Managerial Economics

1
Managerial Economics

• Lecture Three
• Other theories of price competition
• The Entrepreneurial Role

2
Recap

• Blinders research
• 90 of firms have constant or falling marginal
  cost
• Therefore price must be above marginal (and
  variable) cost for firms to be profitable.
• Dont think in terms of marginal revenue, cost
• 50 of firms change prices only once or less a
  year
• 70 of sales to other businesses 85 to repeat
  customers
• 70 have inelastic demand
• So a good deal of microeconomic theory is
  called into question (p. 302)
• Confirms over 140 similar previous surveys
• So conventional (neoclassical) micro cant
  explain output and pricing decisions of firms

3
Other theories of pricing

• If rising costs of production falling dont
  determine how much firms produce, what does?
• According to some economists, things conventional
  (neoclassical) theory of firm omits
• Product differentiation
• Theory assumes firms compete only on price
• Uncertainty
• Theory assumes costs, demand, etc., known by
  firms
• Also probably no one size fits all pricing
  model
• Different price models needed for different
• Industries (Ag Mining vs Manufacturing)
• Products (established vs new)
• Uses (consumables vs assets houses, shares,
  etc.)

4
Manufacturing Operation within capacity

• Alternative theories of manufacturing pricing
  emphasise
• Uncertainty
• Cant know future
• Excess capacity gives room to react to
  unforeseeable events
• Rivalry with other producers
• Output not homogeneous
• Firms compete on product differentiation
• Try to steal market share from competitors by
  non-price competition
• Extra sales profitable because
• Marginal revenue high Price doesnt have to
  drop when non-price competition expands sales
• Marginal cost low fixed costs high

5
Segmented demand heterogeneous goods

• Not a demand curve for a homogeneous commodity,
  but segmented markets for related but very
  different products
• Product made priced for one target income
  group/taste pattern very hard to shift demand.
• Cant do it just by reducing price

Luxury
Price
Sports
Midrange
Standard
Economy
Quantity
6
Manufacturing Operation within capacity

• Product differentiation limits sales because
• Business men, who regard themselves as being
  subject to competitive conditions, would consider
  absurd the assertion that the limit to their
  production is to be found in the internal
  conditions of production in their firm, which do
  not permit of the production of a greater
  quantity without an increase in cost. The chief
  obstacle against which they have to contend
  does not lie in the cost of productionwhich,
  indeed, generally favours them in that
  directionbut in the difficulty of selling the
  larger quantity of goods without reducing the
  price, or without having to face increased
  marketing expenses. (Sraffa 1926)
• Main constraint on sales not conditions of
  supply but conditions of demand

7
Manufacturing Operation within capacity

• Neoclassical model of capitalism supply
  constrained
• Unlimited wants
• Scarce resources
• Post-Keynesian economist Janos Kornai argues
  modern capitalism demand constrained
• Excess capacity the rule
• Not waste but opportunity
• In growing economy, new factory must have much
  more capacity than needed now
• In uncertain world, excess capacity needed to
  react to opportunities
• E.g., 2001 recall of Firestone tyres in USA

8
Firestone recall

• Bridgestones (Japan) Firestone tyres supplied
  with Ford Explorers

The night before...

• Several deaths due to blowouts

• Recall 6.5 million tyres in 2000/2001
• Goodyear (US ) 31 of market Bridgestone 23
  Michelin (French) 23
• Big consumer shift from Bridgestone to Goodyear
• How would supply demand economics analyse
  this?

The morning after...
9
Firestone recall

• Fall in supply (Bridgestone temporarily out of
  market)

• Rise in demand (normal demand plus refit of 6.5
  million tyres)

Supply

• Price should rise, not much change in output

Pe

• What actually happened?
• Much more complex case study in
• Actual competitive dynamics and
• What not to do!

