisions with uncertainty 229 • If you are facing a decision where one of your alternatives would work well in one state of the world but not in the other, and you are uncertain about which state of the world you are in, think about how to mini- mize expected error costs. • Because failed initiatives are visible, but never-attempted initiatives are not, guard against employees becoming too cautious. • Risk can be quantified, estimated, and hedged. Uncertainty cannot. Don’t mistake risk for uncertainty, and try to design insti- tutions flexible enough to deal with unfore- seen contingencies. Multiple-Choice Questions 1. You are taking a multiple-choice test that awards you 1 point for a correct answer and penalizes you 0.25 points for an incor- rect answer. If you have to make a random guess and there are five possible answers, what is the expected value of guessing? a. 0.5 points b. 0.25 points c. 20.25 points d. 0 points 2. A franchise restaurant chain is considering a new store in an unserved part of town. Its finance group estimates an NPV of $10 million if the population growth is 10% (40% probability), an NPV of $4 million if the population does not grow (30% prob- ability), and an NPV of 2$4 million if the population shrinks 5% (30% probability). What is the expected value of NPV (to the nearest dollar) for the following situation? a. $3.4 million b. $4.0 million c. $4.6 million d. $5.2 million 3. You’ve just decided to add a new line to your manufacturing plant. Compute the expected loss/profit from the line addition if you estimate the following: • There’s a 50% chance that profit will increase by $100,000. • There’s a 30% chance that profit will remain the same. • There’s a 20% chance that profit will decrease by $15,000. a. Gain of $100,000 b. Gain of $70,000 c. Loss of $53,000 d. Gain of $47,000 4. Your software development company is considering investing in a new mobile app. If it goes viral (10% probability), you expect an NPV of $1,000,000; if it is mod- erately successful (20% probability), you expect an NPV of $200,000; and if it fails (70% probability), you expect an NPV of 2$200,000. What is the expected NPV of the product? a. $0 b. $280,000 c. $333,000 d. None of the above 5. Suppose an investment project has an NPV of $75 million if it becomes successful and an NPV of 2$25 million if it is a failure. What is the minimum probability of success above which you should make the investment? a. 1/2 b. 1/3 c. 1/4 d. 1/10 6. To test the effectiveness of two Web advertising agencies, you increase your ad purchase with agency A by 50% without changing your purchase through agency B. The referrals to your website from agency A increased by only 34% but the refer- rals from agency B fell by 21%. What do you estimate the referrals per dollar are through agency A? a. 1.2 referrals per dollar b. 1.1 referrals per dollar c. 1.0 referrals per dollar d. 0.9 referrals per dollar 06665_ch17_ptg01_215-232.indd 229 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 SeCTiON V • uncertainty230 7. Your company has a customer list that in- cludes 3,000 people. Your market research indicates that 90 of them responded to the coupon. If you send a coupon to one cus- tomer at random, what’s the probability that he or she will use the coupon? a. 0.03 b. 0.09 c. 0.30 d. 0.90 8. Your production line has recently been producing a serious defect. One of two possible processes, A and B, could be the culprit. From past experience you know that the probability that A is causing the problem is 0.8, but investigating A costs $100,000 while investigating B costs only $20,000. What are the expected error costs of shutting down process B first? a. $80,000 b. $20,000 c. $16,000 d. $4,000 9. You have two types of buyers for your product. Forty percent of buyers value your product at $10 and 60 percent value it at $6. What price maximizes your expected revenue? a. $10 b. $6 c. $7.60 d. $8 10. You are considering entry into a market in which there is currently only one producer (incumbent). If you enter, the incumbent can take one of two strategies, price low or price high. If he prices high, then you expect a $60K profit per year. If he prices low, then you expect $20K loss per year. You should enter if a. you believe demand is inelastic. b. you believe the probability that the incumbent will price low is greater than 0.75. c. you believe the probability that the incumbent will price low is less than 0.75. d. you believe the market size is growing. Individual Problems 17-1 Global Expansion You’re the manager of global opportunities for a U.S. manufacturer who is considering expanding sales into Asia. Your market research has identified the market potential in Malaysia, Philippines, and Singapore as described next: Success Level Big Mediocre Failure Malaysia Probability 0.3 0.3 0.4 Units 1,200,000 600,000 0 Philippines Probability 0.3 0.5 0.2 Units 1,000,000 320,000 0 Singapore Probability 0.7 0.2 0.1 Units 700,000 400,000 0 The product sells for $10 and has unit costs of $8. If you can enter only one market, and the cost of entering the market (regardless of which market you select) is $250,000, should you enter one of these markets? If so, which one? If you enter, what is your expected profit? 17-2 Game Show Uncertainty In the final round of a TV game show, contes- tants have a chance to increase their current winnings of $1 million to $2 million. If they are wrong, their prize is decreased to $500,000. A contestant thinks his guess will be right 50% of the time. Should he play? What is the lowest probability of a correct guess that would make playing profitable? 17-3 Ad Agencies The residential division of Prism’s high-speed Internet service uses one advertising agency while its commercial division uses another. Two ana- lysts, Andy and Brad, are asked to test evaluate the 06665_ch17_ptg01_215-232.indd 230 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 17 • Making Decisions with Uncertainty 231 effectiveness of the two agencies. Andy proposes an A/B test that compares the click-through rates per ad for the two agencies. Brad proposes a dif- ference-in-difference test in which the budgets for both agencies are increased by 50% and the per- cent change in click-through rates are compared. What might be the sources of selection bias for the two proposals? Which is likely to be smaller? 17-4 Disposing of Used Assets Your company has a customer who is shutting down a production line, and it is your respon- sibility to dispose of the extrusion machine. The company could keep it in inventory for a possible future product and estimates that the reservation value is $250,000. Your dealings on the second- hand market lead you to believe that there is a 0.4 chance a random buyer will pay $300,000, a 0.25 chance the buyer will pay $350,000, a 0.1 chance the buyer will pay $400,000, and a 0.25 chance it will not sell. If you must commit to a posted price, what price maximizes profits? 17-5 Saint Petersburg Gambles You are offered the following gamble based on coin flips. If the first head occurs on the first flip, you get $2. If the first head occurs on the sec- ond flip you get $4, and so on, so that if the first head is on the Nth flip, you get $2N. The game ends only when a flip of the coin results in heads. What is the expected value of this gamble? When offered, most people say they would only pay less than $10 to play this game. What are two reasons why people are willing to pay so much less than the expected value? 17-6 Hiring The HR department is trying to fill a vacant position for a job with a small talent pool. Valid applications arrive every week or so, and the applicants all seem to bring different levels of expertise. For each applicant, the HR manager gathers information by trying to verify various claims on resume, but some doubt about fit always lingers when a decision to hire or not is to be made. What are the Type I and II decision error costs? Which decision error is more likely to be discovered by the CEO? How does this affect the HR manager’s hiring decisions? Group Problem G17-1 Uncertainty Describe a decision your company has made when facing uncertainty. Compute the expected costs and benefits of the decision. Offer advice on how to proceed. Compute the profit conse- quences of the advice. 1. All of the insights we develop can be gleaned from discrete random variables that typically take on only a few possible values. A con- tinuous random variable assumes an infinite number of values corresponding to the points on an interval (or more than one interval). 2. A continuous random variable assumes an infinite number of values corresponding to the points on an interval (or more than one interval). 3. Ian Ayres and Peter Siegelman, “Race and Gender Discrimination in Negotiation for the Purchase of a New Car,” American Economic Review 84 (1995): 304. For a further discussion of the results, see http:// islandia.law.yale.edu/ayers/carint.htm. 4. The distinction between risk and uncertainty traces back to the work of economist Frank Knight. See F. H. Knight, Risk, Uncertainty and Profit (New York: Augustus Kelley, 1921). 5. Felix Salmon, “Recipe for Disaster: The Formula That Killed Wall Street,” Wired, February 23, 2009. 6. Renee Dye, “The Promise of Prediction Markets,” McKinsey Quarterly, April 2008. EnD notES 06665_ch17_ptg01_215-232.indd 231 8/10/17 5:00 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 06665_ch17_ptg01_215-232.indd 232 8/9/17 8:41 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 233 Over 700,000 tons of fish move annually through Tokyo’s Tsukiji market, the world’s largest, busiest fish market. Tourists line up before 3 a.m. to gain a glimpse at the market’s centerpiece, the daily sale of dozens of large tuna, each weighing hundreds of pounds. The tuna do not carry price tags. Instead, wholesalers, restaurant owners, and fish stores bid against each other. A fren- zied cloud of hand signals can lead the price on a desirable fish to skyrocket in seconds. The first auction of 2017 saw one prized bluefin tuna (about 10,000 pieces of sushi) sell for over $600,000. Half a world away, just outside of Amsterdam, sits the 128 acre building that houses the Aalsmeer Flower Auction, the second largest building by foot- print in the world. Each day, a majority of the world’s wholesale flowers are sold here. Rather than bidders competing to increasing the price, however, a large display shows a decreasing price on each lot of flowers. The first bidder to accept the current price by pressing a button provided to each bidder ends the auction. Press now and win, or wait a second for a better price, but risk someone else jumping in. Auctions are also used by CarBargains. However, instead of many buyers competing to buy a single good, the service organizes a competition among sellers—local car dealers—to sell to a single consumer. For one student, Car- Bargains persuaded six dealers to participate in an auction, and the bids ranged from $1,500 over factory invoice to $100 over invoice. Unfortunately, the dealer with the exact car (options, color, etc.) that the student wanted came in with the worst bid. But when the student showed the dealer the $100-over-in- voice bid from another dealer, he matched the offer and took care of the deal himself. This cut out the salesman, which meant that the dealer didn’t have to pay a sales commission. It also saved the student the time and hassle of ne- gotiating with a salesman. She concluded that the service was well worth the service’s cost. Auctions18 06665_ch18_ptg01_233-242.indd 233 8/9/17 8:44 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 234 SECTION V • Uncertainty In previous chapters, we examined various types of competition, like price competition and bargaining. In this chapter, we examine another type of com- petition, auctions. Not only do auctions identify the high-value bidder but they also set a price for the item, thereby avoiding costly bargaining. But, as the CarBargains example indicates, auctions are often used in conjunction with bargaining. In this case, the auction identified a potential negotiating partner, and the student used the outside alternative of rival bids to negotiate a deal. 18.1 Oral Auctions A variety of auction formats are available, and we start with the most familiar. In an oral auction or English auction, bidders submit increasing bids until only one bidder remains. The item is awarded to this last remaining bidder. Since every bidder is willing to bid up to his value, but no higher, the high-value bidder wins the item as soon as the second-highest-value bidder drops out. For example, if five bidders have values of $8, $5, $3, $2, and $1, the bid- der with the $8 value will win at a price close to $5, right after the bidder with the next-highest value drops out of the bidding. In auctions, it is the losing bidders who determine the price; the stronger they are, the higher the price. Consider a retail store with a single, unique item remaining in stock but with two interested customers. To illustrate the benefits of using an auction, we compare it to a fixed price. Say the store assumes that each customer val- ues the product at either a high value ($70) or low value ($50), with each value equally likely. The four possibilities are listed in Table 18.1. In setting a fixed price, the store faces the familiar trade-off: price high and sell only if a high-value consumer shows up (a 75% chance), or price low and sell to everyone. A high price generates more expected revenue ($52.50 5 $70 3 0.75) than a low price ($50 5 $50 3 1.00). Table 18.1 Oral Auction with Two Bidders Bidder 1 ($) Bidder 2 ($) Probability Winning Bid ($) 50 50 0.25 50 50 70 0.25 50 70 50 0.25 50 70 70 0.25 70 Suppose instead that the store uses an oral auction among these two customers. The winning bid, listed in the last column of Table 18.1, is equal to the second-highest value. If the auctioneer is lucky, he’ll get two high- value bidders, and the winning bid will be $70. However, this outcome 06665_ch18_ptg01_233-242.indd 234 8/9/17 8:44 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 235Chapter 18 • auctions occurs only 25% of the time. The other 75% of the time, the second-highest value is just $50. The expected revenue of the auction is the weighted aver- age of these two outcomes, where the weights are the probabilities of each: $70 3 0.25 1 $50 3 0.75 5 $55. Compared to a fixed price of $70, the auction in this case gives the seller higher expected revenue. Now suppose that three bidders show up at an auction. As before, they could be either high-value ($70) or low-value ($50) bidders. What is the expected revenue from the auction? The possible outcomes of the auction are listed in Table 18.2. Again, if the auctioneer is lucky, two or more high-value bidders will show up, so the winning bid is $70. But this happens only 50% of the time. The other 50% of the time, we expect at most one high-value bidder, so the winning bid is $50. Expected revenue is $70 3 0.50 1 $50 3 0.50 5 $60. Table 18.2 Oral Auction with Three Bidders Bidder 1 ($) Bidder 2 ($) Bidder 3 ($) Probability Winning Bid ($) 50 50 50 0.125 50 50 50 70 0.125 50 50 70 50 0.125 50 70 50 50 0.125 50 50 70 70 0.125 70 70 50 70 0.125 70 70 70 50 0.125 70 70 70 70 0.125 70 Comparing Tables 18.1 and 18.2, we see that more bidders raise the expected price because you are more likely to get more strong (high-value) bidders. Stronger losing bidders lead to higher winning bids. For example, eBay auctions that remain open for ten days return 42% higher prices than three-day auctions, presumably because the ten-day auc- tions attract a larger number of bidders.1 18.2 Second-Price Auctions A Vickrey auction or second-price auction is a type of sealed-bid auction in which bidders submit their bids without knowing the bids of other participants. The item is awarded to the highest bidder, but the winner pays the second-highest bid. 06665_ch18_ptg01_233-242.indd 235 8/9/17 8:44 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 236 SECTION V • Uncertainty When Google revamped its online advertising platform in 2002, it replaced the traditional fixed price with an auction. To show an ad to a Web visitor, an advertiser had to be the highest bidder. However, instead of charging this advertiser how much they bid, they charged them the bid of the next-highest (losing) bidder. Why would an auctioneer use an auction that seems to leave money on the table? The answer is that a second-price auction induces bidders to bid more aggressively because their bid determines only whether they win, not the price they pay. The optimal strategy in a second-price auction is to bid exactly your value. This is because a second-price auction is actually strategically equivalent to the English auction described earlier. In an English auction, everyone is willing to bid up to his or her value, and the highest-valued bidder wins at a price equal to (or just above) the second-highest value. That’s precisely the outcome that a second-price auction achieves. A second-price auction allows the auctioneer to simulate what would have happened in an English auction, but without the need to have bidders show up at the same place and time. William Vickrey shared the 1996 Nobel Prize in Economics for inventing the Vickrey auction and establishing its equivalence to oral auctions. Recently, however, economists have discovered that second-price auctions were used to sell rare stamps as early as 1893.2 To accommodate bidders who didn’t want to travel to participate in a live auction, stamp dealers held second-price auctions through the mail. So, Vickrey auctions predated Vickrey by nearly a century! Vickrey auctions are also useful for auctioning off multiple units of the same item—say, 10 laptop computers. As in the second-price auction, the high- est losing bid determines the price. In this case, the highest losing bid is the 11th highest. As in the second-price auction, it is optimal to bid your value. 18.3 First-Price Auctions In a sealed-bid first-price auction, the highest bidder wins the item at a price equal to the highest bid. In contrast to a second-price auction, in a sealed-bid first-price auction, you have to pay the amount you bid. Consequently, each bidder faces a trade- off: he can bid higher and raise the probability of winning, but doing so low- ers his surplus (or profit) if he does win. Since bidding exactly your value guarantees zero profit whether you win or lose, each bidder shades his bid; that is, he balances these two effects by bidding below his value. In these auc- tions, experience is the best teacher. In general, you should bid more—shade your value less—if the competition is stronger. 18.4 Bid Rigging Collusion among bidders is one of the biggest challenges for an auctioneer. To illustrate the effects of collusion or bid rigging, let’s return to our simple oral auction in which bidders have values of $8, $5, $3, $2, and $1. Imagine that the two high-value bidders form a bidding ring or cartel. What is the winning bid? 06665_ch18_ptg01_233-242.indd 236 8/9/17 8:44 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 237Chapter 18 • auctions A cartel earns money by eliminating competition among its members. Here, the two highest-value bidders (those willing to pay $8 and $5) decide not to bid against each other. To win the auction, they have to outbid the high- est noncartel member, whose value is $3. Collusion reduces the auctioneer’s revenue by 40%, from $5 (what the price would have been without the cartel) to $3 (the price with the cartel). The cartel members typically split this $2 profit between them. This kind of agreement between bidders in an auction is a criminal vio- lation of the antitrust laws of the United States and of most other developed countries. In addition, most countries offer amnesty to the first conspirator willing to testify against fellow conspirators. These amnesty schemes create a prisoners’ dilemma among the conspirators. This “race to the courthouse” has led to the discovery and prosecution of a number of different cartels. In one type of cartel, antique dealers refrained from bidding against one another at an estate sale. They met after the auction to “reauction” the goods they won at the estate sale. The difference between what the good sold for in the first auction and what it sold for in the second or “knockout” auction is the profit that the cartel members split among themselves. A more common type of cartel is the bid-rotation scheme where bidders refrain from bidding against one another in exchange for similar consideration when it’s their “turn” to win. The weakness of a bid-rotation scheme is that each cartel member must wait for his turn to win. And, cartel members can easily cheat by bidding slightly above the agreed-on bid. Grouping many contracts or items together into a single big auction raises the gains from cheating on the cartel. This leads to our first observation about bid rigging: Collusion is more likely in small, frequent auctions than in big, infrequent ones. In a sealed-bid auction, collusion requires the cooperation of all the cartel members; that is, the cartel members must figure a way out of the prisoners’ dilemma. If any of the cartel members raises his bid above the agreed-on price, he could win the item for himself at a very low price. This temptation often leads cartel members to cheat on the cartel, which makes cartels more difficult to organize. In an oral auction, however, cheating on the cartel offers no benefit. The cartel members know immediately if one of their own tries to bid higher than the agreed-on price. In retaliation, the other cartel members begin bidding competitively, and there is no gain to cheating. This leads to our second obser- vation about bid rigging: Collusion is more likely in oral auctions than in sealed-bid auctions. For bidders to collude, they must devise a way to punish cheaters. But to punish cheaters, you have to know who they are. If cheaters don’t fear pun- ishment from other cartel members, then cheating is likely, and the cartel is unlikely to survive. This leads to our third observation about bid rigging: Collusion is more likely when winning bidders and winning bids are identified. 06665_ch18_ptg01_233-242.indd 237 8/9/17 8:44 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 238 SECTION V • Uncertainty Collusion can be quite costly for the auctioneer. The graph in Figure 18.1 plots the average winning price of a conspiracy that collapsed when a grand jury began investigating auctions to supply the U.S. Navy with frozen fish. The investigators computed the effect of the conspiracy by backcasting (the opposite of forecasting) from the competitive period into the collusive period (the darker line in Figure 18.1). This allowed them to determine that prices would have been 23% lower during the collusive period had bidders behaved competitively. The judge used this information to help determine how long the conspirators would go to prison. Among the reasons for the conspiracy was a set of “domestic content” rules, which prevented foreign suppliers from bidding on new contracts. With- out foreign competition, it was quite easy for the few domestic suppliers of fro- zen seafood to form a cartel. Another reason was the frequent (up to 10 each week) auctions, which made the bid-rotation scheme fairly easy to organize.3 18.5 Common-Value Auctions So far, we have considered auctions in which each bidder has her own private value for whatever is being auctioned. Bidders for an unexplored oil field, on the other hand, have a common value because the amount of oil in the field determines the value of the field and it is the same for all bidders. In a common- value auction, the value is the same for each bidder, but no one knows what it is for sure. Each bidder has only an estimate of the unknown value. Imagine that you are bidding on a suitcase of cash. You are more likely to win the auction if you overestimate the amount of money in the suitcase than if you underestimate it. But you are also more likely to lose money. Winning 2.25 2.75 2.50 3.50 3.25 3.00 1/1/1987 1/1/1988 1/1/1989 Date 3.75 P ri ce Collusion Competition Actual Price Estimated Price Figure 18.1 Collusion in Frozen Fish Bidding 06665_ch18_ptg01_233-242.indd 238 8/9/17 8:44 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 239Chapter 18 • auctions in a common-value auction is bad news: it means that your estimate was the highest and most optimistic. Since the highest and most optimistic estimate is likely to exceed the actual value, the winner will lose, on average. This is known as the winner’s curse. The winner’s curse does not mean you lost money in an auction (this is called bad luck). It does mean that you bid incor- rectly, and put yourself in a position to lose money, on average. To avoid the curse, you must bid as if your estimate is the most optimistic in the first place. To avoid the winner’s curse, you bid as if everyone else thinks the value is less than your estimate. For example, imagine that you estimate the value of the suitcase of cash at $500. If I were to tell you that everyone else (including some very smart people) thinks it is worth less than $500, would you revise your own estimate downward? This revised estimate—based on the assumption that everyone else is more pessimistic than you are—should serve as the basis of your bid. How much you should revise your estimate depends in part on how many other bidders there are. Which would make you doubt your estimate more: if I told you that just one other person thinks it is worth less than $500, or 50 people all think so? It is easy to imagine that one other bidder is wrong and you’re right, but it is harder to imagine that 50 other people are all wrong. The more competitors there are, the more winning is “bad news,” and the lower you should bid. To avoid the winners’ curse, you bid less aggressively as the number of bidders increases. The winner’s curse is especially bad when rival bidders have better infor- mation about the value than you do. For example, some bidders for oil fields own neighboring fields and have better estimates of the amount of oil than those without neighboring fields. In this case, you will win only when others think the item isn’t worth much, or when you overbid. It’s seldom a good idea to bid in common-value auctions when rivals have better information than you do. If you’re the auctioneer, you want to encourage aggressive bidding by releasing as much information as you can about the value of the item. By reducing uncertainty about the value of the item, you mitigate many of the effects of the winner’s curse, which encourages bidders to bid closer to their estimated values. Even if you have adverse information about an item, you should still release it. If you don’t, bidders will correctly infer that the infor- mation is bad. Oral auctions return higher prices in a common-value setting than sealed- bid auctions. One way to release information in a common-value auction is to hold an oral auction. Each bidder can see how aggressively rivals are bidding, which reduces uncertainty and reduces the magnitude of the winner’s curse. Oral auctions result in more aggressive bidding and higher prices in common-value auctions. 06665_ch18_ptg01_233-242.indd 239 8/9/17 8:44 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 240 SECTION V • Uncertainty If releasing information is good for the auctioneer, it must be bad for the bidders. Since the value is the same for each bidder, everyone knowing that value leads everyone to bid away any potential profits. The source of profit in a common-value auction is the information that you have and that others do not. SUMMARY & HOMEWORK PROBLEMS Summary of Main Points • In oral or English auctions, the highest bidder wins but only has to outbid the second-highest bidder. Losing bidders determine the price. • A Vickrey or second-price auction is a sealed-bid auction in which the high bidder wins but pays only the second-highest bid. These auctions are strategically identical to English auctions, but easier to run and well suited for use on the Internet. • In a sealed-bid first-price auction, the high bidder wins and pays his bid. Bidders must balance the probability of winning against the profit they will make if they do win. Optimal bids are less than bidders’ private values. • Bidders can raise profit by agreeing not to bid against one another. If collusion is suspected, • do not hold open auctions; • do not hold small and frequent auctions; • do not announce the winners or the winning bids. • In a common-value auction, everyone has the same value but each has only an esti- mate of what it is. • To avoid the winner’s curse in com- mon-value auctions, bid below your esti- mated value. Bid as if your estimate is the most optimistic and everyone else thinks it is worth less. • Oral auctions return higher prices in com- mon-value auctions because they release more information. Multiple-Choice Questions 1. You are bidding in a second-price auction for a painting that you value at $800. You estimate that other bidders are most likely to value the painting at between $200 and $600. Which of these is likely to be your best bid? a. $1,000 b. $800 c. $600 d. $400 2. Which of the following is true about different ways of conducting a private-value auction? a. A first-price auction is strategically equivalent to a second-price auction. b. A first-price auction is strategically equivalent to an oral English auction. c. A second-price auction is strategically equivalent to an oral English auction. d. None of the above. 3. Suppose that five bidders with values of $500, $400, $300, $200, and $100 attend an oral auction. Which of these is closest to the winning price? a. $500 b. $400 c. $300 d. $200 4. In the above auction, if the bidders with the first- and third-highest values ($500 and $300) collude, which of these is closest to the winning price? a. $500 b. $400 c. $300 d. $200 06665_ch18_ptg01_233-242.indd 240 8/9/17 8:44 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Chapter 18 • auctions 241 5. In a common-value auction, you should a. bid more aggressively the more com- petitors you face. b. bid less aggressively the more competi- tors you face. c. bid the same regardless of the number of competitors. d. bid more aggressively when others have better information than you. 6. If a seller is concerned about collusion among bidders, which of the following changes to the auction should the seller make? a. Hold frequent, small auctions instead of infrequent large auctions. b. Conceal the amount of winning bids. c. Publicly announce the name of each auction’s winner. d. Hold an English auction instead of a sealed-bid first-price auction. 7. You’re holding an auction to license a new technology that your company has devel- oped. One of your assistants raises a con- cern that bidders’ fear of the winner’s curse may encourage them to shade their bids. How might you address this concern? a. Release your analyst’s positive scenario for the technology’s future profitability. b. Release your analyst’s negative sce- nario for the technology’s future profitability. c. Use an oral auction. d. All of the above. 8. Which of the following is true about the winner’s curse? a. The winner’s curse occurs primarily in private-value auctions. b. You successfully avoided the win- ner’s curse if you made money in the auction. c. The winner’s curse means that you bid incorrectly. d. The winner’s curse means that you lost money in an auction. 9. A bidder’s value for a good may be low ($2), medium ($5), or high ($7). There is an equal number of potential bidders having each value. Suppose two bidders participate in a second-price auction. What is the best estimate of the expected revenue from the auction? a. $4.11 b. $3.99 c. $3.56 d. $5.00 10. In a first-price auction, you bid __________ your value, and in a second-price auction, you bid __________ your value. a. at; above b. below; above c. below; at d. below; below Individual Problems 18-1 Effects of Collusion You hold an auction among three bidders. You estimate that each bidder has a value of either $16 or $20 for the item, and you attach prob- abilities to each value of 50%. What is the ex- pected price? If two of the three bidders collude, what is the price? 18-2 Reserve Prices A reserve price is a minimum price set by the auctioneer. If no bidder is willing to pay the reserve price, the item is unsold at a profit of $0 for the auctioneer. If only one bidder values the item at or above the reserve price, that bidder pays the reserve price. An auc- tioneer faces two bidders, each with a value of either $30 or $80, with both values equally probable. What reserve price should the auc- tioneer set, and what is the expected revenue from auctioning the item with and without a reserve price? 06665_ch18_ptg01_233-242.indd 241 8/9/17 8:44 PM Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 242 SECTION V • Uncertainty 18-3 Reserve Prices II Consider the problem above, but now each bid- der has a value of either $60 or $80. What re- serve price should the auctioneer set, and what is the expected revenue from auctioning the item with and without a reserve price? 18-4 Asset Auctions in Sweden In Sweden, firms that fail to meet their debt obligations are immediately auctioned off to the highest bidder. (There is no reorganization through Chapter 11 bankruptcy.) The current managers are often the high bidders for the company. Why? 18-5 Art Auctions When a famous painting becomes available for sale, it is often known which museum or col- lector will be the likely winner. Yet, representa- tives of other museums that have no chance of winning are actively wooed by the auctioneer to attend anyway. Why? 18-6 Contractor Bidding Moe Green estimates the cost of future projects for a large contracting firm. Mr. Green uses pre- cisely the same techniques to estimate the costs of every potential job and formulates bids by adding a standard profit markup. For some companies to whom the firm offers its services, no competitors exist, so they are almost certain to get them as clients. For these jobs, Mr. Green finds that his cost estimates are right, on aver- age. For jobs where competitors are also vying for the business, Mr. Green finds that they al- most always end up costing more than he esti- mates. Why does this occur? Group Problem G18-1 Using Auctions in Your Business Identify something you buy or sell that could be bought or sold using an auction. How would you run the auction? Do a benefit-cost analysis of the auction relative to how you currently buy or sell. 1. David Lucking-Reiley, Doug Bryan, Naghi Prasad, and Daniel Reeves, “Pennies from eBay: The Determinants of Price in Online Auctions,” Journal of Industrial Economics 55 (2007): 223–233. 2. David Lucking-Reiley, “Vickrey Auctions in Practice: From Nineteenth-Century Philat- ely to Twenty-First-Century E-Commerce,”
Journal of Economic Perspectives 14 (2000):
183–192.
