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A Managerial Economics Handbook
Richard A. Stanford
Copyright 2011 by Richard A. Stanford
All rights reserved. No part of this book may be reproduced, stored, or transmitted by any means—whether auditory, graphic, mechanical, or electronic—without written permission of the author, except in the case of brief excerpts used in critical articles and reviews.
CONTENTS
PART A. THE FIRM AND THE DECISION PROBLEM
Chapter 1.
The Nature of the Firm
Chapter 2.
The Nature of the Decision Problem
Chapter 3.
The Goals of the Firm
PART B. THEORETICAL FOUNDATIONS
Chapter 4.
Value and Risk
Chapter 5.
Consumer Behavior and Demand
Chapter 6.
Production
Chapter 7.
Costs
PART C. THEORIES OF THE FIRM
Chapter 8.
The Competitive Environment
Chapter 9.
Pure Monopoly
Chapter 10. Monopolistic Competition
Chapter 11. Oligopolistic Competition
Chapter 12.
Extending the Model of the Firm
PART D. CONCLUSION
Chapter 13.
Realism and Accuracy in Models
APPENDIX. MANAGERIAL ECONOMICS PRINCIPLES
GLOSSARY. TERMS USED IN THIS BOOK
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PREFACE
Virtually all of the managerial economics (ME) texts on the market for use in university-level courses in ME are replete with algebraic and graphic depictions of models of the business firm. The algebra usually is extended into the realm of multivariate calculus. Economists employ the mathematical and graphic models as “short-hand” methods of conveying complex relationships to their students. The conventional wisdom is that the equations and graphs provide a visual depiction of complex relationships but avert the cumbersomeness of the vast amounts of pure verbiage that would be required to convey the same concepts.
Most ME texts run 500 pages or more. While this amount of text matter may be necessary fodder for a semester-long university-level course, the content often is tedious and requires a moderately-high level of mathematical understanding, perhaps more than is necessary for actual managerial decision making in real world business firms.
After completing work on my own nearly 500-page manuscript for a full-blown ME text (Managerial Economics: A Modeling Approach at http://www.dickstanfordecon.com/MI/micro1.htm) and using it in my ME courses at Furman University, I began to wonder whether there might be a place for a version that abstracts from the quantitative matter--the algebra, the calculus, and the graphic depictions of models. I have also wondered whether it is indeed true that the volume of pure prose necessary to convey the concepts would be so voluminous as to require double or even triple the number of pages in a words-only ME text.
In the attempt to explore these questions, I have produced the present book by abstracting and elaborating the prose content of my ME text to present the essential concepts without use of mathematical symbols, equations, and graphs. While the print version of my full ME text occupies nearly 500 pages, it turns out that the print version of the present book has required less than 150 pages to convey the subject matter. Only those who read and teach this book can judge whether the purely prose expositions are both readable and adequate to convey expositions of the subject matter.
Who might be the clients for this little book? People who find themselves in actual business decision making settings, but who have never had any formal training in managerial economics, might find this book helpful. Managers who once did suffer though the tedium of a university-level ME course might find this text useful as a light refresher. Others who need better conceptual understandings of the ME subject matter but consider themselves to be “mathematically challenged” or who suffer “equation shock” or “graph shock” could find his book helpful. And students who are primarily verbal (rather than visual) learners might find that the book meets their needs.
So here is my best effort to meet a prospective need that I have imagined but which can be confirmed only by offering it on the market. For those who start with this book but feel the need for greater depth or quantitative expositions, I have provided at the end of each chapter a link to the corresponding on-line chapter of my ME text. Readers who download the PDF version of the present book will find the links to be ”live” in the sense that they may be “clicked-on” to get to the corresponding on-line chapters in the full ME text.
A companion to this book, Simulation Modeling the Theory of the Firm, is similarly organized, but it uses a graphic approach that is built around a Java applet, SIMMOD, that enables manipulation of parameters in model equations. This book may be accessed at http://www.dickstanford.com/MI/smtf1.htm and is available in print and downloade form at http://www.lulu.com.
The chapters in Part A of this book introduce the nature of the business firm and the decision problems that business firm managers face.
The chapters in part B describe the theoretical foundations of managerial economics: value and risk, consumer behavior and demand, production and cost.
Part C elaborates the competitive environment ranging from pure competition through monopolistic and oligopolistic competition to pure monopoly.
The final chapter in Part D considers issues of accuracy and realism in economic models.
I invite reader feedback on the usefulness of this book at e-mail address dickstanford43@gmail.com.
Richard A. Stanford
June, 2011
BACK TO CONTENTS
PART A. THE FIRM AND THE DECISION PROBLEM
The chapters in Part A of this book introduce the nature of the business firm and the decision problems that business firm managers face.
CHAPTER 1. THE NATURE OF THE FIRM
Economic opportunities lie in the possibilities for supplying other humans with goods and services made with scarce resources. Opportunities may also be found in the removal or disposal of nuisance goods ("bads"). Productive opportunities are enhanced by specialization and division of labor. People have found that they can consume larger quantities of scarce goods and services when they specialize in the functions that they perform best, trading the fruits of their efforts to others in exchange for the things that they can produce most effectively.
The organization of individual capabilities into firms or enterprises can further enhance productive ability relative to that which individuals alone can achieve. The business firm accomplishes such enhanced productivity by serving as a vehicle for organizing the specialization and division of labor. R. H. Coase has noted ("The Nature of the Firm," Economica, New Series, Vol. IV (1937), p. 393) that firms governed by hierarchical, authoritarian control usually can accomplish resource reallocations more efficiently (i.e., at lower costs) than can be achieved by human interaction through market mechanisms on a purely personal level. Coase notes that commercial enterprises may also function as "players" on their own account in market interactions.
Principle 1. The business firm accomplishes enhanced productivity by serving as a vehicle for organizing specialization and division of labor.
Principle 2. Business firms governed by hierarchical, authoritarian control usually can accomplish resource reallocation internally more efficiently than can be achieved by human interaction through market mechanisms on a purely personal level.
The management of such commercial enterprises involves the exercise of authority, usually from a top level of responsibility downward through progressively lower levels of responsibility and function. The decisions made by the manager of the enterprise encompass both the acquisition of scarce resources from outside the enterprise, and the efficient allocation of those resources within the enterprise. Thus, the management of a commercial enterprise ultimately is an exercise in economizing. The motives, behavior, legitimacy of authority, criteria for successful decision making, and consequences of operations constitute the heart of a study of managerial economics.
Principle 3. The management of a commercial enterprise is an exercise in economizing.
The Variety of Managerial Settings in the Firm
Managerial decision making necessarily occurs within any of the organizational forms that modern business enterprises may take. A later section of this chapter describes in some detail the three principal forms, proprietorship, partnership, and corporation. Our purpose in this section is to survey the ranges of decision settings in the larger, more complex commercial enterprises. In most cases this means the corporation since both size and organizational complexity are severely limited in both proprietorships and partnerships. Even so, some of the following remarks may be applicable to aspects of decision making in the simpler organizational forms.The modern corporation is characterized by a pyramidal, hierarchical organization. A manager may be situated in any setting ranging from that of a shop floor foreman, through lower and middle management echelons, to vice presidential and CEO (chief executive officer) positions. A manager may serve in all of these positions at one time or another with progression through the managerial career. The manager may also be placed in staff rather than line positions. A line position is so called because the manager is in a direct line of authority between the top level decision maker and those employees who carry out the essential business of the firm. A staff position, although it is not in the direct line of authority, provides supplemental services or analyses that enable managers to exercise authority more efficiently. Such staff positions include those in accounting, data processing, communications, statistical analysis, marketing, financial analysis and services, personnel, and transportation, among others. Even though a staff officer is not in the direct line of authority over the essential business of the firm, he or she still must manage the resources under his or her control.
Every business firm has at least one office or plant, although in this “information age” the operational site may be virtual rather than physical. Many firms establish multiple places of business, each of which must be directed by an office or plant manager. Such multiple sites may be organized by function or by geographical region. Depending upon the mission of the office or plant, multiple tiers of managerial responsibility and authority may be established at each site. Managers at every site and at every tier are responsible for the efficient allocation of the resources assigned to them.
Corporate operations sometimes become so extensive and complex that a single management team (or bureaucracy) cannot effectively oversee all of the operations of the business. One possible remedy to this problem has been the divisionalization of the firm's operations. Divisionalization allows the establishment of separate management teams to direct the operations of the multiple divisions. The chief operating officer of the division may have a title such as division director, vice president for the division, or even president of the division. Whatever the title, the division manager reports ultimately to the CEO of the corporation. There may emerge multiple tiers of managerial organization within the divisions of a corporation. The divisions may be organized along staff function lines, or by geographic regions if operations are widely dispersed geographically (including internationally). A division may also have multiple offices or plants assigned to it.
Corporate divisions are occasionally "spun off" from the main corporation and constituted as separate corporations that are wholly or partially owned by the parent firm as subsidiaries. A subsidiary relationship may also come into existence when one firm acquires a controlling ownership interest in another firm, but chooses to preserve the acquired firm's corporate identity. Because of the ownership relationship, the management of the acquiring firm can dictate policy to the management of the acquired firm. If the acquiring firm has never conducted business operations or for some reason ceases physical operations but continues to direct the operations of one or more subsidiary operating companies, it may be referred to as a holding company.
The internal structures of enterprises, and their divisions and subsidiary relationships as well, may be organized horizontally, vertically, or in conglomeration. As is common in the automobile and other American industries, numerous divisions of the same enterprise may perform parallel or identical functions, and may even be directed to compete with one another. This constitutes a horizontal structure. In other cases, the multiple plants or divisions of a firm may perform different functions in a vertical sequence ranging from the extraction of raw materials through the refinement of ores and the production of basic shapes, the fabrication of parts, various stages of assembly, and distribution through jobber, wholesale, and retail outlets. The multiple plants, divisions, and subsidiaries of a corporation may be conglomerated in the sense that the functions performed or items produced are unrelated to one another, but are linked in the corporate family for financial or distributional reasons.
Whatever the structure of a firm and its affiliated entities, any line or staff officer of the firm, or any plant, division, or subsidiary manager, must make economic choices in the use of the scarce resources that are assigned to his or her control. It is in this sense that managerial decision making in any of its settings is ultimately an exercise in economizing.
Forms of Enterprise Organization
Commercial enterprises, and thus the settings for managerial decision making, range from the very simple to the highly complex. The simplest form of an enterprise or firm is the proprietorship, exemplified by the baby sitter, the lawn boy, the news agent, the self-employed repair person, the consultant, and the bazaar trader in a developing country. Because a proprietorship coincides with the identity of its owner, its life comes to an end when the owner expires; its financial resources are limited to personal fortune plus any amounts that can be borrowed from relatives, friends, or banks; and the personal fortune of the owner is fully exposed to any liability incurred in the operations of the enterprise. Within the proprietorship there is virtually no possibility of specializing or dividing managerial authority or responsibility.Even with these limitations and negatives, the proprietorship form of commercial organization has two very significant positive aspects. Tax and other legal reporting requirements are minimal, and the proprietor retains full authority over all of the resources at his or her command, answering to no one other than spouse and civil authorities. Within these limits the proprietor may choose to pursue any goal or engage in any activity or behavior desired, including profit, charity, social responsibility, or leisure. It is because of these two positives that the vast majority of commercial enterprises throughout the world are organized as proprietorships. In the United States, nearly three-fourths of the 23 million business firms are proprietorships. This proportion may approach 100 percent in some developing countries.
The partnership form of commercial organization relieves some of the limitations of the proprietorship, but aggravates others. Because two or more principals are involved in the firm, there is some possibility of specialization and division of labor, including managerial responsibility and authority. Also, the personal fortunes and borrowing abilities of the participants may be pooled.
Because there are no clear lines of authority (unless expressly provided for in the partnership agreement), conflicts may emerge among the partners concerning overall goals and the strategies for pursuing them. And while the owner's liability is unlimited in a so-called “unlimited liability” proprietorship, the problem is compounded in the partnership because any liability incurred by a partner or employee may extend through to the personal fortunes of all other partners. Also, the life of the partnership is severely restricted in duration to the shortest life of any of the partners. When one partner dies or withdraws, the partnership legally must be dissolved, although it may be immediately reconstituted by an agreement of the surviving partners who may choose whether or not to accept as new partner(s) the heirs of the deceased partner.
Governments of many countries now enable the status of a “limited liability partnership”, or LLP, in which the partners (or some of them) enjoy limited liability in the sense that one partner is not liable for the actions or liability incurred by other partners.
Most state governments in the United States also enable the status of a “limited liability company”, or LLC. An LLC is a proprietorship or partnership in which the principal(s) enjoy limited liability with respect to each other, but the principals are still subject to personal liability for their actions. LLCs are unincorporated associations for which tax authorities usually allow “pass-through income taxation”, i.e., the income of the LLC is not taxed, but the distributed incomes of principals are taxed as personal income.
Fewer than ten percent of the business enterprises in the U.S. economy are organized as partnerships. Even large partnerships rarely have more than a few dozen partners, and few have as many as a hundred. In recent years some partnerships (particularly of accountants and attorneys) have effected transitions to the corporate form of organization in order to limit the liability of the principals.
The corporate form of commercial organization has been known for centuries; the British East India Company was chartered by the English crown in the 17th century to explore and exploit the resources of the New World. However, the corporation began to achieve popularity as a form of commercial organization only during the 19th century. By the late 19th century, it had attained such notoriety as to induce the Congress of the United States to enact "antitrust" legislation to deal with what were widely perceived to be unacceptable industrial structures and firm behaviors. Similar enactments followed in other countries that also favored competitive market environments.
Because of its hierarchical form of managerial organization, the corporation is especially well suited to specialization and the division of managerial responsibilities and authority. Indeed, there may be numerous tiers of management structure in a corporation. Also, the corporation may acquire financial resources far more extensive than those available to proprietorships or partnerships by selling equity shares (common or preferred stocks) in itself, or by issuing liabilities (bonds) against itself. Although such shares and bonds may be sold locally on an "over-the-counter" basis, the development of "open markets" for stocks and bonds has enabled listed corporations to sell shares or issue bonds to literally millions of investors, enabling the accumulation of billions of dollars to be invested or used as working capital.
Another significant feature of the corporation is the limitation of the exposure to liability that an owner (i.e., a shareholder) of the corporation must suffer. The maximum amount that the shareholder can lose if the corporation is sued or otherwise fails is the amount invested in shares in the company. The personal fortunes of the investors are otherwise insulated from further liability that may descend upon the corporation. This feature is a result of the legal personhood of the corporation. As a legal person (a "corporate person"), the corporation has a life that is independent of the lives of any owners, directors, managers, employees, suppliers, customers, or any other parties associated with the corporation in any way. The corporate person may be sued in a court of law, and may initiate lawsuits in its own behalf. However, such suits against the corporation can hope to capture only the assets of the corporate person, and not the personal fortunes of the shareholders.
Principle 4. Shifting a firm’s organizational form from proprietorship or partnership to corporation may limit the liability of owners, enable access to greater financial resources, and facilitate specialization and division of managerial responsibilities and authority.
There are some negatives associated with the corporate form of business organization. Given the privileges conferred by a corporate charter, the corporation is required to report to governments for tax and other legal purposes far more often than are proprietorships and partnerships. Such legal "red tape" is enough to convince many entrepreneurs to stay with proprietorship or partnership organizational forms. Also, in the United States and many other countries the income of the corporation is subject to double taxation. It is taxed first as income to the corporate person; then if the income is distributed (as dividends) to the shareholders of the corporation, it is taxed again as personal income of the shareholders.
Even with these negatives, the popularity of the corporate form of business organization is on the ascendancy throughout the world. Although only 18 percent of U.S. business firms are organized as corporations, they include the largest firms in the economy, and they are often situated in highly concentrated industries (i.e., a small number of firms accounting for a large proportion of industry output). Some corporations in North America and Western Europe have hundreds of thousands of employees, own billions of dollars worth of assets, and achieve sales in the billions of dollars each year. Such large scale commercial enterprises necessarily entail high levels of managerial complexity.
The Variety of Managerial Settings in the Firm
Managerial decision making necessarily occurs within any of the organizational forms that modern business enterprises may take. Our purpose in this section is to survey the ranges of decision settings in the larger, more complex commercial enterprises. In most cases this means the corporation since both size and organizational complexity are severely limited in both proprietorships and partnerships. Even so, some of the following remarks may be applicable to aspects of decision making in the simpler organizational forms.The modern corporation is characterized by a pyramidal, hierarchical organization. A manager may be situated in any setting ranging from that of a shop floor foreman, through lower and middle management echelons, to vice presidential and CEO (chief executive officer) positions. A manager may serve in all of these positions at one time or another with progression through the managerial career. The manager may also be placed in staff rather than line positions. A line position is so called because the manager is in a direct line of authority between the top level decision maker and those employees who carry out the essential business of the firm. A staff position, although it is not in the direct line of authority, provides supplemental services or analyses that enable managers to exercise authority more efficiently. Such staff positions include those in accounting, data processing, communications, statistical analysis, marketing, financial analysis and services, personnel, and transportation, among others. Even though a staff officer is not in the direct line of authority over the essential business of the firm, he or she still must manage the resources under his or her control.
Every business firm has at least one office or plant, although in this “information age” the operational site may be virtual rather than physical. Many firms establish multiple places of business, each of which must be directed by an office or plant manager. Such multiple sites may be organized by function or by geographical region. Depending upon the mission of the office or plant, multiple tiers of managerial responsibility and authority may be established at each site. Managers at every site and at every tier are responsible for the efficient allocation of the resources assigned to them.
Corporate operations sometimes become so extensive and complex that a single management team (or bureaucracy) cannot effectively oversee all of the operations of the business. One possible remedy to this problem has been the divisionalization of the firm's operations. Divisionalization allows the establishment of separate management teams to direct the operations of the multiple divisions. The chief operating officer of the division may have a title such as division director, vice president for the division, or even president of the division. Whatever the title, the division manager reports ultimately to the CEO of the corporation. There may emerge multiple tiers of managerial organization within the divisions of a corporation. The divisions may be organized along staff function lines, or by geographic regions if operations are widely dispersed geographically (including internationally). A division may also have multiple offices or plants assigned to it.
Principle 5. Divisionalization of a firm’s operations allows separate management teams to achieve more effective oversight, coordination, and control.
Corporate divisions are occasionally "spun off" from the main corporation and constituted as separate corporations that are wholly or partially owned by the parent firm as subsidiaries. A subsidiary relationship may also come into existence when one firm acquires a controlling ownership interest in another firm, but chooses to preserve the acquired firm's corporate identity. Because of the ownership relationship, the management of the acquiring firm can dictate policy to the management of the acquired firm. If the acquiring firm has never conducted business operations or for some reason ceases physical operations but continues to direct the operations of one or more subsidiary operating companies, it may be referred to as a holding company.
The internal structures of firms, and their divisions and subsidiary relationships as well, may be organized horizontally, vertically, or in conglomeration. As is common in the automobile and other American industries, numerous divisions of the same firm may perform parallel or identical functions, and may even be directed to compete with one another. This constitutes a horizontal structure. In other cases, the multiple plants or divisions of a firm may perform different functions in a vertical sequence ranging from the extraction of raw materials through the refinement of ores and the production of basic shapes, the fabrication of parts, various stages of assembly, and distribution through jobber, wholesale, and retail outlets. The multiple plants, divisions, and subsidiaries of a corporation may be conglomerated in the sense that the functions performed or items produced are unrelated to one another, but are linked in the corporate family for financial or distributional reasons.
Whatever the structure of a firm and its affiliated entities, any line or staff officer of the firm, or any plant, division, or subsidiary manager, must make economic choices in the use of the scarce resources that are assigned to his or her control. It is in this sense that managerial decision making in any of its settings is ultimately an exercise in economizing.
BACK TO CONTENTS
CHAPTER 2. THE NATURE OF THE DECISION PROBLEM
Strategic and Tactical Decision Making
Strategic management is concerned with the fundamental direction of the organization's activity, i.e., the businesses that the organization intends to pursue and desired levels of achievement in those lines of business. Such decisions, by their very natures, must be made at the highest policy making level of the organization. The time frame is from the present to as far into the future as the organization's time horizon. The organization's time horizon is limited to that of its least visionary policy maker who constrains the enthusiasm of its would-be innovators.By virtue of the fact that such directional decision making covers the long run and is laden with risk, it should be understood to be entrepreneurial rather than managerial in nature. Although the language of the business administration literature stresses strategic management, it should be more properly understood to be strategic entrepreneurship. In the late twentieth century, the term "entrepreneurship" has come to be associated with new, small, "start-up" business ventures that are highly risky. Entrepreneurship often is not perceived to occur in established or "going" concerns, especially if they have attained large size in terms of assets, employment, market share, or volume of sales.
Strategic entrepreneurship may occur at any level in any organization, whether a new local venture or a well-established multinational enterprise. In a new venture, entrepreneurship is exercised by the founder of the firm. To the extent that fundamental change is initiated at the board room level of an established enterprise, the function of the governing board is almost purely entrepreneurial since the board must assume the risks of its innovational decisions. If proposals for change are devised at lower levels in the administrative organization and only submitted to the governing board for approval, it is the site of the innovative proposal that is the true locus of entrepreneurship. However, in its approval the governing board assumes a substantial portion of the risk of the proposed innovation, and in effect shares risk with the proposer of the strategic change.
Principle 6. Strategic entrepreneurship may occur at any level in any organization, whether a new local venture or a well-established multinational enterprise, but should be accomplished at the highest level of authority commensurate with the mission.
There is some confusion over the meanings of the terms "goals" and "objectives". We shall take the term goal to refer to an ultimate end that the organization at its highest policy making level determines to try to achieve. The term objective is taken to refer to desirable intermediate situations or levels of performance to be achieved in pursuit of the ultimate goals of the organization. By their nature then, goals are long-term and strategic in orientation, whereas objectives are more short-term, immediate, and partial in nature.
In military parlance, the term "tactic" is usually juxtaposed to "strategy" in referring to an action that is taken "in the field" by a specific unit to accomplish a limited objective in pursuit of a strategic goal of the organization. The term "tactic" and its various derivative forms are rarely used in discussions of strategic management. However, decisions taken at various levels in the administrative organization to implement an approved strategic change are oriented toward specific objectives (such as a target volume of sales or share of the market) rather than ultimate goals (such as a required return on investment in a particular line of business), and are thus essentially tactical in nature. In a new venture, goals and objectives may coincide, and strategic and tactical decision making may converge in the mind of the founding entrepreneur.
In the established enterprise, tactical decision making at various administrative levels must confront choices that involve risks. A modicum of entrepreneurship may therefore be exercised by the mid-level manager in the tactical decisions that must be made. However, tactical decisions that involve simply deciding upon increases or decreases in activities already in progress belong to the realm of managerial decision making. It is possible that nearly all of the decisions that must be made in a new business venture are strategic and entrepreneurial rather than tactical and managerial.
A prime example of strategic decision making is found in the international business arena. It is not uncommon for corporations to engage in international transactions or operations, but proprietorships and partnerships may do so as well. By its very nature, much of the business decision making concerning the international realm is entrepreneurial because of the inherent risks attendant upon extending operations into other countries. But once international operations have become established, tactical managerial decision making is required to adjust levels and rates of operations.
The Nature of the Decision Problem
Managers of business firms may make a myriad of decisions every day. Some of the decisions are trivial in the sense that the consequences of them do not matter very much. The consequences of other decisions, for example, what employee health insurance plan to adopt or whether to add or drop a product line from the company's product mix, may be monumental.We shall assume as an operating premise that human beings are basically interested in their own welfare. Rational human behavior consists of trying to maximize the value of some positive quantity, or to minimize the value of something perceived as having negative connotations. Although human nature is culturally influenced, we shall also presume that human beings are more-or-less materialistic, i.e., more is better than less, and hedonistic, i.e., that pain and displeasure are to be avoided or minimized. We consider in Chapter 3 whether these behavior premises truly are viable foundations upon which to erect models of managerial decision making.
Principle 7. Rational human behavior consists of trying to maximize the value of some positive quantity, or to minimize the value of something perceived as having negative connotations.
Human approaches to decisions may be categorized as capriciousness, conditioned response, and deliberate, reasoned choice. The more trivial the consequences of the decision, the less time and effort are devoted to the decision process. Sometimes people seem to act without engaging in any apparent decision-making process. The choices underlying such actions may have been nearly automatic, based upon an implicit summing-up of the current circumstance compared with the decision maker's accumulated stock of past experiences under similar circumstances. Occasionally, however, human beings indulge themselves in a capricious action (an act without deliberate choice), even when the consequences may be non-trivial. If a capricious action constitutes a "bad" decision, the actor must suffer the consequences.
Dimensions of the Decision Problem
Multiple Goals. The decision maker may be confronted with a multiplicity of goals. Since it is technically not possible to try to maximize simultaneously the values of multiple conflicting goals, the decision maker has to choose one of the goals for primary pursuit. The other goals, expressed as minimum or maximum acceptable values, can then be regarded as constraints on the pursuit of the primary goal. The object of the decision is to maximize the value of the primary goal, subject to realization of satisfactory levels of subordinate goals.
Principle 8. When confronted by multiple goals, the decision mode should be to maximize the value of a primary goal, subject to realization of satisfactory levels of subordinate goals.
Multiple Strategies. With respect to any single goal, a decision involves multiple possible courses of action, or strategies. If there were no alternatives, no decision would be required other than selecting the goal for pursuit. The deliberate approach to decision making involves the identification of all possible courses of action and the benefits and costs likely to result from each of the alternatives. The rational choice is the alternative that yields the greatest relative positives or the largest sum of net benefits (positives less negatives), given the decision maker's set of preferences.
Principle 9. The rational choice among alternative strategies is that which yields the largest sum of net benefits (positives less negatives), given the decision maker's set of preferences.
Marginal Changes. In many cases, the choices are not mutually-exclusive alternative courses of action; rather they involve more or less of the same course of action. The range of possible alternatives includes larger or smaller quantities to be selected. Typically, the decision problem is to select some quantity that is an alternative to the present one. Assuming that the alternative quantities are arrayed from smallest to largest, or vice-versa, choosing to shift from one to another involves additions to or subtractions from benefits or costs. Economists speak of such additions and subtractions as incremental changes, or marginal changes if they are the smallest possible changes that can be made. The rational choice in such cases is to make a quantitative change that will yield the greatest marginal benefit relative to marginal cost.
Principle 10. When a decision involves whether to do more or less of something, the rational choice is to continue doing more of it as long as marginal benefit exceeds marginal cost, or to continue doing less of it as long as marginal cost exceeds marginal benefit.
Multiple Outcomes. Often the possible alternative courses of action can be identified, but each decision alternative may have several outcome possibilities. If the decision maker can in some meaningful sense assess the probability of the occurrence of each possible outcome for each of the alternative courses of action, he may then compute the expected value of each alternative. The presumption here is that the sum of the probabilities of the possible outcomes is 100 percent. Each outcome may itself be a net difference between benefit and cost.
Principle 11. When a decision alternative may have multiple possible outcomes and the probability of each can be meaningfully estimated, the rational decision is alternative that promises the largest expected value of possible outcomes.
An extension of the expected value concept may be employed in decision situations that unfold in stages such that subsequent stages depend upon what happens in previous stages. In such cases, the probability of occurrence of an ultimate outcome is a conditional probability, i.e., the product of the probabilities of the final outcome and all prior stages. Other things remaining the same, the decision alternative with the largest expected value should be the decision choice.
Risk. Other things may not be the same, however, if the range of outcome variability differs from one alternative to another. It is typical for decision alternatives to have different expected values, but even if two decision alternatives have approximately the same expected values, one may have a wider range of possible outcome variability than the other. Risk is inherent in the dispersion of possible outcomes about the mean of all such outcomes.
It is not uncommon for a decision alternative with a higher expected value of outcomes also to be riskier in the sense of having a wider range of outcome possibilities. In addition to assessing the riskiness of the decision alternatives, the decision maker must also be able rationally to make comparisons of the expected values of outcomes (or returns) in light of their comparative risks.
Principle 12. A decision maker must decide whether the higher expected value of a decision alternative is adequate compensation for the additional risk that must be assumed.
Imperfect Knowledge. Only rarely does a decision maker have perfect knowledge of a decision environment, the possible alternative courses of action that may be taken, or the range of outcomes that may result from each choice. Where multiple outcomes are possible, a risky situation is said to exist if the decision maker can both identify all of the possible outcomes and meaningfully assess the probabilities of occurrence of each of the possible outcomes. An uncertain situation occurs if the decision maker either cannot identify some of the outcomes, or cannot meaningfully estimate the probabilities of their occurrence. The decision maker may attempt to deal with uncertainty by seeking additional information about outcomes or their probabilities of occurrence. But after all available information is acquired and there is a persisting aura of uncertainty, the decision still has to be made.
Decision theorists have suggested a number of decision rules for situations involving uncertainty, i.e., where outcomes cannot be identified or their probabilities of occurrence cannot be meaningfully assessed. The two that seem to be most useful are the maximin and the minimax regret decision rules. In the former, the objective is to identify the worst-case outcomes of all of the decision strategies under consideration, and then choose the one that yields the least-negative effects, i.e., the best of the worst-case scenarios. This is an extremely conservative approach that is most appropriate to the need to avoid ultimate failure of the enterprise. Its prime deficiency is that it considers only failure states, and does not take into account the possibilities of success.
Principle 13. The maximin decision rule requires that the decision maker identify the worst-case outcomes and chose the one that yields the least-negative effects.
The minimax regret rule requires that the decision maker perceive the best possible outcome of the decision strategies, and then compute the regret associated with all other strategies as the difference between each and the best of the alternate strategies. The strategy of choice then is the one that minimizes the regret that follows from failure to select the best outcome.
Principle 14. The minimax regret decision rule requires that the decision maker choose the decision alternative that minimizes the regret that follows from failure to select the best outcome.
The Time Dimension. Economists refer to a time frame during which some matters can be changed (e.g., the number of workers employed), but others cannot (e.g., the size of plant or the number of assembly lines) as the short run. Short-run decisions usually affect the current situation or the immediate future. The long run is a period long enough so that any- and everything can be changed. Long-run decisions usually have their impacts only after the passage of some time, and do not affect current operations in any significant sense. Most short-run decisions within the business enterprise are to increase or decrease something already being done and thus require marginal comparisons of benefits and costs. Long-run decisions usually affect the scale of the enterprise's operations, and often involve starting something new or stopping some operation currently under way. Given the sharpest possible contrast, short-run decisions are "more-or-less," whereas long-run decisions are "go-no go" decisions.
Entrepreneurial Decisions. Finally, we may distinguish between managerial and entrepreneurial decisions. The managerial context involves making relatively low-risk, routine decisions in regard to processes that change in smooth, continuous fashion, about which much can be known or discovered, and to which marginal analysis is applicable. In contrast, the entrepreneurial decision is risk-laden because it involves innovative discontinuities in operations, about which little can be known in advance, and to which marginal analysis is less likely to be applicable. As a general rule, short-run decisions are often managerial in nature, whereas long-run decisions tend to be entrepreneurial. Managerial decisions are matters of doing more or less of something already in process, whereas entrepreneurial decisions involve starting or stopping activities or significantly altering the structure, scope, or pace of extant processes.
Principle 15. Managerial decisions involve making relatively low-risk, routine decisions in regard to processes that change in smooth, continuous fashion, about which much can be known or discovered, and to which marginal analysis is applicable.
Principle 16. Entrepreneurial decisions are risk-laden because they involve innovative discontinuities in operations, about which little can be known in advance, and to which marginal analysis is less likely to be applicable.
