EC132 Flashcards
3 characteristics that set firms and markets apart
FIRMS
Centralised decision making
Coordination via communication
Personal interaction
MARKETS
Decentralised decision making
Coordination via prices
Anonymous interaction
What is a transaction cost?
A cost to using the market itself
The Fundamental Problem of Exchange
A merchant has cargo and wants to trade to consumers using an agent.
If he trusts the agent, then the agent can sell the cargo and return the revenue, and get paid a wage.
BUT a rational agent might reason differently: since the revenue must exceed the wage, then why not keep all the revenue and never return to the merchant?
BUT a rational merchant realises this and will not trust the agent with his cargo.
What is a cooperation problem?
Individual’s incentives not aligned with the group
Examples of cooperation problems
Price cutting
Advertising
Innovation and product adoption
Overfishing
Drug use in sports
Stockpiling nuclear weapons
Studying on EC132
Grade inflation
What is a coordination problem?
A situation in which the interests of agents coincide, while the aim is to try to reach an outcome in which those interests are satisfied.
Examples of coordination problems
Product differentiation
Trading and specialisation
Bank runs
Competing standards
Coordinating hiring decisions
Crossing the road en-masse
Main differences between cooperation and coordination problems
Cooperation problems:
Conflict between best individual outcome and mutual benefit
Cheating is the major concern
Not always strategic
Coordination problems:
Many feasible mutually beneficial outcomes
Coordination is the major concern
Heavily strategic
Spot contract
Immediate and one-off transaction using established market prices and terms of trade
Advantages of spot contracts
Best for simple transactions where both parties know what they’re getting
No further commitment on both sides
Low transaction cost
Easily and widely implementable
Classical contracts
Legally enforceable contract detailing specific terms of exchange. Long-term and often with finite length.
Advantages of classical contracts
Desirable for long term transactions
Provides what-if contingencies
Prevents opportunism
Can incentivise mutually beneficial investments
Why are classical contracts so important for firms?
UNCERTAINTY IS COSTLY TO MANAGE
-Changing input prices and suppliers
-Hiring new employees
PREVENTS OPPORTUNISM (CHEATING)
-Downstream buyers not paying
-Suppliers sending lower quality goods
-‘Hold-up’
Relational/implicit contracts
Unwritten codes of conduct sustained by the value of future relationships. Roles may be informally defined but no explicit ‘terms’. Long term with no fixed end point.
Examples of a relational contract in a classical contract
Discretionary bonuses / promotions
-Usually on the basis of qualitatively assessed performance
-Can be based on tasks not anticipated/included in classical contract
-Contingent on company performance
Pros of relational contracts
Can incentivise non-contractible outcomes
Does not require legal enforcement
Flexible
Cons of relational contracts
Limited applicability
Open to abuse of power
Exposed to cultural misunderstandings
Cons of classical contracts
High transaction cost
Some things are non-contractible
Require strong legal institutions
Cons of spot contracts
Can lead to short-term opportunism
Difficult to encourage long-term investment
Exposed to price volatility
What is the problem with performance related pay?
Noise, much higher risk for employees
Manipulation of performance metrics
Focus on measurable tasks encourages the employees to neglect other non-measurable tasks (e.g. Teachers only teaching students to pass exams)
What does it mean by a firm being a ‘nexus of contracts’?
Spot contracts between firm and customers
Classical contracts between firms and suppliers
Relational contracts between employees
New incentive problems created by firms
Shirking
Empire building
Lobbying for company resources
5 solutions to coordination problems
Commitment
Authority
Delegation
Convention
Reputation
What does a manager do to solve coordination problems?
Coordinate (set goals and objectives, communicate)
Lead (establish conventions)
Examples of strategic assets
Examples given in lectures:
Natural monopolies
Barrier to entry
Licensing and regulation
Example of resources
Reputation/Brand
Management and governance structure
Nelson (1975) on advertising
Expensive advertising signalled a need for repeat customers (to pay for the advertising) and that repeat custom would only occur if the quality was high.
So the more obviously expensive the advertising (the more famous the celebrity), the more a firm signals quality!
