Managerial Economics Final

Human Capital

Workers often must learn skills for a particular firm that are not transferable to other employers

Potential Entrants

Are individuals and firms that pose a sufficiently credible threat of market entry to affect the pricing and output decisions of incumbent firms

The environment in which computer manufacturers operate is very uncertain. The rate of technical progress among chip, and other hardware, manufacturers increases the marginal cost of signing- long-term contracts

During the beginning of the 21st century, the growth in computer sales declined for the first time in almost two decades. As a result, PC makers dramatically reduced their orders of computer chips from Intel and other vendors. Explain why computer manufacturers such as Dell are likely to write relatively short contracts for computer chips.

Merger A is the only horizontal merger, and therefore the only merger that would be scrutinized under the Guidelines for horizontal mergers. Merger B is a conglomerate merger, while Merger C is a vertical merger.

9. Which of the following would most likely be scrutinized under the FTC and DOJ Horizontal Merger Guidelines? Merger A: Two major players in Internet services and retailing-Amazon.com and ebay-merge. Merger B: Cigarette maker Philip Morris merges with the Miller Brewing Company. Merger C: Lockheed Martin, a large firm that manufactures aircraft, merges with United States Steel.

The principal-agent problem in this situation exists between on-duty police officers (the agent) and the city officials who hire them (the principals). On-duty police officers were supposed to prevent picket lines from blocking worker access. Members of the police union appear to be engaging in opportunistic behavior to improve their bargaining power. The city of Boston has committed to spending $14 million to host the DNC and the police union is attempting to take advantage of this specialized investment. Therefore, the city of Boston is facing the "hold-up problem" as defined in the book. The problem also illustrates the problem of writing contracts: when the city of Boston wrote a contract with Shawmut Design and Construction there were many unforeseeable events that may not explicitly be defined in the contract.

A few years ago, the Boston Globe reported that the city of Boston planned to spend $14 million to convert the FleetCenter sports arena and entertainment center into an appropriate venue for the Democratic National Convention (DNC). The city engaged Shawmut Design and Construction in a contractual relationship to complete the work, which was supposed to start 48 days prior to the commencement of the DNC on July 26. However, when negotiations between Boston's mayor and the police union broke down, the Boston Police Patrolmen's Association took to the picket lines surrounding the FleetCenter and prevented construction crews from beginning the work. The Globe reported that "a truck attempting to deliver steel turned around after a crowd of union members stood at a chain-link gate in front of the arena, shouting 'back it up,' and 'respect the line, buddy.'" Moreover, the Globe reported that "On-duty police officers, who had been instructed to prevent pickets from restricting access, did not intervene." Given the tight construction schedule, construction delays reportedly cost about $100,000 per day. Identify the principal-agent problem in this situation. Did the mayor and the city of Boston face the classical "hold-up problem" or another problem? Explain.

Lerner Index = 1/3 Markup Factor = 1.5

A firm in the airline industry has a marginal cost of $200 and charge a price of $300. What are the Lerner index and markup factor?

Contract

A formal relationship between a buyer and seller obligates the buyer and seller to exchange at terms specified in a legal document

Lerner Index

A measure of the difference between price and marginal costs as a fraction of the product's price

Produce Inputs Internally (Vertical Integration)

A situation where a firm produces the inputs required to make its final product, the occurs when a firm decides to produce not only the final products but at least one of the inputs that are needed for the product. Firms may choose to take this direction because they are no longer have to rely on other firms to provide the desired inputs

Relationship-Specific Exchange

A type of exchange that occurs when the parties to a transaction have made specialized investments

Horizontal Integration

Merging two or more similar final products into a single firm

Market

All firms and individuals willing and able to buy or sell a particular product

Piece Rate

An alternative compensation method is to pay workers based on a piece rate rather than on a fixed hourly wage

Spot Exchange

An informal relationship between a buyer and seller in which neither party is obligated to adhere to specific terms for exchange. This is your typical purchasing of consumer goods and services. For example, when you go to the grocery store to buy a gallon of milk, you are not required to meet any special terms to purchase the milk. You pay the cashier for the milk and you go your separate ways.

Andrew had to make sunk investments to use Initech's products that sum to $2,000. These consist of the $1,000 in sunk capital investments and the learning time (which is also sunk) valued at 40 × $25 = $1,000. Since these investments are sunk, and we know Andrew must make at least this much of an investment to use another product, Initech can come back and try to "rob" Andrew of his investment by asking for $5,000 ( = $3,000 + $2,000). Or, to be sure it is strictly better than any alternative, they may ask for $4,999.