BACK TO CONTENTS
CHAPTER 3. THE GOALS OF THE FIRM
Economists usually presume that rational decision makers attempt to maximize some positive quantity or minimize something that has negative connotations for the decision maker. In modeling the commercial enterprise referred to as the business firm, economists have traditionally assumed that managers attempt to maximize profits. It is because this behavioral premise has been called into question that we devote this chapter to a critical consideration of it.
Eras of Managerial Behavior Patterns
Survival is perhaps the single behavioral goal that has dominated individual productive effort across the span of human existence. It was the organization of human effort into enterprises enabling collective and cooperative effort that necessitated the exercise of management as it is known today. Until such time, however, we may perceive the survival behavior pattern as the effort to minimize hunger and privation, or, if the producer had risen above the biological necessity threshold, to try to maximize the possession of creature comforts. With the emergence of the concept of "income" in money using societies, we can perceive of the individual craftsman, trader, or agriculturalist as simple income maximizers.By the late nineteenth century, economists such as Alfred Marshall theorized about proprietors and partnerships as autonomous owner-entrepreneurs who could attempt to maximize profit, the net difference between their incomes and their costs. Such entrepreneurs were simultaneously owners and managers of their productive enterprises. Little impinged upon their firms from outside to constrain them except for the pressures of competition from other, similar owner-managed enterprises. Their activities and scales of operation had yet to attract social concern, and government was hardly a force to impose curbs on their operations.
Even before Marshall and his contemporaries were contriving descriptions of such competitive conditions, the corporate form of commercial organization was becoming popular as a means of marshalling greater capital resources and enabling specialization and division of labor in management. As the scale of the corporations grew, it was inevitable that the owners would hire managers to run their enterprises for them. As long as owners of enterprises remained relatively close to their operations, they could impose their wills upon their managerial employees. While the managers may have had interests that diverged from those of their owner-employers, their decisions were still constrained by the wills of the owners imposed upon them, and they could still be perceived to be effective profit maximizers.
With the progressive growth of scale of operations, the ownership interests became ever more remote from the managers, whose personal interests could become at least as important as the profit interests of the owners. Such personal interests include, in the words of William Baldwin, "personal financial rewards, security, power and prestige within the organization, desire to be liked, human sympathy, the urge to create, and perhaps occasionally the desire for an easy life."[1] While some of these interests may be compatible with the interests of owners, others are likely to be in conflict with them. The problem for the owners was to keep the emerging interests of their managers subsidiary to their own interests.
Two additional twentieth-century developments have affected the goals of managers and the patterns of their decision making: the dispersion of ownership of corporate shares, and a rising tide of social concern about the operations of the business community, together with managerial recognition of its social responsibilities. The first of these two phenomena emerged during the first half of the twentieth century. Its impact is aptly described by Kanji Haitani:
Principle 17. When stock ownership is widely dispersed, the personal interests of managers may ascend to dominance over the interests of owners.
The rising tide of social concern about the operations of the commercial enterprise is largely a product of the latter half of the twentieth century. Business-related social concerns have ranged from the level of concentration in industry to environmental pollution and the distribution of income between profits and wages. Whatever the impetus to such social concerns, the important point is that business managers have widely acknowledged a level of social responsibility unprecedented in human experience. William Baldwin indicates the emerging managerial attitude as follows:
Principle 18. When there are multiple interests making claims on the business firm, managers may perceive their role to be mediating among conflicting claims rather than pursuing the interests of owners.
Thus, it is apparent that four historical developments have unfolded to lead us to question whether indeed managerial decision makers attempt to maximize profits: the advent and growing popularity of the corporate form of business organization; the increasing scale of operations resulting in the employment of managers who have little or no ownership interests; the progressive dispersion of ownership of the corporation leading to ever greater managerial control; and the emergence of social concerns acknowledged by the managers of large corporations. As these developments have unfolded, the goal of profit has moved from center stage to become but one of the background characters in the drama. And constraints upon managerial decision making, at one time limited only to competitive pressures, seem to have attained the level of obsession with managers of at least some large enterprises.
Alternative Premises
The stage is now set for an examination of a variety of alternative theses about the goals pursued by managerial decision makers and the behavioral patterns exhibited by them in pursuit of those goals. We could identify a large number of plausible behavioral premises and still not exhaust the possibilities. We shall specify five, and invite the reader to explore yet others.(1) The original, classic behavioral premise for the manager of a commercial enterprise is that of simple, absolute, unconstrained profit maximization. While profit is usually taken to be the goal of the manager of the enterprise, recognition of other possible managerial goals requires us to admit that any of those enumerated by William Baldwin in the quotation cited above may be pursued instead of profit. We should then stipulate that the mathematical modeling procedures are the same irrespective of the identity of the dependent variable, i.e., the presumed goal being pursued by the manager.
More than one of Baldwin's enumerated managerial goals may be handled in a model in which it is presumed that the objective of the manager is to maximize personal utility that is affected by multiple goals. While this may be an intellectually satisfying approach to dealing with a multiplicity of possible goals that the manager may pursue, we must note the general impracticality of specification of utility functions. Also, even if a manager's utility function could be adequately specified, this approach provides no single managerial decision criterion upon which the manager can key decisions.
(2) The manager of the enterprise may attempt to optimize the profits of the enterprise, i.e., to maximize profits subject to one or more constraints. The constraints may be limitations on the operations of the enterprise imposed from exogenous sources that are not under the control of the management. Such forces may include physical conditions such as climate, weather, geography, and demography. Social, cultural, religious, and political realities may also constrain the operations of the enterprise.
Kenneth Boulding has suggested that the multiple goals pursued by managers must be regarded in a hierarchy so that the manager can choose one of them for primary pursuit.[4] The problem for the manager in regard to the other, or subordinate, goals is to keep them subordinated to the primary goal that the manager pursues. This is a problem because exigencies of the moment often lead to the "insubordination of subordinate goals." As we shall note in Chapter 7, the subordinate goals can also be incorporated into the decision-making model by treating them as constraints upon the maximization of the primary goal. This treatment then is also a form of optimization.
(3) As noted in (1) above, profit may not be the primary goal of the enterprise's management. William Baumol has theorized on the basis of extensive consulting experience that the primary goal of many enterprise managers is some growth-related variable such as unit sales, sales revenue, or share of market.[5] Particularly, Baumol suggests that the goal of many enterprise managers is to maximize unit sales subject to a constraint in the form of a minimum acceptable amount of profit or rate of profit. If the goal is a so-called "target rate of return" (TROR) on invested capital, the necessary amount of profit can be computed if the investment in capital is known. For example, if a million dollars has been invested in plant and equipment, and an 8 percent return on investment is desired, then the manager must operate the enterprise to yield $80 thousand per annum. Once this target has been met, the manager may be free to pursue another objective, e.g., the volume of sales.
(4) Herbert Simon approaches the behavior of the enterprise manager from the perspective of behavioral psychology:
Intuitive support for the satisficing thesis may also be found in the fictional story recounted by March and Simon about the tailor who had dropped his last of several needles on his shop floor that was covered with straw (in earlier centuries it was not uncommon for animals to be brought into the shop or dwelling at night, hence the straw on the floor). Before he could continue his work the tailor had to find one of the needles, so he swept the straw up into the proverbial haystack. We may now pose the crucial question: what is it rational for the tailor to do, find the sharpest needle in the haystack (which, incidentally, will require him to find all of them), or to find only one that is sharp enough to get the job done? We must admit that the latter is the more economic approach, and that also supports the satisficing thesis.
Simon also prefers the satisficing approach to managerial decision behavior because of its adaptability:
(5) Enterprise managers who perceive themselves to be responsible to a variety of constituencies can probably not be construed as attempting to maximize or minimize any quantity. In fact, their behavior may be in response only to constraints, with no clearly definable objective of pursuit other than "survival." The response pattern has been described as that of mediation among the competing constituencies, an essentially political process. Enterprise managers who give lip service to "social responsibility" may be only attempting to achieve legitimacy for the power that they wield. William Baldwin further hypothesizes that if successive generations of corporate executives repeat often enough their company's litany of social responsibility, they may come to actually believe it and begin to live by it.[8]
Economists have not ventured far enough into the wilderness of political processes to allow us to offer a clearly defined model of constituent mediation for the reader's consideration. We may envision the possibility that some of the management's constituencies may at any time become the primary object of the manager's concern, given the exigencies of the moment. In either case, optimization models may be appropriate for analysis of situations wherein one of the constituencies has, at least temporarily, become the focus of the manager's attention.
However, the manager may attempt only to minimize the value of some negative connotation associated with the constituency, subject to constraints imposed by the perceived need for deference to the other constituencies. If optimization modeling can indeed be applied to the situation of constituent mediation, the manager must anticipate that the identities of the behavioral goal and its constraints will be exchanged from time to time as the concerns of one and then another constituency rise to the surface (the squeaky wheel gets the grease).
Principle 19. When constituent mediation is addressed by optimization, the behavioral goal and its constraints will be exchanged from time to time as the concerns of one and then another constituency rise to the surface.
Choosing a Behavioral Premise
In the previous section we outlined five possible behavioral premises and variations upon them that might be taken to serve as foundations upon which might be erected a theory of managerial decision making. Other behavioral premises could be considered, and perhaps in the future yet other possibilities will surface to prominence in the literature. We now come to the task of making a selection from among them to serve us through the remainder of this text.By virtue of the fact that there is great diversity among the nearly twenty million identifiable business firms in the American economy, it might be defensible to argue that all five of the possible premises outlined above ought to be retained in view of the fact that there are without doubt numerous firms whose managers exhibit the behavioral characteristics of each premise. This would require the development of at least five different models of managerial behavior, and such may indeed be appropriate. In order to economize on our effort (and the volume of matter that the reader must absorb), we shall pursue a strategy of adopting one premise for primary elaboration, but make reference to variations and alternatives where appropriate.
William Baldwin suggests the tack that virtually all writers in the field of Managerial Economics: A Modeling Approach have followed during the past two decades:
Milton Friedman argues that the realism of the assumptions (a behavioral premise is an assumption) underlying a theory are less important than the ability of the theory to explain or predict.[10] In Friedman's parlance, what is important is that people behave as if the assumptions about their behavior are true, whether or not the assumptions are factually descriptive. Applying this concept to the present issue, we may argue that a model based upon the premise of profit maximization may be useful if managers behave as if they are attempting to maximize profits, irrespective of what they actually are attempting to do. So, it does not matter whether it is profit or some other behavioral objective, or whether the decision maker is attempting to maximize, satisfice, or only mediate, the relevant consideration is whether a model erected upon a profit maximization assumption can explain or predict well enough. Baldwin concluded in the quote cited above that the opportunity loss resulting from adopting the profit maximizing assumption would be small.
There may even be reason to believe that the simple profit maximization assumption will be adequate to the modeling of satisficing behavior. Herbert Simon, the inventor of the satisficing idea, even though he judges satisficing models to be richer than maximizing models, acknowledges that "the psychological evidence on individual behavior shows that aspirations tend to adjust to the attainable. Hence in the long run...the level of aspiration and the attainable maximum will be very close together."[11] If this can be taken as a justification for employing a maximizing assumption where a satisficing assumption might be preferable, it is due to the richness of the satisficing approach that accommodates adaptation, rather than the adaptability of the maximization model.
Principle 20. Whatever the actual goals pursued by the managers of business firms or the behavioral patterns with respect to them, profit maximization serves as a satisfactory proxy assumption underlying the theory of managerial decision making.
Profit in the Short and Long Runs
We should recognize from the outset that the unbridled pursuit of profit in any short-run setting could be detrimental to the earning of profit in any subsequent period (each future setting is of course its own short run), or even to the survival of the enterprise in the long run. A wise manager, one whose time horizon stretches beyond the immediate circumstances, upon occasion will see the need to sub-maximize with respect to a profit objective in the short run in the interest of both survival into the long run and the possibility of maximizing profits in future short runs. We thus acknowledge the rationality of deliberate non-maximizing behavior during any particular short-term time frame if justified by long run considerations.
Principle 21. Deliberate profit non-maximizing behavior may be rational during particular short-run time frames if justified by long-run considerations.
One approach to analyzing profit in the long-run time frame is that the manager of the firm attempts to maximize the value of the firm in the long run. This idea can accommodate both profit maximization and deliberate non-maximization behavior in the sequence of short-runs that comprise the long-run.
An Object of Pursuit or an Indicator of Success
A word of caution in regard to profit may be in order for the prospective business manager. Profit, after the fact an easily measurable quantity, may be much like the more nebulous and hard-to-measure state of happiness. Personal happiness is a condition that virtually all human beings (exceptions being masochists) aspire to attain. But it often appears that if happiness per se is taken to be the object of personal pursuit, the harder one tries to achieve happiness, the more elusive it becomes. Particularly, members of a materialistic society often appear to pursue happiness by acquiring things such as bigger and nicer homes, cars, boats, condos at the beach or chalets in the mountains, etc., only to discover that once the object of desire has finally been acquired, they are in fact no happier than they were before. We philosophize to suggest that the more effective way to attain happiness is to pursue and achieve some other personally satisfying or socially beneficial end. Happiness thus would be the by-product rather than the object of pursuit, and may be achievable in greater abundance by not pursuing it than by pursuing it.The application of this consideration to the context of managerial decision making is the possibility that if profit is the object of pursuit, it may turn out to be highly elusive. On the other hand, if the enterprise management takes some other more socially redeeming goal, e.g., to provide well-designed, functional, high-quality merchandise at the lowest possible price, a larger volume of profit may result as a by-product and a reward for successful entrepreneurship then could have been achieved had profit been the primary object of pursuit. Here, the role of profit is to serve as an indicator of success in pursuing some other goal, rather than as the object of pursuit itself. Indeed, some writers have suggested that if profit is the only object of pursuit, profit will be the main product, with poor-quality and high-priced merchandise the by-product. We can only conjecture that the seeming obsession of American corporate enterprise (and the academia that attempts to explain its behavior) with short-run profit is one of the factors in the declining competitiveness of American products on world markets.
Kanji Haitani offers the following indictment of an obsession with profit maximization:
Principle 22. A larger volume of profit may result as a by-product of successful entrepreneurship to provide well-designed, functional, high-quality merchandise than might have been achieved had profit been the primary object of pursuit.
Chapter 3 Endnotes:
[1] William Baldwin, "The Motives of Managers, Environmental Restraints, and the Theory of Managerial Enterprise," in The Quarterly Journal of Economics, May 1964, p. 241.[2] Kanji Haitani, Comparative Economic Systems, Prentice Hall, 1986, p. 228-229.
[3] Baldwin.
[4] Kenneth Boulding, "The Ethics of Rational Decision," Management Science, February, 1966.
[5] William Baumol, Business Behavior, Value and Growth, New York: Harcourt Brace Javanovich, 1967.
[6] Herbert Simon, "Theories of Decision Making in Economics and Behavioral Science," American Economic Review, June, 1959, pp. 253-280.
[7] Simon.
[8] Baldwin, p. 249.
[9] Baldwin.
[10] Milton Friedman, "The Methodology of Positive Economics" in Essays in Positive Economics, University of Chicago Press, 1953.
[11] Simon.
[12] Haitani, p. 240.
PART B. THEORETICAL FOUNDATIONS
< ++br /> The chapters in Part B describe the theoretical foundations of managerial economics: value and risk, consumer behavior, demand, production, and cost.
CHAPTER 4. VALUE AND RISK
Much of the substance of managerial economics is about marginal decision making affecting operations in the short-run time frame. Most of the rest of this book elaborates the marginal criteria for short-run decision making; this chapter is devoted to long-run decision considerations and the analysis of risk.
The Remoteness of the Long Run
In addition to the differences noted in Chapter 2 between long and short runs, a major distinction remains to set the long-run decision problem apart from short-run decision making. Since the effects of the long-run decision can be expected to impact the enterprise in the future, some recognition must be made of the remoteness of those effects. The sense of the problem is that the expectation of a benefit to be realized in the future is worth less to the decision maker than an equivalent benefit received immediately. Specialists in finance often refer to this phenomenon as the "time value of money", but the phenomenon would exist even in a barter economy (one that does not use money). The phenomenon is described by the ancient adage that "a bird in the hand is worth two in the bush." The problem pertains to costs as well as to benefits. In addition, costs that must be paid at some future time are also less meaningful to the decision maker than those that must be paid today, although the wise decision maker should plan and make careful arrangements to cover expected future costs.
Principle 23. The expectation of a benefit to be realized in the future is worth less to the decision maker than an equivalent benefit received immediately.
Since future possibilities are worth less than present realities, economists have acknowledged this phenomenon by discounting the expected future values at an appropriate rate. This rate is usually taken to be the best market rate of interest for which the enterprise can qualify. The interest rate is used as a discount rate on the premise that the equivalent of the expected future value, less the cost of interest, can be had at present by borrowing the future sum. This relationship should be true whether the borrowed principle and the interest to be repaid are expressed in barter or monetary terms.
Principle 24. Since future possibilities are worth less than present realities, expected future values may be discounted at an appropriate rate, usually taken to be the best market rate of interest for which the enterprise can qualify.
If we abstract from the possibility of a scrap value of the capital at the end of its useful life, the discount rate must be just sufficient to make the sum of the net income flows (i.e., revenues in excess of operating costs) over the life of the investment opportunity just equal to its capital outlay. The discount rate is interpreted as a rate of return because if all of the net amounts of the net income flows were invested at the interest rate, they and their interest earnings would add up to the capital outlay. The investment criterion that justifies undertaking the investment opportunity is that its rate of return is at least as great as the best market interest rate for which the enterprise can qualify.
Principle 25. The rate of return on an investment opportunity is the discount rate that is just sufficient to make the sum of the net income flows over the life of the investment opportunity just equal to its capital outlay.
Attitudes Toward Risk
Decision makers' attitudes toward risk vary widely. People who have strong preferences for risk assumption may turn out to be chronic gamblers. Such people get their "kicks" from accepting adverse-odds bets (long shots) with negative expected values. Even though the odds are against them, it is more intellectually satisfying to them to win "big" on rare occasions than to gain small sums more frequently on favorable-odds bets. Risk preferers are likely to lose (on net balance) over the long run. Luckily for society (and themselves), they are in the minority. It is theoretically possible for a decision maker to be essentially risk-neutral, having neither preference for nor aversion toward risk. However, this is such a "razor's edge" state that few people find themselves there.The vast majority of all people who regard themselves as rational thinkers are risk-averse, and the more extreme of them are risk avoiders (they expect bad things to happen to them each morning as soon as they get out of bed). A normally risk-averse decision maker likely would not accept an even-odds bet on a two-possibility event (50 percent chance each way) because the loss of the sum at risk would mean more to them (negatively) than would the gain of an identical sum would mean to them (positively). It is likely that most business decision makers, who tend to be a conservative lot, are risk averse. This does not mean that they seek to avoid risk altogether (if so they would not behave as entrepreneurs); rather, they attempt to manage risk by seeking more information in order to diminish it, by attempting to take offsetting positions, or by attempting to insure against the risk. The ultimate entrepreneurial function is to assume any residual risk after all management alternatives have been exhausted.
Principle 26. Most business decision makers are risk averse and attempt to manage risk.
If it were practical to specify personal utility functions for decision makers, it would be possible to include the decision maker's attitude toward risk as one of the deterministic variables in the function. “Marginal utility” is the addition to a consumer’s total utility (i.e., satisfaction) that results from consuming one more unit of whatever is being consumed. We might find the risk preferer to "consume" risky items under conditions of increasing marginal utility, the risk-indifferent decision maker to exhibit a linear risk utility function, and one who is averse to risk to experience diminishing marginal utility with respect to risk.
Means of Dealing with Risk
A first approach to dealing with risk is to seek more information about the decision alternative. Additional information often reveals that the range of outcome variability is narrower than at first thought, and that the decision alternative is thus less risky than earlier imagined. But information itself is a scarce resource that is costly to acquire. The determination to acquire additional information is a managerial decision that is based on a comparison of the benefits of the additional information relative to the cost of acquiring it.
Principle 27. A decision to acquire additional information should be based on a comparison of the benefits of the additional information relative to the cost of acquiring it.
At some point, the benefits of acquiring additional information must be judged as not outweighing the costs, and the decision must be made under conditions of uncertainty or risk. The decision maker must then find some way to deal with (i.e., manage) the remaining risk, possibly by insuring against it, offsetting it (possibly by hedging), or by simply accepting it. One of the essential functions of an entrepreneur is to assume risk in undertaking new ventures or in changing the operation of the enterprise.
Principle 28. Risk assumption is an essential entrepreneurial function.
Since it has not been found practical to specify utility functions, we shall take a more intuitive approach to how decision makers might deal with risk. A potentially useful concept for short-run decision analysis is that of the certainty equivalent. In this approach, the decision maker must ask himself what certain sum he would be willing to accept in lieu of the risky outcome at issue. The risk-averse decision maker can be expected to indicate a lesser certain sum than the risky possibility ("a bird in the hand is worth two in the bush"), whereas the risk preferer would have to have a larger certain sum as a compensation for the insult of removing the gamble from his consideration.
Principle 29. A risk-averse decision maker is willing to accept a lesser certain sum than the risky possibility.
Another approach is possible in the analysis of risk in the long run. A subjectively determined risk premium may be added to the interest rate that serves as a discount rate. The risk premium serves as a risk adjustment to the discount rate in computing the value of the investment opportunity. The risk-adjusted value will be smaller than before risk adjustment in reflection of the larger discount factor. The risk-adjustment factors will differ from one decision opportunity to another, but their values, adjusted for risk, will be more realistic selection criteria.
Principle 30. The present value of a risky investment alternative will be diminished by adding a risk premium to the discount rate to account for the risk.
Allowing for Anticipated Inflation
Finally, we should note that neither discounting to allow for the time value of money nor risk-adjustment of the discount rate constitutes an allowance for the risk of inflation. If over the life of a decision opportunity inflation is expected to ensue, a deflation factor (i.e., an inflation risk adjustment factor) may be added to the interest rate and other risk adjustment factors that serve as discount rate to the value of the investment opportunity. Each deflation factor is a decimal equivalent of an anticipated rate of inflation, e.g., 4 percent. The deflation factors may differ from term to term if inflation is thought likely to accelerate or decelerate over the life of the decision opportunity.
Principle 31. When inflation is expected to ensue over the life of an investment opportunity, the present value of the opportunity can be deflated by adding an inflation risk premium to the discount rate.
The reader may find an exposition of the mathematical and graphic theory of value and risk in Chapter 5 of Managerial Economics: A Modeling Approach at http://www.dickstanford.com/MI/b1.htm.
CHAPTER 5. CONSUMER BEHAVIOR AND DEMAND
Chapter 6 begins with the assertion that production is the central function of the organized business enterprise. Production is undertaken in the hope of relieving the economic problem of scarcity. But a rational decision to produce any particular good or service is predicated upon the existence of a social phenomenon: an adequate demand by other members of society for the fruits of the productive effort.
Principle 32. A rational decision to produce a good or service should be predicated upon the anticipation of an adequate demand for it.
Before attempting to identify the characteristics of the demand that may be tapped by the productive enterprise, and the possibility of manipulating (creating, increasing, altering) that demand in the interest of the enterprise, it will be necessary to consider the principles of consumer behavior.
Consumer Behavior
People may act without engaging in any prior, deliberate decision making. Indeed, there is reason to believe that human beings often engage in such conditioned responses. Such responses often occur in circumstances where the decision maker has compiled a great deal of past experience with similar conditions, and where the consequences of choosing among alternative courses of action are essentially trivial.We must also admit the existence of capricious actions taken by people who give little or no consideration to the consequences, even when the alternative outcomes are likely to be non-trivial. Each of us probably engages in conditioned response behavior much of the time, and everyone occasionally indulges in the capricious action. While capricious behavior cannot be modeled, conditioned-response behavior may be treated with a default forecasting approach, i.e., the assumption that tomorrow will be like today because today is like yesterday.
Principle 33. Conditioned-response behavior may be based upon the assumption that tomorrow will be like today because today is like yesterday.
We now turn attention to the phenomenon of deliberate, rational decision making on the part of the consumer. We must acknowledge two possibilities with respect to the information upon which the consumer must predicate the decision: the consumer either has perfect information about the possible alternatives to be purchased, or the consumer has some information but lacks knowledge of much that is relevant to the decision context. The task of analyzing consumer behavior would be greatly facilitated if consumers always have all needed information, but, unfortunately, the world is much different from this ideal situation.
We must therefore employ the concept of the expected value of the possible outcomes from the consumer's choice. The expected value of a particular consumer choice is the probability-weighted average of all of the possible outcomes resulting from the choice. In the event that the probability of occurrence of one of the possible outcomes is 100 percent, then the expected value becomes the certain value of the choice. Treating certain value as a special case of expected value, we shall make all subsequent references in this regard to expected value.
The time-honored term that economists have used to refer to the expected value of the outcome of a consumer choice is "utility". Utility, or satisfaction, is an amalgam of a wide range of the consumer's attitudes with respect to the results of the choice. Its dimensions include the extent to which the choice is perceived to meet a particular need, and may extend to such nebulous concepts as the pleasure or enjoyment derived from the outcome of the choice. We must also acknowledge the possibility that the outcome of a consumer choice may be negative in the sense that the perceived need was not met by the choice, or that the choice resulted in displeasure or pain (emotional as well as physical).
In the cases of so-called "big ticket" items that are typically purchased in discrete quantities of ones (e.g., houses, cars, boats, cameras, stereo systems, mink coats, etc.), the consumer's choice usually is of the all-or-nothing variety, i.e., whether or not to make the acquisition. Before the acquisition, the consumer can only estimate the expected value of the choice to acquire the item. Only after the fact of the acquisition (often, long after the fact) can a comparison of the actual outcome be made to the estimate of the expected value made before the acquisition.
The rational decision criterion is whether the expected value of the choice to acquire is greater than the cost of the acquisition. The consumer's decision can be judged to be good or bad only in the retrospective comparison of the actual value of the outcome to the acquisition cost. Intelligent consumers will compile a stock of experience concerning pre-acquisition estimates of expected values compared to post-acquisition realized values. Sellers wishing to manipulate the prospective consumer's demands for their products may attempt to pursue strategies to get the consumers to over-estimate their expected values of the outcomes, or to ignore their accumulated experiences with ex-post realized values relative to ex-ante estimated values.
Principle 34. The rational decision criterion for the choice to acquire a consumer good or service is whether the expected value of the choice is greater than the cost of the acquisition.
An even larger proportion of the consumer's choices is not all-or-nothing, but rather more-or-less choices. In these cases, the consumer, after deciding that some of the good or service is needed, must also decide how much to acquire. All of the principles described above apply to the fundamental decision to acquire any of the good or service. But the quantity question requires recognition of an additional decision criterion. Economists have deduced from a great deal of personal and collective experience that consumers, in acquiring successive additional units of most goods or services, tend to realize declining amounts of additional value (i.e., utility or satisfaction). This phenomenon is referred to the in the economics literature as the "principle of diminishing marginal utility". Marginal utility is the addition to total utility consequent upon consuming one more unit of an item.
Principle 35. Most consumers tend to realize diminishing marginal utility when consuming successive additional units of most goods or services.
Economists recognize that the consumer may experience an initial surge of realized value from consuming the first few units of the good or service, but they have also become convinced of the certainty of eventual diminishing marginal utility for most goods. The qualification is in regard to goods (alcohol, drugs) or activities (hobbies, sex) that may be addictive or compulsive. Although there is much that is yet unknown in regard to addictive behavior, it may be hypothesized that the consumer realizes increasing marginal utility when consuming successive units of goods that are objects of addiction or compulsion.
In the case of a non-addictive good or activity, the rational decision criterion is to continue to consume more of the good, even while realizing declining additional utility, until the marginal value realized in consumption is no longer greater than the marginal cost of the acquisition. In order to make such a comparison, the marginal cost of acquisition must be perceived in units comparable to those in which satisfactions are measured. One way to do this is to regard the acquisition cost in terms of dissatisfaction or disutility at having to part with purchasing power to make the acquisition. If the marginal utility does indeed decline, a point at which additional consumption should cease will be reached.
Principle 36. The rational decision criterion is to continue to consume more of a non-addictive good or activity, even while realizing diminishing marginal utility, until the marginal value realized in consumption is no longer greater than the marginal cost of the acquisition.
In the case of a good or activity that is an object of addiction, since the marginal utility always increases as successive units are consumed, no consumption-limiting criterion is ever reached unless the marginal disutility rises to exceed the increasing marginal utility. Even then, it cannot be assumed that the addictive subject can engage in rational choice.
An enterprise wishing to promote the sale of its product or service may pursue a strategy designed to induce the consumer to suffer the illusion that marginal utility declines at a slower rate than it does in reality, or to believe that marginal utility only increases as with an addictive good or activity. In either case, the naive or unwary consumer may be induced to consume larger quantities than he might with more rational consideration. Intelligent consumers can be expected to add to their stocks of experience such comparisons between ex-ante estimates of expected values of satisfactions and ex-post realizations of actual satisfactions. The manager should be aware that intelligent, experienced, and mature consumers are likely to be more resistant to efforts at manipulation of their preferences. The obverse of this principle is that less-experienced consumers (especially children and adolescents) or less-capable adult consumers may be more amenable to preference manipulation. This possibility should raise ethical "red flags" in the minds of conscientious managers.
Principle 37. A firm wishing to promote the sale of its product or service may implement a marketing strategy designed to induce the consumer to suffer the illusion that marginal utility declines at a slower rate than it does in reality.
Principle 38. Intelligent consumers who rely upon their experiences with ex-ante estimates of expected values of satisfactions and ex-post realizations of actual satisfactions are likely to be resistant to efforts at manipulation of their preferences.
Perhaps a less controversial approach to promoting sales of the product is for the enterprise to try to change one or more of the non-quantity determinants of utility, which to this point have remained unspecified and assumed constant. One of those surely is the consumer's taste for the good or service. An effective promotional strategy may improve the image of the good or service, thereby making it more desirable to the consumer.
Demand Relationships
Demand is the desire for a good or service, together with the purchasing power to make the desire effective, both backed by the willingness of the consumer to part with the purchasing power. The so-called Law of Demand is the proposition that consumers will buy ever greater quantities of the good or service at progressively lower prices, i.e., acquisition costs. The Law of Demand also encompasses the converse: consumer will buy ever smaller quantities of a good at progressively higher prices.
Principle 39. Consumers tend to buy ever greater quantities of a good or service at progressively lower prices, and ever smaller quantities of a good or service at progressively higher prices.
The fundamental behavioral principle underlying the concept of the demand curve is diminishing marginal utility. The connection between demand and utility is that the seller must offer the consumer some inducement to purchase more of the good once his marginal utility has fallen to the level of the disutility realized in paying for the last unit purchased. The obvious inducement is a lower price or acquisition cost. Consumers can be expected to purchase more at lower prices. The inverse is also expected: consumers will purchase smaller quantities at higher prices.
Principle 40. Because of diminishing marginal utility, a seller must offer the consumer a lower price to induce him to purchase more of a good or service.
In addition to the diminishing marginal utility principle, economists offer two other explanations for the Law of Demand, the income and substitution effects. The substitution effect occurs when an increase in the price of a good or service leads consumers to shift their purchases away from the good or service and to its substitutes--hence the inverse relationship between the good's own price and its quantity demanded. A downward change in the price of an item leads to an increase in quantity demanded as consumers shift their purchases away from substitutes and toward the item.
Principle 41. An increase in the price of a good or service leads consumers to shift their purchases away from the good or service and to its substitutes.
The income effect of a price change results from recognition that the consumer is faced with a range of choices. For example, when the price of a good or service falls, the consumer can purchase more of that item itself, more of other items that he normally consumes, or retain unspent purchasing power. The decrease in the price of the item then results in an implicit increase of his income. Conversely, an increase in the price of the item means that the consumer must purchase less of item, less of other items that henormally purchases, or spend more than he has spent in the past. In either case, an inverse relationship between the price of the item and the quantity consumed of it is a consequence.
