Economic

 

At the beginning of the chapter you read about Microsoft’s decision to acquire Intuit. Microsoft has made decisions to purchase other companies besides Intuit. A decision by Microsoft to purchase Nokia cell costs Microsoft $7.6 billion dollars.

Do you think Microsoft’s decisions to purchase firms make sound economic sense? Why or why not? Please explain your answer by incorporating materials from Chapters 5 and 6

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Title: The Organization of the Firm

Contents
Introduction …………………………………………………………………………………………………………………3

Check Your Understanding ……………………………………………………………………………………………3

Question 1 …………………………………………………………………………………………………………………………. 3

Question 2 …………………………………………………………………………………………………………………………. 3

Methods of Procuring Inputs ………………………………………………………………………………………….3

Spot Exchanges …………………………………………………………………………………………………………………. 3

Contracts …………………………………………………………………………………………………………………………… 4

Vertical Integration ………………………………………………………………………………………………………………. 4

Question 3 …………………………………………………………………………………………………………………………. 4

Question 4 …………………………………………………………………………………………………………………………. 4

Transaction Costs ………………………………………………………………………………………………………..5

Types of Specialized Investments …………………………………………………………………………………..5

Site Specificity ……………………………………………………………………………………………………………………. 5

Physical Asset Specificity……………………………………………………………………………………………………… 5

Human Capital ……………………………………………………………………………………………………………………. 5

Dedicated Assets ………………………………………………………………………………………………………………… 5

Implications of Specialized Investments …………………………………………………………………………..6

Costly Bargaining ……………………………………………………………………………………………………………….. 6

Underinvestment ………………………………………………………………………………………………………………… 6

Opportunism ………………………………………………………………………………………………………………………. 6

Check Your Understanding ……………………………………………………………………………………………6

Question 5 …………………………………………………………………………………………………………………………. 6

Question 6 …………………………………………………………………………………………………………………………. 6

Optimal Input Procurement ……………………………………………………………………………………………7

Spot Exchanges …………………………………………………………………………………………………………………. 7

Contracts …………………………………………………………………………………………………………………………… 7

Vertical Integration ………………………………………………………………………………………………………………. 7

Check Your Understanding ……………………………………………………………………………………………7

Question 7 …………………………………………………………………………………………………………………………. 7

Question 8 …………………………………………………………………………………………………………………………. 8

Economic Trade-off ………………………………………………………………………………………………………8

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Check Your Understanding ……………………………………………………………………………………………8

Question 9 …………………………………………………………………………………………………………………………. 8

Question 10 ……………………………………………………………………………………………………………………….. 8

Managerial Compensation …………………………………………………………………………………………….9

Incentive Contracts ……………………………………………………………………………………………………………… 9

External Incentives ……………………………………………………………………………………………………………… 9

Manager-Worker Principal-Agent Problem ……………………………………………………………………….9

Profit Sharing ……………………………………………………………………………………………………………………… 9

Revenue Sharing ………………………………………………………………………………………………………………… 9

Piece costs ………………………………………………………………………………………………………………………… 9

Check Your Understanding ………………………………………………………………………………………….10

Question 11 ……………………………………………………………………………………………………………………… 10

Question 12 ……………………………………………………………………………………………………………………… 10

Concept Scenario ………………………………………………………………………………………………………10

Scenario 1 ……………………………………………………………………………………………………………………….. 10

Scenario 1 Solution ……………………………………………………………………………………………………………. 11

Scenario 2 ……………………………………………………………………………………………………………………….. 11

Scenario 2 Solution ……………………………………………………………………………………………………………. 11

Scenario 3 ……………………………………………………………………………………………………………………….. 11

Scenario 3 Solution ……………………………………………………………………………………………………………. 12

Summary ………………………………………………………………………………………………………………….12

Review Questions ………………………………………………………………………………………………………12

Question 1 ……………………………………………………………………………………………………………………….. 12

Question 2 ……………………………………………………………………………………………………………………….. 13

Question 3 ……………………………………………………………………………………………………………………….. 13

Question 4 ……………………………………………………………………………………………………………………….. 13

What’s Next ………………………………………………………………………………………………………………13

Reference …………………………………………………………………………………………………………………13

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Introduction
Recall that the cost function defines the cost of producing given levels of outputs assuming all
inputs are used efficiently.

In this chapter, we consider techniques a firm can use to ensure that it is operating on the cost
function and not above it. We begin by discussing three methods managers can use to obtain
inputs needed in production: spot exchange, contracts, and vertical integration. For a firm to
minimize costs, it must use the least-cost method of obtaining the inputs.

The manager’s job is to choose the method that minimizes costs. Before we examine how to
determine the best method of acquiring a given type of input, it is useful to get a broad overview
of these three methods of acquiring inputs.

Check Your Understanding
Question 1
Is the following statement true or false?

How a firm obtains inputs can influence profit levels.

Answer

The statement “how a firm obtains inputs can influence profit levels” is true.

Question 2
Which of the following methods is not commonly used to obtain inputs in a cost-effective
manner.

• Vertical integration

• Contracts

• Spot exchange

• Cost backstopping

Answer

The cost backstopping method is not commonly used to obtain inputs in a cost-effective
manner.

