ECON2410

Which of the following circumstances are likely to create early-mover advantages? Explain. (a) Maxwell House introduces the first freeze-dried coffee. (b) A consortium of U.S. firms introduces the first high-definition television.

(a) There are no network externalities or switching costs with freeze-dried coffee. A case may be made for possible reputation and buyer uncertainty effects; that is, if Maxwell House can pioneer a product and establish a reputation for quality, preexisting customers may be unwilling to switch and new customers will seek out the pioneer because of its reputation. However, this effect is very uncertain. If another brand comes along that tastes better, consumers can easily switch. If Maxwell House can patent the freeze-drying process and it cannot be "invented around," the patent may offer a sustainable first-mover advantage. It is also possible that the product would offer first-mover disadvantages. If Maxwell House invests all its money in one process, but another company "free-rides" on its marketing and creates a better product, Maxwell House could face a first-mover disadvantage. (b) There is a potential first-mover advantage to the introduction. The invention might be patentable. It is also possible that the introduction will offer the consortium the network externality advantage in that it can become the "base" for the complementary software (TV programming, providing that these programs must meet the consortium's standard) and for future home-entertainment opportunities. Consumers will want to buy hardware that meets the standard so they can receive the TV programs and tie in to future complementary hardware, if it comes about. Another possible advantage is the learning curve effect. If the consortium successfully introduces the technology, they may be able to produce larger volumes earlier than their competition. A disadvantage could arise if the high definition television was the wrong "bet"; that is, it's the wrong technology, or a different consortium introduces a different standard that dominates the U.S. consortiums

Sources of Diseconomies of Scale

(i) increasing labor costs Workers in large firms tend to get paid more than workers in small firms. Possible reasons are: - unionization is more likely in large firms - work may be more enjoyable in small firms - large firms may have to attract workers from far away places (ii) spreading specialized resources too thin - Many talented individuals believe that having achieved success in one venue, they can duplicate it elsewhere. But they fail because they: - lend names but not personal attention (this is sheer hubris) - lack the skill necessary to translate their success to a new situation - simply spread themselves too thin (unable to devote full attention to all of their endeavors) Other limited resources may be: - desirable location - specialized capital inputs - talented managers (iii) "conflicting out" - when a conflict prevents a company from obtaining business, such as a firm loosing additional work to a new client because they already do work for that client's competitor - The growth of professional services firms (in marketing, accounting, consulting, and law) is limited by a potential conflict of interest -These firms may find it difficult to sign up a client if a competitor is already a client of the firm (iv) incentive and coordination effects When a firm gets large: - it is difficult to monitor and communicate with workers - it is difficult to evaluate and reward individual performance - detailed work rules may stifle the creativity of the workers

Sources of economies of scale/scope

(i) indivisibilities and the spreading of fixed costs (ii) increased productivity of variable inputs (specialization) (iii) inventories (iv) the cube-square rule

optimal output

- change in total revenue = MR x ΔQ - change in total cost = MC x ΔQ - change in total profit = (MR - MC) x ΔQ - if MR > MC, the firm can increase profit by selling more (ΔQ > 0), and to do so, it should lower its price - if MR < MC, the firm can increase profit by selling less (ΔQ < 0), and to do so, it should raise its price - if MR = MC, the firm cannot increase profit by either increasing or decreasing output. It follows that output and price must be at their optimal level

factors that decrease elasticity or are less sensitive to price fluctuations

- comparisons among competitive products are difficult - cost is not fully borne by buyers (due to tax deductions/insurance) - switching to other products is costly - the product is used in conjunction with other product that buyers have committed themselves to

economies of scale vs learning

- economies of scale refer to the ability to perform an activity at a lower unit cost when it is performed on a larger scale at a particular point in time (i.e. history doesn't matter) - economies of learning refer to reductions in units costs due to accumulation of experience over time (i.e. history does matter) - Economies of scale may be substantial even when learning economies are minimal - capital intensive technologies can offer scale economies even if there is no learning

The quantity of a product a firm is able to sell depends on:

- the price of the product; - the prices of related products; - the income and taste of the consumers; - quality of the product, and so on

factors that increase elasticity or are more sensitive to price fluctuations

- the product has few unique features that differentiate it from rival products and buyers are aware of the prices and features of the rival products - buyers' expenditures on the product are a large fraction of their total expenditure - the product is an input that buyers use to produce a final good whose demand is itself sensitive to price

Which of the following represents total surplus in the value creation equation?

B - C.

Which of the following represents consumer surplus in the value creation equation: (B-P) + (P-C)?

B - P

relatively elastic demand

A change in price leads to a more than proportional change in the quantity demanded. - relatively small changes in price cause relatively large changes in quantity 1 < η < ∞

sunk cost

A cost that has already been incurred and that cannot be changed by any decision made now or in the future. All sunk costs are fixed costs, however, not all fixed costs are considered to be sunk because some fixed costs can be recovered

Which of the following is false with respect to the strategy of cost leadership?