Principle 42. A decrease of the price of an item in a consumer’s budget results in an implicit increase of the consumer’s income, thereby enabling the consumer to purchase of more of that good or other goods, or to underexpend his budget.
Normal and Inferior Goods. A normal good is one for which quantity demanded increases when income rises, or decreases when income falls. Both of these are so-called “direct” relationships, .i.e., they change in the same direction. An "inferior" good is one for which quantity demanded decreases when income rises, and increases when income falls. The income-demand relationship for an inferior good would be an inverse relationship, similar to the price-quantity relationship of the Law of Demand. Most of the goods and services consumed by human beings likely are normal in the sense that people will consume more of them when their incomes rise.
Principle 43. A consumer’s purchases of a normal good tend to increase as his income rises and to decrease as his income falls; a consumer’s purchases of an inferior good tend to decrease as his income rises, and to increase as his income falls.
But there are also many examples of inferior goods to examine, although the items with respect to which they are inferior should be identified. For example, in the early twenty-first century American culture, ground beef is probably inferior to most solid beef cuts; margarine is probably inferior to real butter, and Ford Escorts are probably inferior to Lincoln Town Cars. The word "probably" is included in the foregoing sentence because of the highly personal nature of preferences. Even if most of the members of American society would prefer a New York strip steak to a hamburger, there are some members of American society (teenagers come readily to mind) who might prefer a hamburger to the New York strip.
We should also stress that the characteristics of normalcy and inferiority are time and culture bound. For example, potatoes were probably regarded as inferior substitutes for mutton by eighteenth century Irish peasants, whereas twentieth century Americans tend to regard potatoes as complement to both steaks and hamburgers. The inferiority of potatoes relative to meat has ceased to be an issue for Americans, although the issue may be alive in a choice between potatoes and rice.
Principle 44. The characteristics of normalcy and inferiority are time and culture bound.
The normalcy or inferiority of a good may be revealed in the income effect consequent upon a price change, as well as with an explicit change of income. We earlier identified the income and substitution effects of a price change as further (in addition to the principle of diminishing marginal utility) explanations of the Law of Demand. In the case of a normal good, the income effect may be expected to reinforce the substitution effect: when the price of a normal good falls, people will tend to increase their purchases of it, not only because it is now less expensive relative to substitutes, but also because they have realized an implicit increase of income due to the price change.
In the case of an inferior good, however, the income effect will offset the substitution effect: when the price of the good falls, people will tend to consume more of it than more expensive substitutes, but the realization of its inferiority retards the increased consumption. Although economists have found little evidence of its existence, it is hypothesized that the income effect in the case of an inferior good may be so great as to more than offset the substitution effect. If such a phenomenon should occur, the price-quantity demand relationship would be direct rather than inverse, and would thus be an apparent violation of the Law of Demand.
Principle 45. In the case of a normal good, the income effect reinforces the substitution effect; in the case of an inferior good, the income effect offsets the substitution effect.
What are the managerial decision implications of inferiority and normalcy? In a growing economy, or during a period of cyclical expansion, the enterprise should attempt to produce normal goods or services since their demands will increase at the same or a faster rate than incomes are rising. The enterprise should avoid production of inferior goods since their demands will increase at a slower rate (or may even decrease) as incomes rise. However, during a period of cyclical decline, the enterprise would be better off in producing inferior goods because their demands will tend to decrease more slowly (or possibly even increase) as incomes fall.
Principle 46. During a period of expansion, the demands for normal goods or services will increase at the same or a faster rate than incomes are rising; during a period of decline, the demands for inferior goods will decrease more slowly as incomes fall, or they may actually increase.
But suppose that the main product lines of the enterprise are inferior goods that must continue in production through periods of expansion as well as contraction. In this case, the design strategy of the enterprise might be to alter the real nature of the product so that it becomes perceived to be a normal good relative to substitutes. Alternately, the enterprise's promotional strategy might be directed toward improving the clientele's tastes and preferences for the good, or altering the image of the good so that it is perceived to be normal rather than inferior.
Substitutes and Complements. Two other demand determinants that deserve the attention of the manager are the prices of substitutes and complements. The enterprise rarely has ability to directly influence the prices of goods that are substitutes or complements for those produced by the enterprise. But the management of the enterprise should be aware that competitors do produce substitutes for those produced by the enterprise, and that the pricing decisions of competitors can be expected to cause changes of the demands for the enterprise's products. Likewise, the management of the enterprise should be aware that its own pricing decisions will likely result in shifts of competitor's own-price demand curves, and may induce strategic responses from them.
Principle 47. A firm’s own pricing decisions are likely to cause changes of competitor's demands, and may induce strategic responses from them.
Changes of the prices of complements to a firm’s good or service may also affect the demand for it. For example, if the price of gasoline rises in its market, the demand for motor oils (for which gasoline is a complement) may decrease as vehicle owners drive less and need oil changes less often. Of course, motor oil may be a substitute for gasoline in some older motor vehicles.
Principle 48. An increase of the price of a complement to a product produced by a firm will tend to decrease the demand for the firm’s product; and vice versa.
Demand and Revenue
The price of the product can be understood to be its average revenue, or the revenue per unit of the product sold by the enterprise. The total revenue that the enterprise will realize on the sale of a specific number of units of its product is this quantity multiplied by the product price. As price decreases, total revenue may at first increase, then reach a maximum, and eventually decrease.
Principle 49. In an imperfectly competitive market, as the price of a product decreases the total revenue from selling it may at first increase, then reach a maximum, and eventually decrease.
When the price of an item changes, the quantity of it demanded also changes in response to the price change, and in the opposite direction to the price change if the item is a normal good. The “quantity effect” of a particular price change when price is high is a large proportion of the small quantity demanded. It becomes a smaller proportion when price falls and quantity demanded increases. Similarly, the “price effect” of a price change is a small proportion of a high price, but becomes a larger proportion of price as price falls. Similar statements may be made for quantity decreases and price increases.
Principle 50. When price is high, the quantity effect of a particular price change is a large proportion of the small quantity demanded; it becomes a smaller proportion when quantity demanded increases as price falls.
Principle 51. Any particular price change is a small proportion of a high price, but becomes a larger proportion of price as price falls.
Total at first increases as price falls because when price initially is high and quantity sold is minimal, the positive quantity effect outweighs the negative price effect. As price falls further, the increasing price effect eventually perfectly offsets the quantity effect at the output for which TR is maximum. With further decreases of price, the increasing price effect begins to outweigh the diminishing quantity effect to cause TR to decrease. The reader is invited to consider how these statements should be revised to describe the effects on total revenue when price initially is very low and begins to rise.
Principle 52. When price initially is high and quantity sold is minimal, total revenue at first increases as price falls because the positive quantity effect outweighs the negative price effect; as price falls further, the increasing price effect eventually begins to outweigh the diminishing quantity effect to cause total revenue to decrease.
When price initially is high and begins to fall, demand is said to be elastic with respect to price because the positive quantity effect is greater than the negative price effect. As price falls further, demand becomes progressively less elastic as the price effect increases relative to the quantity effect. Demand eventually becomes inelastic with respect to price when the negative price effect becomes large enough to outweigh the positive quantity effect. Price elasticity of demand may be measured as a percentage change in quantity demanded divided by the percentage change in price, assuming no other causative factor has changed.
Principle 53. Price elasticity of demand may be measured as a percentage change in quantity demanded divided by the percentage change in price, assuming no other causative factor has changed.
Principle 54. When price initially is high and begins to fall, demand is elastic with respect to price; as price falls farther, demand becomes progressively less elastic and eventually becomes inelastic with respect to price.
Total revenue increases with falling price over the elastic range of demand, but reaches a maximum and begins to decrease when demand becomes inelastic with respect to price. A comparable statement may be made with respect to price increases. The manager who wishes to increase a product’s sales revenue when demand for the product is elastic with respect to price should cut the price of the product. But when demand for the product is inelastic with respect to price, the price should be raised in order to increase revenue.
Principle 55. Revenue from selling a product can be increased by cutting price when demand is elastic with respect to price; revenue can be increased by raising price when demand is inelastic with respect to price.
Price Change Criteria
In a highly competitive market, demand may be nearly perfectly elastic with respect to price because sellers do not have to lower price in order to sell more units. This implies that AR is approximately constant at the current price as quantity sold increases, and TR increases linearly with the number of units sold. In imperfectly competitive markets, i.e., those within which sellers have some pricing discretion, price must be decreased in order to increase unit sales, so AR diminishes as quantity sold increases in accordance with the Law of Demand. If unit sales are continually increased as price is lowered, AR eventually becomes zero.
Principle 56. Average revenue, the revenue per unit sold, is equivalent to product price; in highly competitive markets, average revenue remains approximately constant as unit sales increase because it is not necessary to lower price in order to sell more units of product; in imperfectly competitive markets, average revenue decreases as unit sales increase because of the necessity of lowering price to sell more product.
Marginal revenue (MR) is the addition to total revenue consequent upon selling one more unit of output at the current price. MR may be interpreted as the rate of change of TR. For the first unit of output sold, MR is equal to TR and AR, and in highly competitive markets it remains approximately equal to AR as quantity sold increases because sellers do not have to lower price in order to sell more. But in imperfectly competitive markets, MR decreases as quantity sold increases and becomes less that AR. This happens because as price is lowered in order to sell additional units of output, the lower price applies to all units sold at any instant, not just to the additional units sold.
Principle 57. Marginal revenue, the addition to total revenue consequent upon selling one more unit of output at the current price, may be interpreted as the rate of change of total revenue; in highly competitive markets, marginal revenue is equal to average revenue as unit sales increase; in imperfectly competitive markets, marginal revenue is less than AR.
Incremental revenue (IR) is like marginal revenue except that is measured for any amount of additional output, not just a one-unit increase of output.
What are the managerial significances of TR, AR, MR, and IR? TR for any level of output can be measured as the product of two pieces of information, the amount sold and the price at which it is sold. AR requires no computation; it is simply the product price. But it can be computed from information about TR; again, only two pieces of information are needed, the current total revenue divided by the quantity sold. For this reason it is tempting to try to base pricing decisions upon AR. But neither TR nor AR at a particular level of sales provide enough information to compute elasticity of demand with respect to the current price and the quantity being sold, and neither provides guidance of whether to raise or lower price.
If the goal of the firm's management is profit maximization, then TR and AR are inadequate pricing and output decision criteria; the appropriate price-related decision criterion for profit maximization is MR compared to marginal cost (described in Chapter 7). But here is a problem, because MR is rarely observable (i.e., for a one-unit change of output). It can be computed mathematically (using the calculus) if one knows the equation that adequately represents the TR function. However, to develop such an equation by statistical means requires information about an adequate number of price and quantity combinations (usually 20 or more).
Principle 58. If the goal of the firm's management is profit maximization, the appropriate price-related decision criterion for profit maximization is MR.
In lieu of such extensive information, the IR can be computed from four pieces of information: quantities produced at two points in time (preferably very close to each other in time and involving as small a quantity change as possible), and the corresponding totals of the direct total revenue. Even for very small changes of price and output, the IR will be at best only an approximation to MR because it will over- or understate MR, and may thereby lead to erroneous price-change conclusions.
Principle 59. Incremental revenue is easier to compute than marginal revenue, but it will be only an approximation to MR and may over- or understate MR, thereby leading to erroneous price-change conclusions.
Where does this leave us? AR may be a sufficient price-related decision criterion if the goal of the firm is simply to maximize total revenue. But as we shall note in Chapters 8 and 9, MR is the appropriate price-related decision criterion when the goal of the firm is to maximize profit. However, MR is hardly observable and may be very costly to compute. Even IR, its approximation, though cheaper to compute, may lead to erroneous conclusions. Yet when the price decision maker, lacking sufficient information to compute MR, employs an iterative approach to seeking the price-quantity combination that will maximize profit, IR may serve as the effective price decision criterion when compared to incremental cost (described in Chapter 7).
Principle 60. When a price decision maker, lacking sufficient information to compute MR, employs an iterative approach to seeking the price-quantity combination that will maximize profit, IR may serve as the effective price decision criterion when compared to incremental cost.
The Economic Tasks of Marketing
Marketing is one of the four functional areas of business administration (management, finance, accounting, marketing), and as such is a variant of applied economic policy in the microeconomic arena. Marketing is concerned with the cost side of microeconomic decision criteria only in providing the demand enabling conditions for spreading overhead costs in the short run and exploiting scale economies in the long run. From an economic theory perspective, there are three tasks for marketing to accomplish in regard to demand:(2) subsequently, to increase the product demand, or prevent it from decreasing; and
(3) to improve the attitude of the demand relationship or prevent its attitude from deteriorating.
Principle 61. Market research may succeed in gaining information adequate to estimating demand at the startup of sales of a product in a new market.
Once a "fix" can be gotten upon the properties of the product demand in the new market, it should be possible to assess price elasticity of demand over some range of product prices. Price elasticity of demand may be measured as a percentage change in quantity demanded divided by the percentage change in price, assuming no other causative factor has changed. Price elasticity of demand information can serve as criteria for determining an appropriate price relative to the firm's behavioral objectives (e.g., profit maximization or satisficing, growth measured by volume of sales, sales revenue, performance relative to recent history, or share of market, or yet other behavioral objectives). If demand is elastic, the firm can increase its revenues only by lowering price; if demand is inelastic, revenues are increased by raising price.
A matter that may cause assessment difficulties with measures of price elasticity of demand is that causative factors other than the product's price may have caused the demand to shift simultaneous with a change of product price. This problem is referred to by economists as an "identification problem". Depending upon whether the demand increased or decreased when price is decreased, measured elasticity will tend to be over- or understated.
Principle 62. The estimate of a product’s price elasticity of demand may be over- or understated when demand determinants other than the product's own price have increased or decreased the demand simultaneously with a change of product price.
2. The second task of marketing is manipulation of the existing demand. With the passage of time, changing non-price determinants of demand can be expected to change demand with consequent changes in price elasticity of demand. On-going monitoring of price elasticity of demand should enable rational price change decisions.
The firm may choose to respond passively to favorable changes of demand. Firms that are oriented toward growth rather than profitability will be inclined toward aggressive marketing efforts designed to increase product demand. Demand increases lower elasticities of demand and facilitate price increases. Adverse changes of product demand may occur in response to economic contractions or intensifying competition. Should the demand for one of the firm's products changes adversely due to changing conditions, demand tends to become ever more elastic at the established price level, and militates in favor of cutting prices. The marketing task is to mount an appropriate campaign to reverse or slow the pace of the adverse change.
Principle 63. Even when a product’s price remains unchanged, a demand increase will lower price elasticity of demand and facilitate a future price increase; decrease of a product’s demand will increase its price elasticity and militate in favor of cutting price.
3. Demand that is elastic with respect to price has a relatively poor attitude from the perspective of managerial decision making. This means that management has little pricing discretion. It also means that the firm must be prepared to cut price in order to increase revenues. From a managerial decision perspective, the attitude of the demand curve may be improved by doing something to cause it to become more steeply downward sloping. Even if the demand for a product is not increasing (or cannot easily be increased by marketing promotion), it may be possible to design a marketing program to enhance perceptions of the image of the product in the public mind to the end of rendering demand less elastic with respect to price.
Principle 64. A marketing effort may enhance perceptions of the image of the product in the minds of consumers to render demand less elastic with respect to price and enable raising price to increase revenue.
BACK TO CONTENTS
CHAPTER 6. PRODUCTION
Production is the central function of the enterprise. In fact, the possibility of engaging in production activity is the reason that enterprises are organized. The occasion for production activity follows directly from the existence of the economic problem: scarcity and the hope of relieving it by concerted, organized effort.
Varieties of Production Activity
In the broadest possible sense, production activity encompasses nearly all of human effort. Even if life were characterized by abundance, the things desired for consumption would still have to be gathered and transferred or transported to the point of consumption, and then possibly held until the propitious moment. The gathering, transporting, and holding activities certainly are forms of production activity.The act of production is the transformation of raw substances (including human labor itself) into other forms that are distinguished by their more desirable functional, locational, or temporal characteristics. Production of tangible goods encompasses gathering, extracting, refining, combining, assembling, packaging, transporting, and distributing activities. Production of services includes performance activities as well.
Principle 65. Production is the transformation of raw substances (including human labor) into other forms that are distinguished by their more desirable functional, locational, or temporal characteristics; production includes gathering, transporting, and holding activities.
Managerial Functions in the Production Process
The essential entrepreneurial functions are the perception of an unfilled market demand and the assumption of risk in organizing a productive process to exploit the market potential. The three crucial managerial problems are (1) to select an appropriate technology for implementation of production, (2) to discern the right volume of output to meet the market demand, and (3) to choose the optimal combination of inputs to produce the target level of output. Associated with these three broad decision areas are a myriad of detailed functions ranging from choosing the site for the production facility, procuring inputs and scheduling production, and packaging and distributing the final product.
Principle 66. The entrepreneurial functions of production are the perception of an unfilled market demand and the assumption of risk in organizing a productive process to exploit the market potential.
Principle 67. The managerial tasks of production are to select an appropriate technology for implementation of production, to discern the right volume of output to meet the market demand, and to choose the optimal combination of inputs to produce the target level of output.
Real-world production processes may be quite detailed and complex. Our task in this chapter shall be to discern general production decision criteria that can be transferred to specific production situations. What we are about is learning how to think about production problems rather than what to do in specific situations.
The Relevant Questions
Every production decision maker must confront four basic questions:b. What size plant should be constructed to implement the selected technology?
c. At what volume of output (or rate of production) should the constructed plant be operated?
d. What are the appropriate quantities of inputs to combine to produce the target output.
These fundamental production questions will not always be addressed in the same sequence. Some of them must be confronted simultaneously. The perceived market demand ultimately constrains the answer to the volume-of-output question and suggests a response to the size-of-plant question. The target production volume may then limit the eligible range of technologies. Assuming that the target volume is known, we shall address the technology question later in this chapter.
The Long and Short-Run Time Frames
Production decision makers might be thought to enjoy a great deal of freedom in varying their inputs. In reality, such freedom of choice is constrained by the time-frame setting of the decision context.In the analysis of how input variation affects output, given a selected technology, economists distinguish three situations: (a) a single input is changed vis-a-vis fixed quantities of all other inputs; (b) all inputs are changed (positively or negatively) by the same proportion (greater or lesser than 100 percent); or (c) inputs are changed in varying proportions vis-a-vis each other. The first case describes the analysis of returns a variable input; the second describes returns to scale; the third describes the general situation, variable proportions, inferences about which may be drawn from an analysis of the first two situations.
The realm of returns to a variable input permits us to distinguish the short run from the long run. In the long run, all inputs are presumed to be variable. The analysis of returns to scale thus belongs to the long-run. A change of a single input, given fixed quantities of other inputs, is then clearly a short-run phenomenon. The short run can be described as the period of time during which at least one of the inputs cannot be changed, but other inputs remain fixed in quantity. The duration of the short run is until the yet-unchanged input(s) can be changed. In the real world, production decision makers may plan for the long-run changes that they intend to make, but all decisions are made in short-run settings, even the decisions to make long-run changes. In this sense, then, the freedom of the decision maker to vary inputs is constrained by the temporal setting.
Principle 68. The short run is a period of time during which at least one of the inputs in a production process can be changed, but other inputs remain fixed in quantity; in the long run all inputs can be changed.
It is tempting to identify capital as the input class that typically is fixed in the short run, but we must recognize that this concept is not descriptive of all real-world situations. An example of this caveat consists in the family-owned business (a farm or a commercial establishment) where the labor force is the fixed input (mom, pop, children, cousins, etc.). The relevant input question in the short run is how much land or capital equipment to use (rent, buy), not how much labor to employ.
The Governing Principle
The labor input range of diminishing returns is characterized by output increasing at a decreasing rate as the labor input increases. The principle of diminishing returns governs all real-world production processes. Diminishing returns may not be evident in the very early stages of production characterized by low levels of labor employment, but it becomes obvious as progressively more labor is employed. It is simply implausible to believe and unreasonable to expect that output can continue to increase at increasing or even constant rates forever as the labor input is progressively increased vis-a-vis a given plant size. This physical relationship was recognized earliest in agricultural settings and subsequently in engineering situations. It has been adopted by economists as the fundamental behavioral premise in the explanation of input-output relationships. Although diminishing returns are rarely subject to direct examination or empirical testing, the essential truth of the principle may be verified by the logical process of reduction to absurdity.
Principle 69. Diminishing returns, characterized by output increasing at a decreasing rate as a variable input is increased relative to other inputs that are fixed in quantity, governs all real-world production processes.
As an example, consider a typical peasant farm in South Asia, perhaps 15 acres in size, equipped with a fixed amount of capital equipment including a yoke of oxen and a wooden plow with metal tip, and perhaps two or three other digging or cultivating implements. The peasant farmer by himself can exact some volume of agricultural production from the 15 acres. It is likely that the farmer and his son, working together, can produce more than twice what the farmer alone could produce (the range of increasing returns). As successive additional workers (usually family members) are employed on the farm, output can be expected to continue to increase, but eventually at a decreasing rate, and ultimately to actually decrease if too much labor is employed. In case the reader is skeptical of this conclusion, we invite him to think about the possibilities of employing 5 workers on the 15 acres, then 10 workers, 15, 20, 50, 100, 1000, 1 million workers on 15 acres. Is there any doubt that the principle of diminishing returns has to be true and applicable (at least, eventually) to every real-world production process?
To this point we have taken the short-run view that some quantity of one or another of the inputs is fixed while quantities of other inputs are variable. Over the long run, quantities of all of the inputs into the production process can vary. While some can be varied almost continuously (for example, labor), others can be adjusted only in discrete increments (for example, sections of land, additions to warehouses, new assembly lines).
Variable Proportions and Returns to Scale
We shall describe the more general case where the quantities of the inputs change in different proportions vis-a-vis each other as the case of variable returns or variable proportions. Variable proportions encompasses the possibility that quantities of some inputs decrease as others increase. While this is certainly the typical case in the real world, let us first consider the special case wherein all of the physical inputs are assumed to change in the same direction and by the same proportion, i.e., to the same scale. This is the phenomenon of returns to scale.If the firm has been producing a quantity of a product by employing a certain amount of labor in a given plant, the firm can increase its scale of operations by increasing both inputs (and all others) by the same proportion. For any particular change of all inputs in a production process by the same proportion, if the output change is in the same direction and
b. of the same proportion as the input change, this is a case of constant returns to scale.
c. of larger proportion than the input change, this is a case of increasing returns to scale.
Principle 70. Returns to scale are characterized by all of the physical inputs into a production process changing in the same direction and by the same proportion which may be greater or less than 100 percent, and may be positive or negative.
Changes in Technology, Entrepreneurship, Managerial Capacity
All of the production relationships discussed thus far have assumed some particular technology, given amounts of managerial capacity and entrepreneurial ability. If there is any significant change in any of these enabling conditions, the input-output production relationship changes. Failure to recognize such change may lead to production decisions that are based upon erroneous criteria.Technological, entrepreneurial, or managerial changes may have the effect of significantly increasing the input-output relationship. A technological change that increases output capacity is an advance that improves productive efficiency in the sense that a larger volume of output can be produced with any combination of the inputs. A decrease of productive capacity, perhaps because the firm has lost managerial capacity or deliberately chosen to retrench to some simpler or more primitive technology, constitutes a decrease in productive efficiency.
Principle 71. A technological change that increases output capacity is an advance that improves productivity; a technological change that enables the same volume of output to be produced with smaller quantities of inputs enhances efficiency.
Some technological changes may have the effect of twisting or warping the production relationship instead of simply shifting it. Such changes may have the effect of using more intensively one productive resource (and hence, less intensively the other resources). The firm's management may deliberately choose such an input-twisting technological change if, for example, resource supply conditions change in such a way as to make one resource significantly more costly or another less costly. An example of the former might be the union organization of the firm's labor force that results in rising wage rates, thereby inducing management to install labor-saving technologies when the occasion arises for capital replacement. An example of the latter might be found in a technological advance that renders a previously uneconomic resource now commercially exploitable, e.g., new technologies enabling the extraction of shale oil or the gasification of coal.
Principle 72. An input-twisting technological change may use more of one type of resource in order to conserve on the use of another type.
This leads to a consideration of the criterion for selecting an appropriate technology in any commercial setting. Given market conditions, the best technology is not necessarily the most recently developed, the most "advanced", the most complex, or the one used most commonly by other firms or in other countries. Rather, the appropriate technology for implementing any productive process is the one that employs extensively the most abundant (cheapest) resources, and conserves most on the scarcest (dearest) resources. Failure to recognize or abide by this criterion has on too many occasions led enterprises in developing countries (that often are labor-abundant and capital scarce) to adopt the most advanced, capital-intensive technologies available in the West.
Principle 73. The appropriate technology for implementing any productive process is the one that employs extensively the most abundant (cheapest) resources, and conserves most on the scarcest (dearest) resources.
Technological changes are almost always implemented via capital investment. Capital replacements are almost always current-technology instead of the earlier vintage being replaced. Likewise, capital expansions typically opt for a later technology than that already in place. Care should be taken by management when any capital replacement or expansion is underway to question whether some technological change is also being implemented. If so, the firm's production relationships should be respecified in order to avoid erroneous production decisions.
Principle 74. When a technological change is implemented during capital replacement or expansion, the firm's production relationships should be respecified.
In earlier discussion of returns to scale, we described the phenomenon but neglected to indicate why it occurs. We are now in a position to suggest that even if all of the physical inputs (labor, capital, materials) are variable in the same or varying proportions, there still must be some ultimate enabling or limiting conditions that govern the scale phenomenon. We may speculate that these enabling and limiting conditions are the entrepreneurial ability, managerial capacity, and technologies that can be understood and implemented by the firm. The firm may possess or acquire abilities far beyond those that it presently is using, so that all of the physical inputs can be utilized more effectively at a larger scale. But eventually the scale of operations can exceed the ability of the management's abilities for coordination and control, with the result of decreasing returns to scale.
Principle 75. The ultimate enabling and limiting conditions that govern production relationships are the entrepreneurial ability, managerial capacity, and technologies that can be understood and implemented by the firm.
An immediate problem for gaining an understanding of the production relationship between output and inputs is that most firms produce a variety or range of products and some are joint products resulting from a common production process. If the firm produces several products in independent production processes, a separate production relationship may govern each of the processes. Where joint products result from a common production process, it may be necessary to identify output as a product mix that is measured in value rather than quantity terms.
Principle 76. Where joint products result from a common production process, it may be necessary to identify output as a product mix that is measured in value rather than quantity terms.
Another problem is that the production process by its nature assumes quantities of resources used and output produced such that measures of flows of inputs and outputs are needed. Example of flows are labor hours employed and capital consumed (i.e., used up) in the production process. But flows are much more difficult to measure than are stocks, such as the number of laborers employed or the number of machines or value of capital invested. Where data for flows are unavailable or too costly to capture, the analyst may attempt to use available data for associated stocks as proxies for the missing flows data. It is then necessary to keep in mind that the available data are only proxies for the desired information, and erroneous decisions based upon them may result.
Principle 77. Output data in production relationships are measured in flows; where input data for flows are unavailable or too costly to capture, available data for associated input stocks may be used as proxies for the missing flows data in the production relationships, but the available data are only approximations for the information needed.
Managing Production
Suppose that the firm's management has been successful in understanding the input-output relationships for as many of its production processes as are needed. How can these production relationships assist the management in its production decision making? The answer of course is to use the production relationships as models to simulate changes in the resource inputs. Since the cost-minimizing or profit-maximizing combinations of inputs are rarely self-evident, management may use the models to try a "what-if" approach to understanding the likely effects of alternatives to the present input combinations.
Principle 78. Management may use production input-output relationships to try a "what-if" approach to understanding the likely effects of alternatives to the present input combinations.
The firm's management should be sensitive to the effects upon its production processes of changing input supply conditions, technological advances, and the gains or losses of managerial or entrepreneurial capacities. In addition to responding passively to such changes that impinge upon the firm, the management may aggressively try to alter its production processes by acquiring different technologies or managerial or entrepreneurial abilities.
On a closing note, we should assert that even if the management never undertakes or succeeds in adequately modeling any of its production processes, an acquaintance with the concepts that we have examined in this chapter should provide the basis for more effective production-related decision making.
CHAPTER 7. COSTS
Relevant Cost
In our discussion of the costs of production, we shall proceed upon the operating premise that any aspect of a production process that has negative implications for the production decision maker is a cost of production that is relevant to the production decision. We may also identify the corollary premise that any aspect of production with a positive implication for the decision maker is a relevant benefit (or revenue if the benefit is denominated in money terms). We should note that this premise could be germane to a barter economy (where no money is used to effect transactions) as well as to the monetized economies with which we are familiar. This means that even in a monetized economy where we are accustomed to denominating costs in money terms, some costs of production are essentially personal, or emotional, or psychic, and hence are not (easily) quantifiable and expressible in pecuniary equivalents.
Principle 79. Any aspect of a production process that has negative implications for the production decision maker is a cost of production that is relevant to the production decision, irrespective of whether or not it is denominated in money terms.
Implicit Costs. We shall refer to non-pecuniary costs as implicit costs, and those that are regularly incurred in money terms as explicit costs. A hypothetical example of an implicit cost might be the negative sense that a production manager feels when he purchases an input from a party whom he personally dislikes (perhaps because he is an alumnus of the state university that is the arch-rival of the production manager's alma mater), even though the money price per unit is lowest from that supplier. Such negative feelings, or psychic costs, could be so substantial as to induce a production decision maker to indulge in the apparently irrational decision to procure inputs from a well-liked supplier at higher prices.
Economists identify opportunity costs as another category of implicit costs. An opportunity cost is incurred when a decision maker either knowingly (for non-economic reasons) or unwittingly opts for a lower-valued opportunity than the highest-valued alternative available. The classic text-book example is that of a single proprietor who chooses to continue to run his own business while realizing an accounting profit (to be defined shortly) that is less than the salary which he could realize in managing one of his chain-store competitor's outlets.
Principle 80. Psychic and opportunity costs are implicit costs that are not denominated in money terms, but are nonetheless relevant to managerial decision making.
Explicit Costs. Another term commonly used for explicit cost is accounting cost by virtue of the fact that such money-denominated costs are visible, readily monitored, and hence easily included by accountants when they design accounting systems. Accountants should be congratulated upon their meticulous efforts to account for all of the "hard" (i.e., money-denominated) costs incurred by a productive enterprise. By the same token they may be chastised for their reluctance to address those non-pecuniary psychic or opportunity costs and benefits that are no less relevant to the production decision. Because such non-pecuniary or psychic costs are excluded from formal cost accounting systems, it is up to the production decision maker to recognize them and account for them in the decision-making process.
Principle 81. Formal accounting systems are designed to recognize explicit accounting costs that are denominated in money terms, but which omit all implicit costs that are not denominated in money terms.
Accounting costs may be subdivided into two categories: disbursement and non-disbursement costs. Disbursement costs are those that result in money out-payments from the enterprise to parties who provide services or resources to the enterprise. Examples are the payroll, payments for energy used, and the disbursements to the vendors of the raw and partially processed materials, components, and subassemblies brought together in the production process.
There is one type of non-disbursement accounting cost: depreciation (the macroeconomic equivalent is "capital consumption"). Depreciation is an allowance for the decline in the value of the capital stock that is attributable to the using-up of part of the enterprise's capital equipment during the production (usually the accounting) period. Such using-up or consumption of capital may occur as wear on the equipment or by weathering (exposure to the elements), whether the capital is used or not. These processes gradually diminish the production capabilities of the capital equipment. The phenomenon of obsolescence due to technical advance should not, however, be treated as a depreciation or capital consumption phenomenon. Obsolescence may reduce the market value of a piece of capital equipment, but it does not per se diminish the physical productive capacities. Nor should a disaster (e.g., fire, flood, earthquake) be regarded as a capital consumption phenomenon even though it may suddenly and catastrophically diminish both the market value and productive capability of the equipment.