Methods of Procuring Inputs
A manager can use several approaches to obtain the inputs needed to produce a final product.
Before we examine how to determine the best method of acquiring a given type of input, it is
useful to have a broad overview of these methods.

Spot Exchanges
When inputs are standardized, spot exchanges are commonly used to exchange inputs. Spot
exchange occurs when the buyer and seller of an input meet, exchange, and then go their
separate ways. With the spot exchange, buyers and sellers essentially are “anonymous”; the
parties may make an exchange without even knowing each other’s names, and there is no
formal (legal) relationship between a buyer and a seller.

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A key advantage of acquiring inputs with spot exchange is that it allows the firm to specialize in
what it does best—converting the inputs into output—and the input manufacturer specializes in
what it does best—producing inputs.

Contracts
A contract is a legal document that creates an extended relationship between a buyer and seller
of an input. It specifies the terms under which they agree to exchange over a given time
framework.

Contracts protect producers and make facets of purchasing decisions, such as price and
quantity of acquired inputs, predictable. Therefore, they offer greater flexibility for purchase non-
standardized inputs.

This method of obtaining inputs works well when it is relatively easy to write a contract that
describes the characteristics of the inputs needed. One key disadvantage of contracts is that
they are costly to write; it takes time, and there are often legal fees for writing a contract that
specifies precisely the obligations of both parties.

Also, it can be extremely difficult to cover all the contingencies that can occur in the future.
Thus, in complex contracting environments, contracts will necessarily be incomplete.

Vertical Integration
Vertical integration occurs when a firm produces the required inputs for its final product.
However, a firm loses the specialization it would have gained had the inputs been purchased
from an independent supplier.

Moreover, the firm now has to manage the production of inputs as well as the production of the
final product produced with those inputs. This leads to higher costs associated with a larger
organization. On the other hand, by self-producing the inputs it needs, the firm no longer needs
to rely on gathering inputs from external sources via spot exchanges or contracts. Check Your
Understanding

Question 3
Which of the following methods of acquiring inputs involves a firm producing its inputs
internally?

• Cost complementarity

• Vertical integration

• Contractual agreements

• None of the above

Answer

Vertical integration is the method of acquiring inputs that are produced by the firm internally.

Question 4
When inputs are non-standardized, which of the following is the most suitable method of
procuring inputs?

• Cost complementarity
• Vertical integration

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• Contractual agreements
• None of the above
Answer

Contractual agreements method is the most suitable method of procuring inputs when inputs
are non-standardized.

Transaction Costs
Costs associated with acquiring an input that exceed the amount paid to the input supplier are
called transaction costs.

Transaction costs arise when a manager incurs expenditures in the process of facilitating an
exchange which include searching for a supplier willing to sell a given input and negotiating the
price for purchasing the input.

Types of Specialized Investments
Transaction costs could be specific to a particular trading relationship or they can be of a
general nature.

Some transaction costs arise due to the specific nature of the transaction. Such transaction
costs need to be incurred, otherwise the transaction will not occur and cannot be recovered in
another trading relationship. Transactions of this type are called specialized investments. Due
to the specialized nature of these transactions, the resulting relationship between the parties is
known as a relationship-specific exchange. As a result of the uniqueness of the needs of both
parties, the two parties are tied together.

Site Specificity
Site specificity occurs when the buyer and the seller of an input must locate their plants close to
each other to be able to engage in exchange. For example, a biofuel plant that is located close
to corn farmers.

Physical Asset Specificity
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. For example, drill bits for drilling in unique geographical
positions.

Human Capital
Human capital refers to a situation where workers occasionally pick up specialized skillsets that
may not be easily transferable to other employers. In such cases, they represent a specialized
investment. For example, a kicker for NFL team may not find his particular talent for kicking field
goals transferable outside the game of football.

Dedicated Assets
Dedicated assets are general investments made by a firm that allows it to exchange with a
particular buyer. For example, a firm’s investment in technology that enables it to produce
fighter jets according to U.S. military specification; aside from the US military, that firm would not
be able to sell those jets to any other buyer.

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Implications of Specialized Investments
Now that you have a broad understanding of specialized investments and relationship-specific
exchange, we will consider how the presence of specialized investments increases transaction
costs of acquiring inputs.

Costly Bargaining
Specialized investments imply that only a few parties are prepared for a trading relationship.

Consequently, there is no “market price” for the input the two parties in the relationship-specific
exchange bargain with each other over a price the input will be bought and sold under. The
bargaining process is costly because each side employs negotiators to obtain a more favorable
price.

Underinvestment
Due to the specific features of the transaction, the level of specialized investment often is lower
than the optimal level. For example, if an input supplier must invest in a specific machine to
produce an input used by a particular buyer (physical-asset specificity) the supplier may invest
in a cheaper machine that produces an input of inferior quality. This is because the supplier
recognizes that the machine will not be useful if the buyer decides to purchase from another
firm, in which case the supplier will be “stuck” with an expensive machine it cannot use. Thus,
specialized investments may be lower than optimal, resulting in higher transaction costs
because the input produced is of inferior quality.

