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Doing Business Around the World A83220

Topic 10—Course Overview Sample Problems

Theory of the Firm

In many developed economies, the corporation is the most prevalent form of firm ownership in terms of total sales. For example, in the US, corporations account for approximately 90% of total firm sales.

a. Please explain why the limited liability feature of corporations contributes to the ability of this form of firm ownership to grow.

b. There has been much written on the problem of separation of ownership from control in corporations. In the early 1990s, stock options were introduced as a possible solution to this problem because managers whose compensation included stock options had objectives that were closer to those of firm owners (stockholders). However, there is strong evidence that stock options had other problematic effects on the way firms were run. Please discuss these effects and comment briefly on them.

Answer:

a. Corporations are companies whose capital is divided into shares that are owned by individuals who have limited responsibility for the debts of the company. This is known as limited liability: if the corporation fails the shareholders’ losses are limited to the price paid for the stock. The shareholder is not liable for the debts of the corporation. Because of this limited liability feature, individuals are more willing to buy shares than they otherwise would be if they could lose more money than what they had spent to acquire the shares. This has allowed corporations to attract shareholders and grow much bigger than under the other two forms of ownership (sole proprietorships and partnerships). In particular, a larger equity (stockholder) base resulting from the limited liability feature makes debt financing cheaper for corporations, thus reducing the overall cost of raising capital. Corporate growth allows firms to take advantage of possible economies of scale and scope, enter large markets and make acquisitions.

b. The stock option is a right to purchase the firm’s stock over a given period of time at a given price (usually below the current market price). The holder of the option makes a profit equal to the difference between the option price and the market price of the stock. When managers’ compensations include a significant amount of stock options, they have a strong incentive to do what they can to increase the price of the firm’s stock so as to profit from the difference between the high market price of the stock and their option price. According to some commentators, this has led to perverse behavior within corporations whereby managers did all they could to increase the price of the stock, including misrepresent earnings, inflate sales data, underestimate cost data, etc….i.e. to lie, cheat and steal to get the stock price up.

Theory of the Firm: Fixed vs. Variable Costs

Rapid Trans runs a commuter train line with the following cost and usage characteristics:

Total fixed cost per day: $900

Total variable cost per train trip: $10, regardless of the number of passengers

No. of trips during rush hour: 20

No. of trips during off-peak hrs: 10

No. of passengers per rush hr. trip: 200

No. of passengers per off-peak trip: 10

Price per passenger per trip: $1.50

Rapid Trans hires a management consultant to advise it regarding train usage strategy. The management consultant argues as follows: the total cost of running the train is $40 per trip ($30 in fixed costs ($900/30 trips) + $10 in variable costs) regardless of the number of passengers. So, the cost per passenger is 20 cents per passenger during rush hour trips and $4 per passenger during off peak hour trips. The consultant concludes that Rapid Trans is losing money during off peak hour trips and therefore should reduce the number of off peak hour trips as much as possible.

I suggest that Rapid Trans fire the management consultant and hire you instead. Can you explain why the consultant is wrong and what you would recommend doing instead?

Answer:

The consultant has not distinguished between fixed and variable costs. Since the fixed costs will be incurred regardless of whether and how much the train is run or not, there is no increase in fixed costs from running the train on off-peak hours. What matters are the variable costs of running the train during the off-peak. As long as the revenues from the fares during off peak hours cover the variable costs of running the train during those hours, the train should make those trips.

The consultant calculates the average total cost (fixed + variable) per passenger ($4 for off-peak and 20c for peak), compares it with the average revenue per passenger ($1.50) and erroneously concludes that since the revenue per passenger < cost per passenger during off-peak hours, it is uneconomic to operate the train during those off-peak hours. But the fixed costs of $900/day have to be incurred whether the train is run off peak or not and therefore should not factor into the calculation. The only thing that is relevant is whether the revenue per passenger during off-peak covers the variable costs during off- peak , which it does:

Variable cost per off-peak trip = $10

Revenue per off-peak trip = $15 ($1.50 per passenger * 10 passengers)

Therefore, the train should be run off-peak.

Strategies in Monopolistically Competitive Markets

a. What is the “monopolistic” aspect of a Monopolistically Competitive Market?

b. Give three examples of successful “monopolistically competitive” products and the strategy underlying their success.