A firm following a strategy of cost leadership is following a generic strategy narrow in scope. The following are TRUE wrt the strategy of cost leadership: (b) A firm can follow a cost leadership strategy through achieving benefit parity by making products with the same B, but at a lower C than its rivals. (c) A firm can follow a cost leadership strategy through achieving benefit proximity by offering a B that is not much less than those of competitors. (d) A firm following a strategy of cost leadership creates more value than its competitors by offering products that have a lower C than those of its rivals.

Explain why small firms are more likely to outsource production of inputs than are large firms?

A firm gains less from vertical integration the greater the ability is of outside market specialists to take advantage of economies of scale and scope relative to the firm itself. A small firm might not be able to take advantage of the economies of scale and scope because its level of production would not offset the significant, up-front setup costs or meet the demands of a large market outside the firm. A large firm might be able to produce a sufficient level of output and achieve the same economies of scale and scope that an outside firm would have.

Which of the following conclusions can we make about vertical integration with regards to product market share and scope?

A firm with multiple product lines will benefit more from being vertically integrated in the production of components for those products in which it can achieve significant market scale

perfectly competitive market

A market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market, (4) each seller is a price taker - A perfectly competitive firm maximises profit by producing the quantity of output that equates marginal revenue and marginal cost (MR = MC)

arc price elasticity of demand

A measurement of the price elasticity of demand where the base quantity or price is calculated as the average value of the starting and ending quantities or prices η = - (ΔQ/(q1+q0)/2)/(ΔP/(p1+p0)/2)

What is a grim trigger strategy in a two firm repeated game

A strategy in which a firm initially cooperates and then aggresses for the rest of the game as soon as the opponent aggresses

Average Cost Function

AC(Q) describes how the firm's average (or per unit-of-output) costs vary with the amount of output it produces → AC(Q) = TC(Q)/Q = total cost/quantity

"Judo economics suggests that economies of scale are useless at best." Do you agree or disagree? Explain.

AGREE: Firms that have economies of scale over smaller or newer market entrants typically have large sunk costs. These costs can become a disadvantage when other smaller firms attack the market with a different substitute product priced below the larger firm. This "judo" tactic results in the revenue destruction effect where the larger firm in cutting its price to match the substitute product's price losses more revenue than the smaller firm due to its large sunk costs. Economies of scale in this case are useless, and actually act as a negative force on the larger firm. DISAGEE: Economies of scale can prevent newer entrants or drive smaller firms from markets in certain circumstances. For example, the value of scale economies would be to have such significant volume that vital resources and vertical processes are effectively closed off to other market participants. Economies of scale - a grand scale - are useful as a deterrent to market entrance by effectively monopolizing the vertical production chain and prohibiting others from participating in the market.

What type of entry exists if structural entry barriers are low, and either (1) entry-deterring strategies will be ineffective or (2) the cost to the incumbent of trying to deter entry exceeds the benefits it could gain from keeping the entrant out?

Accommodated Entry

Identify one or more experience good. Identify one or more search goods. How does the retailing of experience goods differ from the retailing of search goods? Do these differences help consumers?

An experience good is a product whose quality can be assessed only after the consumer has actually consumed the product. For example, a buyer could not decide if he likes the taste of a particular beverage until the buyer actually consumes the beverage. Sometimes the product has to be used for a while in order to understand fully how satisfying is consumption of the good. For example, a consumer may not be able to evaluate the quality of his automobile until he has driven that automobile for several weeks. A search good is one whose objective quality attributes the typical buyer can easily access at the time of purchase. For example, a consumer could determine all the important attributes of a diamond at the time of purchase—wearing the diamond as an owner of the diamond does not generate any additional information. With search goods, the potential for differentiation lies largely in enhancing the product's observable features. When a firm is selling a search good that possesses attributes the seller wants the customer to know about, the customer does not have to take the seller at his word - the customer can observe the attributes. The seller must only provide an opportunity for the consumer to fully observe the good. Sellers who do not reveal the attributes of their products at the time of sale will lose sales to sellers who are willing to reveal their products fully to buyers or these sellers would have to heavily discount their prices. The seller's reputation, however, is not in question—the attributes of the good speak for themselves. When selling an experience good, sellers must often send signals to buyers that the good will not disappointment the buyer post-purchase. Since the buyer does not get to fully appreciate the good until after the good is consumed, the buyer buys under uncertainty. The seller's reputation for delivering products that perform as promised becomes an important feature of the purchase process. The selling processes associated with 'search and experience' goods help insure that consumers purchase goods closer to their "ideal" good. Both processes reduce the risks of buying under uncertainty—the attributes of search goods are revealed at the time of purchase and reputation and other credible signals are used to guide consumers in their purchases of experience goods.

What is a market firm

An independent outsourcing partner

What problem preventing complete contracts refers to a lack of transparency/equal access to the details surrounding a contract

Asymmetric information.

What type of good is one whose quality can be assessed only after the customer has used it for a while?

Automobile and experience good

How does the magnitude of scale economies affect the intensity of each of the five forces? (Note that economies of scale exist when the average cost of producing output declines as the absolute volume of output increases. Scale economies affect the number of competitors that can compete successfully in an industry. There are likely to be fewer firms in an industry with high-scale economies relative to total industry output than in an industry where scale economies are exhausted at relatively low levels of output. Since there are fewer players, the established incumbents would each have large market share and incur low unit production cost). In this context, in what way do scale economies affect the five forces? Explain the effect of scale economies on the five forces).