Principle 82. Firms make explicit disbursement accounting cost payments to parties who provide services, resources, or materials to the firm; depreciation is a non-disbursement explicit cost that allows for decline in the value of the capital stock attributable to the using-up of a portion of the firm's capital equipment during the accounting period.
An allowance for depreciation is not paid out (disbursed) to any party outside the enterprise; rather it is in a sense paid to the enterprise itself for the use of the capital equipment owned by the enterprise. Because it is not paid-out, but still is allowed as an expense against money revenue in computing the taxable profits, the enterprise's tax liability is thereby reduced. For this reason, depreciation may be regarded as a means of outlay recovery, supplying funds internally to the enterprise to finance subsequent reinvestment in its capital stock. But we should be careful to note that capital consumption is a real phenomenon that occurs whether or not a tax authority exists, and regardless of the tax authority's rules for computing the depreciation allowance.
Principle 83. Because depreciation does not require any explicit payment but still is allowed as an expense against money revenue in computing the taxable profits, it may be regarded as a means of outlay recovery, supplying funds internally to the firm to finance subsequent reinvestment in its capital stock.
Because it is impossible to know in advance what will be the actual life of any piece of capital equipment, and because the tax authority may change the depreciation-allowance rules for macroeconomic reasons (i.e., in an effort to stimulate or retard the growth of the economy), it is highly likely that any tax allowance scheme designed by the accountant or permitted under the tax authority's current rules will diverge from the real phenomenon of capital consumption. The depreciation allowance could either exceed or be less than the real wearing out of capital. In the former case, the capital equipment will cease to function before the full amount of the capital outlay has been recovered ("written off"). In the latter case, the capital equipment continues to function productively even after it is fully depreciated. The important point to be recognized by the production manager is that the accounting allowance may not closely match the real weathering and wearing process. Since it is the real process that contributes the relevant cost, the production manager must be prepared to make decision allowances (positive or negative) beyond those designed by accountants or allowed under the tax authority's rules.
Principle 84. A firm’s accumulated depreciation allowances could either exceed or be less than the real wearing out of its capital equipment; in the former case, the capital equipment will cease to function before the full amount of the capital outlay has been recovered; in the latter case, the capital equipment continues to function productively even after it is fully depreciated.
We have made references to the concept of relevant cost. We have already noted that any negative-implications phenomenon that is consequent upon the production process is a relevant cost, whether it is denominated in money terms or not. We should also note that there may be negative-implications phenomena that are not relevant to a particular decision context, but that may be mistaken as being relevant to it. For example, cost factors that do not change in response to any particular managerial decision are not relevant to that decision.
Principle 85. Cost factors that do not change in response to any particular managerial decision are not relevant to that decision.
Variable and Fixed Costs
Economists distinguish between direct costs and overhead costs, or to use the preferred terms, between variable costs and fixed costs. Variable or direct costs are those that vary with the level (or rate) of productive output. Variable costs are always relevant to the rate-of-production decision. Fixed or overhead costs are associated with the existence of the manager, the plant, and the equipment. Examples are contractual salaries and insurance premiums. They continue at the same levels or rates irrespective of the rate of production, even if it is zero. Once the plant has been put in place, these fixed or overhead costs are, so to speak, "sunk" costs, and sunk costs are not relevant to any rate-of-production decisions.
Principle 86. Variable or direct costs change with the level or rate of production; fixed or overhead costs are associated with the existence of the manager, the plant, and the equipment.
The Short Run and the Long Run
The distinction between variable and fixed costs also permits us to distinguish between the time frames of the short and long runs that we have already noted. The short run is the period of time within which some contractual obligations associated with management, plant, and equipment are not alterable by changing the firm's managerial capacity or its scale of operations. The duration of the short run of course varies from enterprise to enterprise and situation to situation, and thus cannot be specified in discrete terms.
Principle 87. Variable costs are relevant to short-run rate-of-production decisions; fixed costs are not relevant to short-run rate-of-production decisions.
In the long run all aspects of the enterprise's operations can be adjusted. All costs are variable in the long run. But we should recognize that any long run consists of a sequence of short runs. All decisions affecting both the enterprise's scale and rate of operation are made in short-run settings, even those decisions affecting the long runs. The distinction between the short and long runs may be more pertinent to academic analysis than to operational decision making. But once we have distinguished the concepts of the short and the long runs, we can assert that the costs that are relevant to short-run decisions (i.e., the rate of production) include no overhead or fixed costs, i.e., sunk costs are "gone costs," and hence are irrelevant to short-run decision making. Fixed costs, though irrelevant to rate-of-production decisions in the short run, become relevant to the scale-of-operations decisions of the long run.
Principle 88. All costs are variable in the long run; fixed costs, though irrelevant to rate-of production decisions in the short run, are relevant to the scale-of-operations decisions of the long run.
Temporal Mismatchings of Production and Costs
Another example of explicit costs that may be irrelevant to decision making in a particular time frame are those that are incurred within the time frame but which affect operations in other time frames. Prime examples are maintenance and repair expenses. Preventive maintenance services are performed in one period to ensure the continuing functionality of the equipment in subsequent periods. Repair service expenses are incurred in one period due to operations in previous periods. If the enterprise is pushing hard to meet a production target or delivery schedule during one period, both preventive maintenance and some repair services may be delayed, and the resulting costs thereby deferred to a subsequent slack period. Such costs then, when they are incurred, are irrelevant to decisions of the period within which they were incurred, but are relevant to some earlier or later period. The moral of this story is that the astute decision maker may have to go to some lengths to match the relevant costs with the appropriate temporal settings, and not rely blindly upon the available cost accounting data.
Principle 89. Preventive maintenance and repair expenses are not relevant to current-period rate-of-production decisions; preventive maintenance expenses occur in one period, but pertain to subsequent periods; repair expenses occur in one period, but pertain to prior periods.
Spill-Over Costs
A final example of costs that are irrelevant to current decision making consists in what economists define as social or spill-over costs. The reader may recall that our operating premise is that a relevant cost is any aspect of a production process that has negative implications for the production decision maker. But what about negative aspects of production that descend upon members of society other than the production decision maker? For example, air, water, and noise pollution are the unfortunate by-products of production processes that affect parties outside the enterprise. These spill-over costs, however, are irrelevant to the production decision context unless or until either the production decision maker experiences a twinge of conscience, or the authorities require the firm to abate, prevent, clean-up, or compensate those who have been harmed. We may say, then, that while such spill-over costs currently are irrelevant to the production decision context, they always have the potential for becoming relevant costs and should not be ignored entirely by the production decision maker.
Principle 90. While spillover costs are not relevant to rate-of-production decisions in the short run, they have the potential to become relevant to managerial decision making in the long run.
Economic Profit
Once we have identified relevant costs (as well as relevant revenues), we are in a position to specify the distinction between accounting profit and economic profit. Accounting profit is the explicit, money-denominated revenues realized by the enterprise during an accounting period, less the explicit, money-denominated costs that are incurred in that same period. Accounting profit does not include any implicit (psychic or opportunity) costs, recognizes no divergence between depreciation allowance and the real phenomenon of capital consumption, and often makes no allowances for the temporal mismatching of production and costs. To the extent that these aspects are omitted from consideration, the computation of an enterprise's accounting profit may over- or understate its true (economic) profit and thereby lead to erroneous decisions.
Principle 91. The computation of a firm’s accounting profit may over- or understate its true (economic) profit and thereby lead to erroneous decisions.
The concept of economic profit is the result of the economist's effort to recognize all benefits (implicit as well as money revenues) and costs (psychic and opportunity costs as well as accounting costs) accruing to the enterprise. Economic costs are all of the costs that are relevant to decision making, whether or not money disbursements were made and whether or not they are recognized in formal accounting systems. The critical significance of economic costs is that they must be paid (or at least given adequate recognition or compensation) in order to retain the services of all productive resources supplied to the firm.
Principle 92. All economic costs must be paid (or at least given adequate recognition or compensation) in order to retain the services of all productive resources supplied to the firm, whether or not money disbursements were made and whether or not they are recognized in formal accounting systems.
The magnitude of the economic cost of any productive factor is its opportunity cost, i.e., at least as large a return as it can realize in its most favorable alternative use. The consequence of failure of an enterprise to pay all of the relevant or economic costs of its factors of production will be their departure to their best alternative employments. We admit that ignorance or irrationality on the part of the owner of the resource may result in the resource remaining in its present employment in spite of economic realities. A critical distinction between a "good management" and "poor management" may lie in the ability of the decision maker to recognize the implicit costs and benefits of managerial decisions.
Principle 93. The economic cost of any productive resource is its opportunity cost, i.e., an amount that is at least as large a return as it can realize in its most favorable alternative use.
Principle 94. A critical distinction between "good management" and "poor management" may lie in the ability of the decision maker to recognize the implicit costs and benefits of managerial decisions.
The Cost-Production Nexus
The phenomena of costs and production are inextricably intertwined. The analysis of the behavior of costs and the specifications of cost-related decision criteria follow directly from the production relationships described in the previous chapter. Costs behave as they do because of the underlying production relationships. In fact, the principle of diminishing returns serves as a common governing principle in the behaviors of both production and cost relationships.
Principle 95. Diminishing returns serves as a common governing principle in the behaviors of both production and cost relationships.
In order to begin our analysis of costs we make three simplifying assumptions, which we can subsequently drop. First we assume that the enterprise already has an installed capital base that determines its plant scale and a particular output range. Second, we assume that there is only one explicitly variable input; for convenience we choose labor, but we could choose any other. There may be other inputs such as materials and energy that must also change with the rate of output, but we can assume that supplies of them are adequate to permit them to be handled with the labor. Third, we assume that labor is hired in a competitive labor market such that any quantity of labor can be hired at the going wage rate.
With these three assumptions in place we have the classic short-run decision question confronting the manager: how much output to produce, or at what output rate should the given plant be operated? Once the answer to this question is determined, the subsidiary question must be addressed: what are the appropriate amounts of inputs to use in producing the target level of output?
The reason that relationships between costs and production are so significant is that our understanding of the behavior of costs is based so exclusively upon the principle of diminishing returns. If the principle of diminishing returns is not true, or not descriptive of the way the world really is, then our understanding of the behavior of costs is also defective and will lead to erroneous production decisions. The other side of this coin is that if we do have an adequate grasp of a principle that truly is descriptive of the way the world works, then production managers need to know how their costs are related to the principle.
In any production process, beyond some point further increases of the variable input results in output increasing at a decreasing rate, i.e., the phenomenon of diminishing returns. And corresponding to this phenomenon, production cost will increase at an increasing rate. Economists refer to this phenomenon as the Law of Increasing Cost. The Law of Increasing Cost is the cost variant of the production principle of diminishing returns.
Principle 96. In any production process, beyond some point further increases of the variable input results in output increasing at a decreasing rate, and production cost increasing at an increasing rate.
Average, Marginal, and Incremental Costs
Operating costs are relevant to production decisions. Average variable cost (AVC) is the operating cost per unit of the product. AVC excludes all fixed or overhead costs. AVC may decrease over an initial range of output, but eventually it reaches a minimum and then increases as ever more of the product is produced. The increasing AVC range of output is a manifestation of the Law of Increasing Costs and the principle of diminishing returns.
Principle 97. Average variable cost may decrease over an initial range of output, but eventually it reaches a minimum and then increases as ever more of the product is produced.
Marginal cost (MC) is the increase in cost consequent upon producing one more unit of product, which in turn requires using additional units of inputs. The MC for any production process at first may decrease, but inevitably it reaches a minimum and increases. The increasing MC range of output is also a manifestation of the Law of Increasing Costs and the principle of diminishing returns.
Principle 98. The marginal cost for any production process at first may decrease, but inevitably it reaches a minimum and increases; MC is less than average variable cost when AVC is decreasing, equal to AVC when AVC is at minimum, and greater than AVC when AVC is increasing.
Incremental cost (IC) is like marginal cost except that is measured for any amount of additional output, not just a one-unit increase of output.
What are the managerial significances of AVC, MC, and IC? The AVC is easiest to compute. Only two pieces of information are needed, the current total operating cost and the quantity being produced. For this reason it is tempting to try to base output decisions upon it. Indeed it can be used as an output decision criterion if the goal of the enterprise is to minimize per-unit operating costs. But if profit maximization is the goal of the management, the circumstances of cost minimization, revenue maximization, and profit maximization are unlikely to coincide.
Principle 99. Average variable cost serves as an output decision criterion if the goal of the firm is to minimize per-unit operating costs.
If the goal of the enterprise's management is profit maximization, then AVC is an inadequate criterion; the appropriate cost-related decision criterion for profit maximization is MC. But here is a problem, because MC is rarely observable (i.e., for a one-unit change of output). It can be computed mathematically (using the calculus) if one knows the equation that adequately represents the cost function. However, to develop such an equation by statistical means requires information about an adequate number of cost and quantity combinations (usually 20 or more).
Principle 100. If the goal of the firm's management is profit maximization, the appropriate cost-related decision criterion for profit maximization is MC.
In lieu of such extensive information, the IC can be computed from four pieces of information: quantities produced at two points in time (preferably very close to each other in time and involving as small a quantity change as possible), and the corresponding totals of the direct operating costs. Even for very small changes of output, the IC will be at best only an approximation to MC because it will over- or understate MC, and may thereby lead to erroneous output-change conclusions.
Principle 101. Incremental cost is easier to compute than marginal cost, but it will be only an approximation to MC and may over- or understate MC, thereby leading to erroneous output-change conclusions.
Where does this leave us? MC is the ideal cost-related decision criterion, but is hardly observable and may be very costly to compute. Even IC, its approximation, though cheaper to compute, may lead to erroneous conclusions. AVC, though not acceptable as a cost-related decision criterion when the goal is profit maximization, is easily computed from a minimal amount of readily-observable information.
Overhead Costs in the Short-Run
We shall take up the nature of overhead or fixed costs in this section, but we run the risk of conveying a misimpression to the reader about the significance of fixed costs to short-run decision making. So, we emphasize that overhead costs are "sunk and gone," and are thus costs that are not relevant to short-run production decision making. We shall be examining the nature of fixed costs in the short-run context purely for information, and not as prospective decision criteria.Before the making of short-run output and pricing decisions, fixed costs should be ignored as irrelevant costs; after the point of decision, they may be regarded purely as information to be considered in any forth-coming long-run decision set. Particularly, the decision maker should not attempt to set price to cover overhead costs or total costs (including overhead); the output decision should not be oriented specifically toward the spreading of the overhead.
Principle 102. Overhead costs are "sunk and gone," and are thus are not relevant to short-run production decision making; after the point of decision, they may be regarded purely as information to be considered in any forth-coming long-run decision set.
BACK TO CONTENTS
PART C. THEORIES OF THE FIRM
CHAPTER 8. THE COMPETITIVE ENVIRONMENT
Now that the theoretical foundations for the analyses of both revenue and costs are in place, we can proceed to bring the two together and begin an examination of goal-oriented decision criteria. To begin this discussion we assume that the decision maker is deliberately trying to maximize the economic profit of the firm.
The decision options of the enterprise manager are constrained by the types and intensities of competition confronting the enterprise in the market for its products. We shall describe a range of competitive types along a continuum between two extremes. In broad terms, the two extremes represent a maximum intensity of competition and no effective competition at all. We readily admit at the start that very few industries and markets in the real world can be characterized by conditions at either extreme. Our objective in this chapter and the next is to identify and describe the limits of the competitive spectrum so that we can then examine decision making under the more realistic conditions between the extremes.
The Maximum-Competition Extreme
We can imagine the descriptive characteristics of a market at the highly competitive extreme of the continuum:(2) The single product that they produce and market is essentially homogeneous across the member firms.
(3) The member firms have virtually identical managerial capacities; they use essentially the same technologies; no one of them has or can acquire any special expertise that is not available to all of the others.
(4) All participants in the market have access to the same information about changing market conditions.
(c) Once a decision has been made to enter the competitive market there is likely be very little incentive or effort to exercise further entrepreneurship, except the decision to exit the market.
(d) The atomistic size and limited financial resources of the competitive firm militate against its acquisition of any special managerial or technical expertise; firms are unable successfully to differentiate their products, and no firm can attain any position of market dominance.
(e) Because of the common knowledge of changing market conditions, all participants in the market become aware of such changes simultaneously, and all adjust at approximately the same rates.
(f) Because of the large number and atomistic size of sellers, competition is essentially anonymous; no seller is aware of or concerned about the identities of other sellers.
(g) A common price likely emerges in the market, and no market participant finds incentive to try to charge any price higher or lower than the market price.
(h) Due to the absence of successful product differentiation, there is little or no point in advertising the firm's product characteristics or its price.
(i) Supernormal and subnormal profits in the competitive market, although they may occur, are fleeting; profits tend toward the economically normal level of opportunity cost (what the firm can realize in the next best alternative application of its resources).
Principle 103. Entry into and exit from a competitive market is cheap and easy.
Principle 104. Once an entrepreneur has decided to enter a competitive market, there is little incentive to exercise further entrepreneurship, except to exit the market.
Principle 105. Firms in competitive markets have little ability to acquire special market knowledge, to acquire and use special technology, or to differentiate or promote their products.
Principle 106. Managers of firms in competitive markets become aware of changing market conditions almost simultaneously and adjust at approximately the same rates; when market conditions change, prices converge quickly to a common level.
Principle 107. Sellers in competitive markets are unaware of and unconcerned about the identities of other sellers in the same market.
Principle 108. Since they can sell all that they can produce at the market price, sellers in competitive markets have little incentive to experiment with price.
Principle 109. Profits in a competitive market tend toward an economically normal level; although super- and subnormal profits may occur, they are short-lived due to easy entry and exit from the market.
Short-Run Adjustment in the Competitive Industry
Market prices will adjust toward an equilibrium combination of price and quantity. Because all firms in a competitive market are similar to one another and significant differences are unlikely to emerge, we can analyze the behavior of a "representative firm" in the competitive market.No single firm in the competitive market will find incentive to charge any price but the market price; at any higher price no one will buy from the firm; the firm can sell all that it can produce at the market price. Therefore, the firm is what we call a "price taker"; it exercises no discretion concerning price except to get into line with the market price when it changes.
The appropriate output decision criterion is a comparison of marginal revenue and marginal cost. Marginal revenue is the addition to total revenue when one more unit of product is produced and sold. Marginal cost is the addition to total cost when one more unit of product is produced and sold. If marginal revenue is greater than marginal cost, output should be increased. An increase of output when marginal revenue is greater than marginal cost will have the effect of adding more to total revenue than to total cost, thereby increasing profit or decreasing loss. A decrease of output will decrease both total revenue and total cost, but total revenue will decrease by more than total cost decreases, thereby increasing loss or decreasing profit. If the goal of the manager is to maximize profit, the firm should increase output when marginal revenue is greater than marginal cost.
An increase of output when marginal cost is greater than marginal revenue will have the effect of adding more to total cost than to total revenue, thereby diminishing profit or increasing loss. A decrease of output will decrease both total revenue and total cost, but total cost will decrease by more than total cost decreases, thereby decreasing loss or increasing profit. If the goal of the manager is to maximize profit, the firm should decrease output when marginal cost is greater than marginal revenue.
Principle 110. When a competitive firm’s marginal revenue is greater than marginal cost, output should be increased in order to increase profit; when marginal cost is greater than marginal revenue, output should be decreased in order to increase profit; profit is maximized when marginal revenue is equal to marginal cost.
The Operate vs. Shut-Down Criterion in the Short Run
Zero is also a possible level of output that may be chosen in the short-run, and it may be rational to shut-down operations if the revenue generated by selling the output cannot cover even the operating (or variable) costs of producing the output. When price is less than per-unit operating cost, the firm should not operate because the revenue resulting from operation would not cover all of the operating costs, and could make no contribution to covering any of the overhead (or fixed) costs. In shut-down mode, the firm minimizes its losses by incurring only the fixed costs. The fixed costs, which continue in the short run whether the firm operates or not, can be saved (or avoided) only by exiting the industry, a long-run decision. The reader is invited to consider the conditions necessary for restart of operations that have been shut down.
Principle 111. The manager of a firm should shut down production when the revenue generated by selling the output cannot cover even the operating (or variable) costs of producing the output.
Principle 112. Fixed costs, which continue in the short run whether or not the firm operates, can be saved (or avoided) only by exiting the industry, a long-run entrepreneurial decision.
There are many exogenous phenomena that may impinge upon the firm in the short run but are not under the discretionary control of the firm's management. A change in the price of an input will have the effect of increasing or decreasing the firm's short-run operating costs and may thereby create a shut-down or restart situation. Such a short-run change may create the need or basis for a long-run decision to exit the industry if the problem cannot be satisfactorily remedied by short-run adjustment. In the long run, revenues must cover all costs of production because there are no fixed costs in the long run.
Short-Run Industry Adjustment of the Competitive Industry
Suppose that firms presently operating in the competitive market can cover all of their operating and overhead costs and enjoy a profit at the current market price. When these profits are perceived by outsiders, and if these profits are greater than can be earned in other markets or markets for other products, the outsiders may exercise their entrepreneurship to enter the market and try to share in the supernormal profits. This entry into the market will have the effect of increasing market supply relative to market demand. As a result, market price will fall. Correspondingly, total revenue will decrease, and the profit earned by the firm will be smaller.
Principle 113. Entry into a competitive market will increase market supply relative to market demand and cause market price to fall.
Theoretically, this adjustment process, driven by ongoing entry into the market, could continue until the price falls to the level of per-unit operating cost; here, supernormal profits have been eliminated and the market price just covers the firm's operating and overhead costs, allowing only a normal return to the firm's ownership interest. The important point is that with no effective way for firms to prevent entry into the market, all super-normal profits will be competed away. But no firm still in the market will be suffering because each will be paying or earning normal returns for all of the resources under its employ. Capital and entrepreneurship, having entered the market, will continue in their present occupation until the prospect of supernormal profits appears elsewhere.
Should over-entry into the product market occur as too many entrepreneurs attempt to capture super-normal profits, price may fall toward the level of per-unit operating cost. Firms in the industry will begin to slow rates of production (a short-run response), decreasing the quantity of product reaching the market. If over-entry causes market price to fall below the level of per-unit operating cost, firms will begin leaving the industry (a long-run response). The total quantity reaching the market can decrease, causing market price to rise. Exit from the industry likely will continue until market price rises to the level of per-unit total cost. Once this price level is reached, firms still in the industry are covering all costs (including normal returns to the entrepreneurs) but earning no super-normal profits. The industry is said to be in long-run equilibrium, and will continue in this state until market demand or supply changes to disturb the equilibrium.
Principle 114. Over-entry into a competitive market may cause market price to fall below the level of per-unit operating costs of some firms whose entrepreneurs may decide to leave the industry.
Principle 115. Once market price has reached a level that is just covering the per-unit costs of all firms still in the industry and entrepreneurs are earning no super-normal profits, the industry is in long-run equilibrium and will continue in this state until market demand or supply changes to disturb the equilibrium.
The interesting thing about equilibrium is that in a dynamic word it is likely to be an ephemeral state that is short-lived and may never actually be observed. The managerial implication is that the manager of a firm selling in a purely competitive market cannot afford to rest upon his laurels in thinking that an equilibrium state will persist.
Principle 116. In a dynamic world, equilibrium is likely to be short-lived condition may never actually be observed; the manager of a firm selling in a competitive market cannot afford to rest in thinking that an equilibrium state will persist.
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CHAPTER 9. PURE MONOPOLY
At the other extreme of the competitive continuum from pure competition is the market structure that economists designate as pure monopoly. Its descriptive characteristics are as follows:
(2) There are no close substitutes for the product(s) sold by the firm, i.e., the product is significantly differentiated from all others.
(3) There are several possible bases for the monopoly position, including
(b) a technological uniquity that may have been developed (internally, by research and development) or acquired (externally, from the inventor);
(c) the grant of an exclusive position by government, e.g., by franchise, patent, trademark, or copyright;
(d) a resource-control uniquity; and
(e) predatory or acquisitive behavior leading to the demise or absorption of former competitors.
Principle 117. Monopoly position may be based upon scale economies, technological uniquities that have been developed internally or acquired externally, grant of exclusive position by government, exclusive control of a resource, or predatory behavior culminating in the elimination of former competitors.
These descriptive characteristics of a pure monopoly lead to a number of consequences or behavioral patterns:
(2) Exit from the market may be equally difficult; if the monopolist has attained large enough scale, exit may be possible only by failure and dissolution.
(3) The monopolist has exclusive control over the market price of the product, but the monopolist is still subject to the discipline of market demand.
(4) Supernormal profits and control over its situation are the two prominent benefits that monopoly position confers upon a firm.
Principle 118. Both entry and exit from a market may be difficult or costly for a monopolist.
Principle 119. Although a monopolist has exclusive control over the market price of a product, it is still subject to the constraints of market demand.
Principle 120. If a monopolist can erect and maintain adequate barriers to entry, supernormal profits may persist.
Short-Run Adjustments by the Monopolist
The thought process that the manager of a pure monopoly must use in selecting the right output level is virtually identical to that of the pure competitor. The same decision criteria are pertinent to both pure competition and pure monopoly. Output should be increased if marginal revenue exceeds marginal cost because more will be added to total revenue than to total cost, thereby increasing profit (or diminishing loss if the firm is operating unprofitably). If marginal cost is greater than marginal revenue, output should be decreased; the resulting decrease of total cost will be less than the decrease of total revenue, so that profit will increase (or loss diminish). Profit is maximized (or loss minimized) when marginal revenue is just equal to marginal cost.
Principle 121. If profit maximization is the monopolist’s goal, output should be increased if marginal revenue exceeds marginal cost; if marginal cost is greater than marginal revenue, output should be decreased; profit is maximized when marginal revenue is just equal to marginal cost.
The major difference between a pure monopoly and a pure competitor lies in the fact that the management of a pure monopoly has at least two realms of decision discretion whereas the pure competitor has only one. The pure competitor can alter the quantity produced, but it is a price taker; it has no alternative but to accept market price as a given. The pure monopoly management not only can alter quantity produced; it must also change market price if it wishes to all of the produced quantity of the product.
To accomplish the desired objective of increasing profits, the monopolist must change product price in the proper direction as long as marginal revenue is not equal to marginal cost, and otherwise mount effective promotional efforts to increase market demand for the product.
Even if the monopoly management does not have perfect knowledge of its revenue and cost conditions (management almost never will), an iterative process (trial and error) employing as decision criteria the comparison between marginal revenue and marginal cost can lead the monopolist toward the profit maximizing price and output levels.
Principle 122. To accomplish the desired objective of increasing profits, a monopolist must not only change quantity produced when marginal revenue is not equal to marginal cost; it must also change product price in the proper direction in order to prevent inventory build-up or draw-down.
Principle 123. Even if the monopolist does not have perfect knowledge of its revenue and cost conditions, an iterative process employing as decision criterion the comparison between incremental revenue and incremental cost can lead the monopolist toward the profit maximizing price and output levels.
But there are other output and price combinations that the monopolist should consider in lieu of profit maximization. For example, if the objective of the firm is growth rather than profit, the monopolist should choose the largest quantity that can be produced and sold without incurring loss. If the firm is attempting to present a low profile to the antitrust authorities, the management should choose the smallest output that can be produced and sold without incurring a loss.
Principle 124. if the objective of the monopolist is growth rather than profit, the monopolist should choose the largest quantity that can be produced and sold without incurring loss, and lower price accordingly to prevent inventory build-up.
A pure monopolist has even more decision-making discretion than just price and output. There is a wide variety of non-price determinants of demand that the marketing decision maker can manipulate in the effort to increase product demand. By creative advertising or other promotional effort, the marketing staff may succeed in increasing the product demand in order to produce a larger output and sell it at the unchanged price.
CHAPTER 10. MONOPOLISTIC COMPETITION
Decision Making under Monopolistic Competition
The descriptive characteristics of monopolistic competition in its modern incarnation are as follows:(2) Unlike pure competition, the firms produce similar but not identical products, although they are enough alike to be regarded by the public as very close substitutes in use. The products may be differentiated in fact by color, texture, structure, function, etc., or only in the imagination of the consuming public. In a sense, monopolistic competition may be said to be like pure monopoly in that each seller is a monopolist of his own product design and brand name (hence the "monopolistic" part of the term).
(3) Like pure competition, firms in the market have comparable managerial capacities and use approximately the same technologies, but unlike pure competition, individual firms may develop or acquire managerial distinctives that are sufficient to enable the pursuit of market strategies. They may also develop or acquire technological variations that are sufficient to differentiate each firm's product.
(4) As in pure competition, all participants in the market have access to the same information about changing market conditions.
(b) Exit from the monopolistically competitive market is also easy, as it is in pure competition.
(c) Because of the possibility of developing managerial distinctives and market strategies, there may be significant incentive for managements of monopolistically-competitive firms to exercise entrepreneurship in order to distance themselves and their products from other competitors and their products.
(d) In spite of the small size and limited financial resources of the monopolistically-competitive firm, it may seek to gain special managerial abilities and technological variants in order to try to achieve some measure of market dominance.
(e) The firm selling in a monopolistically competitive market is a competitor in its close-substitute product market, but a monopolist of its brand name and product design.
(f) Even with ready access to commonly available knowledge of market conditions, and because of the possibility of managerial distinctives, monopolistically competitive firms may react differently from their competitors.
(g) But as in pure competition, monopolistic competition is essentially anonymous; each monopolistic competitor perceives changes only in "the market," and thus reacts only to "the market" rather than to the particular actions of any specific competitor whose identity can be known.
(h) Because of the ease of entry into the monopolistically-competitive market, there is a tendency toward convergence upon a common price.
(i) Because of the possibility of differentiating the product, either physically or only in the perceptions of prospective clients, the manager of the monopolistically competitive firm will be prone to advertise or otherwise promote his product extensively in the hope of attracting the attention of the consuming public.
(j) As in pure competition, super- or subnormal profits will be fleeting due to the ease of entry and exit. Profits will tend toward the economically normal level of opportunity cost.
Principle 125. In a monopolistically competitive market, products may be differentiated in fact by color, texture, structure, function, etc., or only in the imagination of the consuming public.
Principle 126. Monopolistically competitive firms may develop or acquire managerial distinctives and technological variations that are sufficient to differentiate products among sellers and enable pursuit of marketing strategies.
Principle 127. The firm selling in a monopolistically competitive market is a competitor in its close-substitute product market, but a monopolist of its brand name and product design.
Principle 128. Each monopolistic competitor perceives changes only in "the market", and thus reacts only to "the market" rather than to the particular actions of any specific competitor whose identity can be known.
Short-Run Adjustments in the Monopolistically-Competitive Market
In the discussion of pure competition, we spoke of a "representative firm in the market". This terminology may not be appropriate to monopolistic competition because products are not homogeneous, and because monopolistic competitors may develop managerial distinctives. The differentiated products, however, are enough alike to be construed as being within the same market group. We shall analyze the operation of a typical firm in the monopolistically-competitive market group.The comparison of marginal revenue with marginal cost serves just as well for the manager of the monopolistically competitive firm as it does for the pure competitor or pure monopolist in discovering whether to increase or decrease output.
If the monopolistically-competitive firm is typical of all such firms in the market group, the large amount of supernormal profit realized at the profit-maximizing price and output level will not go unnoticed by entrepreneurs presently outside the market. There will likely ensue a rush to enter the market in order to likewise reap such handsome above-normal returns, but they will be competed away just as in pure competition.