Opportunism
A strategy especially used in price negotiations, is when a supplier of specialized inputs knows
they can delay production of a firm that needs that unique input by not supplying it on time,
known as the ‘hold-up’ problem. It is opportunistic for the supplier of an input to take advantage
of the need for his services. The buyer of the input can also engage in opportunistic behavior
knowing that the input supplier would have a hard time selling their product elsewhere. In both
cases, transaction costs increase. However, contracts can be structured to mitigate the hold-up
problem.

Check Your Understanding
Question 5
Which of the following is not a transaction cost?

• Taking time to search the internet for a suitable supplier

• The cost of exchanging currency in order to pay for an imported input

• The cost of delivering a product to a consumer

• Energy costs incurred in production process

Answer

Energy costs incurred in production process is not a transaction cost.

Question 6
Which of the following types of specified investment relates to an individual the most?

• Dedicated assets

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• Human capital

• Physical asset specificity

• Site specificity

Answer

Human capital investment relates to an individual the most.

Optimal Input Procurement
Let’s now examine, how the manager should acquire inputs in such a way as to minimize costs.
The cost-minimizing method will depend on the extent to which there is relationship-specific
exchange.

Spot Exchanges
Spot exchange is the most straightforward way for a firm to obtain inputs for a production
process. We can determine the market price (p*) of an input by the intersection of the supply
and demand curves for the input if there are no transaction costs and there are many buyers
and sellers in the market. Given that the inputs are typically standardized, a manager can easily
obtain the input from a supplier,chosen at random, by paying a price of p* per unit of input. If
any supplier attempted to charge a price greater than p*, the manager could simply decline and
purchase the input from another supplier at the same price.

Contracts
To mitigate the hold-up problem, parties can enter into an appropriately structured contract that
reduces the incentive for either party to engage in any hold-up behavior. This is done by
specifying prices of the input that are acceptable to both parties and that will be honored for a
certain time period prior to either parties making specialized investment expenditures.

Vertical Integration
Complete contracts have their drawbacks. They may not be able to address all features of a
complex transaction or cover all price risks that come from general economic conditions. In
these conditions, the best choice for the firm is to set up a facility to produce the input internally.
Vertical integration is a more suitable choice since it entails that the firm move further up the
production stream toward increasingly basic inputs.

The advantage of vertical integration is that the firm “skips the middleman” by producing its own
inputs. However, vertical integration can be expensive and time-consuming. It also distracts the
firm from its core business and leads it further away from concentrating on what it does best.

Check Your Understanding
Question 7
Is the following statement true or false?

Contract price is determined by market forces of supply and demand.

Answer

The statement is false. Contract price is not determined by market forces of supply and
demand.

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Question 8
Which of the following is true?

• Vertical integration is a strategy best suited when a company need standardized
products.

• Price agreements are an important part of contractual agreements.

• Suppliers of input cannot overprice in spot exchanges.

• Spot exchanges are the easiest path of input procurement.

Answer

The true statement is: Suppliers of input cannot overprice in spot exchanges.

Economic Trade-off
The cost-minimizing method of acquiring an input depends on the characteristics of the input.
The input procurement of choice depends on the importance of the specialized investments that
lead to relationship-specific exchange.

When the desired input does not involve specialized investments, the firm can use spot
exchange.

When the desired input involves specialized investments, the next determination a manager
should make is balancing the cost of navigating the complexity of a contractual environment
against the costs of integration.

If the contractual environment is simple and the cost of writing a contract is less than the
transaction costs associated with spot exchange, it is optimal to acquire the input through a
contract. In this case, the optimal contract length is determined by the intersection of the
marginal cost and marginal benefits of writing a longer contract.

If the cost of navigating the complexity of writing a contract is greater than the cost of
integrating, the manager should integrate vertically to minimize the cost of acquiring inputs
needed for production.

Check Your Understanding
Question 9
Is the following statement true or false?

Standardized input markets typically create complex contracting environments.

Answer

The statement is false. Standardized input markets typically do not create complex contracting
environments.

Question 10
Which of the following would dissuade a manager from pursuing vertical integration the most?

• A firm’s financial resources

• Price risks

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• Complex contract environments

• The hold-up problem

Answer

A firm’s financial resources would dissuade a manager the most from pursuing vertical
integration.

Managerial Compensation
One characteristic of many large firms is the separation of ownership and control. The owners of
the firm are often distantly located stockholders, and a manager runs the firm on a day-to-day
basis. The fact that the firm’s owners are not physically present to monitor the manager, creates
a fundamental incentive problem, termed as the “principal–agent” problem. If the owner is not
present to monitor the manager, how can they get the manager to do what is in their best
interest? Strategies for disciplining managers include incentive contracts and external
incentives.

Incentive Contracts
Incentive contracts are rewards for managers typically based on performance. Such rewards
benefit stockholders as well as C E Os. Reducing performance-based rewards may result in a
decline in profit for the firm.

External Incentives
Forces outside the firm often provide managers with an incentive to maximize profits; such as:

1. Reputation: A manager’s incentive for their high performance is to increase their
chances of getting future job opportunities outside a firm.