Barriers to Entry: Scale economies raise the entry barriers. To bring cost to a level comparable to those of existing players, an entrant would have to enter the industry with large capacity and risk strong reaction from the incumbents. An alternative would be to enter at a small scale and face a cost disadvantage. Both options are undesirable to new entrants. Rivalry: Scale economies can have competing effects on rivalry. On the one hand, scale economies may intensify rivalry because the players have the incentive to increase their market share to sustain and deepen their scale economies. Rivalry may take the form of price competition, advertising battles, and new product introductions. On the other hand, scale economies may result in fewer firms that could facilitate communication and "peaceful coexistence" among industry players. Substitutes: Scale economies increase the threat of the substitute products. If the price performance trade-off of a substitute product improves, firms within the industry lose share which reduces the industry's own price-performance trade-off. Bargaining Power of Suppliers: If high-scale economies result in fewer firms in the industry, it is possible that the bargaining power of suppliers decreases. Fewer firms could co-ordinate their purchases from suppliers, negotiating lower prices, and thereby increasing value creation in the industry. Bargaining Power of Buyers: Using the same reasoning for supplier power, scale economies that lead to higher industry concentration could decrease the bargaining power of buyers. Fewer firms could co-ordinate their pricing activities, thereby reducing consumer surplus. On the other hand, however, the existence of scale economies increases the power of buyers who purchase very large quantities

What type of entry exists if structural barriers are so high the incumbent need do nothing to deter entry?

Blockaded Entry

What type of strategy seeks to serve all customer groups in the market by offering a full line of related products?

Broad-coverage strategy

Which of the following is an example of an early-mover advantage?

Building networks of complementors

What term describes the situation when a firm earns a higher rate of economic profit than the average rate of economic profit of other firms competing within the same market?

Competitive advantage.

Which of the following factors requires the least consideration when assessing supplier power relative to the downstream industry it sells to?

Competitiveness of the output market.

Average Cost and constant returns to scale

Constant returns to scale → If inputs are doubled (and thus costs are doubled assuming input prices are constant), output will double; • AC is constant at all levels of output Increasing returns to scale → If inputs are doubled, output will more than double; • AC decreases at all levels of output. Thus the firm enjoys economies of scale Decreasing/Diminshing returns to scale → If inputs are doubled, output will less than double; • AC increases at all levels of output. Thus the firm faces diseconomies of scale

When multiple firms' price-quality positions line up along the same indifference curve offering a consumer the same amount of consumer surplus, what term describes the situation?

Consumer surplus parity

What is the perceived benefit of a product per unit consumed minus the product's monetary price?

Consumer surplus.

Benefit proximity refers to which of the following?

Cost leading firms offering products with slightly less benefit.

What are agency costs?

Costs associated with slack effort and with the administrative controls to deter it.

What kind of competition is generally described as quantity competition?

Cournot competition.

What empirical method generally is used to measure the degree to which products substitute for each other?

Cross-price elasticity.

What term best describes a targeting strategy in which the firm offers a variety or related products to a particular class of customers?

Customer specialisation

Under what conditions do economies of scale serve as an entry barrier? Do the same conditions apply to learning curves?

Economies of scale can serve as an entry barrier when the investment made by the incumbent is a sunk cost. Incumbent is unlikely to quit when competition intensifies. If the investment is not a sunk cost (reversible investments, general purpose assets) then there will be no entry barriers even if there are economies of scale. Learning curve effects are similar to sunk cost effects. The high cost of production during the learning period can serve as an entry barrier, the same way sunk cost investments do.

"All else equal, an incumbent would prefer blockaded entry to deterable entry." Comment.

Entry is blockaded if the incumbent need not undertake any entry-deterring strategies to deter entry. Blockaded entry may result when there are structural entry barriers, perhaps because production requires significant fixed investments. Blockaded entry may also result if the entrant expects unfavorable post-entry competition, perhaps because the entrant's product is undifferentiated from those of the incumbents. Entry is deterred if the incumbent can keep the entrant out by employing entry-deterring strategies, such as limit pricing, predatory pricing, and capacity expansion. Moreover, the cost of the entry-deterring strategy is more than offset by the additional profits that the incumbent enjoys in the less competitive environment. However, entry-deterring strategies are generally met with various degrees of success. Control of essential resources, economies of scale and scope, and marketing advantages of incumbency are types of entry barriers. The firm who is able to use one or a combination of these entry barriers to blockade entry does not have to actively guard itself against entry and so can focus on other activities. If entry is deterred rather than blockaded, the incumbent must actively engage in predatory acts to discourage entry. A threat of entry will most definitely constrain the incumbent. Given that the incumbent might prefer to be passive rather than active about discouraging entry, blockaded entry would be preferable to deterable entry.

Which of the following does not tend to affect the threat of entry?

Expectations about pre-entry competition the following DO affect the threat of entry: (b) Government protection of incumbents. (c) Consumers highly valuable reputation/consumers are brand loyal. (d) Experience curve.