Suppose that the entire market demand for all of the close-substitute products that comprise the market group can be identified, and that there are n such typical firms in the market group. Unless any of them can distinguish itself and its product to capture a larger share of the market demand, each can expect to exploit a 1/n share of the market demand. When, in response to the perception of the supernormal profits being realized in the market, an additional firm enters the market, each firm in the market (the previouslyexisting firms plus one more) now can count on only a 1/(n+1) share of market demand, i.e., a slightly smaller market share. In the example just described, each of the now 21 firms can count on only 1/21 share of market demand, which is slightly smaller than the 1/20 share before entry of the twenty-first firm.
Principle 129. Each of the n typical firms in a monopolistically competitive market can expect to exploit a 1/n share of the market demand for the close substitute product group; entry of additional firms selling close substitute products will reduce the typical firm’s share-of-market demand.
The firm's share-of-market demand decreases consequent upon the entry of more firms into the market. The diminishing share of the market induces each firm's management to accept a progressively lower price consistent with the goal of maximizing profits. The effect of the decreasing market share and falling price is to decrease the profits of each of the typical firms. Theoretically, enough additional firms will enter the market until all supernormal profits have been competed away, and each of the typical firms is left just barely covering per-unit costs. This state may be described as market (or group) equilibrium.
This result is similar to the market equilibrium in pure competition in that the typical firm in the market is covering all of its economic costs, including normal returns to the entrepreneur and management, but is not realizing supernormal profit. It is different from the purely competitive conclusion because the typical firm operates at an output rate which is below that at which the pure competitor would produce, and sells at a price that is slightly higher than that of the representative pure competitor in market equilibrium.
Principle 130. Enough firms will enter the monopolistically competitive market until all supernormal profits have been competed away, and each of the typical firms is left just barely covering per-unit costs.
Carried into the long run, the manager of the monopolistically- competitive firm will be led to build a (slightly) too-small plant, operate it at a (slightly) too-low rate of output, and charge a (slightly) too-high price compared to equilibrium in a purely competitive market, all while realizing no more profit than would have been realized by the representative pure competitor. Some have argued that these are small prices for a society to pay for product diversity.
Principle 131. In monopolistically competitive market (or group) equilibrium, a typical firm will be led to build a slightly smaller plant, operate it at a slightly lower rate of output, and charge a slightly higher price compared to a representative firm in equilibrium in a purely competitive market, and end up realizing no more profit than would have been realized by the representative pure competitor.
Managerial Implications of Monopolistic Competition
The entrepreneur who decides to enter a monopolistically-competitive market should do so with eyes wide open to the likelihood that those supernormal profits will disappear very quickly. The manager's only serious hope for sustaining the supernormal profits is to make the product and its support system (location, convenience, delivery, service, etc.) as distinctive in a positive way as possible, and thereby to prevent the leftward shift of the genus demand curve. To this end the manager of the monopolistically-competitive firm may engage in efforts to promote and differentiate the product, but not without cost.
Principle 132. The monopolistic competitor's only hope for sustaining supernormal profits is to make the product and its support system (location, convenience, delivery, service, etc.) as distinctive in a positive way as possible, and thereby to prevent decrease of its share-of-market demand.
The relevant question is whether the increased demand for the product will generate enough additional revenues to cover the costs of differentiation and promotion. A successful effort at promotion adds to overhead costs but increases demand by enough to yield enough additional sales revenue to both cover the promotional cost and pad the profits. But there are entrepreneurial risks in monopolistic competition, and this happy result is not guaranteed. If the manager of one typical monopolistic firm can devise an innovative marketing scheme, so too can the managers of other similarly typical firms, and their efforts may simply cancel each other out. In this case they might end up spending more and enjoying less profit.
Principle 133. An important question for a monopolistic competitor is whether an effort to differentiate and promote the product will increase demand and generate enough additional revenue to cover the costs of differentiation and promotion; if other firms in the same close-substitute product market can match the differentiation and promotion effort, they may all end up spending more and enjoying less profit.
To the extent that a monopolistically competitive firm is successful in differentiating and promoting its product to gain a larger-than-typical market share, it and a few other successful firms may be on their way into the realm of oligopoly.
CHAPTER 11. OLIGOPOLISTIC COMPETITION
There are two acid-test criteria for distinguishing the applicability of monopolistic and oligopolistic competition models. If competitors are essentially oblivious of each other's identities, and if profits tend to be dissipated due to entry of new firms into the market, then monopolistic competition is almost certainly the appropriate model to apply. On the other hand, if the competitors are conscious of each other's identities to the point of devising market strategies oriented toward specific competitors, this is a sure sign of oligopolistic competition.
Principle 134. If competitors are essentially oblivious of each other's identities, and if profits tend to be dissipated due to entry of new firms into the market, then monopolistic competition is almost certainly the appropriate model to apply.
Principle 134. If competitors are conscious of each other's identities to the point of devising market strategies oriented toward specific competitors, an oligopolistic competition model should apply.
Describing Oligopolistic Competition
More-or-less standard specifications may be described for pure competition, monopolistic competition, and pure monopoly. Oligopolistic competition, perhaps the most common form of Western industrial and commercial market structure, is the one for which the least standard analytical specification exists. In laying out its descriptive characteristics, we shall focus upon the differences and similarities with both monopolistic competition and pure monopoly.(2) The products (goods or services) sold by the firms in the oligopolistic market may be homogeneous or differentiated. If differentiated, the products must be close-enough substitutes in use or function that prospective consumers give serious consideration to the alternative products before purchasing.
(3) Unlike monopolistic competition, in oligopoly there may occur significant differences in managerial abilities, organizational structures, and technologies.
(4) Unlike monopolistic competition, firms in an oligopolistic market have differing levels of access to information.
(b) As in monopoly, exit from the market is always possible by failure and dissolution, but oligopolists wishing to exit a market may have another option not available to the monopolist, i.e., to combine with or dispose of assets to a competitor.
(c) Because there are few enough sellers for each to know the identities of the others, virtually every market-oriented and productive decision needs to take into account the range of possible reactions by competitors as well as the most likely reaction.
(d) Oligopolists, like monopolists, have a great deal more pricing discretion than do monopolistic competitors, but the pricing discretion may be severely constrained by the pricing practices of competitors and their likely pricing reactions.
(e) Because of the inherent or contrived barriers to entry into an oligopolistic market, supernormal profits may persist.
(f) As in both pure and monopolistic competition, there may tend to be a market-wide convergence upon a common price.
(g) Difficulties with pricing strategies and price leadership/followership relationships in the oligopolistically competitive market may lead the managers to prefer non-price forms of competition.
(h) Difficulties with price leadership/followership relations in an oligopolistically competitive market may lead managers to implement deliberate non-profit-maximizing strategies oriented toward preserving share of market or growth.
Principle 136. Scale of operation, technological complexity, predatory behavior, or governmental grant of exclusive position (by license, certification, franchise, patent, or trademark) may pose effective barriers to entry by new competitors into an oligopolistically competitive market and enable supernormal profits to be sustained.
Principle 137. Because there are few enough sellers for each to know the identities of the others in an oligopolistically competitive market, virtually every market-oriented and production decision needs to take into account the range of possible reactions by competitors as well as the most likely reaction.
Principle 138. Difficulties with pricing strategies in the oligopolistically competitive market may lead managers to prefer non-price forms of competition.
Principle 139. Difficulties with price leadership/followership relations in an oligopolistically competitive market may lead managers to implement deliberate profit-non-maximizing strategies oriented toward growth or preserving market share.
The object of competition in oligopoly often becomes market share rather than profit or any other behavioral goal. A common problem for oligopolists engaging in non-price competition is to incur design, service, or promotion costs (fixed costs) that simply cancel out each other's efforts, leaving their market shares essentially unchanged (the "smoking-more, enjoying-it-less" syndrome). To the extent that non-price competition has self-cancelling effects, profits are diminished. The market leader may have the best hope of gaining market share, and that may be only temporary.
Principle 140. Design, service, or promotion costs (fixed costs) that simply cancel out each other's efforts in a oligopolistically competitive market may leave market shares essentially unchanged but diminish profits.
For each of the other market structure types (i.e., pure competition, pure monopoly, and monopolistic competition), we were able to describe one fairly standard model generally accepted by economists. Unfortunately, this is not possible for oligopolistic competition because the circumstances and the potential for competitor reaction render each oligopolistic situation unique. Since no two oligopolistically competitive situations are alike, it is necessary to model each one to fit the specifics. There is no single oligopoly model as there is a single monopoly model.
We can, however, identify a limited number of oligopolistic behavioral patterns into which nearly any oligopolistic situation can be classified. A general type of model can be specified for some of the patterns. We shall describe seven broad behavioral patterns:
(2) Managers of oligopolistically competitive firms may engage in aggressive competitive behavior, occasionally manifested by open price- (or design-, service-, promotion-) warfare or other predatory or even criminal behavior to the end of eliminating competitors so that monopoly (or more-limited oligopoly) position can be achieved.
(3) Oligopolistic managers may be so fearful of the possible deleterious effects of a ruinous price (or other kind of) war that they enter into extreme decision rigidity (e.g., price rigidity) in a "don't-rock-the-boat" or "don't-make-waves" attitude.
(4) Managers of firms in oligopolistic competition, to avoid both price rigidity and price warfare, may engage in overt collusion (e.g., by forming a cartel). The monopoly model described in Chapter 9 is adequate to the analysis of the behavior of a cartel.
(5) If overt collusion among separate firms is frowned upon by the authorities, the same end may be accomplished by combination (acquisition, merger, forming "trusts") among the competitors to achieve monopoly position. The monopoly model is adequate to the analysis of the behavior of a trust.
(6) If combination to achieve monopoly is frowned upon as well by the authorities, then competitors may try to engage in implicit or covert collusion with no apparent agreement or even contact among themselves. If they are successful in hiding their collusive actions, the monopoly model is adequate to the analysis of their behavior.
(7) And finally, even if none of the above occurs, some type of price leadership/followership is likely to emerge.
Principle 141. A monopoly model may suffice to analyze an oligopolistic market involving collusion (overt or covert), cartelization, trusts, and acquisitions and mergers to achieve monopoly.
Price-Leadership/Followership.
Oligopolistic competition is perhaps the most prevalent form of commercial organization in Western society. The most common pattern of oligopolistic interaction where antitrust laws are vigorously enforced is likely to be price leadership/-followership. But we recognize that each price leadership circumstance is unique and demands its own model for analysis. All that we can do in this section is to select a few of the more prevalent types of price leadership to model as guides for the reader to use in encounters with price leadership circumstances.
Principle 142. The most common pattern of oligopolistic interaction where antitrust laws are vigorously enforced is likely to be some form of price leadership/followership.
Economists have identified four broad categories of price leadership:
(b) Barometric price leadership is where the manager of one of the oligopolistic firms establishes a reputation for perceptiveness and sensitivity to changing market conditions, and a record of making timely and successful adjustments to those perceived changes. Managements of other firms then watch the price leader's activities and attempt to emulate his decisions.
(c) Dominant firm price leadership is where the market consists of a dominant firm surrounded by a competitive fringe of smaller firms. The dominant firm behaves as a benevolent monopolist, tolerating the existence of the smaller firms and allowing them to sell any amount of the product that they wish at the price that the dominant firm prefers. The dominant firm then takes its demand as the residual of the market demand not met by the competitive fringe firms, and proceeds to behave as a pure monopolist in maximizing profits.
(d) Differential characteristics price leadership may be based on three aspects of the constituent firms' characteristics:
(2) differences in sizes of plant; or
(3) differences in market shares.
Principle 143. Common patterns of oligopolistic interaction where antitrust laws are vigorously enforced include asymmetric, barometric, dominant firm, and differential characteristics price leadership.
Price Leadership based on Cost Differences. Suppose that there are only two firms, Firm A and Firm B, in a market for a product and that each initially has a 50 percent market share. Firm B has a cost advantage (it hires labor or buys material inputs, components, or energy in lower-cost resource markets) than does Firm A. In order to maximize its profits, Firm B prefers to sell its product at a lower price than that preferred by Firm A in order to maximize its profits. Conforming to the Law of Demand, Firm A, at its higher preferred price, sells a slightly smaller quantity than does Firm B. Which firm has the potential for exercising price leadership?
If Firm A chooses to continue to charge its preferred higher price, ignoring Firm B's preferred lower price, some of Firm A's customers will defect to purchase product from Firm B. This constitutes a change of a non-price determinant of demand for both firms, i.e., the population of consumers purchasing from each firm. Firm A's demand will decrease, with the consequence that Firm A will prefer a lower price. Firm B's demand will increase so that it will prefer a higher price. Theoretically, these demand changes could continue until the preferred prices converge to a common price, but with a significant difference: the two firms now have divergent market shares, Firm B now with a larger share than Firm A.
Principle 144. An oligopolistic firm that does not meet the preferred lower price of a competitor can expect to lose market share to the competitor and prefer a lower price; the competitor, gaining market share, will prefer a higher price; market shares will continue to diverge until the preferred prices converge.
Alternately, had the manager of Firm A been willing to meet Firm B's preferred lower price (a deliberate short-run profit sub-maximizing), it could have preserved its share of the market. Thus, the firm naturally preferring the lower price (in this case, Firm B) has the potential to be the price leader when demand or cost circumstances change. Other firms in the industry may choose to follow or not; they can either go ahead and meet the leader's preferred lower price and thereby preserve market share, or they can lose market share and end up preferring the same price as the leader.
Price Leadership based on Plant Size Differences. The same phenomenon can be seen where there is no cost or demand difference between firms, but there is a difference in plant sizes. Suppose that the two firms again have equal initial market shares. They also use the same technology and have access to the same labor and materials markets, or different markets with the same market prices. Firm B, however, has a slightly larger plant capacity. Again, Firm B has the potential for price leadership because it naturally prefers a lower price in order to maximize profits. In this case, the basis for price leadership lies in Firm B's larger plant. Firm A can preserve its market share only by meeting Firm B’s preferred lower price (another deliberate profit non-maximizing strategy).
Price Leadership based on Unequal Market Shares. Finally, suppose that the two firms have identical plants and hire labor and purchase materials from the same resource markets. Firm B, however, initially has a slightly larger market share than does Firm A. In this case, Firm A prefers the lower price in order to maximize its profits, and thereby has the potential for price leadership. In this example, the basis for price leadership lies in the smaller initial market share. If Firm B now does not meet the lower price preferred by Firm A, it will lose market share to Firm A. This process theoretically could continue until they have the same market shares and thus prefer the same market price. But if Firm B decides to meet Firm A’s preferred lower price (yet another deliberate profit non-maximizing strategy), it can preserve its larger market share.
Principle 145. The bases for oligopolistic price leadership may include differences in costs of inputs, differences in plant sizes, or initial unequal market shares; the oligopolistic competitor preferring the lowest product price in order to maximize profits has the potential to be the price leader in the market.
While the potential for price leadership can readily be discerned in each of these models, it does not follow that the actual price leader will coincide with the potential price leader. The theoretical follower could "take the bull by the horns" and undercut the price preferred by the theoretical leader in each example (again, a deliberate profit non-maximizing strategy). But by so-doing he risks the initiation of a price war as described earlier.
The Managerial Implications of Oligopolistic Competition
We have reached the end of our survey of possible behavior patterns in oligopolistically-competitive markets, but we have by no means exhausted the range of possibilities. What should the manager of the oligopolistic firm pay attention to? It all depends upon the circumstances of the specific situation. The oligopolistic market can range from a fairly comfortable "live-and-let-live" mentality to an intensely competitive situation characterized by predatory behavior on the parts of some of the managements. Some managers thrive in such an environment while others would rather get out. Business failure will get some of the faint-hearted out of the market, while others will try to escape the intensity of oligopolistic competition by efforts to achieve monopoly. In Western societies where antitrust law exists and is effectively administered, the oligopolistic competition can count upon government scrutiny of its practices and policies.
The Societal Implications of Oligopolistic Behavior and Industry Structure
Oligopolistic industries are populated by firms that range in size from the corner gas station to the mega-buck corporation. Oligopolistic competition among gasoline retailers probably militates in the consumer's interest by ensuring the lowest possible prices and the narrowest possible profit margins consistent with the continued provision of retail gasoline distribution services.
Principle 146. Oligopolistic interaction may be local, national, or international in scope; even if there are many local firms supplying close substitute products, awareness of identity and interactive strategy among near neighbors militates in favor of an oligopolistic model rather than a monopolistically competitive model.
Unless collusion among competitors accomplishes a measure of monopoly control and the realization of supernormal profits, oligopolistic competition at the larger-firm end of the spectrum contributes to technological advance in productive efficiency, better product designs, and better service of the product.
Principle 147. Oigopolistic competition at the larger-firm end of the firm size spectrum may contribute to technological advance in productive efficiency, better product designs, and better service of the product.
Competition, if not subverted by collusion, predatory behavior, the erection of barriers to entry, or the grant of exclusive position by government, can serve as a mechanism for the social control of industry and commerce. Competition doesn't have to be pure in order to exert its controlling function. Even the competition present in the oligopolistically-competitive market in the form of price leadership/followership can be an effective vehicle of social control because the threat of market share loss will induce competitors to meet the lowest price preferred by any firm in the market. Society's job in formulating public policy with respect to oligopoly then is to suppress collusive behavior that exploits consumers, prevent predatory behavior that destroys existing competitors, and disallow the creation of entry barriers that diverts potential competition.
Principle 148. The competition present in the oligopolistically-competitive market in the form of price leadership/followership can provide societal benefits because the threat of market share loss will induce competitors to meet the lowest price preferred by any firm in the market.
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CHAPTER 12. EXTENDING THE MODEL OF THE FIRM
The models that we have examined assumed the simplest possible context
for a
commercial firm: a business with a pre-existing capital base, employing
a
single variable input, producing a single product, which is sold in a
single
market, and which is run by a single manager. The organization of the
market
varied in structure and complexity, ranging from pure competition
through
monopolistic and oligopolistic competition to pure monopoly. But there
are very
few real-world businesses that are so simple. The purpose of this
chapter is to
survey various extensions of the model of the firm.
Non-Price Determinants of Demand
Economists focus almost obsessively upon price as the primary determinant of demand. But price is only one among many influences on a firm’s product demand. Once any one of them has been designated the primary determinant, for purpose of analysis others are assumed constant. A change of any of the assumed-constant determinants results in an increase or a decrease of demand, depending upon how the determinant changed. If such a change occurs without being recognized by the manager, an identification problem may arise. The decision-significance of the occurrence of an identification problem is that the decision criteria will tend to be over- or understated, and could thereby lead to erroneous decisions.
Principle 149. If a change of any of the assumed-constant determinants results in an increase or a decrease of demand (depending upon how the determinant changed) without being recognized by the manager, an identification problem may cause a decision criterion to be over- or understated.
Economists usually assume price to be the primary determinant of quantity demanded, but it is also a convenience to have a deterministic variable that is directly comparable to average and marginal costs. Business decision makers attempting to employ the economic models should pay attention to the non-price demand determinants because autonomous changes in any of them can change the firm's product demand in unexpected ways.
While these are phenomena to be aware of and prepared to adjust to, it may also be possible to make the non-price determinants of demand into components of the firm's promotional strategy. For example, a successful advertising campaign (promotional effort is one such non-price determinant of demand) should have the effect of increasing the firm's demand, or at least preventing it from decreasing in the face of competitors’ promotional efforts.
Principle 150. It may be possible to make non-price determinants of demand into components of the firm's promotional strategy, e.g., a successful advertising campaign may increase the firm's demand or prevent it from decreasing.
Non-Quantity Determinants of Costs
Economists also focus almost exclusively upon quantity produced as the primary determinant of cost. But we have also noted in our discussion of costs that non-quantity determinants of costs should also be considered by the manager. Possible candidates are the market prices of the labor and materials inputs that the firm purchases, the technology used in the production processes, and the firm’s managerial capacity. It is a convenience to take costs primarily to be determined by quantity produced because this allows direct comparison of per-unit costs (average and marginal) with price and marginal revenue. A change in any of the non-quantity determinants of costs can be expected to change the per-unit costs.
Principle 151. A change in any of the non-quantity determinants of costs can be expected to change the per-unit costs of the firm, and thus the profit maximizing combination of output and price.
As in the case of the non-price determinants of demand, it may be possible to incorporate the non-quantity determinants of costs into the firm's production and marketing strategies. For example, one way to gain a "leg-up" on the competition would be to develop or acquire a more efficient (i.e., lower cost) technology, or to find or negotiate lower-priced sources of supply of the materials or labor inputs than competitors can employ. Either would have the potential to increase the firm's profits (or reduce its losses). If the firm's per-unit cost decreases far enough, the manager may be encouraged to initiate a price war.
Principle 152. It may be possible to make non-quantity determinants of costs into components of competitive strategy, e.g., to develop or acquire a more efficient (i.e., lower cost) technology, or to find or negotiate lower-priced sources of supply of the materials or labor inputs than competitors can employ.
The markets in
which a firm
sells can be classified on at least four bases: product, geographic,
demographic, and temporal. We shall defer consideration of multiple
products to
a subsequent section. The geographic
market for a particular product is the locale within which the firm
sells,
and where there is effective competition by other companies selling
closely
competitive products. For most products, the geographic market is
almost
certainly not the world or even the whole geographic of area of a
country. Most
companies sell in multiple geographic markets that are separated by
distance
and the cost of transport so that clienteles are effectively
compartmentalized.
Furthermore, the firm may face varying intensities of competition in
its
different geographic markets: it may be a monopolistic competitor in
some
markets, an oligopolist in some, and a nearly-pure monopolist in a few.
It may
need to pursue different marketing strategies according to the nature
and
intensity of competition faced.
Varying demand conditions make price differentials among the markets feasible. The charging of different prices for the same item where there are no differences in the costs of serving the different customers constitutes price discrimination. Price discrimination is prohibited by law in most Western societies. Although the law usually prohibits the practice of overt price discrimination where there is no cost justification for the price differences, price discrimination between markets should be expected to emerge as a normal concomitant of different demand elasticities in the different markets.
Principle 153. Varying demand conditions for the same product in separable markets make it possible for a firm to increase revenue by practicing price discrimination, i.e., charging different prices for the same product where there are no differences in the costs of serving the different customers.
The firm may also sell to separate temporal and demographic markets within the same geographic market. The bases for demographic market segmentation may include age, race, ethnicity, religion, place of birth, citizenship, etc. Price (and any other kind of) discrimination based on race or ethnicity is usually prohibited by law. The most common demographic forms of price discrimination are by age and citizenship. Theaters typically offer lower-priced children's tickets, even though the seat is as fully occupied by the child as by an adult, and even though the adult really didn't want to see the children's feature. Restaurants as well as theaters may price differently through the day (the "luncheon menu" vs. the "dinner menu," the "afternoon matinee" vs. the "evening feature"). State universities often price discriminate against citizens of other states who apply for admission, and denominational colleges occasionally price discriminate in favor of their own members or the offspring of their ministers and missionaries. Airlines and hotels conventionally price discriminate by days of the week and from one season to the next.
Commercial classification may constitute yet another basis for price discrimination. Wholesalers usually identify "legitimate" retail vendors who then are eligible to buy "at wholesale" whereas members of the general public can qualify only for the higher retail price. Some wholesalers as well as some manufacturers maintain several customer classifications, each of which is eligible for a certain price level or discount from the firm's standard price (wholesalers often express their price schedules as various levels of discount from manufacturer's suggested retail price). Such classification schemes break down when a buyer classed in one group has access to someone classed in another group. Some of us will know "a guy who's got a brother-in-law who can get it for us at wholesale." Also, the recent advent of "wholesale buying clubs" has served to obscure the distinction between retail and wholesale.
Any of these forms of price discrimination is enabled only because demand elasticity varies among groups or from time to time, and it is not feasible for a prospective client to jump from one group or time frame to another. If clients can jump market segments, the basis for price discrimination is destroyed. It can be shown mathematically that if two conditions can be met, the firm can increase its profit by price discriminating across its markets: (a) demands are of different elasticities in the different markets; and (b) there is some means of segmenting markets and keeping customers in the different market segments from jumping segments or from buying for one another.
The managerial implications of price discrimination are clear. The manager of a firm in an imperfectly competitive market may by price discrimination increase the firm's revenues, but only by incurring the costs of establishing and enforcing market separation, and often by risking antitrust prosecution. It may be very troublesome (and trouble translates into costs) to seal off the markets from one another. The costs of enforcing market separation may be greater than the additional revenue realized from discrimination. As with any other managerial decision, the rational approach is to compare the expected benefits with the likely costs before deciding to proceed.
Principle 154. The costs of market segmentation to enable practicing price discrimination may outweigh the increased revenue benefits of price discrimination.
Multiple Products
As we have already
noted, if
the firm produces multiple products for sale in as many product
markets, its
production and marketing operations in each product market can be
modeled
separately. For short-run decision making purposes, this analysis can
be
handled without reference to the overhead costs since they are
irrelevant to
the price and output decisions.
In the long run the allocation of the overhead costs in a multi-product plant becomes critical to the question of whether to delete any particular items from the product line, or to add new items if excess capacity exists. In order for any item currently in the product line to continue to be produced, its price must make an adequate contribution to its overhead costs as well as cover all of the direct costs of its production. This is not an argument for price to be set to cover overhead as well as direct costs; rather, once price has been determined with appropriate economic criteria (marginal revenue compared to marginal cost), the question is whether or not it covers all relevant costs. Since there appears to be no objective criterion for allocating overhead costs among multiple products, this assessment must be based upon the judgment of the decision maker who, in any case of deleting or adding products, is engaging in an entrepreneurial decision.
Principle 155.
Overhead costs are not relevant to short-run production
decisions, but
in order for any item currently in the product mix to continue to be
produced,
its price must make an adequate contribution to its overhead costs as
well as
cover all of the direct costs of its production.
Principle 156. Since there is no objective criterion for allocating overhead costs among multiple products, the assessment must be based upon the judgment of the decision maker in any question of deleting or adding products to the firm’s product mix.
If the firm has excess productive capacity and is considering whether to add items to its product line, the decision maker must make a prior judgment (again, in an entrepreneurial capacity) as to whether the new item can be sold at a price that is high enough to cover all of its direct production costs and make some contribution to covering the overhead costs as well. It can be argued that since the excess capacity already exists, the overhead costs are in effect "sunk costs" and thus not pertinent to the question of adding the item to the product line. Yet, even if an item is added on the basis that its price will be sufficient to cover all direct costs plus some contribution to overhead costs, for the item to be retained in the product line in the long run it will have to be judged to be making an adequate contribution to overhead costs and profit.
If the firm is considering adding an item when it has no excess capacity, then the appropriate criterion is that the item should not be added unless it is possible to sell the item at a price that will cover both its direct costs and the overhead costs resulting from the added capacity. In any case, the rational entrepreneur should add items to the product line in descending order of perceived profitability.
Principle 157. Items should be added to a firm’s product mix in descending order of perceived profitability.
Jointly-Produced Products
The specification
of decision
criteria for jointly-produced products
poses another difficult problem. Jointly-produced products are those
that
result from a common production process. Classic examples are beef and
hides,
gasoline and fuel oil, mutton and wool. Even where the objective is to
produce
one primary product, e.g., metal stampings for auto body parts, there
are
likely to be marketable by-products
such as the metal scrap. In any short-run situation, such joint
products are
produced in fixed proportions. The relevant questions are what quantity
of the
output mix is to be produced and at what prices are the individual
items in the
mix to be sold. In the long run, the management often can vary the
output
proportions, so that the relevant question for the long run is the
profit-maximizing output combination.
The relevant short-run decision criterion for joint product production is the comparison of marginal cost with joint marginal revenue. Joint marginal revenue can be computed by summing the marginal revenues for all of the jointly produced products. The manager should increase output of both products as long as joint marginal revenue exceeds marginal cost, or decrease output if joint marginal revenue is less than marginal cost. The profit maximizing output of jointly produced products occurs at the output level where marginal cost is equal to joint marginal revenue and marginal revenues for both products are positive. If at this level of joint-product output marginal revenue for either product is negative, selling that quantity of the product would reduce total revenue. The quantity sold of that product should be reduced to the level at which its marginal revenue is zero and the rest of that product should be withheld from the market and possibly destroyed or "dumped" in another market (dumping is then a special case of price discrimination). All of product for which marginal revenue is positive or zero should be sold at its profit maximizing price.
Principle 158.
For multiple products jointly produced in fixed proportions,
output
should increase as long as joint marginal revenue exceeds marginal
cost, or
decrease output if joint marginal revenue is less than marginal cost;
profit
maximization occurs at the output level where marginal cost is equal to
joint
marginal revenue and marginal revenues for both products are positive.
Principle 159. If the marginal revenue of any one of jointly produced products would be negative, enough of it should be withheld from the market for its marginal revenue to become zero.
Plant managers typically have little discretion in varying the product mix in the short run. To alter the output mix usually requires a long-run adjustment to plant, equipment, and technology to be effected through capital investment. Without perfect prior knowledge of the costs and revenues of alternative product-mix combinations, the firm's manager, acting in an entrepreneurial capacity, can only proceed iteratively to try an alternative combination when the next occasion for capital reinvestment arises. If the new product mix increases profitability (a successful entrepreneurial decision), the manager can assume that an adjustment in the proper direction has been made.
Principle 160. Altering a firm’s jointly-produced output mix may require a long-run adjustment to plant, equipment, and technology to be effected through capital investment.
Increasing Size and Complexity
To this point we
have assumed
the convenient fiction that the management of the firm consists of the
single
person, the "manager", who makes decisions in pursuit of the profit
objective. The owner-entrepreneur of a small-scale single
proprietorship fits
this description nicely, and there are throughout the world tens of
thousands
of such one-person companies in existence, many of them well-managed,
successful
firms.
But as other firms, organized as partnerships and corporations, have become much larger than could ever have been accommodated under the proprietorship form of organization, a wide variety of approaches has emerged for dealing with the resulting problems of coordination and control. Virtually all of the attempted remedies have been means of specializing and dividing the labor of decision making among a multiplicity of managers. They include:
(a)
distinguishing line from staff functions;
(b) the functional specialization of line managers to ever narrower realms of discretion and responsibility;
(c) the establishment of multiple tiers of managerial responsibility organized along hierarchical lines of authority; and
(d) divisionalization of the firm's
operations.
Principle 161. Approaches for dealing with the problems of coordination and control have included distinguishing line from staff functions, the functional specialization of line managers to ever narrower realms of discretion and responsibility, the establishment of multiple tiers of managerial responsibility organized along hierarchical lines of authority, and divisionalization of the firm's operations.
We shall leave the further elaboration of the first three of these approaches to texts in organizational theory. The purpose of divisionalization is to create several smaller decision units to replace (or in lieu of) a single, large, unwieldy administrative unit. Divisionalization may be along horizontal or vertical lines. The horizontal divisionalization of the firm may be organized along geographic or product lines. Each such horizontal division may be construed as a near-autonomous entity over which the appointed management staff is given the responsibility to be profitable (or to meet some other specified firm goals), and the decision-making discretion and authority to pursue this end (they may be designated "profit centers"). The horizontal divisions may have been created by dividing a previously unified organization. More likely, a horizontal divisional structure is the outcome of one or more acquisitions or mergers where complete integration of the combined companies has not been achieved, and may not even by intended by the acquiring owners. In many cases, the fellow divisions may be expected to compete with each other as well as with other companies. In any case, they must vie with each other for access to the parent firm's financial resources.
Principle 162. Horizontal divisions of a firm must compete with one another for the firm’s limited financial resources.
Since there is often no particular economic reason for the horizontal divisions to be parts of the same firm (unless the objective is merger to avoid competition), the justification for their common ownership lies in the "deeper financial pockets" of the larger firm. We leave further examination of this angle to the auspices of corporate finance.