3. The cartel and its collapse are described in
Luke Froeb, Robert Koyak, and Gregory
Werden, “What Is the Effect of Bid-Rigging
on Prices?” Economics Letters 42 (1993):
419–423.
End nOTES
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243
With over one billion in annual sales, Zappos is the Internet’s largest shoe
retailer. Customer service is a key differentiator for Zappos, and its core value
is to “Deliver WOW through Service.” As part of the hiring process, new
recruits participate in a four-week training program to introduce them to the
company’s strategy, processes, and culture.
Training alone cannot teach employees how to deliver WOW. In addition,
it takes the right personality and attitude. But Zappos has not been able to
figure out how to measure these intangible qualities. Instead, they use a clever
plan to get the WOW employees to identify themselves. After the first week
of training, the company offers $4,000 to any new hire who will quit that
day. About 3% take the offer. The ones who are left are the ones with the
ability to deliver WOW. Zappos has discovered that the $4,000 “screen” is a
relatively inexpensive way to reduce the rate of bad hires, to decrease the costs
of employee turnover, and to protect the company’s reputation for service.1
After acquiring Zappos, Amazon announced a similar “Pay to Quit” program
in 2014, offering its fulfillment-center employees up to $5,000 to leave.
This story illustrates the problem known as adverse selection. It arises
when one party to a transaction is better informed than another—in this case,
workers know more about their work habits and WOW ability than does
Zappos or Amazon. Because low-quality workers typically have worse outside
options, they are more likely than good ones to accept an offer of employment.
Unless employers can distinguish high- from low-quality workers, they are
more likely to hire the wrong sort.
In this chapter, we show you how to anticipate adverse selection, how to
protect yourself from its consequences, and, in some cases, how to get around it.
19.1 Insurance and Risk
The adverse selection problem is most easily illustrated in the market for
insurance. To understand the demand for insurance, we have to return to our
19
The Problem of Adverse
Selection
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SECTION V • Uncertainty244
discussion of random variables. A lottery is a random variable with a pay-
ment attached to each outcome. If I agree to pay you $100 if a fair coin lands
heads-up and $0 otherwise, you face a lottery with an expected value of $50.
Your attitude toward risk determines how you value this random payoff.
A risk-neutral consumer values a lottery at its expected value. A risk-
averse consumer values a lottery at less than its expected value.
Consider the possibility of trade between a risk-averse seller and a
risk-neutral buyer. For instance, a risk-averse consumer might be willing to
sell the $100 coin toss lottery for $40, whereas a risk-neutral consumer would
be willing to pay $50 for the same lottery. If the two of them transact, say at
a price of $45, they create wealth by moving an asset—the lottery—to a high-
er-value use. After the transaction, the risk-averse seller has $45, a sure payout
that he values more than the lottery, and the risk-neutral buyer pays only $45
for a lottery that she values at $50.
Similarly, insurance is a wealth-creating transaction that transfers risk
from someone who doesn’t want it (the risk-averse consumer) to someone
who is willing to accept it for a fee (the risk-neutral insurance company). The
only difference from our lottery example is that the risk-averse sellers face a
lottery over bad outcomes instead of good ones.
For example, suppose that Rachel owns a $100 bicycle that might be sto-
len. The possibility of theft means that the payoff from owning the bicycle
is like that of a lottery: lose $100 if the bike is stolen and lose nothing if
it isn’t. If the probability of theft is 20%, the expected cost of the lottery is
(0.2)($100) 5 $20.
If Rachel purchases insurance for $25 that reimburses her for the value
of her stolen bicycle, she eliminates the risk. By voluntarily transacting, both
Rachel and her insurance company are made better off. Rachel pays to elimi-
nate the risk, and the insurance company earns $5, on average, for accepting
it. Note that the insurance company never earns $5. If the bike is stolen, it
loses $75; if not, it earns $25, so the expected value of offering insurance is
$5 5 0.2(2$75) 1 0.8($25).
Insurance is not the only way of moving risk from those who don’t want
it to those who don’t mind it. One of the financial industry’s main functions
is to move risk from lower- to higher-valued uses. For example, farmers face
uncertain future prices for their crops. To get rid of the risk, they sell forward
contracts to grain companies or speculators. The buyer of the contract takes
possession of the crop on a specified delivery date and accepts the risk that the
crop may be worth less than the price. Selling crops before they are planted
moves risk from risk-averse farmers to risk-neutral buyers.
19.2 Anticipating Adverse Selection
To illustrate the problem of adverse selection, we modify our bicycle insurance
example by assuming that there are two different types of consumers, each
facing different risks. One type of consumer lives in a secure area, where the
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Chapter 19 • the problem of adverse Selection 245
probability of theft is 20%. The other type lives in a less secure area, where
the probability of theft is higher—say, 40%. Each consumer is risk-averse and
would be willing to buy insurance for $5 more than its expected cost; that
is, the low-risk consumer would be willing to pay $25 for insurance, and the
high-risk consumer would be willing to pay $45. If the insurance company
could tell them apart, it would sell different policies, at different prices, to
each.
But when the insurance company cannot distinguish between the high-
and low-risk consumers, it faces potential losses. If the company naively offers
to sell insurance at an average price of $35, only the high-risk consumers will
purchase the insurance. They think it’s a great deal because they’d be willing
to pay as much as $45 for the insurance. In contrast, the low-risk consumers
recognize a bad deal when they see it. They would rather face the possibility of
theft than pay $35 for insurance that they value at only $25.
If only high-risk consumers purchase insurance, the insurance company’s
expected costs are $40, meaning it loses $5 on every policy it sells. This leads
to the first important lesson of the chapter:
Anticipate adverse selection and protect yourself against it.
If the insurance company correctly anticipates that only high-risk con-
sumers will buy, it will offer insurance at $45. At this price, only high-risk con-
sumers buy the insurance, but the company does make money on the policies
it sells.
To see what happens when you don’t anticipate adverse selection, let’s turn
to a real example. In June 1986, the city of Washington, DC, passed the Pro-
hibition of Discrimination in the Provision of Insurance Act, which outlawed
HIV testing by health insurance companies. What do you think happened?
According to press reports at the time, the result was a “mass exodus of
insurers from the city.” Unable to distinguish low- from high-risk consumers,
insurance companies faced the prospect of being able to sell only to high-risk
purchasers. The insurance companies, if not the DC government, correctly
anticipated adverse selection and realized they could not make money selling
only to HIV-positive consumers.
When the law was repealed in 1989, the problem disappeared. Once com-
panies were able to distinguish between consumers with HIV and those with-
out, they offered two polices based on the costs of insuring each population.
When you eliminate the information asymmetry—when the company knows
who is high risk and who is low risk—there is no adverse selection. President
Obama’s signature health-care legislation uses a different solution. Like the
Washington, DC, measure, it also prohibits insurers from distinguishing high-
from low-risk patients, but by requiring everyone to purchase insurance, it
prohibits low-risk purchasers from exiting the market.
In financial markets, adverse selection arises when owners of companies
seeking to sell shares to the public know more about the prospects of the com-
pany than do potential investors. Potential investors should anticipate that
companies with relatively poor prospects are the ones most likely to sell stock
to the public. For example, small Initial Public Offerings2 (IPOs) of less than
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SECTION V • Uncertainty246
$100 million lose money in the long term, on average, whereas large IPOs
have “normal” returns, equal to those of comparably risky assets. Economists
find it puzzling that investors don’t anticipate adverse selection by reducing
the price they pay for these small IPOs.
Finally, we note that the winner’s curse of common-value auctions is a
kind of adverse selection. Unless the winning bidder anticipates that she will
win only when she has the most optimistic estimate of the item’s true value,
she’ll end up overbidding. Only if bidders anticipate the winner’s curse—by
bidding as if they have the highest estimate—will they bid low enough to
avoid overpaying.
19.3 Screening
If our bicycle insurance company sells at a price of $45, the low-risk consum-
ers will not purchase insurance, even though they would be willing to pay a
price ($25) which is more than the cost of the insurance to the insurance com-
pany. This leads to the second point of this chapter.
The low-risk consumers are not served because it is difficult to transact
with them profitably.
Adverse selection represents a potentially profitable, but unconsummated,
wealth-creating transaction. Screening (the subject of this section) and signal-
ing (the subject of the next section) are two ways to overcome the obstacles to
transacting with low-risk individuals.
One obvious solution to the problem of adverse selection is to gather
information so you can distinguish high risk from low risk. If, for example, the
insurance company can distinguish between high- and low-risk consumers, it
can offer two different policies to the two groups—a low-price policy to the
low-risk group and a high-price policy to the high-risk group.
This isn’t as easy as it sounds. Information gathering can be costly; more-
over, privacy and antidiscrimination laws can prevent insurance companies
from acquiring (and using) information that lets them sort customers into high-
and low-risk groups. For example, your credit report is an excellent predictor
of whether you’ll be involved in an auto accident. If you give an insurance
company permission to look at your credit report, you can get car insurance at
a low price, provided your credit is good. But three states, California, Hawaii,
and Massachusetts, prohibit car insurance companies from using credit scores
to price insurance. This restriction reduces the amount of information available
to insurance companies and raises the cost of insurance to good drivers.
Even when it’s hard to gather information about individual risks directly,
you can sometimes gather information indirectly. By offering consumers a
menu of choices, you can get them to reveal information about themselves by
the choices they make. Returning to our bicycle insurance example, suppose
you offer two policies: full insurance for $45 and partial insurance for $15.
Partial insurance would compensate the owner for just half the value of the
bicycle. Typically, partial insurance involves a deductible or a copayment.3
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Chapter 19 • the problem of adverse Selection 247
If high-risk individuals prefer full insurance for $45 to partial insurance
for $15, they will purchase the full insurance, whereas low-risk individuals
will purchase partial insurance. At these prices, the insurance company can
make money because the cost of insuring the high-risk group is (0.4)$100 5
$40 and the cost of partially insuring the low-risk group is (0.2)$50 5 $10. By
offering partial insurance, the insurance company can transact (partially) with
the low-risk consumers.
Screening describes the efforts of the less informed party (the insurance
company) to gather information about the more informed party
(consumers). Information may be gathered indirectly by offering
consumers a menu of choices. Consumers reveal information about
themselves (risk) by the choices they make.
A successful screen has one critical requirement: it must not be profitable
for high-risk consumers to mimic the choice of low-risk consumers. In our
insurance example, the high-risk group must prefer full insurance at $45 to
partial insurance at $15. If high-risk individuals purchase partial insurance,
the screen fails, and the insurance company loses money.4
As a consumer, you can use this information to your advantage when
purchasing insurance. If you’re a low-risk individual, you may be able to
lower your own expected insurance costs by purchasing a policy with a large
deductible or copayment. This choice will identify you as a low-risk individ-
ual to the insurance company and allow you to purchase (partial) insurance
for a lower price, albeit with a large deductible or copayment. Likewise, if
you purchase insurance with a small deductible or copayment, you identify
yourself as a high-risk consumer and pay a higher expected price. Buying a
policy with a small deductible signals that you expect your insurance costs to
be high.
Note that the software price discrimination scheme discussed in Chapter 14
is very similar to screening. By offering consumers a choice between a less
expensive, disabled version of the software and a more expensive, full-featured
version, the software company induced consumers to identify themselves as ei-
ther high- or low-value consumers. This allowed the company to price discrim-
inate. The scheme was successful because it was unprofitable for business users
to mimic the behavior of home users (i.e., by purchasing the disabled version).
Let’s apply these ideas to the used-car market, where adverse selection
is known as the lemons problem. Suppose there are bad cars (lemons) worth
$2,000 and good cars (cherries) worth $4,000. The information asymmetry
is that each seller knows whether he or she owns a lemon, but the buyer
does not.
What happens when an uninformed buyer tries to buy a used car from an
informed seller? If a buyer offers a price of $3,000, only lemon owners would
be willing to sell, so the buyer ends up paying $3,000 for a $2,000 car. If, in-
stead, the buyer offers to purchase at a price of $4,000, both cherry owners
and lemon owners would be willing to sell, so the expected value of any pur-
chased car will be less than $4,000. In both cases, the buyer pays too much, on
average, for what he is getting.
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SECTION V • Uncertainty248
If the buyer anticipates adverse selection, he offers to pay just $2,000. At
this price, only lemon owners will sell, but at least the buyer won’t overpay
for the car. Owners of cherries are analogous to low-risk consumers in the
insurance market because they are unable to transact. Again, adverse selection
represents an unconsummated wealth-creating transaction. Put yourself in the
position of a buyer who wants to buy a cherry for $4,000, and try to design a
screen to solve the lemons problem.
One option is to offer $4,000 for a car, but demand a money-back
guarantee. Sellers of good cars will accept the offer because they know the car
won’t be returned. Lemon owners would be unwilling to offer guaranties like
this. Warranties on products serve a similar purpose. Manufacturers of high-
quality, durable products are more willing to offer longer warranties because
they don’t expect to have to make many repairs.
Screening occurs in a wide variety of contexts beyond the insurance and
auto markets. For example, the state of Louisiana allows couples to choose
one of two marriage contracts: a covenant contract, under which divorce is
very costly, and a regular contract, under which divorce is relatively cheap.
What is the screening function of this menu of choices?
Suppose there are two types of prospective partners: gold-diggers (those
who want only a short-term relationship) and soul mates (those who want
to stay together until death). Given a choice of contracts, you learn some-
thing about your intended by the choice he or she makes. Note that this screen
works only if gold-diggers prefer the regular marriage contract to the cove-
nant marriage.
Finally, as seen in our Zappos story, screens can solve the adverse selec-
tion problem in hiring. The $4,000 payment to quit made it profitable for
low-quality workers to identify themselves as such.
Incentive compensation is another way that employers identify and avoid
low-quality workers. Suppose you can hire two types of salespeople—hard
workers who will sell 100 units per week in their territories and lazy workers
who will sell only 50 units per week. The asymmetric information means that
workers know which type they are but you don’t. The employer could ask
potential employees if they are lazy at the interview, but that is unlikely to be
fully revealing.
Suppose hard and lazy workers alike expect to earn at least $800 for a
week’s work. If you offer a wage of $800 per month, you get a mix of lazy and
hard workers. To screen out the lazy workers, offer a straight $10 commission.
Hard workers will accept the offer because they know they’ll earn $1,000.
Lazy workers, who know they’ll make only $500, will reject the offer. This is
a perfect screen because the workers’ own choices (accept or reject) identify
their type (lazy or hardworking).
However, most incentive compensation schemes expose workers to risk.
In addition to effort, there are factors beyond the salespersons’ control that
affect sales—like consumer income, rival prices, or interest rates. A screen that
works just as well, but presents less risk, is a contract with a flat salary of
$500 in combination with a $5 commission on each sale. This combination
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Chapter 19 • the problem of adverse Selection 249
guarantees each worker a base salary of $500 without risk, and an expected
compensation of $1,000 for good workers. If bad workers do not expect to
sell at least 60 units, they will reject the offer. And the good workers get a
compensation scheme that exposes them to less risk.
19.4 Signaling
Let’s recap what we’ve learned so far. Even when we anticipate it and protect
ourselves against it, adverse selection results in unconsummated wealth-creating
transactions, such as those between
• insurance companies and low-risk consumers;
• car buyers and sellers with good cars; or
• employers and hardworking employees.
Screening is a tactic by the less informed party to consummate these
transactions by getting rid of the information asymmetry. When consum-
ers identify themselves by their choices, wealth-creating transactions can be
consummated.
In this section, we discuss efforts by an informed party—the low-risk con-
sumers, the hardworking employees, and the sellers with good cars—to get rid
of the asymmetric information. This is called signaling.
Signaling describes the efforts of the more informed parties (consumers)
to reveal information about themselves to the less informed party (the
insurance company). A successful signal is one that bad types will not
mimic.
Signaling is closely related to screening. In fact, any successful screen
that separates low- from high-risk consumers, good from bad car sellers, or
lazy from hardworking employees can also serve as a signal. To signal, the
informed party could use the mechanisms just described: low-risk consumers
could offer to buy insurance with a big deductible, good employees could offer
to work on commission, and sellers with good cars could include a warranty
with the purchase.
The crucial element of a successful signal is that it must not be profitable
for the bad types to mimic the signaling behavior of the good types.
For example, much of the value of education may derive not from what it
adds to students’ human capital but rather from its signaling value. Students sig-
nal to potential employers that they’re hardworking, quick-learning, dedicated
individuals (all these qualities are difficult to measure) by dropping out of the la-
bor force and spending lots of money to pursue an education. Consequently, they
receive high offers from employers. It’s not profitable for lazy, slow- learning,
or undedicated individuals to mimic this behavior because their type will be
revealed before they can recoup the investment in education. Once employers
realize that they are low-quality workers, they won’t be promoted or retained.
Further, the education itself is more arduous (expensive) for these types.
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SECTION V • Uncertainty250
Advertising and branding can also serve as signals. By investing significant
money into branding and advertising a product, firms signal to consumers
that theirs is a high-quality product. Low-quality firms won’t mimic this signal
because even consumers who buy will soon learn of its low quality and avoid
the brand in the future. For branding and advertising to serve as a signal, it
must be the case that low-quality producers cannot sell enough to recover
their advertising and branding expenditures. Consequently, consumers are
willing to pay more for branded and advertised goods.
This type of advertising is often called “burning money” as the message
of the advertisement is less important than the fact that money was spent on
it. Burning money is used to signal in nature, too. The male peacock’s colorful
feathers serve as an expensive signal (they serve no apparent survival purpose)
but reflect health and superior genes preferred by females. A less healthy pea-
cock won’t (or biologically can’t) mimic this signal. For the same showy rea-
son, before Federal Deposit Insurance Corporation (FDIC) insurance, banks
were often built of granite. This served to reassure depositors that the bank
owners were not looking to abscond with depositors’ money. Doing so would
not offset the building costs of the bank.
19.5 Adverse Selection and Internet Sales
In 2016, Amazon.com sued over 1,000 sellers using its own Amazon Mar-
ketplace. Amazon claimed that these sellers posted fake reviews about their
products.5 One suit claimed that 1,269 out of 2,242 reviews (54%) were
fraudulent. Amazon and these sellers know that product and seller reviews
are an important mechanism that consumers use to evaluate how satisfied
they will be with the service. Sharing the experiences of third-party con-
sumers has become a valuable signal for retailers and manufacturers. An
additional star on Yelp! due to positive reviews is associated with a revenue
increase of 8%.6
Amazon has an incentive to keep poor performing sellers from its Mar-
ketplace. It fears that dissatisfaction with one seller will reflect poorly on all
sellers on the Marketplace. Sellers have an incentive to seek the Amazon Mar-
ketplace “seal of approval” whether the deserve it or not. Other ways Amazon
discourages fraudulent behavior is to ban reviews “incentivized” by payments
or free items, to develop algorithms that identify fake reviews, and to design
a review system that gives fake reviews less importance by highlighting more
recent and more helpful reviews. Amazon’s continued efforts to address this
adverse selection problem have helped make it the dominant online retailer in
the world.
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Chapter 19 • the problem of adverse Selection 251
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
• Insurance is a wealth-creating transaction
that moves risk from those who don’t
want it to those who are willing to bear
it for a fee.
• Adverse selection is a problem that arises
from information asymmetry, or “hidden”
information. Anticipate it and, if you can,
figure out how to consummate the uncon-
summated wealth-creating transaction.
• The adverse selection problem disappears if
the information asymmetry disappears.
• Screening is an uninformed party’s effort to
learn the information that the more
informed party has. Successful screens have
the characteristic that it is unprofitable for
bad “types” to mimic the behavior of good
types.
• Signaling is an informed party’s effort to
communicate her information to the less
informed party. Every successful screen can
also be used as a signal.
• Online auction and sales sites, like eBay,
address the adverse selection problem with
authentication and escrow services, insur-
ance, and online reputations.
Multiple-Choice Questions
1. An insurance company offers doctors
malpractice insurance. Assume that mal-
practice claims against careful doctors
cost $5,000 on average over the term of
the policy and settling malpractice claims
against reckless doctors costs $30,000.
Doctors are risk-neutral and know whether
they are reckless or careful, but the insur-
ance company only knows that 10% of
doctors are reckless. How much do insur-
ance companies have to charge for mal-
practice insurance to break even?
a. $5,000
b. $7,500
c. $27,500
d. $30,000
2. An employer faces two types of employees.
Regular workers are 70% of the popula-
tion and generate $100,000 in productivity.
Exceptional workers are 30% of the popu-
lation and generate $120,000 in productiv-
ity. Employees know their types and reject
salaries below their productivity. If the
employer offers a salary equal to the aver-
age productivity in the population, what
will be the employer’s per-employee profit?
a. 2$10,000
b. 2$6,000
c. $0
d. $4,000
3. An all-you-can-eat buffet attracts two types
of customers. Regular customers value the
buffet at $20 and eat $5 of food in costs to
the restaurant. Hungry customers value the
buffet at $40 and eat $10 of food. If there
are 100 of each type in the market for a
buffet dinner, what is the restaurant’s max-
imum profit?
a. $2,500
b. $3,000
c. $4,500
d. $6,500
4. To combat the problem of adverse selec-
tion, ________________ informed parties
can employ ________________ techniques.
a. more; signaling
b. less; signaling
c. equally; screening
d. equally; signaling
5. Which of the following can be an example
of a signal?
a. An air-conditioning manufacturer
offers a 50-year warranty.
b. A lawyer offers to be paid only if the
client wins.
c. A student pursues an MBA.
d. All of the above.
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SECTION V • Uncertainty252
6. Which of the following is not an example
of adverse selection?
a. A business bets the proceeds of a bank
loan on the next NFL game.
b. An accident-prone driver buys auto
insurance.
c. A patient suffering from a terminal
disease buys life insurance.
d. A really hungry person decides to go to
the all-you-can-eat buffet for dinner.
7. The demand for insurance arises primarily
from people who are
a. risk-seeking.
b. risk-averse.
c. risk-neutral.
d. None of the above.
8. Which of the following is a potential solu-
tion to the adverse selection problem faced
by insurance companies?
a. Offer plans with different deductibles
so that higher-risk customers accept
higher deductibles.
b. Create a national database of custom-
ers that allows companies to look up
each person’s historical risk.
c. Mandate that every person purchase
insurance.
d. All of the above.
9. An insurance company suffers from
adverse selection if
a. safe customers are less likely to insure
than risky customers.
b. customers know their willingness to
pay for insurance but the company
does not.
c. a customer takes on much greater risk
because he is insured.
d. its customers are risk-averse.
10. Which of the following is an example of
adverse selection?
a. A safe driver taking greater risk in a
rental car than his own car.
b. A terminally ill person purchasing life
insurance.
c. An employment contract encourages
little effort on the part of employees.
d. All of the above.
Individual Problems
19-1 Leasing Residuals
In the late 1990s, car leasing was very popular
in the United States. A customer would lease a
car from the manufacturer for a set term, usu-
ally two years, and then have the option of
keeping the car. If the customer decided to keep
the car, the customer would pay a price to the
manufacturer, the “residual value,” computed
as 60% of the new car price. The manufacturer
would then sell the returned cars at auction. In
1999, the manufacturer lost an average of $480
on each returned car (the auction price was, on
average, $480 less than the residual value).
A. Why was the manufacturer losing
money on this program?
B. What should the manufacturer do to
stop losing money?
19-2 College Degrees Required for Police Officers
Many police officer positions require the appli-
cant to have a college degree even though the
tasks of a police officer rarely call upon college
course material. Why don’t police departments
increase their applicant pool by dropping this
requirement?
19-3 Bicycle Insurance and Information Asymmetry
You sell bicycle theft insurance. If bicycle own-
ers do not know whether they are high- or low-
risk consumers, is there an adverse selection
problem?
19-4 Job Auction7
When China reformed state-owned enterprises,
it tried a new approach to choosing managers: it
put managerial jobs up for auction. The bids for
the jobs consisted of promises of future profit
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Chapter 19 • the problem of adverse Selection 253
streams that the managers would generate and
then deliver to the state. In cases where the
incumbent manager was the winning bidder,
firm productivity tended to increase dramat-
ically. When outside bidders won, there was
little productivity improvement. If incumbent
managers were not generally more qualified,
how can you explain this result?
19-5 “Soft Selling” and Adverse Selection
Soft selling occurs when a buyer is skeptical of
the usefulness of a product and the seller offers
to set a price that depends on realized value. For
example, suppose you’re trying to sell a com-
pany a new accounting system that will reduce
costs by 10%. Instead of naming a price, you
offer to give them the product in exchange for
50% of their cost savings. Describe the infor-
mation asymmetry, the adverse selection prob-
lem, and why soft selling is a successful signal.
19-6 Hiring Employees
You need to hire some new employees to staff
your start-up venture. You know that poten-
tial employees are distributed throughout the
population as follows, but you can’t distinguish
among them:
Employee Value ($) Probability
50,000 0.25
60,000 0.25
70,000 0.25
80,000 0.25
What is the expected value of five employees
you hire?
Group Problem
G19-1 Adverse Selection
Describe an adverse selection problem your com-
pany is facing. What is the source of the asym-
metric information? Who is the less informed
party? What transactions are not being consum-
mated as a result of the information? Could you
(or do you) use signaling or screening to consum-
mate these transactions? Offer your company
some sound advice, complete with computations
of the attendant profit consequences.
1. The payment has increased from $100 in
2008 to $4,000 now. For more on Zappos’
use of this hiring practice, see Keith
McFarland, “Why Zappos Offers New
Hires $2,000 to Quit,” Business Week,
September 16, 2008.
2. An Initial Public Offering of stock describes
the sale of a company by its private owners
to the public who can purchase shares in the
stock.
3. A deductible is a dollar amount the con-
sumer pays (e.g., $50), while a copayment is
a percentage of the total bill (e.g., 50%). In
both cases, the insurance company pays the
remainder.
4. Every time the insurance company sells par-
tial insurance for $15 to a high-risk individ-
ual, it loses $5 (its cost is 0.4 3 $50 5 $20).
5. Sarah Perez, “Amazon Sues More Sellers for
Buying Fake Reviews,” TechCrunch,
October 27, 2016 https://techcrunch.com/
2016/10/27/amazon-sues-more-sellers-for-
buying-fake-reviews/.
6. Michael Luca, “Reviews, Reputation, and
Revenue: The Case of Yelp.com,” Harvard
Business School Working Paper No. 12-016.