Some contracts, such as those between municipalities and highway construction firms, are extremely long with terms spelled out in minute detail. Others, such as those between consulting firms and their clients, are short and fairly vague about the division of responsibilities. What factors might determine such differences in contract length and detail?

Factors that might determine differences in contract length and detail include verifiability and measurability of performance. In the case of the highway construction contract, it may be easier to specify the terms of performance than in the case of the consulting project. That is, it may be easier to specify design specifications, timing, acceptable road quality, etc. When performance under a contract is extremely complicated to specify or hard to measure, as one would expect in the case of the consulting contract, it may be difficult to elaborate each party's rights and responsibilities within a written contract. The language in such contracts is often left vague and open-ended because it is not clear what constitutes fulfilment of the contract.

Which of the following best describes the term, internal rivalry?

Firms jockeying for share within a market.

Which of the following is a concept developed by Michael Porter that describes, in broad terms, how a firm positions itself to compete in the market it serves?

Generic strategy

What term describes the differentiation of a product when only some consumers prefer it to competing products (holding price equal)?

Horizontal differentiation.

What group/type of preferences describes when tastes differ markedly from one person to the next and result in horizontal differentiation?

Idiosyncratic preferences.

"How a firm behaves toward existing competitors is a major determinant of whether it will face entry by new competitors." Explain.

If a firm is "tough" toward existing competitors (e.g., the firm is involved in price or non-price competition), the firm will face less entry because entrants will expect lower profits than if the incumbent were more tolerant of entry. However, if the incumbent has a "soft" stance toward the existing competitors, the entrant may take this as a signal for some accommodation of entry and thus the entry rate could be higher. The incumbent signals what post-entry competition will be like through its current behavior toward other firms in the industry

Which of the following is a potential risk of a brand umbrella?

If a new product under the umbrella fails, consumers may become disenchanted with the entire brand.

Which of the following conclusions can we make about vertical integration with regards to asset specificity?

If asset specificity is significant enough, vertical integration will be more profitable than arm's-length market purchases, even when production of the input is characterised by strong scale economies or when the firm's product market scale is small

What term best describes a resource that cannot 'sell itself' to the highest bidder?

Imperfectly mobile

What is the difference between a soft commitment and no commitment?

In making no commitment, a firm has not taken an action or made an investment that alters its own and/or its rival's competitive responses. In contrast, a soft commitment is one that, no matter what its competitors do, the firm will behave less aggressively than if it had not made the commitment. Thus, in a Cournot game a soft commitment will cause the firm to produce relatively less output, while in a Bertrand game a soft commitment will induce the firm to charge a higher price than if it had not made the commitment

Why are the Cournot and Bertrand models considered static? What aspects of real world behaviour might be missing in static models

In the Cournot and Betrand models of duopoly, each firm decides on the price and quantity choice once. In a dynamic model, there will be multiple periods and these choices will have to be made repeatedly in each period. Each period's decision will have to maximise the present value of future cash flows. This means in a dynamic model a firm has to anticipate what rivals will do in the future, not just react to what it has done in the past. Firms do anticipate their rivals actions and they act across multiple periods.

implicit costs

Indirect, non-purchased, or opportunity costs of resources provided by the entrepreneur

How does the digitisation of books, movies and music affect inventory economies of scale?

Inventory costs drive up the average costs of the goods that are actually sold. The need to carry inventories creates economies of scale because firms doing a high volume of business can usually maintain a lower ratio of inventory to sales. The digitisation of books, movies and music reduces the economies of scale that large firms have because low sales firms can essentially "stock" the same quantity of inventory - the digital files that can be duplicated repeatedly. Larger firms that previously enjoyed a competitive advantage due to their high sales volume and low ratio of inventory to sales now face increased competition from smaller firms that enjoy the same average costs to sales due to inventory

Which of the following is a characteristic of an implicit contract?

It is an understanding between parties in a business relationship.

Tough Commitment

It is bad for competitors

What kind of strategy is one by which a firm maintains price parity with its competitors and profits from its benefit or cost advantage primarily through high price-cost margins, rather than through a higher market share?

Margin strategy.

In what ways are monopolistically competitive markets "monopolistic?" In what ways are they "competitive?"

Monopolistic competition is a market structure when many producers of somewhat different products compete with one another. Monopolistic competition has features in common with both monopoly and perfect competition. As with monopoly, individual sellers in monopolistic competition believe that they have some market power. But, monopolistic competition is probably closer to competition than monopoly. Entry into and exit out of the industry is unrestricted, and consequently, the industry has many independent sellers. In virtue of the relatively free entry of new firms, the long-run price and output behaviour, and zero long-run economic profits, monopolistic competition is similar to perfect competition. However, the monopolistically competitive firm produces a product that is different (i.e. differentiated rather than identical or homogeneous) from others, which leads to some degree of monopoly power. In a sense, sellers in a monopolistically competitive market may be regarded as "monopolists" of their own particular brand. Unlike firms with a true monopoly, however, competition occurs among the many firms selling similar (but not identical) brands.

Which of the following market structures generally has a Herfindahl index at 0.6 and above (usually having light competition, unless threatened by entry)?

Monopoly.

What term describes a firm that faces little or no competition in one of its input markets?