Transfer Pricing
To this point we
have assumed
each firm to be perfectly vertically
integrated, i.e., to perform all operations in proper sequence to
convert a
batch of raw materials into a final product. This fiction (or reality
in a few,
rare cases) allowed us to discuss a single production process,
implicitly
encompassing all sequential productive operations without reference to
any
particular operations. It also permitted us the luxury of imagining the
specification of a single cost process encompassing all of those
separate
operations. Without making it explicit, we have assumed that the
intermediate
product was simply "work in process" to be passed from one processing
stage to the next without having to be "costed" or "priced".
Any profit (normal or supernormal) that resulted would accrue to the
firm as a
whole without any necessity of distributing or attributing it to the
various
productive operations.
The alternative to vertical integration is vertical segmentation (or disintegration) where each identifiable productive operation is performed by a separate firm. Each firm in performing its operation adds value to the intermediate product. The partially-processed product is then sold to another firm that adds more value by performing the next operation in sequence, and so on until the state of "final product" is attained. If a production process were perfectly vertically segmented, each of the firms in the vertical sequence would maximize profits by finding the price and quantity for which marginal revenue is equal to marginal cost. The price that each firm would charge would be equal to its marginal revenue if market conditions were purely competitive, but price might exceed marginal revenue in imperfectly competitive markets. In a vertically-segmented production process, each firm's price would become part of the next firm's per-unit costs.
Principle 163. In perfectly vertically segmented production process, each of the firms in the vertical sequence would maximize profits by finding the price and quantity for which marginal revenue is equal to marginal cost.
From a social perspective, the application of marginal decision criteria in a competitive market would lead to an efficient allocation of resources among the successive operations and profits among the separate companies. From the perspective of a perfectly vertically-integrated firm, efficiency (and hence, profitability) is served by applying the same marginal decision criteria among its vertically related divisions. Virtually all manufacturing companies are to some extent vertically integrated in that they perform more than one identifiable operation in the sequence necessary for the production of the final product. No additional modeling or analysis is required if the vertically integrated firm is organized as a single unit for which one production function and one cost function may be estimated.
Principle 164. In the case of a perfectly vertically-integrated firm, efficiency (and hence, profitability) is served by applying the marginal decision criteria among its vertically related divisions.
However, the vertically integrated firm may be organized into separate, semiautonomous divisions within which managers are given discretion for determining output and responsibility for controlling costs and earning profits. It then becomes necessary to determine the prices of the intermediate products as they are transferred from each division to the division that will undertake the next stage of processing. Realistic transfer prices are as important to the allocation of resources between divisions within the vertically integrated firm as realistic intermediate goods prices are to the allocation of resources between firms in a vertically segmented production process. A too-low transfer price will result in deficient profitability of the division (profit center), and resources will tend to be under-allocated to the division. Since the too-low transfer price becomes a too-low per-unit cost to the next division, profits there will be excessive, and resources will tend to be over-allocated to that division.
Principle 165. Realistic transfer prices are important to avert the appearance of deficient and excessive profits and to prevent under- and over-allocation of firm resources among its divisions.
Transfer pricing among divisions is an especially critical matter if executive or employee compensation across the divisions is based upon the profitability of the divisions. Profitability differentials among the divisions that are due to errors or deliberate distortions in transfer pricing will inevitably lead to a deterioration of executive or employee morale.
Parent firms with subsidiaries in other countries may devise a transfer pricing strategy to shift cash from one country to another. For example, if the parent firm sets prices well above costs on inventory shipped to a foreign subsidiary, cash is shifted from the subsidiary to the parent firm. Vice-versa, if inventory shipped from the subsidiary to the parent is overpriced relative to costs, cash is shifted from the parent to the subsidiary.
Principle 166. A parent firm may shift cash from a subsidiary to itself by pricing items shipped to the subsidiary above costs; vice-versa, if items shipped from the subsidiary to the parent is overpriced relative to costs, cash is shifted from the parent to the subsidiary.
The matter of realistic transfer pricing is even more critical if the division manager is also allowed the discretion to sell some of the output to buyers outside of the firm as an alternative to transferring all of the intermediate good to the next processing division within the firm. If the in-house transfer price is set too low, the division manager may find it more profitable to sell to outsiders at market prices than to transfer intermediate product to the next in-house division, in which case vertical disintegration will occur as the firm becomes less vertically integrated. The firm may instruct one division to price-discriminate in favor of a fellow division and against an outside buyer, but this may lead to interdivisional differentials of profitability, and it is likely to attract the attention of the antitrust authorities. For example, consider the implications if a components producing division of an automobile manufacturer were to sell power steering units to one of its fellow assembly divisions at a more favorable transfer price than to a competitor for installation in its vehicles.
Suppose that a division manager is given the authority to source intermediate goods requirements from outside the firm even though a fellow division produces the intermediate good. A too-high transfer price for the intermediate good will lead to vertical disintegration as the division manager shifts to the externally-sourced supply of the intermediate good at lower market prices.
Principle 167. Vertical
disintegration may occur when an intermediate product division manager
finds it
more profitable to sell to outsiders at market prices than to transfer
the
intermediate product to the next in-house division because the transfer
price
of the intermediate product is set too low.
Principle 168. A too-high transfer price for an intermediate product will lead to vertical disintegration if the division manager is authorized to acquire the intermediate product from external sources at lower market prices.
In the simplest case of transfer pricing, suppose that a product goes through a number of stages of processing where each stage is accomplished in a semi-autonomous division of the firm The manager of each division is given no discretion to source the intermediate product from the market or sell the intermediate product to the market after the division's processing of it. The firm will maximize profits at output level at which firm marginal revenue is just equal to marginal cost at the last stage of production.
Principle 169. A vertically integrated firm can maximize profit at the output level at which company marginal revenue is just equal to marginal cost at the last stage of production.
As processing
ensues through
the stages of production from the first to the last, the marginal costs
at the
respective stages can be imagined to step
upward, approaching that at the last stage. The rationale for the
upward
stepping of the marginal costs is that the transfer price set in any
stage
becomes the per-unit cost of the intermediate product at the next
stage, to
which the marginal costs at the next stage are added to determine the
next
transfer price. Thus the transfer price at each stage is higher than
the
transfer price at the previous stage of processing. If the unit prices
of the
materials inputs in any one of the intermediate production process were
to
increase, the whole set of per unit costs would increase.
In the divisionalized, vertically integrated firm, the price of the intermediate product rises as more value is added to it at each stage of processing. Given an executive decision to produce a quantity of final product to be sold at the profit maximizing price, the transfer price for each intermediate product is its division’s marginal cost at that output level.
Principle 170. Given a decision to produce a quantity of final product to be sold at the profit maximizing price, the transfer price for each intermediate product is its division’s marginal cost at that output level.
BACK TO CONTENTS
PART D. CONCLUSION
CHAPTER
13. REALISM AND ACCURACY IN ECONOMIC MODELS
Simple
Models and
Complex Realities
Business firms
typically
produce a multiplicity of goods and services that often can be
organized into
lines of complementary and sometimes competing items. Occasionally the
goods
produced by the business are conglomerated in the sense that there are
no
apparent relationships among them. Often the multiple goods are joint
products
resulting from a common production process. And commercial enterprises
often
sell their products in a multiplicity of separable market areas. They
employ a
great many variable inputs bought or hired from different resource
markets. It
is not unusual for a business to have several production facilities or
plants,
and each plant may be subdivided into several assembly lines, each of
which can
function as a more-or-less autonomous production unit. And the
management of
the business may include many decision makers, each with limited areas
of
expertise, decision-making authority, and responsibility. They may be
organized
into multiple, hierarchical tiers of authority. The facets of intricacy
and
complexity of the modern business firm are almost innumerable.
How can the simple-minded
models described by economists be relevant to any real-world business
organizations
other than those that match the models in simplicity? The great virtue
of such
simple contexts is that they allow us to peer through the haze of
complexity in
order to come to understandings of the principles governing the
behaviors of
revenues, costs, profit, production, and competition itself without the
encumbrances of a plethora of detail.
Principle 171. The great virtue of simple models is that they allow us to peer through the haze of complexity in order to come to understandings of the principles governing the behaviors of economic relationships without the encumbrances of a plethora of detail.
There are three planes upon which the models that we have described may be beneficial to practical decision contexts. First, the general principles discovered and learned by examining the models can be used as guides to what we shall call "seat-of-the-pants" decision making (see Fritz Machlup, "Marginal Analysis and Empirical Research," in Essays in Economic Semantics, W. W. Norton & Company, 1967, pp. 154-155). Here the decision maker proceeds from an assessment of the best available information about the situation based on an accumulation of experience in similar circumstances compared to the decision criteria discerned in the academic study of the underlying principles. While this decision making procedure may sound a bit loose and uncertain, we believe that the vast majority of all business decision makers who have engaged in any formal study of economic principles are likely to proceed in just this fashion.
Principle 172. Rational decisions are made by proceeding from an assessment of the best available information about the situation based on an accumulation of experience in similar circumstances compared to the decision criteria discerned in the academic study of the underlying principles.
The second plane upon which simplistic models can be used is to simulate small parts of the complex business decision context. For example, if a business has one plant in each of several completely separate markets, and each plant produces several mutually-exclusive products for sale in the market where that plant is located, it should be possible to specify a revenue and a cost function for each of the products in each of the markets in order to establish the relevant marginal decision criteria. This approach becomes cumbersome and costly in the case of a wholesale distributor or a "big-box" retailer that regularly carries 30 thousand different items (in the case of screws, each combination of thread pattern, head design, finish, diameter, and length constitutes a separate item) in its warehouse. The approach breaks down entirely if some of the items are jointly-produced, or if they are produced in a single plant for sale in several markets, or if they are produced in multiple plants but sold in a single market.
Principle 173. Simplistic models can be used is to simulate small parts of the complex business decision context.
On the third plane the simplistic models must be elaborated to handle the intricacies of the situation. The model builder attempts to make the assumptions underlying the model ever more realistic, the structure of the model ever more accurately descriptive of the real context that is being modeled, and the parameters of the model ever more closely tailored to the particular circumstances of the required decision. The progressive elaboration of a model inevitably increases its complexity and detail, as well as the model-building cost. The number of equations in the model increases, and particular equations may have to have more and higher-ordered terms in them.
Principle 174.
Simplistic models may be elaborated to handle the intricacies of
the
situation by making the underlying assumptions ever more realistic and
the
structure of the model ever more accurately descriptive of the real
context
that is being modeled.
On Realism, Accuracy, and Specificity in Models
Economists have traditionally valued simplicity in models, for after all is said and done a model is intended to be a simplified representation of a more complex reality. But economists have also debated the importance of the realism of assumptions and the descriptive accuracy of the structure of their models. Most inevitably have come to the conclusion that it may not be possible to construct a simulation or forecasting model that is perfectly realistic in its assumptions and accurately descriptive in its structure without making it as complex as the real situation from which it is supposed to be an abstraction. This of course would defeat the purpose of attempting to structure a simplified representation of the more complex reality.
Principle 175. It may not be possible to construct a model that is perfectly realistic in its assumptions and accurately descriptive in its structure without making it as complex as the real situation from which it is supposed to be an abstraction.
Economist Milton Friedman argued that the realism of assumptions and the accuracy of the structure of a model are of lesser importance than is the predictive ability of the model ("The Methodology of Positive Economics" in Essays in Positive Economics, University of Chicago Press, 1953). The acid test for a model is how it performs in doing what it was designed to do. According to Friedman, a simplistic model based on unrealistic assumptions may perform satisfactorily; what is important is whether people behave as if the assumptions of the model are realistic, even if the assumptions bear little or no resemblance to the reality.
Principle 176. A simplistic model based on unrealistic assumptions may perform satisfactorily; what is important is whether people behave as if the assumptions of the model are realistic, even if the assumptions bear little or no resemblance to the reality.
An economic perspective on the process of elaborating a model to make it more specific to the context being modeled would examine the benefits and the costs of the elaboration process. A more complex model based on more realistic assumptions may indeed yield better decision criteria, but the process of specifying any model is costly in terms of time and effort, and in money terms if the expertise has to be hired from outside the organization. The cost of specifying an ever more complex model probably obeys the principle of diminishing returns (or its variant, the Law of Increasing Costs) no less so than does any other real production phenomenon. Model-building costs rise at an increasing rate the farther the model builder attempts to go in detailing the model. The relevant economic question then is whether the value of the additional effectiveness of the model is worth the extra cost of improving the fit.
Principle 177. The
cost of specifying an ever more complex
model obeys the principle of diminishing returns (or its variant, the
law of
increasing costs) no less so than does any other real production
phenomenon.
Principle 178. The economic criterion for elaborating a model is whether the value of the additional effectiveness of the model is worth the extra cost of improving the fit.
Our advice
is to apply Occam's Razor to the model-building
context. Under this principle,
one should (use the Razor to) "cut off" the unnecessary complexity of
a model: let suffice the simplest model that will perform
satisfactorily. When
several needles are lost in a haystack, rational behavior on the part
of the
tailor is to search until he finds one that is sharp enough to do the
sewing
job, not until he has found the absolutely sharpest one (which would
require
him to find all of them). But, this is not a recommendation to make no
enhancements to the model. Some models are "simply too simple" to fit
the realities under analysis.
APPENDIX.
MANAGERIAL ECONOMICS PRINCIPLES
Managerial
Decision Making
Principle
1. The business firm accomplishes enhanced
productivity by serving as a vehicle for organizing specialization and
division
of labor. (page 3)
Principle
2.
Business firms governed by hierarchical, authoritarian control
usually
can accomplish resource reallocation internally more efficiently than
can be
achieved by human interaction through market mechanisms on a purely
personal
level. (page 3)
Principle
3.
The management of a commercial enterprise is an exercise in
economizing.
(page 4)
Principle
4.
Shifting a firm’s organizational form from proprietorship or
partnership
to corporation may limit the liability of owners, enable access to
greater
financial resources, and facilitates specialization and division of
managerial
responsibilities and authority. (page 9)
Principle
5.
Divisionalization of a firm’s operations allows separate
management
teams to achieve more effective oversight, coordination, and control.
(page 5)
Principle
6. Strategic entrepreneurship may occur at
any
level in any organization, whether a new local venture or a
well-established
multinational enterprise, but should be accomplished at the highest
level of
authority commensurate with the mission. (page 12)
Principle
7. Rational human behavior consists of
trying to
maximize the value of some positive quantity, or to minimize the value
of
something perceived as having negative connotations.
(page 13)
Principle 8. When confronted by multiple goals, the
decision mode should be to maximize the value of a primary goal,
subject to
realization of satisfactory levels of subordinate goals. (page 14)
Principle
9.
The rational choice among alternative strategies is that which
yields
the largest sum of net benefits (positives less negatives), given the
decision
maker's set of preferences. (page 15)
Principle
10.
When a decision involves whether to do more or less of
something, the
rational choice is to continue doing more of it as long as marginal
benefit
exceeds marginal cost, or to continue doing less of it as long as
marginal cost
exceeds marginal benefit. (page 15)
Principle
11.
When a decision alternative may have multiple possible outcomes
and the
probability of each can be meaningfully estimated, the rational
decision is the
alternative that promises the largest expected value of possible
outcomes.
(page 16)
Risk
and Return
Principle 12. A
decision maker must decide whether the
higher expected value of a decision alternative is adequate
compensation for
the additional risk that must be assumed. (page 16)
Principle
13.
The maximin decision rule requires the decision maker to
identify the
worst-case outcomes and chose the one that yields the least-negative
effects.
(page 17)
Principle
14.
The minimax regret decision rule requires that the decision
maker choose
the decision alternative that minimizes the regret that follows from
failure to
select the best outcome. (page 17)
Principle
15.
Managerial decisions involve making relatively low-risk, routine
decisions in regard to processes that change in smooth, continuous
fashion,
about which much can be known or discovered, and to which marginal
analysis is
applicable. (page 18)
Principle
16.
Entrepreneurial decisions are risk-laden because they involve
innovative
discontinuities in operations, about which little can be known in
advance, and
to which marginal analysis is less likely to be applicable. (page 18)
Principle
17.
When stock ownership is widely dispersed, the personal interests
of
managers may ascend to dominance over the interests of owners. (page 21)
Principle
18.
When there are multiple interests making claims on the business
firm,
managers may perceive their role to be mediating among conflicting
claims
rather than pursuing the interests of owners. (page 22)
Principle 19.
When constituent mediation is addressed by optimization, the
identities
of the behavioral goal and its constraints will be exchanged from time
to time
as the concerns of one and then another constituency rise to the
surface. (page
26)
Principle 20. Whatever the actual goals pursued by the managers of business firms or the behavioral patterns with respect to them, profit maximization serves as a satisfactory proxy assumption underlying the theory of managerial decision making. (page 28)
Principle 21. Deliberate profit non-maximizing behavior may
be rational during particular short-run
time frames if justified by long-run considerations. (page 28)
Principle 22. A larger volume of profit may result as a by-product of successful entrepreneurship to provide well-designed, functional, high-quality merchandise than might have been achieved had profit been the primary object of pursuit. (page 30)
The
Long Run
Principle 23. The expectation of a benefit to be realized in the future is worth less to the decision maker than an equivalent benefit received immediately. (page 35)
Principle 24. Since future possibilities are worth less than present realities, expected future values may be discounted at an appropriate rate, usually taken to be the best market rate of interest for which the firm can qualify. (page 36)
Principle 25. The rate of return on an investment opportunity is the discount rate that is just sufficient to make the sum of the net income flows over the life of the investment opportunity just equal to its capital outlay. (page 36)
Principle 26. Most business decision makers are risk averse and attempt to manage risk. (page 37)
Principle
27. A decision to acquire additional
information should be based on a comparison of the benefits of the
additional
information relative to the cost of acquiring it. (page 38)
Principle
28. Risk assumption is an essential
entrepreneurial function.(page 38)
Principle
29. A risk-averse
decision maker is willing to accept a lesser certain sum
than the risky
possibility. (page 39)
Principle
30. The present value of a risky
investment alternative will be diminished by adding a risk premium to
the
discount rate to account for the risk. (page 39)
Principle
31. When inflation is expected to ensue
over the life of an investment opportunity, the present value of the
opportunity deflated by adding an inflation risk premium to the
discount rate.
(page 39)
Consumer
Behavior
Principle
32. A rational decision to produce a
good or service should be predicated upon the anticipation of an
adequate
demand for it. (page 41)
Principle 33. Conditioned-response behavior may be based upon the assumption that tomorrow will be like today because today is like yesterday. (page 42)
Principle
34. The rational decision criterion for
the
choice to acquire a consumer good or service is whether the expected
value of
the choice is greater than the cost of the acquisition. (page 43)
Principle
35. Most consumers tend to realize
diminishing marginal utility when consuming successive additional units
of most
goods or services. (page 44)
Principle
36. The rational decision criterion is to continue to consume more of a
non-addictive good or activity, even while realizing diminishing
marginal
utility, until the marginal value realized in consumption is no longer
greater
than the marginal cost of the acquisition. (page 44)
Principle
37. A firm wishing to promote the sale
of its product or service may implement a marketing strategy designed
to induce
the consumer to suffer the illusion that marginal utility declines at a
slower
rate than it does in reality. (page 45)
Principle
38. Intelligent consumers who rely upon
their experiences with ex-ante
estimates of expected values of satisfactions and ex-post
realizations of actual satisfactions are likely to be
resistant to efforts at manipulation of their preferences. (page 45)
Demand
Principle
39. Consumers tend to buy ever greater
quantities of a good or service at progressively lower prices, and ever
smaller
quantities of a good or service at progressively higher prices. (page
46)
Principle
40. Because of diminishing marginal
utility, a seller must offer the consumer a lower price to induce him
to
purchase more of a good or service. (page 46)
Principle
41. An increase in the price of a good
or service leads consumers to shift their purchases away from the good
or
service and to its substitutes. (page 47)
Principle
42. A decrease of the price of an item
in a consumer’s budget results in an implicit increase of the
consumer’s
income, thereby enabling the consumer to purchase of more of that good
or other
goods, or to underexpend his budget. (page 47)
Principle
43. A consumer’s purchases of a normal
good tend to increase as his income rises, and to decrease as his
income falls;
a consumer’s purchases of an inferior good tend to decrease as his
income
rises, and to increase as his income falls. (page 47)
Principle
44. The characteristics of normalcy and
inferiority are time and culture bound. (page 48)
Principle
45. In the case of a normal good, the
income effect reinforces the substitution effect; in the case of an
inferior
good, the income effect offsets the
substitution effect. (page 49)
Principle
46. During a period of expansion, the demands for normal goods or
services will
increase at the same or a faster rate than incomes are rising; during a
period
of decline, the demands for inferior goods will decrease more slowly as
incomes
fall, or they may actually increase. (page 49).
Principle 47. A firm’s own pricing decisions are likely to cause changes of competitor's demands, and may induce strategic responses from them. (page 50)
Principle 48. An increase of the price of a complement to a product produced by a firm will tend to decrease the demand for the firm’s product; and vice versa. (page 50)
Principle 49. In an imperfectly competitive market, as the price of a product decreases, the total revenue from selling it may at first increase, then reach a maximum, and eventually decrease. (page 50)
Principle 50. When price is high, the quantity effect of a particular price change is a large proportion of the small quantity demanded; it becomes a smaller proportion when quantity demanded increases as price falls. (page 51)
Principle 51. Any particular price change is a small proportion of a high price, but becomes a larger proportion of price as price falls. (page 51)
Principle 52. When price initially is high and quantity sold is minimal, total revenue at first increases as price falls because the positive quantity effect outweighs the negative price effect; as price falls further, the increasing price effect eventually begins to outweigh the diminishing quantity effect to cause total revenue to decrease. (page 51)
Principle 53. Price elasticity of demand may be measured as a percentage change in quantity demanded divided by the percentage change in price, assuming no other causative factor has changed. (page 52)
Principle 54. When price initially is high and begins to fall, demand is elastic with respect to price; as price falls farther, demand becomes progressively less elastic and eventually becomes inelastic with respect to price. (page 52)
Principle 55. Revenue from selling a product can be increased by cutting price when demand is elastic with respect to price; revenue can be increased by raising price when demand is inelastic with respect to price. (page 52)
Principle 56. Average revenue, the revenue per unit sold,
is equivalent to product price; in highly competitive markets, average
revenue
remains approximately constant as unit sales increase because it is not
necessary to lower price in order to sell more units of product; in
imperfectly
competitive markets, average revenue decreases as unit sales increase
because
of the necessity of lowering price to sell more product. (page 53)
Principle 57. Average revenue, the revenue per unit sold,
is equivalent to product price; in highly competitive markets, average
revenue
remains approximately constant as unit sales increase because it is not
necessary to lower price in order to sell more units of product; in
imperfectly
competitive markets, average revenue decreases as unit sales increase
because
of the necessity of lowering price to sell more product. (page 53)
Principle 58. If the goal of the firm's management is
profit maximization, the appropriate price-related decision criterion
for
profit maximization is MR. (page 54)
Principle 59. Incremental revenue is easier to compute than
marginal revenue, but it will be only an approximation to MR and may
over- or
understate MR, thereby leading to erroneous price-change conclusions.
(page 54)
Principle 60. When a price decision maker, lacking sufficient information to compute MR, employs an iterative approach to seeking the price-quantity combination that will maximize profit, IR may serve as the effective price decision criterion when compared to incremental cost. (page 55)
Principle 61. Market research may succeed in gaining information adequate to estimating demand at the startup of sales of a product in a new market. (page 56)
Principle 62. The estimate of a product’s price elasticity of demand may be over- or understated when demand determinants other than the product's own price have increased or decreased the demand simultaneously with a change of product price. (page 57)
Principle 63. Even when a product’s price remains unchanged, a demand increase will lower price elasticity of demand and facilitate a future price increase; a decrease of a product’s demand will increase its price elasticity and militate in favor of cutting price. (page 58)
Principle
64. A
marketing effort may enhance perceptions of the image of the product in
the
minds of consumers to render demand less elastic with respect to price
and
enable raising price to increase revenue. (page 58)
Production
Principle
65. Production
is the transformation of raw substances (including human labor) into
other
forms that are distinguished by their more desirable functional,
locational, or
temporal characteristics; production includes gathering, transporting,
and
holding activities. (page 59)
Principle
66.
The entrepreneurial functions of production are the perception
of an
unfilled market demand and the assumption of risk in organizing a
productive
process to exploit the market potential. (page 60)
Principle
67.
The managerial tasks of production are to select an appropriate
technology for implementation of production, to discern the right
volume of
output to meet the market demand, and to choose the optimal combination
of
inputs to produce the target level of output. (page 60)
Principle
68.
The short run is a period of time during which at least one of
the
inputs in a production process can be changed, but other inputs remain
fixed in
quantity; in the long run all inputs can be changed. (page 62)
Principle 69. Diminishing returns, characterized by output increasing at a decreasing rate as a variable input is increased relative to other inputs that are fixed in quantity, governs all real-world production processes. (page 63)
Principle 70. Returns to scale are characterized by all of the physical inputs into a production process changing in the same direction and by the same proportion which may be greater or less than 100 percent, and may be positive or negative. (page 63)
Principle
71. A
technological change that increases output capacity is an advance that
improves
productivity; a technological change that enables the same volume of
output to
be produced with smaller quantities of inputs enhances efficiency.
(page 65)
Principle
72.
An input-twisting technological change may use more of one type
of
resource in order to conserve on the use of another type. (page 66)
Principle 73. The appropriate technology for implementing any productive process is the one that employs extensively the most abundant (cheapest) resources, and conserves most on the scarcest (dearest) resources. (page 66)
Principle 74. When a technological change is implemented during capital replacement or expansion, the firm's production relationships should be respecified. (page 66)
Principle 75. The ultimate enabling and limiting conditions that govern production relationships are the entrepreneurial ability, managerial capacity, and technologies that can be understood and implemented by the firm. (page 67)
Principle 76. Where joint products result from a common production process, it may be necessary to identify output as a product mix that is measured in value rather than quantity terms. (page 67)
Principle 77. Output data in production relationships are measured in flows; where input data for flows are unavailable or too costly to capture, available data for associated input stocks may be used as proxies for the missing flows data in the production relationships, but the available data are only approximations for the information needed. (page 68)
Principle 78. Management may use production input-output relationships to try a "what-if" approach to understanding the likely effects of alternatives to the present input combinations. (page 68)
Costs
Principle 79. Any aspect of a production process that has negative implications for the production decision maker is a cost of production that is relevant to the production decision, irrespective of whether or not it is denominated in money terms. (page 71)
Principle 80. Psychic and opportunity costs, implicit costs that are not denominated in money terms, are excluded from formal accounting systems but nonetheless are relevant to production decision making. (page 72)
Principle 81. Formal accounting systems are designed to recognize explicit accounting costs that are denominated in money terms, but which omit all implicit costs that are not denominated in money terms. (page 72)
Principle 82. Firms make explicit disbursement accounting cost payments to parties who provide services, resources, or materials to the firm; depreciation is a non-disbursement explicit cost that allows for decline in the value of the capital stock attributable to the using-up of a portion of the firm's capital equipment during the accounting period. (page 73)
Principle 83. Because depreciation does not require any explicit payment but still is allowed as an expense against money revenue in computing the taxable profits, it may be regarded as a means of outlay recovery, supplying funds internally to the firm to finance subsequent reinvestment in its capital stock. (page 74)
Principle 84. A firm’s accumulated depreciation allowances could either exceed or be less than the real wearing out of its capital equipment; in the former case, the capital equipment will cease to function before the full amount of the capital outlay has been recovered; in the latter case, the capital equipment continues to function productively even after it is fully depreciated. (page 74)
Principle
85.
Cost factors that do not change in response to any particular
managerial
decision are not relevant to that decision.
(page 75)
Principle
86.
Variable or direct costs change with the level or rate of; fixed
or
overhead costs are associated with the existence of the manager, the
plant, and
the equipment. (page 75)
Principle
87.
Variable costs are relevant to short-run rate-of-production
decisions;
fixed costs are not relevant to short-run rate-of-production decisions.
(page 76)
Principle
88.
All costs are variable in the long run; fixed costs, though
irrelevant
to rate-of production decisions in the short run, are relevant to the
scale-of-operations decisions of the long run. (page 76)
Principle
89. Preventive maintenance and repair
expenses are not relevant to current-period rate-of-production
decisions;
preventive maintenance expenses occur in one period, but pertain to
subsequent
periods; repair expenses occur in one period, but pertain to prior
periods. (page 76)
Principle
90. While spillover costs are not
relevant to rate-of-production decisions in the short run, they have
the
potential to become relevant to managerial decision making in the long
run.
(page 77)
Principle
91. The computation of a firm’s
accounting profit may over- or understate its true (economic) profit
and
thereby lead to erroneous decisions. (page 78)
Principle
92. All economic costs must be paid (or
at least given adequate recognition or compensation) in order to retain
the
services of all productive resources supplied to the firm, whether or
not money
disbursements were made and whether or not they are recognized in
formal
accounting systems. (page 78)
Principle 93. The economic cost of any productive resource
is its opportunity cost, i.e., an amount that is at least as large a
return as
it can realize in its most favorable alternative use. (page 79)
Principle
94. A
critical distinction between "good management" and "poor
management" may lie in the ability of the decision maker to recognize
the
implicit costs and benefits of managerial decisions. (page 79)
Principle
95. Diminishing returns serves as a common governing principle in the
behaviors
of both production and cost relationships. (page 79)
Principle
96. In any production process, beyond
some point further increases of the variable input results in output
increasing
at a decreasing rate, and production cost increasing at an increasing
rate.
(page 80)
Principle
97. Average variable cost may decrease
over an initial range of output, but eventually it reaches a minimum
and then
increases as ever more of the product is produced. (page 81)
Principle
98. The marginal cost for any production
process at first may decrease, but inevitably it reaches a minimum and
increases; MC is less than average variable cost when AVC is
decreasing, equal
to AVC when AVC is at minimum, and greater than AVC when AVC is
increasing.
(page 81)
Principle
99. Average variable cost can serve as an output decision criterion if
the goal
of the firm is to minimize per-unit operating cost. (page 82)
Principle
100. If the goal of the firm's
management is profit maximization, the appropriate cost-related
decision
criterion for profit maximization is MC. (page 82)
Principle
101. Incremental cost is easier to
compute than marginal cost, but it will be only an approximation to MC
and may
over- or understate MC, thereby leading to erroneous output-change
conclusions.
(page 82)
Principle
102. Overhead costs are "sunk and
gone," and are thus are not relevant to short-run production decision
making; after the point of decision, they may be regarded purely as
information
to be considered in any forth-coming long-run decision set. (page 83)
Competition
Principle
103. Entry into and exit from a
competitive market is cheap and easy. (page 89)
Principle 104. Once
an entrepreneur has decided to enter a
competitive market, there is little incentive to exercise further
entrepreneurship, except to exit the market. (page 89)
Principle
105. Firms in competitive markets have
little ability to acquire special market knowledge, to acquire and use
special
technology, or to differentiate or promote their products. (page 89)
Principle
106. Managers of firms in competitive
markets become aware of changing market conditions almost
simultaneously and
adjust at approximately the same rates. (page 89)
Principle
107. Sellers in competitive markets are
unaware of or concerned about the identities of other sellers in the
same
market. (page 89)
Principle
108. Since they can sell all that they
can produce at the market price, sellers in competitive markets have
little
incentive to experiment with price. (page 89)
Principle
109. Profits in a competitive market
tend toward an economically normal level; although super- and subnormal
profits
may occur, they are short-lived due to easy entry and exit from the
market.
(page 89).