7. Inspired by John McMillan, Games, Strategies,
and Managers: How Managers Can Use Game
Theory to Make Better Business Decisions
(New York: Oxford University Press, 1996).
EnD nOtES
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255
20
20.1 Introduction
Progressive Snapshot
In 2004, the Progressive Direct Group of Insurance Companies introduced a
new car insurance product called TripSense. Now called Snapshot, the service
includes a free device that plugs into a car’s diagnostic port and records mile-
age totals, the times when the vehicle is driven, and driving style, including if
you slam on your brakes. Progressive uses this information to offer renewal
discounts to customers who drive fewer miles during off-peak times. New cus-
tomers earn an initial discount of up to 10% just for signing up. Renewal
discounts vary from 30% to reported increases of 9%.
At this point, you should be thinking that this is another example of an
insurance company trying to solve the problem of adverse selection by gath-
ering information about the different risks faced by consumers who purchase
insurance. But there is another factor involved. Some of the risky driving be-
havior is caused by the insurance itself. To see this, note that the decision of
how much or how fast to drive is an extent decision. The marginal benefit of
driving more or at faster speeds is obvious. The marginal cost is the cost of
gasoline and wear on the car and the increased risk of accident. Once you buy
insurance, the cost of getting into an accident goes down, so we would expect
to see more accidents. We call this change in behavior moral hazard. Insur-
ance companies anticipate that insured drivers drive less carefully, and they
price policies accordingly. The Federal Communications Commission did not
foresee the moral hazard, and therefore had many companies default on their
risky winning bids.
Social Capital as a Motivator
Imagine you are a budding entrepreneur in a developing country. You proba-
bly don’t have sufficient credit history to obtain a conventional loan. But you
do have a presence on online social networks, and this activity online may
The Problem of
Moral Hazard
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256 SECTION V • Uncertainty
provide insight into your level of integrity in real life. In 2011, Lenddo began
using online behaviors to determine loan applicants’ credit worthiness. Given
permission to access to an applicant’s social media accounts, Lenddo can de-
velop a “Lenddoscore” much like a credit score. The difference is that, instead
of a credit history, the Lenddoscore uses borrowers’ online social network in-
formation to assess their loan riskiness. If your online presence looks like you
have strong roots to the community, for example, then you are more likely
to be worth the risk. Lenddo’s algorithm seems to be effective because many
lenders in developing countries have begun using the Lenddoscore. This helps
with adverse selection.
But even the creditworthy can fall on hard times and have trouble making
payments. Lenddo has a clever approach to help reduce the likelihood that
these borrowers will default. Lenddo members nominate friends as references.
If you are unable to make payments, it will affect your friends’ ability to bor-
row. So, you have this extra incentive to not let your friends down. Also, your
friends will tend to exert a bit of peer pressure on you to pay back the loan.
These social sanctions put extra pressure on borrowers to make every effort to
make repayments. This helps with moral hazard.
Moral hazard is ubiquitous. Researchers have found that improvements in
risk-abatement technology create incentives for consumers to take more risks.
For example, improved parachute rip cords did not reduce the number of
sky-diving accidents. Instead, overconfident skydivers waited too long to pull the
cord. Likewise, workers who wear back-support belts try to lift heavier loads,
and wilderness hikers take bigger risks if they know that a trained rescue squad
is on call. Public health officials cite evidence that enhanced HIV treatment can
lead to riskier sexual behavior. And children who wear protective sports equip-
ment engage in rougher play. The analogy to insurance is obvious. All these costly
technologies reduce the costs of risk taking, which leads to more risk taking.1
The problem of moral hazard is closely related to the problem of adverse
selection, and it has similar causes and solutions. Both problems are caused by
information asymmetry: moral hazard is caused by hidden actions (insurance
companies cannot observe your driving behavior), whereas adverse selection is
caused by hidden information (insurance companies cannot observe the inher-
ent risks that you face). Both problems can be addressed by getting rid of the
information asymmetry.
20.2 Insurance
To illustrate the problem of moral hazard, let’s return to the bicycle insur-
ance example from Chapter 19. Assume there is just one type of consumer, the
high-risk consumer whose probability of theft is 40%. Now, however, suppose
that consumers can bring their bikes inside (“exercise care”), which reduces
the probability of theft from 40% to 30%. If the cost of exercising care is low
enough (let’s say it costs $5 worth of effort to exercise care), then it makes
sense to do so. Each uninsured consumer brings the bike inside because the ex-
pected benefit of doing so—the reduction in the probability of theft multiplied
by the price of the bike, (0.40 2 0.30) 3 $100 5 $10—is greater than the $5
cost of exercising care.2
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Chapter 20 • the problem of Moral hazard 257
These owners still face the risk of theft and are willing to pay $5 more
than the expected cost of insurance to get rid of the risk. In this case, the ex-
pected loss is $30 (or 0.3 3 $100), and the bicycle owner would be willing
to pay the insurance company $35 to insure against this risk. However, once
consumers purchase insurance, any benefit from exercising care disappears.
Moral hazard means that insured customers exercise less care because
they have less incentive to do so.
In our example, the consumer stops bringing the bicycle inside, and the
probability of theft increases from 30% to 40%. This leads to the first lesson
of moral hazard:
Anticipate moral hazard and protect yourself against it.
The insurance company should anticipate that the probability of theft will
rise to 40% and price its policies accordingly; that is, it must charge at least
$40 for the insurance, instead of $35.
What happens when an insurance company doesn’t anticipate moral haz-
ard? To answer this, let’s look at the widespread introduction of modern anti-
lock braking systems (ABS) in the late twentieth century. Insurance companies
thought that ABS would make driving safer, and they offered discounts on
cars with ABS.
What they didn’t anticipate, ironically, is that drivers thought that ABS
would allow them to drive safely on ice and in the rain. When insurers saw
how much money they were losing on policies written for cars with ABS, they
phased out the discounts, except in states that required them.
The second point of this chapter is that the problem of moral hazard can
represent an opportunity to make money.
Moral hazard represents an unconsummated wealth-creating transaction.
If the insurance company could figure out how to get insured consumers
to take care, then it could make more money. For example, if the insurance
company could observe whether the customer was exercising care, then it
could lower the price of insurance to those taking care. This is what Progres-
sive’s Snapshot system tries to do.
20.3 Moral Hazard versus Adverse Selection
Moral hazard and adverse selection often offer competing explanations for
the same observed behavior. Consider the fact that before airbags were re-
quired equipment in cars, people who drove cars equipped with air bags were
more likely to get into traffic accidents. Either adverse selection or moral haz-
ard could explain this phenomenon.
The adverse selection explanation is that bad drivers are more likely to
purchase cars with air bags. If you know you’re likely to get into an accident,
it makes sense to purchase a car with air bags.
The moral hazard explanation is that air bags are like insurance. Once
drivers have the protection of air bags, they take more risks and get into more
accidents. If you don’t believe that people change behavior in this way, try
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258 SECTION V • Uncertainty
running a simple experiment. Next time you drive somewhere, don’t wear a
seat belt. (Make this a thought experiment if a seat belt is required by law.) See
if you drive more carefully. If you do, then this also means that you drive less
carefully when you wear a seat belt. Although wearing a seat belt will protect
you better in the event of an accident, seat belts also cause more accidents.
What distinguishes adverse selection from moral hazard is the kind of
knowledge that is hidden from the insurance company. Adverse selection
arises from hidden information regarding the type of person (high versus low
risk) who is purchasing insurance. Moral hazard arises from hidden actions by
the person purchasing insurance (taking care or not). Adverse selection is the
problem of separating you from someone else. Moral hazard is the problem of
separating the good you from the bad you.
More information can solve both problems. If the insurance company can
distinguish between high- and low-risk consumers, it can offer a high-price pol-
icy to the high-risk group and a low-price policy to the low-risk group, thereby
solving the adverse selection problem. Similarly, if the insurer can observe
whether customers are exercising appropriate levels of care after purchasing
insurance, it can reward people for taking care, thereby solving the problem of
moral hazard. For example, insurance investigators devote a great deal of time
trying to figure out exactly what happened in accidents in order to determine
whether it faces a problem of adverse selection or a problem of moral hazard.
20.4 Shirking
Shirking is a type of moral hazard caused by the difficulty or cost of monitor-
ing employees’ behavior after a firm has hired them. Without good informa-
tion, ensuring high levels of effort becomes more difficult.
Suppose, for example, a commission-based salesperson can work hard or
shirk. Further suppose that working hard raises the probability of making a
sale from 50% to 75%, but the increased effort “costs” the salesperson $100.
How big does the sales commission have to be to induce hard work?
In Figure 20.1, we draw the decision tree of the salesperson who decides
whether to work hard or shirk. The benefit of working hard is the increased
probability of making a sale and earning a sales commission (C). The “cost”
to the salesperson of expending effort is $100. The salesperson will decide to
work hard if 25% 3 C . $100, where C is the sales commission. In other
words, the commission has to be at least $400.3
Unless the company’s contribution margin (P 2 MC) is at least $400, the
company cannot afford to pay a commission that big.4 In this case, it doesn’t
pay to address the moral hazard problem with a simple incentive compen-
sation scheme. Ordinarily, it’s very hard for business students to accept that
sometimes solutions cost more than the problem they are supposed to address.
For these students, we leave you with a simple maxim:
If there is no solution, then there is no problem.
Note that the shirking problem arises from the same lack of information
that leads to moral hazard in insurance: only the salesperson knows how hard
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Chapter 20 • the problem of Moral hazard 259
she is working, just as only the insured driver knows whether he is driving
carefully. The performance evaluation metric that the company does possess—
whether or not a sale is made—is a noisy measure of effort because too
frequently (50% of the time), the salesperson earns a commission for doing
nothing.
Suppose we had a better performance evaluation metric than sales. In par-
ticular, suppose we could hire someone to monitor the behavior of our sales-
person to verify that she was working hard. This could be done, for example,
by tracking the salesperson’s movements with a GPS device. How would you
design a compensation scheme with this different metric?
Think of rewarding the salesperson for effort directly, with either a stick
(work hard or get fired) or a carrot (work hard and earn a reward). If you
have a performance metric like this, then almost any incentive compensation
scheme will work. The new performance evaluation metric allows you to put
the salesperson’s entire compensation or job at risk. If the benefits of keeping a
job and earning a salary are bigger than the costs of exerting effort, the sales-
person will exert effort.
Another solution is to find a worker who has a reputation for working
hard, regardless of whether she is monitored. Having a reputation for working
hard without monitoring is valuable to the company and to the worker, who
should be able to command a higher wage.
This leads directly to our last point about moral hazard—it hurts both
parties to a transaction. Consider, for example, the case of a consulting firm
that gets paid based on an hourly rate. Given the rate structure and the in-
ability of the client to monitor the consultant’s actions, the client expects the
consultant either to bill more hours than the client prefers or to spend time
on projects that the consultant values but that the client does not. Clients
Figure 20.1 Choice between Shirking and Working
Make Sale
(probability = 0.50)
Earn Commission = C
No Sale
(probability = 0.50)
Earn Commission = $0
Salesperson
Make Sale
(probability = 0.75)
Earn Commission = C
No Sale
(probability = 0.25)
Earn Commission = $0
Shirk (cost = $0)
EV = [0.5C + 0.5 $0] – $0 = 0.5C
Work Hard (cost = $100)
EV = [0.75C + 0.25 $0] – $100 = 0.75C – $100
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260 SECTION V • Uncertainty
anticipate shirking and are understandably reluctant to transact, unless the
consulting firm can find a way to convince the client that it can address the
moral hazard problem. The point is this: both parties benefit if they can figure
out how to solve the moral hazard problem. In this case, the consultant can try
to develop a reputation for not shirking, the consultant can accept a portion
of the contract on a fixed-fee basis, or the consultant can provide the client
with information documenting the value of the work being done.
20.5 Moral Hazard in Lending
As a final example, let’s consider the problems that banks face when making
loans. The adverse selection problem is that borrowers who are less likely to
repay loans are more likely to apply for them. The moral hazard problem is
that once a loan is made, the borrower is likely to invest in more risky as-
sets. Both of these factors make repayment less likely. Again, adverse selec-
tion arises from hidden information, whereas moral hazard arises from hidden
actions.
To illustrate the moral hazard problem, suppose you’re considering a $30
investment opportunity with the following payoff: $100 with a probability of
0.5 and $0 with a probability of 0.5. The bank computes the expected value
of the investment ($50) and decides to make a $30 loan at a 100% rate of
interest. If the investment pays off, the bank gets $60. But if the investment
returns zero, the borrower defaults and the bank gets nothing. The expected
return to the bank ($30 5 0.5 3 $60 1 0.5 3 $0) is equal to the loan amount,
so it breaks even, on average. The borrower’s expected profit is the remainder
($20 5 0.5 3 $40 1 0.5 3 $0).
The moral hazard problem arises when, after receiving the loan, the
borrower discovers another, riskier investment. The second investment
pays off $1,000, but has only a 5% probability of success. Although the
expected payoffs of the two investments are the same, the payoffs for the
parties are not. Compare the expected payoffs of the borrower and the
bank in Tables 20.1 and 20.2. Because the borrower receives more of the
upside gain if the investment pays off, he captures a much bigger share of
the expected payoff. And if the borrower does much better, the bank does
much worse. The bank’s share of the expected $50 payout drops to just
($3 5 0.05($60) 1 0.95($0).
Table 20.1
Payoffs to a Less-Risky Investment ($30 Loan at 100% Interest)
Investment Returns
$100 (p 5 0.5)
Investment Returns
$0 (p 5 0.5)
Expected
Payoff ($)
Payoff to borrower
Payoff to bank
$40
$60
$0
$0
20
30
Note: p = that the investment is a success.
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Chapter 20 • the problem of Moral hazard 261
Table 20.2
Payoffs to a More Risky Investment ($30 Loan at 100% Interest)
Investment Returns
$1000 (p 5 0.05)
Investment Returns
$0 (p 5 0.95)
Expected
Payoff ($)
Payoff to borrower
Payoff to bank
$940
$60
$0
$0
47
3
Banks guard against moral hazard by monitoring the behavior of borrow-
ers and by placing covenants on loans to ensure that the loans are used for
their intended purpose.
We can also characterize moral hazard as an incentive conflict between
a lender and a borrower. The lender prefers the less-risky investment because
she receives a higher expected payoff. The borrower prefers the more risky
investment for the same reason.
Remember that moral hazard is a problem not only for the lender, but also
for the borrower. If the lender anticipates moral hazard, it may be unwilling
to lend. The incentive conflict between banks and borrowers is exacerbated
when the borrower can put other people’s money at risk.
Borrowers take bigger risks with other people’s money than they would
with their own.
Savings and loan institutions (S&Ls) are specialized banks that borrow
from depositors and lend to homeowners. In the 1980s, in Texas, the real es-
tate market collapsed and the value of the S&Ls’ assets (the real estate loans)
fell below the value of their liabilities (the money owed to depositors). But be-
fore the regulators could shut these banks down, they borrowed more money
from depositors at very high interest rates and “bet” heavily on junk bonds—
the riskiest investment available to them. Just as in our loan example, this
increased the expected payoffs to the S&L, but decreased the expected payoff
to the lender. When the risky bets failed to pay off, U.S. taxpayers were stuck
with the $200 billion cost of repaying depositors.
To control this kind of moral hazard, lenders must try to find ways to
better align the incentives of borrowers with the goals of lenders. They do this
by requiring that borrowers put some of their own money at risk. If an invest-
ment doesn’t pay off, the lender wants to make sure that the borrower shares
the downside. This is why banks are much more willing to lend to borrowers
who have a great deal of their own money at risk.
20.6 Moral Hazard and the 2008 Financial Crisis
Regulators can reduce the costs of moral hazard by ensuring that banks keep
an equity “cushion” of about 10% so that they can repay depositors who want
their money back. For example, a bank that raises $10 million in equity can
accept $100 million in deposits and make $100 million in loans. Banks earn
money on the spread between the interest they receive from their loans and
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262 SECTION V • Uncertainty
the interest they pay to depositors. The balance sheet of this bank would have
$100 million in liabilities (deposits that must be paid back) and $110 million
in assets (loans plus equity).
When the value of the assets fall, the risk of moral hazard increases. In
late 2008, economists voiced concerns that the U.S. Treasury’s plan to guar-
antee short-term loans would give undercapitalized banks the opportunity to
make risky “heads I win, tails you lose” investments (bets). If the bets paid
off, then the bank would get most of the gain, but if they didn’t, the taxpayers
would absorb most of the losses.
A better alternative is to have the Treasury Department inject equity into
banks. Not only does this get banks lending again but it also gives the bank
owners a “stake” in the bank that mitigates some of the risk of moral hazard.
In addition, it has the benefit of punishing bank owners by making them give
up some of their ownership stake to the government.
Bailing out homeowners raises similar issues. Proponents of the bailout
insisted that only “responsible families” would benefit from a foreclosure pre-
vention program. But it was obvious that the plan would help tens of thou-
sands of borrowers who made risky bets that house prices would continue
to rise. Responsible borrowers, who didn’t buy houses they clearly could not
afford, watched as their less-responsible neighbors were bailed out by the gov-
ernment. Furthermore, expanding the rights of borrowers to renegotiate loans,
which helps those with existing loans, makes new loans even more expensive.
So responsible borrowers are punished twice—once by sharing in the bailout
and again when they face higher loan rates.
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
• Moral hazard refers to the reduced incen-
tive to exercise care once you purchase
insurance.
• Moral hazard can look very similar to
adverse selection—both arise from infor-
mation asymmetry. Adverse selection arises
from hidden information about the type
of individual you’re dealing with; moral
hazard arises from hidden actions.
• Anticipate moral hazard and (if you can)
figure out how to consummate the implied
wealth-creating transaction.
• Solutions to the problem of moral hazard
center on efforts to eliminate the informa-
tion asymmetry (e.g., by monitoring or by
changing the incentives of individuals).
• Shirking is a form of moral hazard.
• Borrowers prefer riskier investments
because they get more of the upside,
while the lender bears more of the
downside. Borrowers who have nothing
to lose exacerbate this moral hazard
problem.
Multiple-Choice Questions
1. Which of the following is an example of
moral hazard?
a. Reckless drivers are the ones most
likely to buy automobile insurance.
b. Retail stores located in high-crime ar-
eas tend to buy theft insurance more
often than stores located in low-crime
areas.
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Chapter 20 • the problem of Moral hazard 263
c. Drivers who have many accidents pre-
fer to buy cars with air bags.
d. Employees recently covered by the
company health plan start going to the
doctor every time they get a cold.
2. In a bad economy, a CEO has a 4% chance
of meeting earnings estimates at regular
effort, and a 5% chance at extraordinary
effort. Extraordinary effort costs the CEO
$10,000 more than regular effort. How large
a bonus should the CEO be paid for meeting
estimates to encourage extraordinary effort?
a. $100,000
b. $200,000
c. $250,000
d. $1,000,000
3. A salesperson can put in regular effort
(resulting in a 40% chance of sale) or high
effort (60% chance of sale). If high effort
costs the salesperson $20 more than reg-
ular effort, how large a per-sale bonus is
required to encourage high effort?
a. $12
b. $20
c. $33.33
d. $100
4. Which of the following is not an example
of a process designed to combat moral haz-
ard problems?
a. Banks include restrictive covenants in
loan agreements.
b. Universities have students complete
evaluations of professor performance
at the end of a class.
c. Insurance companies require applicants
to provide medical history information
as part of the application process.
d. Employers regularly monitor employee
performance.
5. Which of the following is an example of
moral hazard?
a. High-quality products being driven out
of a market by low-quality products.
b. A local charity raising insufficient
funds because no one contributes,
expecting that their neighbors will.
c. A bakery defaults on its loan be-
cause of a new consumer fear of
carbohydrates.
d. A corporation uses a business loan
secured for one investment on another,
higher-risk investment.
6. Which of the following is not an example
of moral hazard?
a. People are more likely to lock their
own car than a rental car.
b. Skateboarders attempt more difficult
maneuvers when wearing a helmet.
c. Bad salespeople are less drawn to com-
mission-based jobs.
d. People with fire insurance are less
likely to install smoke alarms.
7. Which of the following is true?
a. Moral hazard is primarily an issue
prior to a transaction.
b. Adverse selection is primarily an issue
after a transaction.
c. Moral hazard is the result of an infor-
mation asymmetry.
d. Resolving adverse selection also re-
solves moral hazard.
8. Restrictive covenants on loans are used to
avoid
a. moral hazard.
b. adverse selection.
c. free riding.
d. none of the above.
9. Loan applications require a lot of informa-
tion from applicants to avoid
a. moral hazard.
b. adverse selection.
c. free riding.
d. none of the above.
10. Which of the following is true about moral
hazard?
a. Moral hazard arises from actions that
cannot be observed.
b. Shirking is a form of moral hazard.
c. Moral hazard refers to the taking of
excessive risk.
d. All of the above.
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264 SECTION V • Uncertainty
Individual Problems
20-1 Extended Warranties
Your product fails about 2% of the time, on av-
erage. Some customers purchase the extended
warranty you offer in which you will replace
the product if it fails. Would you want to price
the extended warranty at 2% of the product
price? Discuss both moral hazard and adverse
selection issues.
20-2 Business Loan
A colleague tells you that he can get a business
loan from the bank, but the rates seem very
high for what your colleague considers a low-
risk loan.
Give an adverse selection explanation for
this, and offer advice to your friend on
how to solve the problem.
Give a moral hazard explanation for this,
and offer advice to your friend on how to
solve the problem.
20-3 Locator Beacons for Lost Hikers
Lightweight personal locator beacons are now
available to hikers that make it easier for the
Forest Service’s rescue teams to locate those lost
or in trouble in the wilderness. How will this
affect the costs that the Forest Service incurs?
20-4 Auto Insurance
Suppose that every driver faces a 1% prob-
ability of an automobile accident every year.
An accident will, on average, cost each driver
$10,000. Suppose there are two types of indi-
viduals: those with $60,000 in the bank and
those with $5,000 in the bank. Assume that
individuals with $5,000 in the bank declare
bankruptcy if they get in an accident. In bank-
ruptcy, creditors receive only what individuals
have in the bank. What is the actuarially fair
price of insurance? What price are individuals
with $5,000 in the bank willing to pay for the
insurance? Will those with $5,000 in the bank
voluntarily purchase insurance? What is the
effect of state laws forcing individuals to pur-
chase auto liability insurance?
20-5 BPO Services
BPO Services is in the business of digitizing
information from forms that are filled out by
hand. In 2006, a big client gave BPO a distribu-
tion of the forms that it digitized in house last
year, and BPO estimated how much it would
cost to digitize each form.
Form Type Mix of Forms (%) Form Cost ($)
A
B
C
D
25
25
25
25
0.25
0.10
0.15
0.50
Compute the average cost of digitizing a
form.
The client agreed to pay the average cost
computed in A for each form that BPO
processed, but BPO lost money on the con-
tract. How much did BPO lose, on average,
for each form that it processed?
20-6 Frequent Flyers
Frequent flyer programs are targeted more to-
ward business travelers (who do not pay for
their own tickets) than leisure travelers (who
do). Explain their effect on each type of traveler.
Why is there a difference?
Group Problem
G20-1 Moral Hazard
Describe a moral hazard problem your company
is facing. What is the source of the asymmetric
information? Who is the less-informed party?
Are there any wealth-creating transactions not
consummated as a result of the asymmetric in-
formation? If so, could you consummate them?
Compute the profit consequences of any advice.
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Chapter 20 • the problem of Moral hazard 265
1 William Ecenbarger, “Buckle Up Your Seat-
belt and Behave,” Smithsonian, April 2009,
available at http://www.smithsonianmag.
com/science-nature/Presence-of-Mind-
Buckle-Up-And-Behave.html.
2 We thank Mark Cohen for the bicycle in-
surance example.
3 Work hard 5 0.75C 2 $100 . 0.5C 5
shirk; equivalently, 0.25C . $100 or
C . $400.
4 Even if its contribution margin is greater
than $400, it still may find it more prof-
itable to settle for shirking at lower
commissions.
End nOtES
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267
21 Getting Employees to Work in the Firm’s
Best Interests
22 Getting Divisions to Work in the Firm’s
Best Interests
23 Managing Vertical Relationships
Organizational Design
6SECTION
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269
In the late 1990s, a large auction house, Auction Services International (ASI),
employed art experts to manage ASI’s business in various schools of art—
French Impressionism, American Realism, and the like. Each expert’s job was
to persuade art owners to use ASI’s auction services to sell their art. ASI earned
money by charging the art owners a percentage of the final price at auction.
The art expert negotiated this percentage rate with the art owners.
Art experts were given discretion to negotiate rates from 10% to 30%,
depending on the art expert’s assessment of the seller’s willingness to pay and
knowledge of competitors’ offers. Instead, most of these negotiations yielded
relatively low rates, much closer to the 10% minimum. Puzzled, ASI’s CEO
did some investigation and discovered that the art experts were discounting
rates in exchange for gifts from the sellers—cases of fine wine, fur coats, even
luxury cars. After she found out about these kickbacks, the CEO took away
the experts’ discretion to negotiate the rates.
The CEO’s action ended the exchange of gifts for lower rates, but the
experts had become accustomed to the kickbacks, considering them an
important part of their compensation. Consequently, many of the art experts
quit, leaving to set up their own independent galleries in direct competition
with ASI.
To make matters worse, the CEO decided to set a 17% price by conspir-
ing with a rival auction house. When the conspiracy was discovered, the CEO
was sentenced to a year in jail, and the judge tacked on a $7.5 million fine, an
amount calculated as 5% of the $150 million volume of commerce affected by
the price-fixing conspiracy.
Had the CEO read this chapter, she would have known better how to
motivate her employees to work in the firm’s best interest, and she may have
been able to avoid prison.
In this and the final two chapters, we come back to the original
problem-solving framework of Chapter 1. Our goal is to show you the
21
Getting Employees to Work
in the Firm’s Best Interests
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SECTION VI • Organizational Design270
analytical roots of the framework to help you understand why it works in
addition to how it works. To do this, we begin with principal–agent models.
21.1 Principal–Agent Relationships
When we study the relationship between a firm and its employees, we use
what economists call principal–agent models.
A principal wants an agent to act on her behalf. But agents often have
different goals and preferences than do principals.
In the ASI story, for example, the firm or the CEO is the principal, and the
art expert is the agent. We adopt the linguistic convention that the principal is
female and the agent male.
Like the art expert, the agent often has better information than the prin-
cipal. The problem the principal faces is that the agent has different incentives
than does the principal, which we call an incentive conflict. In our example,
ASI’s CEO wanted her art experts to negotiate profitable commission rates,
whereas the art experts wanted to increase personal income, including kick-
backs from customers. In general, incentive conflicts exist between every
principal and every agent throughout the management hierarchy—between
shareholders and managers, between managers and subordinates, and between
a firm and its various divisions.
Incentive conflict generates problems that should sound familiar:
The principal has to decide which agent to hire (a problem of adverse
selection). Once the agent is hired, the principal has to figure out how to
motivate the agent (moral hazard).
We know (from Chapters 19 and 20) that adverse selection and moral
hazard problems are costly to control. In fact, the costs associated with moral
hazard and adverse selection are called agency costs because we analyze them
using principal–agent models. A well-run firm will find ways to reduce agency
costs; poorly run firms often blindly incur agency costs or unwittingly make
decisions that increase them.
We also know that we can reduce the costs of adverse selection or moral
hazard by gathering information about the agent:
A principal can reduce agency costs if she gathers information about the
agent’s type (adverse selection) or about the agent’s actions (moral hazard).
