ECONOMICS 3200B Lecture 2 Ch. 1, 2, 3 September 17, 2013

1. ECONOMICS 3200BLecture 2Ch. 1, 2, 3September 17, 2013

2. Introduction • Decision making • Objectives • Information • Constraints • Trade-offs • Time horizons • Role of self interest, aka “greed” • Scarcity • Distributional issues – equity, fairness • The 1%ers

3. Introduction Decision making • Forward looking: Information requirements and uncertainty • Time horizon: short run vs. long run • Adam Smith: individuals pursuing their own self interest will collectively produce the greatest good  Greed is good, Economics 101 • Importance of incentives: individuals motivated by personal well-being

4. Introduction Decision making • Constrained optimization • Constraints • Character, history, skills, risk tolerance • Competitors’ strategies • Time • Resource constraints – short-run/long run (i.e. availability of resources, quality) • Laws, regulations • Others – directors, investors, competitors, creditors (loan covenants), contracts

5. Introduction • Economic paradigms: • Perfect competition – many firms, homogeneous products • Monopoly – one firm (seller) • Contestable • Monopsony – one firm (buyer) • Oligopoly – small numbers • Monopolistic competition – many, heterogeneous products

6. Introduction • Problem: Competition • Passive/active? • Rivalry – “the goal of competition is to kill your competitors” • Compare to concept of competition in perfect competition model • Michael Porter: Determinants of rivalry • Concentration and balance (Herfindahl-Hirschman index, concentration ratios) – facilitate collusive behavior, deter entry, dominant firm • Threat of entry, exit barriers • Product differentiation – brand identity, switching costs, reputation • Informational complexity • Intermittent overcapacity – airlines, steel • Bargaining power of buyers • Industry growth

7. Introduction • Are suppliers/competitors (including potential entrants) equally well-informed? • Perfect information? • Role of Internet, role of social networks, B2B, B2C • Implications for stability of entry/exit process • Implications for innovation

8. Introduction • Michael Porter: Competitive strategy • Establish profitable and sustainable position factoring in bargaining power of suppliers and buyers, threat of entry, threat of substitutes, intensity of rivalry • Strategies for achieving competitive advantage • Cost leadership • Differentiation • Niche • Role of management and luck • Gamblers’ ruin and industry concentration

9. Introduction • Sustainability of competitive advantage • Barriers to imitation not insurmountable, thus firm must create moving target by investing to continually improve position • Well executed offensive strategy best defense against attack by challenger • Role remains for defensive strategy – increase structural barriers to entry, increase probability of retaliation; retaliate when entry attempted • Deeper pockets • Risk-taking vs. risk aversion – role of regulations, fear of liabilities

10. Introduction • Problem: Market definition • Identification of buyers, sellers – potential entrants, potential sources of supply • Geographic scope • Local, regional, national, international • Trade barriers, information • What constitutes a substitute product? • Cross-price elasticities – measurement, critical values • MR>0: elastic range of demand curve, thus high degree of substitutability with products that are not included in market • Substitutability over time – alternative energy sources

11. Introduction • Entry barriers – ease, speed of entry • Entry by outsiders (who are they?); entry by insiders • Height, perception of entry barriers – reputation, economies of scale/scope, learning curves, access to distribution networks, switching costs, firm specific capital (patents, trade secrets, management skills, location) • Strategic behavior of incumbents – entry accommodation or deterrence • Time period for defining markets – time required for adjustments in buyer/seller behavior in response to certain size price change

12. Introduction • Problem: Information • What do buyers know about availabilities, prices, quality? • Search costs • Uncertainties re. quality – signals by firms for quality (advertising, warranties, investments in creating brand names) • Limited search enhances market power of each firm • Impact of Internet – search sites • What do suppliers know about technologies (product, production), consumer tastes, price elasticity, number and location of buyers, number and competencies of rivals, cost structures of rivals, strategies of rivals • Role of B2B – impact on relative bargaining advantages • What do potential entrants know? • Impact of Internet

13. Introduction Competition • Schumpeter • “This process of creative destruction is the essential fact about capitalism. Every piece of business strategy must be seen in its role in the perennial gale of creative destruction.” • Bob Crandall • “Kill your competitor” • Porter • Competitive advantage

14. Introduction • Among 50 wealthiest: Carlos Slim (#1), Bill Gates (#2), Amancio Oretga (#3), Li Ka-shing (#8), Bernard Arnault (#10), Stefan Persson (#12), Michael Bloomberg (#13), Jeff Bezos(#19), Larry Page & Sergey Brin (#20 and 21), Mukesh Ambani (#22), Carl Icahn (#26), Alberto Gonzalez (#32), Mikhail Fridman (#41), Lakshmi Mittal (#41), Aliko Dangote (#42), Mark Zuckerberg (#66)

15. Introduction • Theory: If, then • If perfect competition, then P=MC • If monopoly, then, P>AC • If no entry barriers and zero exit costs, then markets contestable and P=AC • If economies of scale to Q0 and diseconomies of scale beyond Q0 , then AC curve is U-shaped • If oligopoly, then ??? • If heterogeneous product, then monopolistic competition • If economic profits, then entry occurs