Andrew has decided to open an online store that sells home and garden products. After searching around, he chooses the software company Initech to provide the software for his website since their product required the least amount of specialized investments for him to use it. They agreed upon price of $5,000. To use Initech's software, Andrew makes $2,000 in sunk capital investments and spends 60 hours learning how to use Initech's software, which is very different from other software packages. Both Andrew and Initech view Andrew's time as worth $27 per hour and Initech is fully aware of the investments Andrew must make to use their product. After Andrew's investments were made, Initech came to Andrew and asked for more money. What do you think is the new price Initech requested Andrew to pay?

Clone 1 = Contract Clone 2 = Spot Exchange Clone 3 = Vertical Integration

Clone 1 PC is legally obligated to purchase 300 computer chips each year for the next 3 years from AML. The price paid in the first year is $200 per chip, and the price rises during the second and third years by the same percentage by which the wholesale price index rises during those years. Clone 2 PC purchases 300 computer chips from a firm that ran an advertisement in the bank of a computer magazine. Clone 3 PC manufactures its own motherboards and computer chips for its personal computers. Determine whether the following transactions involve spot exchange, a contract, or vertical integration.

Yes, if after paying the $10 which is a sunk cost, Company A wants to buy from Widgets R Us then it must pay $105 for the widget.

Company A needs a widget for its production process. There are many companies that sell the widgets but each sells it for $100. Company A purchases a sample of widgets from Widgets R Us for $10 to test the quality before making a large purchase.After doing this, Company A calls Widgets R Us to order 1000 widgets. Widgets R Us says that it's new price is $105 her widget. Has Widgets R Us engaged in opportunistic behavior-- Yes or No? Why or why not?

Transaction Costs

Costs associated with acquiring an input that is in excess of the amount paid to the input supplier

Spot Checks

Done sporadically by the manager throughout the day

A contract decreases the problem of opportunism and still allows the firm to specialize in production

DonutVille caters to its retirement population by selling over 10,000 donuts each week. To produce that many donuts weekly, DonutVille uses 1000 pounds of flour, which must be delivered by 5:00am every Friday morning. How should the manager of DonutVille acquire flour? Why?

Research and Development

Expenditures made by firms to gain a technological advantage, with the aim of acquiring a patent

Advertisement

Expenditures made by firms to inform or persuade consumers to purchase their products

Specialized Investment

Expenditures that must be made to allow two parties to exchange but has little or no value in any alternative use

Engine manufacturing involves specific investments and a complex contracting environment. By vertical integrating, the potential for opportunism is reduced. Mirrors are relatively uniform products that can be purchases by spot exchange or contract.

Explain why automobile manufacturers produce their own engines but purchase mirrors from independent suppliers

Capital requirements, patents, economies of scale

Factors that create barriers to entry:

Equity Theory

Fairness about pay differentials among individuals who hold the same job can be established by using: Seniority-based pay systems Merit-based pay systems Incentive plans Skill-based pay systems Team-based pay plans

Underinvestment

If company XYZ purchases a special machine to make parts for company ABC and the parts are no good to any other company other than ABC then XYZ may underinvest in the machine purchase purchase an cheaper machine that produces lower quality parts because it knows that is company ABC every backs out of the relationship then the machine is worthless

Conglomerate Mergers

Integration of two or more different product lines into a single firm

Dedicated Assets

Investments made y a firm that allow it to exchange with a particular buyer

Costly Bargaining

Is the process of negotiating pricing between a buyer and a seller of a special input. The parties may behave strategically to enhance their bargaining position.

Revenue Sharing

Linking compensation to the underlying revenues of the firm

Dansby Willig Performance Index

Measures how much social welfare would improve if firms in an industry expanded output in a socially efficient manner. If an industry is zero, there are no gains to be obtained by inducing firms in the industry to alter their outputs. When it is greater than zero, social welfare would improve if industry output were expended.

Rothschild Index

Measures the sensitivity to price of a product group as a while relative to the sensitivity of the quantity demanded of a single firm to a change in its price

Characteristics of the Spot Exchange

No relationship-specific investment Absence of transaction costs, and many buyers and sellers, imply that the market price is determined by the intersection of demand and supply Characteristics of?

Principal-Agent Problem

Occurs when a principal creates an environment in which an agent's incentives don't align with those of the principle

Profit Sharing

Offering workers compensation that is tied to underlying profitability provides an incentive for workers to put forth more effort

Potential for Entry

Optimal decisions by firms in an industry will depend on the east with which new firms can enter the market

External Incentives

Outside forces can provide managers with the incentives to maximize profits and include reputation or takeover threat

Fixed Salary

Receives wage independent of labor hours and effort, no strong incentive to monitor other employees labor hours and effort; adversely impacts firms performance

HHI = 4400 The four-firm concentration ratio is 1 since the top 3 firms account for all industry sales

Suppose an industry consists of three firms. Two firms have sales of $10 each, and one firm has sales of $30. What is the Herfindahl-Hirschman index for this industry? What is the four-firm concentration ratio?