For adverse selection, information gathering means checking the back-
ground of agents before they’re hired; and for moral hazard, information
gathering means monitoring agents’ actions after they’re hired. This difference
has led some to characterize adverse selection as a pre-contractual problem
caused by hidden information and moral hazard as a post-contractual prob-
lem caused by hidden actions.
At ASI, for example, had the CEO known when agents were reducing rates
in exchange for gifts, she might have devised a simple incentive-compensation
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ChapTEr 21 • Getting Employees to Work in the Firm’s Best Interests 271
scheme (a reward or a punishment) to stop it. But even without this infor-
mation, she should have anticipated the art experts’ opportunistic behavior,
especially since she was paying them flat salaries—compensation unrelated
to performance. Because ASI did not reward art experts for setting profitable
rates, the art owners found it easy to bribe them to set unprofitable ones.
When the CEO decided to take away rate-setting discretion from the art
experts, she compounded her initial mistake. This solution was costly because
the CEO lacked information about what rates owners were willing to pay.
Instead, she tried her “17% solution,” the rate set collusively with her rival.
A better solution would have been to leave the rate-setting authority with
the art experts but change to an incentive-compensation scheme—for exam-
ple, to one that paid art experts a percentage of the revenue they brought to
the firm. This kind of compensation scheme better aligns the agents’ incentives
with the firm’s goals. If the agents set profitable rates, they’ll increase both
the firm’s profit and their own compensation. If you think of the art experts
as salespeople, this incentive-compensation scheme seems like an obvious
solution—most salespeople are compensated with sales commissions.
This solution does have one drawback: like all incentive-compensation
schemes, it exposes the agents to risk. In this case, should the economy decline,
the firm would sell fewer art pieces, and the art experts’ compensation would
fall through no fault of their own.
If you are the principal, imposing risk on the agent may not seem like your
problem, but we know (from Chapter 9) that people must be compensated for
bearing risk. This raises the principal’s cost of using an incentive-compensa-
tion scheme.
Incentive compensation imposes risk on the agent for which he must be
compensated.
The risk of incentive compensation reminds us that most solutions to the
problems of adverse selection and moral hazard involve trade-offs. We adopt
incentive compensation only if its benefits (the agent works harder) exceed its
costs (we have to compensate the agent for bearing risk). We measure these costs
and benefits relative to the status quo or relative to other potential solutions.
21.2 Controlling Incentive Conflict
We don’t have any hard and fast rules for the best way to control incentive
conflicts between principals and agents, but we can identify the trade-offs
associated with various solutions. Once you understand the basic trade-offs,
it is easier to identify the costs and benefits of various solutions. In a well-
run organization, decision-makers have (1) the information necessary to
make good decisions and (2) the incentive to do so. To ensure that decision-
makers have enough information to make good decisions, there are two
obvious solutions:
Either move information to those who are making decisions or move de-
cision-making authority to those who have information.
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SECTION VI • Organizational Design272
Typically, information enters a firm from the bottom so that subordinates
(who are further down in the management hierarchy) are better informed than
their bosses. In the case of ASI, the art experts, but not the CEO, knew how
much clients were willing to pay. When the CEO centralized decision-mak-
ing authority to set rates, her company lost the ability to price discriminate
between high- and low-value customers.
When you centralize decision-making authority, you should also figure
out how to transfer information to the decision-maker.
This is not as easy as it sounds. Information comes from self-interested
parties who may have an incentive to manipulate the decision-maker. For
example, sales agents often tell their marketing bosses that they have to reduce
price in order to make a sale. They have an incentive to lie if they are paid
predominantly based on the number of sales or, in the case of ASI, kickbacks.
The other solution, leaving pricing discretion with the art expert, decen-
tralizes decision-making authority.
When you decentralize decision-making authority, you should also
strengthen incentive-compensation schemes.
The logic is clear. Once you give an agent authority to make decisions,
you want to make sure that he is motivated to make choices in the firm’s best
interest. At ASI, the weak incentives were obvious—the art experts were given
no financial incentive to set profitable rates. The CEO should have adopted
an incentive-compensation scheme to encourage more profitable rate setting.
Recall from Chapter 1 that incentives have two parts: before you can
reward good behavior, you have to be able to measure it. You can measure
performance informally, with some kind of subjective performance evalua-
tion, or formally, using sales or profitability as performance metrics. Once
you have an adequate performance measure, you create incentives by link-
ing compensation to the performance metrics. Here, we speak very generally
about compensation: compensation can be pay, increased likelihood of pro-
motion, bonuses, or anything else that employees value. The link between
performance and compensation creates the incentive for agents to act in the
firm’s best interest.
Designing good incentive-compensation schemes is challenging. Take a
simple example of a fruit farmer trying to decide how to pay pickers. The
obvious solution is to pay workers a piece rate for each piece picked. A com-
plicating factor is that the rate has to be increased when pickings are slim to
ensure that the workers earn the minimum wage required by law. Under this
system, however, workers sometimes monitor each other to discourage fast
picking, resulting in the piece rate being raised. This defeats the purpose of the
incentive-compensation scheme. One solution to this problem is to gauge the
difficulty of picking by having managers test-pick a field and then set the piece
rate based on this test-pick.1
The lesson of this story is to realize that workers have an incentive to
“game”-compensation schemes. Like a teacher rewarded for student test per-
formance will often “teach to the test” rather than foster deeper understanding
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ChapTEr 21 • Getting Employees to Work in the Firm’s Best Interests 273
of the material, employees will often discover ways to maximize their pay or
make themselves better off that don’t improve or even hurt profitability.
To combat gaming, first try to anticipate the more obvious games and
adjust the compensation scheme to prevent them. Second, monitor outcomes
to ensure that you are getting the behaviors you really want. Monitoring gives
the principal a better performance evaluation metric, which allows her to bet-
ter align the incentives of the agent with the goals of the principal.
In the case of ASI, it looks like decentralization, but with stronger incen-
tives, would have been the better solution. In general, the answer to whether
centralization or decentralization is better depends on the relative cost of the
two alternatives. If you want to centralize decision making, how costly will it
be to transfer information from agents to principals? If you want to decen-
tralize, how costly will it be to institute incentives that adequately compensate
agents for bearing risk?
21.3 Marketing versus Sales
The conflict between the art experts and their employer is fairly typical of the
general incentive conflict that arises in organizations with separate sales and
marketing divisions. The two divisions rarely get along, and this is often due
to the different incentives that they are provided. Marketing managers gener-
ally receive profitability bonuses as compensation, whereas salespeople receive
commissions based on revenue. They disagree about what price to charge be-
cause the marketing principal wants to maximize profit—that is, by making
sales where MR . MC. In contrast, the sales agent wants to maximize reve-
nue by making sales where MR . 0. This means that the salesperson prefers
more sales or, equivalently, lower prices.
If the marketing managers know when salespeople are making unprofit-
able sales, they can easily put a stop to it. Without that information, however,
controlling the incentive conflict becomes costly.
To see why, put yourself in the place of a marketing manager who is over-
seeing a salesperson who tells you that he has to reduce price to make a par-
ticularly tough sale even though it will leave the firm with very little profit.
Because you don’t know how much each customer is willing to pay, you can’t
tell whether the salesperson wants to reduce price to make a particularly tough
sale, which would be reasonable from the firm’s perspective, or whether he has
decided that the extra effort to sell at the higher price is not worth the small
increase in commission, despite the big increase in profit for the firm.
Since it seems easy to design an incentive-compensation scheme that
rewards the salesperson for increasing profitability rather than revenue, we
have to wonder why this kind of incentive compensation is not more widely
used. Most salespeople will tell you they prefer performance evaluations based
on revenue because revenue is what they directly control. They may also per-
ceive a change from a sales commission to profit commission as a sneaky way
for the company to cut labor costs. Remember that profit is always lower than
revenue.
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SECTION VI • Organizational Design274
You should be able to persuade the sales agent to accept the change to
a profit commission if you design the profit-based compensation scheme to
be “revenue-neutral” to the salesperson. For example, a 20% commission on
profit is equivalent to a 10% commission on revenue if the contribution mar-
gin is 50%. Agents are guaranteed to earn the same under each compensation
scheme, even if their behavior does not change. But because they can earn
more money if they change behavior (by pricing less aggressively), their com-
pensation should increase under a commission based on profit.
Companies often try to control incentive conflicts simply by asking sales
agents to change their behavior—but actions (and paychecks) can speak much
louder than words. Sales agents will change behavior when they have incen-
tives to do so.
Another common solution is to require that sales agents obtain permission
to reduce price below some specific threshold. The sales agent could do this by
transferring enough information to the marketing principal to convince her
that the price reduction is profitable.
21.4 Franchising
We can understand the growth of franchising in the United States over the
past 50 years as a solution to a particular principal–agent incentive conflict.
The principal is the parent company that owns a popular brand, like McDon-
ald’s. As the company grows, it has a choice—it can open up company-owned
stores, or it can let independent franchisees open and run stores. The fran-
chisees then pay the company a fee for the right to use the parent company’s
brand.
Suppose you are advising the owner of a fast-food restaurant chain. This
chain’s owner is trying to decide whether to sell one of its company-owned
restaurants, currently run by a salaried manager, to a franchisee. If the chain
sells the store, the franchisee will manage it and pay the owner a fixed fran-
chise fee for permission to use the brand. Should the owner sell the store?
Of course, the answer is, “It depends.” In this case, it depends on whether
the franchise organizational form is more profitable than the company-owned
organizational form. With the company-owned structure, managers don’t
work as hard as they would if they owned the restaurant (moral hazard), and
the salaried management job may have attracted a lazy manager (adverse
selection). The company must spend resources on monitoring managers’
productivity.
These agency costs disappear once a franchisee owns the restaurant
because the agent and the principal become one and the same. The franchisee
works harder than a salaried manager because he gets to keep all profit
after paying off his costs—including the franchise fee—and industrious
franchisees will outbid lazy ones for the right to run a franchised restaurant.
Running a franchised store can be thought of as a strong form of incentive
compensation—you turn a manager into an owner (franchisee) when you give
him the residual profit from running the store.
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ChapTEr 21 • Getting Employees to Work in the Firm’s Best Interests 275
However, the franchisee faces more risk than does a salaried manager and,
as a consequence, will demand higher compensation in the form of a lower
franchise fee. If the franchisee demands too much for bearing risk, then the
restaurant could be more valuable as a company-owned store than it is as a
franchise.2
Jointly, the parties can split a larger profit pie if they can figure out how
to balance these concerns. At one extreme, the company-owned store with a
salaried manager leads to shirking on the part of the agent—a type of moral
hazard. As mentioned earlier, it also leads to adverse selection because salaried
jobs are more likely to attract lazy managers. The company may also incur
costs to monitor the managers’ actions.
At the other extreme, the franchise organizational form is analogous to
an incentive-compensation scheme because the franchisee keeps every dollar
he earns after paying off his costs. But if factors other than effort affect profit,
this kind of incentive compensation also imposes extra risk on the agent for
which he must be compensated.
Sharing contracts fall between these two extremes. Instead of a fixed fran-
chise fee, the franchisor might demand a percentage of the revenue or profit
of the restaurant. This arrangement reduces franchisee risk by reducing the
amount the franchisee pays to the franchisor when the store does poorly.
However, sharing contracts also increase agency costs (moral hazard, adverse
selection, and monitoring costs).
21.5 A Framework for Diagnosing and Solving Problems
Understanding the trade-offs between information and incentives is useful, but
it still doesn’t tell you how to identify and fix specific problems within an
organization. For that, you need to be able to find the source of the incentive
conflict and come up with specific alternatives to reduce the associated agency
costs. Then choose the alternative that gives you the highest profit.
To analyze principal–agent problems, we return to the problem-solving
framework introduced in Chapter 1. First, reduce the problem to a bad deci-
sion, and then ask three questions:
1. Who is making the (bad) decision?
2. Does the decision-maker have enough information to make a good
decision?
3. Does the decision-maker have the incentive to do so?
In principal–agent relationships, the source of the problem is almost
always either moral hazard or adverse selection. The first question identifies
the source of this problem. The second examines the employee’s information
and the nature of the information asymmetry. The third identifies how the
decision-maker is evaluated and compensated. Remember that incentives have
two parts: the performance evaluation measures whether the individual is
doing a good job; the compensation rewards good performance.
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SECTION VI • Organizational Design276
Let’s answer the three questions for the ASI example at the beginning of
this chapter:
1. Who is making the bad decision? The art experts. They are negotiating
rates that are too low.
2. Does the decision-maker have enough information to make a good deci-
sion? Yes—in fact, they are the only ones with enough information to set
profitable rates.
3. Does the decision-maker have the incentive to do so? No. The art experts
received a flat salary, making it relatively easy for art owners to bribe
them with gifts.
In general, answers to the three questions will suggest alternatives for
reducing agency costs in three general ways: by (1) changing decision rights,
(2) transferring information, or (3) changing incentives.
In this case, we have two obvious solutions: leave rate-setting authority
with the art experts, but adopt stronger incentive compensation; or transfer
rate-setting authority to a marketing executive, and then transfer crucial infor-
mation to her. The first is a decentralization solution, and the second is a cen-
tralization solution.
To see how well you understand how to use the framework, imagine that
you are called in as a consultant to a large retail chain of “general stores” that
target low-income customers in smaller cities. As the company has grown, the
CEO and the stock analysts who follow the company have noticed that newly
opened stores are not meeting sales projections. The CEO wants you to find
out what’s causing the problem and fix it.
In the course of your investigation, you learn that the company uses
“development” agents to find new store locations and negotiate leases with
property owners. The company rewards these agents with generous stock
options, provided they open 50 new stores in a single year. Although agents
are supposed to open new stores only if the sales potential is at least $1 mil-
lion per year, this is obviously not happening. Newly opened stores earn just
half that amount.
————- Before continuing, try to identify the problem. ————-
Begin your analysis by asking the three questions.
1. Who is making the bad decision? The development agents. They are
opening unprofitable stores.
2. Does the decision-maker have enough information to make a good
decision? Yes. Development agents probably have access to information
about whether the new stores would be profitable. This appears to be a
moral hazard problem.
3. Does the decision-maker have the incentive to do so? No. The agents
received stock options for opening 50 stores each year, regardless of the
new stores’ profitability.
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ChapTEr 21 • Getting Employees to Work in the Firm’s Best Interests 277
The problem is not with information but rather with the incentives of the
agent, who is rewarded for opening stores regardless of profitability. Before
you continue, suggest at least two solutions to the problem and choose the
best one.
————- Before continuing, try to fix the problem. ————-
You have at least two obvious solutions:
1. (Decentralization) The company could change the incentives of the devel-
opment agents by rewarding them for opening only profitable stores.
2. (Centralization) Alternatively, the company could take the decision to
open stores away from agents and then gather its own information about
the potential profitability of new store sites.
The decentralization solution would leave decision-making authority with
the agents, who have specialized knowledge about the profitability of loca-
tions for new stores. But the agents would have to wait for a year of store
operation before receiving compensation (at which point, they know whether
the store made $1 million in sales). However, this solution exposes the agents
to risk beyond their control—their compensation would depend on the behav-
ior of the store manager, as well as on the state of the economy. The agent
would have to be compensated for bearing this risk in the form of higher com-
pensation, which is the usual trade-off between incentive compensation and
risk.
In this case, the general store chain chose the centralization option. It
developed a forecasting model to predict the profitability of new stores based
on local demographic information and the locations of rival stores. Agents
were allowed to open new store locations only if the model predicted sales
exceeding $1 million.
If the model is good at predicting which stores are likely to be profit-
able, this solution will work well. But if the model cannot identify profitable
locations, it will be a poor substitute for the agents’ specialized knowledge
or intuition about which new store locations are likely to be profitable. It
will make both Type I errors (open unprofitable stores) and Type II errors
(fail to open profitable stores). As you should recall from our discussion of
minimizing expected error costs in Chapter 17, if the error costs are asym-
metric (it is more costly to open an unprofitable store), “shade” your predic-
tion threshold to avoid the more costly error (raise the predicted thresholds
for opening stores). In this case, the model predicted well, and the problem
disappeared.
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SECTION VI • Organizational Design278
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
• Principals want agents to work in the prin-
cipals’ best interests, but agents typically
have different goals from those of princi-
pals. This is called incentive conflict.
• Incentive conflict and asymmetric infor-
mation lead to moral hazard and adverse
selection.
• The costs of controlling incentive conflict
(agency costs) go down if the principal can
gather information about the agent’s pro-
ductivity (adverse selection) and about his
actions (moral hazard).
• Three alternatives for controlling principal–
agent conflicts are
1. reassigning decision rights,
2. transferring information, and
3. changing incentives.
• In a well-run organization, decision-makers
have (1) the information necessary to make
good decisions and (2) the incentive to do so.
1. If you decentralize decision-making
authority, you should strengthen incen-
tive-compensation schemes.
2. If you centralize decision-making
authority, you should make sure to
transfer needed information to the
decision-makers.
• Agents may try to “game” incentives, max-
imizing their own profit at the expense of
the principal.
• Three approaches to controlling incentive
conflicts are
1. a fixed payment to the agent (akin to
company-owned stores with salaried
managers, giving rise to agency costs,
and requiring monitoring costs to over-
come them),
2. incentive pay (akin to franchising, re-
quiring no monitoring but requiring
agents to be compensated for bearing
risk), or
3. sharing contracts, which blend the
above two approaches (requiring some
monitoring, some agency costs, and
some risk compensation).
• To analyze principal–agent conflicts, focus
on three questions:
1. Who is making the (bad) decision?
2. Does the decision-maker have enough
information to make good decisions?
3. Does the decision-maker have the in-
centive to make good decisions?
Multiple-Choice Questions
1. Your notebook computer’s hard drive re-
cently crashed, and you decide to take it to
a local repair technician to have it fixed. In
this relationship,
a. you are the agent.
b. the technician is the principal.
c. the technician is the agent.
d. no principal–agent relationship exists.
2. A good incentive-compensation scheme
a. maximizes the agent’s utility.
b. anticipates how an agent will game the
scheme.
c. does not subject a risk-averse agent to
risk.
d. accompanies centralized decision-
making authority.
3. Principal–agent relationships
a. reduce monitoring costs.
b. occur because managers have good
information about employees.
c. are not related to asymmetric
information.
d. are subject to moral hazard problems.
4. All of the costs associated with a principal
interacting with an agent are called
a. opportunity costs.
b. agency costs.
c. monitoring costs.
d. sunk costs.
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ChapTEr 21 • Getting Employees to Work in the Firm’s Best Interests 279
5. Principal–agent problems
a. occur when firm managers have more
incentive to maximize profit than
shareholders do.
b. would be reduced if firm owners had
better information about the actions of
the firm’s managers.
c. are made worse when executives own
stock in their companies.
d. are increased as more information is
shared between the parties.
6. In order to create an effective incentive-
compensation scheme, you must have
a. adequate performance measures.
b. unlimited funds.
c. a flat management structure.
d. none of the above.
7. Decentralization of decision-making au-
thority is consistent with which of the
following?
a. A trend of stronger, more active
CEOs.
b. Shrinking costs of computing band-
width, which allows information to
be inexpensively aggregated from geo-
graphically diverse business units.
c. Development of computing resources
at the corporate, division, and em-
ployee level.
d. Reduction in the use of incentive
compensation.
8. A firm faces two kinds of employees, those
able to sell 10 units/year, and those able
to sell 5 units/year. High-productivity em-
ployees are willing to work for $100K/year,
while low-productivity employees are will-
ing to work for only $50K/year. To screen
out the low-productivity employees, the
firm should
a. offer a salary of $100K.
b. offer a salary of $75K plus $5K/unit
commission.
c. offer a sales commission of $10K/unit.
d. offer a sales commission of $20K/unit
on sales above 5 units.
9. You own a retail establishment run by a
store manager who receives a flat salary of
$80,000. If you set up another store as a
franchise with incentive compensation to
the franchisee, what would be a reasonable
total compensation range that the franchi-
see could earn?
a. $80,000
b. $40,000–$80,000
c. $60,000–$100,000
d. $80,000–$100,000
10. In the magazine Budget Travel, a hotel
maid admits, “I cut corners everywhere I
could. Instead of vacuuming, I found that
just picking up the larger crumbs from the
carpet would do. Rather than scrub the
tub with hot water, sometimes it was just
a spray-and-wipe kind of day. . . . After
several weeks on the job, I discovered that
the staff leader who inspected the rooms
couldn’t tell the difference between a clean
sink and one that was simply dry, so I
would often just run a rag over the wet
spots. . . . I apologize to you now if you
ever stayed in one of my rooms.” Which of
the following organizational forms is more
likely to have caused this kind of shirking?
a. Franchising: where the hotel managers
are the owners of the hotel (franchisee)
and pay a fixed franchise fee
b. Company-owned hotels
c. Franchising with a sharing contract,
where the hotel managers are the
owners of the hotel (franchisee), pay a
small fixed fee but share revenue with
the franchisor
d. None of the above
Individual Problems
21-1 Real Estate Agents
When real estate agents sell their own, rather
than clients’, houses, they leave the houses on
the market for a longer time (10 days longer on
average) and wind up with better prices (2%
higher on average). Why?
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SECTION VI • Organizational Design280
21-2 Airline Departures
Planes frequently push back from the gate on
time, but then wait 2 feet away from the gate
until it is time to queue up for take-off. This
increases fuel consumption and increases the
time that passengers must sit in a cramped
plane awaiting take-off. Why does this occur?
What can be done to fix it?
21-3 Incentive Conflicts
Which of the following are characteristic of
principal–agent conflicts that often exist in a
firm?
a. Managers do not always operate in the
best interest of owners because owners are
generally more risk averse than managers.
b. Managers generally have a shorter time
horizon than owners; thus, managers do
not fully take into account the future long-
run profitability of the firm.
c. Managers do not always operate in the best
interest of owners because managers care
about the noncash benefits of their jobs.
d. Firms can usually find solutions that
reduce agency costs without increasing
monitoring or incentive costs.
21-4 Public School Principals
Each year, public schools are rewarded with
bigger budgets for achieving a rating of “excel-
lent” or “recommended” and are punished for
rating “needs improvement.” These ratings are
based on meeting thresholds on a broad set of
measures such as attendance rates, graduation
rates, standardized test scores, SAT scores, and
so on. Discuss the incentives for school princi-
pals (who are the agents, in this case) under this
scheme and how you might improve them.
21-5 Venture Capital
Venture capital (VC) firms are pools of private
capital that typically invest in small, fast- growing
companies, which usually can’t raise funds
through other means. In exchange for this financ-
ing, the VCs receive a share of the company’s
equity, and the founders of the firm typically stay
on and continue to manage the company.
a. Describe the nature of the incentive conflict
between VCs and the managers, identifying
the principal and the agent.
b. VC investments have two typical com-
ponents: (1) managers maintain some
ownership in the company and often earn
additional equity if the company performs
well; (2) VCs demand seats on the compa-
ny’s board. Discuss how these two compo-
nents help address the incentive conflict.
21-6 Meeting Milestones
A convenience store manager earns a base sal-
ary plus small bonuses for each of 10 different
possible monthly milestones he meets. Typical
managers can meet half of these milestones. Do
they miss the others by a little or a lot?
Group Problems
G21-1 Incentive Conflict
Describe an incentive conflict in your company.
What is the source of the conflict, and how is it
being controlled? Could you control it in a less
costly way? Compute the profit consequences
of the change.
G21-2 Incentive Pay
Describe a job compensated with incentive pay
in your company. What performance evaluation
metric is used, and how is it tied to compensa-
tion? Does this compensation scheme align the
incentives of the employee with the goals of the
company? Estimate the profit consequences of
the scheme relative to the next best alternative.
G21-3 Centralization versus Decentralization
Describe a decision that is centralized (or
decentralized) in your company. How could
you decentralize (or centralize) the decision?
What would happen if it were decentralized (or
centralized)? Compute the profit consequences
of the change.
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ChapTEr 21 • Getting Employees to Work in the Firm’s Best Interests 281
1. For more on the incentive compensation
challenges and solutions in fruit farming, see
Tim Harford, “The Fruits of Their Labors,”
Slate, August 23, 2008, http://www.slate.
com/id/2197735/.
2. The variability of franchisee profit rep-
resents risk, and the franchisee must be
compensated for bearing this risk. Note
also that the franchisor needs to be aware
of the incentive conflict regarding quality.
Franchisees have an incentive to free ride
on the brand name of the franchisor by
reducing quality.
EnD nOtES
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283
Black liquor soap is a by-product of the paper manufacturing process at
Acme’s Paper Division. The Paper Division normally sold the soap to Acme’s
Resins Division, which converted it into crude tall oil, an input into resin
manufacturing. Since a low transfer price increased the Resins Division’s
profit, its managers spent a lot of effort lobbying for a low transfer price while
the Paper Division pushed for a high transfer price.
The Resins Division won this lobbying battle when a relatively low price
was set, but it turned out to be a hollow victory. Given the low transfer price,
the Paper Division decided to burn the soap for fuel rather than sell it to the
Resins Division, which was then forced to buy higher-priced soap on the open
market. On net, burning the soap decreased overall company profit because its
value as a fuel was below that of its value as an input into resin manufacturing.
To make matters worse, the Paper Division’s burners were not designed
to handle black liquor soap, leading to a potentially explosive situation.
Fortunately, corporate headquarters recognized the danger; however, their
“solution” was to spend $5 million for a special furnace to allow the Paper
Division to safely burn the soap.
The moral of this story is that incentive conflict between divisions is costly
to control. In this case, a low transfer price not only prevented the movement
of an asset (black liquor soap) to a higher-valued use (resin manufacturing),
but the parent company compounded its mistake by building a new furnace.
In addition, lobbying by the two divisions diverted management attention
from more important issues. All these costs could have been reduced, if not
avoided, had the managers of Acme read this chapter.
22.1 Incentive Conflict between Divisions
Incentive conflicts arise in the normal course of business; however, these con-
flicts need not reduce a company’s profit. With two simple modifications, we
can apply the framework set up in Chapter 21 to make sure that the incentives
22
Getting Divisions to Work
in the Firm’s Best Interests
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SECTION VI • Organizational Design284
of the various divisions are aligned with the goals of the parent company. The
first is to “personify” the division as being controlled by a division manager.
So when we ask the three questions, we are really talking about the division
manager’s decision rights, information, and incentives.
The most important feature of a division’s incentive is the metric used
to evaluate division performance. For example, we can have a profit center
or revenue center, where the manager is evaluated on division profit or divi-
sion revenue; a cost center where the manager is evaluated on division average
cost; or an investment center, where managers are evaluated on the net pres-
ent value of the investments they make. Understanding the separate concerns
of the divisions allows you to figure out why problems arise. For example,
incentive conflict between the paper and resin divisions is driven by the fact
that each division is trying to maximize its own division profitability, without
concern for the overall profit of the company.
The second modification relates to the first question asked in the frame-
work. A complicating feature of applying our method to problems created
by conflict between divisions is how to reduce the problem to a simple deci-
sion. For a principal with two agents, this is hard to do. In our introductory
example, it is clear that the two divisions are not acting in the best interests
of the parent company, but it is not clear whether one of the two is making a
“mistake.” Consequently, it is important not to “blame” one of the divisions
for the problem, as that may falsely suggest an incorrect fix, but rather think
about the incentive conflict as being driven by their separate concerns. The
question, “Who is making the bad decision?” should be replaced by “What is
the problem?”
OK, now that we have the analytic preliminaries out of the way, let’s apply
our modified framework to the problem.