16. Introduction • Common shortcomings • Time: short run vs. long run • Market/industry boundaries • Competitive behavior – competitive strategies, competitive advantage • First entrant • Tipping point • Networks • Evolution of technology • Disruptive technologies

17. Introduction • Problem: Many paths to the “if”, thus many paths for “then” • Example: Monopoly • How was monopoly created? • Government, natural monopoly, successful strategies, superior management, luck • Entry barriers created as part of process? • Depends on how monopoly created • Strategies to sustain monopoly? • Rent seeking – public vs. private sector • Sustainability

18. Introduction Decision making • Adam Smith: individuals pursuing their own self interest will collectively produce the greatest good  Greed is good (Gordon Gekko, “Wall Street I”), Economics 101 • Margin Call: You succeed by being fist, being smartest or cheating • Importance of incentives: individuals motivated by personal well-being • Politicians – Quebec municipal governments; Africa • Sub-prime loan markets, Madoff and Ponzi, derivatives – CDS, traders – bond vigilantes • What about altruism – George Clooney, Angelina Jolie, Mat Damon? • Giving pledge initiative – Gates and Buffett

19. Introduction • Time horizon • Longer the time horizon – fewer constraints, more uncertainty • Temporal interdependence among decisions made at different points in time • Increasing complexity • Shorter time horizon • Tradeoffs • Rash behavior • Susceptibility to herd mentality – safety in numbers

20. Introduction Markets and players • What is a market? What is capitalism? • Reliance on markets – role of uncertainty, number of competitors • Rules and regulations: role of governments • Ex ante vs. ex post rule making – political risk • Ability to influence rule makers • Market boundaries: Who’s in, who’s out? • Who’s waiting to get in? • Are the boundaries shifting? • Geographic/product?

21. Introduction Teams • Creation of clubs/teams – tribalism • Reinforce early success • Limit competition among members • Economies of scale • Solution to imperfect information, absence of trust • Enhance benefits for all members • Exclusionary • Language, race, religion, culture, nationality, socio-economic

22. Introduction Firms • Organization that transforms inputs into outputs • Collection of people working as team • Existence of firms • Limited liability – raising capital • What does a “firm” maximize? • Who makes the key decisions and why? • Separation of ownership and control • How is accountability managed within the firm? • How are they/how should they be organized?

23. Introduction • From here to there • Defining here • Choosing among all possible theres • Choosing the path to get there • Options created/foregone along each path • How long to get there along each path • What if “there” chosen proves to be the wrong one? • How do you find out? • Role of milestones and contingency planning • Leadership

24. Introduction • Risks • Margin for error: PV/I • Confidence in data and analysis • Size of bet

25. Firms • What is a firm? • Legal structure – corporations, partnerships, sole proprietorships • Ownership of a firm • Private, public, government, not-for-profit • Potash/Air Canada/Petro-Canada/CNR all started as Crown Corporations; privatized • Is government ownership needed? Consider Hydro One, OPG, TTC, LCBO, CMHC, GTAA, AECL, CDIC, Canada Post, EDC, Via Rail • Objectives of a firm • Advantages of a firm • Organization and governance of firms

26. Existence of Firms • Technological • Transactions costs • Contractual

27. Existence of Firms Technological • Team production • Economies of scale – specialization through scale, learning by doing; comparative advantage in use of resources; larger number of production technologies available; indivisibilities • Q(X10) + Q(X20) < Q(X10, X20) • Lower cost to meter/monitor team members internally within firm than externally via the market • Economies of massed reserves through ownership of assets • Insurance against machine breakdowns • Diversification across markets to reduce peak-load capacities • Indivisibilities/synergies in overhead functions: sales, marketing, finance, engineering, legal, research, distribution • Economies of scope

28. Existence of Firms Technological • Need to supervise/monitor/meter • Supervisor measures efforts, determines rewards • Bounded rationality limits scope of control • Rules for compensation – subjectivity, favoritism • Who monitors the monitor? • Compensation to motivate employees • Seniority systems • Vested pensions – less important because of systemic deficits with defined benefit plans • Performance-based bonuses

29. Existence of Firms Technological • Limits because of diseconomies of scale • Shirking – free riding: benefits of leisure accrue to individual, costs of leisure (reduced effort) shared by all members of team • Monitoring and metering costs to minimize shirking • Difficulty in measuring individual effort/contribution • Bounded rationality, noise in transmission of information • Hierarchical organization structure – “guard”/unproductive labor • Boredom and specialization • Motivation – risk aversion

30. Existence of Firms Value Chain and Internalization Primary Activities: • Raw materials  Inbound Logistics  Operations (Manufacturing)  Outbound Logistics  Marketing  After-Sale Service • Operations can be sub-divided into • Fabrication of Materials  Production of Parts  Sub-assembly  Final Assembly • For service activities, the value chain would look different

31. Existence of Firms Value Chain and Internalization Support Services, which overlay the Primary Activities: • Firm Infrastructure – finance, planning, legal • Human Resource Management • Technology Development • Procurement