Answer:

a. Through product differentiation, advertising and marketing, some firms are able to differentiate their products from those of competitors and in this way derive some degree of monopoly power in the market for their products. Successful product differentiation or branding can significantly help firms insulate themselves from competition even in the presence of many competing firms offering similar products—thus the term “monopolistic” competition.

b. (1) Two wine producers, one selling high quality wine (Amarone, Brunello) and the other selling inexpensive wine with a screw-off top in lieu of a cork or sold in cartons. The sales, marketing and pricing of the low end wine merchant is of little relevance to the sales and profitability of the high quality wine merchant. Thus, a reputation for high quality products that appeal to a given sector of the population would meet this standard of product differentiation.

(2) Any form of successful branding which insulates the firm from competition to a certain degree and allows it to charge more than other firms selling not-so-close substitutes (in customers’ minds). Examples include over the counter drugs such as cold, headache and allergy remedies (like Tylenol, Advil, Benadryl), household cleaning products (Kleenex Tissues, Clorox Bleach) and cosmetics (l’Oreal, Clinique, Estee Lauder). Note that sometimes these brand name products have precisely the same ingredients as their less expensive no name brand counterparts.

(3) The market for luxury goods is characterized by successful product differentiation of this type which allows the firms to sell their exclusive products at very high prices to consumers who seem to prefer them to other less expensive substitutes. Examples include the luxury apparel, leather goods, accessories market (e.g. Gucci, Louis Vuitton, Fendi etc.) and the luxury car market (Ferrari, Porsche, etc.)

Strategies in Monopolistically Competitive Markets

a. Suppose you are the head of marketing for a consumer products company. Suppose that you believe that you already have a monopoly (or near monopoly) of the market for one of your products. However, you are eager to propose a new (fairly expensive) advertising campaign for this product that you feel will significantly improve its profitability. Use a graphical analysis (remember you are an economist) to illustrate your proposal.

b. Now suppose you are a member of the board of directors of this consumer product company. Although you are impressed by the head of marketing’s presentation, you are concerned that he may not be correct in his estimate of the increased profitability that will result from the new ad campaign. What parts of his presentation would you question?

Answer:

a. Let D1 and AC1 represent the market demand and average cost of production for the product. Assume the advertising campaign increases the demand from D1 to D2 and the average cost from AC1 to AC2. For simplicity, assume the MC of producing the product does not change. Because you believe you have a monopoly of this market, you maximize profits by pricing like a monopolist. Prior to the new ad campaign your market price would be P1 and quantity sold Q1. As a result of the new ad campaign, the profit maximizing price and quantity both increase to P2 and Q2. More importantly, profits increase from the small rectangular area without the new ad campaign to the much larger profit rectangle as a result of the new ad campaign.

$/Q

MC

P2 AC2

D2

P1 AC1

D1

Q/t

Q1 Q2

$/Q

MC

P2 AC2

Profit

D2

P1 Profit AC1

D1

Q/t

Q1 Q2

b. The size of the profit rectangles are tied to estimates of (a) the cost of the ad campaign, i.e. the position of the new AC curve AC2 and, more importantly (b) the effect of the new ad campaign on consumer demand for the product, i.e. the position of the new demand curve D2. If, for example the cost of the ad campaign is higher than estimated (AC shifts out more than expected from AC1 to AC2) and its effectiveness on the level of demand is less than expected (D shifts out less than expected from D1 to D2) the resulting change in profitability will be much lower. It may even end up being less than the profitability before the proposed ad campaign.

$/Q

MC

AC2

P2 Profit

D2

P1 Profit AC1

D1

Q/t

Q1 Q2

Strategies in Monopoly and Large Share Markets

Consider the following relationship between the price cost margin and the elasticity of demand: (p-mc)/p = -(1/e)

a. Which market structure is characterized by this relationship?

b. Interpret this relationship and its implications for firm behavior.

Answer:

a. The market structure characterized by this relationship is Monopoly. This relationship is referred to as the Lerner Index. It is simply another way of writing the profit-maximizing pricing/output decision for the monopolist, given its costs and market demand which can be described by the elasticity of demand along the demand curve.

b. The price cost margin (i.e. the percentage amount by which the monopolist’s profit-maximizing price exceeds the monopolist’s marginal cost) is inversely proportional to the elasticity of demand in the market. This means that the extent to which a monopolist can profitably price above MC decreases in markets with more elastic demand. The market power of the monopolist is lessened because consumers’ demand is more elastic (because consumers choose to do without the product or consume far less of the product at higher prices or switch to substitutes). Thus, monopolists prefer markets with less elastic demand because their ability to price above marginal cost increases as do their profits. The monopolist (all else being equal) will prefer to enter markets with lower elasticities of demand and/or attempt to reduce the elasticity of demand for its products via advertising, marketing, acquisition of companies that produce competing products, seeking government trade protection against imports, etc.