2. Takeovers: Threats like investor-driven takeovers that replace a firm’s management
could drive managers to perform well.

Manager-Worker Principal-Agent Problem
An important question arises in manager-worker relationships: How can a manager (or a
principal) induce workers (or agents) to perform at their best? This question is central to the
manager-worker or principal-agent problem.

Possible solutions to manager-worker or principal-agent problems include profit sharing,
revenue sharing, and piece costs.

Profit Sharing
Profit sharing involves offering workers compensation that is tied to the underlying profit. It
provides an incentive for workers to put more effort in their tasks.

Revenue Sharing
Revenue sharing involves compensating the workers’ based on the underlying revenues of the
firm such as tips and sales commissions. The drawback, however, is that they incentivize
workers to focus more on revenues and less on minimizing costs.

Piece costs
Piece-cost workers are compensated based on their rate of output, which means the
compensation is dependent on their production quantity. The drawback of this approach is that

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the quantity of output is incentivized without a necessary regard for the quality of the output.
Spot checks could be instituted to ensure that the quality of the work is satisfactory; while time
clocks could be put in place to check if workers are not shirking from work during business
hours.

Check Your Understanding
Question 11
The separation of ownership and control:

• Makes it harder to maximize share price

• Applies to all firms that are not sole proprietorships

• Creates a disconnect between what the workers want and what the owners want

• None of the above
Answer

The correct option is none of the above. The separation of ownership and control creates a
fundamental incentive problem.

Question 12
The best strategy to incentivize workers, when worker productivity is related to revenues rather
than cost, is:

Answer

Revenue sharing is the best strategy to incentivize workers when worker productivity is related
to revenues rather than cost.

Concept Scenario
Scenario 1
You work for an oil and gas company that has offshore drilling facilities. One of the essential
inputs in the extraction process is a gadget, made out of plastic, which ensures that oil is
extracted at a safe and optimal rate. Your company acquires this input from another firm that
manufactures it, using a derivative of petroleum. There are not many manufacturers who can
make this gadget. What options does your firm have to procure this input?

Tip 1

Peer 1: Spot exchanges would be a good option because they are easy to find.

Peer 2: Well it sounds like they produce the product that the input is made out of, so maybe they
could write a contract to get the input from the supplier at a particular price.

Tip 2

Watch the Horizontal and Vertical Integration video to find your solution.

Tip 3

Refer to the lecturette section on vertical integration to find your solution.

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Scenario 1 Solution
Since your firm is at risk for hold-up behavior from the small pool of suppliers who make the
input and produce the raw material (petroleum) that is used to make the input (the plastic
gadget), your firm should consider making the input in-house (vertical integration).

Scenario 2
Suppose you firm has decided to enter into negotiations regarding a potential contractual
agreement with a supplier of an input. One of last remaining issues to agree on is the duration
of contract. You have been tasked by upper management to figure out what the optimal contract
duration should be. What information would you ask for to determine the duration?

Tip 1

Peer 1: Perhaps you should ask the production department how long your firm would take for
the input to be made by your company and use that as a timetable.

Peer 2: It is better to consider the cost of looking for another supplier and use that as a
benchmark for the contract duration.

Tip 2

Watch the instructional video, Scarcity, Opportunity Cost, Trade-Offs & The Production
Possibilities Curve, to find your solution.

Tip 3

Refer to the Lecturette section on the Economic Trade-off to find your solution.

Scenario 2 Solution
You would need to calculate the marginal costs and benefits of a longer contract –where they
intersect would mark the optimal contract duration.

Scenario 3
Suppose you are a manager who owns a transportation logistics company. Your company has
been contracted to haul loads of merchandise. For each delivery, time is of the essence –the
firm is given a bonus for early deliveries and is charged a penalty for late deliveries. You are
trying to think of a compensation system for your workers and/or drivers. Your incentive is to get
the load delivered as fast as possible. Therefore, the best outcome for you is for your drivers to
be taking the shortest trip per load. The best outcome for your drivers is a large wage at the end
of their day. What kind of compensation system would provide your drivers with incentives to
find the quickest route per load?

Tip 1

Peer 1: I think you should pay them according to the distance they travel.

Peer 2: I think you should tell your drivers how important it is to get the merchandise delivered
as fast as possible.

Tip 2

Watch the video The Principal Agent Problem, to find your solution.

Tip 3

Refer to Lecturette section on the Manager-Worker Principal-Agent to find your solution.

12

Scenario 3 Solution
Since delivery time influences revenues, you can consider tying driver compensation to
revenues generated per trip. Therefore, if there is a penalty imposed on the firm for late
deliveries, the driver also experiences a reduction in income. The driver has an incentive to take
the route that ensures on time delivery. Further, since they could receive a larger wage if they
deliver the merchandise early, the incentive for the shortest route is more pronounced.

Summary
Key learning points in this module include:

• Three methods managers can use to obtain inputs needed in production: spot exchange,
contracts, and vertical integration.

• Spot exchange occurs when the buyer and seller of an input meet, exchange, and
then go their separate ways.

• A contract is a legal document that creates an extended relationship between a
particular buyer and seller of an input.

• Vertical integration occurs when a firm produces the inputs required to make its final
product.