Principle
110. When a competitive firm’s marginal
revenue is greater than marginal cost, output should be increased in
order to
increase profit; when marginal cost is greater than marginal revenue,
output
should be decreased in order to increase profit; profit is maximized
when
marginal revenue is equal to marginal cost. (page 91)
Principle
111. The manager of a firm should shut
down production when the revenue generated by selling the output cannot
cover
even the operating (or variable) costs of producing the output. (page
91)
Principle 112. Fixed
costs, which continue in the short run
whether or not the firm operates, can be saved (or avoided) only by
exiting the
industry, a long-run entrepreneurial decision. (page 91)
Principle 113. Entry
into a competitive market will increase
market supply relative to market demand and cause market price to fall.
(page 92)
Principle
114. Over-entry into a competitive
market may cause market price to fall below the level of per-unit
operating
costs of some firms whose entrepreneurs may decide to leave the
industry. (page
93)
Principle
115.
Once market price has reached a level that is just covering the
per-unit
costs of all firms still in the industry and entrepreneurs are earning
no
super-normal profits, the industry is in long-run equilibrium and will
continue
in this state until market demand or supply changes to disturb the
equilibrium.
(page 93)
Principle
116.
In a dynamic world, equilibrium is likely to be short-lived
condition
may never actually be observed; the manager of a firm selling in a
competitive
market cannot afford to rest in thinking that an equilibrium state will
persist. (page 93)
Monopoly
Principle
117.
Monopoly position may be based upon scale economies,
technological
uniquities that have been developed internally or acquired externally,
grant of
exclusive position by government, exclusive control of a resource, or
predatory
behavior culminating in the elimination of former competitors. (page 96)
Principle
118.
Both entry and exit from a market may be difficult or costly for
a
monopolist. (page 96)
Principle
119.
Although a monopolist has exclusive control over the market
price of a
product, it is still subject to the constraints of market demand. (page
96)
Principle
120.
If a monopolist can erect and maintain adequate barriers to
entry,
supernormal profits may persist. (page 96)
Principle
121. If
profit maximization is the monopolist’s objective, output should be
increased
if marginal revenue exceeds marginal cost; if marginal cost is greater
than
marginal revenue, output should be decreased; profit is maximized when
marginal
revenue is just equal to marginal cost. (page 96)
Principle
122.
To accomplish the desired objective of increasing profits, a
monopolist
must not only change quantity produced when marginal revenue is not
equal to
marginal cost; it must also change product price in the proper
direction in
order to prevent inventory build-up or draw-down. (page 98)
Principle
123.
Even if the monopolist does not have perfect knowledge of its
revenue
and cost conditions, an iterative process (trial and error) employing
as
decision criterion the comparison between incremental revenue and
incremental
cost can lead the monopolist toward the profit maximizing price and
output
levels. (page 98)
Principle
124.
if the objective of the monopolist is growth rather than profit,
the
monopolist should choose the largest quantity that can be produced and
sold
without incurring loss, and lower price accordingly to prevent
inventory
build-up. (page 98)
Monopolistic
Competition
Principle
125.
In a monopolistically competitive market, products may be
differentiated
in fact by color, texture, structure, function, etc., or only in the
imagination of the consuming public. (page 103)
Principle
126.
Monopolistically competitive
firms may develop
or acquire managerial distinctives and technological variations that
are
sufficient to differentiate products among sellers and enable pursuit
of
marketing strategies. (page 103)
Principle 127. The firm selling in a monopolistically competitive market is a competitor in its close-substitute product market, but a monopolist of its brand name and product design. (page 103)
Principle
128.
Each monopolistic competitor perceives changes only in "the
market", and thus reacts only to "the market" rather than to the
particular actions of any specific competitor whose identity can be
known.
(page 103)
Principle
129.
Each of the n typical firms in a monopolistically competitive
market can
expect to exploit a 1/n share of the market demand for the close
substitute
product group; entry of additional firms selling close substitute
products will
reduce the typical firm’s share-of-market demand. (page 104)
Principle 130. Enough firms will enter the monopolistically competitive market until all supernormal profits have been competed away, and each of the typical firms is left just barely covering per-unit costs. (page 105)
Principle 131. In monopolistically competitive market (or group) equilibrium, a typical firm will be led to build a slightly smaller plant, operate it at a slightly lower rate of output, and charge a slightly higher price compared to a representative firm in equilibrium in a purely competitive market, and end up realizing no more profit than would have been realized by the representative pure competitor. (page 105)
Principle 132. The monopolistic competitor's only serious hope for sustaining supernormal profits is to make the product and its support system (location, convenience, delivery, service, etc.) as distinctive in a positive way as possible, and thereby to prevent decrease of its share-of-market demand. (page 106)
Principle 133. An important question for a monopolistic competitor is whether an effort to differentiate and promote the product will increase demand and generate enough additional revenue to cover the costs of differentiation and promotion; if other firms in the same close-substitute product market can match the differentiation and promotion effort, they may all end up spending more and enjoying less profit. (page 106)
Oligopolistic
Competition
Principle
134. If
competitors are essentially oblivious of each other's identities, and
if
profits tend to be dissipated due to entry of new firms into the
market, then
monopolistic competition is almost certainly the appropriate model to
apply. (page
109)
Principle
135. If competitors are conscious of
each other's identities to the point of devising market strategies
oriented
toward specific competitors, an oligopolistic competition model should
apply. (page
109)
Principle
136. Scale of operation, technological
complexity, predatory behavior, or governmental grant of exclusive
position (by
license, certification, franchise, patent, or trademark) may pose
effective
barriers to entry by new competitors into the oligopolistically
competitive
market and enable supernormal profits to be sustained. (page 111)
Principle
137. Because there are few enough
sellers for each to know the identities of the others in an
oligopolistically
competitive market, virtually every
market-oriented and production decision needs to take into account the
range of
possible reactions by competitors as well as the most likely reaction.
(page 111)
Principle 138. Difficulties with pricing strategies in the
oligopolistically competitive market may lead managers to prefer
non-price
forms of competition. (page 111)
Principle 139. Difficulties with price leadership/followership relations in an oligopolistically competitive market may lead managers to implement deliberate profit-non-maximizing strategies oriented toward growth or preserving market share. (page 111)
Principle 140. Design, service, or promotion costs (fixed costs) that simply cancel out each other's efforts in a oligopolistically competitive market may leave market shares essentially unchanged but diminish profits. (page 112)
Principle 141. A monopoly model may suffice to analyze an oligopolistic market involving collusion (overt or covert), cartelization, trusts, and acquisitions and mergers to achieve monopoly. (page 113)
Principle 142. The most common pattern of oligopolistic
interaction where antitrust laws are vigorously enforced is likely to
be some
form of price leadership/followership. (page
114)
Principle
143. Common patterns of oligopolistic
interaction where antitrust laws are vigorously enforced include
asymmetric,
barometric, dominant firm, and differential characteristics price
leadership.
(page 115)
Principle
144. An oligopolistic firm that does not
meet the preferred lower price of a competitor can expect to lose
market share
to the competitor and prefer a lower price; the competitor, gaining
market
share, will prefer a higher price; market shares will continue to
diverge until
the preferred prices converge. (page 115)
Principle
145. The bases for oligopolistic price
leadership may include differences in costs of inputs, differences in
plant
sizes, or initial unequal market shares; the oligopolistic competitor
preferring the lowest product price in order to maximize profits has
the
potential to be the price leader in the market. (page 116)
Principle
146. Oligopolistic interaction may be
local, national, or international in scope; even if there are many
local firms
supplying close substitute products, awareness of identity and
interactive
strategy among near neighbors militates in favor of an oligopolistic
model
rather than a monopolistically competitive model. (page 118)
Principle
147. Oigopolistic competition at the
larger-firm end of the firm size spectrum may contribute to
technological
advance in productive efficiency, better product designs, and better
service of
the product. (page 118)
Principle
148. The competition present in the
oligopolistically-competitive market in the form of price
leadership/followership can provide societal because the threat of
market share
loss will induce competitors to meet the lowest price preferred by any
firm in
the market. (page 118)
Extensions
Principle 149. If a change of any of the assumed-constant
determinants results in an increase or a decrease of demand (depending
upon how
the determinant changed) without being recognized by the manager, an
identification problem may cause a decision criterion to be over- or
understated. (page 121)
Principle 150. It may be possible to make non-price determinants of demand into components of the firm's promotional strategy, e.g., a successful advertising campaign may increase the firm's demand or prevent it from decreasing. (page 122)
Principle
151. A change in any of the non-quantity
determinants of costs can be expected to change the per-unit costs of
the firm,
and thus the profit maximizing combination of output and price. (page 122)
Principle 152. It may be possible to make non-quantity
determinants of costs into components of competitive strategy, e.g., to
develop
or acquire a more efficient (i.e., lower cost) technology, or to find
or
negotiate lower-priced sources of supply of the materials or labor
inputs than
competitors can employ. (page 123)
Principle
153.
Varying demand conditions for the same product in separable
markets make
it possible for a firm to increase revenue by practicing price
discrimination,
i.e., charging different prices for the same product where there are no
differences in the costs of serving the different customers. (page 123)
Principle
154.
The costs of market segmentation to enable practicing price
discrimination may outweigh the increased revenue benefits of price
discrimination. (page 124)
Principle
155.
Overhead costs are not relevant to short-run production
decisions, but
in order for any item currently in the product mix to continue to be
produced,
its price must make an adequate contribution to its overhead costs as
well as
cover all of the direct costs of its production. (page 126)
Principle
156.
Since there is no objective criterion for allocating overhead
costs among
multiple products, this assessment must be based upon the judgment of
the
decision maker in any question of deleting or adding products to the
firm’s
product mix. (page 126)
Principle
157.
Items should be added to a firm’s product mix in descending
order of
perceived profitability. (page 127)
Principle
158.
For multiple products jointly produced in fixed proportions,
output
should increase as long as joint marginal revenue exceeds marginal
cost, or
decrease output if joint marginal revenue is less than marginal cost;
profit
maximization occurs at the output level where marginal cost is equal to
joint
marginal revenue and marginal revenues for both products are positive.
(page 128)
Principle
159.
If the marginal revenue of any one of jointly produced products
would be
negative, enough of it should be withheld from the market for its
marginal
revenue to become zero. (page 128)
Principle
160.
Altering the jointly-produced output mix may require a long-run
adjustment to plant, equipment, and technology to be effected through
capital
investment. (page 128)
Principle
161. Approaches for dealing with the
problems of coordination and control have included distinguishing line
from
staff functions, the functional specialization of line managers to ever
narrower realms of discretion and responsibility, the establishment of
multiple
tiers of managerial responsibility organized along hierarchical lines
of
authority, and divisionalization of the firm's operations. (page 129)
Principle
162. Horizontal divisions of a firm must
compete with one another for the firm’s limited financial resources.
(page 130)
Principle
163. In perfectly vertically segmented
production process, each of the firms in the vertical sequence would
maximize
profits by finding the price and quantity for which marginal revenue is
equal
to marginal cost. (page 131)
Principle
164. In the case of a perfectly vertically-integrated firm, efficiency
(and hence, profitability) is served by applying the marginal decision
criteria
among its vertically related divisions. (page 131)
Principle
165. Realistic transfer prices are
important to avert the appearance of deficient and excessive profits
and to prevent
under- and over-allocation of firm resources among its divisions. (page
132)
Principle
166. A parent firm may shift cash from a
subsidiary to itself by pricing items shipped to the subsidiary above
costs;
vice-versa, if items shipped from the subsidiary to the parent is
overpriced
relative to costs, cash is shifted from the parent to the subsidiary.
(page 132)
Principle 167. An intermediate product division manager may
find it more profitable to sell to outsiders at market prices than to
transfer the
intermediate product to the next in-house division if the transfer
price of the
intermediate product is set too low. (page 133)
Principle 168. A too-high transfer price for an intermediate product will lead to vertical disintegration if the division manager is authorized to acquire the intermediate product from external sources at lower market prices. (page 133)
Principle 169. A vertically integrated firm can maximize profit at the output level at which firm marginal revenue is just equal to marginal cost at the last stage of production. (page 134)
Principle
170. Given a decision to produce a
quantity of final product to be sold at the profit maximizing price,
the
transfer price for each intermediate product is its division’s marginal
cost at
that output level. (page 134)
Realism and Accuracy
Principle
171. The great virtue of simple models
is that they allow us to peer through the haze of complexity in order
to come
to understandings of the principles governing the behaviors of economic
relationships without the encumbrances of a plethora of detail. (page
137)
Principle
172. Rational decisions are made by
proceeding from an assessment of the best available information about
the
situation based on an accumulation of experience in similar
circumstances
compared to the decision criteria discerned in the academic study of
the
underlying principles. (page 138)
Principle
173. Simplistic models can be used is to
simulate small parts of the complex business decision context. (page
139)
Principle 174. Simplistic models may be elaborated to handle the intricacies of the situation by making the underlying assumptions ever more realistic and the structure of the model ever more accurately descriptive of the real context that is being modeled. (page 140)
Principle 175. It may not be possible to construct a model that is perfectly realistic in its assumptions and accurately descriptive in its structure without making it as complex as the real situation from which it is supposed to be an abstraction. (page 140)
Principle
176.
A simplistic model based on
unrealistic
assumptions may perform satisfactorily; what is important is whether
people
behave as if the assumptions of the model are realistic, even if the
assumptions bear little or no resemblance to the reality.
(page 140)
Principle
177. The
cost of specifying an ever more complex model probably obeys the
principle of
diminishing returns (or its variant, the law of increasing costs) no
less so
than does any other real production phenomenon. (page 141)
Principle
178. The
economic criterion for elaborating a model is whether the value of the
additional effectiveness of the model is worth the extra cost of
improving the
fit. (page 141)
BACK TO CONTENTS
GLOSSARY
OF TERMS USED IN THIS BOOK
This glossary contains economic terms that are used in the book plus some additional terms that are used in other glossary entries. The included meanings, elaborations, and examples pertain specifically to the contexts of discussions in this book. Undoubtedly, many of the terms have other meanings than those included here.
accounting cost, the explicit money-denominated costs of
conducting
business activity; accounting costs exclude opportunity and psychic
costs
experienced by the entrepreneurial or managerial decision maker;
accounting
costs are recognized in formal bookkeeping systems.
accounting profit, the difference between the total of
monetary
revenues and the sum of all explicit costs, both disbursement and
non-disbursement; accounting profit may omit non-pecuniary benefits and
costs
that may accrue to the entrepreneur and are relevant to managerial and
entrepreneurial decision making.
altruism, an attitude that suppresses self interest
in the
interest of other members of society; a constraint upon rational self
interest.
antitrust law, legal constraints upon the attainment and
exercise
of monopoly power or position by business firms; a.k.a. antimonopolies
law.
appropriate technology, that technology that uses the most abundant
and
least expensive resources, and conserves upon the use of the scarcest
and most
costly resources.
as if assumption, the proposition that the realism
of the premises underlying
a theory are less important than the ability of the theory to explain
and
predict behavior, i.e., what is important is that people behave as
if
the assumptions about their behavior are true, whether or not the
assumptions
are factually descriptive.
asymmetrical
price leadership, occurs when
a firm
in oligopolistic competition is successful in inducing competitors to
follow a
price change in one direction, but not in the other; the kinked demand
model is
reputed to be an explanation of asymmetrical price leadership; may also
be
applicable to non-price modes of leadership.
attitude of demand, the slope of the price-quantity demand
relationship
plotted in two-dimensional coordinate space and referred to as a
“demand curve”
that is downward sloped in conformance to the Law of Demand; a
shallowly-sloped
demand curve is said to exhibit a poor attitude because demand is
elastic and
requires cutting price to increase total revenue because the positive
quantity
effect of the price change outweighs the negative price effect;
marketing
efforts to render the demand curve more steeply downward sloped will
decrease
its price elasticity or render demand inelastic with respect to price
and
enable price increases to increase total revenue because the positive
price
effect will outweigh the negative quantity effect.
average revenue, total revenue from the sale of a product
divided by
the number of units sold; equivalent to the price of the product.
average variable cost, operating cost per unit of the product,
excluding
all fixed or overhead costs; AVC may decrease over an initial range of
output,
but eventually it reaches a minimum and then increases as ever more of
the
product is produced; the increasing range of AVC is a manifestation of
the
principle of diminishing returns; AVC may be an appropriate criterion
for
identifying the per unit least cost level of output, but not for
identifying
the profit maximizing level of output.
bads,
nuisance goods, i.e., things that yield negative satisfaction; items
to be gotten rid of; things to pay others to dispose of.
barometric price leadership, occurs when the manager of one of the
competitors in
an oligopolistic market establishes a reputation for perceptiveness and
sensitivity to changing market conditions, and a record of making
timely and
successful adjustments to those perceived changes, such that
managements of
competitor firms then watch the price leader's activities and attempt
to
emulate his decisions; may also be applicable to non-price modes of
leadership.
barriers
to entry, various conditions
or devices that serve monopoly and oligopoly
markets to prevent other firms from entering the market in competition
with
extant firms, including scale of operations, technological complexity,
predatory behavior, and governmental grant of exclusive position (by
certification, franchise, patent, or trademark).
barter economy, one in which it is common to exchange
tangible goods
and services or each other (“in kind”); in distinction to a monetized
economy
in which goods and services are commonly exchanged for money.
bond,
a liability of a corporation issued in order to raise financial
capital; in case of failure of the business enterprise, bonded
indebtedness
must be satisfied before any equity shares may be liquidated.
business organization, forms of, ways in which business firms may be
structured, including proprietorship, partnership, corporation, and
combinations thereof.
by-product, scrap resulting from the production of a
product that
may have marketable value; may be treated as a joint product in the
production
process.
capital consumption, the using up of the productive ability of
plant and
equipment due to wear and weathering; capital consumption is recognized
by
depreciation allowances in formal accounting systems.
capriciousness, acting upon whim without devoting thought
to
consequences of the action; acting without deliberate choice.
certainty, a special case of risk in which there is
only one
possible outcome of an event, and the probability of its occurrence is
100
percent.
certainty equivalent, a risk management approach in which the
decision
maker asks himself what certain sum he would be willing to accept in
lieu of
the risky outcome at issue; a risk-averse
decision maker can be expected to indicate a lesser
certain sum than the risky possibility, whereas a risk
preferer would have to have a larger certain sum
as a compensation
for the insult of removing the gamble from his consideration.
complement, a good that is consumed along with another
good; an
increase in the price of a complement for a good may cause the quantity
demanded of the good to decrease.
conditional probability, the product of the probabilities of all
prior stages
in the unfolding of an event.
conditioned response, an action based upon an implicit summing-up
of a
current circumstance compared with accumulated past experience.
conglomeration, the structure among divisions or
subsidiaries of a
firm that are not related to one another by vertical structure or
product mix;
the principal motivation to conglomeration is greater financial
resources or
exploitation of well-regarded brand name; conglomeration enables
product
diversification so that the firm is not highly dependent on a single
product.
constituent mediation, a political process in which the managerial
decision
maker must address and play-off against each other the divergent and
conflicting interests of parties who are associated with the firm, who
can make
claims against the firm, or who are innocent third parties to the
firm’s
operations; constituent mediation may involve optimization (i.e.,
maximization
subject to constraints) where the primary goal is ever changing to the
concern
of the constituent currently making the current or the most insistent
complaint
or claim.
coordination and control, managerial problems emerging with growth in
the size
of an organization; often addressed by divisionalization of the firm,
the
functional specialization of managers to ever narrower realms of
discretion and
authority, and the establishment of multiple tiers of managerial
responsibility
along hierarchical lines of authority.
corporation, a business organization chartered by
government
authority and accorded status of a legal person; corporations are
empowered to
issue equity shares (stock) in themselves and instruments of
indebtedness
(bonds) to raise financial capital, to conduct business activity of
production
and distribution nature (tangible goods and intangible services), to
employ or
purchase and control the use of productive resources, and to sue and be
sued in
courts of law; the personal fortunes of shareholders in a corporation
are
insulated from liability that may descend upon the corporation itself
in the
sense that the most that a shareholder may lose is the amount invested
in
shares of the corporation’s stock; in most countries, the profits of
corporations are taxed, and then the net income of corporations
(profits) that
are distributed to owners (shareholders) of the corporation are taxed
again as
personal income of the recipients; corporations may engage in market
transactions that allocate resources among users, including
corporations, but
resources are allocated within corporate structures by exercise of
hierarchical
authority.
corporate person, the legal designation granted by the
government
agency that charters a corporation; corporate personhood sets it apart
from any
person or entity involved with the corporation as owner, employee,
manager,
supplier, or customer; the legal corporate personhood of the
corporation means
that the corporation can sue and be sued in courts of law; the
corporate person
has a life apart from the lives of any entities associated with the
corporation, and the corporation does not expire when any single
shareholder
expires (as is the case of a partnership); however, a corporate person
may die
(cease to exist) when it enters bankruptcy that distributes its
remaining
assets to liability claimants, including bond holders, and finally
equity share
holders.
cost,
the negative aspects of an activity; accounting costs are those
explicit negatives that are denominated in monetary terms; “real” or
economic
costs include all psychic and opportunity costs in addition to
money-denominated costs.
cost accounting system, a formal system intended to recognize all
explicit,
money-denominated costs of business activity, but excluding any psychic
and
opportunity costs experienced by the managerial or entrepreneurial
decision
maker.
cost minimization, a common behavioral assumption about
managerial
decision making; the level of output that achieves cost minimization
rarely
coincides with that for profit maximization.
decision rules, rules for situations involving uncertainty
where the
outcomes cannot be identified or their probabilities of occurrence
cannot be
meaningfully assessed; examples include the maximin and minimax regret
decision
rules.
default forecasting, the assumption that tomorrow will be like
today
because today is like yesterday.
deliberate choice, selecting a courses of action from among a
range of
possibilities after consciously comparing the likely benefits of an
action to
the costs of the action.
demand, the
desire for a good or service, together with the
purchasing power to make the desire effective, both backed by the
willingness
of the consumer to part with the purchasing power.
demographic market separation, the segmentation of markets based on age,
race,
ethnicity, religion, place of birth, citizenship, etc., that may enable
price
or service discrimination.
depreciation, the economic phenomenon of wear and
weathering that
reduces the productive capacity of capital equipment.
depreciation allowance, a non-disbursement explicit cost recognized
in
formal accounting systems; the depreciation allowance is intended to
recognize
the real economic phenomena of wear and weathering of capital equipment; depreciation allowance amounts and rates
typically are specified and constrained by the tax authority, and
therefore may
diverge from the real wear and weathering phenomena.
differential
characteristic price leadership,
oligopolistic market competitive behavior patterns based on differences
in
per-unit production costs, sizes of plants, or market shares.
differentiated oligopoly, a market structure populated by a small
number of
firms that are aware of each others’ identities and
that sell a products which may be
distinguished from the products sold by competitors by physical
characteristics
or only in the imaginations of the consuming public.
differentiation, product, a characteristic of monopolistic
competition and oligopoly which is manifested in product distinctives
in the
forms of color, texture, structure, function, etc., or only in the
imaginations
of the consuming public; the ability to differentiate its product from
those of
other sellers in the same market enables a firm to conduct marketing
efforts;
perceived differentiation may be a result of marketing effort.
diminishing marginal utility, the fundamental principle of consumer
behavior that
normal people consuming normal goods or activities will eventually
experience
ever smaller increments of satisfaction as ever more of the good or
activity is
consumed; goods or activities subject to compulsion or addiction do not
obey
the principle of diminishing marginal utility.
diminishing returns, the short-run phenomenon of output
increasing at a
decreasing rate as one input increases, all others remaining unchanged;
though
commonly described with respect to labor, diminishing returns may occur
with
respect to any input; the principle of diminishing returns serves as a
common
governing principle in the behaviors of both production and cost
relationships.
direct costs, those costs that change with the rate of
production;
a.k.a. variable costs; a.k.a. operating costs.
disbursement costs, those that result in money out-payments by
the
business firm to parties who provide services or supply resources to
the firm.
discounting, reducing the expected future value of an
asset or a
prospective investment to reflect the remoteness of the long run; the best market rate of interest for which
the firm can qualify is used as a
discount rate on the premise that the equivalent of the expected future
value,
less the cost of interest, can be had at present by borrowing the
future sum;
the discounting computation is to divide the expected future value of
the asset
by 1 plus the decimal equivalent of the interest rate; e.g., if the
interest
rate is 4 percent, the discount denominator is 1.04.
dispersion of ownership, widespread distribution of corporate shares
so that
no single shareholder possesses a controlling interest in the
corporation.
division, a separate productive activity within a
corporate
business organization over which top-level management authority
appoints a
subsidiary management teams to the end of achieving greater oversight,
coordination, and control that can be exercised by the top-level
management
authority.
division of labor, the process of dividing the activities
required to
produce a good or service and spreading the activities of a productive
process
across a number of workers in order to increase worker efficiency.
divisionalization, the process of establishing separate
productive
activities within a corporate business organization and the appointment
by
top-level management authority of subsidiary management teams to the
end of
achieving greater oversight, coordination, and control of the separate
productive activities than possible by the top level management
authority
within the business organization.
dominant firm price leadership, an oligopolistic market structure
consisting of a
dominant firm surrounded by a competitive fringe of smaller firms; the
dominant
firm behaves as a benevolent monopolist, tolerating the existence of
the
smaller firms and allowing them to sell any amount of the product that
they
wish at the price that the dominant firm prefers; the dominant firm
then takes
its demand to be the residual of the market demand not met by the
competitive
fringe firms, and proceeds to behave as a pure monopolist in maximizing
profits.
double taxation, the phenomenon in most countries that the
net profit
of a corporation is taxed at a corporate tax rate, and then any
dividends
distributed by the corporation to shareholders are taxed as personal
income.
economic functions of marketing, upon introduction of a new product or entry
into a
new market, to estimate the initial demand conditions; subsequently, to
increase the product demand, or prevent it from decreasing; and to
improve the
attitude of the demand relationship or prevent its attitude from
deteriorating.
economic problem, the juxtaposition of the insatiability of
human
wants against the scarcity of resources in nature; the economic problem
requires the efficient use of available resources to meet as many of
the human
wants as possible.
economic profit, the difference between the sum of all
benefits
accruing to a firm (or its entrepreneur) and the sum of all negatives
suffered
by the firm (or its entrepreneur), including opportunity and psychic
costs as
well as explicit disbursement and non-disbursement costs; economic
profit
includes all benefits and costs that are relevant to managerial and
entrepreneurial decision making, and may be greater or lesser than
accounting
profit; economic profit is a more appropriate criterion for managerial
and
entrepreneurial decision making than is accounting profit that omits
some
relevant benefits and costs.
economics, the study of human need relative to the
scarcity of
resources in nature, and society’s institutional relationships for
dealing with
scarcity, including choosing the product mix, determining methods of
production, allocating the scarce resources, and distributing the
output of
productive processes to the members of the society.
economy, the set of a society’s institutional
arrangements
that achieve selection of its product mix, determination of productive
methods,
allocation of the society’s resources to productive processes, and
distribution
of the output of the productive processes to users or consumers; the
process of
achieving efficiency in a productive process by conserving on the use
of a
scarce resources.
efficiency, the ratio of output of a productive process
to the
input(s) necessary to produce it; efficiency increases if the same
amount of
output can be achieved with smaller amounts of input(s).
elastic demand, with respect to price, the relative
responsiveness of
quantity demanded to a specific price change, assuming that no other
determinant of demand has changed; measured as the ratio of the
percentage
change of quantity demanded to the percentage change of price that
induces the
change of quantity demanded; demand is more elastic with respect to
price at
higher prices than at lower prices; quantity demanded becomes less
responsive
to price changes as price falls, and more responsive to price changes
as price
rises; when demand is elastic with respect to price, total revenue from
selling
a product may be increased by lowering the product price because the
positive
quantity effect of the price change outweighs the negative price
effect; the
concept of elasticity can be applied to the relationship between a
dependent
variable and any independent variable.
enterprise, a venture entailing some amount of risk and
intended
to produce goods or services for sale on markets.
entrepreneurial decisions, choices about business operations that are
risk-laden because they involve innovative discontinuities in
operations, about
which little can be known in advance, and to which marginal analysis is
less
likely to be applicable; long-run decisions that involve starting or
stopping
activities or significantly altering the structure, scope, or pace of
extant
processes are entrepreneurial in nature.
entrepreneurial functions, the perception of an unfilled market demand
and the
assumption of risk in organizing a productive process to exploit the
market
potential.
entrepreneurship, the capacity of a person or group to assume
risk in
innovation; pertaining to business enterprise, the initiation of new
productive
processes or a change of an existing productive process, the success of
which
is not certain.
entry, the
ability of a firm to become an active market participant; entry may be
easy
into purely competitive and monopolistically competitive markets, but
is likely
to be difficult into an oligopolistically competitive market, and
blocked into
a monopoly’s market.
equilibrium,
in a market for a product, the equivalence of quantity demanded to
quantity
supplied so that there is neither inventory depletion nor accumulation;
competitive pressures and entry tend to adjust market price for a
product
toward an equilibrium combination of price and quantity transacted, and
to
eliminate supernormal profits; once an equilibrium state occurs in a
market, it
may persist until disturbed by changes of non-price determinants of
demand or
supply; in a dynamic world, market equilibrium is an ephemeral state
that is so
short lived that it may actually never be observed.
equity share, an ownership interest in a corporate
business
enterprise; holders of shares of stock are residual claimants on the
assets of
a corporation upon its failure.
excess productive capacity, an enabling condition to adding items to
the
production line or disposing of unneeded capacity.
exit, the
departure of a firm from a market, possibly by choice of the
entrepreneur, but
more likely by failure or acquisition by a competitor; exit is easy and
of low
cost from purely competitive and monopolistically competitive markets,
more
costly from an oligopolistically competitive market if the oligopolist
cannot
find a merger partner or a competitor to acquire its business and
assets, and
most costly of all for a monopolist that suffers bankruptcy and
distribution of
assets to claimants.
exit
criterion,
when price is less than per unit operating cost, loss is greater than
average
fixed cost, and the a loss situation appears that it will persist into
the long
run with no possibility of improving market conditions, the firm should
exiting
the industry (an entrepreneurial decision).
expected value, a probability weighted average of the
possible
outcomes of an event; rational behavior is to choose the alternative
course of
action that promises the highest expected value.
externalities, the side (or spillover) effects of the
operations of
a business firm that descend upon innocent third-party members of the
larger
society that hosts the business firm; examples of negative
externalities
include all forms of environmental pollution and health threats that
are
attributable to the operations of business firms.
financial pockets, the financial capacity of a firm,
increasing as the
size of the firm increases by acquisition, merger, divisionalization
and
conglomeration, and which may enable or facilitate price competition,
price
discrimination, and promotion and product mix experimentation.
firm,
business, an organization intended to produce or provide goods or
services for sale on markets; a.k.a. enterprise.
fixed costs, those costs that do not change with the
rate of
production; a.k.a. overhead costs; fixed costs are not relevant to
current
operating decisions.
gambler, one who gets satisfaction from accepting
adverse-odds bets (long shots) with negative expected values; a risk
preferer
who “consumes” risky activities under conditions of increasing marginal
utility.
geographic
market, the locale within
which the firm sells its product, and where there
is effective competition by other companies selling closely competitive
products; for most products, the geographic market is almost certainly
not the
world or even the whole geographic of area of a country; most firms
sell in
multiple geographic markets that are separated by distance and the cost
of
transport so that clienteles are effectively compartmentalized.
goal, an ultimate end that the
organization at its highest policy making level determines to try to
achieve.
goods,
tangible items produced by business firms.
hedonism, the philosophical view that pleasure is to
be
pursued and pain avoided.
hired manager, to be distinguished from an
owner-entrepreneur, an
agent who is commissioned by the owner(s) of a business firm (the
principal) to
make managerial decisions on behalf of the owner(s); hired managers are
subject
to the problem of moral hazard.
holding company, a non-operating business enterprise that
holds
ownership in and controls the activities of other companies that may
operate in
horizontal or vertical relationships with one another in the production
and
distribution of goods and services.
homogeneous oligopoly, a market structure populated by a small
number of
firms that are aware of each others’ identities and
that sell a product which cannot be
distinguished from the products sold by other firms in the same market.
horizontal structure, the relationship among divisions of a
corporate
business firm that perform similar functions and may compete with one
another.
identification problem, the difficulty of estimating the true
magnitude of
price elasticity of demand when demand determinants other than price
are
changing; the presence of an identification problem will result in
estimates of
demand elasticity of demand being too large or too small or even
perverse,
depending on the direction in which the other demand determinants
changed.
imperfectly competitive market, one in which sellers have some pricing
discretion, i.e.,
some monopoly power; in an imperfectly competitive market price must be
decreased in order to increase unit sales of a product.
implicit costs, costs incurred in economic activity that
are not
denominated in monetary terms and not recognized in formal accounting
systems;
examples are opportunity and psychic costs.
income
effect of a price change, when the price of a good or service falls,
the consumer can purchase more of that item itself, more of other items
that he
normally consumes, or retain unspent purchasing power; the decrease in
the
price of the item then results in an implicit
increase of his income.
incremental cost, the increase in cost of production
consequent upon
producing an additional amount of
product (not necessarily only one more unit as is required to
measure
marginal cost); IC is easy to measure but is only an approximation to
true
marginal cost; comparison of IC compared to marginal revenue for
identifying
the maximum profit level of output may lead to erroneous conclusions.
incremental revenue, the increase in total revenue consequent
upon
increasing product sales by any amount; in contrast to marginal revenue
which
is the increase in total revenue consequent upon increasing sales by
one unit
of product; incremental revenue may be an appropriate price and output
decision
criterion when the firm is using an iterative approach to discovery of
the
price and quantity combination that will maximize profit.
inelastic demand, with respect to price, the relative
unresponsiveness
of quantity demanded to price changes at low price levels and as price
falls
toward zero; assuming no changes of any other determinants of demand,
when
demand is inelastic with respect to price, total revenue from selling a
product
may be increased by raising the product price because the positive
price effect
of the price change outweighs the negative quantity effect; the
concepts of
elasticity and inelasticity may be applied to the relationship between
a
dependent variable and any independent variable that may affect it.
inferior good, one for which quantity demanded decreases
when
income rises, and increases when income falls.
inflation risk, the likelihood that the price level will
rise over
the life of an investment opportunity; a deflation
premium may be added as inflation risk adjustment factor
to the interest rate and other risk adjustment factors that serve as
discount
rate to the value of an investment opportunity.
input flows, though often difficult to
measure, input flows are the appropriate
criteria for use in estimating output rates; data for input stocks are
sometimes used as proxies for input flows, though with some error in
estimating
output rates.
input stocks, though easy to measure, input stocks are
inferior to
input flows in estimating output rates;
data for input stocks are sometimes used as proxies for input
flows,
though with some error in estimating output rates.
international business, commercial activity that spans national
boundaries;
international business may include exporting product, sourcing
materials
overseas, outsourcing manufacturing activity to firms in other
countries, and
offshoring production by establishing processing facilities in other
countries.
irrelevant costs, those that do not pertain to decision
making in the
short run; costs that do not change such as overhead costs and
contractual
salaries and payments; preventive maintenance and repair service
expenses.
joint marginal cost, the addition to total cost that can be computed by summing the marginal costs
of all of a firm’s jointly produced products.
joint marginal revenue, the addition to total revenue that can be computed by summing the marginal
revenues for all of a firm’s jointly produced products.
joint products, two or more items produced in a common
production process;
one or more of the joint products may be by-products of the process
intended to
produce a primary product; joint products may be produced in fixed or
varying
proportions.