Strategies in Non-Cooperative Oligopoly Markets

In the movie business, one of the trickiest decisions producers face is what type of movie to make. Suppose there are 2 movie studios and that their the producers are trying to decide whether to make an Action Adventure (AA) or Romantic Comedy (RC) movie. Suppose each of the studios does not know what type of movie the competing studio is planning to make that same year and that they do not trust each other in the least. They face the following payoff matrix.

Studio 1

RC AA

Studio 2 RC (50,50) (90,60)

AA (60,90) (75,75)

(The figures in parentheses show total estimated box office revenues in millions for Studio 1, then for Studio 2.)

a.

What strategy (make an AA or RC movie) will each of the studios chose?

What is the payoff to each of the 2 studios given the strategies they choose?

b. Now, suppose that AA are much more expensive to make than RC and therefore the expected profitability of the two types of movies differ. Suppose that AA cost $70 million per movie and RC cost $25 million per movie.

What is the new strategy for each of the studios? Is it different from the one in a?

What is the payoff to each of the 2 studios given the strategies they choose?

Answer:

a.

From Studio 1’s perspective:

Studio 1’s payoff

RC 50

RC

AA 90

Studio 2

RC 60

AA

AA 75

Same outcome for Studio 2.

From studio 1’ s perspective: if studio 2 makes a RC, studio 1’s payoff is $50 million if it also makes a RC and $90 million if it makes an AA. If studio 2 makes an AA movie, studio 1’s payoff is $60 million if it makes a RC and $75 million if it makes an AA. Therefore, studio 1 will choose the strategy “make an AA movie”. Since the payoff matrix is symmetric (same payoffs to the studios for the same decisions) the same will apply to studio 2 who will also choose the strategy “make an AA movie”.

Thus, “make an AA movie” is a dominant strategy for both studios since this gives them the highest payoff, no matter what the other studio does. The resulting payoff will be $75 million for each studio.

b.

New payoff matrix:

Studio 1

RC AA

Studio 2 RC (25,25) (20,35)

AA (35,20) (5,5)

The new payoff matrix is derived by simply subtracting the cost of making the types of movies from the expected box office revenues.

The corresponding extensive representation of the game is:

From Studio 1’s perspective:

Studio 1’s payoff

RC 25

RC

AA 20

Studio 2

RC 35

AA

AA 5

Same outcome for Studio 2.

(3) Given the new payoff matrix, Studio 1 is best off choosing the strategy RC no matter what Studio 2 does and the same for Studio 2. Thus, the new dominant strategy for both studios is “Make a RC movie”.

(4) The resulting payoff is $25 million (after costs) for each of the studios.

Strategies in Cooperative Oligopoly Markets

In 2001, the European Antitrust Commission fined several of the world’s largest pharmaceutical companies approximately $800 million euros for conspiring to fix prices and the market shares of vitamin products in the 1990s. In that same year, the US Department of Justice (DOJ) found that the auction houses Sotheby’s and Christies were guilty of colluding to fix prices (commission levels) in the art auction market. Price fixing harms consumers because it results in higher prices paid by buyers.

a. In your view, how was this bad for competition, i.e. how does it harm the competitive process, including other competitors who were not engaging in price fixing?

b. In particular, in view of their behavior, why didn’t new competitors enter the market and offer lower prices and/or better service?

Answer:

a. The competitive process is harmed because so-called competitors are not competing but colluding. Therefore, other market participants, including consumers, other competitors, potential entrants and lawmakers are misled into thinking that the market is competitive whereas it is not. The result may be not only higher prices, but also less innovation, fewer products offered, lower quality or level of service.

b. Why don’t these outcomes then cause other competitors to enter the market with lower prices and better service? In the case of the pharmaceutical companies, it may be because they represented the bulk of the market for vitamins so that, in effect, their collusion turned what looked like a noncooperative oligopoly into a near monopoly in terms of their behavior. Other smaller firms and potential entrants may not have had the required information to realize that the higher prices charged were significantly above the competitive levels. Also, the established pharmaceutical firms may have significant brand name advantages which make entry into their market difficult and expensive. The brand name advantage was certainly a determining factor in why other competitors did not try to enter the art auction market notwithstanding the high commissions charged by Sotheby’s and Christies’ as a result of price fixing. These two firms have retained a very large market share for a very long time based primarily on their reputation and contacts. They have developed a very valuable brand name in that business.