Total Industry Sales= $50 Sales of the Four Largest Firms are $40 The Four Firm Concentration Ratio is: 0.80 The four largest firms in the industry account for 80 percent of total industry output

Suppose an industry is composed of six firms. Four firms have sales of $10 each, and two firms have sales of $5 each. What is the four-firm concentration ratio for this industry?

The reduction in another supplier's cost of producing airbags reduces Honda's marginal benefit of contracting. Therefore, the 150year contract that has been negotiated is too long; the optimal contract length is now less than 15 years.

Suppose that Honda is on the verge of signing a 15-year contract with TRW to supply airbags. The terms of the contract include providing Honda with 85% of the airbags used in new automobiles. Jus prior to signing the contract. a manger reads that one of TRW's competitors has introduced a comparable airbag using a new technology that reduces the cost by 30%. How would this information affect Honda's optimal contract length with TRW?

HHI

Takes into account the relative size distribution of the firms in a market. It approaches zero when a market is occupied by a large number of firms of relatively equal size and reaches its maximum of 10,000 points when a market is controlled by a single firm.

The four-firm concentration ratio is: C4 = ($310,000 + $235,000 + $205,000 + $140,000) / $1,500,000 = 0.59. a.) The HHI is calculated as follows: HHI = 10,000[($355,000 / $1,615,000)2 + ($825,000 / $1,615,000)2 + ($435,000 / $1,615,000)2] = 3,818. b.) 100% c.) If the firms with sales of $355,000 and $435,000 were allowed to merge, the resulting HHI would increase by 1,184, to 5,002. Since the postmerger HHI exceeds that under the Guidelines (2,500) and the HHI increases by more than that permitted under the Guidelines (200), the merger is likely to be challenged.

Ten firms compete in a market to sell product X. The total sales of all firms selling the product are $1,000,000. Ranking the firms' sales from highest to lowest, we find the top four firms' sales to be $160,000, $105,000, $95,000, and $80,000, respectively. Calculate the four-firm concentration ratio in the market for product X. An industry consists of three firms with sales of $310,000, $640,000, and $240,000. a. Calculate the Herfindahl-Hirschman index (HHI). b. Calculate the four-firm concentration ratio (C4). c. Based on the FTC and DOJ Horizontal Merger Guidelines described in the text, is the Department of Justice likely to attempt to block a horizontal merger between two firms with sales of $310,000 and $240,000?

The first important point to make with shareholders is the restructuring the incentive plan is designed to maximize shareholder value. This is achieved by giving employees incentives to stay with the company longer. thereby reducing costly employee turnover and increasing the company's profitability. Also, by restructuring the incentive plan, employees will want to find ways to work more productively make the company more profitable. The benefits to the shareholders and the employees will be a higher stock price.

The Wall Street Journal reports that Juniper Networks, Inc.- a maker of company network equipment- plans to offer its more than 1000 employees the opportunity to reprice their stock options. Juniper's announcement comes at a time when its stock price is down 90%, leaving many employees' stock options worthless. How do you think Juniper's CEO justified repricing the employees' stock options to the shareholders?

Capping pension fund managers' compensations would reduce the executives' incentives to maximize the value of the fund under their control, thereby reducing the overall return to the fund participants.

The manager of your company's pension fund is compensated based entirely on fund performance; he earned over $1.2 million last year. As a result, the fund is contemplating a proposal to cap the compensation of fund managers at $100,000. Provide an argument against the proposal.

Incentive Contract

Tie manager wage to firm performance (like profits), manager makes labor-leisure choice and is accordingly compensated

Merge

Two of more existing firms "unite" into a single firm

Site Specificity, Physical-Asset Specificity, Dedicated Assets, Human Capital

Types of Specialized Investments (4)

Integration

Uniting produttive resources of firms, can occur during the formation of a firm

Characteristics of Contracts

Use when inputs require a substantial specialized investment Typically requires substantial up-front expenditures Specifics prices of inputs prior to making specialized investments Requires decision on optimal contract length Characteristics of?

Opportunism and the "Hold-Up Problem"

When a specialized investment must be made to acquire an input, the buyer and seller may attempt to capitalize on the sunk cost of the investment by engaging in opportunism

Physical-Asset Specificity

When capital equipment is needed to produce an input designed to meet the needs of a particular buyer and cannot be adapted to produce the needs of other buyers

Site Specificity

When the buyer and seller of an input locate their plants close to each other to engage in exchange