Monopsonist.

Which real-world market closely approximates perfect competition?

Most agricultural markets.

"Niche strategies are generally more profitable than "mass-market" strategies because they usually imply weaker price competition." Comment.

Niche strategies (focus strategies) often insulate a firm from competition. If the focuser's industrial segment is small - either because it offers a narrow set of product varieties or serves a narrow set of customers, or does both - it may face little competition and earn substantial returns. Fewer competitors reduces price competition and allows the niche firm be more flexible in its pricing strategy.

Rivalry among firms in an industry is typically stronger when which of the following is true about the underlying industry economics? Note: It is possible that more than one - or none - of the answers to this question are correct. Explain the reason. (a) Fixed costs of production are high. (b) There are two competitors in the industry. (c) Products are differentiated. (d) Production capacity in the industry is low relative to current demand.

None of the above listed industry economics increase or maintains strong rivalry among firms. Reason: (a) When fixed costs of production are high, they create strong barriers to entry of new firms. As a consequence, the market has few participants and rivalry is limited. (b) If there are only two competitors in a market the rivalry between them will be low. When there are many competitors there is a good chance one will be dissatisfied with the status quo and will want to lower price to improve market share. (c) Differentiated products do not increase or sustain strong internal rivalry. When products are un-differentiated and switching costs are low, firms believe that price reductions will generate substantial increases in market share. (d) If production capacity is low, firms have no incentive to lower prices and therefore internal rivalry is minimised. Only when there is excess production capacity do firms have an incentive to lower prices to boost sales.

Coke and Pepsi have sustained their market dominance for nearly a century. General Motors and Ford have recently been hard hit by competition. What is different about the product/market situation in these cases that affects sustainability?

One problem facing the auto industry is even the most popular of cars, such as Ford's 1960 Mustang faces a limited technological as well as a general product life cycle. That is, changes in technology and taste force automakers to eventually phase out even the most popular models. Coke and Pepsi, on the other hand, face no real pressure to change their formula. In short, automakers must incur huge recurring capital outlays in order to produce, while Coke and Pepsi only need to continually invest in their brands.

What happens when the process by which governance develops exhibits path dependence?

Past circumstances could exclude certain possible governance arrangements in the future.

How can incumbents legally erect entry barriers around novel and non-obvious products or production processes

Patents

Which of the following processes is most representative of a vertically integrated firm on the "make" end of the make-or-buy continuum?

Perform activity internally.

Which of the following asset specificity forms describes why glass container production requires molds custom tailored to particular container shapes and glass making machines?

Physical asset specificity.

What term represents the conduct and performance of firms in the market after entry has occurred?

Postentry competition.

explicit costs

The actual payments a firm makes to its factors of production and other suppliers.

Total output and price

Q(Monopoly) < Q(Cournot) < Q(Stack.) < Q(Perf.comp.) P(Monopoly) > P(Cournot) > P(Stack.) > P(Perf.comp)

Which of the following is not a result of the holdup problem

Reduction in the transaction costs of arm's length. the following ARE results of holdup problem (b) More difficult contract negotiations and more frequent renegotiations. (c) Distrust. (d) Investments to improve ex post bargaining positions

physical asset specificity

Refers to a situation where the capital equipment needed to produce an input is designed to meet the needs of a particular buyer and cannot be readily adapted to produce inputs needed by other buyers

What term describes the situation where a firm does exceedingly well due to good luck or exceedingly poorly due to bad luck, but returns to normal performance following?

Regression to the mean

What concept describes the situation where the owner of an asset grants another party the right to use that asset, but the owner retains all controlling rights that are not explicitly stipulated in the contract?

Residual rights of control

What term describes a framework used in strategy based on resource heterogeneity which posits that for a competitive advantage to be sustainable, it must be underpinned by resource capabilities that are scarce and imperfectly mobile?

Resource-based theory of the firm.

What criterion developed by the DOJ is used to identify all potential competitors within the market?

SSNIP criterion

How do economies of scale affect sustainability?

Scale economies limit the number of firms that enter a market. This limits competition for the existing large (scale efficient) firm. Likewise, smaller firms in the market are discouraged from expanding since expansion, while leading to reduced costs, would also lead to reduced revenues for all firms and most likely lack of profit. As a consequence, economies of scale limit market entrants and limit competitor expansion, both of which increase sustainability for the firm that is recognizing MES.

What type of good is one whose quality is relatively easy to evaluate before purchase?

Search good

What kind of strategy is one by which a firm exploits its benefit or cost advantage through a higher market share rather than through high price-cost margins?

Share strategy

What kind of economies come from reductions in average costs due to increases in capacity utilisation

Short-run economies of scale

What are the two types of barriers to entry?

Structural and strategic

Which of the following describes when a manufacturer produces some of an input quantity itself and purchases the remaining portion from independent firms?

Tapered integration.

What term describes when a firm is using the least-cost production process?