Strategies in Large-Share Markets

a. Give two examples of industries (include a list of the market participants in this industry) which are characterized by a high degree of market concentration but do not necessarily exhibit a significant degree of market power, i.e. do not have the ability to price significantly above cost.

b. Give two examples of industries (include a list of the market participants in this industry) which are characterized by a high degree of concentration but, in your estimation, do exhibit a significant degree of market power. Please distinguish whether, in your view, the market power is related to lack of competition among the market participants or to other types of advantages (e.g. branding, reputation, successful product differentiation, etc.)

Answer:

a.

(1) Cellular telephone market: few major firms (TIM, Vodafone, Wind in the Italian market; Verizon, AT&T, Sprint T-Mobile in the US market) but lots of healthy competition among them with regard to services offered and price.

(2) Airline industry: a fairly limited number of major and discount airlines (Delta, American Airlines, Northwestern, United, Continental, Jet Blue in the US market; British Airlines, AirFrance, KLM, other major airlines + EasyJet, Ryan Air, Air Berlin in the EU market) which compete strenuously among each other.

(3) Non luxury car market: a half dozen major car manufacturers (Volkwagen, Peugeot, Citroen, Toyota, Fiat, Nissan, Mitsubishi, Honda, Kia, Chrylser, Ford) which compete based on car models, features and price.

(4) Computer (PC) manufacturers: (IBM, HP, Dell, Lenovo, Gateway) which compete strenuously on features and prices.

b.

(1) Brand-name over the counter headache medicines (Tylenol, Advil, Bayer Aspirin, Aleve, Excedrin in the US market; similar brand-name medications in EU markets). There are few major competitors who compete with each other but are nonetheless able to keep price significantly above cost and significantly above the no-name brand substitutes due to their significant brand name advantage.

(2) Luxury car manufacturers (Mercedes, BMW, Audi). They strongly compete with each other but through product differentiation, customer loyalty, reputation and brand name are able to charge prices significantly in excess of costs.

(3) Music recording market: few large players (BMG/Sony, EMI, Warners), some of whom have recently merged to become even larger. They seem to compete strenuously with each other but have been able to retain very high profitability due to brand name and exclusive deals with artists.

(4) Luxury goods market: dominated by 3 large players: LVMH, PPR and Richmond which, among them account for a very large share of the market but, nonetheless, strongly compete with each other. At the same time, they are able to charge prices significantly above cost because of very strong brand name advantages as well as reputation and successful product differentiation.

(5) Cold breakfast cereal producers (General Mills, Post, Kellogs, General Mills). They were sued years ago for “brand proliferation” but, according to some, seem to still dominate the market and exercise their market power by keeping the price of cereal very high. This may be due to a combination of brand name advantage and collusion among the players.

Government Intervention into Markets—Regulation of Natural Monopolies

The price cap for the Italian highway system we studied in class is:

(T ( or ( (P – X + (*(Q

where (T = the permitted increase in the toll in the given year

(P = the most recent estimate of inflation

X = the productivity index in the given year--a measure of technological change or productivity improvement-- which would cause costs to decline.

(Q = the quality index in the given year

( = a corrective factor (between 0 and 0.5) which is linked to the overall quality achieved over the past 5 years.

a. What are the advantages for this regulated monopoly from being subject to price cap rather than cost-based regulation?

b. What are the disadvantages?

c. From consumers point of view (e.g. people who use the highway system) is price cap regulation preferable to cost based regulation, and why or why not?

d. What is the importance of the role of the quality index Q? What problems may arise if the quality index were excluded from the formula?

