Economics and the Competitive Environment

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Economics and the Competitive Environment
Introduction

• BUSI 7130/6
• Dr. D. M. Gropper
• Fall 2008

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In all recorded history there has not been one
economist who has had to worry about where his
next meal would come fromPeter Drucker
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The Economic Way of Thinking

• Economics is a method rather than a doctrine, an
  apparatus of the mind, a technique of thinking
  which helps its possessor to draw correct
  conclusions.
• John Maynard Keynes

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What is the relevance of Economics for strategic
managers?

• Help to understand the big picture the broad
  business trends and the forces which drive them
• The external macro-economic environment - our
  national economy and others
• the other firms with which we compete now and in
  the future our external environment

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What is the relevance of Economics for strategic
managers?

• Help to improve internal firm efficiency - use
  these rules of thumb
• 1. Profit maximization MRMC
• 2. Cost minimization MP1/p1MP2/p2.MPX/pX for
  all x inputs
• 3. Align incentives to reward desired behavior

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Some Fundamental Economic Concepts

• Scarcity and Choice
• Opportunity Cost
• Costs Benefits drive human behavior -
  Incentives matter
• Decision Makers Choose Purposefully
• Economizing Behavior
• Rational Self Interest

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Economic Fundamentals, continued

• Firm cost structure
• Total, fixed and variable costs
• average and marginal costs
• Short run vs. Long run
• Economies of scale and scope

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Economic Fundamentals, continued

• Demand curves and Firm revenues
• Elasticity of demand
• own price
• cross price
• income
• Elasticity and firm revenue effects

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The Economic Fundamentals, continued

• Market structure and competition
• Perfect competition
• Monopoly
• Intermediate cases
• Contestable markets

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Fundamental Economic Questions

• What will be Produced?
• How will it be produced?
• For Whom?

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Benevolent Dictators exercise
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Free-Market Economic System

• Importance of Well Defined and Enforced Property
  Rights
• Voluntary Exchange Creates Value
• Coordination of factors of production
• Importance of Societal Institutions

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The Market Mechanism

• Supply and Demand
• Role of Price in a Market System
• Allocate
• Communicate
• Motivate
• Adam Smiths Invisible Hand

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The opening up of new markets, foreign or
domestic, and the organizational development from
the craft shop and factory to such concerns as
U.S. Steel illustrate the same process of
industrial mutationif I may use that biological
termthat incessantly revolutionizes the economic
structure from within, incessantly destroying the
old one, incessantly creating a new one. This
process of Creative Destruction is the essential
fact about capitalismEvery piece of business
strategy acquires its true significance only
against the background of that process and within
the situation created by it

• Joseph Schumpeter
• Capitalism, Socialism and Democracy 1942

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Role of Private Businesses in a Market Economy

• Transform inputs into outputs
• Increase value of societys resources
• Make profits for business owners
• Entrepreneurs - identify new opportunities
• Social responsibilities?

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Role of Government in a Free Market Economy

• Define and Enforce Property Rights
• Create and maintain a stable environment
• Address Market Failures?
• Address Macroeconomic Issues?
• Federal Reserve System - monetary policy
• Federal Budget - fiscal policy

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Questions?
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Macroeconomic Issuesfor Strategic Managers

• Strategic Analysis and the Competitive
  Environment
• Dr. D. M. Gropper

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Nobel Prize winning Economiston Inflation

• Inflation is everywhere and always a monetary
  phenomenon.
• Milton Friedman

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Popular baseball player and everyman
philosopher on inflation

• A dime aint worth a nickel anymore.
• Yogi Berra

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Managers and Macroeconomic Issues

• General Conditions
• Unemployment rates
• Inflation rates
• International Issues
• Exchange rates
• Product prices foreign vs. domestic
• Government Policy

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Macroeconomic Issues

• Business Cycles Output (GDP) Cycles
• Expansion
• Recession
• Indicators of Cyclical Conditions
• National Output - GDP
• Unemployment Rate
• Inflation Rate-CPI, PPI, GDP deflator

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Macroeconomic Issues

• Why do Business Cycles Occur
• Private Sector reasons
• Public Sector reasons
• What to do about these fluctuations
• Laissez-Faire
• Activist Policy
• Fiscal Policy
• Monetary Policy

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Macroeconomic Policy IssuesManaging the Business
Cycle

• Philosophical Issue - Should We?
• Theoretical Issues - Can We?
• Is it even possible, in theory or reality?
• Practical Issues and Experience -
  Realistic Expectations

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Macroeconomic management problems

• Time and information problems
• - lags in gathering information
• - lags in making decisions
• - lags in implementation
• - lags in impact
• Targeting problems - leakage rates
• Secondary effects
• Good politics vs. good economics

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Macroeconomic Data, page 1

• Daily data sources
• stock market
• Bond and credit markets
• Foreign exchange markets
• Commodities markets

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Macroeconomic Data, page 2

• Weekly releases
• Federal Reserve - Money Supply and Credit
  Aggregates
• Labor Department - New claims for unemployment
  insurance-Jobless claims