1. What is the problem? The Paper Division is burning the soap for fuel,
even though transferring it to Resins would increase the firm’s profit.
2. Do the divisions have enough information to fix the problem? Between
the two divisions, they have enough information to understand that soap
has a higher value to the Resins Division.
3. Do the divisions have the incentive to fix the problem? No, each division
is concerned only with division profitability. Incentive conflict between
the two divisions is the core of the problem.
Treating divisions as profit centers and rewarding managers based on di-
vision profit has a number of benefits. First, it often makes sense to assign
some decision-making authority to division managers because they have the
best information about how to run their own divisions. As part of the as-
signment of decision-making authority, we also want to give these manag-
ers incentives to make good decisions. Another virtue of a profit center with
delegated decision-making authority is that it doesn’t require a lot of parent
company involvement. The parent company looks at division revenue, sub-
tracts division costs, and rewards managers based on the difference. Division
managers are given a lot of discretion because the parent company has a good
performance evaluation metric, and it’s relatively easy to tie management pay
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Chapter 22 • Getting Divisions to Work in the F irm’s Best Interests 285
to division performance. But, as we see with this example, running divisions as
profit centers can lead to conflict between the divisions. And, this conflict can
sometimes reduce company-wide profit.
OK, now that we understand the source of the problem, how do we fix it?
There are three generic fixes to problems caused by incentive conflict between
divisions: we can (1) reallocate decision rights to either the parent firm, or one
of the two divisions; (2) change the information flow; and/or (3) change the
incentives of one or both of the divisions.
One obvious solution is simply to give information to senior management
that would allow them to set a better transfer price. But where does senior
management of the parent company get the information necessary to set a
good transfer price? If they have to rely on reports from interested parties,
like those from the buying and selling divisions, they are likely to see only
information favorable to one side or the other. This solution only shifts the
divisions’ attention away from lobbying for a favorable price to attempting to
produce more favorable information.1
Another possible solution is to alter the incentives of the Paper Division
so that it is evaluated based on parent company profit. Although this might
eliminate the incentive conflict over the transfer price, it sacrifices the benefits
of treating the division as a profit center. For example, it might create a free-
riding problem. Division managers might exert less effort because they have
less control over parent company profit compared to division profit.2
Another solution would be to change the decision rights by giving the
Paper Division managers the right to sell black liquor soap to the external
market if they couldn’t negotiate favorable terms with Resins. With this simple
organizational change, the Paper Division would burn the soap only if the
Resins Division was not willing to pay very much. And this is exactly the de-
cision that maximizes parent company profit. Additionally, this organizational
change means that senior management doesn’t need to spend time resolving
disputes between divisions about the transfer price.
Choosing the best solution depends on the magnitude of all the costs and
benefits of the various solutions. From what we know, this last solution ap-
pears to be the best.
This story has a happy ending (and no explosions). Soon after the com-
pany had the burners redesigned to handle black liquor soap, an increase in
the price of energy raised the soap’s value as a fuel, making it profitable for the
Paper Division to burn it. So the company’s initial mistake became profitable,
thanks to an unforeseen increase in the price of energy. In other words, Acme
got lucky. But once the price of energy falls, the problem will reappear, so it is
still important to try to address it.
22.2 Transfer Pricing
Transfer pricing is a contentious issue for almost any company where di-
visions buy from or sell to each other. Together with corporate budgeting
(a topic we’ll cover later in this chapter), transfer pricing causes more con-
flict between divisions than almost any other issue. To illustrate a more
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SECTION VI • Organizational Design286
typical transfer pricing conflict, let’s return to our paper company and ex-
amine the transfer of paper from the upstream Paper Division to the down-
stream Cardboard Box Division. Paper is the most expensive input into box
production.
When two profit centers negotiate a transfer price, sometimes the divi-
sions bargain so hard that they reach an impasse. And sometimes, the down-
stream Box Division will purchase from an external supplier, even though the
parent company would prefer that the Box Division purchase from the Paper
Division. And finally, even if the divisions reach agreement, the cost of interdi-
vision haggling may exceed any benefit the parent company derives from the
transfer.
In this case, the two divisions agreed on a transfer price that was 25%
higher than the marginal cost (MC) of the Paper Division. Although this price
ensured that the Paper Division found it profitable to transfer paper to the
Box Division, it also raised the costs of the downstream Box Division, making
the boxes more difficult to sell.
To understand the effects of a high transfer price, look at Figure 22.1.
The MC of paper production is $100. The Paper Division produces the paper
and transfers it to the Box Division at a price of $125. The downstream Box
Division counts the transfer price as part of its costs and then makes all sales
where MR
Box
. MC
Box
1 $25. The $25 represents the markup that Paper Di-
vision builds into the transfer price, and MC
Box
is the MC of producing boxes
(and includes the $100 paper production cost). This is a higher threshold for
making sales than the profit-maximizing threshold, MR
Box
. MC
Box
. In other
words, under this scheme, the Box Division makes fewer sales, and charges
higher prices, than would maximize parent company profit.
FIGure 22.1 Transfer Pricing
Transfer Price:
MC + Markup
$100 + $25 = $125
Paper
Firm
Optimal Decision:
Produce/Price
Actual Decision:
Produce/Price
Where MRBox MCBox + $25Where MRBox MCBox
Consumer Sales
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Chapter 22 • Getting Divisions to Work in the F irm’s Best Interests 287
Note that this problem is the opposite of the one faced by a marketing
division in Chapter 21. There, the sales agents made more sales and charged
lower prices than those that would have maximized company-wide profit.
Let’s see how well our framework does in analyzing this problem:
1. What is the problem? The boxes are priced too high, so the company is
not selling enough of them.
2. Do the divisions have enough information to make a good decision? Yes.
Between the two, they have enough information to make a good decision.
3. Do the divisions have the incentive to make a good decision? No. The di-
visions are run as separate profit centers, so they work to increase profit
of their own divisions, even if it means reducing parent company profit.
The analysis makes clear that the conflict arises because two profit centers
are each trying to extract profit from a single product. For this reason, we call
this the “double markup” or “double marginalization” problem. One way of
solving it would be to turn the upstream Paper Division into a cost center.
Cost centers are not evaluated based on the profit they earn, so they don’t
care about the transfer price. If the Paper Division became a cost center, its man-
agers would not object to transferring paper at marginal cost. And this would
cause the downstream division to reduce box prices to their profit-maximizing
level.
But cost centers have other problems. For example, the cost center may
try to reduce cost by reducing quality, so the company may have to add a
quality control and testing facility to the factory. As long as this kind of mon-
itoring is not too costly, the cost center may be the best solution. As always,
the right answer depends on the magnitude of the benefits and costs of the
alternative solutions.
As we might expect, once our Paper Division became a cost center and be-
gan transferring paper at marginal cost, the Box Division began winning more
jobs from its rivals. Ironically, though, the Box Division’s success set off a price
war in the industry that lasted for five years. The previous inefficient orga-
nizational form had the hidden benefit of softening price competition with
rival box producers, the third of our generic strategies from Chapter 10.3 This
underscores another lesson for decision-makers—make sure that you also con-
sider indirect consequences of changes before you make them.
22.3 Organizational Alternatives
Many firms are organized into functional divisions. Adam Smith’s pin factory
and Henry Ford’s automobile assembly line are classic examples of production
processes that divide tasks into narrow functional steps.
A functionally organized firm is one in which various divisions perform
separate tasks, such as production and sales.
Functional organization offers firms the advantage that workers develop
functional expertise and can easily share information within their division.
This setup also helps firms realize any economies of scale inside the function
because all the activities of a particular function are grouped together. For
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SECTION VI • Organizational Design288
example, a global consumer products manufacturer might choose to centralize
all its R&D activity in order to capture economies of scale and learning curve
effects rather than have separate R&D facilities across the globe. Functional
divisions also make it easy to tie pay to performance because performance is
more narrowly defined and thus relatively easier to measure. Piece-rate pay—
compensation based on the number of units a worker produces—is an exam-
ple of such a simple performance evaluation metric.
The major difficulty in running a functionally organized firm is ensuring
that the functional divisions are working toward a common goal.4 Consider
the problems faced by a functionally organized company when it designed
a new turbine jet engine. The Engineering Division designed the engine, the
Production Division manufactured it, and the Finance Division decided how
much to charge for it. The engineers came up with a radical new design in-
corporating hollow fan blades. The award-winning design required less fuel
than conventional engines, but the hollow fan blades were very difficult (and
costly) to build. When the Finance Division computed the operating costs of
the engine, it discovered that the new engines were much more expensive to
buy and operate than rival engines, even after accounting for the expected fuel
savings. The lack of coordination between the divisions resulted in a product
whose total cost was higher than its value.
A similar coordination problem arose at a midsized regional bank divided
into a Loan Origination Division (LOD) and a Loan Servicing Division (LSD).
The LOD identifies potential borrowers, lends money to them, and then hands
them over to the LSD. The LSD collects interest on the loan and makes sure
that borrowers repay the loans as payments come due. However, the bank suf-
fered an unusually high number of defaults.
Again, let’s use our framework to diagnose the problem:
1. What is the problem? The LOD was making risky loans that resulted in a
high number of defaults.
2. Do the divisions have enough information to fix the problem? The LOD
had access to information on the credit status of the borrowers.
3. Do the divisions have the incentive to fix the problem? The parent bank
evaluated the LOD managers on the amount of money they were able to
lend. They had little incentive to restrict lending to qualified borrowers.
In other words, the LOD made loans regardless of their profitability.
We could change the incentives of the LOD so that its managers are re-
warded for making only profitable loans. But this would be difficult to imple-
ment because it can take many years before a bank knows whether loans are
unprofitable, and then only when borrowers don’t repay them.
We could adopt a solution similar to the one used by the General Store
from Chapter 21 where development agents were opening unprofitable stores.
If we could design a good predictor of whether a loan would be profitable, we
could let the LOD make loans only when the model predicts a good chance of
repayment.
Another solution, and one that banks commonly use, is to put the origi-
nation and servicing personnel in the same division, essentially reorganizing
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Chapter 22 • Getting Divisions to Work in the F irm’s Best Interests 289
the bank into an M-form or multidivisional company with process teams built
around a multifunction task:
An M-form firm is one whose divisions perform all the tasks necessary to
serve customers of a particular product or in a particular geographic area.
Multidivisional or M-form structures have the advantage of higher flexi-
bility to customize a firm’s products or services to particular customer needs.
They also improve coordination across functional departments and take ad-
vantage of expertise on servicing specific types of customers. This, of course,
comes with the cost of having duplicate functional areas in each division.
In a bank, an M-form reorganization might consist of two divisions: one
focused on both originating and servicing residential loans and the other fo-
cused on commercial loans. In each division, the profit of the loans originated
and served would measure performance and subsequent compensation.
In fact, our bank decided to do just that—reorganize as an M-form. Not
only did the number of bad loans decrease, but the speed of decision making
increased. The M-form organization made it relatively easy for the divisions
to respond to the changing conditions in local markets because its managers
no longer had to coordinate with a sister division who shared responsibility
for the customer. The bank also found it easier to develop long-term customer
relationships because customers always dealt with the same person, whose re-
sponsibility included both origination and servicing.
The answer to whether it is better to organize as a functional or M-form
organization is, of course, “It depends.” Each form has particular benefits and
drawbacks, and the right choice will depend on the magnitude of these costs
and benefits in specific cases.
22.4 Budget Games: Paying People to Lie5
One of the functions of corporate budgets is to transfer information between
divisions that need to coordinate with one another. Consider a toy company
where the Marketing Division submits a budget that includes a forecast of the
number and types of toys it expects to sell in the upcoming holiday season.
The Manufacturing Division uses the sales forecast to plan production for the
coming year. An accurate sales forecast means that the company will produce
the right number of toys in time for the holiday demand. At least, that’s how
the process is supposed to work.
Put yourself in the place of a division manager who has good information
about how much her division can earn. Regardless of her information, she
always has an incentive to try to reduce the goal if her bonus is tied to reach-
ing it. If her divisional budget goal is above what she thinks she can earn, she
complains to senior managers that her goal is unreachable. The CEO under-
stands her incentives and typically treats what she says with skepticism. They
eventually hammer out a compromise that has more to do with the bargaining
ability of the various divisional managers than with the information that they
possess. As a consequence, the budget process often fails in its most basic func-
tion—transferring information from one division to another.
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SECTION VI • Organizational Design290
This lack of information can cause problems. For example, if the Mar-
keting Division of the toy manufacturer lobbies successfully for a low sales
budget, the Manufacturing Division may produce too little of a popular item
just as the holiday season begins.
And the problems do not end there. Once the goal is set, a division may ac-
celerate sales or delay costs to make sure that it can meet the goal. For example, a
division’s managers may ship products near the end of the year and record these
shipments as sales. They do this even though they know that it is likely that the
items will be returned later. This is sometimes referred to as “channel stuffing.”
Alternatively, division managers who have already met their goals—or
those who know they have no chance of meeting their goals—may delay sales
or accelerate costs to make it easier to meet next year’s budget goals. And
these practices can generate real losses for the parent company. If, for exam-
ple, a division tries to persuade a customer to delay purchasing a new piece of
equipment, that customer might demand a discount or purchase from a rival
instead of waiting to place the order.
Basing rewards on achieving specific target levels of performance can cre-
ate problems. Let’s run this problem through our framework:
1. What is the problem? The budgeting process takes an enormous amount
of time and accurate information does not reach the CEO.
2. Do the divisions have enough information to fix the problem? Each divi-
sion has good information about how much individual division profit it
will likely earn.
3. Do they have the incentive to fix the problem? No. Each division has an
incentive to say that the budgeted profitability goal is too high, regardless
of whether this is true. Once budget goals are set, divisions have an incen-
tive to accelerate or delay profit, or to stop work once the goal is reached.
Figure 22.2 illustrates the problem for a fairly typical compensation
scheme that pays division managers a bonus when they reach a minimum
$75,000
$95,000
$115,000
$4 million $5 million
(Target)
Profit$6 million
To
ta
l C
o
m
p
en
sa
ti
o
n Compensation depends on
realizing a minimum profit
level. Managers have an
incentive to game the system
to reach the $4 million level.
Also, managers have no
additional incentives once
profit has reached $6 million.
FIGure 22.2 Typical Incentive Compensation Scheme
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Chapter 22 • Getting Divisions to Work in the F irm’s Best Interests 291
profit goal (e.g., a $20,000 bonus for reaching $4 million in profit). Note the
kink in the compensation scheme. This kink gives division managers an incen-
tive to lie about the information they have in order to make the goal easier to
reach.
Figure 22.3 shows a simple solution to this budget-gaming problem:
remove all kinks from the compensation schedule. Straight-line pay-for-
performance functions eliminate division managers’ incentives to lie about the
budget because compensation does not depend on meeting a particular budget
goal. Managers get rewards for doing more and punished for doing less, no
matter where they are relative to the budget target. This compensation scheme
eliminates managers’ incentives to lie about the budget.
$4 million Realized
Profit
Performance
Profit$6 million
Compensation
Level
To
ta
l C
o
m
p
en
sa
ti
o
n Compensation no longer
depends on realizing a
minimum profit level. With
no incentive to game the
system (pay is the same
whether profit was targeted
at $4 million or at
$6 million), budgets will be
more accurate and useful
in the planning process.
FIGure 22.3 A Better Compensation Scheme
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
• Companies are principals trying to get their
divisions (agents) to work profitably in the
interests of the parent company.
• Transfer pricing does not merely transfer
profit from one division to another; it can
stop assets from moving to higher-valued use.
Efficient transfer prices are set equal to the
opportunity cost of the asset being transferred.
• A profit center on top of another profit
center can result in too few goods’ being
sold; one common way of addressing this
problem is to change one of the profit cen-
ters into a cost center. This eliminates the
incentive conflict (about price) between the
divisions.
• Companies with functional divisions share
functional expertise within a division and
can more easily evaluate and reward divi-
sion employees. However, senior manage-
ment must often coordinate the activities of
the various divisions.
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SECTION VI • Organizational Design292
• An M-form or multidivisional structure has
divisions that perform all the functional
tasks to serve specific customer types or
geographic areas.
• When divisions are rewarded for reaching a
budget threshold, they have an incentive to lie
to make the threshold as low as possible, thus
ensuring they get their bonuses. In addition,
they will often pull sales into the present,
and push costs into the future, to make sure
they reach the threshold level. A simple linear
compensation scheme solves this problem.
Multiple-Choice Questions
1. A computer manufacturer has two divisions:
one serving residential customers and one
serving business customers. If an incentive
conflict arises between the two divisions, how
will overall company profits be affected?
a. Profits will definitely fall.
b. Profits will definitely rise.
c. Profits may fall, but it depends on the
nature of the conflict.
d. The conflict has no potential to affect
overall profit.
2. Which of the following changes might
help solve a divisional conflict regarding a
decision?
a. Change who has authority to make the
decision
b. Transfer information to the decision-
makers so they are better informed
c. Change the performance evaluation
and associated compensation of the
decision-makers
d. All of the above
3. Joe runs the Service Division for a car deal-
ership. The overall dealership has a profit
of $10 million on sales of $100 million and
costs of $90 million. Joe’s division contrib-
uted $9 million in sales and $7 million in
costs. If the Service Division is evaluated as
a profit center, what dollar amount is most
relevant to Joe?
a. $2 million
b. $7 million
c. $9 million
d. $10 million
4. If you were a manager of a cost center,
which of the following areas would be of
most interest to you?
a. Capturing potential economies of scale
b. Increasing the quality of your product
c. Hiring more marketing staff to figure
out how to increase prices
d. Adding additional features to your
product
5. Transfer prices should be set at
a. marginal cost of the selling division
plus a reasonable profit amount.
b. marginal cost of the selling division
unless it is evaluated as a profit center.
c. the opportunity cost of the asset being
transferred.
d. whatever price is negotiated between
the selling and buying divisions.
6. Which type of organizational form has the
benefit of closer coordination to serve a
particular product or geographic area?
a. Profit centers
b. Functional organizations
c. M-form organizations
d. Functional and M-form organizations
have the same benefits
7. Which of the following provides an exam-
ple of divisions based on a functional orga-
nizational structure?
a. Americas, Africa, Asia, Europe
b. Research and development, produc-
tion, finance, marketing
c. Youth products, teen products, senior
products
d. Business users, home users, educational
users
8. Which of the following organizational forms
requires the strongest management oversight
to ensure coordination of functions?
a. Profit centers
b. Functional organizations
c. M-form organizations
d. Functional and M-form organizations
likely require similar oversight
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Chapter 22 • Getting Divisions to Work in the F irm’s Best Interests 293
9. Which of the following actions is consis-
tent with a manager whose compensation
depends on meeting a budget goal and who
does not believe he can make that goal?
a. Asking a vendor to preship and invoice
materials for the following year.
b. Discovering a “problem” in the or-
der-taking process, thereby forcibly
pushing sales into the ensuing year.
c. Increasing accounting reserve esti-
mates, leading to higher recognized
expenses.
d. All of the above.
10. One of the basic functions of the budgeting
process is
a. assigning decision rights.
b. transferring information.
c. evaluating managerial performance.
d. implementing structural change.
Individual Problems
22-1 Transfer Pricing
Suppose that a paper mill “feeds” a down-
stream box mill. For the downstream mill, the
marginal profitability of producing boxes de-
clines with volume. For example, the first unit
of boxes increases earnings by $10, the second
by $9, the third by $8, and so on, until the tenth
unit increases profit by just $1. The cost the up-
stream mill incurs for producing enough paper
to make one unit of boxes is $3.50.
a. If the two companies are separate profit
centers, and the upstream paper mill sets
a single transfer price (the price the box
company pays the paper mill), what price
will it set, and how much money will the
company make?
b. If the paper mill were forced to transfer at
marginal cost, how much money would the
company make?
22-2 Transfer Prices Set by Headquarters
List three reasons why it might be a bad idea
to have corporate headquarters set transfer
prices.
22-3 Chargebacks
Your local fast-food chain with two dozen
stores uses the company’s internal corporate
marketing department to produce signage,
print ads, in-store displays, and so forth. When
placing an order, store managers are assessed a
chargeback (transfer price) that reduces store
profitability but increases marketing depart-
ment profitability. Lately, the store managers
have been ordering more and more marketing
services; the marketing department is swamped,
and it cannot afford to hire more staff. What
does this indicate about the chargeback rates?
22-4 Divisional Profit Measure
Discuss the advantages and disadvantages of
using divisional profit as the basis of incentive
compensation for division managers compared
to using company profit as the basis.
22-5 Furniture Forecasting
Futura Furniture Products manufactures up-
scale office furniture for the “Office of the
Future.” The sales division comprises region-
ally based sales offices made up of sales rep-
resentatives and regional managers. Sales
representatives—who report to the regional
managers—conduct direct sales efforts with
customers in their regions. As part of the sales
process, representatives gather information
about likely future orders and convey that in-
formation back to the regional managers. Re-
gional managers use that information to create
sales forecasts, which are then used as the basis
for manufacturing schedules.
Sales representatives and regional managers are
both compensated on a salary plus commission
(percentage of revenue as pricing is centrally
controlled). However, a regional manager’s
commission is adjusted based on regional sales
that exceed the forecasted budget.
Corporate managers are concerned with one
of Futura’s key products, the “DeskPod.” They
worry that DeskPod forecasts are inaccurate,
causing extreme havoc in the manufacturing
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SECTION VI • Organizational Design294
process. How are the forecasts likely to be in-
accurate? What do you think is driving this in-
accuracy? How might this problem be solved?
22-6 Jet Turbine Design
This problem is mentioned in the text (see the
section on “Organizational Alternatives”). Your
task is to propose an organizational solution.
To briefly recap, a manufacturer is trying to
design the next generation of turbine engines
for jet airplanes. The company is divided along
functional lines. Engineering designs the engine,
production manufactures it, and finance figures
out how much to charge for it. The engineers
invented a radical new design that used hollow
fan blades. The award-winning design used less
fuel than conventional engines, but the hollow
fan blades were very difficult to build. When the
Finance Division computed the marginal cost of
an engine, it discovered that the new engines
were much more expensive than rival engines,
even accounting for the expected fuel savings.
No one purchased the engine. How would you
make sure that this problem does not recur?
Group Problems
G22-1 Transfer Pricing
Does your company use transfer pricing to
“charge” divisions for the cost of the prod-
ucts they consume? Are these prices set equal
to the opportunity cost of the product? Why
or why not? Can you think of a better orga-
nizational architecture? Compute the profit
consequences of changing the organizational
architecture.
G22-2 Divisional Evaluation
Discuss a division or subunit of your organi-
zation and how it is evaluated (revenue center,
profit center, cost center, etc.). How does the
evaluation scheme affect performance? If it is
optimal, explain why. Otherwise, explain why
you think it is suboptimal, and recommend
what you would do if you were free to change
it. Compute the profit consequences of the
change.
G22-3 Budget Games
Does your company tie compensation to meet-
ing a budget? If so, what kind of problems
does this practice cause? What can you do to
fix these problems? Compute the profit conse-
quences of changing the process.
G22-4 Functional Silos versus Process Teams
Is your company organized around functional
divisions? If so, what kind of problems does
this cause? What can you do to fix these prob-
lems? Compute the profit consequences of fix-
ing the problem.
1. Using this solution would also require that
you make sure senior management has the
correct incentive to set a good transfer price.
2. This solution would also expose the manag-
ers to additional risk, likely requiring addi-
tional compensation.
3. See Mikhael Shor and Hui Chen, “Decen-
tralization, Transfer Pricing and Tacit Collu-
sion,” Contemporary Accounting Research
26, no. 2 (2009): 581–604.
4. For one example of the challenge
of organizing economists, see Luke
M. Froeb, Paul A. Pautler, and Lars-
Hendrik Roller, “The Economics of
Organizing Economists,” Antitrust Law
Journal 76 (2009): 569–584.
5. This section was inspired by the ideas of
Michael Jensen, “Paying People to Lie: The
Truth about the Budgeting Process,” HBS
Working Paper 01-072, September 2001.
An executive summary of this paper entitled
“Corporate Budgeting Is Broken, Let’s Fix
It” was published in the Harvard Business
Review November (2001).
EnD nOTES
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295
When Jacques Papillon was appointed marketing manager for Argent
Tobacco, one of the first things he did was commission a study of retail prices
in the drugstores, supermarkets, and convenience stores that sold Argent cig-
arettes. What he found was disturbing. Whenever Argent reduced the whole-
sale price in order to promote its brand, fewer than half of the retail outlets
responded with price cuts of their own. Instead, most retail outlets “ate” the
price reduction, which increased retail profit but did nothing for Argent’s sales
or profitability.
M. Papillon traced the source of the problem to an incentive conflict
between Argent, who is interested in the profit from sales of its own brand,
and retailers, who are trying to maximize profit from sales of all the brands
they carry. In other words, when a customer comes into a store, Argent wants
the customer to purchase Argent’s brand, while the retailer is content if the
customer purchases any brand. As a consequence, retailers were reluctant to
“pass through” Argent’s price reductions because doing so would cannibalize
sales of other brands they carried.1
As you should now be able to recognize, this is a type of a principal–agent
conflict (Chapter 21) caused by moral hazard (Chapter 20). The manufacturer
is the principal, the retailer is the agent, and the principal finds it difficult to
control the pricing behavior of the agent. If the manufacturer could figure out
which price the retailer should charge, it would be a simple matter to write a
contract, offering the wholesale price reduction in exchange for a reduction
in the retail price. The problem for Argent was that there were thousands of
different retail outlets, each with different pricing strategies and each facing
different demand elasticities. M. Papillon couldn’t write and enforce contracts
specifying a discount off the regular price because he didn’t know what the
regular price should be. He came up with a clever solution. In the contract, he
specified the “regular” price as the price of Argent’s closest rival brand. So, for
example, when Argent reduced the wholesale price by two cents, the retailer
would have to reduce the retail price of Argent by two cents below the retail
23
Managing Vertical
Relationships
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SECTION VI • Organizational Design296
price of the rival brand. This contract gave each retail outlet the flexibility to
set the overall level of prices according to the demand they faced, while find-
ing a way to get wholesale price discounts passed through to Argent’s retail
price. The contract raised the profit from selling and promoting Argent ciga-
rettes, which was shared between Argent and its retailers.
This kind of incentive conflict between firms in the same vertical supply
chain is quite common. This chapter is about how vertically related firms use a
variety of informal and formal measures, like the Argent Tobacco contract, to
control the incentive conflict to increase profit. We also discuss tax avoidance,
and end the chapter with a discussion of the legal (antitrust) and financial con-
cerns associated with vertical relationships.
23.1 How Ver tical Relationships Increase Profit
To illustrate how a variety of contractual or organizational forms can increase
profit in a vertical supply chain, let’s return to the simple example of rent
control. Suppose a rent-controlled apartment has a price ceiling of $1,000,
meaning that city regulations limit the rent to less than $1,000 per month. If
a renter is willing to pay $1,500 per month, the landlord has an incentive to
evade the price regulation by bundling the apartment, say, with overpriced
furniture or by tying furniture rental to the apartment rental. In the first case
(bundling), the landlord offers a “furnished apartment” for $1,500; in the
latter (tying), the landlord requires the renter to rent furniture from the land-
lord for an additional $500.
The general principle behind the profit-increasing effects of vertical con-
tracts is easy to articulate:
If unrealized profit exists at one stage of the vertical supply chain, firms
can capture some of the unrealized profit by adopting a variety of con-
tractual or organizational forms.