Demand
Qe
10
Firestone recall

• The Firestone recall briefly swamped Goodyear
  with more business than it could handle. It also
  convinced Goodyear executives that their brand
  carried a reassurance of safety for which
  Americans would pay a premium price But once the
  Firestone recall fell out of the headlines, the
  public did what it has increasingly been doing
  buying whatever was on sale.
• Goodyear's sales deflated Its North American
  market share fell last year to 28.4 from nearly
  31 in 2001. Japan's Bridgestone Corp., whose
  market share slipped only about two percentage
  points to 21 as a consequence of the recall,
  managed to stem a further decline in part by
  launching a massive advertising campaign under
  the slogan "Making It Right." (Wall Street
  Journal 19th February 2003)

11
Firestone recall

• No diminishing marginal productivity rise in
  cost of production
• Goodyear simply increased output to capacity
• But firm tried to profit from Firestone recall by
  increasing its markup
• Rivals (including Firestone) fought back with
  non-price competition
• Goodyear lost market share
• Analysts argued worst mistake was increasing price

12
Firestone recall

• Goodyear's biggest mistake appears to be its
  effort to capitalize on the Firestone recall by
  raising its prices. Starting in January 2001,
  Goodyear boosted prices on its passenger and
  light-truck tires up to 7, and followed up with
  another hefty increase the following June.
  Partly, the company saw itself asserting its
  right to charge prices closer to those of
  Michelin, which generally had the highest in the
  market.
• But in the eyes of many customers, Goodyear
  failed to justify the increases. To charge a
  premium, a tire maker has to offer some
  advantage, even if it's just an aura of
  qualitywhich Michelin has historically
  promoted. (Wall Street Journal 19th February
  2003)

13
Firestone recall

• Price response with no matching non-price
  compensation brought Goodyear undone despite
  windfall from Firestone
• Strategic responses of rivals not on price but
  design, image, availability
• In the tire industry, innovations are quickly
  copied, so it's hard to retain a genuine edge for
  long. But Goodyear has underspent its rivals on
  research and development. Goodyear spent 376
  million on RD in 2001, while Bridgestone spent
  476 million and Michelin spent about 645
  million.
• In years past, Goodyear made up for that through
  muscular sales and marketing and a network of
  dealers that pushed its products with
  near-religious zeal. But Goodyear's price
  changes came at a time when dealers were already
  in near-rebellion over a host of other
  complaints. (Wall Street Journal 19th February
  2003)
• Need model of manufacturing competition that fits
  situations like these

14
Alternative models of firm behaviour

• In manufacturing
• Few very large firms
• Differentiated products quality and feature
  variation
• Competition mainly on product development,
  marketing, services (availability, after-sales
  support)
• Price banding price reflects quality so market
  segmented
• Product diversity non-price competition limit
  output, not costs
• Income distribution also limits potential sales
• Main problem not producing with DMP, but
  selling output given constrained effective demand

15
Alternative models of firm behaviour

• Conventional economic supply demand model based
  on small, price taking firms
• Model doesnt fit data any alternative model
  must!
• Basic fact wide dispersion of firm sizes, but
• Most industries dominated by few large firms
• E.g., US industry aggregate data

• Lets break that down by percentages

16
Alternative models of firm behaviour

• 95 of firms earn less than 5 million
• Less than 1 in 400 earns more than 100 million
  but

• Bottom 95 of firms responsible for only 25 of
  salaries 15 of sales
• Top 0.25 responsible for 51 of salaries and
  62 of sales
• Its a big world out there Model of big
  pricing needed

17
Galbraith Institutional Analysis

• One alternative Institutional economics view
• Focuses on institutions of society
• Sees dominant institution as large manufacturing
  firm
• Some competition good necessary
• Restrains prices (e.g., Goodyears experience)
• Encourages innovation (Apple v IBM v Dell)
• But small firms/competitive industries not
  automatically superior to concentrated industries
• Too small scale of operation
• Inability to plan for technology/market
• Institutionally inferior to large firms because
  less effective manager of vagaries of market

18
Galbraith Institutional Analysis

• Focus of Galbraiths institutional analysis of
  firms
• Nothing so characterizes the industrial system
  as the scale of the modern corporate enterprise.
  In 1969, the five largest industrial
  corporations, with combined assets of 59
  billion, had just under 11 per cent of all assets
  used in manufacturing. The 50 largest
  manufacturing corporations had 38 per cent of all
  assets. The 500 largest had 74 per cent (89)
• Companies achieve scale because it facilitates
  planning of technology, and control of the
  market