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Macroeconomic Data, page 3

• Monthly and Quarterly Data
• Real GDP - Quarterly releases, plus revisions
• Components - monthly
• Retail Sales
• Disposable and overall personal income
• Personal saving
• Merchandise Trade

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Macroeconomic Data, page 4

• Monthly and Quarterly Data Continued
• Labor Market - Household survey, establishment
  survey
• Industrial Production - Capacity utilization
• Inflation
• Consumer Price Index - monthly
• Producer Price Index - monthly
• GDP deflator - quarterly

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Macroeconomic Data, page 5

• Index of Leading Economic Indicators- monthly by
  the Conference Board
• Components
• Avg weekly hours of production workers, mfg.
• Avg weekly initial claims for unemployment
• Manufacturers new orders for consumer goods and
  materials (In constant s)
• Vendor delivery performance (higher bigger
  delays)

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Macroeconomic Data, page 5

• Index of Leading Economic Indicators cont.
• New contracts and orders for plant and equipment
• Index of new building permits
• Change in manufacturers unfilled orders for
  durable goods
• Stock Prices (SP 500)
• Real money supply (M2, in constant s)
• Index of Consumer sentiment - Survey by U of
  Michigan

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Macroeconomic Data, page 6

• Accuracy ..
• Revisions ..

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Determinants of Economic Growth Rates

• Technology
• Resources
• Infrastructure
• Institutions
• government
• societal
• Mancur Olson Rise and Fall of Nations..

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A Brief U.S. Monetary History

• early years - mixed currencies
• 1800s Private bank notes circulating
• 1913 Formation of the Federal Reserve system
• Replace private bank notes with FR notes
• Reduce, then drop Gold and Silver backing for FR
  notes
• Overall trend and lessons for today?

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Monetary Principles

• Full bodied vs. token money
• Debasement controversy -- debasement is theft !
• Greshams Law -- Bad money drives out the Good !

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The Federal Reserve System

• Structure Board of Governors, FOMC, etc.
• Philosophy Independence! ( obfuscation)
• Goals sustainable GDP growth, low unemployment,
  low interest rates, low inflation
• Policy Tools Discount rate, Open Market
  Operations, Reserve requirements

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Federal Reserve System, page 2

• Operations during early 1970s - efforts to hit
  and maintain lower interest rate targets led to
  increased inflation.
• Volcker shift in October 1979 - switch from
  targeting FFR to targeting reserves (and the
  money supply)
• Why announce?
• Short run vs. long run effects --- on the
  economy, and on Carter and Reagan..

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Federal Reserve System, page 3

• Operations during 1980s and 1990s - efforts to
  hit monetary targets often missed, but interest
  and inflation still reasonable...
• Deregulation and innovation in financial markets
  changes things.which money supply to target?
• Concern with all financial markets, stocks too.
• Late 1990s through 2000s.whither Greenspan and
  the Fed???
• In early 2006 Ben Bernanke takes over

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Fed Watching

• What to watch? Desiderata controllable,
  important, regularly/frequently available
• Possible items
• Aggregates total or nonborrowed reserves,
  monetary base, money supply
• Interest rates short term (FFR), medium and
  longer term prime rate, 30yr bond rate
• Speeches, etc.

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Budget Deficits, Surpluses and the National Debt

• Sheer size -- millions, billions, trillions.
• Temptation to finance by inflation
• Refinance to short term interest rates

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Term Structure of Interest Rates (yield curve
analysis)

• Two elements of yield on long term bond
• 1. average of expected yields on short term bonds
  over same time period
• 2. add a risk premium for longer bond

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Term Structure of Interest Rates (yield curve
analysis)

• Yield curve interpretation
• steep upward slope - higher expected future
  interest rates (and higher expected inflation
  rates)
• shallow upward slope - expected future interest
  rates same, slope reflects risk premium only
• downward slope - lower expected future interest
  rates

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Risk Structure of Interest Rates

• Spread between bonds of differing default risk,
  U.S. Treasury vs. Corporate bonds
• increasing spread gives early indication of
  recessions
• decreasing spread gives early indication of
  expansions
• Useful as a market indicator of expected business
  conditions

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Federal Reserve Interest Rate policy 1999
through mid-year 2001
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Federal Reserve Interest Rate policy 2000
through early 2002
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Federal Reserve Interest Rate policy 2002
through mid-year 2004
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Federal Reserve Interest Rate policy 2002
through mid - 2005
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Federal Reserve Interest Rate policy 2004
through mid - 2007
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Federal Reserve Interest Rate policy 2005
through mid 2008
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Fiscal Policy Lessons learned

• Tax rate changes have largest effects when viewed
  as permanent
• Deadweight loss from tax increases can be
  considerable
• Expansionary effects of deficit spending are not
  likely to be large
• Tax rebates are not as stimulative as tax rate
  cuts of similar dollar amounts

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Monetary Policy Lessons learned

• Central bank credibility is key
• Money and Interest rate changes are more rapidly
  enacted than tax changes, but affect things with
  a long lag
• Monetary policy changes have largest effects when
  unanticipated
• Deadweight loss from unanticipated inflation
  can be considerable