In the opening story, the unrealized profit is a consequence of incentive
conflict between the upstream manufacturer and downstream retailers. In the
apartment example, unrealized profit is a consequence of the price regula-
tion. You can think of “furnished housing” as our vertical supply chain, which
comprises two links, apartment rental and furniture. The solutions (tying or
bundling) are contractual links that allow the landlord to extract some of the
unrealized profit.
Exclusion can accomplish the same thing. If a building owner can make it
costly or difficult for rival furniture sellers to sell to the tenant (by “excluding”
them), the tenant is forced to purchase or rent furniture from the landlord.
The landlord can then capture some of the unrealized profit through the sale
of overpriced furniture.
Regulators usually anticipate these strategies and often require unbundled
pricing, or they make it illegal to tie the sale of a regulated good to the sale of
an unregulated one. To thwart exclusionary tactics, regulators mandate access
for rival sellers, but this is often difficult to enforce.
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Chapter 23 • Managing Vertical relationships 297
Like regulatory evasion, multinational companies can use vertical inte-
gration to evade national profit taxes. A company manufacturing shirts in
Mexico, for example, can transfer the shirts at a low price to a sister division
located in the Cayman Islands, where they are marked up and shipped to the
United States for sale to final consumers. The company reduces its tax burden
by choosing to realize most of its profit in the Cayman Islands, which has
lower taxes than Mexico or the United States.
Regulators in Mexico anticipate this strategy and force goods to be trans-
ferred at a price at least 5% over cost. This forces the company to realize at
least some of its profit in Mexico.
23.2 Double Marginalization
The price paid to an upstream supplier is viewed by the downstream pur-
chaser as part of its marginal cost (MC). Unless the upstream supplier prices
at MC, the price of the downstream product will include multiple, successive
markups. This is commonly referred to as “double marginalization” because
the downstream firm sets prices where marginal revenue (MR) equals MC
plus the supplier’s markup. These successive markups result in prices that are
too high (where MR , MC), higher than would maximize profit for the whole
supply chain. This becomes a larger problem when both firms have more mar-
ket power and each markups is larger. This is similar to the incentive conflict
that occurs over transfer pricing (covered in Chapter 22).
If two “links” in this supply chain were to merge, they could increase
total profit by coordinating their pricing. For example, the merged form could
operate the downstream division as a profit center and convert the upstream
division to a cost center, and transfer the input at MC. This would increase
profit because the downstream firm would price at the optimal point, where
MR 5 MC. Many vertical contracts aim to achieve the same end, reducing
the price charged by the downstream firm, and sharing part of its profit with
the upstream firm. Vertical contracts that aim to decrease final prices typically
benefit all parties in the supply chain as well as the consumer.
23.3 Incentive Conflicts between Retailers and Manufacturers
Double marginalization is but one example of incentive conflict in a verti-
cal supply chain. There are many others. In this section, we look at incen-
tive conflict between manufacturers (the upstream supplier) and retailers (the
downstream purchaser) over quality, promotion, advertising, and new product
introduction. Both the manufacturer and retailer have an incentive to control
these conflicts to increase the size of the profit “pie” that they split.
Quality Control
A manufacturer of perishable food may want her product kept fresh and at
a controlled temperature. If not kept fresh, a consumer might mistakenly
attribute an unsatisfying experience with the brand (at least partly) to the
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SECTION VI • Organizational Design298
manufacturer. This would harm the manufacturer’s reputation and reduce sales
across all retailers that carry the brand. This incentive conflict arises because
the retailer does not bear the full cost of the consumer response and may not
have sufficient incentive to invest in refrigeration and inventory management.
Recognizing this possibility, a manufacturer might “give” a refrigerator to the
retailer to guarantee freshness. The gift might come with the stipulation that
the retailer keep at least 60% of the refrigerator shelf space stocked with the
manufacturer’s product.
The same concern with quality control arises between manufacturers of
copy machines and the firms that service them. If a machine breaks down, a
consumer might mistakenly infer that it is due to faulty design or manufacture
when, in fact, it is due to faulty service. To better protect its reputation, the
manufacturer might “bundle” service with the sales of the machine, or try to
“exclude” any but its own qualified technicians from servicing and repairing
the machines. It can do this by refusing to provide diagnostic software and
spare parts to third-party firms that service the machines.2
Promotional Activities
Advertising, service, promotion activities, and higher-quality service can
increase customer interest, awareness, and sales. However, since the retailer
earns only a fraction of the revenue from these sales, the retailer often does
not have sufficient incentive to invest in these important demand-enhancing
activities.3
To see this, consider a customer who adopts a new brand of cigarettes as a
result of the promotional efforts of a retailer. This consumer will subsequently
purchase the brand from many different retailers, and each of those sales ben-
efits the manufacturer, but not the original retailer. Since the original retailer
fails to realize the full benefits of its promotional activities, it will underinvest,
at least from the manufacturer’s point of view, and this reduces both their
profit.
Consider, for example, an investment of $5,000 in a display cabinet that
returns $8,000 of additional profit. Clearly, this is a profitable investment.
However, if the profit is divided equally between the retailer and manufac-
turer, neither would have the incentive to make the investment on its own
because each would realize only a benefit of $4,000 but pay a cost of $5,000.4
Vertical contracts can provide the retailer with incentive to undertake these
costly activities.
“Free Riding” among Retailers
Another reason why retailers do not find it profitable to engage in promo-
tional activities is the ability of competing retailers to “free ride” on these
efforts. If a retailer invests in promotional activities, displays, or expensive
storage, the consumer is provided with a higher-quality product and a better
ability to choose. However, since these activities are costly, a retailer that pro-
vides these services would need to charge a higher price than a retailer that
does not. Retailers are reluctant to invest in these activities if they risk losing
customers to lower-service rivals, who sell at lower prices.5
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Chapter 23 • Managing Vertical relationships 299
As an example, consider PING golf clubs. PING wants its retailers to spend
considerable time and effort custom-fitting clubs to individual customers.
But discount retailers can tell consumers to visit a full-service retailer to get
a custom-fitting session, and then bring the specifications back to the dis-
counter for a lower price. This kind of “free riding” by the discounters on
the custom-fitting efforts of the full-service retailers weakens the incentive of
full-service retailers to perform these services.6
Vertical contracts can often overcome this problem. For example, award-
ing retailers exclusive territories prevents consumers from going to discount-
ers in the same area. Although these agreements can lead to higher prices (in
accordance with service, quality, and promotional activity), they also result in
higher sales, suggesting that consumer awareness and willingness to pay are
both increased.7 Recently the Supreme Court ruled that it may be okay for
manufacturers like PING to set minimum retail prices to prevent this kind of
free riding. This limits free riding from discounters because they are prohibited
from selling at lower prices. However, in some U.S. states, and in foreign juris-
dictions, contracts specifying retail prices are still illegal.
New Product Introduction
A similar kind of incentive conflict between retailers and manufacturers sur-
rounds the introduction of new products. It is often quite costly to introduce
and promote a new product. Sufficient resources must be invested in promo-
tional pricing, advertising, and customer education. Ability to free ride on
these investments by rival retailers reduces retailer incentives to invest in new
products. Additionally, retailers often have very little information about a new
product’s sales prospects, while manufacturers, having invested in market
research, are better informed. Various forms of vertical agreements reward the
retailer for incurring the risk inherent in introducing a new product and the
cost of managing an expanded inventory. Further, large lump-sum payments
from the manufacturer to the retailer sometimes serve as a credible “signal”
because only a manufacturer who believes in the likely success of her product
would be willing to make such a payment.8
23.4 Price Discrimination
By itself, the upstream manufacturer cannot implement a price discrimina-
tion scheme against downstream consumers because downstream retailers can
defeat it. To see this, suppose that home gardeners and farmers both use the
same herbicide. Home gardeners are willing to pay $5 for a one-liter spray
bottle ($5 per liter), whereas farmers are willing to pay $600 for a 200-liter
barrel ($3 per liter).
If the manufacturer tries to price discriminate (by pricing at $5 per liter to
home retailers and $3 per liter to farm retailers), the farm retailers could buy
herbicide in 200-liter barrels, put it in small spray bottles, and sell it to home
gardeners. By vertically integrating into retail operations, the manufacturer
can prevent this kind of arbitrage. Note that the manufacturer has to integrate
only into low-price retailing to accomplish this.
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SECTION VI • Organizational Design300
Use Vertical Integration When Contractual Solutions
Aren’t Enough
Sometimes, you can control the conflict only by buying your upstream sup-
plier or downstream customer. By putting the two firms under the same cor-
porate “roof,” you eliminate the incentive conflict, but you also create a bigger
firm that is more difficult and costly to manage. In addition, new incentive
conflicts can appear in different parts of the organization. For example, if a
manufacturing firm buys a retail outlet, and operates it as a separate profit
center, the incentive conflict between two separate firms becomes a conflict
between two separate divisions of the same company. These conflicts were
covered in Chapter 22.
23.5 Antitrust Risks
Most countries have antitrust laws governing vertical relationships between
firms in the same vertical supply chain. The laws are generally focused on two
types of anticompetitive risks. The first is that a dominant firm at one level of
the supply chain will use vertical contracts to extend its market power to other
levels of the supply chain. The second is that vertical contracts will reduce the
intensity of competition and harm consumers. In the case of Argent Tobacco,
for example, a competition agency sued Argent and its retailers because it
thought that the contracts reduced the intensity of price competition among
cigarette manufacturers. Eventually, Argent was exonerated by a court, but
only after a long and costly trial.
It is instructive to compare the effects of horizontal agreements (like
those between two retailers or two manufacturers) and the effects of verti-
cal agreements. Horizontal agreements generally run contrary to the goals
of consumers because they eliminate competition between firms selling sub-
stitute products, and this often results in higher prices. Vertical agreements,
on the other hand, as seen earlier, are typically undertaken to control incen-
tive conflict and reduce the costs of the firms that use them. In this way,
they are much like agreements between firms producing complementary
products, which often result in lower prices. What this means is that the
antitrust risks from vertical restraints are typically smaller than those from
horizontal agreements. But these risks are not negligible, especially for big
or dominant firms.
For example, European authorities have prohibited Coke from purchas-
ing refrigerators for retail outlets (a demand-enhancing investment) because
the practice may exclude rival soft drink manufacturers from retail outlets
that use Coke’s refrigerators. In the United States, Dentsply has been con-
victed of excluding rival tooth manufacturers from its dealer distribution
network, which forces rivals to use less efficient and higher cost ways of
distributing their product. Similarly, 3M has been convicted of unfairly
using discounts to encourage retailers to carry only 3M products. Again this
makes it more costly for rival manufacturers to get into retail outlets that
carry 3M products.
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Chapter 23 • Managing Vertical relationships 301
These practices are called abuse of dominance in Europe and monopoli-
zation or exclusion in the United States. Even though these practices can help
manage incentive conflict, and thus reduce costs, they can also harm com-
petitors, and sometimes consumers. To avoid running afoul of these laws, we
repeat the following advice taken on antitrust law:
If you have significant market power, you should consider the effect any
planned action will have on competitors.9
If your plans are likely to hurt your competitors, be sure that such a harm
is a by-product of actions that have a sound business justification. These laws
are in a state of flux right now, so be sure to seek legal counsel if your firm is
dominant in your market and you are considering adopting contracts or prac-
tices that would disadvantage your competitors.
23.6 Do Buy a Customer or Supplier Simply Because
It Is Profitable
We end this chapter with a warning—one that most of you will forget when
you have the opportunity to buy a profitable customer or supplier.
Purchasing a profitable upstream supplier or downstream customer will
NOT necessarily increase profit.10
Rather, it depends on what price you pay. The current owners know how
much the company is worth, so you’ll be paying a price exactly equal to the
value of the company’s discounted future profits. In addition, adverse selection
is a potential problem because current owners typically have better informa-
tion about the value of the firm than do potential buyers. They are likely to
sell only when a buyer offers too much.
Without some kind of synergy that makes an asset more valuable to the
buyer than it is to current owners, the acquisition will not be profitable. Based
on the stock price reactions following acquisition announcements, it appears
that about half of all corporate acquisitions are unprofitable. The sharehold-
ers of the acquired firm gain a little, but the shareholders of the acquiring firm
typically lose a lot.
However, even if acquisitions turn out to be unprofitable, this doesn’t
necessarily mean that acquiring the company was the wrong thing to do at
the time of the acquisition. In 1999, for example, AT&T purchased the cable
assets of Tele-Communications, Inc. (TCI), for $97 billion, anticipating that
the acquisition would allow them to offer local telephone service through TCI’s
cable lines. Three years later, the technology failed to develop as expected,
so AT&T sold the old TCI cable assets to Comcast for $60 billion. AT&T
purchased the company because it anticipated a synergy. After that synergy
failed to materialize, it sold the assets and moved on. A lesser firm might have
held onto the assets to avoid the embarrassment of publicizing a $37 billion
mistake—a version of the sunk-cost fallacy.
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SECTION VI • Organizational Design302
SUMMARY & HOMEWORK PROBLEMS
Summary of Main Points
• If unrealized profit exists at one stage of the
vertical supply chain—as often happens as
a consequence of incentive conflict—a firm
can capture some of the unrealized profit
by integrating vertically, tying, bundling, or
excluding competitors.
• Double marginalization problems occur
in supply chains because the same input is
marked up multiple times. Vertical integra-
tion or price contracts that keep marginal
input prices closer to MC will raise total
profit.
• Manufacturers typically want higher-qual-
ity, lower retail prices, higher sales effort,
and higher levels of promotional activity
than retailers want to provide. Manufactur-
ers and retailers use a variety of formal and
informal agreements to more closely align
the incentives of retailers with the profit-
ability goals of manufacturers.
• Vertical integration can facilitate down-
stream price discrimination schemes.
• Most countries have antitrust laws that
regulate vertical relationships. To avoid
running afoul of these laws, remember that
if you have significant market power, you
should consider the effect that any planned
action will have on competitors.
• Do not purchase a customer or supplier
merely because that customer or supplier
is profitable. There must be a synergy that
makes it more valuable to you than it is to
its current owners. And do not overpay.
Multiple-Choice Questions
1. Alpha Industries is considering acquiring
Foxtrot Flooring. Foxtrot is worth
$20 million to its current owners under
its existing operational methods. Because
there are some opportunities for synergies
between the two companies, Alpha believes
that Foxtrot is worth $25 million as part
of Alpha Industries. What do you predict
for a sales price of Foxtrot?
a. Less than $20 million or Alpha will
not buy
b. More than $25 million or Foxtrot will
not sell
c. Something between $20 and $25
million
d. The different valuations make a sale
very unlikely
2. All of the following provide a motive for
vertical agreements except
a. effective execution of price
discrimination.
b. elimination of free riding among
retailers.
c. quality control.
d. diversification.
3. Which of the following is an example of
vertical integration?
a. A custom software company
purchasing a competing software
firm
b. A soft drink producer buying a brand
of iced tea
c. A coal producer purchasing a nuclear
power plant
d. A gourmet cheese company purchasing
a dairy
4. Why are contact lens manufacturers
reluctant to sell their lenses through the
Internet?
a. The Internet price is too high due to
double marginalization.
b. Search costs are lower, so the Internet
sales are too competitive.
c. Doing so reduces the incentives of
retailers to provide point-of-sale
services.
d. They are afraid of antitrust lawsuits.
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Chapter 23 • Managing Vertical relationships 303
5. In which of the following instances would
an acquisition make the most sense?
a. The target is a very profitable
company.
b. Synergies exist between the acquirer
and the target.
c. Integration costs are low between the
two.
d. Synergy benefits outweigh the costs of
integration.
6. Why do vertical agreements typically
pose less antitrust risk than horizontal
agreements?
a. Vertical agreements occur less often
than horizontal agreements.
b. Vertical agreements often result in
lower prices, which are beneficial to
the consumer.
c. Vertical agreements are rarely profitable.
d. Vertical agreements do not pose
less antitrust risk than horizontal
agreements.
7. CUS Pharmacy wishes to carry Pepgro blue
pills. But Daisy Pharmaceuticals, the maker
of Pepgro, will not supply CUS unless CUS
agrees to carry other medications that
Daisy makes. This is an example of
a. exclusion.
b. tying.
c. territory restriction.
d. bundling.
8. A multinational firm acquires many of its
components preassembled from suppliers.
One of these suppliers operates in a coun-
try with a much lower corporate income
tax rate. How does this affect the vertical
relationship between this supplier and the
multinational?
a. This will not affect the relationship.
b. The multinational should stop working
with the supplier.
c. The multinational should consider pur-
chasing this supplier.
d. The multinational should move all
its operations to the supplier’s home
country.
9. In which of the following cases might you
expect to find a manufacturer granting
exclusive territories?
a. A pet supply chain that requires heavy
local advertising to drive sales
b. Custom computer sales that require a
good deal of consultation
c. A submarine sandwich chain that relies
on its nationwide brand reputation
d. All of the above
10. Local Spanish TV markets cater to
individual cities by producing local content.
This content can be produced in-house by
a network or they can also purchase rights
to third-party produced content. Recently,
Spanish cities have erected barriers to entry
in television content production that allows
content producers more market power.
How would this have affected vertical
integration between content providers and
TV networks?
a. There is more vertical integration to
limit arbitrage by price discriminating
content producers.
b. There is less vertical integration because
point-of-sale services are less important.
c. There is more vertical integration to
reduce the double marginalization
problem.
d. There is less vertical integration because
evading regulation is less important.
Individual Problems
23-1 Local Phone Companies
State utility commissions typically regulate local
phone companies, but local phone companies
also offer long-distance service to their custom-
ers. Rival long-distance carriers also connect
to local phone lines to provide long-distance
service to customers. Recently, the rival long-
distance carriers have complained that the local
phone company repair persons have put peanut
butter on rival long-distance carriers’ phone
lines to encourage rats to eat through the lines.
If true, why is this a profitable strategy?
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SECTION VI • Organizational Design304
23-2 Integration of Physician Groups and
Testing Services
Under a proposed health-care reform, doctors’
fees will be capped at 80% of their current rate,
but doctors can order blood tests that will be
reimbursed at 90% of the current rate. How
does vertical integration of physician groups
into testing services increase profits?
23-3 Online Cosmetics
Australian cosmetics maker, Eternal Beauty
Products, pressures online retailers to either sell
goods at prices charged by brick and mortar
stores or risk being cutoff. If online retailers are
paying the same wholesale prices, why would
Eternal not want online retailers to charge lower
prices?
23-4 Wedding Dresses
Stores that sell wedding dresses do not typi-
cally permit photos, and do not have tags in the
dresses that would identify the manufacturer
and style type. What is the purpose of these
rules? Suggest one other way of accomplishing
the same objective.
23-5 Herbicide Integration
Suppose the herbicide manufacturer mentioned
in the chapter can vertically integrate only into
home gardening retailing. Would this allow the
manufacturer to price discriminate?
23-6 Loyalty Payments
Intel made large loyalty payments to HP in
exchange for HP buying most of their chips
from Intel instead of rival AMD. AMD sued
Intel under the antitrust laws, and Intel settled
the case by paying $1.25 billion to AMD. What
incentive conflict was being controlled by these
loyalty payments? What advice did Intel ignore
when they adopted this practice?
Group Problems
G23-1 Managing Vertical Relationships
Identify a vertical relationship in your company
and determine whether it could be managed
more profitably by tying, bundling, exclusion,
or vertical integration. Clearly identify the
source of the profitability (e.g., regulatory eva-
sion, elimination of double markup, better goal
alignment, or price discrimination), and describe
how to exploit it. Estimate the change in profit.
G23-2 Undoing Vertical Relationships
Identify a vertical relationship in your com-
pany, and determine whether it could be man-
aged more profitably by outsourcing, untying,
unbundling, inclusion of rivals, or vertical dis-
integration. Clearly identify the source of the
profitability and describe how to exploit it.
Estimate the gain in profit from the change.
1. We have simplified the theory for this exam-
ple. In general, pass through depends not
only on how many other competing brands
a store carries, but also on things like the
curvature of demand. See Luke Froeb, Ste-
ven Tschantz, and Gregory Werden, “Verti-
cal Restraints and the Effects of Upstream
Horizontal Mergers,” in The Political
Economy of Antitrust, edited by Vivek
Ghosal and Johann Stennek (Amsterdam:
North-Holland Publishing, 2007). Available
at SSRN: http://ssrn.com/abstract5917897.
2. There may be some antitrust risks in doing
this as we discuss later in the chapter.
3. See Benjamin Klein and Kevin M. Murphy,
“Vertical Contracts as Contract Enforce-
ment Mechanisms,” Journal of Law and
Economics 31, no. 2 (1988): 265–296; and
Paul H. Rubin, “The Theory of the Firm and
the Structure of the Franchise Contract,”
END NOTES
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Chapter 23 • Managing Vertical relationships 305
Journal of Law and Economics 21, no. 1
(1978): 223–233.
4. See, for example, Benjamin Klein, “The
Economics of Franchise Contracts,” Journal
of Corporate Finance 2, no. 1–2 (1995):
9–37; and James C. Cooper, Luke M. Froeb,
Daniel P. O’Brien, and Michael G. Vita, “A
Comparative Study of United States and
European Union Approaches to Vertical Pol-
icy,” George Mason Law Review 13, no. 2
(2005): 289–308.
5. Brief of Amici Curiae Economists in
Support of Petitioner, et al., Leegin. v.
PSKS, 75 U.S.L.W.3207 (U.S. Nov. 3, 2006)
(No. 06-480) (On Writ of Certiorari to the
United States Court of Appeals for the Fifth
Circuit).
6. See brief of PING, Inc. as Amicus Curiae
in Support of Petitioner, Leegin Creative
Leather Prods., Inc. v. PSKS, Inc., 127 S.
Ct. 2705 (2007), at 9–15 (noting PING,
Inc.’s significant costs in operating a unilat-
eral RPM policy), available at: http://www
.abanet.org/antitrust/at-conversation/pdf/
Leegin_PING_Amicus .
7. See Tim R. Sass and David S. Saurman,
“Mandated Exclusive Territories and
Economic Efficiency: An Empirical Analy-
sis of the Malt-Beverage Industry,” Journal
of Law and Economics 36, no. 1 (1993):
153–177.
8. See Wujin Chu, “Demand Signalling and
Screening in Channels of Distribution,”
Marketing Science 11, no. 4 (1992):
327–347.
9. John Shenefield and Irwin Stelzer, The
Antitrust Laws: A Primer, 4th edition
(Washington, DC: AEI Press, 2001).
10. For more on this topic, see Luke Froeb,
“If Merger Is the Answer, What Is the
Question?” M&A Journal 41, no. 3
(March 2006), reprinted in Owen Manager
(2006) and in Proceedings of the I Lisbon
Conference on Competition Law and
Economics (Frederick, MD: Kluwer Law
International).
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307
24 Test Yourself
Wrapping Up
7Section
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309
The preceding chapters have given you some tools to solve business prob-
lems. In this chapter, we give you an opportunity to use these tools to solve a
set of problems faced by real businesses. After the question, pause and take a
couple of minutes to identify the source of the problem. Then propose a solu-
tion to fix it.
24.1 Should You Keep Frequent Flyer Points for Yourself?
When Jimmy and Evelyn founded a new restaurant, they purchased supplies
on company credit cards and used the points for personal travel. As the chain
grew, they brought in a second investor, and the three of them shared the
points among themselves, allowing them to purchase several business-class
tickets to Europe each year.
As the chain continued to grow, two more outside investors were brought
in. The new CFO who came with them insisted that the points be used only
for company-approved travel. The relationship between the founders and the
new shareholders began to sour, and, eventually, the new shareholders forced
a buyout of the founders and terminated their employment with the company.
Question: Was the new CFO justified in forcing out the original owners?
Answer: Using the points for personal travel was OK when they were
shared among the owners because they were essentially spending what they
already owned. But when the new owners were brought in, the founders were
spending the new shareholders’ money on themselves.
This should be an easy question, as it represents the principal/agent incen-
tive conflict of Chapter 21. The principals are shareholders, and their agents
are the employees of the company.
Test Yourself24
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SECTION VII • Wrapping Up310
But if you do not recognize that the CFO stopped what was essentially
theft, please read Milton Friedman’s article, “The Social Responsibility of
Business Is to Increase Profit.”1
24.2 Should You Lay Off Employees in Need?
Jorge Pine is a restauranteur who attributes success to three elements: great
food, great operations, and enough capital to support them. However, after
opening up a new restaurant, “Taco Love,” he noticed a problem with oper-
ations. The profit margin (net income divided by revenue) was only 5%, well
below the 20% required to cover the cost of capital.
After looking at the books, Jorge noticed that labor costs were unusu-
ally high. He spoke to his manager and discovered that she was reluctant to
send workers home when demand was low, as on rainy days. “They need the
money,” the manager explained, pointing out several workers who supported
young families, or sent money back to struggling parents in Mexico.
Question: What is the problem, and how do you fix it?
Answer: The cause of the problem is obvious: the manager was motivated
more by compassion for her fellow employees than by whatever incentive pay
scheme Jorge is using. An obvious solution would be to make her incentive
pay stronger but, in this case, Jorge found a better solution.
Jorge sat his manager down and said, “Look, if you do not hold costs down,
this restaurant won’t earn a profit, and my investors will not fund our next
one.” Jorge had plans to open three more “boxes” under the same brand name. 
Jorge continued, “Think about the families of the workers that I am not
going to be able to hire, and what is going to happen to them if you don’t earn
a profit.” The manager responded positively to Jorge’s talk, and now Taco
Love is so successful that Jorge plans to expand to other cities.
The moral of this story is still one of incentive alignment—successful busi-
nesses will find ways to give workers enough information to make good deci-
sions and the incentive to do so—but incentives include more than just money.
Great managers learn what motivates employees, and use that knowledge to
get them to do the right thing.
This story also illustrates: (i) the zero-sum fallacy (when the restaurant
makes more profit, workers also benefit), (ii) the consequentialist morality of
earning profit, and (iii) the hidden-cost fallacy (the manager ignored the hidden
cost of her initial decision—on the workers who were not going to be hired).
24.3 Manufacturer Hiring
When a manufacturing firm in South Carolina, Rivets & Bolts, Inc. (R&B),
hires assembly workers, it wants employees whose work ethic is strong. But
this is difficult to measure, so firms like R&B frequently hire workers who can
be best described as “shirkers.” Shirkers are difficult to manage and have high
1Milton Friedman, “The Social Responsibility of Business Is to Increase Profit,” New York Times Magazine, September 13, 1970.
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ChapTEr 24 • Test Yourself 311
absentee rates. Shirkers also reduce worker morale, which ultimately raises
production costs.
Question: How would you improve the quality of R&B’s workforce?
Answer: R&B’s human resources managers asked candidates to go
through a prehire process (24 hours of classes over eight days during a four-
week period). The HR managers told potential employees that this process
would be the final step before full-time employment and that candidates
would receive no pay for attending these classes. The candidates thought the
prehire classes were an orientation to the company; however, the firm used
the classes to screen out less motivated candidates. Candidates who missed
a class—or showed up late—were sent home and not allowed to return. On
average, R&B’s managers dismissed 2 from each class of 30 people. Overall,
this prehire screening has been very successful; the rate of bad hires has fallen
from about 8% to less than 1%.
This question sometimes confuses students because they tend to think about
shirking as moral hazard (Chapter 20), a post-contractual change in behavior
caused by the difficulty of observing employee effort. However, in this case, the
tendency to shirk is unobserved information about an employee’s “type” that
leads to the pre-contractual problem of adverse selection (Chapter 19).
Warning: This kind of screening may be illegal. Before trying something like
it, consult an attorney to ensure that you are in compliance with labor laws.