19
Galbraith Institutional Analysis

• The firm must be large enough to carry large
  capital commitments of modern technology. It must
  also be large enough to control its markets. But
  the present view also explains what the older
  explanations don't explain. That is, why General
  Motors is not only large enough to afford the
  best size of automobile plant but is large enough
  to afford a dozen or more of the best size and
  why it is large enough to produce things as
  diverse as aircraft engines and refrigerators,
  which cannot be explained by the economies of
  scale and why, though it is large enough to have
  the market power associated with monopoly,
  consumers do not seriously complain of
  exploitation. The size of General Motors is in
  the service not of monopoly or the economies of
  scale but of planning. And for this planning -
  control of supply, control of demand, provision
  of capital, minimization of risk - there is no
  clear upper limit to the desirable size. It could
  be that the bigger the better. The corporate form
  accommodates to this need. Quite clearly it
  allows the firm to be very, very large. (91)
• How large? Check Fortune 500 list of Americas
  top companies

20
Fortune 500 Top 26
21
Post Keynesian Price Theory

• Post Keynesian School focuses on
• Manufacturing prices for established products
• Input prices raw materials, agriculture
• Several variants, but basic ideas
• Manufacturing prices average cost at target
  output a markup
• Target historic market share growth objective
• Markup reflects degree of competition in
  industry
• Manufacturing supply flexible
• Production well within capacity
• Subject to constant/falling marginal costs
• Demand fluctuations covered mainly by changes in
  stocks

22
Post Keynesian Price Theory

• Prices set by markup on input costs
• Price is set by adding together direct
  material and labor costs per unit output, plus
  overhead costs determined at standard volume
  output, plus a predetermined (conventional)
  profit margin. Because the pricing procedure is
  not explicitly designed to maximize profits, the
  full cost price is no a profit maximizing price
  or, in fact, a price that maximizes anything.
  Rather the pricing procedure is designed to
  enable the firm to reproduce itself and grow.
  (Lee 1984 1108)

23
Post Keynesian Price Theory

• View of firms costs
• Based on empirical data
• High fixed costs
• Constant variable costs
• Costs fall to full capacity
• Planned output within capacity

Andrews 1950 61

• Emphasis on realism
• Post Keynesians often stunned that model not
  accepted by economists

24
Post Keynesian Price Theory

• Granted that the principle is so generally
  adhered to in manufacture, the mystery is that it
  has not yet emerged as a postulate of economic
  analysis. It should obviously be an accepted
  principle in pricing-theory. Those economists who
  have thought about it have been too concerned
  with trying to explain it on the basis of the
  existing theory, instead of accepting it
  Scientific method would suggest that the right
  thing to do at the existing state of knowledge
  would be at least to accept the principle as a
  basis for further theory in its own fieldthe
  analysis of price-policy. (Andrews 1950 82)
• Main danger for firm is that target sales will
  not be met
• If sales below target then costs (including debt
  servicing) can exceed revenue
• Sales above target greatly increase profit

25
Post Keynesian Price Theory

• Main focus of competition between firms then
  non-price
• Attempt to alter profile of demand towards own
  product and away from competitors
• Hence advertising, marketing, etc.
• Attempt to lower/control costs increase quality
• Research development key focus of firm
• Non-manufacturing prices quite different
• Minerals, foodstuffs etc. subject to very
  different dynamics
• Products much more homogeneous than manufactures
• Supply less under control of producer (esp.
  agriculture)
• Often more difficult to stockpile
• Productive capacity more difficult to alter

26
Post Keynesian Price Theory

• As a result, manufacturing prices administered
  while minerals/agriculture market
• Administered
• Price set by firm on target output costs plus
  markup
• Changed rarely
• Changes in demand met by changes in output
• Increase in output can allow drop in markup
• Market
• Price set by some market mechanism, mainly
  demand-determined
• Changed often
• Changes in demand initially met by change in
  price
• Change in supply only after sustained change in
  demand
• Prices will rise fall with the trade cycle

27
Post Keynesian Price Theory

• In PK theory, volatile market prices tend to rise
  in boom, fall in slump relative to stable
  administered prices
• Distinction between administered and market
  prices set by frequency of price changes
• 1935 study (Means)
• Administered lt 3 changes/year or less
• Market 1 change/month or more
• On this basis, following classification of
  administered vs market prices by industry