Law of Demand, the
proposition that consumers will buy ever greater quantities of a good
or
service at progressively lower prices, or smaller quantities at
progressively
higher prices.
Law of Increasing Cost, production costs increase at an increasing
rate as
output increases; the cost variant of the principle of diminishing
returns.
liability, a claim against the assets of a person;
corporate
persons may issue bonds as liability claims against themselves as a
means of
raising financial capital.
limited liability, the feature of corporate shares that
insulate the
holders of the shares against liability that may descend upon the
corporate
issuer of the shares; share holders may lose the value of their shares
to
corporate liability, but their fortunes otherwise are insulated from
the
corporate liability; limitation of liability may be a feature of a
so-called
Limited Liability Partnership (LLP) agreement.
line position, a managerial role of one who is in a direct
line of
authority between the top level decision maker and those employees who
carry
out the essential business of a firm.
long run, a period of time that allows all resources
used by an organization to be changed;
changes
made in the long run with respect to resources that in the short run
are fixed
in availability (e.g., plant and capital equipment) are entrepreneurial
in
nature.
loss,
the negative of profit; managerial decision makers are presumed to
attempt to avoid losses or to try to minimize losses by adjusting rates
of
production and finding lower cost inputs into the production process.
management, the routine exercise of control by a
supervisor of
resources engaged in a productive process; the “team” within a business
organization that is charged with such supervisory control.
managerial decision, a determination by a manager or a
management team of
a business organization to adjust rates of production or resource
allocation
within the organization to the end of enhancing productivity, achieving
greater
efficiency, or increasing profitability; relatively low-risk, routine
choices
in regard to processes that change in smooth, continuous fashion, about
which
much can be known or discovered, and to which marginal analysis is
applicable;
short-run decisions about rates of activity or resource allocation
within a
firm generally are managerial in nature.
managerial distinctives, knowledge and technological capabilities
specific to
the management of a firm that enable it to differentiate its products
and mount
marketing efforts to promote them.
managerial economics, the study of the motives, behavior,
legitimacy of
authority, criteria for successful decision making, and consequences of
operations of business firms.
managerial tasks, selection of an appropriate technology for
implementation of production, discerning the right volume of output to
meet the
market demand, selecting the optimal combination of inputs to produce
the
target level of output, procuring inputs, scheduling production, and
packaging
and distributing the final product.
marginal change, the change in the value of an object of
pursuit
consequent upon the smallest possible change in the value of a
causative
influence (realistically, one indivisible unit).
marginal cost, the increase in cost of production
consequent upon
producing one more unit of product; MC may decrease over an initial
range of
output, but eventually it reaches a minimum and then increases as ever
more of
the product is produced; MC is less than average variable cost when AVC
is
decreasing, equal to AVC when AVC is minimum, and greater than AVC when
AVC is
increasing; the increasing range of MC is a manifestation of the
principle of
diminishing returns; MC compared to marginal revenue is the essential
criterion
for identifying the profit maximizing level of output.
market, a social phenomenon entailing participation
of individuals or groups
(including business firms) as buyers and sellers who are perceived to
engage in
bids and offers to effect voluntary transactions of the ownership of
goods or
services; on analogy with political democracy, markets enable buyers to
vote
their incomes or wealth on the goods and services that they need or
want.
market price, the price of a product determined in a
market for
the product in which voluntary transactions are negotiated between
buyers and
sellers; competitive pressures and entry tend to adjust market price
for a
product toward an equilibrium combination of price and quantity
transacted, and
to eliminate supernormal profits; competitive market prices reflect all
private
costs of production but fail to recognize spillover costs; the greater
is the
market power of firms in a market (oligopolistic, monopoly), the
greater the
potential for price to exceed per unit production cost, thereby
yielding
profit.
market share, the portion of total market demand that any
one firm
in the market can attempt to exploit.
market share preservation, the
willingness of oligopolistic competitors to forego profit maximization
pricing
in the interest of retaining share of market.
marketing, the functional area of business
administration that
is concerned with identifying demand for a product, increasing the
demand, and
improving the price elasticity of the demand.
materialism, the view that more of any good is better
than less
of it; an acquisitive behavior mode with respect to economic goods.
maximin, a decision rule that may be used to select
an
alternative course of action where the objective is to identify the
worst-case
outcomes of all of the decision strategies under consideration, and
then choose
the one that yields the least-negative effects.
maximizing behavior, the presumed most common behavior mode of
managerial
decision making to pursue the greatest possible value of an outcome of
a
decision process, to the exclusion of all other possible goals.
meeting the competition, a deliberate non-profit-maximizing behavior
by firms
in an oligopolistic market to charge the same price as a competitor
that
prefers to charge a lower product price in order to maximize its profit; meeting the competitor’s lower price is
intended to preserve share of market.
minimax regret, a decision rule requiring that the decision
maker
perceive the best possible outcome of alternative decision strategies,
and then
compute the regret associated with all other strategies as the
difference
between each and the best of the alternate strategies.
model realism, the extent to which the assumptions
underlying a
model (a simplified representation of a real phenomenon) approximates
the
complexity and realism of the real phenomenon.
model specificity, the deterministic variables included in the
equations of an explanatory, forecasting, or simulation model, together
with
the parameters (constants in the model equations) that specify how the
deterministic variables relate to the variable to be explained or
forecasted,
and assessments of the statistical significance (or reliability) of the
parameter values; ever greater model specificity is achieved by
including more
equations and more deterministic variables in the equations that
enhance the
explanatory or predictive ability of the model; ever greater model
specificity
necessarily increases the complexity of the model toward the complexity
of the
real world phenomenon being modeled.
monetized economy, one in which it is common to exchange
tangible goods
and services for money; in distinction to a barter economy in which
goods and
services are exchanged for each other (“in kind”).
monopoly, a single seller of a product for which
there are no
close substitutes; monopoly may vary in scope from the local
neighborhood to
the regional, national, or global scene; monopoly is usually
characterized by
the presence of barriers to entry that protect the monopolist’s
position; in
most western societies, antitrust (or antimonopolies) laws have been
enacted to
prevent or constrain the behavior of monopolies.
monopoly power, in an imperfectly
competitive market, the pricing discretion exercised by a seller;
sellers with
monopoly power must decrease price in order to increase unit sales of a
product.
monopolistic
competition, a market
structure characterized by a large number
of very small firms that operate within the same product market and
produce
similar products that are regarded by the public as very close
substitutes in
use; the products may be differentiated in fact by color, texture,
structure,
function, etc., or only in the imagination of the consuming public;
each seller
is a monopolist of his own product design and brand name; firms in the
market
have comparable managerial capacities and use approximately the same
technologies, but they may develop or acquire managerial distinctives
that are
sufficient to enable the pursuit of market strategies; firms may also
develop
or acquire technological variations that are sufficient to
differentiate each
firm's product; all participants in the market have access to the same
information about changing market conditions.
moral hazard, the problem that emerges when the
principals of a
business firm (owners, entrepreneurs) hire managers and commission them
to
function as agents in making managerial decisions on their behalf, but
the
managers undertake actions that serve their own interests and conflict
with the
interests of the principals.
non-disbursement costs, a category of explicit costs that are
recognized in
formal accounting systems but do not involve in money out-payments;
depreciation
allowances are examples of non-disbursement costs.
non-price competition, forms of competitive interaction among
firms in
monopolistically competitive and oligopolistically competitive markets
based on
demand determinants other than product price; such competition may be
based on
differences in product characteristics, performance, service, or image
created
by promotional efforts.
non-price determinants of demand, other influences upon the demand for a
product than
the product’s own price; non-own-price determinants include the incomes
of
buyers, their tastes for the product, their indebtedness levels, and
the prices
of other products related as substitutes or complements, i.e., the
“cross
prices”; changes of non-own-price determinants of demand will cause
identification problems in the effort to estimate the true price
elasticity of
demand for a product.
non-quantity determinants of cost, other influences upon the firm’s costs than
the
amount being produced; non-quantity determinants include the prices of
resources, parts, components, and labor used in the production process,
the
technology being used, and the managerial capacity of the firm; changes
of
non-quantity determinants of costs will cause identification problems
in the
effort to estimate the true cost conditions for a product.
normal good, one for which quantity demanded increases
when
income rises, or decreases when income falls.
normal
profit,
profit equivalent to that which can be earned in markets for other
products;
the opportunity cost of retaining the capabilities of the entrepreneur
in the
present employment of his resources.
objective, relative to an ultimate organizational
goal, a
desirable intermediate situation or level of performance to be achieved
in
pursuit of the ultimate goals of the organization.
obsolescence, the effect of technological advance to
render
existing plant and equipment “out of date”; obsolescence does not per se reduce productive capacity of the
installed capital stock; not to be confused with the phenomenon of
depreciation
due to wear and weathering of capital equipment that does reduce its
productive
capacity.
Occam’s Razor, a principle that requires using the
simplest
approach to a problem that will achieve a solution to the problem,
i.e., to
“use the razor to cut off” the redundant complexity.
oligopolistic behavior patterns, include ignoring competitors, aggressive
competitive
behavior, extreme price (or other demand determinant) rigidity, price
warfare,
cartelization, overt collusion, covert collusion, merger with
competitors,
acquisition of competitors, and price (or other demand determinant)
leadership/followership.
oligopolistic competition, a market structure characterized by a
relatively
small number of firms in the product market; products may be
homogeneous or
differentiated; oligopolistic market firms may exhibit significant
differences
in managerial abilities, internal organizational structures, and
technologies,
and may have differing levels of access to market information;
oligopolistic
competition may be characterized by barriers to entry to the product
market;
the managements of firms in oligopolistic competition are aware of each
others’
identities, can feel the effects of each others’ policy actions, can
initiate
policy actions that affect competitors, and can respond or react to
policy
actions taken by competitors.
operate
criterion, if price is at
least as high as per unit operating cost (average
variable cost), the firm should continue to operate because it can
cover all
operating costs and possibly make some contribution to covering
overhead
(fixed) costs.
operating costs, those costs that change with the rate of
production;
a.k.a. variable costs; a.k.a. direct costs.
opportunity cost, the highest value foregone in an economic
choice to
undertake an activity or purchase a good or service; the income
foregone by an
entrepreneur in operating his own business rather than working for
another
party.
optimizing behavior, in managerial decision making, the attempt
to
maximize the value of one goal while treating other goals as constraint
upon
the pursuit of the primary goal.
outlay recovery, the process of accumulating depreciation
allowances
that are treated in formal accounting systems as costs that reduce the
tax
liability but do not involve explicit disbursements; implicitly, the
firm “pays
itself” the depreciation allowances, thereby recovering the original
capital
outlay; the funds so recovered may be used to replace the worn-out
capital
equipment that has been depreciated over its accounting life.
output
decision criteria, if
marginal revenue is greater than marginal cost,
output should be increased in order to increase profit or reduce loss;
if
marginal cost is greater than marginal revenue, output should be
decreased.
over-entry
into a competitive market may occur when entrepreneurs perceive the
possibility
of earning supernormal profits in a market, enter the market
simultaneously (or
nearly so), driving market price down to below per-unit cost and
putting some
firms into short-run loss situations; firms suffering per-unit losses
greater
than average fixed cost (when price is less than average variable cost)
will
shut down in order to limit losses to their average fixed costs,
thereby
causing market supply to decrease and market price to rise.
overhead costs, those costs that do not change with the
rate of
production; a.k.a. fixed costs; a.k.a. sunk costs; overhead costs are
not
relevant to current operating decisions.
owner-entrepreneur, a single proprietor who makes all
managerial and
entrepreneurial decisions affecting his wholly-owned business venture.
partnership, the form of business organization that
enables
agreement by two or more principals to conduct business activity so
that there
is some possibility of pooling financial resources and borrowing
capacity, and
specialization and division of labor including managerial
responsibility and
authority; unless limited by the partnership agreement (in the case of
a
Limited Liability Partnership), the liability of each principal is
exposed to
the activities of the other principals in the partnership; a
partnership must
be dissolved upon the expiration of any one of its partners, but the
partnership may be reconstituted by the remaining partners and the
heirs of the
deceased partner; most government authorities do not tax partnership
income,
but do tax the personal incomes of partners.
plant,
a site and facility in which a business firm conducts some or all of
its productive activity.
predatory behavior, an oligopolistic behavior mode intended to
eliminate
competitors or increase share of market at their expense; predatory
behavior
often entails cutting product price below competitor’s per-unit
operating costs
in order to induce shut-down in the short run and exit from the
industry in the
long run; predatory price cutting is facilitated by “deep financial
pockets”
often associated with a conglomerated firm, i.e., a firm producing a
wide
variety of unrelated products.
preventive maintenance expenses, costs that are incurred in one accounting
period but
have their effects in subsequent accounting periods to insure the
continuing
functionality of equipment; preventive maintenance expenses are not
relevant to
decision making in the period in which they are incurred, but should be
relevant to the subsequent periods.
price,
that which must be foregone in order to acquire a good or service;
prices in a monetized economy are expressed in money-denominated terms;
prices
in a barter economy are expressed in terms of the real items given up
in the
transaction.
price discrimination, the charging of different prices for the
same item
where there are no differences in the costs of serving the different
customers;
price discrimination is prohibited by law in most Western societies.
price effect, the percentage by which price changes when
price is
high compared to when price is low; the price effect of a price change
is a
small percentage of a high price, but becomes a larger percentage of
price as
price falls.
price elasticity of demand, the relative responsiveness of quantity
demanded to
a specific price change, assuming that no other determinant of demand
has
changed; measured as the ratio of the percentage change of quantity
demanded to
the percentage change of price that induces the change of quantity
demanded.
price
taker,
the behavioral mode of a firm in a purely competitive market; at any
higher
price no one will buy from the firm; the firm can sell all that it can
produce
at the market price, so there is no incentive to try to charge any
price other
than the market price.
price war, competitive price cutting by firms in an
oligopolistic market intended to lower price far enough to force
competitors
out of business; a price war may be as ruinous for the initiator as for
those
the initiator intended to harm.
primary goal, one among many possible objects of pursuit
that is
chosen, taking subordinate goals to be constraints upon the pursuit of
the
primary goal; the identities of the primary and subordinate goals may
change.
product differentiation, a characteristic of monopolistic
competition and
oligopoly which is manifested in product distinctives in the forms of
color,
texture, structure, function, etc., or only in the imagination of the
consuming
public; the effort by monopolistic and oligopolistic competitors to
make their
products different from those of competitors to the end of creating or
increasing demand for their products and gaining share of market for
products
that are similar enough still to be sold in the same market group.
product line, the collection of items that the management
of a
firm chooses to produce and sell; in order for any item currently in
the
product line to continue to be produced, its price must make an
adequate
contribution to its overhead costs as well as cover all of the direct
costs of
its production.
product mix, the collection of items selected by
management for a
firm to produce and distribute.
product promotion, the marketing effort to increase the demand
for a
firm’s product; contingent upon product differentiation and managerial
distinctive.
production, the central function of the business
enterprise; the
process of transforming raw materials, parts, and components into final
product; production of tangible goods encompasses gathering,
extracting,
refining, combining, assembling, packaging, transporting, and
distributing
activities; production of services includes performance activities.
productivity, the ratio of the output of a productive
process to
the input(s) necessary to produce it; productivity increases if output
increases while the amounts of inputs in the productive process remain
the
same.
profit, the residual revenue that remains after
costs of production have been
satisfied; accounting profit is the difference between the total of
monetary
revenues and the sum of all explicit costs, both disbursement and
non-disbursement; economic profit is the difference between the sum of
all
benefits accruing to a firm (or its entrepreneur) and the sum of all
negatives
suffered by the firm (or its entrepreneur), including opportunity and
psychic
costs as well as explicit disbursement and non-disbursement costs;
economic
profit may be greater or lesser than accounting profit.
profit center, a semiautonomous division of a firm the
revenues of
which are expected to cover operating and overhead costs and yield a
profit to
the firm.
profit maximization, the usual behavioral presumption for
managerial
decision making that underlies the economic theory of the firm.
proprietorship, the form of business organization that
coincides
with the identity of its owner; its life comes to an end when the owner
expires; its financial resources are limited to personal fortune plus
any
amounts that can be borrowed from relatives, friends, or banks; the
personal
fortune of the proprietor is fully exposed to any liability incurred in
the
operations of the enterprise.
psychic cost, the negative feeling experienced by
economic
decision maker in engaging in an activity or consuming a product.
public policy, actions taken by political authority
intended to
control or constrain the behavior of business firms.
pure
competition, a competitive
environment characterized by a large number of very
small firms that operate within the same product market, a single
product that
is essentially homogeneous across the firms in the market, firms having
virtually identical managerial capacities and using essentially the
same
technologies, no one firm having any special expertise that is not
available to
all of the others, and all participants in the market having access to
the same
information about changing market conditions.
pure monopoly, a market structure characterized by a
single firm
that supplies the market, a completely differentiated product such that
no
close substitutes for the product sold by other firms, and barriers to
entry
that forestall competition by other firms.
quantity effect of a price change, the percentage by which
quantity
changes in response to a particular price change is high compared to
the
quantity percentage change in response to the same magnitude price
change when
price is lower; the quantity effect of a price change is a large
percentage of
quantity sold when price is high, but is a smaller percentage of
quantity sold
at lower prices.
rate of return, the discount rate that makes the sum of the
expected
future net income flows from an investment just equal to the capital
outlay
needed to purchase the investment; if the rate of return on an
investment
possibility is at least as great as the best market interest rate at
which the
firm can borrow, the investment is financially viable.
rational decision criterion, concerning any contemplated course of
action, the
deliberate comparison of costs of taking the action to expected
benefits if the
action is successful.
rational self interest, the presumed behavior mode of all humans to
address
their own needs and wants; rational self interest may be qualified or
constrained by altruism.
relevant costs, all costs of conducting business activity,
including
both explicit money-denominated costs and implicit psychic and
opportunity
costs; entrepreneurial and managerial decision makers should base
decisions on
all relevant costs, not just explicit costs that are recognized in
formal cost
accounting systems.
repair expenses, costs that are incurred in one accounting
period to
address effects of operations in previous accounting periods; repair
expenses
are not relevant to decision making in the period in which they are
incurred,
but should be relevant to the earlier periods.
representative
firm, in a purely competitive
or monopolistically competitive market, a
firm that is typical of all of the firms operating in the market; a
representative firm possesses no special entrepreneurial or managerial
abilities, has no special knowledge not available to managers of other
firms in
the market, and uses commonly available technology.
restart
criterion, if price has been
less than per-unit operating cost (average variable
cost) and the firm is in a shut-down mode, when market price increases
to
exceed per-unit operating cost, the firm should restart operation in
the short
run (a managerial decision), cover operating costs, and make some
contribution
to covering the overhead (fixed) costs.
returns to a variable input, in a short-run time frame, the change of
output from
a productive process when the quantity of a single input is changed,
all other
inputs remaining unchanged.
returns to scale, in the long run, the change of output from
a
productive process when the quantities of all inputs (fixed as well as
variable) are changed (positively or negatively) by the same
proportion;
returns to scale may be decreasing, constant, or increasing.
risk,
the variability in the possible outcomes of an event; risk may be
measured as the standard deviation of the values of the possible
outcomes; risk
may be diminished by gaining additional information about the possible
outcomes; risk may be managed in a number of ways, including
diversification,
scheduling activities, and purchasing insurance; assumption of risk
that cannot
be managed is the essence of entrepreneurial behavior.
risk aversion, the attitude toward risk held by the vast
majority
of people who regard themselves as rational thinkers; the normal
attitude
toward risk held by managers and entrepreneurs who rationally attempt
to
diminish or manage risk; one who is risk averse experiences diminishing
marginal utility with respect to risk; risk avoidance is the extreme of
risk
aversion.
risk management, the attempt by normally risk averse
decision makers
to take offsetting positions, to use operational approaches (e.g., to
schedule
payments and receipts to minimize losses), and to insure against risk;
the
ultimate entrepreneurial function is to assume any residual risk after
all
management alternatives have been exhausted.
risk premium, a risk adjustment to the discount rate in
computing
the value of an investment opportunity; a risk-adjusted
value will be smaller than before risk adjustment in
reflection of the larger discount factor.
risky decision context, a situation in which a decision maker can
both
identify all of the possible outcomes and meaningfully assess the
probabilities
of occurrence of each of the possible outcomes.
satisficing behavior, in managerial decision making, the effort
to achieve
an acceptable amount of a goal, though not necessarily the maximum
attainable;
an example is target rate of return on invested capital.
scale,
the size of a productive operation; scale is increased by changing
all of the inputs , fixed and variable, by the same proportion (greater
or less
than 100 percent).
self-adjustment,
the feature of a competitive market that causes it to attempt to move
toward a
market-wide equilibrium in which all firms still in the industry are
earning
normal profits, none are suffering losses, and none are earning
supernormal
profits; the vehicles of self-adjustment are entry by new firms into
the market
when supernormal profits appear, and exit from the market when losses
persistently exceed average fixed costs.
short run, a period of time during which at least one
of the resources
used by an organization (e.g., plant, capital equipment) are fixed in
availability and cannot be changed; changes made with respect to
variable
resource input usage (e.g., labor, materials) in the short run are
managerial
in nature.
shut-down
criterion, if price is not as
high as per unit operating cost (average variable
cost) causing loss to exceed average fixed cost, the firm should shut
down
operation in the short run (a managerial decision) and suffer only the
overhead
(fixed) costs; if the loss situation persists into the long run and
there is no
reason to expect improving market conditions, the firm should exiting
the
industry (an entrepreneurial decision).
simulation model, a depiction
in the form of graphs or equations of the relationship between a
dependent variable and one or more
independent variables that enables hypothetical varying of the
independent
variables in order to estimate the effects upon the dependent variable;
in the
theory of the firm, models may be designed to simulate utility,
production,
cost, revenue, and profit relationships.
social responsibility, concern on the parts of owners,
entrepreneurs, and
managers of business firms with the externalities (spill-over benefits
and
costs) resulting from their operations; business firm owners,
entrepreneurs,
and managers are often thought by non-owners, non-entrepreneurs, and
non-managers to lack adequate social concern.
specialization, the process of pairing resources to
productive
processes according to the abilities of the productive resources.
spillover costs and benefits, negative and positive externalities (side
effects)
of the operations of business firms that descend upon innocent
third-party
members of the larger society that hosts the business firm; examples of
negative
spillovers include all forms of environmental pollution and health
threats that
are attributable to the operations of business firms; spillover costs
are not
relevant to short-run managerial decision making, but could become
relevant due
if social pressures force the internalization of them to the firm.
staff position, functionary in an organization who is not
in the
direct line of authority but who provides supplemental services or
analyses
that enable line position managers to exercise authority more
efficiently;
examples include financial, accounting, and marketing positions.
stock,
a share of equity interest in a corporation; holders of stock are
residual claimants on the assets of a corporation upon its failure.
strategic management, the exercise of organizational control that
concerned with the fundamental direction of the organization's
activity, i.e.,
the businesses that the organization intends to pursue, and desired
levels of
achievement in those lines of business; to the extent that strategic
management
decision pertain to fixed assets in the long run, it should be
understood to be
strategic entrepreneurship.
strategy, a plan of action to achieve an ultimate
goal of an
organization; strategic plans and decisions generally are
entrepreneurial in nature
(rather than managerial).
submaximizing behavior, a managerial behavior pattern that
accommodates
deliberate decisions to forego or diminish profits in the short-run in
the
interest of survival, or maintenance of profitability, or the
possibility of
maximizing the value of the firm in the long run.
subnormal
profit, profit less than that
which can be earned in markets for other
products; subnormal profits earned by firms operating in a market are
likely to
precipitate exit from the market to other markets where normal or
supernormal
profits can be captured.
subordinate goals, other goals than the primary goal that is
the object
of pursuit by a managerial decision maker; subordinate goals may serve
as
constraints on the pursuit of the primary goal in the process of
optimization;
a principal concern in a process of optimization is the keep the
subordinate
goals subordinated to the primary goal.
subsidiary, a productive organ of a corporate business
firm that
is maintained with an identity apart from that of the business firm,
and whose
activities are directed by a sub-management team appointed by the
top-level
authority of the business firm; a subsidiary may be wholly or partially
owned
by the corporate business firm, and may be jointly owned with other
business firms.
substitute, a good that is either identical or close
enough in
features that it can be used in place of another good; an increase in
the price
of a substitute for a good may cause the quantity of the good demanded
to
increase.
substitution effect, with respect to a price change, when an
increase in
the price of a good or service leads consumers to shift their purchases
away
from the good or service and to its substitutes, resulting in an
inverse
relationship between the good’s own price and its quantity demanded.
success indicator, with reference to profit, the possibility
that
profit may serve as a measure of the success of a business firm rather
than a
goal to be pursued.
sunk costs, those costs that do not change with the
rate of
production; a.k.a. overhead costs; a.k.a. fixed costs; sunk costs are
not
relevant to current operating decisions.
supernormal
profit, profit in excess of
that which can be earned in markets for other
products; supernormal profits earned by firms operating in one market
invite
entry to the market by firms not yet in the market.
survival, the single behavioral goal that has
dominated
individual productive efforts across the span of human existence; the
survival
of the business firm in the long run involves maintaining and
increasing the
value of the firm, even if losses occur
in some of the short-run time intervals comprising the long run.
tactic, an action that is taken "in the field" by a
specific unit
of an organization to accomplish a limited or intermediate objective in
pursuit
of a strategic goal of the organization; tactical decisions generally
are
managerial in nature (rather than entrepreneurial).
target rate of return (TROR), usually with respect to invested
capital, a
growth-oriented goal of managerial decision making that exhibits the
characteristic of satisficing (pursuing an adequate amount of the goal,
but not
the maximum attainable).
time horizon, the time interval over which the chief
decision
makers in an organization are concerned about the activities of the
organization and its level of performance.
total revenue, the product of the price of an item times
the
quantity of it that is sold at that price.
transaction, an exchange by market participants of one
good or
service for another good or service; both participants to an exchange
must
perceive themselves to gain from the transaction if it is voluntary.
transfer price, the price at which an intermediate product
is
transferred to the next division within a firm for further processing.
typical firm in a monopolistically-competitive market
group,
similar in concept to a “representative firm” in a purely competitive
market
except that products produced by the monopolistic competitor firms are
differentiated in fact or in consumer perception, and monopolistic
competitors
may develop managerial distinctives that permit them to implement
marketing
strategies.
uncertainty, a situation in which a decision maker
either cannot
identify some of the outcomes of an event, or cannot meaningfully
estimate the
probabilities of their occurrence.
utility, the satisfaction derived from consuming a
good or
undertaking an activity.
variable costs, those costs that change with the rate of
production;
a.k.a. operating costs; a.k.a. direct costs; variable costs are
relevant to
short-run production decision making; all costs are variable in the
long run.
variable proportions, the change of output from a productive
process when
the quantities of inputs are changing by different amounts or rates;
variable
proportions spans the short and long runs; in a production context of
variable
proportions, quantities of some inputs may decrease as others increase,
as for
example when capital is substituted for labor.
vertical disintegration, the termination of transferring
intermediate product
from one division of a firm to another division of the same firm,
attributable
to the ability of a division to acquire intermediate product from
external
sources at lower prices than the transfer price from the fellow
division of the
same firm.
vertical integration, a corporate business firm’s process of
undertaking
all (or as many as deemed economic) intermediate productive activities
in
sequence from extracting raw materials, refining ores, producing basic
shapes,
fabricating parts and components, assembly of components and final
product, and
distribution of final product.
vertical segmentation (or disintegration), a structure of
production in
which each identifiable productive operation is performed by a separate
firm;
each firm in performing its operation adds value to the intermediate
product;
the partially-processed product is then sold to another firm that adds
more
value by performing the next operation in sequence, and so on until the
state
of "final product" is attained.
vertical structure, the sequence of productive activity within
a
corporate business firm ranging from extraction of raw materials
through
refining ores, producing basic shapes, fabricating parts and
components,
assembly of components and final product, and distribution of final
product; a
business firm may be vertically integrated to varying degrees,
depending on the
productive activities performed “in-house” and those that are
“out-sourced” to
other business firms.
vertically-integrated production process, the sequence of activities within a single
firm that
involves separate identifiable production processes upon intermediate
products
accomplished by divisions of the firm, and culminating in a final
product.
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