24.4 American Airlines
In 1992, American Airlines (AA), the market share leader in the airline
industry, announced a new pricing strategy—Value Pricing. AA narrowed
the number of possible fares from 500,000 to 70,000 by classifying each into
one of four classes (first class, coach, 7-day advance purchase, and 21-day
advance purchase). It also began pricing based on flight length.
According to AA, the purpose of Value Pricing was to create “simplicity,
equity, and value” in its prices. AA believed that Value Pricing would address
customer complaints, stimulate demand by lowering prices, increase market
share, and reduce costs by increasing load factors.
Question: Is this pricing program likely to be successful?
Answer: AA failed to anticipate its competitors’ reactions to this new pricing
plan. Competitors responded with aggressive price cuts, and industry profits
plummeted. The Value Pricing initiative was abandoned within months of its
launch. Had Robert Crandall, the CEO of AA at the time, understood the lessons
of game theory, a devastating industry price war might have been avoided.
Crandall should have tried a strategy that was less easily mimicked by his rivals.
24.5 Law Firm Pricing
In response to competitive pressure, a Chicago law firm (the “firm”) created
a program to move some of its best clients to a flat monthly fee instead of
traditional hourly billing. The clients received unlimited legal representation
in three practice areas: employment, litigation, and small transactional work.
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SECTION VII • Wrapping Up312
Clients wanted the flat-fee billing to better predict and control their
expenses, and the law firm thought it could profitably accommodate this
request by utilizing lower-cost and younger attorneys at the firm.
Question: How well did this program work?
Answer: The new program resulted in big losses for the law firm.
Predictably, clients requested more assistance on relatively trivial mat-
ters because the marginal cost (to the client) decreased to zero. Although the
requests and inquiries were minor on a case-by-case basis, in aggregate, they
represented a significant outlay of attorney time and expense.
Harder to predict was another change in clients’ behavior: they were less
likely to engage in preventative measures and were more aggressive in settle-
ment negotiations. For example, in the employment practices area, the clients
did not perform supervisor training with the same frequency as before and
were more confrontational when dealing with disgruntled employees—both
potential areas of risk for employment discrimination claims. This change in
behavior increased legal costs borne by the firm. After six months of losing
money on the program, the law firm ended it.
Note that this is a kind of moral hazard (Chapter 20) that is difficult to
control because it is hard to write a contract specifying exactly the kind of
behavior you would expect.
24.6 Should You Give Rejected Food to Hungr y Ser vers?
When customers order a meal at Taco Love, and what they receive isn’t what
was expected, they often send it back. If food gets returned, the restaurant has
a rule to prevent the cooks and servers from eating it. On its face, this seems
inefficient, as good food is discarded. Indeed, one of the managers at one of
Taco Love’s stores asked the new chief operating officer (COO) whether she
would change the rules to allow the manager to give food to his staff
Question: Should the new COO let the restaurant manager give rejected
food to his staff?
Answer: To answer the question, consider all the benefits and costs that
vary with the consequence of the rule (Chapter 3).
• The obvious benefit of giving food to hungry servers and cooks is that
you increase the attractiveness of working at the restaurant, which allows
you to reduce wages, or to attract higher-quality workers (the “compen-
sating wage differentials” of Chapter 9).
• However, the hidden cost of giving rejected food to the staff is that you
create incentives for hungry staff members to deliberately mess up orders
so they can get free food.
The new COO should also realize that if a restaurant has rules preventing
staff from eating rejected food, the previous COO must have thought that
the benefits of the rule were bigger than its costs. Unless the new COO has
evidence that the existing rule should be changed, it is probably best to keep
it as it is.
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ChapTEr 24 • Test Yourself 313
24.7 Managing Interest-Rate Risk at Banks
Banks are often functionally organized (Chapter 23), with a deposit division
responsible for gathering deposits, and a loan division responsible for making
loans. Banks make money by borrowing short (from depositors) and lending
long (to homeowners). If the short-term rates they pay to depositors (costs)
are lower than long-term rates they earn from mortgage loans (revenue), the
banks make money.
Banks are often tempted to reduce costs by reducing the maturity of depos-
its (short-term deposits pay lower rates) and to increase revenue by increasing
the maturity of loans (longer-term loans earn higher rates).
However, increasing the maturity on loans and reducing the maturity on
deposits increases interest-rate risk: if interest rates rise (as they did in the early
1980s), bank borrowing costs increase quickly as depositors demand higher
rates. However, revenue from loan payments does not increase at the same rate
because rates are fixed for longer maturity loans. A regional bank was surprised
to discover that it was exposed to a particularly high level of interest-rate risk.
Question: How could you better manage interest-rate risk at the bank?
Answer: Let’s start by looking at the incentive conflict between the two
divisions and the bank. The loan division raises its profitability by making
longer-term loans while the deposit division raises its profitability by accepting
shorter-term deposits. The resulting mismatch between the maturities of loans
and deposits exposes the bank to interest-rate risk.
Another way of thinking about the problem is that the bank has two goals
(increasing profit and reducing interest-rate risk), but it rewards each division
for only one of the goals (increasing profit). If you can measure interest-rate
risk, you can use it as a performance metric, and reward each division for
reducing it. For example, since risk is closely related to mismatch between
the maturities of the deposits and loans, you can reduce risk by rewarding the
deposit division for increasing the maturities of deposits (e.g., 10-year certif-
icates of deposit) and the loan division for decreasing the maturities of loans
(e.g., 15-year instead of 30-year mortgage loans).
This solution relies on the ability of senior management to recognize that the
two functional divisions are working at cross-purposes to each other and to adjust
performance metrics to more closely match the riskiness of loans and deposits.
Another solution would be to put the deposit and loan decisions in the
same division, and then tie division evaluation to interest-rate risk. This would
move the responsibility down from the firm level to the division level.
24.8 What You Should Have Learned
If you’ve read and understood this book, you should now know how to do the
following:
1. Use the rational-actor paradigm, to identify problems, and then fix them
2. Give employees enough information to make good decisions, and the in-
centive to do so (incentive alignment)
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SECTION VII • Wrapping Up314
3. Use benefit-cost analysis to make profitable decisions
4. Use marginal analysis to make profitable extent (how much) decisions
5. Make profitable investment and shutdown decisions
6. Set optimal prices and price discriminate
7. Predict and explain industry-level changes using demand-supply analysis
8. Understand the long-run forces that erode profitability
9. Develop long-run strategies to increase firm value
10. Predict how your own actions will influence rivals’ actions
11. Bargain effectively
12. Make decisions in uncertain environments
13. Solve the problems caused by moral hazard and adverse selection
14. Motivate employees to work in the firm’s best interests
15. Motivate divisions to work in the best interests of the parent company
16. Manage vertical relationships with upstream suppliers or downstream
customers
Now go forth and move assets to higher-valued uses.
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315
Can Those Who Teach, Do?
by Luke Froeb
I finished the first edition of this book while managing 110 employees in the
Bureau of Economics at the Federal Trade Commission. The experience taught
me much about management that isn’t in this book.
The government has no well-defined goals, few metrics to measure per-
formance, and no sticks or carrots to align employees’ incentives with organi-
zational goals. In addition, most federal employees are lifetime civil servants,
with better information and strong ideas about what the agency ought to be
doing. And they can easily outlast the political appointees who come to man-
age them for just a couple of years.
In this environment, the rational-actor paradigm predicts that government
employees would shirk or follow objectives of their own choosing. While this
was certainly true of some, others put in long hours and take pride in their
work. If you want to accomplish anything during a short government stint,
you have to identify these employees and motivate them to work toward a
common goal.
Before you can work toward a goal, you must have one. Set realistic goals
during annual or semi-annual meetings that review past performance and out-
line what you hope to accomplish in the future. Be as specific as possible with
timetables and measurable benchmarks. Refine and readjust your goals as new
information becomes available. If you discover that a goal has become too
costly to reach, drop it and replace it with another.
Constantly monitor progress toward your goals. Otherwise, subordinates
will infer that your priorities have changed and, as a consequence, stop work-
ing to achieve them. To guard against this, require weekly reports from them
or ask questions during weekly staff meetings to assure them that you still care
about what they’re doing. Remember that criticism is much easier to accept if
it is framed as a question, e.g., for a late report, simply ask “how is the report
coming?”
If the organizational structure is broken, fix it. Otherwise, respect the
organizational structure you have, that is, figure out what you can do that
no one else in the organization is capable of doing, and then do it. If you find
yourself doing something that your subordinates can do, stop. In particular, let
EpiloguE
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316
your subordinates manage their own people. If you jump over them to become
directly involved in specific matters, you’re implicitly telling them that you
don’t think they’re capable of doing their assigned jobs. Every time I did this, I
ended up creating more work for subordinates with no better outcome.
If you manage a functional division, meet with the managers of other
functional divisions to ensure cooperation and to resolve conflict. If you man-
age a divisional organization, make sure that you recognize and reward func-
tional expertise.
Manage yourself. Set goals, hold yourself accountable for meeting them,
and adjust them as circumstances change or as you learn more. Importantly,
do not let your inbox run your life. Put yourself on a schedule so that you do
the routine tasks at the same time every day, like answering e-mail. Otherwise
you can find yourself glued to your computer, putting out fires instead of ac-
complishing your goals.
Finally, learn to point the finger at yourself. When something goes wrong,
it is human nature to blame others and react with anger or frustration. Often,
however, it is more effective to try to understand the source of the problem
from the point of view of those involved. When you begin like this, more often
than not, the problem will resolve itself, as those involved come to understand
its cause. Or you may find that the problem lies with your own attitude or
assumptions, and not with other people’s behavior.
EpiloguE
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317
A
Accounting costs costs that appear on the
financial statements of a company.
Accounting profit profits as shown on a
company’s financial statements. Accounting
profit does not necessarily correspond to real
or economic profit.
Adverse selection refers to the fact that “bad
types” are likely to be selected in transactions
where one party is better informed than the
other. Examples include higher risk individuals
being more likely to purchase insurance, more
low-quality cars (lemons) being offered for sale,
or lazy workers being more likely to accept job
offers. Adverse selection is a precontractual
problem that arises from hidden information
about risks, quality, or character.
Agency costs costs incurred in principal–agent
relationships; these costs are associated with
moral hazard and adverse selection problems.
Agent a person who acts on behalf of another
individual (a principal). Principal–agent prob-
lems are created by the incentive conflict
between principals and agents.
Aggregate demand curve describes the buying
behavior of a group of consumers. We add
up all the individual demand curves to get
an aggregate demand curve (the relationship
between the price and the number of purchases
made by a group of consumers).
Arbitrage a means to defeat a price discrim-
ination scheme; it occurs when low-value
individuals are able to resell their lower-priced
goods to the higher-value group.
Average cost the total cost of production
divided by the number of units produced.
Avoidable costs costs that you get back if you
shut down operations.
B
Break-even price the price that you must
charge to at least break even (make zero
profit). It is equal to average avoidable cost
per unit.
Break-even quantity the amount you need to
sell to at least break even (make zero profit).
The formula (assuming that you can sell all you
want at price and with constant marginal cost)
is Q 5 F/(P 2 MC), where F is fixed costs, P is
price, and MC is marginal cost.
Bundling the practice of offering multiple
goods for sale as one combined product.
Buyer surplus the difference between the buy-
er’s value (what he is willing to pay) and the
price (what he has to pay).
C
Common-value auction in a common-value
auction, the value of the item being auctioned
is the same for each bidder, but no one knows
what it is. Each bidder has only an estimate
of the unknown value, and the value is the
same for everyone. In common-value auctions,
Glossary
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318 Glossary
bidders have to bid below their values in order
to avoid the winner’s curse.
Compensating wage differentials differences
in wages that reflect differences in the inherent
attractiveness of various professions or jobs
(once equilibrium has been reached).
Competitive industry competitive industries
are characterized by three factors: (1) firms
produce a product or service with very close
substitutes meaning demand is very elastic,
(2) firms have many rivals and no cost advan-
tage over those rivals, and (3) the industry has
no barriers to entry or exit.
Complement a good whose demand
increases when the price of another good
decreases. Examples include a parking lot
and shopping mall or a hamburger and a
hamburger bun.
Constant returns to scale when average costs
are constant with respect to output level.
Consumer surplus See Buyer surplus.
Contribution margin the amount that one unit
contributes to profit. It is defined as price–
marginal cost.
Controllable factor something that affects
demand that a company can change. Exam-
ples include price, advertising, warranties, and
product quality.
Cost center a division whose parent company
rewards it for reducing the cost of producing a
specified output.
Cross-price elasticity of demand the cross-price
elasticity of demand for Good A with respect
to the price of Good B measures the percentage
change in demand of Good A caused by a per-
centage change in the price of Good B.
D
Decreasing returns to scale See Diseconomies
of scale.
Demand curves curves that describe buyer
behavior and tell you how much consumers
will buy at a given price.
Difference-in-difference an estimator that
identifies the causal effect of a treatment, like
a special promotion, by comparing the peri-
ods before and after the treatment between
an experimental group and a control group.
The second difference is designed to remove
selection bias.
Direct price discrimination scheme a price dis-
crimination scheme in which we can identify
members of the low-value group, charge them
a lower price, and prevent them from reselling
their lower priced goods to the higher value
group.
Diseconomies of scale exist when average costs
rise with output.
Diseconomies of scope exist when the cost
of producing two products jointly is more
than the cost of producing those two products
separately.
E
Economic profit a measure of profit that
includes recognition of implicit costs (like the
cost of equity capital). Economic profit mea-
sures the true profitability of decisions.
Economies of scale exist when average costs
fall as output increases.
Economies of scope exist when the cost of pro-
ducing two products jointly is less than the cost
of producing those two products separately.
Efficient an economy is efficient if all assets are
employed in their highest-valued uses.
Elastic a demand curve on which percentage
quantity changes more than percentage price is
said to be elastic, or sensitive to price. If |e| . 1,
demand is elastic, where e is the price elastic-
ity of demand. If |e| 5 0, demand is perfectly
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319Glossary
inelastic while if |e| is infinite, demand is per-
fectly elastic. If |e| 5 1, demand is unit elastic.
English auction See Oral auction.
Exchange rate the price at which two different
currencies are exchanged, for example, ¥10 to
the dollar, or $.010 per yuan.
Exclusion the practice of blocking competitors
from participating in a market.
Extent decision a decision regarding how
much or how many of a product to produce.
F
First Law of Demand consumers demand (pur-
chase) more as price falls (i.e., demand curves
slope downward), assuming other factors are
held constant.
Five Forces a framework for analyzing the
attractiveness of an industry. Attractive indus-
tries have low supplier power, low buyer
power, low threat of entry, low threat of
substitutes, and low rivalry.
Fixed costs costs that do not vary with output.
Fixed-cost fallacy consideration of costs that
do not vary with the consequences of your
decision (also known as the sunk-cost fallacy).
Foreign exchange See Exchange rate.
Functionally organized firm a firm in which
various divisions perform separate tasks, such
as production and sales.
H
Hidden-cost fallacy occurs when you ignore
relevant costs, those costs that do vary with the
consequences of your decision.
I
Implicit costs additional costs that do not
appear on the financial statements of a
company. These costs include items such as the
opportunity cost of capital.
Incentives have two pieces: a performance
evaluation metric, like sales, profit, or invest-
ment return, and a reward scheme that rewards
better performance, like a bonus, the promise
of a promotion, or a commission. Perfor-
mance evaluation metrics can be objective or
subjective.
Incentive alignment or goal alignment occurs
when an employee has enough information to
make a good decision and the incentive to do so.
Incentive conflict a situation where parties
have different, competing goals. In agency rela-
tionships, the different goals of principals and
agents is an example of incentive conflict.
Income elasticity of demand measures the per-
centage change in demand arising from a per-
centage change in income.
Increasing returns to scale See Economies of
scale.
Indifference principle if an asset is mobile,
then in long-run equilibrium, the asset will be
indifferent about where it is used; that is, it will
make the same profit no matter where it goes.
Indirect price discrimination scheme a price
discrimination scheme in which a seller cannot
directly identify low- and high-value consum-
ers or cannot prevent arbitrage between two
groups. The seller can still practice indirect
price discrimination by designing products or
services that appeal to groups with different
price elasticities of demand.
Individual demand curve a curve that tells you
how much an individual consumer will buy at
a given price.
Inelastic a demand curve on which percentage
change in quantity is smaller than percentage
change in price is said to be inelastic, or insensi-
tive to price. If |e| , 1, demand is price inelastic
(where e is the price elasticity of demand).
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320 Glossary
Inferior goods for inferior goods demand
decreases as income increases.
Interest the cost that creditors charge for use
of their capital.
L
Law of diminishing marginal returns as you
try to expand output, your marginal produc-
tivity (the extra output associated with extra
inputs) eventually declines.
Learning curves a phenomenon in which expe-
rience leads to learning meaning that current
production lowers future costs.
Long-run equilibrium when firms are in
long-run equilibrium, economic profit is zero
(including the opportunity cost of capital),
firms break even, and price equals average
cost (i.e., no one wants to enter or leave the
industry).
M
Marginal cost the additional cost incurred by
producing and selling one more unit.
Marginal profit the extra profit from produc-
ing and selling one more unit (MR − MC).
Marginal revenue the additional revenue
gained from selling one more unit.
Market equilibrium the price at which quan-
tity supplied equals quantity demanded.
Mean reversion suggests that performance
eventually moves back toward the mean or
average.
M-form firm a company whose divisions per-
form all the tasks necessary to serve customers
of a particular product or in a particular geo-
graphic area (also known as a multidivisional
company).
Monopoly a firm that is the single seller in
its market. Monopolies have market power
because they produce a product or service
without close substitutes, they have no rivals,
and barriers to entry prevent other firms from
entering the industry.
Moral hazard post-contractual increases
in risky or negative behavior. Examples are
reduced incentive to exercise care once you
purchase insurance and reduced incentives to
work hard once you have been hired. Moral
hazard is similar to adverse selection in that it
is caused by information asymmetry; it differs
in that it is caused by hidden actions rather
than hidden types.
Movement along the demand curve change in
quantity demanded in response to change in
price.
N
Nash equilibrium a pair of strategies, one for
each player, in which each strategy is a best
response against the other.
Nonstrategic view of bargaining a view that
does not focus on the explicit rules of the game
to understand the likely outcome of the bar-
gaining. This view says that the likely outcome
of bargaining is determined by each player’s
gains to agreement relative to alternatives
to agreement. Sometimes called “axiomatic
bargaining” or “Nash bargaining.”
Normal (goods) for normal goods, demand
increases as income increases.
NPV rule if the present value of the net cash
flows is larger than zero, the project is profit-
able (i.e., earns more than the opportunity cost
of capital).
O
Opportunity cost the opportunity cost of an
alternative is the profit you give up to pursue it.
Oral auction in this auction type, bidders
submit increasing bids until only one bid-
der remains. The item is awarded to the last
remaining bidder.
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321Glossary
P
Perfectly competitive industry See Competitive
industry.
Post-investment hold-up an attempt by a trad-
ing partner to renegotiate the terms of trade
after one party has made a sunk cost invest-
ment or investment specific to the relationship.
Price ceilings price controls that outlaw trade
at prices above the ceiling.
Price control a regulation that allows trade
only at certain prices.
Price discrimination the practice of charging
different people or groups of people different
prices that are not cost justified.
Price elasticity of demand (e) a measure of
how responsive quantity demanded is to
changes in price. Formula: (% change in quan-
tity demanded) 4 (% change in price).
Price floors price controls that outlaw trade at
prices below the floor.
Principal an individual who hires another (an
agent) to act on his or her behalf.
Prisoners’ dilemma a game in which conflict
and cooperation are in tension; self-interest
leads the players to outcomes that no one likes.
It is in each player’s individual interest to not
cooperate regardless of what the other does.
Thus, both players end up not cooperating.
Their joint interest would be better served,
however, if they could find a way to cooperate.
Profit center a division whose parent company
evaluates it on the basis of the profit it earns.
R
Randomized Experiment of observations to
treatment and control groups is designed to
eliminate selection bias, any systematic differ-
ence between the two groups.
Random variables a variable whose val-
ues (outcomes) are random and therefore
unknown. The distribution of possible out-
comes, however, is known or estimated.
Random variables are used to explicitly take
account of uncertainty.
Rational–actor paradigm this paradigm says
that people act rationally, optimally, and
self-interestedly.
Relationship-specific investments See Specific
investments.
Relevant benefits all benefits that vary with the
consequence of a decision.
Relevant costs all costs that vary with the con-
sequence of a decision.
Risk premium higher expected rates of return
that compensate investors in risky assets. In
equilibrium, differences in the rate of return
reflect differences in the riskiness of an
investment.
Risk-averse a risk-averse individual values a
lottery at less than its expected value.
Risk-neutral a risk-neutral individual values a
lottery at its expected value.
Robinson-Patman Act part of a group of laws
collectively called the antitrust laws govern-
ing competition in the United States. Under
the Robinson–Patman Act, it’s illegal to give
or receive a price discount on a good sold to
another business. This law does not cover ser-
vices and sales to final consumers.
S
Screening a solution to the problem of adverse
selection that describes the efforts of a less
informed party to gather information about the
more informed party. A successful screen means
that it is unprofitable for bad types to mimic
the behavior of good types. Any successful
screen can also be used as a signal.
Sealed-bid first-price auction a sealed-bid auc-
tion in which the highest bidder gets the item at
a price equal to his bid.
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322
Second-price auction See Vickrey auction.
Selection bias the difference between two
groups, a treatment or experimental group and
a control group, if both were given the same
treatment. The observed difference between
two groups is equal to the causal effect of the
treatment only if the selection bias is zero.
Seller surplus the difference between price
(what the seller is able to sell for) and the sell-
er’s value (what she is willing to sell for).
Sequential-move games in these games players
take turns, and each player observes what his
or her rival did before having to move.
Sharing contracts a type of franchising agree-
ment under which the franchisee pays the
franchisor a percentage of revenue rather than
a fixed fee.
Shift of the demand curve a change in demand
caused by any variable except price. If demand
increases (shifts up and to the right), consum-
ers demand larger quantities of the good at
the same price. If demand decreases (shifts
down and to the left), consumers demand
lower quantities of the good at the same price.
Shifts are caused by factors like advertising,
changes in consumer tastes, and product qual-
ity changes.
Shift of the supply curve a change in supply
caused by any variable except price. If supply
increases (shifts down and to the right), sellers
supply larger quantities of the good at the same
price. If supply decreases (shifts up and to the
left), sellers supply lower quantities of the good
at the same price. Shifts are caused by factors
like changes in costs, technological change,
changes in capacity, and entry or exit of new
firms.
Signaling a solution to the problem of adverse
selection that describes an informed party’s
effort to communicate her type, risk, or value
to less informed parties by her actions. A
successful signal is one that bad types won’t
mimic. Any successful signal can also be used
as a screen.
Simultaneous-move games in these games
players move at the same time. Neither player
knows prior to moving what the other has
done.
Specific investment investments that are less
valuable outside of a particular relationship.
They are similar to sunk costs in that the costs
are “sunk” in the relationship.
Stay-even analysis allows you to determine
the volume required to offset a change in cost,
price, or other revenue factor.
Strategic view of bargaining a view that
focuses on how the outcome of bargaining
games depends on the specific rules of the
game, such as who moves first, who can com-
mit to a bargaining position, or whether the
other player can make a counteroffer.
Substitute a good whose demand increases
when price of another good increases. For
example, two brands of cola soft drinks are
substitutes.
Sunk costs costs that cannot be recovered.
They are unavoidable even in the long run.
Sunk-cost fallacy See Fixed-cost fallacy.
Supply curves curves that describe the behavior
of sellers and tell you how much will be offered
for sale at a given price.
T
Treatment effect is the causal effect of a treat-
ment, like a promotion, on an outcome vari-
able, like sales.
Tying the practice of making the sale of one
good conditional on the purchase of an addi-
tional, separate good.
U
Uncontrollable factor something that affects
demand that a company cannot control. Exam-
ples are consumer income, weather, and interest
rates.
Glossary
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323
V
Value an individual’s value for a good or ser-
vice is the amount of money he or she is willing
to pay for it.
Variable costs costs that change as output
levels change.
Vertical integration refers to the common own-
ership of two firms in separate stages of the
vertical supply chain that connects raw materi-
als to finished goods.
Vickrey auction a sealed-bid auction in which
the item is awarded to the highest bidder, but
the winner pays only the second-highest bid.
W
Winner’s curse arises in common-value
auctions and refers to the fact that the
“winner” of the auction is usually the bidder
with the highest estimate of the item’s value. To
avoid bidding too aggressively, bidders should
bid as if their estimate is the most optimistic
and reduce their estimate accordingly.
Z
Zero-sum fallacy the fallacy of assuming that
if someone is winning (e.g., making money)
someone else must necessarily be losing (e.g.,
losing money).
Glossary
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325
A
AC. See Average cost (AC)
Accounting cost, 27–28, 31
Accounting profit, 27–29, 31, 33, 36n6, 44, 52
Adobe, 172, 174
Adverse selection
anticipation of, 244–246, 251, 262
defined, 222, 243, 251
insurance/risk and, 243–244, 251
internet sales and, 250
moral hazard vs., 257–258, 262
and principal-agent relationships, 270–271
screening and, 246–249
signaling and, 249–250
Advertising. See also Promotional activities, and
vertical relationships
“burning money,” 250
effect on decisions, 41–42
as signal, 250
and vertical relationships, 298
Advertising dilemma, 192, 193
Advertising/promotional pricing, 157–158, 162
Agency costs, 270
Agent, 270, 277. See also Principal-agent
relationships
Aggregate demand curve, 69, 176
AIG, 104
Airbus, 89
Amazon.com, 250
American Airlines (AA), 88, 311
Anti-Chain-Store Act, 167
Antitrust law, 88, 167, 175, 193–194, 300–301
Antitrust risks, 300–301, 304n2
A&P, 167
Apple, 120–121
Arbitrage, 146, 166, 168, 169, 191
Asset mobility, 116
AT&T, 301
Auctions, 233–242
benefits of using, 234
bid rigging, 236–238
collusion and, 236–238
common-value, 238–240, 246
first-price, 236
online, 236, 251
oral (English), 234–235, 236, 240
sealed-bid first-price, 236, 240, 241
second-price (Vickrey), 235–236, 240
winner’s curse, 239–240, 246
Average cost (AC), 25, 38
defined, 38, 46
example of, 41
Avoidable cost, 56, 57 (fig.), 60
Axiomatic bargaining view, 208–210
B
Backcasting, 238
Bargaining
chicken game and, 205–206
first-mover advantage, 207
nonstrategic view of, 208–210
strategic view of, 206–208
Best Buy, 228
Best practices, 113, 132
Bidding ring, 236–238
Bid rigging, 236–238
Boeing, 88–89
Bottlenecks, 84
Brand elasticity, 75, 76, 79
Brandenburger, Adam, 130
Branding, as signal, 250
Break-even analysis, 53–55
Break-even price, 56–58
Break-even quantity, 54–55, 60
Brinner, Roger, 67
Index
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Index326
Bubbles, 137, 142–146
Budget games, 289–291
Buffett, Warren, 125–126, 133
Bundling, 177–178, 296, 302
Business
economics and, 18–21
price controls, 20–21
subsidies, 19–20
taxes, 19
Buyer surplus, 16
C
Cadbury India, 27–29, 36n3
Cannibalization, 154, 155, 173–174
Capitalism, and wealth, 16–17
CarBargains, 233–234
Carry trade, 140, 147
Cartel, 236–238
Centralization, 273, 276–277
Channel stuffing, 290
Chicken game, 195–197, 205–206, 211
Chrysler, 54–55
Coca-Cola, 158, 203n4
Collusion, 236–238
Common-value auction, 238–240, 246
Commonly owned complements, 155
Compensating wage differentials, 117, 121
Competition, 120. See also Market equilibrium;
Sustainable competitive advantage
auctions, 233–240
coopetition (cooperative competition), 130
indifference principle, 116–120
and market makers, 108
monopoly, 120–121
perfect, 96
reduction of intensity, 132–133
Competitive industry, 114–116
Complements
commonly owned, 155
and elasticity, 75, 79
Complements pricing, 96–97, 155, 160
Compounding, 49–51
ConAgra, 89–90
Consequentialists, 8
Constant returns to scale, 86, 91
Consumer surplus, 69–70, 167
Consumer values, and simple pricing, 68–70
Controllable factor, 96–97
Coopetition (Brandenberger and Nalebuff), 130
Cost-based pricing, 78
Cost center, 284, 287, 291
Costco, 153
Cost curve, 26–27, 26 (fig.)