• Costs associated with acquiring an input that exceed the amount paid to the input
supplier are called transaction costs.

• There are different types of specialized investments, namely: site specificity, physical
asset specificity, human capital, and dedicated assets.

• Specialized investments increase transaction costs because they lead to costly
bargaining, underinvestment, and opportunism.

• The input procurement of choice depends on the importance of the specialized
investments that lead to relationship-specific exchange.

• The inability of a firm’s owners to monitor the manager creates the principal-agent
problem.

• Strategies to mitigate the owner-manager principal-agent problem include: incentive
contracts and external incentives.

• The challenge of monitoring workers to prevent shirking from work creates the manager-
worker principal-agent problem.

• Possible solutions to the manager-worker principal-agent problem include: profit sharing,
revenue sharing, and piece rates.

Review Questions
Question 1
When inputs are standardized, which of the following is the most suitable method of procuring
those inputs?

Answer

When inputs are standardized, spot exchanges are most suitable for procuring those inputs.

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Question 2
If an input is non-standardized and the contractual environment is simple, what method of input
procurement is the most appropriate?

Answer

If an input is non-standardized and the contractual environment is simple, the contracts method
of input procurement is the most appropriate.

Question 3
Under what conditions would vertical integration be an appropriate method of input
procurement?

Answer

When substantial specialized investments are required and the desired input has complex
characteristics that are difficult to specify in a contract, or when it is very costly to write into the
contract all the clauses needed to protect the parties from changes in future conditions, the
manager should integrate vertically.

Question 4
Describe the difference between the owner-manager principal-agent problem and the manager-
worker principal-agent problem.

Answer

The owner-manager principal-agent problem asks the question: How can the owner (the
principal) induce the manager (the agents) to perform in their interests to the best of their
ability? Whereas, the manager-worker principal-agent problem asks the question: How can the
manager (the principal) induce the workers (the agents) to perform at their best?

What’s Next
In Module 6, we will cover Chapter 7, which shows that different industries have different market
structures and require different types of managerial decisions. We will explore how firms in the
industry, the structure of demand and costs, the availability of information, and the behavior of
other firms in the industry affect managerial decision making. We will examine different
approaches to measure market concentration and how they provide managers with information
about industry cost and demand conditions.

We will close the chapter by revealing industry-wide differences in activities such as advertising,
research, and development.

Reference
Baye, M. R., & Prince, J. T. (2013). Managerial economics and business strategy (8th edition).
New York, NY: McGraw-Hill Education.

1

Title: The Nature of Industry

Contents

Introduction …………………………………………………………………………………………………………………3

Check Your Understanding ……………………………………………………………………………………………3

Question 1 …………………………………………………………………………………………………………………………. 3

Question 2 …………………………………………………………………………………………………………………………. 3

Market Structure ………………………………………………………………………………………………………….3

Features Defining Market Structure …………………………………………………………………………………4

Firm Size …………………………………………………………………………………………………………………………… 4

Technology ………………………………………………………………………………………………………………………… 4

Barriers of Entry ………………………………………………………………………………………………………………….. 4

Industry Concentration ………………………………………………………………………………………………….4

Herfindahl-Hirschman Index …………………………………………………………………………………………..5

Demand Conditions………………………………………………………………………………………………………5

Check Your Understanding ……………………………………………………………………………………………6

Question 3 …………………………………………………………………………………………………………………………. 6

Question 4 …………………………………………………………………………………………………………………………. 6

Integration and Mergers ………………………………………………………………………………………………..6

Vertical ……………………………………………………………………………………………………………………………… 7

Horizontal ………………………………………………………………………………………………………………………….. 7

Conglomeration ………………………………………………………………………………………………………………….. 7

Check Your Understanding ……………………………………………………………………………………………7

Question 5 …………………………………………………………………………………………………………………………. 7

Question 6 …………………………………………………………………………………………………………………………. 7

Performance ……………………………………………………………………………………………………………….8

Check Your Understanding ……………………………………………………………………………………………8

Question 7 …………………………………………………………………………………………………………………………. 8

Question 8 …………………………………………………………………………………………………………………………. 8

Approaches to Studying Industry…………………………………………………………………………………….8

Check Your Understanding ……………………………………………………………………………………………9

Question 9 …………………………………………………………………………………………………………………………. 9

2

Question 10 ……………………………………………………………………………………………………………………….. 9

Problem Statements……………………………………………………………………………………………………..9

Problem 1 ………………………………………………………………………………………………………………………….. 9

Problem 1 Solution ……………………………………………………………………………………………………………. 10

Problem 2 ………………………………………………………………………………………………………………………… 10

Problem 2 Solution ……………………………………………………………………………………………………………. 10

Problem 3 ………………………………………………………………………………………………………………………… 10

Problem 3 Solution ……………………………………………………………………………………………………………. 11

Summary ………………………………………………………………………………………………………………….11

Review Questions ………………………………………………………………………………………………………12

Question 1 ……………………………………………………………………………………………………………………….. 12

Question 2 ……………………………………………………………………………………………………………………….. 12

Question 3 ……………………………………………………………………………………………………………………….. 12

Question 4 ……………………………………………………………………………………………………………………….. 12

Question 5 ……………………………………………………………………………………………………………………….. 13

What’s Next ………………………………………………………………………………………………………………13

References ……………………………………………………………………………………………………………….13

3

Introduction

Various factors affect the managerial decision-making process, such as output levels, price, and
how much to allocate toward expenditures for research and development, and advertising
among others.