28
Post Keynesian Price Theory

• Means concluded majority of prices were
  administered
• Manufactured goods account for 85 of turnover,
  so majority of most important prices administered

29
Post Keynesian Price Theory

• Empirically valid theory but
• Limited model of how markups etc. set
• Limited development of implications
• makes some predictions re inflation, cycles
• Increase in administered prices mainly reflects
• Changes in distribution of income (higher wages
  passed on in higher prices) increase during
  booms
• Change in cost of raw materials inputs increase
  during booms
• Change in economic activity (increase means lower
  markups needed for same profit) fall during
  booms
• Market prices take brunt of fall during slumps
• But lacks real theory of interaction between
  different prices, etc.

30
Post Keynesian Price Theory

• Interesting example of ideas from recent
  newspaper

• The 71.5 per cent price rise achieved by iron ore
  producers this week ... the rest of us should be
  bracing for a dose of cost-of-living reality as
  those prices flow through the production chain.
  Everything ... will be affected. Or, at least,
  they would be affected if the price rises were
  passed down the chain.

31
Post Keynesian Price Theory

• The iron ore producers and steel makers can raise
  prices almost at will. But the story is different
  as the metal gets closer to the price-sensitive
  customer. Here price rises can become more a
  dream than a reality...
• The price rises reflected a world shortage ...
  Steel prices have been jumping at an alarming
  rate, with the most common industrial feedstock,
  ... rising from US330 to US630 a tonne in the
  past 14 months.
• The pain has been obvious during this profit
  season. At least it was if companies could secure
  steel supplies
• "We have all been struggling, not just with
  prices, but a lack of availability," "The
  problem was a lack of notice from BlueScope
  Steel. There is a three-month lag for us to
  recover steel price rises." And that's only if
  Hills can raise prices. "There is a fine line
  between recovering prices and being able to
  retain the business," Mr Simmons said. "If you
  raise the price, a retailer is just as likely to
  say Well, we'll get it offshore'."

32
Post Keynesian Price Theory

• Post Keynesian Price Theory
• Similar to institutional in that emphasises
  decision-making power of firm
• Firm sets markup thus price
• With some constraint from degree of monopoly
• Different to neoclassical
• Argues market sets price, argues decision-making
  power of firm limited to non-existent
• But theory flawed and empirically invalid
• Another pricing theory Sraffian or Classical
• Similar to Post Keynesian in that empirically
  valid (constant marginal costs)
• Similar to neoclassical in that argues prices set
  by markup

33
Sraffian Price Theory

• Based on work of Piero Sraffa
• Sraffa used model to critique neoclassical price
  theory
• Followers extend model to alternative theory of
  price, output
• Prices based on
• Cost of production (input costs)
• Markup (like Post Keynesian) but
• In equilibrium, markup
• Constant across industries (uniform rate of
  profit)
• Constrained by need to enable each industry to
  reproduce itself
• Reproduce Sell output at price that lets it
  buy inputs and make uniform rate of profit

34
Sraffian Price Theory

• Basic idea
• In equilibrium, price of output must equal price
  of inputs times a profit margin

• Equation expressed using Matrix notation
• P vector of prices one for each commodity in
  economy
• Q matrix each element shows fraction of one
  input needed to produce one unit of relevant
  output
• Mathematics puts limits on markup (profit
  rate)
• Generalised to include Labour inputs needed

• Labour needed also vector labour-time needed to
  produce one unit of each commodity in economy

35
Sraffian Price Theory

• Many macroeconomic ideas extracted from model
• One crucial idea distribution of income (between
  wages and profits) affects prices
• Model rejects neoclassical argument that wage
  equals marginal product of labour
• Marginal product theory key link between
  neoclassical micro and macroeconomics
• Undermined already by empirical finding that
  marginal product constant for vast majority of
  firms
• Instead see wage/profit split reflecting relative
  political strength of workers vs capitalists
• Sees legitimate role to industrial relations, etc.