Answer:

a. Being subject to price cap regulation allows the highway system to retain for itself as profit any cost savings it is able to obtain relative to allowable price cap. For example, if (P = 3% in a given year, but the highway system is able to keep cost increases at less than 3%, it can keep the difference for itself.

b. Under price cap, the highway system has less protection on the upside if its costs increase by more than the allowable increase under the price cap whereas under cost-based regulation, it would be able to recover all increases in its costs in its tolls.

c. From the consumers’ point of view the price cap is most probably preferable because t forces the highway system to keep its toll increases within the limits of the price cap rather than allowing for toll increases based on the highway system’s cost increases. Under price cap, the regulated company would also tend to be more efficient about its costs than under the cost-based system so it is likely that under a cost=based system toll increases would be greater.

d. Without the quality index, the highway system could have an incentive to make even more money under the price cap by cutting costs by reducing the quality of the service. The quality index is an added incentive (since it has a positive sign in the formula) to keep quality high or at least to meet the applicable quality standards.

Government Intervention into Markets--Antitrust

The proposed merger between office superstores Staples and Office Depot was rejected by the US Federal Trade Commission (FTC) on the grounds that it would give the merged company excessive market share and market power, resulting in post-merger HHIs ranging from 5000 to over 9000. In estimating the market share of the merged company, the FTC defined the relevant product market as “the sale of office supplies through office superstores” and the relevant geographic market as the “42 metropolitan areas where both Staples and Office Depot operated at the time as well as numerous additional metropolitan areas where Staples and Office Depot were planning to expand” (prior to the merger). Suppose you were one of the attorneys for Staples and you were seeking to develop arguments to convince the FTC to accept the merger. What arguments would you make?

Answer: I would make two arguments:

(1) First, that the merger would result in significant efficiency gains and cost reductions. These efficiency gains would come from economies of scope and scale, sharing of common costs and other synergies associated with merging the two companies. I would add that these cost savings could then be passed onto customers. (Note: the FTC would probably respond that the substantial increase in market power associated with the merged company would make it unlikely that these cost savings would be passed onto customers but rather that they would translate into higher profits for the company.)

(2) Second, I would argue that the FTC’s definition of the product and geographical markets was too narrow. I would try to define these markets as broadly as possible. For example, I would define the product market not as limited to “sale of office supplies through office superstores” but “all stores selling office supplies” which would include smaller stationary stores, and would therefore broaden the overall product market definition, thereby reducing the merged company’s share of this product market. I would define the geographic market as the entire US rather than limit it to the metropolitan areas in which Staples and Office Depot currently operate or had planned to expand to. Both of these changes in market definition would have the effect of reducing the merged company’s estimated market share. (Note: It is unlikely that the FTC would accept these alternative market definitions on the grounds that they are too broad.)

Government Intervention into Markets: Deregulation

In 1984, the Federal Communications Commission (FCC) deregulated rates for basic cable television service in the United States.

a. The current consensus is that it was too early to deregulate. Why was it too early? What occurred as a result of deregulation?

b. The industry was re-regulated in 1992 and, finally, deregulated again in 1998. Was it finally ripe for deregulation then? What factors determine whether an industry is ripe for deregulation?

Answer:

The FCC’s decision to deregulate was based on the view that the cable companies faced enough competition from other means of receiving television programming (over the air, VCRs and the expected growth of satellite) so that a lifting of price regulation would not result in their taking advantage of the fact that they were monopoly providers of cable service. The FCC also wanted to incentivize the cable companies to invest in their businesses. What happened after deregulation was that the cable operators immediately raised basic cable rates from very low levels under regulation to average prices of $35 per month. Thus, obviously the FCC was mistaken in assuming that the cable companies faced adequate competition from other sources of television programming. Why did the cable companies increase basic cable rates so dramatically immediately after they were permitted to do so? Because the demand for basic cable is far less elastic than the demand for the premium services (customers need to subscribe to the basic service in order to get premium services and for customers who do no get good quality over the air reception, basic cable service is necessary in order to see the programs.) Somehow, the FCC did not see this coming. Cable customers began complaining loudly to the FCC about the rate increases and also of poor service. At the same time, post deregulation, the industry began investing heavily in capital improvements to its cable network, increasing channel capacity-- which was one of the desired outcomes of deregulation. However, at the same time, the industry underwent substantial consolidation (lots of mergers and acquisitions), which raised antitrust concerns.

b. Yes, by 1998, changes in technology and the presence of other entrants in the market made the industry ripe for deregulation. The growth and promise of satellite television (DirecTV was launched in 1996 and Dish Network/Echostar in 1998) and the advent of the internet as a means of getting news and information (e.g. the weather) contributed to the sense that the cable television industry had less market power absent regulation and could not indiscriminately increase its rates without driving its customers to other alternative ways of receiving programming.

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