Industries differ in their features, that is they have different aspects that define internal
movements and behaviors. As such, the optimal decisions of a manager differ by industry.

Check Your Understanding

Question 1

Is the following statement true or false?

Managers in different industries are responsible for understanding the features of their industry.

Answer

The statement is true. Managers in different industries are responsible for understanding the
features of their industry.

Question 2

Is the following statement true or false?

Managers in different industries make the same optimal managerial decisions.

Answer

The statement is false. Managers in different industries cannot make the same optimal
managerial decisions. Numerous factors affect decisions such as how much output to produce,
what price to charge, and how much to spend on research and development, advertising, and
so on.

Market Structure

The market in which a company operates gives form to the decisions that the manager makes.

1. Perfect Competition: It is generally characterized by many firms that produce a
homogenous

product.

2. Monopoly: It is generally characterized by a major dominant firm.

3. Monopolistic Competition: It is generally characterized by several firms that
produce slightly differentiated products.

4. Oligopoly: It is generally characterized by a few large firms.

4

Features Defining Market Structure

Features such as the number and size of firms that compete in a market, the nature of
consumer demand, technology, costs of operating in that market, and the ease with which firms
can enter or exit the industry define the structure of a market.

Firm Size

Firms that are larger relative to their competition tend to have a larger market share than their
competitors. As such, they can make different decisions regarding how they manage their
operations.

Technology

Technology is a crucial part of competitiveness in an industry. If, relative to its competitiveness,
a firm has access to technology that increases the productivity of capital or labor, or reduces
costs, that firm will have the competitive advantage in that industry. If the firm has a significant
technological advantage, its competitive advantage in the industry will be considerable. Firms
can gain technological advantages by investing in research and development.

Barriers of Entry

The easier it is for firms to enter into a particular industry, the more firms will exist in that
industry. Conversely, the higher the barriers for entry, the fewer the number of firms that exist in
that industry.

Examples of barriers for entry include: initial cost of capital, legal restrictions such as patents,
and economies of scale.

Industry Concentration

The distribution of firms by size in an industry affects the makeup of the industry. Whether there
are few or many small industries, or few or many large industries affects how managers do their
business.

Concentration ratios are frequently used to measure industry concentration. They measure the
percentage of total output in a particular industry that is produced by the largest firms in that
industry. Two of the most commonly used industry concentration ratios include: the four-firm
concentration ratio and the Herfindahl-Hirschman index (HHI).

The four-firm concentration ratio captures the percentage of sales accrued by the four largest
firms in a particular industry.

The four-firm concentration ratio is defined by:

Where,

𝐶4 =
𝑆1 + 𝑆2 + 𝑆3 + 𝑆4

𝑆𝑇
or 𝐶4 = 𝑤1 + 𝑤2 + 𝑤3 + 𝑤4

5

S 1 to S 4 are the sales of the four largest firms in a particular industry;

When C 4 equals zero, the industry is not concentrated that is there are many sellers; when C 4
equals 1, the industry is highly concentrated that is there are few sellers. More sellers means
more competition while fewer sellers means less competition.

Herfindahl-Hirschman Index

Herfindahl-Hirschman index (H H I) is calculated by,

HHI values closer to zero indicate competitive markets that is many sellers. HHI values closer to
10,000 indicate few sellers. Generally, industries with high HHI values have high C 4 values.

Although the concentration ratios mentioned are informative, they have the following drawbacks:

a. They do not take into account competition from foreign firms in domestic markets

in the calculation of S T.

b. Concentration ratios are typically cast at the national level which may not reflect

industry concentration realities at lower levels of disaggregation like the city level.

c. The types of products (product classes) that are or are not included in an industry

affects the number of companies and sales that are counted as part of the

industry. Thus, affect the values of concentration ratios.

Demand Conditions

When demand is low, only a few firms can be sustained; however, an industry with a high base
of consumer demand could attract several firms. Depending on the number of substitutes in the
particular industry, the elasticity of demand for the products of particular firms influences how
firms maintain market shares and thus the concentration ratio in that industry.

The Rothschild index, whose value lies between 0 and 1, is a common measure of how price
sensitivity of quantity demanded for an individual firm compares to the entire market. It is given
by,

𝐻𝐻𝐼 = 𝑤𝑖
2 ∗ 10,000

6

Where E base T is the elasticity of demand of an individual firm and E base F is the elasticity of
demand for the entire market.

• What does it indicate when R is closer to 1?

The price sensitivity of quantity demanded for an individual firm is almost equivalent

to the price sensitivity measured market-wide – which indicates fewer firms are

present.

• What does it indicate when R is closer to 0?

The price sensitivity of quantity demanded measured at the firm level is greater than

that the market-wide measurement – which indicates many firms are present.

Check Your Understanding

Question 3

Which of the following is true about concentration ratios?