Technical efficiency

What do the vertical boundaries of a firm refer to

The activities the firm itself performs versus purchases from independent firms

why is herfindahl better than concentration ratio

The concentration ratio is the most commonly found measure of market concentration because it is so user friendly. To derive it all that is needed is to rank the firms in an industry in terms of market share then add the N largest firms' (4 in this example) percentage market share together. The problem with this measure is that it emphasises the top four firms but ignores the rest. It does not always yield an unambiguous comparison of concentration between two industries. The Herfindahl index is a now widely used method of measuring market concentration that is more reliable than the concentration ratio. It still ranks firms by market share but includes all firms in the industry of significance. By squaring the respective market shares, the index gives additional emphasis to large firms.

What is a catchment area?

The contiguous area from which a firm draws most of its customers.

Which of the following is not a characteristic of a complete contract?

The contract allows for a party to exploit weaknesses in another party's position as the transaction unfolds

Which of the following is true with regard to the difference in production costs between an item produced in a vertically integrated firm and an item exchanged through an arm's length market transaction as the level of asset specificity increases?

The cost difference declines with greater asset specificity

Which of the following is not a condition under which an incumbent firm can successfully deter entry by holding excess capacity?

The excess capacity investment must be recoverable prior to entry

Which of the following relationships hold true for safety stock?

The higher the profit margin per unit, the higher the safety stock necessary.

minimum efficient scale (MES)

The lowest level of output at which a firm can minimize long-run average total cost. It is the scale of production where the economies of scale have been fully exploited (and thus the firm no longer benefits from economies of scale) The minimum point on a U-shaped average cost curve

"Integrated firms are more efficient than independent firms if the central office is more efficient than the courts." Explain this statement. To what extent do you agree?

The production of a good or service by a firm can either have some or all of its processes made or bought. If the firm is able to exercise strong governance and internal controls over its integrated processes, its costs from agency and coordination effects will be minimal. Comparatively, if the firm does not have an efficient central control system over its processes, then its productions costs will be high. Purchasing upstream and downstream processes can offset the high costs of central office efficiency and administration, but only to the extent the contracts for those processes are near complete. Incomplete contracts can result in litigation which increases the cost of buying versus making production. This quote implies that all, or most, contracts are incomplete to the extent they will end in litigation. Likewise it assumes the cost of that litigation will exceed the expense of strong central office controls. Most contracts do not end in litigation and therefore the cost of buying versus making is most likely skewed towards buying

What is the property rights theory of the firm?

The property rights theory (PRT) of the firm states that integration determines the ownership and control of assets and it is through ownership and control that firms are able to exploit contractual incompleteness. Integration matters because it determines who gets to control resources, make decisions, and allocate profits when contracts are incomplete and trading partners disagree.

Why is the "technical efficiency" line (represented by T) above the x-axis?

The technical efficiency line represents the minimum cost of production under vertical integration minus the minimum cost of production under arm's-length market exchange. The technical efficiency line is above the x-axis indicating that the minimum cost of production under vertical integration is higher than the minimum cost of production under arm's-length market exchange, irrespective of the level of asset specificity. The reason costs are higher under internal organisation is that outside suppliers can aggregate demands from other buyers and thus can take better advantage of economies of scale and scope to lower production costs.

The steepness (slope) of an indifference curve indicates which of the following?

The tradeoff a consumer is willing to make between price and quality.

Universities tend to be highly integrated—many departments all belong to the same organisation. There is not a technical reason why a university could not consist of freestanding departments linked together by contracts, much in the same way that a network organisation links freestanding businesses. Why do you suppose that universities are not organised in this way?

The underlying reasons behind the existence of "integrated" universities include: Coordination Costs: There are several issues with regard to coordination, including 1) timing (individual departments must coordinate around a common academic calendar) and 2) sequencing (a common sequence of courses towards degree requirements needs to exist). Arranging these elements through contracts would be extremely difficult and costly to achieve. Organisational Issues: The university departments are bound by ties of social similarity such that they value their association with each other in addition to any monetary issues involved in their departments. This commitment supplements the more formal governances inside the university making internal governance more effective than market governance. Culture can also complement formal governance mechanisms within the university making the internal organisation more effective than the market could be. Contracting a common culture for a "networked" university promises to be virtually impossible. Economies of Scale: By remaining integrated, a university can take advantage of several economies of scale, including 1) purchasing economies of scale, 2) marketing economies of scale in attracting both students and professors, 3) the spreading of fixed investments such as real estate, information technology and sports-related investments, and 4) the spreading of administrative overhead. These activities could not be accomplished as efficiently through contracting.

How can the value chain help a firm identify its strategic position?

The value chain is a technique for describing the vertical chain of production. The value chain is also a useful device for thinking about how value is created in an organization. The value chain depicts the firm as a collection of value-creating activities, such as production operations, marketing and distribution, and logistics. Each activity in the value chain can potentially add to the benefit (B) that consumers get from the firm's product and each can add to the cost (C) that the firm incurs in producing and selling the product. A firm creates more value than competitors only by performing some or all of these activities better than they do. We can often categorise strategic positions into two broad categories, either a cost advantage or a differentiation advantage. If a firm outperforms other firms in activities that generate superior B (differentiation) or in activities that generate a lower C (cost), the firm's strategic position should rely on these activities.