Natural monopoly characteristics
There is only room for one firm, small market size
A competitive firm cannot break even. The industry is loss making where MC=AR
Firms that are forced to compete will leave the industry
Only a monopoly firm that sets supply where MC=MR can make a profit and remain in the industry
Increasing returns to scale (Large fixed costs + Network effects)
Increasing returns to scale
When a firm finds it cheaper to produce as they grow in size and output
Examples of natural monopolies
Railroad networks
Public utilities (water, power)
Previously:
Telephone
Satellite TV in the 1980s
Examples of barriers to entry
Increasing returns to scale
Switching costs
High sunk costs
Limited access to natural resources
_________
Strong brand presence
Customer loyalty
Government’s role in strategic assets (3)
Govt action can create monopolies (nationalisation for the sake of revenue, protecting output or employment)
Govt purchasing can foster concentration by excluding outsiders (e.g. military procurement)
Firms can be heavily subsidised to compete (e.g. long-haul airlines such as Emirates, Etihad and Qatar Airways)
Strategic assets vs resources for helping long-term profitability
Firms benefit from strategic assets: they generate profit and restrict competition
However, they do not drive the economy forward, they are not about boosting productivity, lowering costs or innovating
Most economists believe that the better avenue for long-term profitability comes from resources
These include reputation (for quality), managerial techniques and innovative capacity.
Two types of innovation
Product innovation
Process innovation
Product innovation
The introduction of entirely new products
(this may be because it was not cheap enough to be supplied/demanded before)
Process innovation
The production of existing goods at lower cost (a continuation of product innovation)
Why can innovation add value to the firm?
Continuous innovation -> continuous cost advantage
Provides a source of product differentiation
May spill over to reputation/brand
Innovation and knowledge creation are what type of goods?
Public goods
Characteristics of public goods
They are not depleted the more people use them
It is difficult to prevent others using them
What is the free rider problem?
Those who benefit from resources, public goods and common pool resources do not pay for them or under-pay.
How does innovation affect producer surplus in a competitive industry?
It doesn’t affect it at all - there is no added value to the firm
How does innovation affect producer surplus in a monopolised industry?
Producer surplus increases - the firm has an incentive to innovate
How to solve this issue:
Competitive industries provide maximum total gain from innovation.
BUT monopolised industries provide firms with the much needed incentives to undertake (costly) innovation
Patents
Problems with patents
Costs of litigation, and may not work (Apple vs Samsung)
Length
Breadth
Patent races
Can all ideas be patented?
Should all ideas be patented?
Ethical issues
Patent trolls
Can all ideas be patented? Example
Restaurants
Menu and signature dishes are a major source of competitive advantage.
But a restaurant’s menu cannot be patented!
However, chefs around the world continue to be innovative due to tacit knowledge, fast moving product lines, and possibly relational contracts?
Should all ideas be patented? Example
Software industry
Innovation occurs organically without patents (open source software)
Software innovations are strongly complementary with other innovations - restricting diffusion may limit innovation elsewhere
Software patents are often broad and abstract, vagueness can lead to ‘patent wars’ and costly litigation
What do executives think about the most common reason for mergers to fail?
Synergies
Economies of scope
More efficient to produce product X and Y in a single firm than in two distinct firms
Winner’s curse
If all firms who bid for something according to their values, the winner will be the one who overvalued it the most.
This makes synergies crucial for mergers and acquisitions
Valid reasons for integration
We should merge with ‘Company X’ to exploit economies of scope (synergies)
We should merge with ‘Company X’ to reduce competition
We should acquire ‘Company X’ to secure its resources (e.g. its patents)
Ways a merger can fail even if it’s conducted for the right reasons
Mismatch of relational contracts
Free-rider problem
Vertical integration
Performing two or more stages in one firm
Make vs Buy - 2 arguments for both sides
Make:
Eases coordination of production flows
Good when classical contracts too ‘costly’
Buy:
Market firms can achieve economies of scale more easily
Market firms ‘disciplined’ by the market. Must be efficient and innovative to survive. Overall corporate success may shelter in-house departments.
What is the ‘hold up’ problem
Relationship specific assets - a contractor may know that I need their outputs and may try to renegotiate a contract to extract more.
Equations for accounting profit and economic profit
Accounting profit = Total Revenue - total cost
Economic profit = Accounting profit - opportunity cost (a.k.a Value added)
What criteria must be met if a firm were to achieve a competitive advantage?
A firm has a competitive advantage in a market if it earns a higher rate of economic profit than the average rate of economic profit (in that market).
Characteristics of perfect competition
Free entry
Imitation costless
Consumers fully informed
Perfect factor mobility
Why strategic assets are rarely a source of competitive advantage
Strategic assets may give us profit, but they mostly apply to monopolies, where the notion of competitive advantage is meaningless.
They may apply more broadly but often all firms in the same market will have access to the same strategic assets, so it is not a competitive advantage.
Criteria used to determine if the competitive advantage is long-run sustainable
Valuable
Rare
Inimitable
Non-substitutable
VRIN
The 2 main routes of securing a competitive advantage
Creating barriers to entry
Creating barriers to imitation
Survivor bias
We do not observe the many firms who tried to follow these techniques and failed miserably.
We have no real idea of the true success rate.