• They account for imports

• They are a measure of national industry concentrations

• Do not depend on product classes

• None of the above

Answer

Concentration ratios are a measure of national industry concentrations.

Question 4

Is the statement true or false?

If the value of the Herfindahl-Hirschman index for a particular industry is 0.01, the barriers for
entry into that industry are probably low.

Answer

The statement is true. If the value of the Herfindahl-Hirschman index for a particular industry is
0.01, the barriers for entry into that industry are probably low.

Integration and Mergers

The process of combining productive resources is referred to as integration. Integration can
occur at the onset of a firm’s formulation. The integration process can also occur via a merger
whereby at least two firms merge to form a single firm.

Mergers can arise for various reasons: to help reduce costs, to help achieve economies of
scale, to increase market share, or to help access markets. When two firms voluntarily enter into
a merger process, it is regarded as a friendly merger. Hostile mergers occur when one firm
moves to merge with another firm that does not want to enter into a merger.

7

Vertical

A vertical merger occurs when one firm that produces a particular final product merges with a
firm that produces an input or part for its final product; this is usually done to reduce transaction
costs. For example, a potato chip company merging with a potato farming operations.

Horizontal

Horizontal happens when a firm that produces a particular final product merges with a firm that
produces a similar or related final product. The benefits that could be derived from horizontal
mergers include the generation of economies of scale and to gain market share. For example,
two computer manufacturing firms merging to form one computer manufacturing firm.

Conglomeration

Conglomeration occurs when a firm that produces a particular product merges with a firm that
produces a dissimilar or unrelated product. Companies could benefit by, for example, using
revenue from one product class to support the operations of another product class.

Check Your Understanding

Question 5

Which of the following is not a form of integration?

• Vertical integration

• Conglomerations

• Horizontal integration

• Duopoly

Answer

Duopoly is not a form of integration.

Question 6

If the markup factor is large, then:

• The Lerner Index is equal to zero

• Price is larger than marginal cost

• Marginal cost is larger than price

• The Lerner index is equal to 1

Answer

If the markup factor is large, then price is larger than marginal cost.

8

Performance

Gauges of industry performance include profits and social welfare. We know the established
measurement of profit is the difference between total revenue and total cost. Similarly, we also
have measurement for social welfare which itself is the sum of consumer and producer surplus.

What would happen to social welfare if companies in a particular industry increased their output
in a socially efficient manner? The Dansby-Willig (DW) performance index tries to measure this.

If the value of the DW index is zero, then an increase in industry output would not increase
social welfare, which means social welfare is maximized. When the DW index is greater than 0,
then there is room to improve social welfare by altering output.

Check Your Understanding

Question 7

Is the following statement true or false?

The Dansby-Willig Index is useful as a profit measurement.

Answer

The statement is false. Dansby-Willig Performance Index measure by how much social welfare
would improve if firms in an industry expanded output in a socially efficient manner.

Question 8

Is the following statement true or false?

When the DW Index is positive, consumer welfare has been maximized.

Answer

The statement is false. When the DW index is greater than 0, then there is room to improve
social welfare by altering output.

Approaches to Studying Industry

As we have discussed, market structure, firm behavior or conduct, and performance all matter in
understand the topology of an industry.

The structure of an industry involves factors such as technology, concentration, and demand or
market conditions. Conduct involves pricing, advertising, research and development investment
decisions. Performance is concerned with profits and social welfare.

Tab 1: The Causal View

The Structure-Conduct-Performance (SCP) Paradigm: Causal View of industry outcomes
assumes that the structure of markets influences firms toward a certain behavior. So the
manner in which firms choose to allocate their resources determines their market performance.

Tab 2: The Feedback Critique

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The feedback critique asserts that market structure, conduct and performance influence each
other. For example, technological innovations can create firm concentration which can
eventually influence market structure and pricing.

Check Your Understanding

Question 9

Is the following statement true or false?

Firm concentration could affect firm conduct.

Answer

The statement is true. Firm concentration could affect firm conduct.

Question 10

Is the following statement true or false?

The feedback view is that industry is embedded with causal interactions between components
that affect industry outcomes.

Answer

The statement is true. The feedback view is that industry is embedded with causal interactions
between components that affect industry outcomes.

Problem Statements

Problem 1

You are a manager of a company that produces a particular good X. In the production of good
X, your company uses a component made by the Green Pepper Company. The Chairmaker
Company is a company operating in an industry outside of your company’s industry. The
Herfindahl-Hirschman Index is close to zero in the Chairmaker Company’s industry. A merger
with the Green Pepper Company could lead to savings of $225,000. While a merger with the
Chairmaker Company is estimated to lead to an increase in revenues of $225,000.

Your company can only conduct one merger. Which merger would you advise your company to
pursue and why?

Tip 1

Peer 1: Go with the Green Pepper Company because it will be cheaper to make your product.

Peer 2: Go with the Chairmaker Company because your company will get to participate in
another industry.

Tip 2

Watch the video Measuring Market Concentration to find your solution.

Tip 3

Refer to the lecturette section on firm concentration.