Special sources of scale and scope economies

There are at least four sources of economies of scale and scope that are related to areas other than production; (i) purchasing - Purchasing in bulk offers benefits in discounted price (big buyers tend to be more price-sensitive) - Thus, large firms can gain economies of scale by purchasing items in bulk at discounted price - But, why suppliers offer discounts? - it is less costly for a seller to sell to a single buyer (lower contract and negotiation costs) - suppliers may dislike disruption to operations and may offer better deals to bigger buyers (ii) advertising - (cost of sending message/potential # of consumers receiving the message)/(# of actual consumers as a result of the message/potential # of consumers receiving the message) (iii) research and development - The fact that there is a substantial indivisible investment in R&D implies that average fixed costs will decline rapidly as output/sales increase - R&D is also a major source of economies of scope. Ideas from one project can help another project (positive spillovers) (iv) complementarities and strategic fit - Strategic fit is the degree to which the activities of different sections of a business or businesses working together complement one another to achieve competitive advantage and business success

Why do price-sensitive buyers tend to harm cooperative pricing in a market?

There is an increase in temptation to cut price, even if competitors are expected to match

Why are suppliers in a competitive upstream market said to have "indirect power"?

They can sell their services to the highest bidder

Recall from Chapter 2 Adam Smith's dictum, "The division of labour is limited by the extent of the market." How does market growth affect the viability of a focus strategy?

Under a focus strategy, a firm concentrates either on offering a single product or serving a single market segment or both. Four examples of focus strategies are: (i) Product specialisation: The firm concentrates on producing a single type of product of a variety of different market segments. (ii) Geographic specialisation: The firm offers a variety of related products within a narrowly defined geographic market. (iii) Customer specialisation: The firm offers a variety of related products to a particular class of customers. (iv) Niche strategy: A firm produces a single product for a single market segment. The basic economic logic of a focus strategy is that the firm is sometimes able to achieve deep economies of scale by concentrating on a particular segment or a particular product that is would be unable to exploit if it expanded beyond the segment or product it is concentrating on. The growth of a market can make a focus strategy that at one time was not feasible become a very profitable opportunity. Growth might also increase the benefits of economies of scale for the focuser. If a market grows to the point where a firm's economies of scale are exhausted, the firm might have to worry about entry.

What term describes the differentiation of a product when it is unambiguously better or worse than competing products?

Vertical differentiation.

What term describes a situation where two or more parties expend resources battling each other?

War of attrition.

positioning analysis

What step of Ghemawat's framework for analyzing commitment intensive choices involves analyzing whether the firm's commitment is likely to result in a product market position in which the firm delivers superior benefits to consumers or operates with lower costs than competitors?

Marginal Cost (MC) and Average Cost (AC)

When MC is below AC, AC is falling When MC is above AC, AC is rising When AC is at a minimum, MC = AC, so the two curves must intersect

When is predatory pricing a most effective entry barrier?

When a firm has a reputation for toughness or competes in multiple markets.

Suppose that two firms compete in a market where consumers have identical preferences. The benefits and costs of the two firms are B1, C1 and B2, C2 respectively, where (B1 - C1) is greater than (B2 - C2). What price should firm 1 set so that it can capture the entire market and maximise profits?

With firm 1 already having a better (higher) B - C, its product price should be set below that of firm 2. Since consumers have equal preference for both products, with firm 1 already having a B - C advantage, setting its price below that of firm 2 will increase consumer surplus for its product and ultimately capture the entire market.

unit elastic

a given change in price causes a proportional change in quantity demanded - any change in price is matched by an equal relative change in quantity η = 1

perfectly elastic demand curve

a horizontal line reflecting a situation in which any price increase reduces the quantity demanded to zero; the elasticity has an absolute value of infinity - an infinitesimally small change in price results in an infinitely large change in quantity demanded η = ∞

learning curve

a line that displays the relationship between processing time and the cumulative quantity of a product or service produced - The learning curve (or experience curve) refers to advantages that flow from accumulating experience and know-how - Learning economies depend on cumulative output rather than the rate of output - Learning leads to lower costs, higher quality, and more effective pricing and marketing Y = aX^b where - Y = the cumulative average time (or cost) per unit - X = the cumulative number of units produced - a = time (or cost) required to produce the first unit - b = index of learning (b = log of the learning rate/log of 2) - When a firm enjoys the benefits of a learning curve, the marginal cost of increasing current production is the expected marginal cost of the last unit of production the firms expects to sell - Learning firms should be willing to price below short-run costs (firms may earn negative accounting profits in the short-run but will prosper in the long run)

price elasticity of demand

a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price → η = - (change in Q/original Q)/(change in P/original P) change in Q = Q1 - Q0 change in P = P1 - P0 → If η < 1, we say that demand is inelastic (i.e.demand is less sensitive to price) → If η > 1, we say that demand is inelastic (i.e.demand is less sensitive to price)

tit-for-tat strategy

a policy in which a firm is prepared to match whatever change in strategy a competitor makes A means of encouraging cooperation by at first acting cooperatively but then always responding the way your opponent did (cooperatively or competitively) on the previous trial

normal profit

a profit that allows a business to survive and grow. → Normal profit occurs when the difference between total revenue and total cost (explicit and implicit) is equal to zero → Normal profit is also called zero economic profit → Normal profit is the minimum level of profit needed for a firm to remain competitive in the market → Zero economic profit means that you are doing no better but also no worse than you could do in some other business