Sources of market power
Govt protection (e.g. patents)
Strategic assets (e.g. returns to scale, barriers to entry)
Strategic behaviour and product differentiation
Price discrimination
Pricing products differently for different customers
The discounts are offered to individuals who would not pay the normal price.
Draw a diagram for monopoly with and without price discrimination
pg12 week 6 first lecture
3 problems with price discrimination
Need a way to verify the buyer’s ‘type’
Consumers have moral objections
Must prevent arbitrage
What is positioning?
How the product compares to its rivals, mostly in terms of:
Price
Quality
What is the advantage of firms positioning their products to target different consumers?
Consumers pick the price/quality pair which suits them.
Positioning can allow firms to extract more consumer surplus.
What is an experience good?
A good or service where it is difficult to know the value of the product before purchasing.
Lemons Problem (Akerlof, 1970)
Assume high and low quality sellers exist
A consumer is willing to pay £6 for a good.
It costs £7 for a high quality seller to make it, which is too costly. Only low quality sellers can afford to sell at that price.
Sheer existence of low quality sellers means neither type can sell.
-High types cannot cover costs
-Buyers should realise any seller willing to sell must be low quality
Solutions to quality uncertainty problems
Reputation (developed over time)
Commitment (warranties?)
Third party quality certification
Signalling via advertising
Problems with warranties
What if the product cannot be recovered after use?
What if the seller cannot verify whether it was faulty/low quality?
Problems with third party quality certification
How tough should regulation/standards be?
Industry capture
Fraudulent reviews
Ratings shopping
Firms can display ratings they find favourable
Why do expensive advertising campaigns act as a credible signal?
It indicates that the firm expects to have many repeat purchases.
This is a credible signal precisely because it is costly.
Only a high quality firm would spend so much, as a low quality firm would never recoup their investment.
What is a best response? (game theory)
A strategy is a best response if it yields the highest payoff, given your opponent’s choice of straetgy
Dominant strategy
A strategy which is always a best response, no matter your opponent’s choice.
3 characteristics of a Nash Equilibrium
A self-enforcing outcome where no individual has incentive to change action
The resting point of a dynamic process of adjustment (update our best responses over time in a trail and error fashion)
A focal outcome of the game - the only rational way to play the game; other outcomes hard to justify if all players are rational (and know others are rational)
Assumptions of the Cournot Model
Products are homogeneous
Firms pick their output
Price determined by joint output produced by all firms
Firms compete just once and pick outputs without observing the other’s decision
Barriers to entry prevent other firms competing
No fixed cost and constant marginal cost
Method to find best responses (Cournot Model)
Write profit function
Differentiate with respect to our quantity
Set this differential equal to zero
Solve for our quantity
Bertrand Model - what was his criticism of Cournot’s model?
Quantity competition is not realistic, firms usually pick prices.
Assumptions of the Bertrand Model
Products are homogeneous
Firms pick prices
Buyers know all prices and buy from the cheapest firms
Firms compete just once and pick prices without observing the other’s decision
No fixed cost and constant marginal cost
Why does it make a difference if firms choose prices vs. quantities?
Full control over prices encourages competition - allows firms to differentiate along a dimension consumers care about
Increasing quantity also lowers competitors price - no relative advantage
What is efficient rationing?
It is assumed within the Cournot model, in which consumers with the highest WTP will get the good.
Tacit collusion
Hidden collusion
This could be through price matching
Stackelberg game (game theory)
This game is identical to Cournot except firms differ in the timing of their production decisions.
One firm will be a ‘leader’, the other a ‘follower’
Vertical differentiation
Products differentiated so that all buyers can agree on which is better
Horizontal differentiation
Buyers don’t agree on which product is better
Hotelling model
Players must ‘position’ themselves in some space
Players often compete for buyers/voters who have preferences over these locations (e.g. Location A is best, B is worst)
The Principle of Minimum Differentiation
In this two player model when prices are fixed then players have an incentive to move inward.
In the extreme case they become completely identical
It may explain the prevalence and success of centrist politicians AND why TV channels schedule similar programming at similar times
How does the repeated game model explain why relational contracts must be open ended?
Relational contracts enforced by the ‘shadow of the future’ rather than a court.
Relationships with certain finite length prone to break down before their conclusion.
Tit-for-tat strategy
If you cooperated yesterday I will cooperate today, if you cheated yesterday I will cheat today
Potential for players to ‘repent’
Grim trigger strategy
I’ll trust you by cooperating, but if you cheat me I’ll never cooperate again.
One similarity and one difference on strategic assets and resources
They both make one firm more profitable than another.
However, strategic assets are for industry specific reasons. Resources are for firm specific reasons.