10

Problem 1 Solution

A Herfindahl-Hirschman Index value that is close to zero means that there is a lot of competition
in that industry. Therefore, the Chairmaker Company is operating in a competitive industry. A
merger with them will expose your company to more competition and might also mean that the
revenue estimate may not always hold. It is better to vertically integrate in order to capture the
cost savings which you are sure you will be able to capitalize on.

Problem 2

Suppose you have been asked to justify why your company should use its net cash reserves to
invest in research and development rather than pursue a merger. What would be the main
points of your case?

Tip 1

Peer 1: Research and development would lead to better insights about your product which could
add value to consumers.

Peer 2: Research and development would lead to the creation of more job which would be good
for society.

Tip 2

Refer to the link, Firms & Technological Change to find your solution.

Tip 3

Refer to the Lecturette section on market structures and technology.

Problem 2 Solution

Your company should invest in research and development (R&D) because competitive
advantages are derived from the innovations that come out of R&D. Those competitive
advantages could allow the company to achieve the same benefits as a merger, if not more,
internally.

Problem 3

If the Dansby-Willig performance index is 2.5, make a case as to why you would or would not
increase output?

Tip 1

Peer 1: I think you should decrease output because The Dansby-Willing performance index is
positive.

Peer 2: I think you should increase output because profits can increase 2.5 times.

Tip 2:

Select the link and read the content to get a hint.

The Competitive Market or Industry Analysis: Slide 19

Tip 3:

Refer to the lecturette section on performance.

https://slideplayer.com/slide/5863548/

https://smandaljr.files.wordpress.com/2013/09/6_industry-analysis-and-monopoly

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Problem 3 Solution

When the Dansby-Willing performance index is greater than zero, welfare has not been
maximized. Therefore, there could be more producer surplus to accrue.

Summary

Key learning points in this module include:

• Various factors affect the managerial decision making process, such as: output
levels, price, and how much to allocate toward expenditures for research and
development, advertising etc.

• Market structures are influenced by: barriers for entry, demand conditions,
technology, industry concentration, and firm size.

• The four main classifications of market structures are: perfect competition, monopoly,
monopolistic competition, and oligopoly.

• Two of the most commonly used industry concentration ratios include: the four-firm
concentration ratio and the Herfindahl-Hirschman index (HHI).

• The four-firm concentration ratio captures the percentage of sales

accrued by the four largest firms in a particular industry.

• The industries with high higher Herfindahl-Hirschman indices have high

four-firm concentration ratio values.

• If the firm has a significant technological advantage, it will have considerable

competitive advantage in the industry.

• The Lerner index is a measure of the relative difference between price and marginal

cost, it is measure of markup.

• The process of combining productive resources is referred to as integration.

• There are three types of mergers: vertical, horizontal, and conglomerations.

• A vertical merger occurs when one firm that produces a particular final

product merges with a firm that produces an input or part for its final

product.

• A horizontal merger occurs when a firm that produces a particular final

product merges with a firm that produces a similar or related final product.

• A conglomeration occurs when a firm that produces a particular final

product merges with a firm that produces a dissimilar or unrelated final

product.

• Industry structure is shaped by technology, firm concentration, demand, or market

conditions.

• Conduct involves pricing, advertising, research and development, and investment

decisions.

• Performance is concerned with profits and social welfare.

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Review Questions

Question 1

Differentiate between perfect competition and monopolistic competitive market structure.

Answer

Perfectly competitive market structures are characterized by many sellers producing a
homogenous product whereas monopolistic competitive markets have a number of sellers with
some differentiation in the products they make.

Question 2

List three factors that influence market structure.

Answer

Factors that influence market structure include firm size, industry concentration, technology,
demand conditions, and barriers for entry.

Question 3

Suppose an industry is composed of 10 firms. The first four firms have sales of $100,000 each,
the next two firms have sales of $90,000 each, and the last four firms have sales of $120,000
each. What is the four-firm concentration ratio for this industry?

Answer

Therefore, four-firm concentration ratio is 0.452.

Question 4

If Price is twice marginal cost, what is the likely value of the Lerner Index?

Answer

So, upon rearranging the Lerner Index we can represent price as:

Therefore,

Four firm concentration ratio =
𝑆1 + 𝑆2 + 𝑆3 + 𝑆4

𝑆𝑇
=

$120 ,00+$120,000+$120 ,000+$120 ,000

$1,060,000
=

0.452

𝑃 = 2 ∗ 𝑀𝐶

𝑃 =
1

1 − 𝐿
∗ 𝑀𝐶

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Question 5

List three types of mergers.

Answer

Vertical Integration, Horizontal Integration, and Conglomerations.

What’s Next

In Module 7 we will examine managerial decisions in three market environments: perfect
competition, monopoly, and monopolistic competition. Each of these market structures provides
a manager with different decision parameters toward the goal of maximizing profits.

References

Baye, M. R., & Prince, J. T. (2013). Managerial economics and business strategy (8th edition).
New York, NY: McGraw-Hill Education.

2 =
1

1 − 𝐿

1 − 𝐿 ∗ 2 = 1

2 − 2𝐿 = 1 → 2 − 1 = 2𝐿 → 1 = 2𝐿 →
1

2
= 𝐿