36
Sraffian Price Theory

• Neoclassical theory
• only one set of relative prices will clear market
• wage rate simply another price, as is rate of
  profit
• Sraffian
• Income distribution not determined by market but
  by social/political forces
• Except that productivity of economy sets maximum
  feasible rate of profit
• Many different sets of relative prices will clear
  market
• One for each feasible distribution of income

37
Summing up alternatives

• Some guidance from Post Keynesians Sraffians re
  pricing for managers
• Supply demand cant explain 95 of prices
• In general, prices set by markup on costs
• Markup constrained by
• Competitive pressures
• Productivity of industry
• Minerals/agriculture largely demand-determined
  prices
• But theories dont explain all prices
• Pricing theory for new products
• Pricing theory for assets (Finance section of
  subject)

38
New products

• Doesnt fit Post Keynesian or Sraffian models
  because
• Both refer to established products
• Sraffian (in particular) considers equilibrium
  positions
• Cant fit into neoclassical model either
• Model flawed for all products
• More importantly, even if model was OK
• Model fits equilibrium only when new products are
  disequilibrium phenomena
• In equilibrium, profits are zero
• Best understood by Austrian school of economics
• In particular, Joseph Schumpeter in an exchange
  economy the prices of all products must, under
  free competition, be equal to the prices of the
  services of labor and nature embodied in them
  (30)

39
New products

• Schumpeter accepted neoclassical general
  equilibrium as accurate model of unchanging
  economy
• Defines profit as surplus of receipts over cost
• In equilibrium, receipts exactly equal cost in
  all industries
• All products sold at marginal cost (assuming
  rising MC)
• Wages equal marginal product of labour
• Return to capital equals marginal product of
  capital
• But capital (machinery) itself an assembly of
  products
• All paid for at marginal cost
• Hence profit zero

40
New products

• The businessman considers as his costs those
  sums of money which he must pay to other
  individuals, in order to procure his wares or the
  means of producing them, that is his expenses of
  production. We complete his calculation in that
  we also include in costs the money value of his
  personal efforts. Then costs are in their essence
  price totals of the services of labor and of
  nature. And these price totals must always equal
  the receipts obtained for the products. To this
  extent, therefore, production must flow on
  essentially profitless. (31)
• But profit the driving motive of production in
  capitalist economy!
• Yes, but not in equilibrium (argues Schumpeter)

41
New products

• In Schumpeters vision, profit arises out of
  change
• Conventional (neoclassical) economic model
  describes system in static equilibrium
• Describes state of rest given one set of data
• Ignores process of change to new state of rest
  after change
• Schumpeter argues profit arises in the process of
  change from one state of rest to another
• Hence conventional economics unable to understand
  profit
• Also unable to understand pricing or strategy
• Need model of discontinuous change that disturbs
  equilibrium

42
New products

• Neoclassical economics describes economic life
  from the standpoint of the economic system's
  tendency towards an equilibrium position, which
  tendency gives us the means of determining prices
  and quantities of goods, and may be described as
  an adaptation to data existing at any time These
  tools only fail where economic life itself
  changes its own data by fits and starts. Static"
  analysis is not only unable to predict the
  consequences of discontinuous changes in the
  traditional way of doing things it can neither
  explain the occurrence of such productive
  revolutions nor the phenomena which accompany
  them. It can only investigate the new equilibrium
  position after the changes have occurred. (62-63)

43
New products

• Schumpeter builds model of economic development
  that
• Uses neoclassical as description of equilibrium
• Adds process of qualitative change
• Explains profit as outcome of one of 5 types of
  qualitative change caused by entrepreneurial
  activity
• (1) The introduction of a new good
• (2) The introduction of a new method of
  production
• (3) The opening of a new market
• (4) The conquest of a new source of supply of raw
  materials or half-manufactured goods
• (5) The carrying out of the new organisation of
  any industry (66)
• Explains introduction ( pricing) of new products
• In doing so, overturns many conventional economic
  beliefs not as false, but as only applying in
  equilibrium

44
Schumpeters model

• Simplifying assumptions
• All innovation done by new firms
• it is not essential to the matter - though it
  may happen - that the new combinations should be
  carried out by the same people who control the
  productive or commercial process which is to be
  displaced by the new. (66)
• All resources (land, labour, machinery) currently
  fully employed
• we must never assume that the carrying out of
  new combinations takes place by employing means
  of production which happen to be unused. In
  practical life, this is very often the case...
  This certainly is a favorable condition ...
  But as a rule the new combinations must draw
  the necessary means of production from some old
  combinations we shall assume that they always
  do so. (67-68)