Costs
accounting, 27–28, 31, 36
average cost (AC), 25, 38, 46, 91
avoidable cost, 57, 57 (fig.), 60
capital, 28–29
customer acquisition, 39–40
decision-making and, 29–30
economic, 27
expected error costs, 226–227
explicit, 29
fixed, 26, 33, 38, 46, 54, 57 (fig.), 86, 160
fixed-cost fallacy, 30, 33, 38
hidden, 29, 32, 312
hidden-cost fallacy, 30, 32, 33
high acquisition, 6
implicit, 28–29
increasing marginal costs, 84–86, 91
irrelevant, 33
marginal, 38, 44, 46, 54–55, 84–86, 91
opportunity, 29, 29 (fig.), 30, 33, 41, 209
overhead, 30, 33
relevant, 28, 31, 33
sunk 31, 57–59
total, 26
of under- and over-pricing, 157, 160
variable, 26, 33, 57 (fig.), 86
Cost Taxonomy, 56–57
Cross-price elasticity of demand, 77, 79
Currency devaluation, and foreign exchange,
140–142
Cusumano, Michael A., 130
D
Dating game, 197–198
Decentralization, 273, 276–277
Decision making, 272
bargaining, 205–211
centralized, 272. See also Uncertainty
data-driven, 223–226
fixed costs and, 38
functional silos vs. process teams, 294
incentive conflict and, 283–285
strategic games, 185–199
and transfer pricing, 285–287
Decreasing returns to scale, 86–87, 91
Deductible, 246–247, 253n3
Dell, Inc., 163, 168
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Index 327
Demand. See also Elasticity of demand
bubbles and, 142–146
and bundling different goods, 177
effects of expectations on, 97, 142
excess, 100
explaining industry changes using, 103–104
forecasting using elasticity, 76–77
market, 108
and market for foreign exchange, 138–142, 147
predicting industry changes using, 100–103
shifts in, 96–98
Demand curves
aggregate, 69, 176
consumer values and, 68–70
individual, 176
for low-value consumers, 165
market, 69
market-making and, 106–108
predicting industry changes using, 100–103
shifts in, 96–97, 108
and simple pricing, 68–78
Demand shock, 115–117
Dentsply, 300
Deontologists, 8
Depreciation, 27–28, 28 (table), 30–31, 36n4
Diagnosing and solving problems, framework for,
275–277
Diminishing marginal productivity, 84–86
Direct price discrimination scheme, 166–167
Discounting, 49–51, 60
Discrimination. See Price discrimination
Diseconomies of scale, 86, 91
Diseconomies of scope, 90–91
Divisions
incentive conflict between, 283–285
organizational alternatives, 287–289
Double marginalization, 287, 297, 302
Double-markup problem, 287
Duracell, 83
E
eBay, 235, 251
Economic cost, 27
Economic profit, 27–29, 60
accounting vs., 27–29
and decision making, 52
negative, 115
positive, 115
sources of, 128–132
Economics
efficiency of, 18
ethics and, 7–9
in job interviews, 9–11
price controls, 20–21
solving problems using, 3–4
subsidies, 19–20
taxes, 19
usefulness of, to business, 18–21
Economic Value Added (EVA), 27, 29
Economies of scale, 83–84, 86–87, 91, 129, 133,
287–288
Economies of scope, 89–90
price controls and, 20
profit from inefficiency, 20
Elasticity of demand, 72, 78, 120–121
advertising/promotional pricing and, 157–158
defined, 72
forecasting using, 76–77
and simple pricing, 75–76, 77–78
Eli Lilly, 106
Employees
diagnosing and solving problems, framework for,
275–277
franchising, 274–275
incentive conflict and, 271–273
marketing vs. sales, 273–274
principal-agent relationships, 270–271
Energizer, 83
English auction, 234–235, 236, 240
Equilibrium price, 99–100, 108. See also Long-run
equilibrium
Equity risk premium, 118, 119 (fig.)
Ethics, 7–9
Excess demand, 100
Excess supply, 99
Exchange rate, 137–140, 147. See also Foreign
exchange
Exclusion, 296, 301
Expected error costs, minimizing, 226–227
Explicit costs, 29
ExxonMobil, 57
F
Fannie Mae, 104, 113, 143
Federal Communications Commission (FCC), 255
Federal Reserve, 104
First law of demand, 69, 72
First-mover advantage, 196 (fig.), 207
Five Forces model, 128–130, 134
Fixed cost, 26, 33, 38, 46, 54, 57 (fig.), 86, 160
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Index328
Fixed-cost fallacy, 30, 33, 38
Foreign exchange
bubbles and, 142–146
currency devaluation and, 140–142
market for, 138–140, 147
purchasing power parity and, 146
Franchising, 274–275, 281n2
Freddie Mac, 104
Free riding, 192–193, 298–299
Functionally organized firm, 287–288
Functional silos, 294
Future value, 50–51
G
Gains from trade, 16
Gawer, Annabelle, 130
General Motors (GM), 198
Goldman Sachs, 7
Goodyear Tires, 198
Google, 228, 236
Government
and antitrust risks, 300–301, 304n2
and Federal Reserve, 104
and reducing costs of moral hazard, 261–262
and regulatory evasion, 297
role of, in wealth-creating process, 17–18
subsidies, 19–20
and tax avoidance, 296
taxes, 19
H
Hazard. See Moral hazard
Hazlitt, Henry, 18
Hermitage Museum, The, 163, 168
Hewlett Packard, 106, 174–175
Hidden-cost fallacy, 30, 32, 33
Hold-up, 57–59
Home Depot, 159
Horizontal agreements, 300
I
IBM, 97, 174
Implicit costs, 28–29
InBev, 154–155
Incentive compensation scheme, 31, 44–45, 46, 209,
248, 270–271,272–275, 290
Incentive conflict, 270, 278
defined, 270, 278
between divisions, 283–285
controlling, 271–273
employees and, 273–274
fixing problems, 284–285
marketing vs. sales, 273–274
between retailers/manufacturers, 297–299
and vertical relationships, 230, 295–297
Incentive pay, 6–7, 43–44, 45–46
Income elasticity of demand, 76–77, 79
Increasing marginal costs, 84–86, 91
Increasing returns to scale, 86–87, 91
Indifference principle, 116–120, 147
Indirect price discrimination, 166, 172–175, 179
Individual demand curve, 176
Industrial organization (IO) view of profit,
128–131, 134
Industry and market changes
market equilibrium and, 99–100
market making and, 106–108
prices convey information about, 104–106
qualitative/quantitative changes, 102, 108
and shifts in demand, 96–98
and shifts in supply, 98–99
using supply and demand as predictors, 100–103
using supply and demand to explain, 103–104
Industry (external) view, 128–131, 134
Inelastic demand, 73, 79
Information asymmetry, 275
and adverse selection, 245, 247, 249, 251
and moral hazard, 256, 262
Initial Public Offering, 245, 253n2
Insurance. See also Progressive Snapshot
adverse selection and, 244–246, 251
moral hazard and, 256–257
risk and, 243–244
Interest-rate risk, 313
Internet sales, adverse selection and, 250
Investment decisions
break-even analysis, 53–55
compounding and discounting, 49–51
determining whether investments are
profitable, 51–53
right manufacturing technology,
choosing, 55–56
shut-down decisions and break-even prices, 56–57
sunk costs and post-investment hold-up, 57–59
Investments
basic strategies, 132–133
hold-up and, 57–59
profitability of, 51–53
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Index 329
J
Job interviews, economics in, 9–11
John Deere, 55–56, 103
K
Kahneman, Daniel, 158
Kohn, Alfie, 45
Kraft, 89
Kroger, 191–192
L
Labor negotiation, 206–208. See also Bargaining
Land Rover, 139
Landsburg, Steven, 116
Law of diminishing marginal returns, 84, 86, 91
Learning curves, 87–89, 91, 288
Lehman Brothers, 32, 104
Lemons problem, 247–248
Lending, moral hazard in, 260–261
Lereah, David, 144
Long Beach Financial, 32
Long-run equilibrium, 115, 116–117, 144, 145
Long-run marginal cost, 156
Long-run marginal revenue, 156
M
Management vs. labor union game, 207 (fig.)
Marginal analysis, 39–40, 42–43, 56, 70–71,
154–156
Marginal benefit, 43–44
Marginal cost (MC), 38, 44, 46, 54–55, 84–86, 91
and breakeven analysis, 53–55
defined, 39, 46
example of, 39
increasing, 84–86, 91
Marginal revenue (MR), 39, 70
defined, 39, 46
price elasticity and, 72–74
and simple pricing, 72–74
Market demand, 78, 108
Market demand curve, 69
Market equilibrium, 99–100, 108
Marketing vs. sales, 273–274
Market maker, 106–108, 107 (fig.)
Market supply, 108
Mattel, 67, 78
MC. See Marginal cost (MC)
McDonald’s, 274
McDonnell-Douglas, 89
Mean reversion, 115, 121
Mervyn’s, 17
Metering scheme, 175, 178
M-form firm, 289, 292
Michelin, 198
Microsoft, 77, 97, 106, 121, 126, 131, 174
Mobil Oil, 57. See also ExxonMobil
Monopoly, 95, 120–121
Moral hazard, 270, 278
adverse selection vs., 257–258
anticipating, 262
banks and, 261
defined, 257, 258, 262
FCC financing, 255
and financial crisis of 2008, 261–262
insurance, 256–257
in lending, 260–261
and principal-agent relationships, 270–271
Progressive Snapshot, 255
shirking and, 258–260, 262
social capital as a motivator, 255–256
Morita, Akio, 85–86
Movement along the demand curve, 96, 108
MR. See Marginal revenue (MR)
N
Nalebuff, Barry, 130
Nasar, Sylvia, 186
Nash, John, 186, 208–210
Nash equilibrium, 186, 189–190, 191–194,
197–198, 199, 208. See also Equilibrium
National Basketball Association (NBA), 205
National Geographic, 58
Net present value rule (NPV rule), 51–52, 60
New York Stock Exchange, 19
Nike, 75
Nissan, 54–55, 137, 140
Nonstrategic view of bargaining,
208–210, 211
Notre Dame, 8
O
Obama, Barack, 245
Oil Ventures International (OVI), 3
Online auction, 236, 251
Opportunity cost, 29–30, 32, 33, 41, 209
Oral (English) auction, 234–235, 236, 240
Organizational alternatives, 287–289
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Index330
Organizations, wealth creation in, 21
Outsourcing, 55
Overhead cost, or expense, 30, 33
P
Parthenon Group, 67
Pay
incentive, 43–44
tie to performance measures that reflect effort,
44–45
Perdue Chicken, 133
Perfect competition, 96
Peso devaluation, 141
Phillip Morris, 192
Piece-rate pay, 288
PING, Inc., 299, 305n6
Platform strategy, 130
Porter, Michael, 128, 130, 136n7
Post-investment hold-up, sunk costs and, 57–59
Present value, formula for, 50
Price and pricing
advertising and promotional, 157–158
and break-even analysis, 56–57
commonly owned products, 154–155
cost-based, 78
degree of over- or under-pricing, 156–157, 160
direct price discrimination, 163–170
elasticity, 77–78
as extent decision, 78
flexible, 20
indirect price discrimination, 166–167, 171–181
marginal analysis of, 70–71
marginal revenue and elasticity of, 72–74
as mechanism for market to communicate, 104–
106, 108
“monopoly” model of, 95
psychological, 158–159
reference, 158–159
revenue and yield management and, 155–157
Robinson-Patman Act, 167–168
simple pricing, 67–81
surge, 20–21
transfer pricing, 285–287, 291
uncertainty in, 222–223
volume discounts as, 176–177
Price ceiling, 20–21
Price controls, 20–21
Price discrimination, 223, 299–300. See also
Screening
arbitrage and, 169
defined, 165, 169
dilemma, 191–192
direct, 166–167, 169
how, increases profit, 164–166
implementing schemes, 168–169
indirect, 166, 172–175, 178
motivation for, 165
Robinson-Patman Act, 167–168
volume discounts as, 176–177
Price discrimination dilemma, 191–192
Price elasticity
estimated, 78
marginal revenue and, 72–74
and simple pricing, 72–74
Price floors, 20–21
Price-gouging laws, 9
Principal, defined, 270, 278
Principal-agent relationships, 270–271, 274–275,
295
Prisoner’s dilemma, 190 (table), 190–195, 197 198,
199
getting out of, 193–194
repeated, 194–195
Probability
random variables and, 218–222
Problem solving. See also Decision making
principles, 4–6
self test, 6–7
tips for, 5, 11
using economics for, 3–4
Product introduction, new, 299
Profit
accounting, 27–29, 31, 33, 36n6, 44, 52
economic, 27–29, 60
formula for, 67
and vertical relationships, 296–297
Profit center, 284–285, 291
Progressive Snapshot, 255, 257
Promotional activities, and vertical relationships, 298
Promotional pricing, 157–158
Property rights, 8, 17–18
Prospect theory, 158
Psychological pricing, 158–159
Purchasing power parity, 146
R
Random variables, 218–222
Rational-actor paradigm, 4, 7–8, 11
RBV. See Resource-based view (RBV)
Reference price, 158–159
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Index 331
Regulatory evasion and vertical integration, 297
Relationship-specific investment, 59
Relevant cost, 38
Resource-based view (RBV), 128, 131–132, 134
Revenue, 155–157. See also Marginal analysis
Right manufacturing technology, choosing, 55–56
Risk-averse consumer, 244
Risk-neutral consumer, 244
Risk premium, 117–119
Risk
antitrust, 300–301
insurance and, 243–244
vs. uncertainty, 227–228
R.J. Reynolds, 192
Robinson-Patman Act, 167–168
S
Safeway, 191–192
Samsung, 120
SanDisk, 120
Sara Lee, 89
Scale. See Economies of scale
Scholastic Publishing, 153
Schultz, Howard, 125
Screening, 246–249, 251. See also Price
discrimination
Sealed-bid first price auction, 236, 240, 241
Second-price (Vickrey) auction, 235–236, 240
Seller surplus, 16
Sequential-move games, 186–188, 196, 197, 199
Sharing contracts, 275
Shift of the demand curve, 96–97, 108
Shift of the supply curve, 98–99, 103–104
Shiller, Robert, 144–145
Shirking, 7, 43–44, 192–193, 258–260, 262, 275
Shirking/monitoring game, 198–199
Short run, 114–116
marginal cost (MC), 56, 156
marginal revenue (MR), 156
Shutdown decisions, 56–57
Signaling, 249–250, 251
Simple pricing. See also Price and pricing
consumer values/demand curves and, 68–70
cost-based pricing, 78
defined, 67
elasticity of demand and, 75–76, 77–78
and forecasting demand using elasticity, 76–77
marginal analysis and, 70–71
price elasticity and marginal revenue and, 72–74
stay-even analysis, 77–78
Simultaneous-move games, 188–190, 196, 197, 199
Sony, 85
Specific investment, 59
Spectrum Brands, 83
Starbucks, 125, 127, 132, 133
Stay-even analysis, 77–78, 79
Stern Stewart & Co., 27
straight-line depreciation, 31
Strategic games
advertising dilemma, 192
changing payoff structure, 193
chicken game, 195–197
dating game, 197–198
entry accommodation, 187 (fig.)
entry deterrence with commitment, 188 (fig.)
entry game, 186 (fig.)
free-riding dilemma, 192–193
learning from, 193–194
Nash equilibrium and, 186, 188–190, 191–194,
197–198, 199
price discrimination dilemma and, 191–192
prisoner’s dilemma and, 190 (table), 190–195,
197, 198, 199
sequential-move games, 186–188, 199
shirking/monitoring game, 198–199
simultaneous-move games, 188–190
Strategic view of bargaining, 206–208, 211
Subprime mortgage crisis (2008), 32, 49, 113
Subsidy, 19–20
Substitutes in elasticity, 75–77, 79
Substitutes in pricing, 96–97, 154–155
Sunk cost, 31, 57–59
defined, 31
and post-investment hold-up, 57–59
Sunk-cost fallacy, 30–31, 33, 301
Sunk-cost investments, 56
Supply
effects of expectations on, 142
excess, 99
explaining industry changes using, 103–104
predicting industry changes using, 100–103
Supply curves
defined, 96
market-making, 106–108, 107 (fig.)
shifts in, 98–99, 103–104
Supply shock, 115, 117
Sustainable competitive advantage, 125, 126–127,
131, 132, 133. See also Economic profit;
Investments
Swedish Stock Exchange, 19
Synergies, 83, 301
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Index332
T
Tax avoidance and vertical integration, 296
Taxes, 19, 78
TCI. See Tele-Communications, Inc. (TCI)
Tele-Communications, Inc. (TCI), 301
3M, 300
Total costs, 28–29, 38n1
Transfer pricing, 285–287, 291
TVA, 57
Tversky, Amos, 158
Tying, 296, 302
U
Uncertainty, 227
data-driven decision making, 223–226
defined, 227
entry decision with, 221 (fig.)
expected error costs, minimizing, 226–227
experiments to reduce, 224–226
in pricing, 222–223
random variables and probability, 218–222
risk vs., 227–228
Uncontrollable factor, 96–97
Union/Management game, 209
U.S. antitrust laws, 88, 167
U.S. Federal Reserve, 104
U-shaped average cost curve, 84–85
V
Value, 16
Value pricing, 311
Variable cost, 26, 33, 57 (fig.), 86
Versatile, 55–56
Vertical contracts, 296, 298–299, 300
Vertical relationships
addressing incentive conflict, 230, 295–297
antitrust risks, 300–301
double marginalization, 297
free riding, 298–299
incentive conflicts between
retailers/manufacturers, 297–299
new product introduction, 299
price discrimination, 299–300
profit and, 296–297
promotional activities, 298
quality control, 297–298
tax avoidance, 296
Vickrey, William, 236
Vickrey (second-price) action, 235–236, 240
Volume discounts, 176–177
W
WACC. See Weighted average cost of capital
(WACC)
Walmart, 72, 77, 90, 132, 153, 167
Wealth
capitalism and, 16–17
creation of, in organizations, 21
defined, 16
government role in creating, 17–18
Weighted average cost of capital (WACC), 49
Winner’s curse, 239, 246
Y
Yield management pricing, 155–157
Z
Zappos, 243, 248, 253n1
Zero sum fallacy, 17, 310
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Title Page
Copyright Page
Brief Contents
Contents
Preface: Teaching Students to Solve Problems���������������������������������������������������
Section I: Problem Solving and Decision Making
Chapter 1: Introduction: What This Book Is About
1.1 Using Economics to Solve Problems��������������������������������������������
1.2 Problem-Solving Principles�������������������������������������
1.3 Test Yourself������������������������
1.4 Ethics and Economics�������������������������������
1.5 Economics in Job Interviews��������������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 2: The One Leson of Busines
2.1 Capitalism and Wealth��������������������������������
2.2 Does the Government Create Wealth?
2.3 How Economics Is Useful to Business����������������������������������������������
2.4 Wealth Creation in Organizations�������������������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 3: Benefits, Costs, and Decisions
3.1 Background: Variable, Fixed, and Total Costs�������������������������������������������������������
3.2 Background: Accounting versus Economic Profit��������������������������������������������������������
3.3 Costs Are What You Give Up�������������������������������������
3.4 Sunk-Cost Fallacy����������������������������
3.5 Hidden-Cost Fallacy������������������������������
3.6 A Final Warning��������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 4: Extent (How Much) Decisions
4.1 Fixed Costs Are Irrelevant to an Extent Decision�����������������������������������������������������������
4.2 Marginal Analysis����������������������������
4.3 Deciding between Two Alternatives��������������������������������������������
4.4 Incentive Pay������������������������
4.5 Tie Pay to Performance Measures That Reflect Effort��������������������������������������������������������������
4.6 Is Incentive Pay Unfair?
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 5: Investment Decisions: Look Ahead and Reason Back
5.1 Compounding and Discounting��������������������������������������
5.2 How to Determine Whether Investments Are Profitable��������������������������������������������������������������
5.3 Break-Even Analysis������������������������������
5.4 Choosing the Right Manufacturing Technology������������������������������������������������������
5.5 Shut-Down Decisions and Break-Even Prices����������������������������������������������������
5.6 Sunk Costs and Post-Investment Hold-Up�������������������������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������

Section II: Pricing, Costs, and Profits
Chapter 6: Simple Pricing
6.1 Background: Consumer Values and Demand Curves��������������������������������������������������������
6.2 Marginal Analysis of Pricing���������������������������������������
6.3 Price Elasticity and Marginal Revenue������������������������������������������������
6.4 What Makes Demand More Elastic?
6.5 Forecasting Demand Using Elasticity����������������������������������������������
6.6 Stay-Even Analysis, Pricing, and Elasticity������������������������������������������������������
6.7 Cost-Based Pricing�����������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 7: Economies of Scale and Scope
7.1 Increasing Marginal Cost�����������������������������������
7.2 Economies of Scale�����������������������������
7.3 Learning Curves��������������������������
7.4 Economies of Scope�����������������������������
7.5 Diseconomies of Scope��������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 8: Understanding Markets and Industry Changes
8.1 Which Industry or Market?
8.2 Shifts in Demand���������������������������
8.3 Shifts in Supply���������������������������
8.4 Market Equilibrium�����������������������������
8.5 Predicting Industry Changes Using Supply and Demand��������������������������������������������������������������
8.6 Explaining Industry Changes Using Supply and Demand��������������������������������������������������������������
8.7 Prices Convey Valuable Information���������������������������������������������
8.8 Market Making������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 9: Market Structure and Long-Run Equilibrium
9.1 Competitive Industries���������������������������������
9.2 The Indifference Principle�������������������������������������
9.3 Monopoly�������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 10: Strategy: The Quest to Kep Profit from Eroding
10.1 A Simple View of Strategy�������������������������������������
10.2 Sources of Economic Profit��������������������������������������
10.3 The Three Basic Strategies��������������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 11: Foreign Exchange, Trade, and Bubles
11.1 The Market for Foreign Exchange�������������������������������������������
11.2 The Effects of a Currency Devaluation�������������������������������������������������
11.3 Bubbles�������������������
11.4 How Can We Recognize Bubbles?
11.5 Purchasing Power Parity�����������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������

Section III: Pricing for Greater Profit
Chapter 12: More Realistic and Complex Pricing
12.1 Pricing Commonly Owned Products�������������������������������������������
12.2 Revenue or Yield Management���������������������������������������
12.3 Advertising and Promotional Pricing�����������������������������������������������
12.4 Psychological Pricing���������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 13: Direct Price Discrimination
13.1 Why (Price) Discriminate?
13.2 Direct Price Discrimination���������������������������������������
13.3 Robinson-Patman Act�������������������������������
13.4 Implementing Price Discrimination���������������������������������������������
13.5 Only Schmucks Pay Retail������������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 14: Indirect Price Discrimination
14.1 Indirect Price Discrimination�����������������������������������������
14.2 Volume Discounts as Discrimination����������������������������������������������
14.3 Bundling Different Goods Together���������������������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������

Section IV: Strategic Decision Making
Chapter 15: Strategic Games
15.1 Sequential-Move Games���������������������������������
15.2 Simultaneous-Move Games�����������������������������������
15.3 Prisoners’ Dilemma������������������������������
15.4 Other Games�����������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 16: Bargaining
16.1 Strategic View of Bargaining����������������������������������������
16.2 Nonstrategic View of Bargaining�������������������������������������������
16.3 Conclusion����������������������
Summary & Homework Problems����������������������������������
End Note���������������

Section V: Uncertainty
Chapter 17: Making Decisions with Uncertainty
17.1 Random Variables and Probability��������������������������������������������
17.2 Uncertainty in Pricing����������������������������������
17.3 Data-Driven Decision Making���������������������������������������
17.4 Minimizing Expected Error Costs�������������������������������������������
17.5 Risk versus Uncertainty�����������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 18: Auctions
18.1 Oral Auctions�������������������������
18.2 Second-Price Auctions���������������������������������
18.3 First-Price Auctions��������������������������������
18.4 Bid Rigging�����������������������
18.5 Common-Value Auctions���������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 19: The Problem of Adverse Selection
19.1 Insurance and Risk������������������������������
19.2 Anticipating Adverse Selection������������������������������������������
19.3 Screening���������������������
19.4 Signaling���������������������
19.5 Adverse Selection and Internet Sales������������������������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 20: The Problem of Moral Hazard
20.1 Introduction������������������������
20.2 Insurance���������������������
20.3 Moral Hazard versus Adverse Selection�������������������������������������������������
20.4 Shirking��������������������
20.5 Moral Hazard in Lending�����������������������������������
20.6 Moral Hazard and the 2008 Financial Crisis������������������������������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������

Section VI: Organizational Design
Chapter 21: Geting Employees to Work in the Firm’s Best Interests
21.1 Principal–Agent Relationships�����������������������������������������
21.2 Controlling Incentive Conflict������������������������������������������
21.3 Marketing versus Sales����������������������������������
21.4 Franchising�����������������������
21.5 A Framework for Diagnosing and Solving Problems�����������������������������������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 22: Geting Divisions to Work in the Firm’s Best Interests
22.1 Incentive Conflict between Divisions������������������������������������������������
22.2 Transfer Pricing����������������������������
22.3 Organizational Alternatives���������������������������������������
22.4 Budget Games: Paying People to Lie����������������������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������
Chapter 23: Managing Vertical Relati onships
23.1 How Vertical Relationships Increase Profit������������������������������������������������������
23.2 Double Marginalization����������������������������������
23.3 Incentive Conflicts between Retailers and Manufacturers�������������������������������������������������������������������
23.4 Price Discrimination��������������������������������
23.5 Antitrust Risks���������������������������
23.6 Do Buy a Customer or Supplier Simply Because It Is Profitable�������������������������������������������������������������������������
Summary & Homework Problems����������������������������������
End Notes����������������

Section VII: Wrapping Up
Chapter 24: Test Yourself
24.1 Should You Keep Frequent Flyer Points for Yourself?
24.2 Should You Lay Off Employees in Need?
24.3 Manufacturer Hiring�������������������������������
24.4 American Airlines�����������������������������
24.5 Law Firm Pricing����������������������������
24.6 Should You Give Rejected Food to Hungry Servers?
24.7 Managing Interest-Rate Risk at Banks������������������������������������������������
24.8 What You Should Have Learned����������������������������������������

Epilogue: Can Those Who Teach, Do?
Glossary���������������
Index������������

2017-10-24T01:24:01+0000
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