Most favored customer clause

a provision in a sales contract that promises a buyer that it will pay the lowest price the seller charges A price protection clause (sometimes referred to as a "most-favored-nation clause") specifies that the supplier, over the duration of the contract, will not offer a lower price to other buyers, or if a lower price is offered to others, it will apply to this contract as well.

relatively inelastic

a term used when the price elasticity of demand is less than 1 but greater than zero - relatively large changes in price cause relatively small changes in quantity 0 < η < 1

economies of scale

average cost per unit falls as output rises i.e. a cost advantage experienced by a firm when it increase its level of output

weak kitten

commitment strategy involves soft commitment postures, strategic complements for the stage 2 tactical variables, a refrain commitment action and an acceptance of the status quo out of fear thus waiting to follow the leader

Diversification

company growth through starting up or acquiring businesses outside the company's current products and markets Diversification occurs when a business develops a new product or expands into a new market - Diversification across products and across markets can exploit economies of scale and scope - Diversification is costly, especially when one firm acquires another Firms may choose to diversify for either of two reasons: (i) diversification may benefit the firm's owners by increasing the efficiency of the firm (ii) if the firm's owners are not directly involved in deciding whether to diversify, diversification decisions may reflect the preferences of the firm's managers

Law of Demand

consumers buy more of a good when its price decreases and less when its price increases. the law of demand may not hold if high prices: - confer prestige, or - enhance a product's image, or - when consumers cannot objectively assess the potential performance of a product and use price to infer quality

focal point strategy

cooperation-inducing strategy defined as one so compelling that a firm would expect all other firms to adopt it

fixed costs

costs that do not change with an increase or decrease in the amount of goods or services produced (e.g. a company's lease on a building)

variable costs

costs that vary with the quantity of output produced (e.g. direct labor)

In the long run, a monopolistically competitive firm _______

earns zero economic profit

direct effect

effect that describes how a commitment impacts the present value of the firm's profits, assuming the firm adjusts its own tactical decisions in light of this commitment and that its competitor's behavior does not change

The word 'monopolistic' in monopolistic competition refers to the fact that ______.

firms have some control over price

The word monopolistic in monopolistic competition refers to the fact that _________.

firms have some control over price

The reduction of co-ordination and hold-up problems depends on

governance arrangements

Brand loyalty _____________.

makes the demand curve less price-elastic

100% learning curve

no learning has been achieved

Suppose we have two firms (Firm 1 & Firm 2) enter into a transaction where Firm 1 is upstream of firm 2 in a vertical chain. What term best describes the organisation of the transaction where the two firms are independent, each with control over its own assets?

nonitegration

Early mover advantage suggests that ________.

pioneering businesses are able to obtain higher profits and other benefits as the consequence of early market entry

economies of scope

savings that come from producing two (or more) outputs at less cost than producing each output individually, despite using the same resources and technology is an economic theory stating that average total cost of production decreases as a result of increasing the number of different goods produced

Which of the following types of fit (used to aide in coordination along all dimensions of production) explains a situation where the steps of a particular process must occur in a particular order?

sequence fit

In the short run a monopolistic competitor ___________.

sets MR = MC

Monopolistic competition results in ________.

some production inefficiency

According to Porter, if an organisation does not follow either a cost reduction strategy or a differentiation strategy they are _________.

stuck in the middle

Powerful buyer exist when ________.

switching costs are low and there are few buyers

Total Revenue Function

the functional relationship that shows the total revenue (price times quantity) received by a producer as a function of the level of output - TR(Q) = P(Q)Q = price per quantity x quantity

price umbrella

the leader maintains the price at a high enough level that competitors can earn a profit at that or lower levels

If the firms in an oligopoly collude __________.

the profit of the industry is maximised

diseconomies of scale

the property whereby long-run average total cost rises as the quantity of output increases

constant returns to scale

the property whereby long-run average total cost stays the same as the quantity of output changes

marginal cost

the rate of change of total cost with respect to output. It is the increase in cost that results from expanding output by one extra unit. - is less than average cost when average cost is decreasing → MC(Q) = change in total cost/change in quantity

accounting profit

total revenue - explicit costs

Profit (π)

total revenue - total cost → TR = R = R(Q) = P x Q → TC = C = C(Q)

economic profit

total revenue minus total cost, including both explicit and implicit costs P > AC

perfectly inelastic demand curve

vertical line. the case where the quantity demanded is completely unresponsive to price and the price elasticity of demand equals zero - the percentage change in price exceeds the percentage change in quantity demanded of a good - quantity demanded is unaffected by any change in price η = 0

marginal revenue function

→ MR(Q) = change in total revenue/change in quantity → MR is closer to price as demand becomes more elastic - MR(Q) = p(1 - (1/η)) therefore MR < P but if η = ∞, then MR = P When demand is elastic (η > 1) MR > 0 - the increase in output brought about by a reduction in price will raise total sales revenues When demand is inelastic (η < 1) MR < 0 - the increase in output brought about by a reduction in price will lower total sales revenues